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Coffee, NFTs, and Noncompliance?

Posted on Nov. 28, 2022
Mahima Chaudhary
Mahima Chaudhary
Garrett L. Brodeur
Garrett L. Brodeur

Garrett L. Brodeur is an associate and Mahima Chaudhary is a paralegal at Kostelanetz LLP.

In this article, Brodeur and Chaudhary examine Odyssey, a new blockchain-based rewards program from Starbucks, and its potential tax pitfalls for unwary customers.

Introduction

Digital assets are becoming mainstream, and commercial enterprises are racing to find new ways to encourage consumers to buy in. While commercial on-ramps into digital marketplaces promote crypto fluency and financial flexibility, some recent alternatives may pose tax compliance concerns. One example is Starbucks Odyssey, a soon-to-launch blockchain-based customer rewards program. Odyssey participants are invited to complete games, challenges, and learning exercises (journeys) to acquire digital journey stamps, which are non-fungible tokens (NFTs)1 that unlock exclusive rewards.

While Odyssey is pioneering and innovative in its approach, the program might hinder tax compliance because as advertised, it disguises the fact that many participants will be rewarded with NFTs — a reportable and potentially taxable event.2

On-Ramps and Odyssey

In industry terms, on-ramping describes the process of leaving the traditional monetary system and entering the virtual world of digital assets — for example, using a fiat or regular currency to buy bitcoin.3 Consumers may access digital marketplaces through a variety of on-ramps. The most common are centralized exchanges, such as Coinbase or Binance, which allow users to open accounts, buy cryptocurrencies using a credit card, and maintain custodial wallets to engage in cryptocurrency transactions. Users may also on-ramp through NFT marketplaces, such as OpenSea or Rarible, which allow direct credit card purchases of NFTs.

On September 12 Starbucks announced the anticipated launch of Odyssey,4 a blockchain-based rewards program. Based on descriptions of the program, members will complete Odyssey journeys, such as interactive games or educational challenges about Starbucks or coffee more generally.5 As a reward, members will receive digital collectible journey stamps, which Starbucks acknowledges are NFTs.6 Each journey stamp will be assigned a point value based on its rarity, allowing it to be traded among Odyssey members or redeemed for exclusive Starbucks benefits or experiences, such as unique merchandise, virtual espresso martini-making classes, or even an invitation to the Starbucks Hacienda Alsacia coffee farm in Costa Rica.

In addition to earning journey stamps by completing games and challenges, Odyssey members will also be able to purchase limited-edition stamps (NFTs) directly with their credit cards through the Odyssey marketplace. These purchases will not require a crypto wallet or cryptocurrency but will allow members to interact with blockchain technology and “claim an ownership stake in their loyalty to Starbucks.”7

Odyssey has yet to launch, so it is hard to predict how the program will actually operate, but Starbucks executives have explained that Odyssey “intentionally [obscures] the nature of the technology underpinning the experience in order to bring in more consumers — including non-technical people” — to the program’s online platform.8 As a result, Odyssey participants “may not actually know they’re interacting with blockchain or NFTs.”9

In summary, Odyssey uses blockchain technology as an enabler10 to on-ramp existing Starbucks rewards members and other consumers into a new digital marketplace in which they will be encouraged to collect, trade, and exchange NFTs without any express indication that they are engaging in digital asset transactions for tax purposes. This lack of disclosure could pose an obstacle to tax compliance.

Reporting Requirements for Digital Assets

Since 2019, the IRS has included a virtual currency question on Form 1040 and other tax forms, which has required taxpayers to check “yes” or “no” to report the extent of their virtual currency activities. The structure or location of the question has changed each year to address new issues or practical developments in audits and examinations.11

In late July, the IRS released a draft Form 1040 for tax year 2022,12 which presented a new and substantially revised question concerning digital assets:

At any time during 2022, did you (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?

In comparison with virtual currency questions from prior years, the question on Form 1040 for 2022 introduced the term “digital asset.”13

In October the IRS released multiple sources of guidance that explicitly categorize NFTs as digital assets for tax purposes. The agency first issued draft instructions for the 2022 Form 1040, which confirm that NFTs and stablecoins are digital assets.14 The instructions also explain that taxpayers must check “yes” in response to the Form 1040 digital assets question for 2022 if, at any time during the year, they received digital assets as a result of a reward or award, disposed of digital assets in exchange for property or services, disposed of a digital asset in exchange for another digital asset, sold a digital asset, transferred digital assets for free as a bona fide gift, or otherwise disposed of any other financial interest in a digital asset, among other activities.15 However, taxpayers are not required to check “yes” if they merely held a digital asset in a wallet or account or purchased digital assets using U.S. or other real currency, including through a payment platform, without any further activities.16

The IRS also published a new website dedicated solely to digital assets.17 Consistent with the draft instructions released one week earlier, the website clearly indicates that digital assets include NFTs. The website also specifies that taxpayers “may owe taxes” on some transactions, such as the sale of a digital asset, the exchange of digital assets for property, goods or services, the exchange of one digital asset for another, or the receipt or transfer of a digital asset for free (that is, without providing any consideration) in a manner that does not qualify as a bona fide gift.18

Tax Implications for Odyssey Participants

What does this mean for Odyssey participants if they, for example, complete a journey and are rewarded a journey stamp or purchase a limited-edition journey stamp through the Odyssey marketplace? First, both the plain language of the digital assets question on the 2022 Form 1040 and the IRS’s recent draft instructions indicate that the receipt of an NFT or any other digital asset as a reward or award requires one to check “yes” on Form 1040. So, if an Odyssey participant completes a journey and is rewarded a journey stamp in 2022, they are required to check “yes.” This reporting obligation poses an issue for Odyssey participants who may not be fully informed that they are engaging with NFTs.19 While there is no civil penalty for inaccurately checking “no” (unless the taxpayer has underreported their taxes by not reporting digital asset transactions), technically, this would be a false return.

The IRS is increasing its efforts to identify and track taxpayers’ virtual activities, particularly those involving the receipt of digital assets such as NFTs.20 For fiscal 2023, the Treasury Inspector General for Tax Administration will audit the IRS’s oversight of taxpayer compliance for NFTs and taxable cryptocurrency transactions.21 With the IRS bolstering its cryptocurrency enforcement efforts and TIGTA reviewing the IRS’s oversight of NFTs and other taxable cryptocurrency transactions, Odyssey participants and taxpayers more generally should expect that the IRS will carefully scrutinize their digital asset activities. Tax compliance for digital assets begins with properly checking “yes” on Form 1040 to report specific activities, but the design of the Odyssey program could confuse participants who don’t understand that they are acquiring NFTs.

Aside from the issue of checking “yes” or “no” on Form 1040, Odyssey raises additional tax considerations because participants who receive journey stamps may owe taxes as a result, though the amount would probably be minimal. While the IRS has not issued direct formal guidance on the tax treatment of NFT transactions, the agency’s new digital assets website suggests that Odyssey participants who purchase a limited-edition journey stamp (NFT) in Odyssey’s online marketplace will likely realize capital gain or loss on a subsequent disposition or sale of the stamp.22 Odyssey participants who earn a journey stamp (NFT) as a reward for completing a journey will likely face additional tax uncertainty. The IRS’s digital assets website indicates that the “receipt or transfer of a digital asset for free (without providing any consideration)” may be taxable, but it is unclear whether the receipt of the journey stamp itself is a taxable event, or whether the stamp must first be redeemed for exclusive Starbucks rewards or experiences to be taxable. The Tax Court has held that the redemption of reward points for a noncash benefit constitutes a taxable event.23 If the redemption of a journey stamp for a noncash Starbucks reward (for example, a virtual espresso martini-making class) is a taxable event, then the amount an Odyssey participant must include in gross income is the fair market value of the reward, and that amount must be reported for tax purposes in the year of the redemption.

It remains unclear, however, whether the receipt of a journey stamp itself could be considered a taxable event. To the authors’ knowledge, the Tax Court has not directly addressed the issue in a court-reviewed opinion.24 The receipt of a journey stamp could be viewed as a customer rebate (as opposed to a receipt of taxable income) that reduces the purchase price of an exclusive Starbucks reward or experience upon redemption of the stamp. In Rev. Rul. 76-96, 1976-1 C.B. 23, as modified by Rev. Rul. 2005-28, 2005-1 C.B. 997, the IRS set forth the “rebate rule,” which holds that a purchase incentive, such as credit card rewards or points, is not treated as income but as a reduction of the purchase price of what is purchased with the rewards or points.25 Starbucks may be relying on this characterization, possibly on the advice of counsel, as a way to side-step immediate tax concerns for Odyssey participants. If the IRS decides not to apply the rebate rule to journey stamps, it could take the position that the receipt of a journey stamp is similar to the receipt of taxable income under either the constructive receipt26 or cash equivalency27 doctrine. In Anikeev,28 although not based on the cash equivalency doctrine, the Tax Court held that the receipt of certain American Express “Blue Cash” rewards dollars was taxable as ordinary income. The rewards dollars were received in exchange for the purchase of cash equivalents, and not a product or service, and therefore were not reconcilable with the IRS’s rebate rule.29 It remains premature to make any determinations as to how the IRS may view Odyssey journey stamps, because the Odyssey program has not yet launched and has only been described in general terms.30

Conclusion

As commercial enterprises begin on-ramping customers into new marketplaces with incentive programs like Starbucks Odyssey, there is a danger that taxpayers may not be aware that they are dealing with digital assets in ways that trigger reporting obligations or tax consequences. While Odyssey’s threat to tax compliance may be relatively minor given that the program involves noncash benefits with generally little resale value, it is symbolic of a broader trend. As more commercial enterprises develop rewards programs involving digital assets, some will assuredly feature rewards or noncash benefits with greater dollar values at stake (for example, rewards offered by cruise lines or hotel chains) and create more profound tax compliance concerns. Though Odyssey is pioneering and innovative in its approach, if pumpkin spice latte fanatics want to reap the benefits generated by their Starbucks loyalty, in return, they should be informed of the potential tax implications of the Starbucks Odyssey program.

FOOTNOTES

1 Unlike digital coins and fungible tokens (that function as virtual currency), NFTs are unique and noninterchangeable units of data that can signify ownership of associated digital items, such as images, music, or videos. NFTs can themselves be sold or traded in digital marketplaces, but NFT ownership doesn’t necessarily entail legal ownership of a digital or physical item. NFT owners generally purchase only the right to the NFT’s metadata or token and not the underlying item. See “Non-Fungible Tokens (NFTs),” Congressional Research Service, R47189 (July 20, 2022).

2 Odyssey raises many other issues, including the tax treatment of consumer loyalty rewards. This issue is briefly discussed but not explored in depth in this article.

3 On-ramping is the process of transitioning assets from fiat into cryptocurrency and therefore moving value between two distinct monetary systems with different rules, attributes, and entry requirements.

4 The Odyssey program is scheduled to launch late this year. Starbucks offers a waiting list for anyone interested in participating in the program. Invitations will be sent to select waiting list members in late 2022 who will be among the first to explore the program.

5 Odyssey is an extension of Starbucks’ current loyalty rewards program. At this time, it appears that Starbucks rewards members will be able to access Odyssey using their existing Starbucks login credentials.

6 Starbucks, “Starbucks Brewing Revolutionary Web3 Experience for Its Starbucks Rewards Members,” Starbucks Stories and News (Sept. 12, 2022).

7 Id.

8 Sarah Perez, “Starbucks Details Its Blockchain-Based Loyalty Platform and NFT Community, Starbucks Odyssey,” TechCrunch, Sept. 12, 2022. Starbucks’ concern over consumer hesitation to embrace new market innovations may not be entirely misplaced. See Andrew Griffin, “Meta Share Price Collapses After Mark Zuckerberg Says He Will Not Give Up on the Metaverse,” Independent, Oct. 29, 2022.

10 See Perez, supra note 8 (“It happens to be built on blockchain and web3 technologies, but the customer — to be honest — may very well not even know that what they’re doing is interacting with blockchain technology. It’s just the enabler.”).

11 See Garrett L. Brodeur, “New Crypto Tax Question Foreshadows IRS Enforcement Priorities,” Tax Notes Federal, Sept. 5, 2022, p. 1571.

12 Note that this is only a draft form, and any language in it (including the cryptocurrency question) is subject to change.

13 The cryptocurrency question on Forms 1040 for 2019, 2020, and 2021 used the term “virtual currency,” which by definition did not encompass NFTs and stablecoins. IRS officials have now commented on the broad reach of the new digital assets question as well as its educational role. See, e.g., Nathan J. Richman, “IRS Says 1040 Cryptocurrency Question Is Meant to Be Broad,” Tax Notes Federal, Nov. 7, 2022, p. 868; Isabel Gottlieb, “Crypto 1040 Tax Return Question Has ‘Educational’ Role, IRS Says,” Bloomberg Tax, Nov. 2, 2022.

14 According to the instructions, “Digital assets are any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology. For example, digital assets include non-fungible tokens (NFTs) and virtual currencies, such as cryptocurrencies and stablecoins.” 2022 Form 1040 Instructions, at 16 (Draft as of Oct. 17, 2022).

15 Id. The instructions further provide that a taxpayer has a financial interest in a digital asset if they are “the owner of record” of the digital asset, “have an ownership stake in an account that holds one or more digital assets, including the rights and obligations to acquire a financial interest,” or if they “own a wallet that holds digital assets.”

16 Id.

17 IRS, “Digital Assets” (last reviewed or updated Oct. 25, 2022).

18 Id.

19 While earning a digital asset as a reward or award requires one to check “yes,” it should be noted that the mere purchase of a digital asset alone in a given tax year generally does not require one to do so based on the IRS’s draft instructions. Therefore, Odyssey participants who do nothing more than purchase a limited-edition stamp through the Odyssey marketplace will not be required to check “yes” based on the IRS’s draft instructions for the 2022 Form 1040.

20 See, e.g., David van den Berg, “Joint Int’l Task Force to Target Crypto, NFTs, IRS Official Says,” Law360, Mar. 4, 2022.

21 On October 24 TIGTA announced its plans for a series of audits and reviews for fiscal 2023 to be conducted by its Office of Audit and Office of Inspections and Evaluations. Of relevance here, the Office of Audit will conduct planned compliance and enforcement reviews of “the IRS’s strategy for addressing taxpayer compliance with respect to the use of Non-Fungible Tokens” and the IRS’s ability to identify “income earned from transactions involving cryptocurrency.” See TIGTA, “2023 Annual Audit Plan,” at 3-4 (Oct. 24, 2022).

22 The website states that taxpayers “may owe taxes” on specified transactions, including a “sale of a digital asset.” The draft instructions for the 2022 Form 1040 explain that taxpayers who dispose of property held as a capital asset (including digital assets such as NFTs) through either a sale, exchange, gift, or transfer, must calculate and report any gain or loss on the disposition. The IRS requires taxpayers to use Form 8949, “Sales and Other Dispositions of Capital Assets,” to calculate the gain or loss and Schedule D to report the gain or loss on Form 1040. To meet these reporting requirements, taxpayers must maintain records of their receipts, sales, exchanges, or other similar dispositions of digital assets, and they should document the assets’ FMV to assist with cost basis calculations. See IRS, “FAQs on Virtual Currency Transactions,” Q46.

23 In Shankar v. Commissioner, 143 T.C. 140 (2014), a taxpayer purchased an airline ticket by redeeming “thank you points” that Citibank had issued as a reward for opening a bank account. After the IRS challenged the taxpayer’s failure to include the FMV of the ticket as income on his tax return, the Tax Court determined that the ticket’s FMV was includable in gross income.

24 In Shankar, 143 T.C. 140, the Tax Court addressed the tax treatment of the redemption of customer rewards points, but neither the taxpayer nor the IRS addressed the treatment of the actual receipt of the rewards points, so the court declined to address whether the taxpayer’s receipt of the award itself was a taxable event.

25 See also Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956) (generally, when a payment is made by a seller to a customer as an inducement to purchase property, the payment does not constitute income but instead is treated as a purchase price adjustment to the basis of the property).

26 Reg. section 1.451-2(a) (“Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”).

27 In general terms, the cash equivalency doctrine is used to determine whether items that are either actually or constructively received must be accrued as income. The doctrine treats some noncash payment transactions like cash transactions for federal income tax purposes if they have the same value as cash.

28 Anikeev v. Commissioner, T.C. Memo. 2021-23.

29 The taxpayers in Anikeev received some of their reward dollars in exchange for direct money order purchases and infusions of cash into reloadable debit cards. The Tax Court declined to apply the rebate rule because the money orders and cash infusions were not products or services, and therefore were incompatible “with the IRS policy excluding credit card rewards for product and service purchases from income.” See Anikeev, T.C. Memo. 2021-23, at *22.

30 Some tax issues involving routine consumer digital asset transactions could largely be avoided by the formal adoption of a de minimis rule excluding specific transactions from capital gains tax. See, e.g., S. 4356, “Lummis-Gillibrand Responsible Financial Innovation Act,” section 201(a) (June 7, 2022) (proposing to exclude from gross income any gain or loss from personal cryptocurrency transactions for goods or services of less than $200).

END FOOTNOTES

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