As you invest more and more into NFTs, you will eventually reach an interesting dilemma: at what point should you consider putting your NFT holdings in a separate LLC? Below I provide various scenarios in which forming an LLC can be beneficial from both a tax liability and overall structural standpoint. Before doing anything, you should consult your tax or legal advisor to determine what might be best for you.
Buying NFTs with a group
Forming a group is a great way to combine funds to buy otherwise individually unattainable NFTs. It is also a great way to spread out liquidity demands for long-term holds. For example, my group of friends all very interested in investing in land on Sandbox. None of us expects this virtual land to be a quick +2x flip, but we love the idea of buying land near Zed.run’s land and the integration of NFTs into the metaverse. For that group investment, we are forming an LLC.
An LLC operating agreement serves as a contract and defines exactly what the group is planning on purchasing, how the purchase is funded, who manages the asset(s), and what happens when the assets are sold or the group otherwise agrees to cash out. As a commercial litigator, I cannot count how many times people invest in something with friends or family, and when that investment blows up (in either a good way or bad way) memories change on what was agreed and the ensuing dispute ruins the relationship. A defined agreement often helps prevents things from getting messy and, if messiness is unavoidable, makes sorting through the rubble much more manageable and inexpensive.
It also makes it easy for tax liability. If the LLC elects to be treated as a partnership (which is the IRS default), then the LLC itself is not taxed and each individual member splits the tax liability as defined in the Operating Agreement. Usually this is based on distributive share. I.e., 20% owner pays 20% of taxes, 40% owner pays 40%, etc. All the LLC files with the IRS is a Form 1065 which tells the IRS what the LLC’s taxable income for the year, and lists the members’ distributive shares. Each member then files a schedule E with their usual 1040 and their share of the LLC’s income is taxed at that member’s tax rate.
Alternatively, the LLC can elect to be taxed at the corporate tax rate. In this scenario, the LLC pays the IRS directly at a 21% tax rate. Any distributions to members are then taxed again at that member’s capital gains rate. If the group plans to sell often and reinvest earnings back into the LLC, then corporate tax rate is probably best. If the group plans to either hold long term or distribute earnings to members upon sales, then partnership treatment is probably best for you.
Regularly Flipping NFTs
If you regularly buy and sell NFTs over a short period of time, an LLC may save yourself (and your accountant) a lot of time and effort determining what your tax liability may be. As stated above, an LLC is treated as a partnership by default and does not pay taxes. It merely reports income, and it is the individual member(s)’ responsibility to pay those taxes. However, an LLC makes it easy to separate NFT funds from general funds and prevent commingling of assets. LLCs can open separate bank accounts, have separate wallets on crypto exchanges, and otherwise separate funds. It makes tracking tax liability relatively easy. Also, if you are re-investing those gains into other NFTs, you can take advantage of the 21% corporate tax rate discussed above.
Every time you buy, sell, or trade an NFT that is a taxable event. If you are involved in something like Zed.run (Axie Infinity) then you know that there are LOTS of taxable events. If you breed a horse for .03 ETH that is a taxable event based on the USD price of ETH that day vs. the price you purchased that ETH at. If you then sell that horse for .1 ETH, you now have .07 ETH in income as taxable income. If you win a race that is a taxable event. If you lose a race that is a taxable event. Having all your NFTs and NFT funds in a segregated account makes it easy to at least get a baseline: how much did you make on NFTs that year minus how much you spent on NFTs that year. That’s your baseline income to be reported. Your accountant can then determine if certain transactions should be taxed at some other rate depending on the type of NFT holding (some may be entitled to collectable capital gains rate, some may be regular capital gains rate, some may be treated as regular income, etc.).
Long Term/Major NFT Purchases
Say you grind your way up and can finally afford that grail NFT which you plan to hold for life (or, at least, for the foreseeable future) such as a CryptoPunk or a Bored Ape. First, as stated above, having this separate from your other holdings makes it easier from a tax standpoint to report earnings whenever that NFT is sold. Second, if the price of that NFT ever goes down but you still want to hold long term, you can sell (for a loss) and buy a replacement at that now lower value to effectively re-set the basis in your investment.
Let’s say you buy a male punk at 22 ETH this year. Next year, the NFT market crashes and people are selling similar male punks for 15 ETH. You can now sell your punk for 15 ETH, take a 7 ETH loss which can be reported as a loss by both the LLC and, in turn, you individually. You can use that 15 ETH to buy an equivalent punk and continue to hold. Now you have both a CryptoPunk to hold long term and easily tracked losses which can offset your regular income and help with the financial sting that an NFT crash could cause somebody heavily invested in the industry.
Finally, there may come a time when you want to realize some of the gains of your investment without selling completely. If you have an LLC formed, it is easier to sell a position to a potential investor in that holding company LLC than it would be to sell a partial stake in the NFT alone.
As the new world of NFTs combines with old world rules such as IRS tax guidelines and corporate structures, there are likely to be some growing pains. For significant investments or investments among groups, an LLC may be the best investment vehicle to overcome and deal with those hurdles as they come up.
If you have any questions or would like me to write about anything else, let me know on either of my twitter pages! As always, I am an attorney, I am not your attorney. For legal advice, you should always consult (and pay for) an attorney.