State Taxation of Cryptoassets: Key Concepts and Emerging Guidance

Andrew Appleby

Walter Hellerstein

Walter Hellerstein is the Distinguished Research Professor Emeritus and the Francis Shackelford Professor of Taxation Emeritus at the University of Georgia Law School, a visiting professor at the Vienna University of Economics and Business, and chair of the Tax Notes State advisory board. Andrew Appleby is an associate professor of law at the Stetson University College of Law.

In this article, Hellerstein and Appleby describe the emerging guidance regarding state taxation of transactions involving cryptoassets.

Copyright 2023 Walter Hellerstein and Andrew Appleby.
All rights reserved.

I. Introduction

After providing an overview of generally accepted definitions and classifications of cryptoassets for tax and other legislative purposes, this article describes the emerging guidance regarding state taxation of transactions involving cryptoassets.¹ It does so with the full recognition that the guidance is piecemeal, rapidly evolving, subject to controversy, and the focus of an enormous amount of commentary. Accordingly, the principal objective of this article is to describe these developments without entering into the extensive and contentious discussion of the appropriate approach to their tax treatment, which nevertheless is reflected in the sources cited throughout the article.²

II. Overview of Cryptoassets

A. Defining Cryptoassets

The term “cryptoasset” encompasses a wide variety of assets whose precise technical and legal characteristics depend on the context in which they are defined. With the preceding caveat in mind, we would nevertheless offer the following generic definitions from governments and governmental organizations as a useful starting point for the ensuing discussion. The OECD’s cryptoasset reporting framework defines a cryptoasset as “a digital representation of value that relies on a cryptographically secured distributed ledger or a similar technology to validate and secure transactions.”³ The U.S. Treasury Department has employed a similar description of cryptoassets as referring “broadly and generically to all types of representations of value or claims in digital form that rely on the use of a method of distributed ledger technology,” but explicitly “excluding central bank digital currencies (CBDCs).”⁴ The European Commission’s proposal for a regulation on markets in cryptoassets defines such an asset as “a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology.”⁵

“Cryptographically secured distributed ledger technology” may be described in more familiar terms as a shared ledger or record of transactions between parties in a network that is not controlled by a single central authority and is protected (or secured) by the use of cryptography, which may be defined as “secret writing,” “the enciphering and deciphering of messages in secret code or cipher,” or “the computerized encoding and decoding of information.”⁶ Another (perhaps more comprehensible) description of a cryptoasset is simply that it is a representation (or “token”) of something for something else.⁷

B. Classifying Cryptoassets

Developing a taxonomy of cryptoassets is a significant task unto itself, and those efforts have been undertaken across the globe in tax and other contexts by governments and governmental organizations,⁸ by tax advisers,⁹ and by academics.¹⁰ Classification of cryptoassets is critical to the application of existing legal frameworks — and to the modification of such frameworks to address the challenges associated with such assets — in the areas of property law, intellectual property law, commercial law, securities law, and, needless to say, tax law.¹¹

1. Tokenization

Just as there is no precise technical and legal definition of cryptoassets,¹² there is also no universally agreed upon taxonomy of the different types of assets that compose cryptoassets. Nevertheless, based on their economic function, regulators and researchers from jurisdictions throughout the world broadly classify cryptoassets into three main categories: payment tokens, security tokens, and utility tokens.¹³

a. Defining a “token.” Before describing these categories of tokens, it may be helpful briefly to consider what is meant by the term “token” in this context. Token is a word that is used in many contexts. A token, in the most general sense of the word, typically is understood simply to mean something that represents something else, for example, a tangible object that represents an intangible object, such as a “token of affection.” In the legal context, tokenization is reflected in “bodies of law that recognize the fact that possession or control of one thing, traditionally a piece of paper, may convey certain exclusive or relative rights in something else, which may be either an intangible right or a tangible asset.”¹⁴ Indeed, there is nothing new about tokenization in the legal context, and doctrinal tokenization has been happening for many centuries.¹⁵ In short, when we refer to payment tokens, security tokens, or utility tokens, we are focusing on a digital entry or related set of entries on a decentralized ledger that represents something of value associated with that set of entries, for example, a bitcoin or access to specified goods or services.

b. Principal token-related categories of cryptoassets. The OECD has described the principal token-related categories of cryptoassets as follows:

Payment tokens (virtual currencies):

• Intended to operate most similarly to traditional, fiat currencies (legal tender backed by the issuing government).

• Usable as a means of exchange for goods or services, and possibly also as a store of value and unit of measurement.

• Examples include bitcoin, litecoin, and ether.

Security (or Asset and Financial) tokens:

• Designed as tradable assets held for investment purposes and classified as a security (or equivalent) under applicable laws.

• Examples include Spice, tZero, and BCAP.

Utility (or Consumer) tokens:

• Primary use to facilitate the exchange of or access to specific goods or services.

• May serve as a license to allow the holder access to a particular service or as a prepayment or voucher for a good or service (even when that good or service is not yet available).

• Examples include Storj, a token that provides access to a peer-to-peer network cloud storage service.¹⁶

One may further divide the category of utility or consumer tokens into “fungible” and “non-fungible” tokens. As the U.S. Treasury has described fungible tokens, “each token unit must be equal in character and value to other token units, and therefore indistinguishable and interchangeable.”¹⁷ By contrast, Treasury has defined non-fungible tokens (NFTs) as:

III. Payment Tokens (Virtual Currencies)

A. Federal Income Tax Treatment

We describe the federal income tax guidance on the treatment of cryptoassets insofar as it may influence the state tax guidance on such treatment because of conformity and other considerations. Indeed, as the discussion of the state tax treatment of cryptoassets below reveals, the federal tax guidance on the treatment of cryptoassets has already influenced the state tax guidance.¹⁹

The characterization and treatment of cryptoassets for U.S. federal income tax purposes is not settled, but the IRS has issued some guidance on these issues. In 2014 the IRS issued guidance regarding “convertible” virtual currencies, that is, “virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency.”²⁰ The guidance provides that virtual currency should be treated as property and that “general tax principles applicable to property transactions apply to transactions involving virtual currency.”²¹ These include receipt of virtual currency as payment for goods and services (taxpayer must treat the fair market value of the virtual currency as gross income); the basis of virtual currency received (the fair market value of the virtual currency when received); gain or loss upon receipt of property in exchange for virtual currency (value of property received less adjusted basis in virtual currency); and other issues.

The guidance also declares:

B. State Tax Treatment

1. Income Taxation

a. Illinois. The Illinois Department of Revenue relied on the federal tax guidance in providing state income tax guidance regarding cryptocurrency. Its guidance declares:

b. Michigan. Like Illinois, Michigan has adopted the federal income tax guidance on cryptocurrency. Its guidance declares that “Michigan does not have any rules or policies with respect to digital currency transactions that differ from the federal policies regarding such transactions.”²⁴ The guidance suggests that “taxpayers engaging in transactions involving digital currencies such as Bitcoin may want to consult IRS Notice 2014-21, which gives guidance to individuals and businesses on the tax treatment of transactions using virtual currencies.”²⁵

c. Wisconsin. The Wisconsin DOR has issued general guidance regarding the tax treatment of virtual currency, which explicitly includes cryptocurrency.²⁶ The guidance defines such currency as “a digital representation of value that functions as a unit of account, a store of value, and a medium of exchange.”²⁷ The guidance provides that “virtual currency is intangible property that is treated for tax purposes similar to other types of intangible property, and taxpayers must report income, gains, expenses, and losses as required under the Internal Revenue Code.”²⁸ The guidance notes:

The guidance identifies the following scenarios in which payments involving virtual currency may involve tax obligations: A payment made using virtual currency is subject to information reporting to the same extent as any other payment made with intangible property (for example, filing W-2 forms and 1099 forms); the sale, exchange, or other disposition of virtual currency may result in ordinary or capital gains or losses; and a business that receives virtual currency for the sale of goods/services must report gross sales revenue valued at the virtual currency’s exchange price at the time of sale.

2. Sales and Use Taxation

A growing number of sellers accept virtual currencies (for example, bitcoin) as payment for their goods and services. Although these currencies do not have status as legal tender,³⁰ they are nonetheless valuable consideration when exchanged for goods or services. Accordingly, the value of these currencies is includable in the measure of the sales prices for sales and use tax purposes, as is the case with the value of items exchanged in more traditional barter transactions.

a. California. The California State Board of Equalization advised, for example, that “if a retailer enters into a contract where the consideration is virtual currency, the measure of the tax for the sale of the product is the amount allowed by the retailer in exchange for the virtual currency (generally, the retailer’s advertised price of the product).”³¹ The board provided the following example:

b. Kansas. Kansas defines digital currency as including “subsets of the digital currency group, and includes, but is not limited to, digital money, electronic money, electronic currency, cyber cash, virtual currency, bitcoin, ethereum, and cryptocurrencies, whether they exist within the blockchain network or not.”³³ As to its treatment in payment for taxable retail sales, Kansas has declared that the measure of the tax is “the fair retail market value of the property or service received in payment for the property or service sold, and will be calculated using the list price in U.S. dollars of a good or service, not the value of the digital currency.”³⁴

c. Michigan. The Michigan Department of Treasury has observed that taxpayers are required to remit sales and use tax liabilities based on the dollar value of the consideration exchanged for taxable property; that if the consideration given in exchange for the property is not U.S. dollars, the taxpayer must convert the value of the consideration to U.S. dollars as of the date and at the time of the transaction; and that this requirement includes convertible virtual currency exchanged for taxable property.³⁵ Accordingly, a taxpayer accepting virtual currency in a retail sales transaction must convert the value of the virtual currency to U.S. dollars as of the day and the exact time of the transaction. The guidance observes, however, that “virtual currency itself is not tangible personal property for purposes of the General Sales Tax Act or the Use Tax Act. Therefore, purchases of virtual currency — as contrasted with purchases made with virtual currency — are not subject to sales or use tax.”³⁶

d. Minnesota. The Minnesota DOR has advised that “all alternate forms of currency used to buy goods or services are treated the same as cash. Examples include scrip and cryptocurrency.”³⁷

e. Missouri. The Missouri DOR ruled that the cash purchase of bitcoins through an ATM (which the ATM then deposited into the customer’s electronic wallet) is not subject to tax because the exchange involves only nontaxable intangibles.³⁸

f. New Jersey. New Jersey treats convertible virtual currency as an intangible for sales tax purposes. As a result, the purchase or use of virtual currency is not subject to sales tax, but tax does apply when virtual currency is exchanged for taxable goods or services. For valuation purposes, New Jersey “conforms to the federal tax treatment of convertible currency as detailed in Notice 2014-21,”³⁹ and “taxpayers are required to determine the fair market value of the convertible currency in U.S. dollars as of the date of payment or receipt.”⁴⁰

g. New York. The New York taxing authority issued a memorandum explaining its policy regarding transactions involving convertible virtual currency for income and sales tax purposes, and it concluded that the use of such currency to pay for goods and services is a barter transaction.⁴¹ Because convertible virtual currency is an intangible, its sale or exchange is not subject to sales tax.⁴² The exchange of taxable property or services for convertible virtual currency, however, is subject to tax, measured by “the market value of the convertible virtual currency at the time of the transaction, converted to U.S. dollars.”⁴³ The memorandum does not offer any guidance on the valuation of convertible virtual currency other than by making general reference to IRS Notice 2014-21.⁴⁴

h. Tennessee. The Tennessee DOR has advised that virtual currency is intangible property for the purpose of Tennessee taxation.⁴⁵ Therefore, when an individual purchases virtual currency, the transaction is not subject to sales or use tax or business tax. However, sales of taxable goods or services that are purchased with virtual currency are still taxable sales. The tax base for such transactions for sales and use tax and business tax purposes would be the advertised price of the taxable good or service.

i. Washington. The Washington DOR issued guidance regarding its treatment of bitcoin⁴⁶ for sales and use tax purposes.⁴⁷ The guidance observed that:

1. Bitcoin is treated as consideration for the purchase of goods or services;

2. when Bitcoin is converted into dollars at the time of sale, the measure of the tax is the value of the consideration is the amount converted into dollars; and

3. when Bitcoin is not converted into dollars at the time of sale, the measure of the tax is value of the consideration is the amount converted into dollars, and this value may be determined by means of a reliable cryptocurrency pricing index.⁴⁸

j. Wisconsin. As noted above, the Wisconsin DOR has issued general guidance regarding the tax treatment of virtual currency, which includes cryptocurrency.⁴⁹ The sales tax guidance defines virtual currency as “a digital representation of value that functions as a unit of account, a store of value, and a medium of exchange.”⁵⁰

IV. Non-Fungible Utility Tokens

A. Federal Income Tax Treatment

In 2023 the IRS issued proposed guidance for federal income tax purposes determining that NFTs may be collectibles under IRC section 408(m), which defines a collectible as any work of art, rug or antique, metal or gem, stamp or coin, alcoholic beverage, or “any other tangible personal property” specified by the Treasury Department.⁵²

The proposed guidance first defines an NFT as follows:

According to the proposed guidance, the IRS intends to determine whether an NFT constitutes a collectible using a “look-through analysis”:

A look-through approach is an intuitive way for taxing authorities to reach the substance of the transaction, although it may raise problems in application.⁵⁵

In addition to the IRS guidance, the Treasury Department issued proposed regulations that address tax reporting obligations for cryptoasset brokers and platforms.⁵⁶ The proposed regulations and related commentary are extraordinarily detailed and will likely serve as a framework for cryptoasset tax reporting regimes at the state level.⁵⁷ The proposed regulations define digital assets broadly as “a digital representation of value that is recorded on a cryptographically secured distributed ledger (or similar technology).”⁵⁸ This broad definition creates an income tax reporting requirement for cryptoasset transactions that may not be imposed for analogous transactions carried out in a traditional manner (for example, the sale of physical artwork by means of an NFT rather than the sale of physical artwork at a gallery).⁵⁹ The proposed regulations also provide that when cryptoassets are also securities or commodities — deemed “dual classification assets” — the cryptoassets must be reported as digital assets.⁶⁰ By contrast, when the sale of cryptoassets also constitutes the reportable sale of real estate, the transaction is required to be reported as a real estate transaction.⁶¹

Federal guidance on the taxation of cryptoassets, while focused on income taxation, has influenced and is likely to continue to influence state tax guidance in both the income and sales tax contexts, as noted in the ensuing discussion.

B. State Sales and Use Tax Treatment

1. Overview

Transactions involving NFTs challenge existing state tax regimes because each transaction ultimately reflects multiple transactional layers, each of which may require distinct tax treatment and involve different locations or values.⁶² The rapid proliferation of transactions involving NFTs necessitates a tax framework capable of managing these challenges. The state tax framework must resolve four fundamental issues:

1. whether the transaction is subject to tax under an imposition statute;

2. the value of the property or amount of consideration;

3. which taxing jurisdictions may impose tax on the transaction, and to what extent (sourcing and substantive jurisdiction); and

4. whether the taxing jurisdiction has the power to compel the seller, purchaser, or other party to collect and remit the tax (what we have characterized as “enforcement jurisdiction”⁶³).

In addition, taxing authorities must contend with the genuine risk of tax evasion because blockchain-based tokenization intrinsically obscures the ownership and transfers of underlying assets, thereby facilitating such evasion.

Although there are various potential approaches to the tax treatment of transactions involving NFTs, the most common approach essentially disregards the NFT transaction, recasts the transaction based on the underlying asset or assets, and applies existing tax regimes to the transaction as recast.⁶⁴ Whether cryptoasset transactional layers may (or should) be recast is a crucial threshold question. If a state adopts an approach that looks through or disregards the intangible NFT transaction, the state can apply existing tax rules based on the underlying asset or assets.

The look-through approach is the most practical approach because it adds just one step to the analysis and does not require a wholesale reconstruction of a state’s tax regime.⁶⁵ The look-through approach is also consistent with the current federal income tax approach.⁶⁶ Nevertheless, the look-through approach does not solve all problems associated with NFT transactions. Looking through the NFT transaction places the underlying transaction within the analytical framework of existing tax regimes that have struggled to adapt to the growth of the digital economy. States that adopt such an approach must address bundled transaction rules and sourcing rules in increasingly complex transactional structures.⁶⁷ States adopting such an approach must also confront the question whether the NFT transaction falls within their existing marketplace platform provisions, and if not, how to modify their existing platform provisions to encompass such transactions. Transactions involving cryptoassets should in principle be amenable to integration with state marketplace platform provisions because cryptoasset transactions generally require third-party marketplaces to facilitate the NFT transaction.⁶⁸ Moreover, integrating the NFT transactions with the marketplace platforms should mitigate the tax avoidance risks associated with blockchain-based transactions.

In an ideal world, state legislatures would quickly respond to the foregoing tax challenges created by the increasing economic significance of NFTs by providing detailed statutory authority addressing these challenges and integrate them into their marketplace platform provisions. As every reader is well aware, however, the reality is that enacting such legislation is a lengthy process. As a consequence, for the moment at least, state taxing authorities must address these issues by issuing guidance under existing statutes and regulatory authority, as they did a decade earlier regarding cloud computing.⁶⁹ States have commenced this cryptoasset taxation guidance process, as noted in the ensuing discussion.

2. State Tax Guidance on Sales and Use Tax Treatment of NFTs

a. Illinois. The Illinois DOR issued a general information letter in 2023 that added digital assets to the state’s annual tax survey.⁷⁰ The department defined digital assets as “blockchain (distributed ledger technology) based intangible digital assets, including nonfungible tokens (NFTs), cryptocurrency, equity tokens, utility tokens, etc.”⁷¹ In 2023 the department provided no response to all the questions related to digital assets.⁷²

b. Michigan. The Michigan Department of Treasury defined an NFT as a “digital code on a blockchain comprised of unique identification codes and metadata that distinguish them from one another” and considered NFTs to be digital goods.⁷³ Michigan does not impose sales and use tax on digital goods and thus does not impose sales and use tax on NFTs.⁷⁴

c. Minnesota. The Minnesota DOR issued a sales tax fact sheet that addressed the extent to which NFTs are subject to Minnesota sales and use tax.⁷⁵ The department adopted a look-through approach, concluding that NFTs “are subject to sales and use tax when the underlying product (goods or services) is taxable in Minnesota.”⁷⁶ The department also noted that:

• Digital products such as music, audio visual works, or video games

• Admissions to sporting events or concerts

• Prepared food and beverages

• Tangible personal property such as collectibles or memorabilia.⁷⁷

d. Pennsylvania. The Pennsylvania DOR issued notices that include NFTs in the list of items, such as “canned software” and “digital goods,” that are subject to Pennsylvania sales and use tax.⁷⁸

e. Washington. The Washington DOR issued a detailed interim guidance statement addressing the sales and use tax treatment of NFTs.⁷⁹ The statement defined NFTs as “digital code on a blockchain comprised of unique identification codes and metadata that distinguish them from one another.”⁸⁰ The statement went on to define other terms used in its guidance but specified that they “are not legal definitions but are rather functional descriptions that the department has developed based on how the terms are used by industry participants.”⁸¹ The statement observed:

The statement then addressed the extent to which NFTs are subject to sales and use tax. In essence, the department adopted a look-through approach: “NFTs are taxed based on the character of the underlying products (goods and services) included in the sale.”⁸³ The department noted that:

The statement also addressed other aspects of NFT transactions. It considered how to determine the transaction sales price, particularly in the typical situation in which the NFT is purchased with cryptocurrency instead of fiat currency. In that case, the sales price is determined by converting the cryptocurrency to its value in U.S. dollars at the time of the sale. The statement considered bundled or mixed transactions and described the application of Washington’s bundled transaction rules to “sales of NFTs that entitle the purchaser to a digital product (that is, the NFT itself) and one or more other products or services.”⁸⁵ The statement explicitly recognized that “marketplaces that facilitate retail sales of NFTs may qualify as market facilitators for Washington tax purposes”⁸⁶ and thus may have tax collection and remittance obligations under the state’s marketplace platform provision. The statement also addressed sourcing of the transaction but simply restated Washington’s general sourcing rules for digital products.

The guidance identified four basic types of transactions involving NFTs:

• When the object of the purchases is a standalone digital product (that is, the NFT itself), the transaction will be subject to tax, because sales of digital products are normally subject to retail sales tax, and the department considers an NFT to be intrinsically associated with any code or file for an underlying digital product for which the NFT constitutes the certificate of ownership or authenticity. Examples include digital artwork, photographs, and videoclips, and autographs. The seller would also be subject to [business and occupation (B&O)] tax on such transactions, measured by the gross proceeds of sale.

• When the object of the purchase is a standalone good or service (other than a digital product) that is classified as a retail sale, the department does not consider the NFT to be the object of the customer’s purchase. In other words, the department recognizes a conceptual distinction between an NFT and an underlying good or service, other than a digital product. In such cases, the sale of the goods or services generally defined as sales under the retail sales tax would be subject to tax and the seller would be subject to retailing B&O tax on the gross proceeds of the sale.

• When the object of the purchase is a standalone good or service that is not classified as a retail sale under the general retail sale provisions, the NFT is not the object of the customer’s purchase and such sales are not subject to retail sales tax. The seller may, however, be subject to B&O tax, use tax, or some other excise tax measured by the gross proceeds of the sale.

• If the sale of an NFT includes a royalty payment to the NFT creator, or other party who retains the right to royalties for future use or distribution of the NFT, the gross income from the royalties will be subject to the B&O tax on royalties.⁸⁷

f. Wisconsin. The Wisconsin DOR issued a tax bulletin stating that an NFT “is a unique digital identifier that is recorded in blockchain. NFTs are used to certify authenticity and ownership of a particular product and cannot be copied or substituted.”⁸⁸ The department adopted a look-through approach, stating that “the sale or purchase of a NFT may be taxable if the underlying product, good, or service is taxable in Wisconsin.”⁸⁹ The bulletin provided the following three examples:

• NFT entitles the purchaser to download music or movies. The sale of the NFT is a taxable specified digital good.

• NFT entitles the purchaser an admission to a sporting event. The sale of the NFT is a taxable admission.

• NFT entitles the purchaser to a tangible piece of artwork. The sale of the NFT is taxable tangible personal property.⁹⁰

C. State Income Tax Treatment

Although states have focused principally on the sales and use tax issues involving cryptoassets, cryptoassets raise state income tax questions as well.⁹¹

P.L. 86-272 Restraints on State Income Taxation of Cryptoasset Transactions

Public Law 86-272 limits the states’ power to impose net income taxes on income derived by any person on income derived within the state if the person’s business activity in the state is limited to the “solicitation of orders” for the sale of tangible personal property.⁹² The New Jersey Division of Taxation issued guidance regarding digital and internet-based activities that constitute or exceed solicitation of orders of tangible personal property for purposes of P.L. 86-272.⁹³ Although this guidance largely reflected the substance of the Multistate Tax Commission’s 2021 guidelines on protected and unprotected activities under P.L. 86-272,⁹⁴ New Jersey’s guidance also addressed cryptoassets. The New Jersey guidance explicitly listed as unprotected activities “the offering, soliciting, selling, accepting, or buying of digital assets such as virtual currency or non-fungible tokens (NFTs) and/or the offering of services pertaining to them.”⁹⁵ The guidance concluded that such activities involving cryptoassets constitute “the offering and selling of financial products, financial instruments, and financial services” that are not protected by P.L. 86-272.⁹⁶

Notwithstanding our comment at the outset of this article that we would refrain (for the moment) from participating in the contentious discussion of the appropriate approach to the issues raised by state taxation of cryptoassets, we cannot resist suggesting that in our view, the New Jersey guidance is overbroad because it fails to recognize the substantial and meaningful variability of cryptoassets. Although many transactions involving cryptoassets may involve financial products (for example, the sale of security tokens), other transactions involving cryptoassets may fairly be characterized as the sale of tangible property.⁹⁷ If the sale of a cryptoasset such as an NFT reflects a transfer of ownership rights of “real-world” tangible property (for example, physical artwork or a vehicle), the transaction arguably may be characterized as the sale of tangible personal property — potentially protected under P.L. 86-272 — rather than the sale of a financial product or service. Accordingly, an NFT, rather than amounting simply to an electronic or paper representation of a financial asset, may more persuasively be characterized, in substance, as the transfer of ownership of tangible personal property, and the New Jersey guidance may be regarded as inconsistent with the IRS’s proposed look-through approach for NFT taxation.⁹⁸