Clients rely on their estate planners for advice on wealth transfers. We are seeing a new form of wealth—digital assets—and ownership, storage and transferability of digital assets differs significantly from traditional forms of wealth.
What Is a Digital Asset?
A digital asset is as an electronic record in which an individual has a right or interest. There are “sentimental digital assets” and “investment digital assets.”
“Sentimental digital assets” are those to which a client has an emotion tie, such as social media accounts and digital photos and videos. For these assets, a wealth planner’s main concern is allowing access to loved ones upon a client’s death. To do so, clients should update their settings on the specific app or device to allow a loved one to access the asset upon passing. Google, for example, offers an “inactive account manager” tool, and Apple and Facebook allow users to designate a “legacy contact.”
“Investment digital assets” are defined by the IRS as “any digital representation of value which is recorded on a cryptographically secured distributed ledger [i.e., a blockchain] 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.
To advise a client on how to transfer an investment digital asset, it is important to understand how the client stores and owns it.
Storing Digital Assets
Investment digital assets are stored in “digital wallets,” which can be web-based or hardware-based.
“Hot wallets” are web-based and run on internet-connected devices such as smartphones or computers, which makes them more susceptible to cyberattacks or unauthorized access. Given their potential security issues, many investors use them for small amounts of cryptocurrency and for frequent trading.
“Cold wallets” are hardware-based wallets stored on tangible devices not connected to the internet, thereby reducing the risk of cyberattacks or unauthorized access. A cold wallet can only communicate with the internet-enabled device into which it is plugged. An investor will be given a seed phrase or back up code to access the cold wallet, which the investor must store in a secure place, like a safe-deposit box or safe.
Understanding a client’s storage system is important for estate planning for two primary reasons:
- Beneficiary Access. The recipient of a gift or bequest of the digital asset must have access to the relevant storage device in order to have access to the actual investment. Sharing such information comes with risk since access is inherently tied to value.
- Fiduciary Access. If only the client has access, then heirs will have no way to access the digital asset upon death. Digital exchanges do not often allow a user to name a contact to access the user’s investment information upon death. This may be because most exchanges do not have centralized entities to record such information. In fact, Coinbase will not flag unclaimed assets. If access is denied to the heir, the investment could be lost.
Transferring Digital Assets
To transfer digital assets by death or gift means providing access to beneficiaries and/or fiduciaries. Here are ways to structure such a transfer while minimizing the risk of theft or loss.
Limited Liability Company (“LLC”). Clients can transfer the digital asset to an LLC and, subject to certain limitations, retain control over the management of the digital assets by serving as manager of the LLC. Administration of the digital asset can be seamless since control and decision-making stays with the client. For example, instead of having to share access with the donee, the client can transfer the LLC interests to the donee and avoid disclosing passcodes or registering the transfer on a blockchain.
Transfers of LLC interests can also provide a mechanism to discount the value of the transferred interests. If the transfer is of a minority interest, it lacks control and marketability, especially in the case of an LLC invested in a highly volatile, difficult to access asset. Discounts when transferring minority interests can range from 15-40%.
In addition, LLCs can provide asset protection since in most states, LLCs protect a member’s personal assets from an LLC’s liabilities. In certain jurisdictions, the LLC can also protect the digital asset from the member’s personal liabilities.
Directed Trustee. A directed trust is another way to transfer a digital asset while keeping control and decision-making with the client. In Delaware and Connecticut, for example, a directed trust can have an “investment trustee” or “investment trust director” who exclusively handles responsibility for investments, including managing and storing digital assets. In many cases, the client can serve in this role, which allows the client to share the value of the underlying gift with the donee while keeping storage and access information with the client.
Naming a Digital Fiduciary. Even with the two methods discussed above, eventually someone other than the client will have to be granted access to the digital assets. One way to do this is by naming a “digital fiduciary” — someone tasked only with managing the digital assets.
As in other cases, a fiduciary should be someone trusted and responsible, and when the asset is unique, like digital assets, the fiduciary should have knowledge on investing, managing and storing the asset. This would work best for clients who trust one party to manage their estate, for example, but another party to manage the digital asset portfolio specifically.
Modifications to Wills and Revocable Trusts
When investors of digital assets need base estate planning documents, there are three additional aspects to keep in mind when drafting:
- Prudent Investor Rules. Enforced in all states, these rules guide fiduciaries to invest with risk and return objectives reasonably suited to trusts. Due to digital asset volatility, estate planning documents should include waivers to align investments with prudent standards.
- Explicit References. Estate plans involving digital assets must clearly outline heirs for both: (1) the digital investment; and (2) its tangible storage device. If silent, the digital investment will likely pass with residuary. Complexities can arise if the residuary beneficiaries differ from tangible property beneficiaries, who receive the storage device.
- Fiduciary Access Statute. Documents governing digital asset disposition should incorporate the state's fiduciary access statute for granting access. Clients should ensure their digital fiduciary has access to asset lists and login details.
Vanessa Maczko is a partner at Wiggin and Dana LLP.