by GERRY W. BEYER
Your client may own non-fungible tokens (NFTs) and ask you for estate planning advice. Would you be caught off-guard and give your client the classic “deer in the headlights” look? Obviously, that would not be prudent. To make sure this doesn’t happen to you, this article uses a FAQ approach to provide you with the background and information you need so that you will understand NFTs and how to give your client sage advice on how to handle them during the client’s lifetime and upon death.
- What is a non-fungible token?
A non-fungible token (NFT) is an electronic asset that is uniquely identified. It is non-fungible meaning that each NFT is distinguishable from all other NFTs; no two are the same like snowflakes. It is a digital token rather than a physical token like a casino chip or a coupon. By comparison, cryptocurrency like Bitcoins are fungible tokens in that every Bitcoin is the same as every other Bitcoin.
- What do NFTs represent?
NFTs may represent photographs, videos, music, artwork, on-line gaming content, tweets, and other types of digital files. They are electronic representations (tokens) of this property compared to a physical token like a casino chip that represents a specific number of physical dollars.
Unless specifically included, the NFT does not encompass the underlying intellectual property such as the copyright for the work the NFT represents.
- Where are NFTs stored?
NFTs are stored on a blockchain that certifies that the digital asset is unique and not interchangeable with another asset. A blockchain is a distributed database often referred to as the ledger, that is, a list of transactions and their details such as the date and time of the transaction, which is held by individuals who agree to share the database with all other users of the same database. The database is then continuously updated and synchronized. This results in all users having the complete record of the NFT transactions instead of having only one central computer or entity that processes all transactions. Each transaction or block is added to the chain along with a timestamp and link to the previous block. These transactions immediately revise all of the other copies of the database. This results in a record that is virtually impossible to hack.
- How does a person create an NFT?
The creation process of an NFT is called “minting.” NFTs are minted on a blockchain in a similar manner to cryptocurrency. Currently, Ethereum is the most popular platform but other platforms may also be used. The creator such as an artist, performer, or author links the NFT to the specific item of digital property that it represents. To enhance the value of an NFT, the creator may promise to limit the number of NFTs created. For example, the creator may decide to make only one NFT that represents the digital property or limit creation to a specified limited number (e.g., a series of ten so purchasers would own 1 of 10, 2 of 10, etc.). The minting process is described in more detail in a later FAQ.
- Why does a person create an NFT?
A person creates an NFT in the hopes of selling the NFT to make a profit. Each NFT is unique; no two NFTs are the same. They may not be copied. The name of an owner of an NFT is part of the public blockchain record and thus anyone can verify ownership. NFT creators may sell their work on a global market as well as retain the right to receive royalties each time the NFT is sold by using smart contract technology.
- I still am confused. Are there old-school analogies that may help me understand NFTs?
Yes. NFTs are digital counterparts of physical autographs, baseball cards, stamps, coins, comic books, artworks, and other similar collectible items.
- What is the value of an NFT?
The value of an NFT depends on market forces (supply and demand) because the NFT has no intrinsic value just like other collectible items. For example, one baseball card may have significant value because it is scarce and highly sought after by collectors while another card has little or no value because a huge number of the cards are available or the person depicted is not famous.
- What are some examples of notable NFTs?
- The NFT of Beeple’s (Mike Winkelmann) Everydays: The First 5000 Days, a collage of 5,000 individual pieces created over a 13-year period, sold for $69,346,250 by Christie’s on March 11, 2021. This is said to be the most expensive NFT ever sold and the first by a major auction house. See Jacob Kastrenakes, Beeple Sold an NFT for $69 Million, The Verge (Mar. 11, 2021).
- In the on-line game CryptoKitties, a digital cat sold for $172,000. The game is designed for players to buy, trade, and breed the digital cats. However, the cost is rarely this high. In 2018, the average price paid for a CryptoKitty was $60 with the median price being $9. See Mark Serrels, Someone Just Bought a Cryptocurrency Cat for $172,000, CNet (Sept. 4, 2018).
- An NFT entitled Lebron James: Dunk From the Top sold for $208,000. See Elizabeth Lopatto, Top Shot is Playing the Long Game in the NFT Craze, The Verge (Mar. 30, 2021).
- Major League Baseball sold a digital copy of Lou Gehrig’s Luckiest Man speech for $70,400 on July 4, 2021. See Kenneth Rapoza, MLB Goes All In On NFTs With Lou Gehrig, Now LA Dodgers Art. Why is This Still a Thing?, Forbes (July 12, 2021).
- The swag bag at the recent Oscars included an NFT of Chadwick Boseman, the actor who portrayed the Marvel superhero Black Panther. See Nancy Dillon, Chadwick Boseman Gets NFT Tribute in Oscar Nominee Swag Bags, NY Daily News (Apr. 25, 2021).
- An NFT of the first tweet by Jack Dorsey, the co-founder of Twitter, sold for $2.9 million. See Taylor Locke, Jack Dorsey Sells His First Tweet Ever as an NFT for Over $2.9 Million, CNBC (Mar. 22, 2021) (The tweet says, “just setting up my twttr,” and was posted on March 21, 2006).
- Other than collectibles, what are some other possible uses of NFTs?
NFTs could be used to secure and authenticate physical assets, both personal and real property. For example, Nike has patented a system for using NFTs to protect against counterfeit shoes so subsequent purchasers of high-end sneakers would be certain of their shoes’ authenticity. See Hilary George-Parkin, How Nike’s Likely NFT Move Could Shake Up the Sneaker Resale Market, Footwearnews.com (Apr. 16, 2021).
There is also speculation that NFTs could operate as a highly secure method of transferring title to real property and to store electronic wills and other estate planning documents.
- How do NFT owners store and access their NFTs?
NFTs reside in digital “wallets” that can be stored in many different ways such as on an exchange accessed over the Internet, software on a computer, tablet, or cell phone, or on a dedicated flash drive. To be able to retrieve an NFT and transfer it, the person must have the private key or the seed phrase, that is, a list of random words (typically 12, 18 or 24 words) which allows the person to recover the wallet containing the NFT. A seed phrase would look something like this “warlock implode lawyer drink love close cactus river street double water most.” These words are tied to the private key through a complex computation process. The seed phrase needs to be kept secure at all times. Otherwise, anyone with knowledge of the phrase could access the NFT. If the wallet resides on a commercial platform, the NFT may be accessible by a person who knows the user name, password, answers to security questions, and has the ability to satisfy other verification steps.
- What is the first step I need to take regarding NFTs when working with an estate planning client?
It is essential for you to determine if your client owns or intends to purchase NFTs. You should include a question on your client intake questionnaire or in your initial client interview. If you do not know your client owns NFTs, you will not be able to help your client plan for them properly.
- What type of records should a client keep about NFTs?
The client must keep careful records of the price paid for each NFT and the price for which it is sold so that the correct amount of capital gain or loss is reported for tax purposes.
- Is there a special concern if the client purchases an NFT with cryptocurrency?
Yes. Many clients will purchase NFTs with cryptocurrency rather than traditional money which will lead to an additional concern. Cryptocurrency is property, not money. See I.R.S. Notice 2014-21. Thus, if a client uses cryptocurrency to purchase an NFT, a capital gain or loss will occur based on the price the client paid for the cryptocurrency that the client used to purchase the NFT. This gain or loss must be reported for tax purposes.
- Should the client consider holding NFTs in a business entity?
Yes. The client may wish to hold the NFT in an entity such as a limited liability company (LLC). Potential advantages include (1) the ease of transfer of LLC interests compared to transferring the NFT itself which requires a blockchain transaction, (2) transfer tax discounts may be possible as the LLC interests may be minority in nature or there may be a lack of marketability, and (3) asset protection. See Joshua Caswell & Leigh E. Furtado, NFTs for Estate Planners, Not Just a Token Concern, Prob. & Prop., Sept./Oct. 2021, at 10, 13.
- How should the client protect the information needed to access NFTs?
The private key or seed phrase required to access the digital wallet in which the NFT is stored must be protected while the client is alive and then transferred to the beneficiary upon the client’s death. Just like cryptocurrency, without the means of accessing the NFT, it will be lost forever. Some clients elect to keep this information in their safe deposit boxes in old-school written form or on a flash drive or other digital media which may also be encrypted to add another layer of protection. Others will engrave the information on a metal plate to assure it will survive fires, floods, hurricanes, tornadoes, earthquakes, and other disasters. Some people will use complex methods such as dividing the seed phrase into sections and storing them in different places so that only by bringing them all together like the Infinity Stones can the NFT be accessed. An even more sophisticated method is Shamir Secret Sharing where an algorithm is used to divide the seed phrase into multiple seeds (e.g., five) and the client indicates how many (e.g., 3) need to come together to create the entire seed phrase. See Sidd, The Ultimate Guide to Safe Seed Phrase Storage, http://whatismoney.info (last visited Nov. 14, 2021).
- How should a client’s will address NFTs?
The client may make a specific gift of individual NFTs or a general gift of all NFTs the client owns. If NFTs are not specifically mentioned, they will pass under the will’s residuary clause. As discussed previously, it is important to provide a method of transferring the NFT access information to the beneficiary outside of the will. Access information should not be included in the will because it becomes a public document once filed for probate.
If the client’s NFT collection is extensive, the client may wish to consider appointing a separate “digital executor” who has the responsibility of dealing with digital assets for the benefit of the client’s estate. Even if a separate person is not appointed, the client may wish to direct the executor to hire a person with the skills needed to prudently manage NFTs.
- I am a personal representative of a decedent’s estate. Can I access the decedent’s NFTs?
Yes, a personal representative has the authority to access NFTs under the Revised Uniform Fiduciary Access to Digital Assets Act which has been enacted in almost all states. However, the authority to access NFTs is worthless unless the personal representative has the access information.
- I am a personal representative of a decedent’s estate. Is there anything special regarding NFTs about which I should be immediately concerned?
Yes, you should document the value of the NFT as of the date of the decedent’s death. The beneficiaries who receive NFTs are entitled to a step-up in basis to the value of NFT as of the date of the decedent’s death rather than the decedent’s basis. I.R.C. § 1014. If the NFT has increased in value since the time of purchase, being able to document the date of death value will reduce the amount of capital gains taxes owed when the beneficiary sells the NFT.
- I am a trustee. Can I retain NFTs in a trust or invest in NFTs?
In almost all states, a trustee is bound by the prudent investor standard, that is, investment decisions must be made “in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” The value of NFTs is extremely volatile and would likely be considered too risky of an investment for a prudent investor. Accordingly, a trustee should be very hesitant to retain or invest in NFTs without express permission from the settlor in the trust instrument, a written release by all beneficiaries, or authorization in a valid court order.
- Are there any religious-based considerations I need to keep in mind with respect to NFTs?
Yes. Some religions may frown upon its members investing in cryptocurrency and perhaps NFTs as well. For example, at least one Islamic council ruled that using Bitcoin and other cryptocurrencies as a means of payment is unlawful under Islamic law because they are deemed gambling due to the price volatility. See Indonesian Islamic body forbids crypto as currency, CNN.Com (Nov. 11, 2021).
- If I plan on advising clients about NFTs, is there anything else you would recommend that I do?
Yes, I recommend that you create a digital wallet and create an NFT. You will learn a great deal by going through the process yourself and then you will not be like a marriage counselor who has never been married giving advice on how to maintain a successful marriage.
- Here are the basic steps you can take:
- Locate a website or application that streamlines the NFT minting process considering the ease of use and the cost (referred to as gas) you will pay to compensate for the computing energy needed to process and validate the NFT transaction. (I used https://www.Mintable.app.) Create an account with a user name and password. Note that most apps link to the most popular NFT blockchain, Ethereum. Many of these platforms will walk you through the process described below in a step-by-step manner.
- If you do not already have a digital wallet in which you can store NFTs, create one and obtain the seed phrase. (I used https://MetaMask.io which you can access on your computer or via a phone app.)
- Link the app to the digital wallet using an extension to your Internet browser or smartphone app.
- Take and save a picture on your computer or phone of something you think is interesting, e.g., your office, favorite pet, a selfie, the view out your window, etc.
- Follow the steps in the app to upload the picture and mint an NFT linked to the picture.
- You can either keep the NFT in your wallet, transfer it to someone else’s wallet, or list it for sale at a fixed price or as an auction item.
- If my client mints NFTs, are there any additional special warnings I should provide the client?
Yes, the client needs to be leery of creating NFTs that link to copyrighted work without permission of the copyright holder. “[U]nder U.S. copyright law, the creator retains exclusive rights to reproduce and distribute copies of, make derivatives of, and publicly perform and display the copyrighted work.” Richard Acello, Big Money, ABA J., Oct./Nov. 2021, at 25, 26. Thus, a client should not mint an NFT that is linked to copyrighted property such as songs, videos, and artwork.
- What are some future issues I may be asked to address about NFTs?
There are several potential issues regarding NFTs beyond those already mentioned that may cause concern in the future. Once example is whether NFTs could be subject to federal security laws. Another example is whether NFTs are commodities so that they would be subject to regulation by the Commodity Futures Trading Commission. See Richard Acello, Big Money, ABA J., Oct./Nov. 2021, at 25, 26.
© 2021 Gerry W. Beyer