Creating and hosting an NFT drop is exciting. There’s nothing better for a creator or artist than sharing your creative work with the world.
At the same time, your NFT drop is full of legal landmines and financial exposure. In fact, I can’t think of a time in my 35 years of practicing law when I’ve observed so much potential exposure to claims and lawsuits. Over the next year or two, I expect many creators to have their personal assets like bank accounts, home equity, and retirement plans seized by judgment creditors because of the business liability side to NFTs.
One way to minimize and, in some cases, completely avoid exposing your personal assets to very real NFT business liabilities is to use corporate entities. Established legal tools like corporations and limited liability companies are proven ways to keep your business liability issues away from your personal assets and life. When used correctly, corporate entities also allow you to maximize tax deductions while minimizing end-of-year tax consequences.
Before I dive into this article, please know that no legal or financial advice is being given. Full disclaimer incorporated here. If you have questions, you should reach out to a qualified lawyer in your state or country. Now let’s get started.
Step #1: Create Your Legal Entity
If you’re doing business online, and this includes minting, selling, buying, and investing in NFTs, the first thing you want to do is create a corporation or limited liability company. Let’s call your business the XYZ Corporation.
Your choice of the specific type of entity (c-corp, s-corp, LLC, DAO, and others) depends on the state you’re doing business in, the kind of business you have, and the goals you have as a business. Over the years, I’ve provided legal advice and help to over 200 startups at different stages of the process. I can report, without exception, that every single successful startup began or quickly transitioned to doing business as a legal entity. The best time to create your legal entity is at the beginning of your journey. The second best time is now.
Step #2: Create Your First NFT Project*
When your company, the XYZ Corporation, is ready to start creating an NFT project for your first drop, your company (not you) will create a second legal entity. As an example, let’s call the second legal entity ABC Corporation. Everything done around this first NFT creation and drop is done through the ABC Corporation.
This second business entity will be the company that contracts with third parties for design, marketing, branding, and hosting platforms. The ABC Corporation will be the entity that sets up the related discord, Twitter Spaces, digital wallet, and hosting account needs. Everything about this first NFT drop is done by the ABC Corporation.
The relationship between your main company (XYZ Corporation) and your second company (ABC Corporation) is documented using written agreements. With proper legal advice, business structures, and tax planning, additional tax benefits through new business expenses and deductions available only to corporate entities can be created and maximized.
Step #3: Creating Your Second NFT Project
Just like you did with the first drop, the XYZ Corporation will create a separate new legal entity. As an example, it might be called the DEF Corporation. You coordinate and finance this second drop entirely through the second business entity following the same approach. When done, this is how things may look:
Advantages of Using These Approaches
The advantages of handling your NFT drops and projects this way are as follows:
-You’re not personally involved in the NFT drop. Your personal assets are not part of each NFT project and drop.
-You’re leveraging the power of having what’s called a “corporate veil” protect you. This is a legal concept that separates an individual from being personally liable for the corporation’s debts and other obligations. If a claim or lawsuit relating to fraud, or breach of contract (in good or bad faith) is brought against your NFT project, it stops at your business entity and does not flow over into your private life. This assumes you’re doing everything you are supposed to do as a business, and I shared a few tips below, allowing you to do things the right way. Learn more about a corporate veil here.
-You may be able to create new corporate business deductions and write-offs, allowing you to minimize taxes and maximize end-of-year profits. Note that some of these entities provide you with the legal protection I mentioned while allowing for pass-through tax treatment (you’re not taxed twice as both a corporation and also as an individual).
-If your business model involves the possibility of acquiring venture capital or an exit sale to investors, you will be taken more seriously as a business.
#1: After your NFT project drops, you find out there’s a copyright violation in your NFTs. Using this approach, it would be only the company involved in this particular NFT drop and not any of your other companies or you individually, who would be properly named in a copyright lawsuit. The result is that you have kept your personal assets and other business interests and companies separate from this particular liability issue.
#2: Different NFT drops have different requirements and liability exposure. Not lumping the high-risk SEC types of NFT drops (fractional NFTs that fall under the Howie case) with more traditional and safer NFT drops is just smart business.
While I have your attention, do you know what the Howie case is all about? Well, under the U.S. Supreme Court case SEC v. Howey Co., 328 U.S. 293 (1946), the court gave four factors for determining whether an investment is a security:
#1. Is there an investment in money?
#2. In a common enterprise?
#3. Is there an expectation of profit?
#4. Is the profit expected to be derived from the efforts of a promoter or third party?
My take (remember my disclaimer– this isn’t legal advice) is that the sale of a single NFT may take on the form of a work of art or collectible rather than a security. Having said that, factional NFTs are tokens that represent an interest or fractional ownership of an NFT. The four factors of the Howey test seem to be present in fractional NFTs more so than the sale of a single NFT work of art or collectible.
Looking at how things are done in the real world, most companies dealing with fractionalized art ownership of traditional physical art (yes, this is actually a thing) comply with SEC rules, regulations, and requirements. With this in mind, the safe bet is that many, if not most, fractional NFTs may also be determined to be investments in securities. Learn more about the Howey case here.
Smart players in the NFT sandbox are already using legal entities to help keep these drops separate from their other NFT projects and businesses. Are you?
Several additional things you must wrap your head around, and do, when using business entities are as follows:
-Run your business like a business. Do not commingle your personal affairs with your business activities. Failing to do so may allow a judgment creditor to pierce the protective corporate veil;
-Sign all docs as an officer of your corporation or member of the LLC.;
-Contact your accountant to coordinate obtaining a Tax ID number for your new entity and to determine your annual State and Federal tax reporting requirements;
-Calendar what documents need to be filed each year. If you fail to run a legitimate business, you will not have the protection I mention in this article;
-Open up a checking account in the name of the entity. Do not commingle funds. Keep all financial accounts and transactions separate from all other personal or unrelated business activities;
-Start to establish credit for the entity, obtain one or more credit cards in the entity name only (as opposed to using your name or other businesses);
-To maximize your liability protection, run your entity like a real business. Website, social media, business cards, and letterhead should all reflect your corporate status;
-Set up your digital wallet for each NFT drop using your new corporate entity;
-Create your NFT hosting account relationships as a business entity and not in your name:
-Avoid co-signing as individuals guaranteeing entity debts;
-Keep entity business completely separate from personal or other business interest;
-Make sure that your entity is properly managed and controlled. Changes and modifications all need to be reflected in writing using standard forms;
-Get proper business insurance. Your personal policies may not protect you. This may also include coverage for officers and directors and errors and omissions;
-Incorporate your entity interest into your existing estate planning and business succession plans;
-Stay organized and follow all state and federal reporting rules.
Treat your NFT drops as a business, especially the more significant drops that include fractionalized elements of investing or profit-sharing.
The key to protecting your personal and business assets is creating and using business entities the right way. Partnering with the right lawyer and CPA to create, manage and integrate the interactions of these companies with your NFT drops will allow you to take advantage of the protections and business tax benefits.
Have questions? Consider this as a friendly reminder to find and meet with a qualified lawyer and CPA in your state or area of the world.
PS- Each week I share ideas, solutions and tips, based upon 35 years of practicing law, in my LinkedIn newsletter, “Metaverse, Web3, Law and Tech.”
*If you’re an individual creating a single NFT item now and then, you’re probably OK with doing all of this under a single corporate entity. It’s perhaps a bit of overkill to create the additional sub-entities I mention in this article. For larger drops, especially those involving fractional NFTs, I recommend creating a separate corporate entity for each drop. Again, check with an expert in your state or region of the world.