Don’t Let Volatile Digital Assets Blow Up a Client’s Estate Plan

This article was originally published by Bloomberg Tax*. Reproduced with permission. Copyright 2024 Bloomberg Industry Group, Inc. (800-372-1033) bloombergindustry.com.  

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Estate planners Matt McClintock and Abbie M.B. Everist explain the importance of addressing digital asset issues, particularly given the nascent and “cryptic” nature of the asset, the industry, and the technology through which it is administered — and likely the novel understanding of estate fiduciaries who would administer such assets.

Digital assets present distinct valuation and administrative challenges that require specific strategies as part of an individual’s estate plan. The complex manner in which these volatile assets are controlled poses risks to fiduciaries and beneficiaries alike. Beyond Bitcoin, Ether, or other large market-cap blockchain tokens, lack of market depth and liquidity present uncertainty and unpredictability in sales and trading markets. As a result, it’s essential to consider the unique characteristics of digital or “virtual” assets when creating an estate plan.

The Need for a Trusted Administrator

Individuals should ensure that a trusted person, such as the planned executor for their estate or their successor trustee, knows about these assets, has at least a rudimentary understanding of digital assets, and is able to access them reliably and securely. Like cash, physical gold, or bearer bonds, Bitcoin and other digital assets are “bearer” assets — they are treated as though they are owned by whoever holds the assets at any given moment. Bearer assets have no title. Absent clear evidence to the contrary, an individual who can control a digital asset is deemed to own the asset.

Most digital assets are controlled through cryptographically secured digital signatures by the owner using a secret “private key” (see Appendix below). Especially as this may involve assets of significant value, keeping private key information secure is paramount to the asset owner, fiduciaries, and beneficiaries.

Because wills may become public documents through the probate process, passwords, key phrases, or other details regarding accounts, account numbers, or other sensitive information should never be appended as a schedule to an estate planning document. Moreover, wills become effective only after an individual’s death and after the will is successfully admitted to probate in a court of competent jurisdiction, depending on the state’s probate laws. Wills are of no help if an individual has become incapacitated but has not died, a possibility that may be covered in a power of attorney.

Properly funded trusts generally avoid the public probate process, maintaining privacy for an individual who becomes incapacitated or who dies. While it may be appropriate to include schedules that generally describe assets that an individual intends to be held by the trust — of course, including a limited description of the nature of the individual’s digital assets — highly sensitive information should not be shared with a drafting attorney, entered into a document assembly program, stored on an internet-connected computer, or shared with a nominated fiduciary before it’s truly necessary.

Further, because digital assets with significant monetary value are relatively nascent, technology for safely storing, accessing, and exchanging these assets changes rapidly and frequently. Many owners of digital assets exchange the assets with some regularity and may also experiment with various storage techniques. To this end, any estate plan designed for digital assets must be actively maintained to ensure both that the substantive provisions of the documents are current and that any references to specific assets or storage methods in use remain up to date. 

The range of methods for securing digital assets is truly dizzying. An individual may use various software wallets on their computer or mobile device, they may have one or more external peripherals (key signature devices), several custodial or exchange accounts, and hard copy writings that indicate the nature and extent of their digital assets. Adding to the complexity, different applications are required for different types of assets. To allow for “storage,” many digital assets have specific technical requirements, which are often incompatible with other types of digital assets.

An industry is developing to provide custody solutions for digital assets, similar to holding assets in a bank. Many people initially invested in digital assets, in part, to allow for private financial transactions without the involvement of a custodial intermediary. Indeed, disintermediation of financial transactions is a key part of the original thesis in which Satoshi Nakamoto described Bitcoin as a “peer to peer electronic cash system.” Long-term digital asset purists often do not trust corporate custodians; however, many companies are reputable, closely regulated, and appropriately insured and will significantly ease the burden of administering digital assets, especially when family members and other trustees do not have expertise in this niche area. digital assets, especially when family members and other trustees do not have expertise in this niche area.

As digital assets become more mainstream — and frankly, more valuable — individuals who first acquired digital assets as a novelty or countercultural expression must shift their perspective and plan carefully to mitigate tax liability from sales or gifts of their assets, protect themselves and their loved ones from potential creditor claims, and structure inheritances for the beneficiaries of what may be a surprising amount of wealth. Professional custodians allow digital assets to be held in custodial vaults that may be titled in the name of a trust or other entity. This makes it possible to incorporate the full range of estate planning techniques to digital assets, just as for conventional assets.

Challenges Posed by Volatility

Digital assets may attract investors due to their apparent high-return potential, but this also entails risk, especially for estate and gift planning purposes. Valuing digital assets for tax purposes can be challenging if the asset is either not traded on an open market or traded so infrequently that there are few comparable transactions as of the date of transfer. 

The difficulty involved in valuing these digital assets presents an additional problem for gift and estate planning, because gift reporting requires a qualified valuation as of the date of transfer for adequate disclosure, and the substantiation requirements for a charitable gift in excess of $5,000 with a contemporaneous written acknowledgement from the charity. This problem may be alleviated for certain digital assets that have a robust market, such as Bitcoin, but it is imperative that clients discuss these issues with their tax and valuation professionals before conducting any gifting.

Additionally, past markets have shown that digital assets are often subject to extreme price volatility and protracted downturns. Market prices of digital assets are influenced not only by investor sentiment and movements of large volumes in thinly liquid markets, but also by the uncertain and uneven regulation in the United States. To the extent there is significant fluctuation of value before a gifting plan is initiated, special care must be taken to determine the proper asset allocation that should be transferred. While a significant decline in value before gifting may present an opportunity to transfer a larger percentage of assets, it would be unwise to further reduce an individual’s asset base beyond their means. Finally, this increased market risk may be especially important when digital assets are gifted in trust. Generally, trustees must act as “prudent investors” and any estate planning documents should contemplate the application of the statutory prudent investor rule; if appropriate, the rule should be modified or waived.

Security Concerns

As described above, digital assets are unique in the way the owner holds and maintains them. Although there is a growing number of regulated, qualified custodians who provide bank-grade management of digital assets, it’s safe to assume that most individuals who own digital assets maintain them in self-custody. Access to the assets is maintained in cryptographically secured software applications called “vaults” or “wallets,” and managed by complex passwords or cryptographic “private keys.” Often, the owner will use a peripheral key signature device to generate a wallet address and manage digital asset transactions. Manufacturers of such devices include Ledger, Trezor, ColdCard, Keystone, SecuX, and other companies. While the devices are not the actual keys, they are used to manage digital asset transactions secured by the individual’s private keys. 

Because digital assets are bearer assets, the security of passwords, private keys, and key signature devices is paramount. The short history of virtual currency is littered with tales of real individuals who have lost very large fortunes. One notable example was an early Bitcoin investor, Mircea Popescu. Estimates of Popescu’s holdings at the time of his drowning in June 2021 off the coast of Costa Rica reportedly range from the tens of thousands to more than 1 million Bitcoins. Popescu was 41 when he died, and his alleged cache would be worth well in excess of $2,000,000,000. A self-described “sovereignty maximalist,” it appears that Popescu did not have an asset succession plan in place when he died. To date, there has been no known successful retrieval of his fortune.  

Regulatory and Legal Concerns

Digital assets are still in their infancy, and there are many gaps and uncertainties in how the assets are regulated. The IRS stated in Notice 2014-21 that “convertible virtual currencies” like Bitcoin and other digital assets are considered property under the tax laws and are subject to income tax treatment as such. This means that in general, compensation in digital assets is taxable as ordinary income when received, and subject to capital gains tax when sold or used. There is mixed guidance — or in some areas, no guidance — as to the tax treatment of air drops, staking or delegation rewards, or other forms of receiving digital assets. The IRS has made compliance and enforcement of tax laws a high priority and now dedicates significant taxpayer resources to pursuing noncompliant taxpayers who have underreported digital asset transactions. and now dedicates significant taxpayer resources to pursuing noncompliant taxpayers who have underreported digital asset transactions.

Estate Tax Savings Opportunities With Digital Assets

Individuals with large estates often engage in advanced estate planning to use their federal gift, estate, and generation-skipping transfer tax exemptions during life to shift value and future wealth appreciation out of their taxable estates to reduce future estate tax liability. Under the 2017 Tax Cuts and Jobs Act, the basic exclusion amount for U.S. individual taxpayers was temporarily raised to $10,000,000, adjusted annually for inflation — in 2024 it is $13,610,000. After Dec. 31, 2025, the BEA will revert to $5,000,000 unless Congress intervenes. 

By proactively applying their federal gift tax exemption (and, when appropriate, allocating generation-skipping transfer (GST) tax exemption) to completed gifts during their lifetime, wealthy donors may shift the future income and appreciation out of their estate and avoid federal (and, if applicable, state) estate tax on those assets. Because the federal estate tax rate of 40% applies to every dollar above the estate tax exemption, proactive estate tax-oriented planning can be extremely valuable. 

Ideally, donors would use their transfer tax exemption to shift assets with the highest probability of appreciation out of their estates. Of course, individuals should consider the volatility of their holdings before gifting to trusts. As with all volatile assets, there is inherent risk in gifting digital assets, because if they were to decline in value (and the taxpayer dies before the value recovers), the taxpayer would have used their transfer tax exemption inefficiently. Trying to time a gift transfer for dips in the market may mitigate some of this risk. If the assets have a lower valuation when transferred, more assets may be transferred out of the taxable estate along with future associated growth. (Of course, trying to time any financial market may easily work against the donor.)

Another technique that may be applied in conjunction with that illustrated in Example 1 is the creation and funding of a family investment entity with tokens and other assets that may justify valuation adjustment for lack of marketability or lack of control. 

Layering estate planning strategies is a very important concept to designing a tax-efficient plan while achieving the donor’s goals. 

Gifting to irrevocable completed gift grantor trusts, often referred to as intentionally “defective” grantor trusts (IDGTs), is a favored estate planning strategy that may incorporate both techniques described above. These trusts proactively use the donor’s transfer tax exemption for a lifetime gift, avoiding future estate tax when the donor dies. IDGTs also provide other important opportunities that other trust types may not: 

• The grantor is responsible for income tax on trust income that reduces the grantor’s taxable estate; 
• The grantor is able to sell additional assets to the trust without the sale creating a tax recognition event (including into a GST exempt trust); and 
• If provided in the trust terms, the grantor or a qualifying powerholder is able to substitute assets between individually owned grantor assets and trust-owned assets. 

Below are examples to demonstrate each of these points. 

Completed gifts made during life receive a carryover basis, meaning the recipient’s basis is the same as the donor’s original basis for purposes of calculating the recipient’s gain and tax liability thereof upon any later disposition of the asset (§1015). (This is as opposed to an “incomplete” gift receiving a “step-up” in basis or “basis adjustment” on the date of the donor’s death.) Thus, grantor trusts often include as one of the retained grantor trust powers a “power of substitution,” which causes the grantor to be treated as the income tax taxpayer. The power to substitute assets is an “administrative” power contemplated by the phrase “…power to reacquire the trust corpus by substituting other property of an equivalent value” under §675(4)(C). The power must be exercisable in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity. The trustee does have an affirmative duty to ensure that the substituted assets are in fact of equivalent value.. The power must be exercisable in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity. The trustee does have an affirmative duty to ensure that the substituted assets are in fact of equivalent value.

Because the grantor of the trust is treated as the taxpayer for income tax purposes, all income tax attributes (such as credits and deductions) will be reported on the grantor’s individual income tax return for federal and state income tax purposes, even though the value of the principal in the trust is outside the grantor’s estate for transfer tax purposes. 

The next point to discuss is the donor’s ability to sell assets to an IDGT without triggering tax recognition. The concept is the same as in Example 1, except that the estate savings on the gain are limited to the value in excess of the note payable and related terms of the sale. 

When using lifetime gifting for estate planning, there is an important income tax tradeoff that must be considered — and potentially mitigated — with the trust design and asset monitoring. 

When assets are inherited through a decedent’s estate, the inheritor receives a new basis in those assets for income tax purposes, pursuant to §1014. This is typically referred to as a “step-up” in basis, although the inheritor may actually receive a “step-down” in basis if the assets have gone down in value. By contrast, under §1015, assets received through a lifetime gift — whether outright or to an irrevocable trust — receive a “carryover” basis equal to the basis in the hands of the transferor who made the gift.  

Income tax basis is important in determining the amount of taxable gain or loss when an asset is later sold. Intelligent estate planning must consider the tradeoff between shifting value out of the estate for estate tax purposes (potentially eliminating 40% estate tax on value above the estate tax exemption) and losing the ability to reset income tax basis by removing the value of an appreciated asset from being included in the donor’s estate. Fortunately, when using an IDGT, there’s a workaround through the use of a substitution power to create grantor trust status for an irrevocable trust.

If Alice were to hold those coins for one year or less, her gains would be short-term capital gains subject to tax at the ordinary income tax rate. If longer than one year, her gains would be long-term capital gains, subject to lower graduated rates. In this case, her long-term capital gains tax rate will be 20% tax on that gain. In either case, she may also be subject to 3.8% net investment income tax.

The trust’s value is preserved without income tax erosion from the recognized LTCG. If Alice is a resident of California, her state income tax liability could be up to an additional 13.3%. Alice’s personal income tax from this sale could be as high as $3,339,000, as the combined California and federal long-term capital gains tax rate could be as high as 37.1%. Ouch!

If trust assets are sold after the trust becomes non-grantor due to either Alice’s passing or her release of grantor powers, because Alice’s gift to the grantor trust during life shifts her basis to the trust, the trust will recognize gain based on the value of the assets at the time of sale reduced by Alice’s original basis. Because the value of the assets will not be included in her estate, the trust will likely not receive the step-up in basis under §1014 when Alice dies. Although the estate will avoid the 40% federal estate tax (and state estate or inheritance tax, if applicable), the trust may later incur considerable income tax liability for federal and, likely, state income tax purposes. 

How may the impact of carryover basis be mitigated? If the trust includes the power to substitute assets, and if the power was exercised before the grantor’s death, she might have swapped the low-basis assets in the trust for high-basis assets of equivalent value. The low-basis assets will be included in her estate and receive a new basis when Alice dies. Let’s look at the numbers once more.

As a practical matter, the biggest issues with optimizing the swap power are ensuring that the estate planning strategies are consistently monitored to exercise asset swaps over time and the that the grantor has high-basis assets to swap.

One last planning consideration to review is the impact of GST exemption in trust on multigenerational estate, gift, and GST taxes. GST tax is imposed at a 40% rate in addition to estate or gift tax for transfers that have not been allocated GST exemption to beneficiaries who are more than one generation below the grantor (for example, grandchildren). Every person is currently given the same amount of GST exemption as the gift and estate exemption ($13,610,000 in 2024). Allocating GST exemption to trusts protects trust assets from additional levels of estate, gift, and GST tax for future generations.

For ultra-high-net-worth families, GST planning is an incredibly impactful way to protect assets multi-generationally from gift, estate, and GST taxes. Effective GST planning includes in-depth analysis of jurisdiction selection for trust situs based on the location of family members, assets, and fiduciaries; type of assets; creditor protection; and trust duration. State trust law changes frequently, so if a trust has already been established, all these factors should be reviewed to see if it continues to meet family goals.

Conclusion 

Digital assets are increasingly in demand as investments and should be discussed during the estate planning process for proper administration, so the value of the assets is not lost. It is important to consider digital assets when creating an estate plan. Because the digital asset space is constantly evolving, it’s essential to revisit your estate plan frequently to verify that it remains up to date with the latest developments. By doing so, you may help protect your digital assets and confirm that they are passed on to your loved ones or charitable beneficiaries according to your wishes.