Cryptocurrencies are becoming a larger component of investors' portfolios, especially for millennials and Generation Z, who collectively make up 94 percent of cryptocurrency buyers.
While it may seemingly be too early for some of these investors to contemplate death or the next generation, many already have families and estate plans in place, and they should be aware of their options and specifically consider how their digital assets, as defined below, play into their wider current tax planning and ultimately estate planning goals.
The dramatic decline in value of many digital assets at this article's publication informs the risks associated with such assets as well as potential opportunities for planning with the right digital assets in a possible rebound.
Background and Practical Logistics
On March 9, 2022, the White House released its Executive Order on Ensuring Responsible Development of Digital Assets, which defined digital assets to include primarily cryptocurrency and other mediums of exchange that are recorded on the blockchain. A more commonly-used definition of virtual assets has a much broader implications on estate planning and should be addressed at a later time.
In many ways, digital assets are similar to other individual investments. The IRS, through the application of IRS Notice 2014-21, treats cryptocurrency as personal property. This means that digital assets are considered similar to stocks and thus not traditional fiat currency (i.e., cash). The highs and lows of trading are taxed the same as any other capital gains and losses, and the failure to report exchanges has the same consequences.
For this and other reasons, total tax avoidance using digital assets is not advisable. The IRS has taken aggressive measures, including using the courts to require Coinbase (a leading cryptocurrency exchange) and other cryptocurrency exchanges to release transaction information on their users. Further, the U.S. Securities and Exchange Commission (SEC) has been pushing for certain products to qualify as investment contracts and thus subject to strict securities regulations. While this article will not discuss securities regulation, it is paramount that any investor holding digital assets – be it an individual or a trustee on behalf of a trust – remain vigilant of the dynamic regulatory environment of the digital asset sphere of investments and determine which regulatory authority may apply to a given asset.
Another important component of planning with digital assets is to remember the maintenance of private keys used to access the digital assets or the wallets that hold the keys. If a family is unaware of digital assets at upon death or cannot find the keys, then they may be lost or at least forever inaccessible.
When compared to a more typical cash or securities account, one logistical benefit of digital assets is that there is no need to present a death certificate or letters testamentary in order to access the wallet. Whoever has the key has the access. However, if an investor used the "cold storage" method for added protection, the storage device (e.g., a USB drive) could be considered part of the probate estate and thus subject to a lengthy probate process. To avoid this issue, some investors decide to place cold wallets in safe deposit boxes owned by a limited liability company (LLC) that passes outside of probate.
Investors may also use trusts to protect their digital assets and include them in their succession plan. From a practical standpoint, if permitted by the exchange, investors should register the transfer of the particular digital assets to the trust or holding entity utilized as part of the plan. Once validated by the blockchain, the authorized individual on the entity – be it a manager, personal representative or trustee – now has the confirmed ownership of the digital asset as an authority to transact further.
Regardless whether it is a will, trust or power of attorney, estate planning documents should be drafted to provide explicit authority to transfer the key and title of the digital assets to the successor in interest. Certain banks and professional trustee services have developed crypto custody services, including actual custody of the key for the benefit of the future personal representative, trustee or manager, but these services are not yet widely available. Some banks may back the holdings with dollar reserves. Any investor wary of passing a key to a trustee prior to his or her death should consider utilizing these services. However, it is important to understand that most institutional custodians and trustees consider digital assets high risk and may immediately liquidate digital asset holdings. If that is an undesirable result, specific provisions, waivers and instructions should be incorporated into the estate plan.
Selected Estate Planning Strategies with Digital Assets
While many well-established estate planning strategies are currently compatible with digital assets, below are a few examples in the context of the current environment surrounding them.
Gifting and Estate Tax
As with other property, transferring digital assets to a complete trust results in all subsequent growth of the digital assets to be outside the taxable estate of the transferor. Due to the inherent volatility of many digital assets and the limits of one's lifetime gift and estate tax exemption, a gift to a trust may be risky, so great care should be employed when 1) choosing whether to make digital assets part of a gift, 2) determining which cryptocurrency may be the right choice and 3) the best time to make a gift. Transferors should attempt to utilize the dips of the market of a particular cryptocurrency to peg the date of a gift into trust in order to minimize the use of their lifetime gift and estate tax exemption. While the current cryptocurrency and non-fungible tokens (NFT) market provides an extreme example of such an opportunity, future planning can still utilize more marginal adjustments. Accordingly, contemporaneous documentation confirming the date of transfer and a qualified appraisal of value of the particular digital asset at that date and time are good rules of the road. Basis and holding period will carry over to the trust upon transfer, so a sharp increase in the value of the digital asset followed by a sale could quickly result in a substantial gain to the trust without causing any gift or estate tax liability. Further, if transferring to an intentionally defective grantor trust, a grantor will be responsible for the income tax of the trust, thus continuing to decrease his or her taxable estate.
State Income Tax Minimization
While several states have enacted or introduced legislation regarding digital assets, the legislation typically focuses on matters unrelated to this article or follows the lead of the IRS with respect to treatment as personal property. As digital assets are intangible personal property under current law, they can be easily transferred outside the individual's state of residence. Most states levy a tax on capital gains income, which inherently applies to digital assets. Residents of such states may therefore choose to create and transfer their digital assets to particular types of trusts sitused in other jurisdictions (e.g., Nevada) to avoid state income tax on gains associated with their digital assets.
For example, prior to selling a position in a particular cryptocurrency, an individual transfers his or her rights in the coin to a trustee of such a trust. If the trust later sells that position, any gain associated with the digital asset should not be taxable in the individual's state of residence. As discussed above, depending on the structure of the trust, the gain after the gift may also be entirely outside the taxable estate of the grantor. As this area is increasingly dynamic and inherently state-specific, great care should be used before engaging in this type of planning.
Investors lucky to get into the crypto space early may have extremely low-basis digital assets that they are hesitant to liquidate due to the immediate tax burden. If the digital assets are held in or transferred to a partnership, investors can defer their capital gain in certain fact patterns if structured properly. The investor could choose to sell his or her interest in the partnership to an irrevocable non-grantor trust in exchange for a promissory note of equivalent value. Through use of the Section 754 election, the partnership may step up the inside basis (i.e., the value of the digital assets owned by the partnership) upon this transfer to be equal to the outside basis of the value of the promissory note. Gain is not payable by the investor until the trust repays the promissory note. If the partnership later decides to sell the digital assets to a third party on an exchange, proceeds may then be redeployed in other digital assets or other more traditional investments. As with other strategies, the volatility of digital assets makes this a higher risk strategy than with more traditional assets. Unlike a gifting strategy, the timing may not be ripe as of the time of this article's publication, as ideally an investor would implement this deferral strategy when his or her digital assets have substantially more valuable than their basis.
Certain providers have created self-directed individual retirement accounts (IRAs) to hold digital assets, meaning that an IRA may own an LLC invested in digital assets, thus allowing a federally protected and tax-efficient way to invest and defer gains while participating in the space with a component of one's portfolio. It remains to be seen if these options will continue to expand as the digital asset market contracts.
Digital assets, especially highly appreciated assets, can be beneficial for charitable giving. Unlike gifting shares of an S corporation or certain partnership interest, digital assets will not subject the charity to unrelated business income tax. As digital assets are capital assets, a donor can deduct up to 30 percent of the value of the gift of assets held more than a year and up to 50 percent of assets held less than a year, subject to certain other restrictions, each with a five-year carry forward.
Other typical charitable strategies – e.g., charitable remainder trusts – may be difficult to provide the necessary income stream with a highly volatile digital asset. However, if digital assets are merely one of many assets contributed to (for example, a charitable lead annuity trust) and are not required to provide the income stream for payment of the annuity, potential dramatic increases in the value of the digital asset during the term of such a charitable trust could lead to a windfall to non-reversionary beneficiaries at the end of the term, thus providing substantial estate tax savings.
Conclusions and Takeaways
Digital assets are a dynamic space that offer tremendous opportunity for cutting-edge estate and tax planning as well as fresh approaches to established techniques, but the privacy and limited regulation creates multiple potential pitfalls for those who do not properly plan.