Quantcast
Channel: Wealth Management - Trusts & Estates
Viewing all articles
Browse latest Browse all 733

The Fiduciary’s Guide to Cryptocurrency: Part I

$
0
0

Acceptance and management by executors and trustees.

Cryptocurrencies are digital assets that present unique challenges for fiduciaries. In a two-part series, we use the lifecycle of the fiduciary relationship as a framework to provide a practical guide to the acceptance, management, investment and distribution of cryptocurrency by executors1 and trustees. In Part I, we’ll introduce the basic principles of cryptocurrency and address common issues relating to acceptance and management of cryptocurrency by executors and trustees.

The Basics

Cryptocurrency is a digital representation of value that functions as a unit of account, a store of value and/or a medium of exchange (similar to the function of fiat currency) and is secured through cryptography. Transactions in cryptocurrency are recorded on a distributed ledger using blockchain technology. Blockchains are distributed computer networks that validate transactions using a consensus algorithm. Each block of transactions is cryptographically linked to the one before, making the transactions immutable. The ledger of transactions in the cryptocurrency isn’t held by a single trusted third party but rather is transparent and distributed, an identical copy of which is held by all participants.

Individuals typically acquire cryptocurrency by purchasing it through an online exchange. Some exchanges have an omnibus account in which their customers’ cryptocurrency holdings are custodied and maintain off-chain records of each customer’s holdings. Others give customers the option to store their alphanumeric “private keys” necessary to access and further transact the cryptocurrency in their own “wallets.” Once cryptocurrency is purchased from an online exchange, an individual would need to determine whether to allow the exchange to continue to custody the cryptocurrency (if offered by the exchange) or instead direct the transfer of the cryptocurrency to the individual’s own wallet.

Cryptocurrency wallets can be maintained using either “hot storage” or “cold storage.” Hot storage is the storage of a wallet on the Internet or on a device connected to the Internet. Hot storage using an online exchange’s platform or an online “wallet provider” that custodies private keys, but doesn’t consummate cryptocurrency transactions, is referred to as a “hosted” wallet. An individual may also maintain a hot storage wallet using software on a personal computer connected to the Internet that requires the entry of the individual’s private keys to transact the cryptocurrency held in the wallet. This type of hot storage wallet and cold storage wallet (discussed below) are referred to as “unhosted” or “non-hosted” wallets.

Cold storage is the storage of a wallet on a device or in a location not connected to the Internet. Using cold storage, an individual might store private keys on a specialized USB flash drive or typed or handwritten on physical paper. The individual could also dispense with any offline back-up mechanism and simply try to memorize the private keys. The wide range of storage mechanisms available for cryptocurrency distinguishes it from other financial assets and can complicate fiduciary acceptance and management of cryptocurrency.

Trustee Taking Title

How does the trustee take legal title to the cryptocurrency? Trustees generally have the duty to segregate and separately identify trust property.2  Although determining the best storage method for cryptocurrency (discussed below) can be complicated, the trustee shouldn’t commingle cryptocurrency with the trustee’s own or others’ assets. Unlike traditional financial institutions, commonly used online cryptocurrency exchanges or wallet providers might not offer users the ability to create trust (or estate) accounts. If the settlor holds the cryptocurrency wallet in cold storage, the settlor could transfer physical possession of the wallet (along with the public and private keys for the device) to the trustee. If the settlor holds the cryptocurrency wallet in hot storage, the settlor may direct the transfer of the cryptocurrency held in that account to a physical cold storage wallet and then transfer physical possession of the wallet to the trustee. The settlor may also transfer the cryptocurrency directly to a cold storage device maintained by the trustee. In either case, a trustee holding a cold storage device in trust must make it clear that the device is separate from the trustee’s own assets and secured, for example, by physically storing the cold storage device in a safety deposit box maintained by the trustee in such capacity.

Alternatively, because certain online cryptocurrency exchanges and wallet providers may allow business entities to create accounts,3 the settlor can form a new entity, such as a limited liability company (LLC), transfer the cryptocurrency to the entity and then separately transfer interests in the entity to the trustee. Note that if using a business account provided by an online exchange or a wallet provider for the “entity wrapper,” the wallet would remain in hot storage unless transferred to a cold storage device by an individual acting on behalf of the entity.4 In the wake of recent guidance from the Office of the Comptroller of the Currency clarifying that national banks may provide cryptocurrency custodial services5 and continuing development by traditional financial institutions of custody services for cryptocurrency,6 additional solutions for titling cryptocurrency in the fiduciary’s name may become available.

In all cases, the cryptocurrency’s basis, which generally would be the same carryover basis in the trustee’s hands as it was in the settlor’s hands in the case of a gift,7 should also be noted at the time of transfer for gift and future income tax reporting purposes.

Hot and Cold Storage

What are the advantages and disadvantages of hot storage and cold storage? Hot storage using an online exchange or an online wallet provider (hosted) or a personal computer (unhosted) generally allows for easier and faster liquidation by the cryptocurrency holder but may be susceptible to hacking because of the live connection of the wallet to the Internet. Hosted hot storage using an online exchange that maintains an omnibus account for all customers also requires the cryptocurrency holder to trust the online exchange to accurately maintain its own internal ledger and protect private keys from theft, destruction or misplacement. The online exchange may use elements of cold storage, such as offline hard drives and paper backups, for additional security.8 

Conversely, cold storage in a physical wallet can make it harder to liquidate quickly if desired, particularly if the cold storage device is itself stored in a secure location. Cold storage is desirable for those who espouse the decentralized nature of cryptocurrency and wish to maintain complete control of their private keys offline. However, although the risk of loss from hacking or mismanagement by a third party is lower, the risk of loss from theft, destruction or misplacement of a cold storage device remains.

Can the trustee be certain that the settlor hasn’t duplicated a cold storage wallet prior to transferring possession to the trustee? No, because the private keys necessary to transact cryptocurrency could be maintained on multiple cold storage wallets, giving the settlor who retained a cold storage wallet the ability to transact the same cryptocurrency ostensibly given to the trustee. As a technical matter, a cold storage device may be able to generate private keys based on the user’s input of a series of 24 words. This series, sometimes referred to as a “recovery phrase,” could later be used to regenerate identical private keys on a new cold storage device if the original cold storage device were lost. This functionality can be used to create two or more identical cold storage wallets, because the same recovery phrase used on each cold storage device would generate the same private keys.

In the context of lifetime gifts, it’s thus possible for a settlor to purchase multiple cold storage devices, associate them with identical private keys and then give only one of the wallets to the trustee. A deed of gift or other contemporaneous memorandum in which the settlor represents that an identical cold storage wallet hasn’t been retained may provide some evidentiary basis in establishing that the trustee has the only private keys associated with the cryptocurrency following the transfer.9 To minimize concerns relating to retention of cold storage private keys by the settlor (or others who may have had access to the recovery phrase), the settlor should consider transferring the cryptocurrency to a wallet held only by the trustee in an irreversible on-chain transaction.

Entity Selection

What type of entity should be used as an “entity wrapper” for titling and facilitating the transfer of interests in cryptocurrency? Limited partnerships (LPs) and LLCs are commonly used in the estate-planning context to hold traditional investment assets, interests in closely held businesses or private fund interests when it’s expected that a transferor will give or sell interests in the LP or LLC to family members or trusts for their benefit. Under applicable state law, LPs and LLCs generally offer flexibility in determining and allocating management rights and economic entitlements among partners or members and third parties. While there are no restrictions other than those imposed by the entity’s own governing documents on the ability of a C or S corporation to hold cryptocurrency, family LPs and LLCs traditionally used with other types of assets in the estate-planning context can also function as holding entities for cryptocurrency.

The foregoing discussion assumes that the settlor has already created or is willing to create a domestic LP or LLC. If the settlor is interested in purchasing cryptocurrencies through offshore exchanges, the settlor may wish to create a foreign entity for such purpose, as offshore exchanges may not permit U.S. citizens to use their platforms directly.10 In addition to careful consideration of the income tax implications of individual and fiduciary ownership of foreign entities, which is beyond the scope of this article, the settlor (or the trustee, if an interest in the foreign entity is transferred to a nongrantor trust) should also remember that ownership of an interest in a foreign entity must be disclosed to the Internal Revenue Service if the value of the interest exceeds a certain threshold during the taxable year.11

Executor Responsibilities

How can an executor discover whether a decedent owned cryptocurrency? An executor’s function generally begins with “marshaling” (that is, searching for, taking into possession and preserving) the personal assets of the decedent. Ideally, the decedent will have informed estate-planning counsel or nominated executors of the extent of the decedent’s cryptocurrency holdings during life so that a plan for transferring title to the cryptocurrency wallet can be developed and later implemented on death. Even a decedent who had only a passing interest in investing in cryptocurrency during life, however—perhaps out of mere curiosity—might end up with holdings worth substantially more than expected at death, which form a significant part of the estate. As with other financial assets that are managed primarily in electronic form, such as bank or brokerage accounts in which the account holder receives emailed statements and conducts all transactions online, it may be necessary for an executor to access information the decedent stored on the Internet using a third-party host, such as an email service provider, to confirm whether a decedent owned cryptocurrency.

Federal computer communications and privacy laws generally prohibit unauthorized access to and disclosure of a user’s information stored on a server maintained by a third party.12 In the estate administration context, a consequence of these laws is generally a prohibition on an executor using a decedent’s password to access an account, such as an email account, maintained on a third-party server—even if the decedent voluntarily disclosed the password to the executor or estate-planning counsel during life—and a parallel prohibition on the host disclosing the contents of the account to the executor. Notwithstanding that doing so could technically violate federal law, as a practical matter, a decedent’s family members might simply choose to access the decedent’s email accounts using stored passwords on the decedent’s devices and share asset information so acquired with the executor. When online accounts are for some reason inaccessible, however, direct involvement with the service provider will be necessary.

The Uniform Fiduciary Access to Digital Assets Act, Revised (RUFADAA)13 provides a framework requiring disclosure by a “custodian”14 of a “digital asset”—that is, an electronic record in which an individual has a right or interest15—to a fiduciary under certain circumstances. In the easiest case, an individual can use an online tool, if offered by the custodian, to direct the custodian to disclose some or all of the individual’s digital assets to designated recipients.16 However, not all custodians offer online tools, and even when they do, a decedent might not have chosen to use that functionality. In these cases, when a decedent consented by will to the disclosure of “contents” of the decedent’s electronic communications or a court directs such disclosure, the custodian generally must disclose the contents to the executor of the decedent’s estate if certain procedural requirements, including furnishing copies of the decedent’s death certificate, letters testamentary and other information requested by the custodian, are met.17 When a decedent didn’t consent by will to (but didn’t prohibit) the disclosure of the catalogue of the decedent’s electronic communications or a court directs such disclosure, the custodian generally must disclose the catalogue to the executor if the same procedural requirements are met.18 “Content” of an electronic communication is generally the substance of a communication,19 while “catalogue” of an electronic communication is information that identifies each person with which a user has had an electronic communication, the time and date of the communication and the electronic address of the other person (that is, metadata).20 

Because catalogue information includes senders and recipients of electronic communications, an executor who gains access to catalogue information associated with an email account may be able to conclude whether a decedent ever transacted in cryptocurrency using an online exchange, assuming that the decedent didn’t permanently delete such emails. Given the prevalence of web-based management of financial accounts generally, even without the need to address the specific technical nuances applicable to cryptocurrency, it’s critical for estate-planning counsel to discuss fiduciary access to digital assets with clients and prepare estate-planning documents granting fiduciaries access to digital assets (including access to the content of electronic communications) as permitted under RUFADAA. Even if an individual doesn’t execute a will granting this explicit authority to the executor, as long as the individual doesn’t prohibit access to the catalogue of electronic communications, a custodian is ostensibly required to disclose the catalogue information to the executor pursuant to RUFADAA. Hassle-free and timely cooperation by a custodian, however, can’t be guaranteed.

How can an executor take possession of cryptocurrency forming part of a decedent’s estate? Once the executor has determined that the decedent owned cryptocurrency, the executor must further determine the storage mechanism for the cryptocurrency wallet. If the wallet is stored using hot storage on an online exchange or a wallet provider, the executor should contact the exchange or provider to obtain account information and, eventually, provide distribution directions. This process may take time and require patience on the part of the executor and/or legal counsel, particularly if the decedent held cryptocurrency through offshore exchanges or providers unfamiliar with the legal concept of an executor.

Wallets stored using unhosted hot storage and cold storage present different potential difficulties. It may be obvious to a decedent’s family members that the decedent maintained an unhosted hot storage wallet on a personal computer, but if the private keys associated with the cryptocurrency held in that wallet can’t be found among the decedent’s possessions, the cryptocurrency maintained in that wallet is lost. Although a cryptocurrency wallet stored using cold storage might be easy to find if the decedent made its location known to family members, the executor or estate-planning counsel prior to death, a physical search of the decedent’s home, office, safe deposit box or other location may be necessary. If the decedent made multiple copies of the same cold storage wallet, the executor might face the risk of someone else finding one of them and irreversibly transferring (that is, stealing) the cryptocurrency, rendering the decedent’s cold storage wallet worthless. The more ordinary risks of misplacement, theft or destruction, typically associated with valuable tangible personal property, also apply to cold storage wallets.

Once the executor has learned of the existence of cryptocurrency held by a decedent, the executor may wish to consider transferring the cryptocurrency in an on-chain transaction to a wallet originally created and held by the executor for purposes of the estate’s administration. Given that online exchanges and wallet providers may not yet be able to accommodate fiduciary accounts, the executor may need to use a cold storage wallet for this purpose.

Instead of relying on the executor to marshal cryptocurrency after death, can an individual give the private keys to the nominated executor or estate-planning counsel during life to simplify the estate settlement process? Yes, but even if the individual transfers a copy of the private keys (such as an identical copy of a cold storage device) to the nominated executor or estate-planning counsel while retaining a copy, such a transfer presents significant risks to all involved. The transfer should be memorialized in a manner that makes it clear that the transferee is holding the private keys purely as nominee for the individual and that the transferee, or their successor in interest, will return the private keys to the individual or destroy the copy promptly on request. This is particularly important if private keys are given to a nominated executor who might later become disabled, die or simply fall out of favor with the individual, potentially making it difficult for the individual to regain complete control of the private keys. Absent release and indemnification by the individual, the transferee might be held liable if the private keys were lost, stolen or destroyed while in the transferee’s custody and a copy of the private keys didn’t exist or couldn’t later be found among the individual’s possessions. Rather than preemptively distributing the private keys or copies thereof in advance of death, the individual may wish to consider using an online tool provided by an online exchange or wallet provider to designate a recipient of information about the cryptocurrency holdings (in the case of hosted hot storage wallets, if offered by the host) or informing the nominated executors and/or estate-planning counsel of their location (in the case of unhosted hot storage or cold storage wallets) so that they can be marshaled promptly after death.

How should the executor value cryptocurrency for federal estate tax purposes? Cryptocurrency passing from a decedent on death isn’t immediately sold on an online exchange or recorded on the distributed ledger. With regard to such “off-chain” transactions, online guidance published by the IRS states that the IRS will accept as evidence of fair market value (FMV) the value determined by a cryptocurrency explorer that analyzes worldwide indices of cryptocurrency and calculates the value of the cryptocurrency at an exact date and time.22 If a taxpayer doesn’t use an explorer value, the taxpayer must establish that the value used is an accurate
representation of the cryptocurrency’s FMV.23    

The use of index prices to value cryptocurrency is similar to estate tax valuation principles applicable to publicly traded securities, but determining a price as of an exact date and time is a significant difference from the traditional “mean high/low” daily pricing information generally used in the estate tax valuation context.24 Although the IRS hasn’t issued further guidance specific to the valuation of cryptocurrency for estate tax purposes, the current IRS guidance suggests that the FMV of a decedent’s cryptocurrency should be valued as of the date and time of death, rather than a simple average of the high and low prices on the date of death or a more sophisticated, per-hour or per-minute average as of such date.25 For additional assurance, an executor might choose to engage a valuation firm to prepare an appraisal of the decedent’s cryptocurrency for estate tax purposes, though the appraisal firm would likely rely (at least in part) on the same index prices that are publicly available.

Looking Ahead

In Part II, we’ll apply the concepts discussed here in exploring the investment and distribution of cryptocurrency by fiduciaries, including limitations on fiduciary liability for cryptocurrency holdings and the income tax consequences of cryptocurrency sales and distributions. 

— This article is intended for general discussion purposes and not as specific legal advice.

Endnotes

1. This article uses the term “executor” for convenience when discussing concepts applicable to estate fiduciaries (executors, personal representatives, administrators, etc.) generally.

2. Restatement (Third) of Trusts, Section 84.

3. Coinbase, for example, permits business accounts to be created. See Coinbase, Coinbase Pro: Applying for a Coinbase business account, https://help.coinbase.com/en/pro/getting-started/other/applying-for-a-coinbase-business-account.

4. Choice of entity when creating an “entity wrapper” is discussed in “Entity Selection.”

5. Office of the Comptroller of the Currency, Federally Chartered Banks and Thrifts May Provide Custody Services For Crypto Assets, News Release 2020-98 (July 22, 2020).

6. Northern Trust Corporation, for example, recently announced the joint development of a cryptocurrency custodial function. Northern Trust Corporation, Standard Chartered and Northern Trust partner to launch Zodia, a cryptocurrency custodian for institutional investors, www.northerntrust.com/united-states/pr/2020/standard-chartered-northern-trust-launch-zodia.

7. See Internal Revenue Code Section 1015.

8. E.g., Coinbase, Security for Your Peace of Mind, www.coinbase.com/security

9. The settlor’s retention of the private keys in connection with a gift of cryptocurrency is unsettled for federal gift tax purposes and may cause the gift to be: (1) treated as incomplete, (2) treated as subject to a retained interest, or (3) subject to a valuation discount based on the possibility that the settlor can sell or spend the cryptocurrency before the trustee does (the “double-spend” problem).

10. Although a foreign account holding virtual currency (as opposed to an interest in a foreign entity holding virtual currency) isn’t a reportable account under the Report of Foreign Bank and Financial Accounts (FBAR), the Financial Crimes Enforcement Network (FinCEN) at the U.S. Department of the Treasury has announced its intention to propose regulations under the Bank Secrecy Act including virtual currency as a type of reportable account for FBAR purposes. See FinCEN Notice 2020-2 (Jan. 31, 2021).

11. See IRS Form 8938, Statement of Specified Foreign Financial Assets.

12. See generally the Electronic Communications Privacy Act, 18 U.S.C. Section  2510 et seq., the Stored Communications Act, 18 U.S.C. Section 2701 et seq. and the Computer Fraud and Abuse Act, 18 U.S.C. Section 1030.

13. As of this writing, a version of the Uniform Fiduciary Access to Digital Assets Act, Revised (RUFADAA) has been enacted in 45 states and the District of Columbia. See Uniform Law Commission, Fiduciary Access to Digital Assets Act, Revised, www.uniformlaws.org/committees/community-home?CommunityKey=f7237fc4-74c2-4728-81c6-b39a91ecdf22

14. RUFADAA broadly defines “custodian” as an individual or entity that “carries, maintains, processes, receives, or stores a digital asset of a user.” RUFADAA Section 2(8).

15. Ibid., Section 2(10).

16. Ibid., Section 4(a).

17. Ibid., Section 7.

18. Ibid., Section 8.

19. Ibid., Section 2(6).

20. Ibid.

21. Coinbase, for example, provides specific instructions for estate fiduciaries in this regard on its website. See Coinbase, How do I gain access to a deceased family members Coinbase account?, https://help.coinbase.com/en/coinbase/managing-my-account/other/how-do-i-gain-access-to-a-deceased-family-members-coinbase-account.

22. Internal Revenue Service, Frequently Asked Questions on Virtual Currency Transactions, www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions

23. Ibid.

24. See Treasury Regulations Section 20.2031-2(b)(1).

25. The generally applicable principles would suggest that cryptocurrency’s fair market value for gift tax purposes should also be determined as of the date and time of the gift transfer.


Viewing all articles
Browse latest Browse all 733

Trending Articles