Investment and distribution by executors and trustees
Ivan Taback, Stephen L. Ham IV
Cryptocurrencies are digital assets that present unique challenges for fiduciaries. Here, we provide a practical, question-and-answer guide exploring the investment and distribution of cryptocurrency by executors1 and trustees.
Investing in Cryptocurrency
What basic principles applicable to the investment of property held in a fiduciary capacity can present problems for fiduciaries holding cryptocurrency?
Trustees have the general duty to invest and manage trust assets as a prudent investor would, in light of the purposes, terms, distribution requirements and other circumstances of the trust.2
Executors may have identical3 or similar duties under applicable law, which can depend on the length of time property is expected to be held prior to distribution to an estate’s beneficiaries.4 Most states and the District of Columbia have adopted a version of the Uniform Prudent Investor Act (the Act), which codifies the common law duty to invest and sets forth specific requirements and considerations for trustees, subject to the terms of the governing instrument.5 Because certain jurisdictions may apply the Act or similar legislation to executors and their management of estate assets,6 we use the Act as the basis for describing issues posed by fiduciary ownership of cryptocurrency.
Chief among cryptocurrency’s challenges as an investment asset is its volatility,7 with even tweets driving significant price fluctuations.8 Unless the governing instrument provides otherwise (addressed below), the Act requires fiduciaries to consider the expected total return from the appreciation of capital9 and the needs for preservation or appreciation of capital.10 A fiduciary may find it difficult to demonstrate due consideration of such factors following a significant decline in the price of a trust or estate’s cryptocurrency holdings. Conversely, the fiduciary may find it difficult to justify a sale of a significant portion of a trust or estate’s cryptocurrency holdings soon after qualifying given the potential for cryptocurrency to appreciate rapidly and in a manner not necessarily correlated with systemic market trends.
The Act’s mandate that a fiduciary consider appreciation and preservation of capital presents risks to the fiduciary when volatile assets, such as cryptocurrency, form part of the trust or estate. Issues of volatility might not be present if the cryptocurrency is a so-called “stablecoin” designed not to fluctuate, either through a computer algorithm or by virtue of being backed by an asset such as fiat currency.11
Cryptocurrency’s volatility and potential for rapid appreciation may also make it possible for a trust or estate’s cryptocurrency holdings to constitute a much larger portion of the total value of the portfolio than originally desired. Rather than requiring a fiduciary to “consider” doing so, the Act generally requires a fiduciary to actually diversify investments except when special circumstances cut against diversification or the governing instrument specifically directs otherwise (as addressed below).12
The fiduciary might breach the duty of diversification if the cryptocurrency holdings unexpectedly increase in value to form a large portion of the overall portfolio, and the fiduciary takes no action to diversify or otherwise manage such positions. A breach might also result if the cryptocurrency holdings were significant at the beginning of the fiduciary relationship (that is, after death or on acceptance in trust), and the fiduciary took no action to liquidate and reinvest the sale proceeds in other assets.
As discussed in Part I of our article,13 however, the technical aspects of cryptocurrency can limit the ability of a fiduciary to liquidate the cryptocurrency in a timely manner.
If the fiduciary maintains the cryptocurrency in an unhosted cold storage wallet (that is, offline storage), the fiduciary must retrieve the wallet (which, for additional security, might be kept in a secure location, such as a safe deposit box), transfer the cryptocurrency to hot (that is, online) storage and then sell it using an online exchange, which may result in potential delays.
Even if the cryptocurrency is maintained in hot storage or custodied directly with an online exchange, during periods of heavy trading volume, transaction processing may be delayed,14 extending the risk of further price fluctuations. Finally, a cryptocurrency with small market capitalization that’s traded on fewer exchanges than large market capitalization cryptocurrencies (such as Bitcoin and Ethereum) is generally less liquid even if all technical barriers to liquidation are satisfied,15 potentially introducing another risk to the fiduciary.
Governing Instrument Provisions
What provisions in a governing instrument would make it easier for a fiduciary to buy, sell or retain cryptocurrency?
While the Act provides default rules requiring fiduciaries generally to consider specific factors and take certain actions with respect to investments, the provisions of the governing instrument may expand, restrict, eliminate or otherwise alter the rules applicable to a given fiduciary.16
Although asset purchases by an executor may not be necessary in the estate administration context, an individual may wish to expressly provide by will that the executor isn’t required to consider the appreciation or preservation of capital in managing the estate’s cryptocurrency holdings in light of cryptocurrency’s volatility.
Similarly, the executor may be relieved of the duty to diversify the estate’s portfolio if a significant increase or decrease in the value of the estate’s cryptocurrency holdings causes the portfolio to become less diversified overall. To absolve the executor of all responsibility for fluctuations in cryptocurrency pricing, the individual could direct by will that the executor sell the estate’s cryptocurrency on a certain date (for example, six months after the individual’s death), though some flexibility and discretion on the executor’s part likely would be desirable.
Modifications to the prudent investor rule or similar rules are more important in the context of longer term trust administration. If a trust’s settlor initially transfers cryptocurrency to a trustee, the settlor may consider providing in the trust instrument that the trustee isn’t required to make investment decisions or take actions based on short-term fluctuations in the cryptocurrency’s price, even if the increases or decreases are substantial.
The settlor might also consider expressly authorizing the trustee to purchase cryptocurrency, regardless of its volatility and potential delays in its liquidation, with a view toward the trustee’s ongoing management of trust property as cryptocurrency becomes more generally accepted as an investment asset. Finally, the settlor might consider granting the trustee broad discretion as to how to custody the trust’s cryptocurrency holdings, permitting the trustee to choose any of the storage methods described in Part I of this article7 regardless of the advantages and disadvantages of each.
In all cases, however, any limitation on fiduciary liability in a governing instrument, whether investment-related or otherwise, might itself be limited by applicable law establishing a minimum standard of fiduciary liability.18
Investing Prohibitions
Can a governing instrument prohibit a fiduciary from investing in cryptocurrency or from selling cryptocurrency transferred to the fiduciary?
Although the Act ordinarily permits a fiduciary to invest in any kind of property or type of investment,19 which would encompass both purchases of new investment assets and sales of existing investment assets, this default rule can be modified under the terms of the governing instrument.20 Accordingly, a settlor wary of cryptocurrency’s volatility or skeptical of its long-term viability as an investment asset (addressed below) could prohibit the trustee from investing in it. Conversely, a settlor convinced of cryptocurrency’s investment potential may prohibit the trustee from selling it.
Rather than provide rigid investment directions in the governing instrument favoring or disfavoring cryptocurrency, however, an individual might consider inserting precatory language expressing personal views as to the relative desirability of investment in cryptocurrency. Indeed, a court may override especially strict investment limitations imposed on a fiduciary by a governing instrument based on changed circumstances.21
Income Tax Consequences
What are the income tax consequences of a sale of cryptocurrency by an estate or a trust?
Cryptocurrency is treated as property for federal income tax purposes.22 With respect to cryptocurrency held for investment, gain or loss on the sale of such cryptocurrency is generally treated as capital gain.23 Cryptocurrency held in an estate following the death of the decedent would be considered to have been acquired from or passed from the decedent24 and would have a basis in the hands of the estate equal to its fair market value (FMV) at the date of the decedent’s death.25
Because capital gain property taking such a step-up in basis, if sold by the estate, would generally be treated as held for more than one year even if sold within one year of a decedent’s death,26 gain or loss on such a sale would be long-term capital gain or loss.27 Capital gain would generally be excluded from the estate’s distributable net income (DNI) and thus not be taxable to the estate’s beneficiaries if it’s allocated to corpus and not paid, credited or required to be distributed to any beneficiary during the tax year, or paid, permanently set aside or to be used for charitable purposes.28
If cryptocurrency were sold in the same tax year as the estate’s terminating distributions, however, any capital gain resulting from the sale would be included in the estate’s DNI,29 included in the beneficiaries’ income30 and deductible by the estate.31
Cryptocurrency held in trust would generally have a basis in the hands of the trustee equal to the settlor’s basis,32 unless the trustee used other assets to purchase the cryptocurrency, in which case it would have a basis equal to its cost.33 A sale of cryptocurrency by a nongrantor trust for federal income tax purposes would result in tax consequences to the trust and its beneficiaries generally the same as those for an estate, as discussed above. Income or loss resulting from a sale of cryptocurrency by a grantor trust for federal income tax purposes—that is, a trust deemed wholly owned by its grantor34—would flow through to the grantor.
Ban on Cryptocurrency
Could a government “ban” cryptocurrency?
Yes. An indirect method of restricting or banning cryptocurrency would be through taxation or regulation of cryptocurrency investors, online exchanges or financial institutions in a manner that makes it prohibitively expensive or illegal to transact cryptocurrency.
China, for example, has banned financial services businesses from providing cryptocurrency-related services.35 A direct ban on cryptocurrency is also possible. India, for example, has proposed a ban even more restrictive than China’s ban, criminalizing the possession, issuance, mining, trading and transferring of cryptocurrency.36
Distributing Cryptocurrency
Can a fiduciary distribute cryptocurrency to a beneficiary of an estate or trust?
Yes, subject to the terms of the governing instrument and applicable law. The same technical considerations applicable to transferring title to cryptocurrency to a fiduciary described in Part I of this article37 would also apply to the transfer by the fiduciary to the beneficiary. The beneficiary would need to choose how to maintain a cryptocurrency wallet capable of receiving the transfer from the fiduciary and provide the fiduciary with the beneficiary’s “public key” for purposes of directing the transfer. The fiduciary should consider memorializing the transfer in a contemporaneous receipt and release agreement with the beneficiary.
What are the income tax consequences of distributing cryptocurrency to a beneficiary of an estate or trust?
As described above, cryptocurrency is treated as property for federal income tax purposes. Property distributed to a beneficiary of an estate or a nongrantor trust generally has a basis in the hands of the beneficiary equal to its basis immediately prior to the distribution, adjusted for any gain or loss recognized to the estate or trust on the distribution.38 No gain or loss to the estate or trust would be recognized on the distribution unless the property were distributed in satisfaction of the right to receive a specific dollar amount, specific property or income (if income is required to be distributed currently)39 or if an election is made to recognize gain or loss on the distribution.40
The amount deductible by the estate or trust and includible in the beneficiary’s income would be the lesser of the cryptocurrency’s basis or its FMV,41 unless gain or loss is recognized, in which case such amount would be its FMV.42
Cryptocurrency distributed by a grantor trust to a beneficiary would generally be treated for federal income tax purposes as acquired by the beneficiary directly from the trust’s grantor, with the beneficiary taking a basis in the cryptocurrency equal to its basis immediately prior to the distribution,43 no amount includible in the beneficiary’s taxable income44 and no gain or loss recognized to the grantor.45
Smart Contracts
What are “smart contracts”? Can they automate distributions from estates or trusts?
A “smart contract” is computer code that automatically executes certain functions when certain events take place without the need for human intervention.46
Certain blockchains, including Ethereum, are capable of incorporating both the terms of the contract47 and off-chain external inputs (sometimes referred to as “oracles”48) that, if pushed to the relevant blockchain, trigger events under the terms of the contract. A typical example of a smart contract would be the transfer of certain value to an on-chain wallet when a cryptocurrency price hits a certain threshold.
Smart contracts have the potential to automate distributions and other functions of estates and trusts. However, because smart contracts can’t pull in information from outside sources, they require a method for the external input to be pushed to the relevant blockchain. In a simple case, a trust term providing for a mandatory outright distribution of principal to a beneficiary when the beneficiary reaches a certain age could be adapted into a smart contract, with the date and time constituting the external input and trust and beneficiary account information incorporated into the smart contract if desired. Similarly, a particular asset held in a trust could be automatically sold if its price on an exchange (the external input) falls below or exceeds a certain threshold.
External inputs relevant to other features of estate and trust information, however, may be harder to obtain or more susceptible to manipulation or misinterpretation. Consider a smart contract between an individual and financial institution granting the individual’s nominated executor a right to access account information following issuance of letters testamentary to the executor. Issuance of letters by a court of competent jurisdiction should be sufficient to substantiate the individual’s actual death and admission of the will to probate, but how would the external fact of issuance be communicated to the financial institution? Human intervention is currently necessary to bridge the gap between a probate court’s decree and the diligence requirements of a financial institution. Consider further a trust provision suspending a beneficiary’s rights to all distributions of trust income and principal if the beneficiary has substance abuse issues. Even if substance abuse were apparent via public (for example, arrest records) or semi-public (for example, social media posts) sources, the push of these external facts to the smart contract’s blockchain could be both over- and under-inclusive.
Despite their technical limitations under current circumstances and limited usefulness in circumstances in which executor and trustee discretion rather than hard-and-fast rules would otherwise be favored, smart contracts have significant potential in the estate and trust administration context and should be carefully considered by estate-planning practitioners and co-advisors going forward.
Further Clarification
Part II of this article, which is intended for general discussion purposes and not as specific legal advice, concludes our discussion of the fiduciary acceptance, management, investment and distribution of cryptocurrency. As cryptocurrency investing continues to gain broader public appeal, we anticipate that developments in state and federal law will further clarify the fiduciary duties and tax consequences associated with estate planning using cryptocurrency.
Endnotes
1. This article uses the term “executor” for convenience when discussing concepts applicable to estate fiduciaries (executors, personal representatives, administrators, etc.) generally.
2. Restatement (Third) Of Trusts Section 90.
3. Uniform Probate Code Section 3-703(a) (“A personal representative is a fiduciary who shall observe the standards of care applicable to trustees . . . . .”).
4. E.g., In re Heidenreich, 378 N.Y.S.2d 982 (Sur. Ct. Nassau County 1976) (holding that estate funds may be retained in a checking account if distribution is expected to be made shortly after appointment).
5. See Uniform Law Commission, “Prudent Investor Act” (the Act), www.uniformlaws.org/committees/community-home?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9.
6. E.g., N.Y. Estates, Powers, & Trusts L. Section 11-2.3(e)(1) (broadening the term “trustee” as it appears in New York’s version of the Act to include a “personal representative” and other fiduciaries).
7. See Erin Griffith, “We’re All Crypto People Now,” New York Times (April 25, 2021), www.nytimes.com/2021/04/25/technology/cryptocurrency-mainstream.html (June 13, 2021).
8. Ephrat Livni, “Tesla’s U-turn on Bitcoin raises questions of the cryptocurrency’s stability,” New York Times (May 13, 2021), www.nytimes.com/2021/05/13/business/tesla-bitcoin-elon-musk.html (June 13, 2021).
9. The Act Section 2(c)(5).
10. Ibid. Section 2(c)(7).
11. See generally James Mackintosh, “Bitcoin’s Reliance on Stablecoins Harks Back to the Wild West of Finance,” Wall Street Journal (May 27, 2021).
12. The Act Section 3.
13. Ivan Taback and Stephen L. Ham IV, “The Fiduciary’s Guide to Cryptocurrency: Part I,” Trusts & Estates (May 2021).
14. In an extreme case, Coinbase crashed during a cryptocurrency sell-off in May 2021; Jessica Bursztynsky, “Coinbase back online following outage for some users amid bitcoin sell-off,” CNBC (May 19, 2021), www.cnbc.com/2021/05/19/coinbase-is-down-for-some-users.html.
15. Werner Vermaak, “Liquid vs. Illiquid Crypto Markets and Bitcoin,” CoinMarketCap.com (Jan. 11, 2021), https://coinmarketcap.com/alexandria/article/liquid-vs-illiquid-crypto-markets-and-bitcoin.
16. The Act Section 1(a).
17. Supra note 13.
18. New York, for example, deems the exoneration of an executor or testamentary trustee from liability for failure to exercise reasonable care, diligence and prudence as contrary to public policy and void. N.Y. Estates, Powers, & Trusts L. Section 11-1.7. See also Uniform Trust Code (UTC) Sections 1008(a)(1), 105(b)(10) (mandatory rule under the UTC deeming unenforceable a term of a trust that relieves a trustee of liability for a breach of trust if committed in bad faith or with reckless indifference to the purposes of the trust or its beneficiaries).
19. The Act Section 2(e).
20. Ibid. Section 1(b).
21. E.g., In re Flesch, New York Law Journal, at p. 31 (Sur. Ct. Suffolk Cty. April 19, 2004) (eliminating testamentary trust provision limiting investments to bank accounts and certificates of deposit based on fears of market volatility in light of sustained lower interest rate environment).
22. Internal Revenue Service, Frequently Asked Questions on Virtual Currency Transactions, www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (IRS Virtual Currency FAQ), A2.
23. Ibid., A4.
24. Internal Revenue Code Section 1014(b)(1).
25. Section 1014(a)(1). As noted in Part I of this article, supra note 13, IRS guidance suggests that the value of cryptocurrency should be determined as of an “exact date and time,” rather than merely a particular date. See IRS Virtual Currency FAQ, supra note 22 at A27.
26. IRC Section 1223(9).
27. IRC Section 1222(3).
28. IRC Section 643(a)(3).
29. Ibid.
30. IRC Section 662(a)(2).
31. IRC Section 661(a)(2).
32. IRC Section 1015(a); IRS Virtual Currency FAQ, supra note 22, at A32. When determining loss, however, cryptocurrency would take a basis equal to its fair market value (FMV) at the time of transfer. Section 1015(a); IRS Virtual Currency FAQ, supra note 22 at A32.
33. IRC Section 1012(a).
34. See IRC Sections 671–77.
35. “China bans financial, payment institutions from cryptocurrency business,” Reuters (May 18, 2021), www.reuters.com/technology/chinese-financial-payment-bodies-barred-cryptocurrency-business-2021-05-18/.
36. Aftab Ahmed and Nupur Anand, “India to propose cryptocurrency ban, penalising miners, traders—source,” Reuters (March 14, 2021), www.reuters.com/article/uk-india-cryptocurrency-ban-idUSKBN2B60QP.
37. Supra note 13.
38. Section 643(e)(1).
39. Treasury Regulations Section 1.661(a)-2(f).
40. Section 643(e)(3)(A).
41. Section 643(e)(2).
42. Section 643(e)(3)(A)(iii). Again, because the IRS Virtual Currency FAQ, supra note 22, suggests that cryptocurrency must be valued as of a particular date and time, the fiduciary should consider noting the time of the distribution of the beneficiary for income tax reporting purposes.
43. IRC Section 1015(a). Note that the beneficiary’s basis in the cryptocurrency would be equal to its FMV for purposes of determining loss if basis exceeded FMV at the time of the distribution.
44. IRC Section 102(a).
45. IRC Sections 1001(c) (gain or loss recognized on “sale or exchange” of property), 1015(a).
46. See generally Stuart Levi, Alex Lipton and Christina Vasile, “Legal issues surrounding the use of smart contracts,” Global Legal Insights: Blockchain & Cryptocurrency Regulation (2d ed. 2020), at p. 155.
47. Ethereum Foundation, Introduction to Smart Contracts (March 29, 2021), https://ethereum.org/en/developers/docs/smart-contracts/.
48. Ethereum Foundation, Oracles (April 27, 2021), https://ethereum.org/en/developers/docs/oracles/.