Look-through analysis.

Clinton Donnelly, president and founder of CryptoTaxAudit, and Andrew B. Gordon, CPA, Esq., and Managing Partner of Gordon Law Group, recently discussed the IRS's proposal of a look-through analysis for Non-Fungible Tokens (NFTs) and the potential impact on taxation. The IRS aims to classify NFTs as collectibles based on the underlying assets or rights connected to them. Although the concept seems straightforward, as the conversation unfolds, it becomes evident that implementing the look-through rule presents a myriad of challenges, particularly concerning digital art and in-game NFTs.

Understanding the look-through analysis.

The look-through analysis involves examining the underlying asset or right of an NFT to determine if it meets the criteria for classification as a collectible. This approach seems logical in principle, but when applied practically, it introduces complexities that may hinder proper tax reporting and compliance. Andrew pointed out that digital art ownership rights can vary significantly in the real world, leading to difficulties in straightforward classification.

Challenges and compliance issues.

The proposed look-through rule can potentially lead to confusion and complicate tax reporting for NFT projects. Many crypto investors and traders are already struggling to report their holdings accurately, and the addition of this rule only adds another layer of complexity, necessitating the assistance of tax professionals. Furthermore, existing software may not differentiate between collectible and non-collectible assets, requiring additional tracking and reporting measures.

The burden on tax preparers.

The look-through analysis places a significant burden on tax preparers, requiring them to determine whether an NFT qualifies as a collectible. This raises questions about whether preparers should trust clients' declarations or educate them on collectible definitions. The uncertainty and ambiguity in the tax code, especially concerning art's definition, can lead to widespread frustration among taxpayers and preparers alike.

The juice isn't worth the squeeze.

Both Clinton and Andrew expressed skepticism about the necessity and effectiveness of the proposed rule. They questioned whether the enforcement of this rule would yield meaningful results in closing the tax gap, considering the complexities it introduces. Instead, they argued that the focus should be on ensuring proper reporting of NFTs rather than implementing vague and complicated rules.

Conclusion.

The look-through analysis for NFTs presents significant challenges and potential compliance issues for crypto investors and tax preparers. While the IRS may be seeking to address certain tax evasion concerns, the proposed rule's complexity raises doubts about its effectiveness. The priority should be on providing clearer guidelines and reporting requirements for NFTs, allowing taxpayers and preparers to navigate the tax landscape more confidently and accurately.

The full interview.

View the full interview on The Clinton Donnelly Show.