You’re building your NFT business to scale. You’ve worked with your legal and tech team to ensure your non-fungible token will both stand up to legal challenges and generate a revenue stream and value for years. However accounting for NFTs is often an afterthought and something most business owner’s leave to their tax accountant at the end of the year. In reality, the way you do your NFT accounting can impact your profitability, your prospects and your NFT tax liability.
Just because your NFT’s related transactions are on the blockchain, doesn’t necessarily mean that your accounting will flow accurately into your financial statements. While not as exciting as developing your legal structure, revenue model, and royalty contracts, understanding how your NFT accounting will be done is important.
When accounting for NFTs– you need three things:
- The right crypto accounting system
- A strong accounting team that understands the nuances of NFT accounting
- A collaborative development team to assist where needed in developing reporting specific to your NFT project.
In our experience, no two NFT projects are the same. From the differences in the underlying assets, ownership rights, tokenization, revenue streams, and distribution channels, each NFT business needs to ensure that the accounting team understands the nuances of the project so that everything is captured in the financial statements accurately.
Because NFT Accounting can be complex, it’s important that your accounting team understands the full life-cycle of an NFT from acquisition/ minting to disposition and burning as all of those factors impact how your NFT will be recorded. A useful exercise is to have your legal, development and accounting team pull together a flow chart of your NFT project and map out all of the complexities in the project.
The legal and accounting side of NFTs go hand in hand. It’s more than just recording what happens on chain, but a well-designed accounting process can help you accurately represent your NFT holdings on your books as well as give you rich data analytics on profitability and costs.
Here are five things you should think about when it comes to your NFT Accounting:
Accounting for NFT ownership
Who owns an NFT asset (and when) can make big difference in how the asset is accounted for in your books. It also depends on what type of business you are in. If you are a collector, there is one accounting treatment. If you are minting and selling, there is another. If you are actively trading NFTs there could be another. If you are holding and licensing, it can also make a difference in how the asset it recorded on your books. For example, if you are a collector of NFTs, hoping they will appreciate in value, you will record your NFTs as assets on your balance sheet. The same goes if you are minting and holding NFTs. However, if you are minting and selling the NFTs and ownership transfers at time of sale the accounting is very different.
If you are holding NFTs as assets on your balance sheet, how you acquired them can impact the value of that asset on your books. Because each non-fungible token is, by definition, unique, there are no easy to access market rates other than the two data points from the time you bought it and the time you sold it. Because NFTs are digital assets, they fall under the IRS’s guidance that they are intangible assets, and as such are subject to impairment. Meaning, that you will periodically need to write down (impair) your asset to market value. Outside of the most well-known NFTs like Crypto Punks and Bored Apes, it can be difficult to value NFTs to do this impairment exercise. For many companies, this is not a big issue, however, if you need an audit or need to produce GAAP-compliant financials you may need to do this.
How NFT Accountants Can Optimize Your Revenue Model
We’ve seen some pretty complicated revenue contracts when it comes to NFTs. Just because there is an immutable record on the blockchain, and you’ve received payment, doesn’t mean that the accounting is flowing as easily. It is critical your accounting for NFTs matches what is happening on the blockchain. Your accounting team needs to understand your contractual obligations so that revenue shares, royalties, and commissions are properly calculated, distributed, and accounted for.
It may seem easy to pull in transactions from wallets and exchanges into a crypto ledger system- just hook up the API and off you go, right? Not always. We find that how you pull that information into the ledgers and code it can make a difference. With a little extra thought and design, you can maximize the information coming out of each transaction. Many companies short-change themselves and forego critical information when they batch feed transactions into their accounting system. A simple example is recording only the net proceeds of a transaction and what lands in your wallet as revenue. By only recording the net, you give up valuable information that, with a little extra effort or programming, can yield some pretty interesting insights. You’ll be able to see lifetime value of assets, of clients and of product lines in addition to keeping an eye on trends and margins.
In addition, your accounting team, when they are properly engaged with the leadership team, can help design the way revenue flows into the various wallets and exchanges to provide an audit trail and also a way to validate you are receiving all the revenue royalties, licensing fees, etc from your NFT.
How you account for NFT expenses can affect your taxes
When it comes to expenses for NFTs there are two tax treatments. You can either capitalize them–meaning incorporate them into the acquisition cost of the asset– or expense them, like normal business expenses. Unfortunately, you don’t get to arbitrarily choose which way you account for expenses with NFTs. Just like the way NFTs are treated differently based on your business model and ownership transfer, the treatment of expenses related to NFTs also falls into different categories. If you purchase an NFT, the purchase price of that asset will get recorded on your balance sheet including any costs associated with the acquisition. This can include but not limited to any gas or transaction fees. If you are creating NFTs for sale, those gas and transaction fees, as well as any direct costs to produce the NFT would be expensed right away as Cost of Good Sold on your Profit & Loss Statement. Ensuring you have the right crypto accounting system for your NFTs is critical to accurately capture the transactions and ensure the accounting treatment is correct. While there are many different models for NFTs, understanding the accounting for NFT expenses will ensure you have a good picture of the profitability of your project and also that assets on your balance sheet are accurate.
What are the secondary market potential, ownerships and restrictions of your NFT?
With the sheer potential volume of secondary market transactions, ensuring your accounting team understands the post-sale revenue models is critical for both ensuring that your contracts are executing, and expected revenue is being received. A good accounting process for royalties, commissions, sales, licensing or any other post-sale revenue streams acts as a secondary audit/ reconciliation to ensure you are getting paid what you are owed.
Will You Owe Sales Tax on NFTs?
While we don’t believe any states have explicitly included NFTs in their definition of digital assets that are subject to sales tax, we don’t think it is far off from becoming a reality once states understand the volume of sales happening in this space. Sales tax can be a very big challenge to maintain and file in normal non-crypto businesses. Add the complexity of the anonymous and global aspects of crypto– determining the location of your buyer to calculate sales tax is even more challenging. While there are some technologies that help you file sales tax, another, bigger challenge is that if you file sales tax in a state, sometimes it creates nexus, meaning you have to register and file not only sales tax but income taxes in that state as well. Sales tax could be a big issue in the near future, so it is important to consult with your tax advisor on your potential liability.
In our experience, very few NFT companies have the same exact model. With that uniqueness, comes different complexities and challenges. Ensuring that your accounting team is keeping lock-step with your leadership team as new offerings are developed is critical. Well-designed accounting processes are critical to ensuring you both minimize taxes and have an auditable way to ensure you are capturing all the revenue you are owed.