What CPAs should know, and ask, about NFTs

Sean Stein Smith, CPA, CGMA, DBA, is speaking June 7 at AICPA & CIMA ENGAGE on the blockchain ecosystem. Nonfungible tokens (NFTs) are a part of that ecosystem. In this podcast episode, Stein Smith explains what NFTs are and aren’t, how baseball cards or other physical items can be “tokenized,” and more.

Also, get an update on two recent IRS items, related to estate and gift tax proposed changes and the public input sought on prioritization of tax issues.

Resources

Here are three recent JofA articles about NFTs:

• NFTs Come With Big Valuation Challenges
• Tax Consequences of NFTs
• How NFTs Work and Where They Get Their Value

What you’ll learn from this episode:

• An overview of nonfungible tokens.
• What Smith means when he says NFTs cannot be subdivided.
• Some of the questions CPAs and individuals are asking about NFTs with regard to taxes and auditing.
• A recent example of one high-dollar NFT sale.

Play the episode below or read the edited transcript:

To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.

Transcript:                                                            

Neil Amato: Welcome back to the Journal of Accountancy podcast. I’m Neil Amato. This episode’s main segment takes a closer look at a specific type of digital asset, a nonfungible token or NFT. You’ve probably heard of NFTs; now you’re getting to learn more about them. We also have news related to estate and gift tax proposed changes after the interview, and it’s all coming up after this brief sponsor message.

Amato: Now on the podcast is CPA Sean Stein Smith. Sean is a member of the Wall Street Blockchain Alliance’s advisory board, and he is chair of the alliance’s accounting working group. Sean is an author, a university professor, and a speaker at ENGAGE on the current state of the blockchain ecosystem. Sean, I’ll start with this question: What is a nonfungible token or NFT?

Sean Stein Smith: Sure thing, Neil. The best way to try to introduce a topic like this is to also point out what it isn’t. An NFT is a token, which it all falls under that overarching digital asset umbrella. But it’s actually an NFT is a blockchain-verified, blockchain-traceable record of ownership that actually connects the virtual asset, the NFT itself and the underlying asset, which in turn gives the NFT a good chunk of its economic value.

Neil Amato: What makes an NFT different from some of those other assets out there? If you want to further educate the audience, including me, you could talk about some of those other assets as well.

Stein Smith: Sure, thanks. The core underlying difference here, Neil, is that the context of bitcoin; ether; tether; everyone’s favorite, stablecoin. But in the context of these other cryptoassets, all of them are fungible, meaning that each bitcoin equals every other bitcoin, ether to ether or tether to tether.

But a nonfungible token, NFT, is an individual unique asset, so every NFT, from an audit point of view, evaluation point of view, is its own individual asset and has to be treated as its own unique value proposition, as opposed to other crypto assets out there, one.

Then two, adding on to that, like every other or almost every other cryptoasset out there — again, be it bitcoin, privatization stablecoins, all the rest – were actually built to be used to some extent as an actual medium of doing business, as a medium of transactions, whereas NFTs are not able to be subdivided, in order to be used as a actual medium of doing business.

It really is an asset class that falls under the umbrella of crypto. On the surface, NFTs are 100% crypto, but they are different from other crypto out there and other assets currently being traded, if that makes sense.

Amato: The reason we’re having you on this podcast, why do CPAs need to understand NFTs?

Stein Smith: The main impact that NFTs are having on anybody working in corporate accounting, public accounting, nonprofit accounting, government accounting, all the rest, is that it really is changing how both individuals are trading, buying, using crypto and how enterprises are also trying to onboard crypto into their core operations.

Actually talking on bitcoin only, it’s a bit of old news, at this point. Most of us out here understand that the very least at a basic level, what bitcoin is, how it works and then how it is being treated on a financial statement basis.

NFTs though, as I was outlining earlier, are quite different from other crypto. On an income tax side, everyone’s favorite time, and an audit side, there are a few questions that only pop up when NFTs are entering our conversations.

One, how do you actually treat NFTs on an income tax basis? The answer is, it depends actually. Depending on the origin of the NFT and how that NFT is brought into ownership. Meaning, how an individual or institution comes to own an NFT in turn influences how it can be treated on an income tax angle.

Then on the audit side, how do you actually audit an NFT? The basic question that honestly has to be asked and is only right now starting to be asked is, are you auditing on the token itself, on that NFT crypto token? Or as an auditor, are you auditing the underlying asset and then how it’s connected to the underlying token.

All of those questions there hadn’t really been answered yet in an objective way and are questions that all of us are going to have to think about going forward.

Amato: Yes, definitely still some guidance that people would like to have on those. I guess I’ll ask that leads to my next question. When someone buys an NFT, what do they actually own?

Stein Smith: How much time do you have, Neil? Trying to unpack what you actually own as you own an NFT is, on the one hand, very straightforward. But it’s not really that basic as you actually said pop the hood on these assets out there, but because as an NFT investor, and I own several NFTs.

I own these NFTs, I don’t own the underlying asset. I don’t have any rights outside of the ownership of that token. As an NFT investor, I own that token, cut and answered.

But on the other hand, there are more and more cases and types of NFTs that on top of owning or having custody over that token itself, also in turn grant other extra rights and options to that token holder. The most common one being is that as an NFT owner, as a condition of that contract of purchase, I in turn have the right to actually monetize my ownership over that token.

Then to add some extra hot sauce in there, if we have, and we are now starting to see this, NFTs connected to real tangible, physical property, then are there any extra rights, obligations, any government issues, issues that are also a component of owning NFT as they are connected to real tangible assets of building, all the rest.

On the one hand, it’s an easy question to answer that as the holder of the NFT, I own actually that token, but under or as you pop the hood on these issues then it all becomes much more complicated. Again, reinforcing the fact that each NFT is an individual and unique asset and so has to really be analyzed on a case-by-case basis.

Amato: So I’m going to do a little visual aid here even though we’re doing a podcast.

Stein Smith: OK.

Amato: Because I want to ask if an NFT is tied to a physical asset. Are you telling me that this 1987 baseball card could eventually be turned into an NFT somehow?

Stein Smith: Absolutely. I can turn anything into an NFT, Neil. Actually, the first-ever tweet on Twitter was auctioned off by Jack Dorsey back in, I believe, the first quarter of the first half of 2021, and it actually was sold for $2.9 million.

So yes, anything technically can be turned into an NFT. Now, how the evaluation goes is a whole other question. But on paper, any image, any ownership stake can be transformed into an NFT or a tokenized form of ownership over an asset, yes.

Amato: So are those two examples, I’ll probably get this wrong, but I’ll let you correct me if needed. Would the baseball card example versus a tweet, would those be the difference between tangible and intangible NFTs?

Stein Smith: Sure. The best way to try to answer that question is to try to bifurcate it that up until the present, halfway through 2022, for instance, the bulk of an NFTs have been connected to either virtual artwork, online streaming, content, sort of virtual assets.

But as we enter the back half of ’22, there are more conversations on how to properly tokenize and how to actually connect NFTs to real-world assets. It’s not really an issue of intangible and tangible NFTs because under the current guidance, which I have some questions about, all digital assets are treated as indefinite live intangible assets.

It’s not so much a question on the treatment of the NFT itself, it’s a question as to how that NFT, how that crypto token is then connected to that external asset and actually whether that underlying asset is virtual in nature or physical. That’s the real question now.

Amato: What are some of the challenges of – whether it’s related to accounting or ownership, if that Mark McGwire rookie card, it’s turned into an NFT – what  are the challenges of those NFTs backed by physical assets?

Stein Smith: The outstanding challenges, there are quite a few out there. As in any new asset class or financial instrument, there are always going to be questions.

But a handful of the issues that are directly connected to this new tangible, NFT space, are one, ownership. Who actually owns what? If I own a building in Fort Lee in New Jersey and I as the building owner, turn that building into an NFT. I basically tokenize ownership rights over that building. What are the ownership rights of those token holders? I still own that actual physical building. Then what are the rights and possible obligations of these NFT holders now, for NFTs connected to a real physical asset who has rights and obligations linked to it, one.

Then two, how do we track of the actual provenance of this ownership as these NFTs after being auctioned off, are then traded, swapped, all the rest. How do we track and actually make sure that our records are up to date and are actually current?

Then ultimately point three is how do we audit an NFT? Echoing back to that earlier comment, how do we audit this NFT ecosystem? Are we auditing the ownership and the provenance and the record of these tokens, or are we auditing the process by which a underlying asset is then tokenized, because they’re two totally separate questions.

Then, as always, anything around crypto, there are always questions around income tax treatment, international holders, and then all of the compliance and internal control work that has to be done to make sure that, as companies enter into this space, their internal workflows and controls are up to par. Quite a few issues still.

Amato: Certainly plenty more issues to arise as time goes on. Now, Sean, I understand you have written a whitepaper on this topic for a little more information. We may have a link to that depending on when we publish this episode.

Obviously there’s more to say on this topic and there’s always going to be more to say as standards change, guidance emerges, and things just change in the digital realm, but Sean, anything you’d like to add in closing?

Stein Smith: I would just say that our upcoming whitepaper is an excellent primer and an overview of the opportunities and the issues still facing NFTs as they become more and more integrated into the broader, mainstream conversation.

As always, there are open items and questions on blockchain, on cryptoassets at large, but it’s also a tremendous opportunity for firms and for individuals who are proactive, motivated and interested in being more involved in the space.

Amato: Again, that was Sean Stein Smith, a CPA and ENGAGE speaker. Thanks to Sean for his time on the podcast. We will link to the ENGAGE agenda in the show notes. That event is coming up in June in Las Vegas.

In other news, IRS-proposed regulations would provide an exception to the anti-clawback rule that preserves the benefits of the temporarily higher gift and estate tax basic exclusion amount.

Also, the IRS has invited the public to recommend tax issues to be addressed in its Priority Guidance Plan. That plan is used by the IRS and Treasury to identify and rank tax issues that can be addressed through regulations, revenue rulings, and other guidance. The Journal of Accountancy‘s Paul Bonner has that coverage which we will link to in the show notes for this episode.

Thanks for listening to the Journal of Accountancy podcast.