Introduction

The rising popularity of digital assets has increased the likelihood that clients, advisors and fiduciaries will soon encounter it in estates and trusts. The identification and administration of the asset can present unique challenges, which require specialized expertise. As a result, those planning for and administering trusts and estates must understand cryptocurrency and the various challenges it can present.

Cryptocurrency and Blockchain

Cryptocurrency (or crypto) is a digital currency created, stored and secured using cryptography. Cryptography is a tool that primarily uses mathematical algorithms to encrypt plaintext into a secure form of data that unintended recipients cannot understand or decipher. 

The existence and exchange of cryptocurrency relies on peer-to-peer computer networks that enable transactions to take place without traditional third-party intermediaries like banks, brokers and governments.  In other words, traditional third-party intermediaries such as financial institutions are not a prerequisite for crypto transactions to effectuate cryptocurrency.

 Cryptocurrency transactions use distributed ledger technology, otherwise known as blockchain technology.  A blockchain is a secure, public ledger or database, similar to a giant spreadsheet with unique data in each cell. The blockchain stores encrypted data by tracking and recording transactions on the ledger each time cryptocurrency is exchanged; again, each user can view each transaction and know how much cryptocurrency is held by each wallet address.2 Each block on the blockchain contains transaction data, including the wallet address, the acquisition date and time, and the number of units transacted. 

A decentralized network of computers, which helps to prevent fraud and ensures accounting for transactions are correct, constantly verifies the receipt of these transactions. The blockchain is accessible by everyone who is part of the network, and when cryptocurrency transactions occur, everyone’s ledger is updated accordingly. This is in contrast to traditional ledgers, where a traditional third-party intermediary, like a bank, records all transactions and keeps track of the assets’ owners. 

Certain blockchain transactions can be completed faster than those processed by governments or banks, executed 24/7/365, and may be less expensive than traditional brokerage or bank transactions due to the absence of infrastructure and regulatory expenses.  Additionally, parties may transfer cryptocurrency internationally without paying high fees to third parties for making such transfers.  

Identifying cryptocurrency ownership

As of March 2022, over 19,000 different cryptocurrencies were in existence. While many have little to no following or trading volume, others are very popular. The most heavily transacted cryptocurrencies include:

• Bitcoin - The original cryptocurrency created in 2009 by an anonymous developer(s) under the name Satoshi Nakamoto.
• Ethereum - The cryptocurrency Ether is transacted on the Ethereum blockchain, which processes transactions faster than the original blockchain.
• Tether - A stablecoin with a value pegged to the U.S. Dollar.
• Dogecoin - A meme coin popularized by social media networks and influencers.
• Cardano - A coin created by the co-founder of Ethereum. Cardano allows for smart contracts and other technologically superior uses of blockchain technology.
• Solana - A coin that has enhanced the growth of smart contracts. Solano allows for self-executing smart contracts based on blockchain technology.
• Litecoin - A coin that transacts using ultrafast technology and gained popularity when Paypal allowed transactions to be made in Litecoin.
• XRP (formerly known as Ripple) - A coin built for enterprise use that aims to be a fast, cost-effective cryptocurrency for cross-border payments

Wallets have a public key and private key, known as a cryptographic pair. The public key is used to transfer crypto to a wallet, and the private key is required to establish ownership, transact and verify crypto transactions. While the public key is similar to a bank account number, the private key is comparable to bank login credentials or the PIN used to access an account.  You might provide your bank account number to another party to send funds to your account, but merely having your account number does not enable them to debit funds from your account. Without the private key, cryptocurrency cannot be accessed by anyone (even the owner), so secure storage of the private key is critical.  There are many high-profile cases of a cryptocurrency’s owner losing the private key.  In such an event, the cryptocurrency is permanently inaccessible.

Private keys are alphanumeric codes commonly stored in a wallet, which could be either a hot wallet (i.e., connected to the internet) or a cold wallet, not connected to the internet.  Hot wallets are online storage mechanisms (sometimes associated with a crypto exchange), which allow you to store your keys online.  However, holding a private key online can increase the risk of loss through hacking or cybersecurity breaches. On the other hand, cold wallets are often stored in secure physical locations such as safe-deposit boxes or safes. Therefore, using a cold wallet, which might entail storing private keys in a document within a thumb drive, or even writing them down in a notebook, could be viewed as a more secure storage method. Additionally, cold wallets are not connected to the internet in order to help prevent cyber hacking or other tampering. For owners who hold crypto in a wallet linked to a cryptocurrency exchange, or owners who custody cryptocurrency with an institution, the exchange or custodian generally holds the private key and manages the crypto’s safekeeping on behalf of the owner.  Best practices at such institutions include keeping the cold wallets in vaults, with limited employee access to such vaults.

Clients, fiduciaries, and anyone else who holds cryptocurrency on behalf of a client should develop a secure protocol to protect private keys, including backup storage of those keys.  Some hot wallets rely on a seed phrase to enable an owner to recover the keys from their wallet if lost or forgotten.  The seed phrase is typically a list of random words that can unlock the wallet, but that seed phrase should be written down and kept in a secure location as well.  Clients can also consider commercial tracking tools that store information about where keys are located, whether on a home computer, in cloud-based storage, on an external hard or flash drive, on a memory card, or simply as a typed or handwritten note.  It is not unusual for clients to hold more than one type of cryptocurrency as well as more than one wallet; thus, it is vital for clients to document cryptocurrency holdings and the location of the private keys. 

Barriers to access

In settling an estate, the fiduciary of the estate (e.g., the executor or personal representative) has a duty to marshal and protect a decedent’s assets, including digital assets like cryptocurrencies. However, numerous obstacles exist for fiduciaries and others who need access to a decedent’s crypto accounts.

First, the decedent’s ’s password, private key or seed name must be located and secured in order to obtain access. Additionally, the decedent’s information may be encrypted.

Next, (in the US) two federal statutes must be considered:

• The Electronic Communication Privacy Act (18 U.S.C. §2701), also known as the Stored Communications Act, stipulates it is a crime to intentionally access a facility, without authorization, through which electronic communication service is provided. The Act, however, does not apply to conduct that is authorized.
• The Computer Fraud and Abuse Act (18 U.S.C. §§1030 et. seq.) prohibits accessing a computer without authorization.

Furthermore, state law may pose additional obstacles. Many states have adopted the Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA) or some version thereof. The RUFADAA grants a fiduciary the authority over the contents of a decedent’s electronic communications if the user explicitly consents to disclosure. A user can direct or prohibit disclosure in a will, trust, power of attorney or other record. Absent explicit consent, only a court order that directs disclosure can provide access. Thus, the RUFADAA grants fiduciaries legal authority to manage digital assets and electronic communications. It also grants the custodian of digital assets and electronic communications the necessary legal authority to deal with fiduciaries or their users. The act is intended to facilitate fiduciary access and custodian disclosure. Thus, a client and fiduciary should learn if his or her state has adopted the act or similar legislation, and they should familiarize themselves with what protection the legislation provides.

Finally, the account’s terms of service agreement (TOSA) should also be reviewed. When an individual  opens an account, he or she will be required to agree to the provider’s terms of service agreement. Service providers may have policies which outline the outcome in the event of an account holder’s death. However, individuals eager to open an account sometimes agree to the terms of service without carefully reading the agreement. TOSAs generally restrict user access to digital assets during his/her lifetime and prohibit third-party access following the user’s death. Thus, clients must be advised that absent some affirmative action, the TOSA will govern whether a custodian may grant a fiduciary access to the user’s account. The RUFADAA, mentioned above, does not change any legal rights under a TOSA or restrictions the TOSA or user may have placed on fiduciary rights. Nevertheless, the RUFADAA (or similar state laws) can allow fiduciary access to a user’s account in cases where the service provider or custodian does not have specific provisions in the TOSA governing fiduciary access.

Estate planning & Cryptocurrency

As with any other asset, clients should establish goals and objectives for investments in cryptocurrency. It is especially important for clients to advise their attorney of any cryptocurrency holdings so the drafting attorney can effectively dispose of the cryptocurrency at death according to the client’s wishes. Should the crypto be retained or sold?  Should it pass as a specific bequest to one or more individuals, or pass as part of the residuary estate?  Who should have authority over the cryptocurrency? These are all key questions that should be considered between a client and his/her  attorney when drafting an estate plan.

Clients should also determine how to transfer private keys to the fiduciary or beneficiary. Without this information, the crypto could be rendered irretrievable. Drafting attorneys would be wise to consider the following issues in planning for cryptocurrency:

1. Identify the fiduciary: Specifically identify who can access the crypto and who will manage it after death. Ask your client whether the party designated to act as fiduciary has the required technical knowledge.  Naming an executor or trustee is an important consideration. If a corporate fiduciary is being considered, determine if they can accept and manage an estate or trust with crypto as an asset. As a precaution, the client’s estate plan could bifurcate responsibility between multiple fiduciaries and identify an individual to serve as digital fiduciary: an individual with sole responsibility for managing cryptocurrency who has the required knowledge to resolve the associated complex issues.
2. Consider post-death valuation:  The crypto will need to be valued after the client’s death. The recent volatility of certain cryptocurrency can make this an even more challenging endeavor. In addition to volatility, cryptocurrency valuation could be impacted by other factors.  For example, are sales of the cryptocurrency restricted in any way?  Is the cryptocurrency held directly or indirectly in an LLC or a different entity managed by another party?  Is trading limited such that a blockage discount may be warranted?
   
3. Specifically dispose of digital assets:  Estate planning documents should generally dispose of cryptocurrency via a specific gift, rather than as a residuary bequest. The document should specify whether crypto is deemed tangible personal property for state law purposes, eligible to pass under a tangible personal property clause. If not, the estate planning document should indicate that crypto is not included in the definition of tangible personal property. The documents should also specifically grant the fiduciary (or a third-party, if applicable) the authority to hold, manage and access cryptocurrency regardless of where the private keys are stored.  This language should be included in wills and trusts, as well as a durable power of attorney to effectively plan for incapacity. To facilitate access, estate planning documents should allow fiduciaries to bypass, reset or recover passwords; however, the documents themselves should never disclose the private key, seed name, exchange logon or other access information.
4. Trust investments:  Unless expressly provided otherwise in the governing instrument, trust investments are subject to applicable state laws, including the Uniform Prudent Investor Act. If cryptocurrency will be held in a trust, the estate planning drafter should consider including instrument-specific language in the trust, authorizing the trust to hold and manage crypto as a trust investment.  As a best practice, planners should consider including very specific language setting forth the client’s intentions around cryptocurrency investments if they are to remain in a trust.  Alternatively, depending on the circumstances, and as advised by estate planning counsel, the client could designate a third party to direct the trustee as to cryptocurrency holdings or approval of holdings.  Other alternatives for planners may include seeking consent from the beneficiary or court to retain the crypto as an investment. Absent an explicit waiver of the requirements of the prudent investor standard in the governing document, or absent an express direction in the document to acquire and retain crypto assets, the fiduciary may be exposed to liability if the cryptocurrency comprises a substantial portion of the portfolio. As the crypto world continues to evolve quickly, planners may consider including language releasing the fiduciary for acting in good faith to manage any interests in cryptocurrency.  Keep in mind that the fiduciary may need to seek court instructions or undertake added costs and diligence to deal with unanticipated issues. 
5. Add Flexibility:  Planners may also consider including authority in the trust document to change the trust situs, decant or modify the trust to deal with unanticipated problems. To that end, planners could include appropriate language in trust documents providing authority for the trustee to delegate authority to others with specialized technical knowledge to hold and manage the crypto. 

Taxation of cryptocurrency

Although many traditional rules of taxation apply, novel issues have begun to surface regarding the taxation of cryptocurrency.  In 2014, the Internal Revenue Service issued Notice 2014-21, stating that for tax purposes, cryptocurrency will be treated as property, not currency. Thus, crypto transactions are subject to taxation as capital assets, and sales or exchanges will trigger short or long-term gains depending on the holding period.  Owners of cryptocurrency should remember that purchasing one cryptocurrency with another cryptocurrency will trigger a capital gain or loss, since that transaction is an exchange. In 2019, the Internal Revenue Service (IRS) issued Revenue Ruling 2019-24, which provided further guidance and included a list of frequently asked questions to assist taxpayers in understanding the tax consequences of crypto. 

Absent traditional third-party intermediaries, the taxpayer generally bears the burden of tracking and recording tax reporting information, such as the date crypto was purchased, the quantity of units or tokens purchased, and the cost basis of each unit or token purchased. Larger crypto exchanges may provide recordkeeping of this information for purchasers, but reporting capabilities are not consistent between all exchanges. An exchange may lack basic information about the identity of buyers and sellers, since crypto transactions were intended to be executed on a private network without intermediaries. 

From an estate tax standpoint, under current law, crypto receives a stepped-up cost basis at death equal to the fair market value at the date of death, just as with other capital assets owned at death.  Thus, the fiduciary must determine the date of death value for all cryptocurrency owned by a decedent.  

The IRS has taken an interest in cryptocurrency valuation and reporting. In 2019, the IRS added a question to Form 1040 requiring taxpayers to identify if he/she had engaged in certain virtual currency transactions during the tax year. Additionally, legal questions have arisen regarding income tax consequences of mining and staking new cryptocurrency coins. It is likely that novel tax issues will continue to arise as cryptocurrency use proliferates.

Conclusion

Cryptocurrency presents numerous challenges for owners, their advisors and their fiduciaries. Laws governing digital assets, particularly cryptocurrency, continue to evolve.

Cryptocurrencies held in an estate or trust can have major implications for an estate plan, such as how the assets will be held for custody, taxation and fiduciary responsibility. The presence of cryptocurrency in an estate or trust inevitably will become more commonplace as clients increasingly acquire interests in cryptocurrency. In the meantime, advisors and fiduciaries must become familiar with the administrative and tax issues raised by cryptocurrency ownership. Estate planners should ensure that a client’s legal documents support post-death access to information, as well as clear disposition of digital assets. As with any other asset, good recordkeeping during the client’s lifetime helps provide for predictable tax results and administration.