With more investors diversifying their investment portfolios, cryptocurrencies and other kinds of digital assets (i.e., non-fungible tokens “NFTs”) have become a more popular option in recent years. With the Internal Revenue Service declaring that digital assets are property, they can be accessed by creditors, however, so certain kinds of trusts may be established to help protect these assets as well as enabling access to online accounts, especially for cryptocurrency assets. A state-based Domestic Asset Protection Trust (DAPT) enables a trust creator (“trustor”) to protect their exiting digital assets through a legal instrument that shields them from creditors. Previously, these types of trusts were only available offshore. Fortunately, many states across the U.S. have adopted DAPT statutes to allow this type of trust to be legally-established within their jurisdictions.
What is a Domestic Asset Protection Trust?
Before DAPTs were enacted, a trustor/settlor would have to establish an irrevocable trust created by a third party in order for asset protection. A DAPT is a self-settled trust that allows the trustor/settlor protection to be the beneficiary, transfer a portion of estate assets to the trust, and provide for certain protections from future creditors, legal complaints, malpractice claims, and other financially-consequential events. Formally known as a qualified spendthrift trust, it is a trust that enables the trustor to transfer assets into a trust of which the trustor/settlor is also a beneficiary to protect themselves from creditors. This type of irrevocable trust may assure that wealth can be safeguarded for future generations and protects wealth from liability risk.
Each state has slightly different statute of limitations and creditor exemptions. So far, the states of Alaska, Connecticut, Delaware, Hawaii, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming have passed DAPT legislation. Additionally, DAPT legislation usually abolishes the Rule Against Perpetuities and allows for dynasty trusts.
Meanwhile, ten states that have not passed DAPTs, such as New York, do offer similar provisions within an irrevocable grantor trust.
With not every state enacting a DAPT statute, case law has primarily determined that residents of states without DAPT laws who establish a DAPT in a DAPT state will not likely have their trusts upheld in their home states. The situs of the trust, which is typically determined at inception, will likely determine whether or not DAPT law will apply. Ultimately, while cryptocurrencies and other digital assets on the blockchain are a global currency, the location of the trust situs will determine whether a DAPT law applies. While the state-by-state adoption of the DAPT legislation is not universal yet, at least a trustor/settlor can establish a DAPT in the U.S. knowing that their assets won’t have to be sent overseas in order to be protected.
Trusts and Cryptocurrencies Tax Liabilities
A trustor/settlor could use a DAPT solely for their cryptocurrency and digital assets. However, the cryptocurrency will still be subject to federal (and state) taxation. Crypto transferred into a living trust is taxable because the living trust is not considered a separate taxpayer. With non-grantor trusts, the transferor is not taxed, but the trust pays taxes and trust distributions may be taxed. With the self-settled, irrevocable trusts, the trustor/settlor remains the beneficiary so any taxable income or deduction earned by the trust will be taxed on the trustor/settlor’s tax return. Even offshore digital asset trusts will be subject to U.S. taxation. If the trustor/settlor decides to open an offshore asset protection trust instead of a domestic one, they will be responsible for filing IRS Forms 3520, 3520-A, 8938 and FinCEN Form 114 (also referred as FBAR).
As covered in our prior Insight post, the Internal Revenue Service (IRS) treats cryptocurrency as property and not currency (see IRS Notice 2014-21). The fair market value (FMV) is determined at the time of the purchase of the cryptocurrency and in turn, gains/losses will be calculated when the digital asset is sold, either converted back into U.S. dollars or into another cryptocurrency or another digital asset (i.e., NFT). Gains or losses from cryptocurrencies is reported on IRS Form 8949 and Form 1040 Schedule D, which apply to short-term and long-term capital assets. Currently, the IRS has not issued known federal gift or estate taxes for DAPTs.
Considerations for Cryptocurrency and Digital Asset Trusts
As a decentralized digital currency, cryptocurrencies are stored on the blockchain and each token or coin has a unique signature. While this aspect may be attractive due to less regulation, it can prevent problems for trustees or non-owners to access the digital assets after the owner dies. When delegating fiduciary responsibility for crypto assets in a trust, trustors and/or trustees will need to be very cautious about access to digital wallets. Once someone has access to the digital wallets or crypto keys, a person can access the digital assets without the owner’s permission. Knowing the volatility of cryptocurrencies, a trust should be designed to have instructions in place in case a cryptocurrency value crashes. The trustee will need explicit guidelines and ability to access the digital wallets and crypto keys in case of an emergency such as a market crash.
More entities are able to act as trustees over cryptocurrencies and digital assets, so there are more options. In July 2020, the U.S. Office of the Comptroller (OCC) issued an interpretive letter that authorized federally-chartered banks and federal savings associations to provide custody services for cryptocurrencies, including the by holding the unique cryptographic keys.
Whichever trust company or bank or entity that a cryptocurrency or digital asset owner decides to use, these trustees will need to carefully determine which people have control over the digital wallets and crypto keys to ensure not one single person can access the assets to reduce the chances of theft or mismanagement. With the rise of the number crypto and digital asset owners and the increasing value of these assets, asset protection trusts provide a new vehicle to protect these assets from creditors, enable access for beneficiaries and trustees, and preserve them for future generations.
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