You may have heard a LOT about “NFTs”, or non-fungible tokens, recently. The buzz around NFTs reached a crescendo on March 11, when Beeple’s digital artwork with a unique NFT sold in a Christie’s digital auction for over $69 million.  Basketball fans are trading digital highlights in NFT form in an online marketplace. Charmin is even getting in on the NFT-craze, selling unique toilet-paper inspired digital artwork to raise money for Direct Relief.

Given the amount of money swirling around NFTs and the digital art world, nonprofits and their benefactors have started to consider how to leverage the new technology for charitable ends. With any new technology come questions and in this article I will try to cover some considerations for nonprofits that are getting into the NFT-craze.

The Basics – What Are NFTs?
NFTs (non-fungible tokens) are a fully-digital method of proving ownership of an asset. Most assets associated with NFTs are digital assets, but NFTs could be implemented with physical assets as well. In the same way that a unique piece of art might come with a certificate of authenticity and history of ownership, NFTs use a technology that was originally developed in connection with virtual currency (called blockchain) to record and track ownership. Blockchain uses cryptography to validate transactions, making the system relatively secure. Blockchains can be private or public, depending on the use case, and NFTs are mostly stored on a public-based blockchain associated with the cryptocurrency Ethereum.

Almost anything digital can be ascribed an NFT. A tweet can be given an NFT and sold. The rights to music can be sold using an NFT.  Uses for NFTs, and the underlying blockchain, are seemingly endless – anything that involves tracking custody, ownership, or use could make use of NFTs and blockchain.  Whether or not businesses and consumers will want to buy, sell, and store an asset’s ownership records digitally on the blockchain is a different question – while cryptocurrency and blockchain supporters have been touting the technologies for over a decade, blockchain and NFTs have only gone mainstream publicly in the past few months.

Some people question the value of some NFT assets – who really wants to own the rights to an NBA highlight that is available on YouTube for free? Apparently a lot of people (at the time of writing, a Lebron James dunk is listed at $250,000 – it is a very good dunk). The original Mona Lisa painting is extremely valuable, whose worth isn’t decreased by additional prints being sold or versions being viewable for free online. Ownership is key to the asset’s value, whether we’re talking about a physical painting or a digital highlight.

NFTs and Charities – Similar to Auctions of Traditional Art
When an NFT is auctioned to benefit charity, it is deeply analogous to a traditional art auction (a topic I discussed in another post). If the artist or collector who donates a piece of digital art for sale at a charity auction wants to receive a charitable deduction, they may need to get an appraisal. The charity will need to be careful to keep records related to the donation and valuation of the asset. Prospective bidders should be told what the value of the item is, assuming a reasonable value can be determined. And winning bidders must be given a receipt which describes how much of the amount paid exceeds the fair market value of the item, if any.

Valuation of NFT-assets will be an extremely nuanced part of the charity auction process because the market for NFTs is so new and valuations fluctuate wildly. As an example, last year Beeple “dropped” artwork on an NFT marketplace that was resold. Between October 30 2020 and January 9, 2021, a piece that sold for $1 was resold 10 times and increased in value to $7000. Any artist, donor, or charity that places a valuation on donated digital artwork or other NFT-assets should consult with experts to document the valuation appropriately and ensure that everything is properly recorded and filed.

NFTS and Charities – New Platforms and New Problems
When Beeple’s Christie’s auction concluded, the winner paid in cryptocurrency, typical of many of the NFT marketplaces that use the Ethereum-based cryptocurrency Ether. NBA Top Shot, in contrast, will let you sign up with a credit card. As donors and charities work through the various platforms to decide with whom they want to partner to host an NFT auction, they need to consider what methods of payment are available and who their target audience will be. If the pool of potential bidders is Beeple-crazed crypto-enthusiasts, an NFT platform that requires Ether will probably work just fine. If, on the other hand, a charity wants to engage its traditional donor-base, it may want to find an auction platform that can receive traditional payments.

If the auction invites bids in cryptocurrency, the charity also needs to think through whether to hold that currency or convert it into fiat currency immediately upon receipt. Many charities, in the wake of the cryptocurrency boom of 2017, developed policies related to holding cryptocurrency – typically, the currencies were liquidated immediately upon receipt. Charities should consider crypto as a highly volatile asset, with potentially huge upsides and downsides. Most charities hold minimal amounts of crypto and only as part of a comprehensive, diversified investment strategy.

If the charity expects an auction to generate a lot of interest and a lot of funding, the charity needs to do some due diligence on the platform with whom they plan to work. With the interest in NFTs surging, so are the numbers of outlets that claim to support NFT marketplaces. If a charity wants to partner with a relatively new platform, the charity should vet the platform to make sure it is capable of performing – that it can host the auction, accept the payments, and deliver the winnings to the charity. Charities should make sure their agreement with the platform is crystal clear in terms of fees, timing, and the risk of loss if something should happen to an asset. Charities need to work with the platforms to make sure disclosures to bidders and donors are very clear on how the auction or donation will work – some states have begun to consider required disclosures for fundraising platforms, which can serve as a guide for charities and platforms.

Finally, some platforms that are operating in the NFT, blockchain, and cryptocurrency spaces may be subject to regulation as money transmitters, payment processors, or financial institutions. If a charity plans to store its assets with a platform that provides payment processing services, the charity should confirm that the platform is appropriately registered or is exempt from regulation.

Art Charities and NFTs
Similar to the concerns outlined above about vetting platforms, if an art-based charity wishes to accept a donation of NFT artwork to retain as part of its collection, the charity needs to work through the many issues around accepting and storing NFT artwork. Review the terms and conditions of any third-party platform involved in hosting or displaying the artwork. Work with the artist or collector to confirm details around the transfer, valuation, receipt, and the costs associated with the transfer on the network. Many of the tax rules governing NFT-art donations will be identical to those applicable to donations of physical art.

International Concerns
One of the appealing aspects of NFTs and blockchain is that transactions are borderless and frictionless. A digital marketplace based in ether cryptocurrency can receive payment without worrying about converting currency; there are no costs for shipping and the purchases can be delivered instantaneously. A charity that is considering receiving digital payments, selling digital goods, or transferring digital assets using NFTs or cryptocurrency has to be conscious of the risks associated with international transfers. The U.S. Department of the Treasury’s Office of Foreign Asset Control has published some guidance for charities working internationally, both in the context of specific countries as well as more generally. Charities should be cognizant of the risk posed by receiving large payments from or sending payments to individuals or organizations that are overseas and may only be known as a username or Ethereum address. Charities should work with their advisors to ensure they are taking reasonable precautions to avoid the legal and reputational trouble that could arise if the charity does business with disreputable donors or recipients. Additionally, the platforms dealing in NFTs and online fundraising may also have “Know Your Customer” requirements – charities should check with the platform that they are compliant with any applicable rules.

Other Compliance
Whether a nonprofit holds an auction online or in person, selling digital or physical art, there are traditional fundraising compliance considerations that will apply. Depending on the state in which the nonprofit is operating, the nonprofit may be required to register (my colleague Tracy Boak has a great article discussing charitable fundraising regulation). Depending on the nature of the items sold and where buyers are located, there may be sales tax considerations. Charities should check with their advisers to confirm they have considered all legal aspects of online fundraising compliance.

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In launching such an organization beyond its native borders, NGOs often find themselves in cloudy legal waters.   The primary issue when establishing a US presence centers on the amount of control the foreign parent can exercise over the newly formed US entity.  What can prevent the American fledgling from running rogue, ignoring the mandate of the parent charity, and possibly even harming the foreign NGO’s reputation?  What can prevent the US organization from spending the funds it raises in a way that defies the parent NGOs wishes?    The following is a brief illustration of some of the ways to solve or at least mitigate these concerns.

Foreign NGO’s control over affiliated US entities

Foreign NGOs often find that the United States is fertile ground for fundraising, research and other activities related to its purposes.  When they seek to raise funds here, they want American taxpayers to receive a tax deduction for their donations.  To do so, NGOs often establish what is commonly referred to as a “Friends of” organization, taken from the common use of the wording “friends of” in the organization’s name, such as American Friends of the Louvre or American Friends of Bucerius.  Typically, the parent organization tries to retain as much control over the US counterpart as possible  to ensure compliance with the foreign entity’s charitable goals.

Of utmost significance to this “control issue” is the IRS mandate that in order for donations from Americans to be tax-deductible, the US entity receiving the donations cannot be organized and operated solely as a “conduit” to solicit earmarked funds on behalf of a pre-existing foreign entity. If the IRS determines that the US charity is such a conduit, it will disregard the US charity in determining the deductibility of donations and rely on the tax status of the end recipient of the funds.  If the recipient is not tax- exempt as is the case with the majority of foreign NGOs, then there is no tax deduction to the donor.  Furthermore, the IRS can rescind the tax-exempt status of a US Friends of Organization if it finds that its sole purpose is to raise and transmit funds to a non-exempt entity.

To avoid being deemed a conduit, the US “friends of” organization must maintain discretion and control over the funds solicited within the United States.  It may be that the US organization primarily directs its funds to support the foreign institution, and may even disperse all grants to it. But to avoid conduit status, all funding decisions must be made on a per-grant or per-project basis by the US charity, and cannot be explicitly promised or committed to the foreign institution as part of the organization’s legal structure. In other words, the US organization must have the right to say no to the foreign parent.

With this in mind, there are a variety of ways in which to structure the legal relationship between a foreign institution and its American offshoot in order to retain some form of control such that it preserves the tax deduction for US donors.

Governance and Bylaws

In my experience, the optimum way to achieve this goal is through the US charity’s bylaws.   The bylaws name the foreign NGO as the sole member of the US charity with the right to appoint and remove all directors at will.  These appointed directors may or may not be persons on the foreign entity’s own board.  This structure allows the NGO to replace directors if they are not fulfilling their charitable purpose[1] or if they are harming the reputation of the foreign NGO. Hopefully, if they do have to be replaced, the new directors uphold and protect the parent’s vision[2].

Use of Trademarks

If the NGO has used the name of the US charity in interstate commerce, it can register the name as a trademark in the US.  Usually, this is possible when a NGO has been fundraising or conducting other activities in the US prior to forming the American entity.  If the NGO qualifies for trademark protection, it can then license the name to the US organization. The terms of the license can include requirements to support the charitable programs and maintain the NGO’s reputation.

In the event of a breach of the agreement, the NGO can subsequently disallow the US charity from using the name.   While the US charity will remain a tax-exempt entity, it will be required to change its name which could have serious adverse effects.  This action frees the NGO to start another charity and license the trademarked name to it. [3]

Affiliation Agreements

Many US charities and foreign entities draft “affiliation” agreements to limit the activities of the US charity.  While these agreements can be enforceable, they must give the US charity enough discretion over its operations and funds to avoid being deemed a conduit by the IRS, thus resulting in the loss of tax exemption and/or the disallowance of tax deduction to donors. The agreements must be carefully tailored as it is possible that the cumulative control the NGO retains can tip the scales into making the US charity a “conduit” when the separate provisions of the agreement will not.

There are hundreds of foreign NGOs which have established US charities to support the their goals and further their missions. To do so successfully, it’s wise to establish a solid foundation that will help the organization to continue to raise tax deductible donations in the United States.

[1]NGO should not replace directors if the organization fails to give money to the foreign entity. This could be considered an abuse of control and could lead to a loss of the US entitiy’s tax exemption.

[2] It should be noted that if the US charity is required to produce audited financial statements (e.g., when registering to solicit in certain states) this type of control will require the NGO and the US charity to issue consolidated financial statements. If required, it would create additional work for the foreign NGO’s auditors.

[3] THE NGO and the new charity must be transparent with any donors, vendors and other interested parties. Notice should be given that the new US entity is not affiliated with the old US entity that is barred from using the name.

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