These answers to frequently asked questions are general guidelines only and do not constitute legal advice.Please consult directly with an attorney for advice that applies to you.
NFTs are exploding in popularity despite relying on a technology many still find confusing and opaque. As with any new technology, NFTs present incredible opportunities for innovation in the world of digital goods. Musicians hope to directly distribute their music to paying fans, artists can sell unique digital prints and the NBA can give fans the ability to “own” the clip of a game-winning three-pointer. However, NFTs are also a wild west rife with the potential for abuse and fraud. Because no court has ruled on an NFT dispute yet, the intellectual property (IP) and contractual issues raised by NFT transactions remain murky. To help explain some of these issues and nuances, Lutzker & Lutzker has created these FAQs.
A. NFT stands for Non-Fungible Token.
A. Famous examples include the first ever Tweet issued by Jack Dorsey, a new song by Snoop Dogg, a collection of digital artworks by the artist Beeple, an article from the New York Times and a series of trading cards created by four-time Super Bowl champion Rob Gronkowski.
A. A token is a very long string of characters that is encrypted so that it cannot be changed. The string of characters is meant to contain all the information about a specific piece of digital content. Importantly, the token is non-replaceable, meaning it is unique and potentially impossible to clone. The token is different from the underlying digital content. Exact copies of the digital content are often available elsewhere on the Internet.
A. A coin is a base unit of cryptocurrency. Much like the U.S. dollar, one coin can be subdivided into many smaller subunits, making it common to see transactions involving a fraction of a coin. For example, a new Tesla vehicle may sell for 1.38 Bitcoin.
A. The blockchain is a public ledger of every transaction made with a specific cryptocurrency. There is a Bitcoin ledger, an Ethereum (ETH) ledger, a Dogecoin ledger, etc. There are as many blockchains as there are cryptocurrencies. Once a transaction is requested using a specific cryptocurrency, say ETH (where NFTs are booming right now), 10,000 computers located across the globe start analyzing the entire ledger to determine if the payor actually possesses the requested amount of ETH coins. If the payor’s ledger history reflects that they do in fact own the requested amount of ETH, the transaction is approved, and the coins are transferred to the payee.
A. When a buyer purchases an NFT, the blockchain records a transaction request showing coins being transferred in exchange for a digital token. If the network approves the transaction, the coins are digitally transferred from buyer to seller. Simultaneously, the token is digitally transferred from seller to buyer via a program called a smart contract.
A. A smart contract is a program that automatically executes when an NFT transaction on the blockchain is approved. The program can contain a variety of parameters, including the digital token, who the token must be transferred to, what rights the new token holder possesses and what rights the seller maintains.
A. No. A smart contract and a legal contract are different. A smart contract is a digital program that enacts a transaction. A legal contract is an agreement between two or more parties creating mutual obligations enforceable by law. Some smart contracts are the only record of a specific transaction. In those cases, it would be useful for the smart contract to be legally binding. Recognizing that fact, Arizona, Nevada, Tennessee and Wyoming have passed legislation making smart contracts legally binding. It is currently unclear if smart contracts would be legally binding in states that have not passed such legislation.
A. In most cases, the only right received is to claim ownership of the token and to exclude others from claiming ownership of the NFT.
A. In most cases, no. Ownership of an NFT does not automatically grant ownership of the underlying content or any associated IP rights. For many NFT transactions the original owner of the digital content maintains the copyright. Accordingly, an NFT buyer may not be permitted to reproduce, distribute copies, publicly perform, display or make derivatives of the original work. However, NFT transactions are potentially capable of transmitting IP rights, meaning a digital content owner is theoretically able to transfer copyright to the NFT buyer. Many sellers simply choose not to transmit the copyright.
A. Maybe. To transfer a copyright interest to a new owner, the seller must do so in writing signed by the copyright owner. It is not clear if courts would find a smart contract written in a coding language to be a piece of writing that can convey copyright interests, and how a copyright owner could “sign” the smart contract. NFT buyers who engage in transactions that purport to sell the IP rights to the digital asset are advised to exercise extreme caution, as the IP transfer may not be legally enforceable.
A. Maybe. While the terms of the smart contract are legally binding in states that have passed legislation on the subject, the transfer of copyright requires a signature. It is still unclear how a court would rule on the validity of a digital signature in the smart contract.
A. You have the right to claim ownership of the NFT.
A. Yes. A smart contract on the Ethereum blockchain can ensure that a musician receives a percentage of all future sales of that token. Importantly, it is often impossible to stop a person from downloading the audio file of the song and distributing it for free. This means the distribution of the underlying song may not generate revenue, but future sales of the NFT will.
A. Yes, but caution is advised. An NFT is a unique and impossible to duplicate string of characters. If the buyer can ensure that the NFT seller is the legitimate owner of the underlying digital content, the NFT can serve as digital provenance. The tricky part is ensuring that the seller is legitimate. Transaction on the blockchain can be conducted with complete anonymity, so it is best to exercise discretion and care when purchasing NFTs.
A. Yes. The IRS considers any crypto-for-crypto exchange taxable. This includes purchasing an NFT with cryptocurrency, trading one NFT for a different NFT and selling an NFT for cryptocurrency.
A. Mostly capital gains taxes. For example, if you purchased an NFT for 2 Ethereum Coin (ETH) when ETH was $1,000 (for a total purchase price of $2,000), but later sold it for 2 ETH when ETH was $2,000 (for a total sales price of $4,000), you would recognize a gain of $2,000. You would owe the IRS capital gains taxes on that $2,000. If a seller derives income from the sale of NFTs, they may need to pay income tax on these transactions. It would be best to consult with a tax professional to determine if income tax applies to an individual seller.
A. No. There are currently no licensing requirements for buying or selling NFTs.