Cryptocurrency and Non-Fungible Tokens: NY Tax Considerations for Fund Managers
It is stating the obvious to note that virtual currency or cryptocurrency (Crypto) has become more mainstream in 2021. As major financial institutions have begun working with Crypto, it has become a more accessible asset class, and New York State (NYS) and City (NYC) tax questions have begun to arise for traders and fund managers in NY. This Legal Update addresses potential NYC Unincorporated Business Tax (UBT) and NYS Personal Income Tax (PIT) considerations, namely, whether transactions in Crypto should be considered eligible for the taxes’ respective “self-trading” exemptions. It also addresses whether Crypto should be subject to sales and use tax in NYS and NYC.
Overview
The federal tax treatment of Crypto, together with the structure of the UBT and PIT tax exemptions, guidance from NYS, and recent case law, supports the position that trading Crypto should qualify as an exempt self-trading activity under the UBT and PIT, assuming it does not occur in connection with an otherwise taxable business, such as that of a dealer. Similarly, Crypto’s status as intangible property under NYS guidance means that it should not be subject to sales and use tax.
UBT Exemption
Unincorporated businesses, other than dealers, engaged entirely in buying and selling “property” for their own account are not subject to tax under the UBT based on a statutory provision that is commonly referred to as the “self-trading” exemption.1 A partial exemption exists if the entity earns income from taxable activities, but at least 90% of its assets still meet the criteria for exemption; in that case, its business income remains taxable, but its self-trading income is exempt.2
A UBT taxpayer determines its net income by reference to federal gross income and deductions, which means the UBT conforms to the Internal Revenue Code where applicable.3 The statute defines qualifying “property” broadly to include stocks, bonds, derivatives, commodities, foreign currencies and other securities, but it does not reference Crypto.4 Crypto’s absence from this list is not surprising given its relative infancy compared to the NYC tax code, but it raises issues for funds and traders that are trading Crypto. If it is not a “good” asset, it could both generate taxable income and break full or partial self-trading exemptions, potentially rendering funds and trading entities taxable on otherwise exempt income. The UBT regulations, however, state that “property” comprises real and personal property and includes but is “not limited to” a series of common financial assets.5 This definitional structure would logically include Crypto because it is personal property and a financial asset that serves an investment purpose when it is not held by a dealer for sale. This is exactly the type of asset that is intended to qualify for the self-trading exemption, and the “not limited to” language leaves the exemption open to new types of assets, such as Crypto.
While NYC has not published clarifying guidance, the Internal Revenue Service (IRS) has stated that Crypto is “property” for federal income tax purposes; this treatment should confirm Crypto’s status as a qualifying asset for UBT purposes as well. In 2014, the IRS issued Notice 2014-21, which contains several FAQs addressing the federal tax treatment of transactions involving Crypto. The IRS recognized that Crypto may be used to pay for goods or services, held for investment and digitally traded among users.6 Thus, in response to the first question raised in the notice—how virtual currency should be treated for federal income tax purposes—the IRS answered, “virtual currency is treated as property,” and “general tax principles applicable to property transactions apply to transactions using virtual currency.”7 The IRS goes on to state in Answer 7 that “a taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer.”8 This approach should flow through to the UBT. The UBT does not distinguish between capital gains and losses, but the federal treatment as property is fundamental to the calculation of income or loss from the asset, which then determines UBT gross income and loss. The UBT is therefore tied to the federal status of Crypto as property.
PIT Nonresident Exemption
For PIT purposes, a resident is taxable on all income wherever earned, and the exemption status of Crypto is less relevant—that is, residents are taxable on all their income from Crypto trading, and no exemption applies. Nonresidents, including investors and partners in funds managed from NYS, however, are only taxable on income sourced to NYS, either as business income or income that is specifically allocated to NYS, such as salary or gains from NYS real estate. In this regard, buying and selling property for one’s own account is not considered to be a trade or business.9 Further, income from intangible property is not sourced to NYS unless the underlying asset is used in a trade or business carried on in NYS.10 This means most nonresident partners in NYS managed funds are able to claim that their shares of income from the funds are not NYS-sourced because they do not arise from an NYS trade or business and are not otherwise allocated to NYS.
The PIT, unlike its UBT cousin, does not define “property” or “intangible property” or provide an exclusive list of qualifying assets. This provides more flexibility than the UBT and has generally meant that a partial self-trading exemption exists without the same strictures contained in the UBT. Nevertheless, the PIT also does not mention Crypto and therefore leaves some ambiguity around its status for nonresident exemption purposes. Fortunately, NYS has, however, conformed to the IRS approach through guidance issued by the NYS Department of Taxation and Finance (the Department). The Department has stated it will characterize Crypto as “property,” all but ensuring its status as an asset that qualifies for the self-trading exemption.11
The New York Tax Appeals Tribunal’s recent decision in In re LePage12 also supports this treatment. The tribunal determined that for purposes of the state’s mandatory S-corporation election under N.Y. Tax Law § 660(i), “investment income” includes gain realized on the sale or exchange of property, including goodwill. The tribunal reasoned that the federal treasury regulations’ approach to goodwill as property should determine its treatment for NYS personal income tax purposes because of the state’s federal conformity rule in N.Y. Tax Law § 607(a).13 The tribunal’s analysis in the S-corporation election context supports applying Crypto’s federal status as property to the NYS and NYC self-trading exemptions as well.
NYS and NYC Sales Tax Considerations
Trading Crypto or using Crypto as currency in the purchase or sale of goods or services may also raise sales tax questions. Fortunately, the Department has issued guidance on the sales tax treatment of transactions involving Crypto. The Department determined that because Crypto is intangible property, the purchase of Crypto is not a taxable transaction for sales tax purposes.14 Thus, buying and selling Crypto for investment purposes should not trigger any sales tax obligations. However, if someone uses Crypto as payment for taxable goods or services, the purchaser will owe sales tax on the market value of the Crypto at the time of the transaction.15
Non-Fungible Tokens
The treatment of non-fungible tokens (NFTs) as qualifying property likely requires a more fact-specific analysis. Unlike Crypto, which is fungible and operates like a traditional currency, each NFT has a unique digital signature representing a single item, such as a piece of art, a video or even a tweet. Whereas one unit of Crypto may be exchanged for another unit, or converted into dollars, the same is not necessarily true of two NFTs. This means that each type of Crypto is its own, specific type of property, but an NFT is defined by the item that it represents, which may be Crypto or something else. Thus, the tax status of an NFT may depend on the circumstances of the purchase and sale and the nature of the particular NFT in a way that is different from Crypto.
Similarly, the individual circumstances surrounding the purchase and sale of an NFT may affect whether the transaction remains exempt from sales tax as intangible property pursuant to the Department’s guidance for Crypto. Prior Department guidance in a somewhat related context, however, may be helpful. Specifically, the Department has consistently determined that sales of music recordings electronically transferred or downloaded are not subject to sales tax because such transactions involve intangible property.16 Though NFTs may not be exactly the same as digital music downloads, they also involve the online transfer of digital property and, thus, would likely constitute intangible property that is not subject to sales tax under the Department’s rationale for music downloads.
Conclusions
Crypto raises a variety of state and local tax questions. Fortunately, in New York, the existing statutory frameworks and guidance support treating Crypto as an asset that can fit within current exemption frameworks.
1 N.Y.C. Admin. Code § 11-502(c)(2).
2 N.Y.C. Admin. Code § 11-502(c)(4)(B).
3 N.Y.C. Admin. Code §§ 11-506, -507.
4 N.Y.C. Admin. Code § 11-502(c)(1)(A).
11 New York Dep’t Taxation and Finance, TSB-M-14(5)C (Dec. 5, 2014); TSB-M-14(7)I (Dec. 5, 2014); TSB-M-14(17)S (Dec. 5, 2014).
12 No. 828035 (N.Y. Tax App. Trib., May 17, 2021).
13 Id. at 25 (referencing 26 C.F.R. § 1.61-6(a)).
14 New York Dep’t Taxation and Finance, TSB-M-14(17)S (Dec. 5, 2014).
16 New York Dep’t Taxation and Finance, TSB-A-07(14)S (May 17, 2007); TSB-A-01(15)S (Apr. 18, 2001).
