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The Private Client Services team is pleased to announce the launch of the “Estate Planning with Digital Assets” series. In the first issue, Vanessa L. Maczko discusses terminology that estate planners and their clients must understand to engage in conversations about digital assets in an estate planning context, as well as the necessary information clients must share for the conversation to be productive and effective.

As estate planning attorneys, it is our job to assist clients with the proper disposition of their assets at death. Part of this process involves advising clients with respect to lifetime gifting to reduce or eliminate the estate tax burden they may face at death. One frequent conversation we have with our clients is how to dispose of their digital assets, whether at death or as part of a lifetime gifting plan. We will outline this conversation in a multi-part series. In this first part, we introduce terminology that estate planners and their clients must understand to engage in this conversation as well as the necessary information our clients must share for the conversation to be productive and effective.

5 QUESTIONS FOR CLIENTS TO ANSWER.

Before engaging in an estate planning transaction with a digital asset, clients must answer the following five questions:

  1. Do you invest in digital assets?
  2. What type of digital assets do you own?
  3. Do you have a record of when you acquired the digital asset and what you paid?
  4. Do you use a hot wallet and/or cold wallet for storage of the digital asset?
  5. Who has access to the hot and/or cold wallets?

To process this information and advise clients effectively, the estate planner must understand the types of digital assets and how they are stored.

WHAT ARE DIGITAL ASSETS?

First and foremost, it is helpful to understand what a digital asset actually is. The Revised Uniform Fiduciary Access to Digital Assets Act defines a digital asset as an electronic record in which an individual has a right or interest. This definition would cover what we consider to be two different types of digital assets: “sentimental digital assets” and “investment digital assets.” The former would cover digital assets that are sentimental in nature such as emails, social media accounts and digital photos and videos. For these types of assets, our main concern as estate planners is allowing loved ones to access to such assets upon a client’s death.[1] For investment digital assets, the concerns are more numerous and are the main discussion of this series.

Investment digital assets are defined by the IRS on Form 1040, U.S. Individual Income Tax Return, for calendar year 2022 as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” These types of digital assets include, but are not limited to, convertible virtual currency and cryptocurrency, stablecoins and non-fungible tokens (an “NFT” or “NFTs”).

Cryptocurrency Generally.

The most common “investment-type” of digital assets that we read and hear about is cryptocurrency. There are more than 4,000 types of different cryptocurrencies in existence, with Bitcoin and Ethereum as two of the most well-known. Despite its name, cryptocurrency is distinct from currency, like the U.S. dollar, in two important ways:

  1. Cryptocurrency is not treated like money (also known as “fiat”); it is considered property.
  2. There is no central or regulating authority for cryptocurrency — no Federal Reserve is involved. Instead, cryptocurrency is based on a network that is distributed across a large number of computers. Transactions with cryptocurrency are supported by a technology known as blockchain, which uses a coding and decoding process called cryptography that is essentially a digital ledger of transactions. The ledger is duplicated and distributed across an entire network of computer systems on the blockchain making it difficult to counterfeit or cheat the system.

Stablecoins and NFTs.

Stablecoins are a type of cryptocurrency where its value is pegged to another asset class, such as another currency, commodity, or financial instrument. NFTs turn a digital file — a sports highlight, a work of art, or even a tweet — into a token. The token is then bought, sold and tracked through a blockchain. The token cannot easily be interchanged with another token — it is unique and, thus, non-fungible. Ownership of an NFT can be complicated in that only one individual or a set number of individuals own the token. A different individual can own the intellectual property rights to the content behind the token, and many different individuals may own a digital copy of the NFT. Like cryptocurrency, stablecoins and NFTs are property and also have no central or regulating authority.

Estate Planning Takeaways.

The two characteristics of cryptocurrencies mentioned above are important, especially in the context of estate planning, because:

  1. As property and not currency, cryptocurrency has a basis (likely, equal to the acquisition price). When disposing of cryptocurrency, the seller will have a gain or loss, equal to the difference between the sale price and the seller’s basis. When gifting cryptocurrency, the donee will inherit the donor’s basis. Therefore, investors must keep diligent records of their basis in their investment-type digital assets.
  2. Further, as property, cryptocurrency has a fair market value, which may be difficult to determine. Some digital assets will have a value determined with reference to a price index. Others, however, may not or may have a value determined with reference to a variety of inconsistent price indexes. For these, a qualified appraiser should engage.
  3. Without a central or regulating authority, there is no insurance, like the FDIC, for the cryptocurrency investor and, at an even more basic level, there is no customer service — there is no phone number to call or entity to email to obtain information on an investor’s investments. This latter point can become a big problem when an investor dies and his or her heirs are left without information on what digital assets the decedent owned.

Example. Consider the tragedy of Matthew Mellon, who was an early investor in Ripple, a cryptocurrency and digital payment network. He died unexpectedly with an outdated Will, and his holding of XRP, a cryptocurrency managed by Ripple, was reportedly worth $193,000,000 at the time of his death. However, no one had the necessary passwords for his Executor to access these assets. It is believed Mr. Mellon held his passwords in a cold wallet (discussed in the next section).

As a result, Mr. Mellon’s Executors and their counsel had a highly fluctuating asset that they could not liquidate in order to pay off debts and his estate tax bill. About a year and a half after Mr. Mellon’s death, his estate was worth less than half of its original value, and the price of XRP was still on the decline. The only thing in their favor was the fact that XRP was managed by Ripple, whereas most cryptocurrencies are not closely tied to a centralized entity. Therefore, the lawyers were luckily able to get ahold of XRP through Ripple. Due to an agreement between Mr. Mellon and Ripple, his estate could sell off XRP in small amounts daily.

HOW ARE DIGITAL ASSETS STORED?

Digital Wallets.

“Investment-types” of digital assets are stored in a “digital wallet,” which can be webbased or hardware-based, and are described below:

  1. Web-based wallets, known as “Hot wallets,” are wallets that run on internet-connected devices such as smartphones, tablets or computers. These wallets generate the private keys to your coins on such internet-dependent devices. Although hot wallets can be convenient in the way you are able to access them and handle transactions with your assets, they are digital so they lack security and can potentially lead to stolen currency through hacking. Given their potential security issues, many investors use hot wallets for small amounts of cryptocurrency and for frequent trading.
  2. Hardware-based wallets, known as “Cold wallets,” on the other hand, are stored on tangible devices not connected to the internet so there is far less risk of being compromised by cyberattacks or unauthorized access. Sometimes cold wallets are also known as offline wallets or hardware wallets. An investor will use a private key or passcode to access the cold wallet, which will then generate a private key or passcode for the investor to use to access her digital assets. As with a hot wallet, once a user has access to someone’s wallet, the user has access to that person’s digital assets. However, whereas a hot wallet can be hacked, a cold wallet can only be accessed by physical possession of the device and knowing the private key to access the device.

Estate Planning Takeaways.

In order to successfully engage in estate planning with a digital asset, the donee of a gift or heir of a bequest must be given access to the donor’s hot wallet or cold wallet holding the digital asset. For many clients, providing complete access to their wallets during their lives is a definite no and the ability of a trusted individual to gain access after death can be difficult if private keys and wallets are not accessible by the heirs or estate fiduciaries.

Although each client’s personal situation is different, we have recommendations for providing access upon death for the most common ways digital assets are stored:

  1. For clients who store their private key, seed phrase (i.e., a sequence of random words that sores the data required to access or recover cryptocurrency), or cold wallet in a safe, they may wish to keep the code for the safe with their original Will.
  2. Alternatively, clients can store such information in a safe deposit box, which will become accessible to their Executor after death (and after appointment by a local probate court). However, there will be a delay between the date of death and the Executors ability to access the safe deposit box, which could be meaningful in a volatile market.
  3. A third option for clients is to divide the private key into sections and share different sections of it with several individuals. This requires the individuals to come together and coordinate action.

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Next in this series, we will discuss additional methods for ease the transition of digital
assets upon their death as well as techniques for clients to gift digital assets during life,
even while maintaining access to the gifted assets. In the meantime, please contact a
Wiggin and Dana attorney if you have questions about the information shared in this
article, or to discuss other aspects of digital asset estate planning. We would be happy
to speak with you.