Taking the ‘Cryptic’ Out of Cryptocurrency in Estate Planning: Part I

Cryptocurrencies have a more important role in estate planning than they did a decade ago. Since Bitcoin was introduced over a decade ago, cryptocurrencies have steadily grown in acceptance. Recent surveys indicate that 10% of people in the United States now own some form of cryptocurrency. Moreover, a 2020 survey by the Cremation Institute shows that 89% of those surveyed worry about whether their crypto assets will be passed on to their loved ones and only 23% of crypto owners reported having a documented plan for passing on their assets after their death. Unfortunately, many cryptocurrency holders don’t understand the significance of documenting crypto-assets in their estate plan.

What Is Cryptocurrency?

A cryptocurrency, broadly defined, is virtual or digital money that takes the form of tokens or “coins.” Though some cryptocurrencies have ventured into the physical world with credit cards or other projects, the large majority remain entirely intangible.

The “crypto” in cryptocurrencies refers to complicated cryptography that allows for the creation and processing of digital currencies and their transactions across decentralized systems. Alongside this important “crypto” feature is a common commitment to decentralization; cryptocurrencies are typically developed as code by teams who build in mechanisms for issuance (often, although not always, through a process called mining) and other controls.

Cryptocurrencies are almost always designed to be free from government manipulation and control—although, as they have grown more popular, this foundational aspect of the industry has come under fire.

Since its inception, Bitcoin has seen a dramatic increase in value and in the last year alone, Bitcoins’ gains were increasing by 440% (one Bitcoin worth $5,413 in March 2020 was worth $48,634 by March 2021). The cryptocurrencies modeled after Bitcoin are collectively called altcoins and have often tried to present themselves as modified or improved versions of Bitcoin. Though some of these currencies may have some impressive features that Bitcoin does not, matching the level of security that Bitcoin’s networks achieve largely has yet to be seen by an altcoin. Based on this appreciation and a mainstream adoption in the markets, it’s clear why Fortune 500 companies and individuals are enthusiastic to invest in cryptocurrencies. Advisors need to inform their clients about the consequences of any crypto transactions, including how to incorporate their crypto-assets into their estate planning.

Learn From The Mistakes Of Others

When German-born programmer Stefan Thomas recently made headlines after a lost Bitcoin password rendered $220 million worth of his Bitcoin inaccessible, there was a universal gasp of dismay from people around the world. This mishap served as an important wake-up call to cryptocurrency holders, reinforcing the need to develop a plan to protect and pass on their digital assets. Without a password, cryptocurrencies are inaccessible because there is no system for password recovery. The digital “currency” is created through an algorithm and does not save a person’s password or “key”. With national attention on Stefan’s costly error, more clients are seeking expert guidance from wealth advisors on how to best account for crypto-assets.

Record and Document All Crypto-Investments

Unlike traditional investments, there are no traditional ownership or beneficiary designations on cryptocurrency accounts. Bitcoin and other cryptocurrencies are entirely anonymous, so if the holder dies without communicating that they owns a cryptocurrency and does not provide the corresponding password or “private key,” the asset dies with them. Ownership is established by “blockchain” records and transactions, similar to the County Recorder which keeps records of deed transfers. Imagine you lost the deed to your house, and the County Recorder did not exist (decentralized)—you would not be able to sell the house or prove your interest in it. The only way to access Bitcoin is with the password or “private key.” Without the private key, you have no access, and without access, you have no Bitcoin, and all the value is lost.

Given the significant increase in cryptocurrency values, advisors should help clients document what they own, where the passwords are stored, and what the purchase price was for each cryptocurrency. Advisors should also ascertain how the client wants these assets to be handled in their estate plan. It is important to understand how to manage cryptocurrency assets and maintain the security of passwords, while being mindful of the IRS tax treatment of virtual currency transactions.

Cryptocurrencies can be purchased on exchanges such as Coinbase and held there. Exchanges like Coinbase provide easy access to the owner but are not as secure as “wallets.” Outside of exchanges, there are two main ways to store cryptocurrencies—in “cold” or “hot” wallets. Cold wallet storage refers to offline storage devices such as a USB drive, computer, phone or tablet that are not connected to the internet. Hot wallets are online or desktop apps that allow you to store keys and passwords to access cryptocurrencies. There is significant literature that outlines the pros and cons of each option, and ultimately clients need to decide what they are most comfortable with and document their choice.

Secure Accessibility To Crypto-Assets

The most problematic aspect of owning cryptocurrencies is that the person with the encryption key is the “owner.” Anyone with the key to the account, can access the cryptocurrency and move it to some other location which the original owner cannot access. As with all passwords, advisors should never keep the passwords to any digital assets, but instead be familiar with password storage options available to clients and ensure that their clients have a documented process whereby named fiduciaries can access the accounts.

As an initial step in the estate planning process, clients should document their ownership of cryptocurrencies as part of their net worth statement and provide a document to their chosen fiduciary about how to access those assets after their death or disability The simple step of keeping an asset inventory and documenting where passwords can be found on an exchange or a “wallet,” can help ensure that crypto-assets are not lost at the death of the original owner.

Address Cryptocurrencies In Clients’ Estate Documents

Your estate planning documents should outline how the cryptocurrencies are to be distributed at death and provide the named fiduciary with authority and the powers to own cryptocurrencies in the estate. The plan should also authorize fiduciaries to provide passwords to the beneficiaries who are to inherit the crypto-assets when the assets are “distributed.” It is important to discuss with the client whether a special trustee should be selected to manage just the crypto-assets. As with all trustee selections, clients should select a trustee they trust since the passwords and encryption keys are extremely sensitive. Clients should also consider who will have the authority to deal with the cryptocurrency during disability, and make sure that any power of attorney executed have the proper provisions for this type of asset and have the information to access the crypto accounts.

Consider All Tax Implications

The IRS treats cryptocurrency as property, not as a currency. General tax principles applicable to property transactions apply to virtual currency, and as such, cryptocurrency transactions have tax consequences that may result in tax liability in the form of capital gains or losses. The foregoing is subject to change under proposed legislation by the Biden Administration.

Any transaction involving the sale of a cryptocurrency will result in capital gains or loss reflecting the need to track the tax basis in order to correctly report the gain or loss. For tax purposes, gifts of cryptocurrency are treated as gifts of property, in which the donee receives the donor’s cost basis in the property. At the death of the “owner” cryptocurrencies receive a step-up in basis like other property assets. The carryover and step-up rules governing these assets should be factored into decisions about what to do with the cryptocurrencies in a clients’ estate plan.

To reduce tax liability, some clients may be interested in making gifts of cryptocurrency. By donating appreciated cryptocurrency to qualified charities, the taxpayer can receive a charitable deduction on his/her income taxes for the value of the gift and avoid paying capital gains taxes on the appreciation.

Some best practices for gifting cryptocurrency include obtaining an appraisal to establish the fair market value of the cryptocurrency being gifted and executing a separate 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. Since blockchain transactions are anonymous, the memo should state that the donor has given up control and dominion over the donee’s cryptocurrency address to confirm that the gift is complete. If the gift is being made to a charitable organization, the memo should state that the gift meets the tax requirements to record that it qualifies for an income tax charitable deduction.

Keep The Estate Plan Up To Date

An estate plan should align with your client’s status and an annual review taking into account life and financial changes is good practice. Due to the significant gains experienced in many cryptocurrencies in the last few years tracking cryptocurrency assets is important given the estate, gift, and income tax implications. An annual review of all asset values can ensure that advisors can assist clients with revising their plans as their net worth increases and remind them to document passwords and keys so that fiduciaries have access to existing and new crypto-assets.

The features that make cryptocurrency attractive, such as privacy and decentralization, can also increase the risk that your client’s fiduciaries may lack access to crypto holdings if not properly documented. You should address cryptocurrency and all digital assets with your clients to ensure that they minimize the risks of loss and maximize the opportunities for these assets to be distributed according to your client’s wishes after death. If more information is desired with regard to recommended language that should be incorporated into your clients’ estate plans, please reach out to the experienced Pleasanton CA estate planning attorneys at Tierney Law Group, PC.

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