This article was originally published in Tax Notes Federal and Tax Notes State on March 14, 2022.
Recent headlines about hundreds of millions in net worth being lost because of mismanagement of cryptocurrency accounts[1] may leave many of us with a head-shaking sense of schadenfreude, but as crypto assets become more ubiquitous, and regular investors enter the market, it behooves us as advisers to begin instilling good crypto hygiene habits in our clients.
Practitioners are increasingly likely to encounter some exposure to crypto assets in taxable estates. This article addresses the procedural tax and practical issues that may arise in the life cycle of administering a taxable estate with a cryptocurrency component.[2]
Access
One of the early steps in any estate administration is for the executor or trustee to obtain access to the decedent’s assets, and when appropriate, change title to an administrative trust (usually the case in larger estates with complex holdings).
Before even turning to the issue of accessing a decedent’s digital wallet, there is the fundamental issue of how the executor or trustee (hereinafter collectively referred to as the fiduciary) is supposed to be aware of the existence of these assets. Unlike brokerage or bank accounts, which usually have some form of account statements, crypto exchanges do not issue account statements — and of course, there is no public record of privately stored coins.
Probate rules governing estate or trust administration usually impose an affirmative duty on the estate administrator to control and preserve the decedent’s property,[3] and especially in case of a probate, file an inventory and appraisal with the relevant state court.[4] But how far does a duty of due diligence stretch if it isn’t immediately apparent that the decedent owned cryptocurrency? Do beneficiaries have a claim against a fiduciary who does not independently detect the presence of cryptocurrency?
In the absence of any case law or specific guidance on the point, a “reasonable person” standard is likely to hold. While it may be reasonable to expect the fiduciary to review prior tax returns to determine if any crypto gains were reported, it would certainly not be reasonable to require any fiduciary to find a way to access and review all the decedent’s possible data storage devices accumulated during a lifetime. Just as the fiduciary is not expected to try to guess what every key tucked away in any remote corner of a decedent’s house may unlock, the same logic should apply to digital devices. Further, if a beneficiary suspects that any person has knowledge of a decedent’s cryptocurrency assets, the beneficiary may be able to avail themselves directly of some actions — for example, they may be able to proactively request an interrogatory or examination under oath.[5]
The next (and most obvious hurdle) for estate administration is for the fiduciary to access the asset. The keystone of cryptocurrency ownership are the private “keys” that are required to access and transfer the coins from the wallets. These keys are complex digital codes, and stories abound of early bitcoin enthusiasts who lost their private keys.[6] Cryptocurrency wallets are generally of two broad types with two subtypes: (1) an exchange-hosted wallet (that is, when an exchange such as Coinbase or Kraken takes custody of the private keys) or (2) noncustodial wallets (that is, when the owner controls the private keys). Another dichotomy is whether the wallet is “hot” (that is, connected to the internet) or “cold” (offline). Trading/spending cryptocurrency is completed through a hot wallet. Some exchanges allow transfer to a personal device, while others may not.
A fiduciary seemingly steps into this spiral of passwords protected by additional passwords. Some of this burden may be alleviated if the cryptocurrency is held in an established exchange because it is more likely to have protocols in place to transfer accounts.[7] As these platforms grow and become more mainstream, transfer-on-death or pay-on-death capabilities may also become available, though of course it is not of much help to a fiduciary when the deceased owner fails to make use of the designation. Currently, no exchange offers beneficiary designations.
Although many states (currently 46) adopted either the Uniform Law Commission’s Uniform Fiduciary Access to Digital Assets Act (2014) or the revised version,[8] these rules may be of scant help to a fiduciary trying to access an exchange wallet or some form of hardware wallet. Although these rules impose a disclosure requirement on a custodian, this affirmative duty to disclose is very narrow and the custodian is not required to share passwords and may further require the fiduciary to produce usernames or account identifiers for access.[9] In case of a hardware wallet, the manufacturer is unlikely to even qualify as a custodian, so these rules are probably not applicable in that context. With exchange wallets, in most cases, if the fiduciary already has the noted information, the fiduciary could access the account directly without requiring any action from the custodian exchange.
As other commentators have noted, entrusting one person with private keys may have its own pitfalls since it provides unregulated ability to make transfers. For example, the fiduciary could make unauthorized transfers that would likely not be recoverable.[10] Of course, if the estate beneficiaries are aware of the existence of the asset, the fiduciary may bear full fiduciary liability of such actions.
Beneficial interest
It is common practice for most standard testamentary documents to include a simple designation of the testator’s personal property, sometimes with reference to a separate written instrument. This model generally intends to distribute true tangible items like jewelry, art, and vehicles and less valuable items like clothes. Usually these are outright distributions that are made off the top, before the remainder of the estate is administered.
Of course, this may not be how the decedent wanted the cryptocurrency to be distributed, but the fiduciary may not have a choice. The IRS has not revised Notice 2014-21, 2014-16 IRB 938, which classifies cryptocurrency as property (rather than a security or cash), which would arguably subject the distribution of cryptocurrency to the same dispositive provisions as the decedent’s favorite necklace or cat statue!
However, if the testamentary documents specify that the off-the-top distributions are limited to tangible personal property, it should not apply equally to cryptocurrency, which is per se intangible. That said, if the private keys are stored on an offline storage device, that device itself would be tangible personal property presenting a peculiar conundrum for the fiduciary. In such cases, a fiduciary may be well advised to obtain instructions from the court regarding applicable dispositive provisions before making any distributions of cryptocurrency assets, because it may directly affect beneficial interests (for example, it is not uncommon to leave personal property outright to a spouse but create irrevocable lifetime trusts with current and residual beneficiaries for the remaining estate).
Estate tax liability
Determining the dispositive provisions also has a significant impact on the tax liability related to cryptocurrency assets, specifically whether the burden is borne by the beneficiary of the asset or the remainder beneficiary. When the two are the same, this may not be an appreciable difference but when the two classes differ, it may lead to unexpected results.
For example, consider a circumstance in which the decedent would not have had a taxable estate but for cryptocurrency and left his personal property to children and the remainder estate in trust for grandchildren. If the distribution of personal property is off the top before the payment of estate tax, the remainder estate would be depleted by the payment of estate tax and may even become bankrupt! In a true adding-insult-to-injury situation, not only did the grandchildren end up bearing the tax liability for an asset that didn’t pass to them, but they may end up with little or nothing at all.
When the presence of a wallet is known but the wallet itself is inaccessible, the fiduciary may not even know whether the estate is taxable until the wallet is accessed. This of course leads to a fundamental question — is there even a reportable asset if it is inaccessible? Or has the asset itself “disappeared,” given that it is inaccessible? Reasonable minds may disagree, but the author’s opinion is that the asset itself does not disappear even if it is inaccessible. After all, there exists the possibility — however remote — that it can be accessed in the future. In such a situation — when a wallet exists with an unknown amount of cryptocurrency (and therefore unknown value) — one approach may be reporting it on Form 706 with a value of zero. Another approach, which may be better, would be to report it as “indeterminate value” while also reporting it as a loss of the estate with the same notation. The latter approach would also work when the amount of cryptocurrency is known. In that case, the value should be reported both in the gross assets on Form 706[11] and offset as a loss of the estate. Schedule L of Form 706 provides for reporting of losses from thefts, fires, storms, shipwrecks, or other casualties that occur during the settlement of the estate.
Of course, convincing the IRS that the asset is irredeemably lost because of misplacement of the private key may be another matter. In many instances, the proof of loss is made by submitting an insurance claim — but there is so far no insurance available to protect against a loss attributable to forgotten or lost passcodes or private keys. Some prominent insurers are starting to provide insurance protection for private keys but only when those keys are held in an online wallet.[12] An analysis by a cryptosecurity expert evidencing that the wallet is inaccessible — or the like — would strengthen the case (but by no means offer an airtight solution) that the loss should be allowed against the estate.
Liquidation/duty to diversify
As with any volatile assets or concentrated positions, the duty to diversify (usually espoused under a state’s prudent investor rule[13]) will pose an ongoing challenge for any trustee administering an estate with substantial holdings in cryptocurrency. Any owners who feel strongly about allowing or maintaining a concentrated position should proactively ensure that such duties are waived. This must be counterbalanced with the possibility that an unsophisticated fiduciary maintains a cryptocurrency position because the fiduciary doesn’t fully appreciate the complexities of this asset.
As the above discussion reflects, cryptocurrencies heighten administration challenges inherent in any estate for a layperson acting as a fiduciary, and may present unforeseen additional issues. Keeping this in mind, at the very least, any owner of cryptocurrency is well advised to name fiduciaries who are well versed in this asset and to enable them by taking basic measures to allow for a successful estate administration.
“Estate Administration of Cryptocurrencies,” published on March 14, 2022, Tax Notes Federal, cover and pp. 1525-1528 and Tax Notes State, cover and pp. 1153-1156.
