As cryptocurrencies like BitCoin, LiteCoin, and Ripple increase in circulation and longevity, estate planning attorneys are likely to see more clients acquiring these assets and incorporating them into their estate plans. As interest in cryptocurrencies has increased, the IRS is paying more attention to these kinds of assets. For example, just last year, a popular cryptocurrency exchange called Coinbase was court-ordered to release transaction information on approximately 13,000 of its users to the IRS, indicating that the IRS is beginning to monitor cryptocurrency transactions closely. Ryan Derousseau, The IRS Is Coming for Your Cryptocurrency Profits, Money Time (2018).
Although there is little authority on the tax treatment of cryptocurrency to date, attorneys should be aware of the ins and outs of this specialized property in order to create the best estate plans for clients holding cryptocurrency and properly administer the estates of deceased clients who owned cryptocurrency at their death.
What is Cryptocurrency?
Although over 1,000 different versions of cryptocurrencies exist, the essential hallmarks remain the same for nearly all of them. All Cryptocurrencies, Coinmarketcap.com (2018), https://bit.ly/2deiFHU. At its core, a cryptocurrency is a digital currency that uses blockchain technology to create a decentralized, immutable, public digital ledger. Cryptocurrencies are available only in digital form, which means that in order to use a cryptocurrency one must have access to a computer or smartphone device. The blockchain is a “digital ledger that is shared across a decentralized network of independent computers, which update and maintain it in a way that allows anyone to prove the record is complete and uncorrupted.” Michael J. Casey & Paul Vigna, The Truth Machine: The Blockchain and the Future of Everything (2018). Using this digital ledger, individuals can earn, purchase, and sell digital currency, or “cryptocurrency,” through a network of independent computers that track all of the payments through complex algorithms.
Transfers of cryptocurrency are accomplished through the blockchain technology. The transferor enters the transferee’s public address where the transferee will receive the cryptocurrency, along with the transfer amount and an optional note into the digital ledger. Once those pieces of information are entered, the transferor simply needs to press “send,” and the decentralized network of independent computers will validate the transfer. The transferee need not to do anything besides share his public address. Once the transfer is validated, the ledger is updated to reflect that the transfer has been made. No other documentation is required for the transfer to be complete.
Although cryptocurrency can be treated under various laws like conventional fiat currency (i.e., cash), the IRS’s current position is to treat cryptocurrency as property and not currency for tax purposes. US Dept. of the Treasury, Internal Revenue Service Notice 2014-21, Washington: GPO (2014), https://bit.ly/220DnKP. In a 2014 notice (Notice 2014-21), to date the most comprehensive guidance from the IRS on cryptocurrency tax issues, the IRS stated that “[f]or federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.” Id. As a result, when creating an estate plan or administering an estate, it is important to view any cryptocurrency in an estate as property rather than currency. Among other things, this means that the transfer of cryptocurrency can result in losses or gains. For example, cryptocurrency can be converted into fiat currency, which may result in a loss or gain. Unlike stock, however, cryptocurrency does not pay dividends, and unlike bonds or certificates of deposit, cryptocurrency does not accrue interest either. Rather, cryptocurrency increases (or decreases) in value like real estate. The market capitalization for all cryptocurrencies as of the date of this article is approximately $122 billion. Sam Ouimet, Bitcoin Pops Above $3,700 As Crypto Market Flashes Green, Coindesk (2019), https://bit.ly/2tbjlTX.
Why Are Some People Interested in Cryptocurrency?
Cryptocurrency has characteristics that are enticing to certain classes of risk-taking investors, traders, or speculators. Because of the semi-anonymous nature of the cryptocurrency market, there are typically few to no privacy concerns for individuals making transactions with cryptocurrency. Compared to bank accounts, there are few tax or other regulatory reporting requirements for account holders. This itself has attracted numerous holders. Advocates say that because cryptocurrency relies on the distributed ledger of blockchain technology, it protects holders from the risks associated with cyberattacks on banks and other traditional holders. This, too, is attractive to some.
People have started to use cryptocurrency as a flexible holder of value. For example, cryptocurrency can be used to secure loans. Will Yakowicz, Bitcoin Millionaires Have a New Way to Cash Out Without Ever Selling a Single Bitcoin, Inc.com (2018), https://bit.ly/2HMAjBd. Loans backed by cryptocurrency allow for cryptocurrency owners to put this asset to use without “cashing out” their cryptocurrency and therefore potentially incurring negative tax consequences as a result (discussed in detail below). Another method of investing cryptocurrency holdings and deterring taxes is through an individual retirement account (IRA) that owns 100 percent of an LLC invested in cryptocurrency. Jeff Vandrew Jr., How to Hold Cryptocurrency in a Retirement Account—Without Fees, Bravenewcoin (2018); see also Investing in Cryptocurrency using an IRA, NuView Trust Company, https://bit.ly/2V2zjfp.
To its backers, cryptocurrency is the money of the future and, just as platforms like Uber, Airbnb, and eBay have disrupted and replaced traditional middlemen, so too will cryptocurrency replace banks and other traditional financial intermediaries. In the meantime, cryptocurrency fans believe there are appreciation opportunities available to those who purchase at what they perceive to be the early stages in the life of this asset class.
What Are Some of the Downsides to Cryptocurrency?
Cryptocurrency is a relatively new type of asset that began when the Bitcoin network came into existence in January 2009. Benjamin Wallace, The Rise and Fall of Bitcoin, Wired (Nov. 23, 2011). As a result, there are many issues surrounding cryptocurrency that have yet to be settled. On May 30, 2018, the American Institute of Certified Public Accountants (AICPA) sent a letter to the IRS requesting additional guidance on the taxation of cryptocurrency, beyond its initial 2014 notice. Annette Nellen, Re: Updated Comments on Notice 2014-21: Virtual Currency Guidance (2018), https://bit.ly/2LWcRTL. This is the second letter of this nature AICPA has sent to the IRS, the first having been sent in 2016. The ABA’s Tax Section also sent a similar letter seeking advice from the IRS on the taxation of certain aspects of cryptocurrency on March 19, 2018. Karen L. Hawkins, Re: Tax Treatment of Cryptocurrency Hard Forks for Taxable Year 2017 (2018), https://bit.ly/2veucOg.
Some of the guidance sought in these letters includes what types of retirement accounts may hold cryptocurrency, whether a charitable contribution of cryptocurrency valued in excess of $5,000 will be treated the same as contributions of publicly traded stock, which do not require a qualified appraisal, and whether taxpayers may choose either the specific identification method or the first-in-first-out method as the accounting method for computing capital gains and losses. Id. To date, many of these issues remain unresolved.
One major taxation aspect that the IRS has addressed regarding cryptocurrency is capital gains and losses. Because the IRS treats cryptocurrency as property for tax purposes, an exchange or sale of cryptocurrency can lead to capital gains or losses. Failure to report these and other cryptocurrency transactions on a timely-filed income tax return can lead to fines and even possibly prison time, as taxpayers were warned by a letter released by the IRS in March 2018. Internal Revenue Service, IRS Reminds Taxpayers to Report Virtual Currency Transactions, IRS.gov (2018), https://bit.ly/2pGC34F. As a result, any trust holding cryptocurrency that wishes to liquidate cryptocurrency assets in order to make a distribution to a particular beneficiary should be aware of and properly report any capital gains or losses that ensue from the liquidation.
In addition, the SEC guidance on cryptocurrency is a work in progress. As of now, the SEC says that Bitcoin is not subject to regulation as a security, but it has noted that many cryptocurrencies are subject to regulation as securities, even as many of those issuers have not made the required regulatory filings. Louise Matsakis, Rest Easy, Cryptocurrency Fans: Ether and Bitcoin Aren’t Securities, Wired (June 14, 2018), https://bit.ly/2JQYPhZ. See also Bob Pisani, Bitcoin and Ether are not Securities, but Some Initial Coin Offerings May be, SEC Official Says, CNBC (June 14, 2018), https://cnb.cx/2sXrRGh.
Making Gifts with Cryptocurrency
Some individuals may be interested in making gifts of cryptocurrency in order to reduce income taxes accruing on their holdings. Even better, by donating appreciated cryptocurrency to qualified charities, the taxpayer can receive a charitable deduction on her income taxes for the gift and avoid paying capital gains taxes on the appreciation. Robert W. Wood, Tax-Free Ways to Transfer Bitcoin and Other Crypto: Expert Take, Cointelegraph (2018), https://bit.ly/2BCjzcm. In fact, charitable organizations sometimes welcome donations in the form of cryptocurrency, as the transfer of cryptocurrency requires less red tape than a typical wire transfer. 12 Nonprofits that Accept Cryptocurrency, [Blog] WeTrust (2018), https://bit.ly/2TH5kYO.
As noted earlier, the IRS’s current position treats cryptocurrency as property. See Notice 2014-21, supra.Therefore, gifts of cryptocurrency should be treated for tax purposes as gifts of property, in which the donee receives the donor’s cost basis in the property. As a result, when making a gift of cryptocurrency, it is important to properly track the basis of the gift. According to Notice 2014-21, a taxpayer’s basis in cryptocurrency that the taxpayer receives for goods and services is equal to the fair market value of the cryptocurrency on the date the taxpayer received it. Id.
For tax purposes, best practices for giving cryptocurrency include getting an appraisal of the fair market value of the cryptocurrency being gifted and executing a contemporaneous memorandum that includes details of the gift, such as the date of the transfer, the donor’s basis in the gift, and the fair market value of the gift at the time of the transfer, because blockchain transactions are anonymous. Although there is no authority on this issue, the memorandum should also include that the donor has given up control or dominion over the donee’s cryptocurrency address to verify that the gift is complete and, if the gift is being made to a charitable organization, that the gift meets the requirements of IRC § 170(f), to record that it qualifies for an income tax charitable deduction.
Cryptocurrency in Estates
Cryptocurrency has at least one procedural advantage over other financial assets in estate administration. Unlike a traditional bank or broker, which typically requires executors to produce an original death certificate and letters testamentary in order to take control of accounts in the deceased owner’s estate, cryptocurrency merely requires the fiduciary to have the decedent’s passcode to access and transfer the account for estate administration purposes. Sudhir Khatwani, Bitcoin Private Keys: Everything You Need to Know, CoinSutra—Bitcoin Community, (2018) https://bit.ly/2VHjbo7. The fiduciary then would hold the complex, multi-character passcode needed to access, invest and distribute the estate’s cryptocurrency assets to the beneficiaries as needed and as permitted by the relevant estate planning document. J.P. Buntinx, What Are Cryptocurrency Trusts, NullTX (2018), https://bit.ly/2Jo77l5. Because cryptocurrency offers ease of administration, there are fewer checks on a fiduciary who is handling a cryptocurrency account. Individuals who own cryptocurrency or have a trust that holds cryptocurrency should be exceptionally cautious when selecting an executor or trustee because the fiduciary could use the passcode to access and manage the cryptocurrency account, unlike a traditional bank account, which provides more oversight. In addition, should the fiduciary make a transfer of cryptocurrency that is not authorized by the relevant estate planning document, the transfer could be traced but would be nearly impossible to recover.
Although providing the passcode to the fiduciary may seem like the easiest method, it is important to ensure that doing so does not violate any federal or state privacy laws, terms of service agreements, or computer fraud and data protection laws. Such laws may include the Uniform Prudent Investor Act, the Uniform Prudent Management of Institutional Funds Act, the Federal Computer Fraud and Abuse Act, and the Revised Uniform Fiduciary Access to Digital Assets Act. In addition, by requiring only the passcode to access the cryptocurrency account, there is no way to ensure that a former fiduciary who has been replaced by a successor fiduciary does not access the account despite the lack of fiduciary authority to do so.
There are certain technological controls that can be employed to reduce this risk. “Cold storage” is a method used to keep cryptocurrency account information offline, adding an extra layer of security for cryptocurrency accounts. How to Setup Bitcoin Cold Storage, Bitcoin.com (2017), https://bit.ly/2A6I1ic. Through cold storage, a USB drive or similar device contains the account’s passcode concealed from users and privately transmits the passcode without the user knowing the passcode personally in order to access the account. In this way, a trust’s cold storage USB drive can be handed from a former fiduciary to the successor fiduciary without the former fiduciary retaining the passcode and without either fiduciary directly knowing the passcode themselves. Even with cold storage, fiduciaries should still take care to not run afoul of any terms of service that apply to the cryptocurrency account.
One downside to the cold storage method is that it is unclear whether the device or the cryptocurrency itself constitutes tangible personal property in an estate. Although Notice 2014-21 provides that cryptocurrency is “property” for tax purposes, it is silent on the nature of that property. As a result, until these issues have been more fully settled, it is important to carve out this exception when disposing of tangible personal property through an estate planning document.
In addition, because the IRS treats cryptocurrency as property rather than currency, it will most likely require an appraisal for estate tax purposes. Notice 2014-21 provides that the fair market value of cryptocurrency is based on the exchange rates at the relevant date for appraisal purposes. See Notice 2014-21, supra.
Estate Planning Techniques
When planning an estate, it is crucial to obtain information on any cryptocurrency held by the individual and to include language in the estate planning documents that permits fiduciaries to access, retain, and manage the cryptocurrency without extraneous liability. Fiduciaries should be made aware of the existence of cryptocurrency in the estate and should inquire with the decedent’s family members and financial advisors to determine whether the decedent owned cryptocurrency at death. Properly drafted estate planning documents will also permit fiduciaries to access the decedent’s digital assets, such as laptops and cell phones, which may have information about any cryptocurrencies owned by the decedent at death. It is important to provide these powers to the fiduciaries in an estate in order to allow the fiduciaries to access the decedent’s cryptocurrency after death. Even if the decedent provides the fiduciary with her cryptocurrency passcode during her life, the fiduciary’s use of the passcode after death without the proper permissions in the decedent’s estate planning documents and related laws could cause the fiduciary to violate federal or state privacy laws, terms of service agreements, or computer fraud and data protection laws. It is generally not recommended that an individual share her passcode with others for security reasons, but once a passcode is lost it is virtually impossible to recover, so individuals with cryptocurrency should consider writing down the passcode and storing it in a secure but accessible location (or multiple locations).
In theory, to fund a trust with cryptocurrency directly, one could simply provide the trustee with the passcode or the cold storage device for the cryptocurrency account to access and manage the account on behalf of the trust. As noted earlier, however, it is important to ensure that doing so does not violate any applicable laws or terms of service agreements. Because cryptocurrency’s history thus far is short—about ten years as of the date of this article—and volatile, it may be more prudent to hold cryptocurrency as a small part of a larger trust portfolio. Benjamin Wallace, The Rise and Fall of Bitcoin, Wired (Nov. 23, 2011). At a minimum, a cryptocurrency investor who wants to establish a trust holding solely cryptocurrency should release a trustee from any duty to diversify and provide the trustee with the necessary indemnification. If the trust’s cryptocurrency were held in a larger portfolio with a financial institution, the institution would simply change the trustees on its forms as needed.
Currently there is no authority preventing the funding of any trust with cryptocurrency or directing how such transfers should be memorialized for tax purposes. Ivan Taback & Nathaniel Birdsall, The Bitcoin GRAT, Wealth Management (2014), https://bit.ly/2w2lAu4. Therefore, it is important to prepare contemporaneous memoranda recording any transfer and to ensure that the donor has not retained any control over the transferred cryptocurrency (for example, by having access to the trust’s private cryptocurrency key). Id.
Leaving aside the all-important fact that the value of cryptocurrencies has to date proven extremely volatile, certain intermediaries have proven untrustworthy, and its regulatory framework is unclear, a believer in the future of one or more particular cryptocurrencies could find them well-suited in an irrevocable family trust that will pass the appreciated property to later generations. An individual who owns cryptocurrency could establish an irrevocable family trust with her children, grandchildren, and later generations as beneficiaries and fund it with a variety of assets, including her cryptocurrency holdings, as briefly described above. If cryptocurrencies increase in value over time, the appreciated value of the cryptocurrency in the trust would pass to the grantor’s descendants free of any estate taxes or further gift taxes. In this way, greater wealth can be passed down to later generations while avoiding unnecessary death taxes that would be incurred if the cryptocurrency had not been placed in a trust.
A grantor retained annuity trust (GRAT) may also be a useful vehicle for cryptocurrency because of its volatility. A GRAT funded with cryptocurrency is relatively easy for a trustee to administer. Id. A GRAT can be funded with cryptocurrency by employing the best practices for cryptocurrency transactions recommended above, including a qualified appraisal of the value of the cryptocurrency transferred to the GRAT upon which the annuity amount of the GRAT will be based. If the trustee also opens up a simple bank account for the GRAT at the time of funding, the trustee can use the power of substitution to exchange the cash in the bank account for cryptocurrency in the GRAT that has appreciated significantly, thus locking in the increased value of the cryptocurrency. Id.
An annuity payment is made with cryptocurrency by the trustee sending it to the grantor’s public cryptocurrency address as briefly described above. Once an actuary determines the annuity amount in regular currency, the trustee will need to determine how much cryptocurrency is necessary to satisfy the annuity payment. Because the IRS has deemed cryptocurrency to be property for tax purposes, the value of cryptocurrency for these purposes would be the price at which the property would change hands between a willing buyer and a willing seller on the date of the transfer. Treas. Reg. 25.2512-1 (2019). Best practices for determining the value of the cryptocurrency needed to satisfy the annuity include taking a weighted average of the mean between the highest and lowest cryptocurrency prices from multiple cryptocurrency exchanges. Taback & Birdsall, supra.
Cryptocurrency is a new asset class that estate planning attorneys are likely to see in their clients’ portfolios in the future. Although the IRS has not set forth clear guidance on every tax aspect of these assets, attorneys should take care to ensure that they are properly treated in the estate plan. It is important to include language in every will and trust that permits the fiduciaries to access the digital records necessary to properly administer any cryptocurrency in the estate. It is also important for clients to select trustworthy fiduciaries who will properly manage the cryptocurrency and follow the client’s intent. With proper planning and attention to the latest publications from the IRS regarding this asset, estate planning attorneys can help their clients who are interested in this new asset class.