Mining Your Own Business: Tax and Estate Planning with Crypto

Cryptocurrency, a digital form of currency that uses cryptography for security, has become a significant part of the global financial landscape. As such, it has also become an important consideration in estate planning. This Dechert OnPoint provides an overview of the ownership and estate planning considerations and implications for U.S. and non-U.S. persons.

Access and Ownership

Cryptocurrencies, such as Bitcoin and Ethereum, can be owned by individuals or entities and are not typically tied to a physical location. They rely on digital wallets, which can be stored either on local devices not connected to the internet or on traditional or cloud-based servers. Financial service providers and platforms, such as Fidelity, Binance, and Robinhood, also offer third-party cryptocurrency custody and trading services using digital wallets that they control, rather than their customer.  And in January 2024, the Securities and Exchange Commission announced it would approve bitcoin exchange traded funds (ETFs).  The nature of cryptocurrency ownership can significantly impact estate planning, particularly when determining which jurisdiction has the right to tax and oversee probate proceedings.

Access to cryptocurrencies held in these digital wallets is secured by alphanumeric private keys, ideally only accessible to the digital wallet's owner.  In the event of the owner's death, accessing these assets can be challenging depending on the digital wallet security features, such as so-called administrator's policies.  The loss of a private key can also pose significant problems, as it may render the cryptocurrency inaccessible.

Income Tax Classification and Treatment

For income tax purposes, the U.S. treats cryptocurrency as property and taxes it as capital gains.  This means that cryptocurrency is generally subject to the same rules as any other property with respect to determining character of gain (long-term versus short-term), loss carryforward, etc.

In certain areas, the IRS has announced rules specific to cryptocurrency.  The IRS considers yields or rewards received from “staking” cryptocurrency (roughly analogous to receiving interest on a loan) as income that must be reported.  Likewise, any cryptocurrencies procured through mining must be reported as income.  And in 2023, the IRS announced that charitable donations of cryptocurrency exceeding $5,000 will only be deductible if the taxpayer submits a qualified appraisal.

Estate Planning Considerations

Inclusion in Estate Plan

Cryptocurrency should be explicitly addressed in the owner’s will or revocable trust, whether they are U.S. persons or non-U.S. persons.  If not addressed, the default rules under the laws of many states will treat cryptocurrency the same as other digital assets (e.g., digital photos, emails) and distribute the cryptocurrency accordingly.  A digital asset instruction letter can provide access and management instructions (though depending on the jurisdiction, it may not be binding).  If cryptocurrency is sold during estate administration, the sale may be subject to informational reporting and income tax filings to federal and state regulators.  

Trusts

Contributing cryptocurrency to a trust can ensure it is managed according to the contributor’s wishes. However, not every jurisdiction recognizes the validity of trusts.  For cryptocurrency held in a digital wallet, there should be checks in place to ensure that all records of transactions and distributions are adequately maintained and that the private key is securely managed by the trustee.

Cross-Border Issues for U.S. Persons

U.S. citizens are subject to estate tax on their worldwide assets wherever situated.  However, the estate tax rules of other countries could potentially subject a U.S. citizen’s cryptocurrency to double taxation.  For example, if a U.S. citizen held her cryptocurrency on a physical zip-drive and died while the zip-drive was physically located in South Korea (which does not have an estate tax treaty with the U.S.), the cryptocurrency would be subject to US estate tax and may also be subject to South Korean estate tax depending on the local South Korean estate tax rules.  Similarly, if a U.S. citizen died while her cryptocurrency was owned through a South Korean-based crypto exchange, the same double estate tax issue may apply.    

Considerations for Non-U.S. Persons

Non-U.S. persons are subject to U.S. estate tax only on their US situs property.  The U.S. situs rules for cryptocurrency are not yet developed, leading to potential jurisdictional issues and double taxation concerns.  In addition, the U.S. has estate tax treaties with 14 countries that may affect the taxation of cryptocurrency.  Some treaties, such as the U.S.-Germany estate tax treaty, assign situs based upon the domicile of the decedent as determined under the treaty, with the exception that real property and permanent establishment property may be taxed by the country where such property is physically located regardless of domicile.  Therefore, cryptocurrency of a decedent subject to the U.S.-Germany estate tax treaty would likely be subject to estate tax by the decedent’s country of domicile as determined under the treaty, regardless of where the cryptocurrency was physically stored or custodied.

Non-U.S. persons may also have separate reporting requirements in their home country and should ensure their estate planning documents are valid in both their home country and the U.S.

Cryptocurrency classification and regulation vary by jurisdiction. At least one jurisdiction (El Salvador) classifies certain cryptocurrencies as official national currency and legal tender.  Other jurisdictions, like the U.S., U.K., Canada, and others, generally treat cryptocurrency as property for tax purposes.  Still other jurisdictions, such as China, have banned or restricted certain activities related to cryptocurrencies.  

Given the complex and rapidly evolving nature of cryptocurrency regulation and its implications for estate planning, it's crucial that holders of cryptocurrency seek professional legal and tax advice.