An attorney discusses the legal, tax, and estate issues in cryptocurrency. How do you own cryptocurrency? How is cryptocurrency taxed? What are best practices for protecting cryptocurrency for loved ones? Can you put cryptocurrency in a Living Trust? How is crypto stolen? How do you pass cryptocurrency on to your heirs?
By James L. Cunningham Jr, Attorney at Law
Cryptocurrency is one of the hottest topics in the financial world—but despite the mountains of information, it remains mysterious, confusing, and even downright otherworldly to many.
I get urgent questions every week on cryptocurrency tax, cryptocurrency estate planning, and cryptocurrency legal issues from clients with significant holdings. The subject is ever-evolving, but let me try to give you some key understandings in this article—which I will try to keep updating as issues and answers arise, to ensure you have the best possible information. I also invite you to contact my office for high net worth tax planning in California.
Let’s start by acknowledging that while crypto may be exciting, it is not without risk. As a store of value, most crypto is extremely volatile–as we’ve seen from the collapse of major cryptocurrencies and the dramatic swings in price occurring even as I write. But beyond the value issues, Crypto simply does not afford the sorts of protections investors expect from more traditional financial instruments, making it extremely important to understand the relevant privacy and security issues in the space.
To get closer to a working definition for crypto from a legal perspective, it might be easier to start with what cryptocurrency is not. It’s not “cryptic” in the sense of being hidden: transactions made using crypto are not fully anonymous: they’re right there on a public ledger for all to see. It’s also not “foreign currency,” in the eyes of the governments of the United States or of California, which treat it as property that functions like foreign currency. Cryptocurrency is intangible, which means it cannot be held in your hand and used (and disposed of) as if it were a tangible object.
Even though many of my readers may know the basics, or even consider themselves crypto experts, I think it’s important to review those basics so you fully understand the legal realities—and uncertainties—of investing in cryptocurrency.
What is crypto?
Cryptocurrency is not “currency,” at least not in the United States. It is a store of value created when a digital and immutable blockchain is used as a ledger for transactions.
What is a blockchain?
A blockchain is a specific type of database that stores data in buckets, or “blocks.” As these fill up, they are chained together in chronological order. They contain massive amounts of information that is continuously being created and updated.
This sounds more complex than an Excel file, and it is. A blockchain functions like a database, not like a spreadsheet. Like a database, a blockchain is designed to house large amounts of information that can be quickly accessed, filtered, and manipulated by large numbers of people simultaneously. The information is housed on a computer system that may be spread across multiple computers while maintaining its internal consistency.
The most common use for blockchains is as ledgers for transactions, aka “crypto.” Crypto uses blockchains in a decentralized way, so that no single person, group, or judge has control over it. It’s controlled collectively by all of its users. Because of its decentralized nature, it is considered impossible to erase or overwrite a block in the chain.
What is a smart contract?
A smart contract is a self-executing contract between two parties (for instance, a buyer and seller), recorded on a blockchain and enforced through the consensus of all the users of that blockchain.
How do I participate in the crypto economy?
You can buy crypto pretty easily—that information is readily available and I won’t cover it here. You can then use crypto to buy, sell, lend, deposit assets for staking, or perform many other functions of money. Again, in the eyes of the government, crypto is not a currency, it is property, but in some ways, it functions like a currency.
Most significantly, the crypto economy, and transactions made in crypto, require no banks or other intermediaries.
This has historically made it popular among those who, for legal or philosophical reasons, wish to transact business without direct government or institutional oversight.
Although crypto exists outside the jurisdiction of the government, it does intersect with financial and legal systems in ways that produce financial and legal consequences.
When you use crypto you are not above the law, including the laws of taxation! And obviously, I advise you not to use crypto to attempt to break the law.
How is crypto defined by the government?
The governments of the United States and California treat crypto as property. There is no physical Bitcoin, at least not yet. It’s intangible, meaning it has no physical presence, but it can be owned, used, and disposed of, making it property in the eyes of the law. The same is true of all the other cryptocurrencies.
A court can order someone to tender a private key (the password to ownership of crypto), but a judge has no power to order a blockchain network to do anything, the way a judge could order a bank to do something. That’s because blockchain technology operates autonomously, on its own, outside the jurisdiction of the state or country.
Traditional legal instruments such as contract law are not required and don’t really fit. Why? A contract is enforceable in the jurisdiction in which it is made, and crypto has no jurisdiction!
Is crypto legal tender?
No. In California and the United States, crypto is treated as property, not currency, and does not function as legal tender. Some other countries treat it as money, and El Salvador recognizes crypto as legal tender, but that’s a long way from happening here… and the size of El Salvador’s economy is a lot smaller than that of Vermont… the smallest economy in the United States!
How is crypto owned? What is a crypto key?
A crypto “private key” is a form of digital cryptography, and your key is your password that establishes ownership of your crypto. In Bitcoin, for example, a private key is a 256-bit number typically represented by 64 digits in the range 0-9 and A-F.
If you know the key, you own the crypto. Period.
To fully understand the implications of that statement, it’s important to understand how crypto is significantly different from other kinds of property. For instance:
- When you buy a car, you get the title, you get the keys, and you’re allowed to drive it around. If you lose the keys, the car still legally belongs to you, and you can have new keys made. Not true in crypto.
- When you buy a condo, you receive the keys and a deed, which is a piece of paper by which the courts recognize you as the legal owner. Not true in crypto.
- When you buy a puppy, it may be registered with the government or not, but you are recognized as the owner after your purchase, even if you forget the puppy’s original name. Not true in crypto.
- If you have a bank account and someone robs the bank, your money is protected by insurance, the other resources of the bank, and ultimately the FDIC. Not true in crypto.
By contrast, crypto:
- Has no title.
- Is intangible, and therefore cannot be physically possessed.
- Is not controlled by any financial institution or government.
- Exists in an immutable form on a blockchain, potentially forever, where it is publicly viewable.
- Is “pseudo-anonymous” insofar as it’s encrypted with numbers rather than linked to legal names, but is still public information.
How is ownership of crypto determined?
Whoever owns the private key fully controls the crypto stored in the corresponding public addresses. With crypto, ownership is key, pun intended. If you own the key, you are presumed to be the owner of the crypto, and possession of a key constitutes prima facie ownership. The password is the whole ballgame. Sometimes use of a “digital signature” can be used to prove ownership of crypto when needed, without revealing the private key. The point here is that not all crypto is created equally. You need to fully understand how to hold a particular cryptocurrency before buying it.
What is the importance of privacy and security in crypto?
I hope all the above is sinking in, because in crypto, possession isn’t nine-tenths of the law, it’s ten-tenths of the law. If someone steals your key, they then own your crypto. Therefore, it may be wise to distribute your crypto and not keep it all stored in any one “digital wallet” or device. Also, be sure to use maximum security on any wallet or device you use to store crypto.
You should make it close to impossible for anyone to access your keys without your permission.
What is a crypto wallet?
Using a third-party “wallet” may be your simplest solution for using crypto securely. But the various kinds of wallets will require some research on your part. Basically, there are four kinds: Online Wallets, Software Wallets, Hardware Wallets, and “Paper Wallets.”
An Online Wallet is a service that stores your private keys, theoretically keeping your cryptocurrency both safe and accessible. You can use this online wallet to send, receive, and spend cryptocurrencies. Just as with cash, you don’t have to keep it in a wallet or an account, but it makes it more secure, controlled, and easy to use.
Software Wallets work similarly to Online Wallets, but the software exists only on your own computer, possibly making it more secure, but bringing other issues of technical reliability and security.
Some people believe that a Hardware Wallet is the most secure method. Hardware Wallets are physical fobs similar to USB thumb drives that can include advanced security of various grades. They may also be easier to lose.
Paper Wallets are a nice way of saying that you have written your private keys on paper and (hopefully) stored that paper away safely.
How is crypto created?
Crypto is created through a computer process called “mining,” where computers solve hugely complex math problems and have their answers verified by the blockchain’s consensus mechanism. It then goes to the public address of the first possessor.
How is crypto transferred?
Crypto can be transferred by giving your key to another party or through the execution of “smart contracts.” Often this is done through a digital wallet.
How do I spend crypto?
Transfer to a third party is performed mainly by agreement on behalf of the possessor. To transfer crypto, you simply create a smart contract, hit ‘return,” and there it goes. Once broadcast to the network, transactions cannot be modified. They’re carved in granite.
Are crypto transactions reversible?
No. Information on blockchains is immutable, irreversible, and will live on forever, or for at least as long as the network keeps running. Once you’ve entered the information, it’s there permanently and cannot be reversed, any more than you can “un-ring” a bell or pull the cream out of the coffee. This is the major reason why crypto lacks the sorts of institutional consumer protections an investor finds with more traditional financial instruments. The technology explicitly excludes the sorts of interventions that would be necessary to facilitate such protections.
Because these assets exist outside of the jurisdictions of the courts, you may find your recourse for such theft is extremely limited. Although there are exceptions, a court order may well prove ineffective in getting it back, especially if the thief disposes of the assets.
How is crypto taxed?
IRS Notice 2014-21 describes in a FAQ format how crypto is taxed under the power of the United States government, and how general tax principles apply to cryptocurrencies. It puts it all pretty clearly, and you can download and read IRS Notice 2014-21 about cryptocurrency taxation here.
What does IRS Notice 2014-21 say about crypto?
Under United States law, outlined in Notice 2014-21, crypto can be lawfully used to pay for goods and services and can also be held as an investment. It is defined as a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value.
Does crypto, as a digital representation of value, have any intrinsic value in the real world? That’s a heavier philosophical question, but at the risk of being facetious I think the ultimate answer is probably somewhere between “YES!” and “maybe” and “no” and “DEFINITELY no!” Of course, no currency is ever worth more than the interested parties agree that it’s worth. Or, to quote the movie Blow: “Money isn’t real…. It doesn’t matter. It only seems like it does.”
Virtual currency that has an equivalent (and constantly shifting) value in US dollars, such as Bitcoin, is described as a “convertible” virtual currency. That means it can be digitally traded between users or exchanged for dollars, euros, and other “real” currency.
How is crypto taxed in the United States?
The coins may be virtual, but never forget that crypto transactions have real-world tax consequences that may result in complex and unexpected tax liabilities. Remember, everything is publicly available to you, to me and to the IRS.
To understand crypto taxation, remember that crypto is treated as property and taxed accordingly. For instance, if you buy Bitcoin for one dollar, exchange it for ten dollars, and then use the nine dollars of value you created to buy something, you are taxed on your nine dollars in realized gain over the basis.
The “basis” is the fair market value (FMV) value of the cryptocurrency at the time you acquired it, with any gain or loss determined by how much it’s worth when you trade it—even if it’s one hour later. This can become extremely difficult to track if you start buying a lot of stuff with crypto.
Are there tax reporting requirements for gains from crypto investments?
Yes. If you realize capital gains on crypto holdings through a third-party wallet service such as Coinbase, that service may report it to the IRS. If you execute transfers between cryptocurrencies, such as exchanging Bitcoin for Ethereum, this type of trading can result in a gain or a loss for tax purposes.
Every transaction is a taxable event. Buying a diet coke from a vending machine could potentially be a “taxable event!”
What is the Fair Market Value (FMV) of crypto, and how is it determined?
The fair market value (FMV) of a cryptocurrency is determined by the value of that cryptocurrency at the moment a transaction occurs. It’s determined by the taxpayer as of the date of payment or receipt and must be reasonably and consistently applied.
Do I have to pay tax on payments made using crypto?
Yes. If you spend more than $600 on goods or services using crypto, it’s your responsibility to keep track of the FMV and pay crypto taxes accordingly. If you receive payment for goods or services in virtual currency, you must report it as income. If you mine crypto, you realize income on receipt of that crypto (and may also be subject to self-employment tax). If you make payroll using crypto, that’s also subject to taxation.
Am I required to perform information reporting and backup withholding on payments made using crypto?
Yes. Payments over $600 that are made using crypto are subject to information reporting. This includes rent, salaries, wages, premiums, annuities, and compensation. If you make a payment to an independent contractor of more than $600 using crypto, you must file a 1099-MISC, just as you would with dollars. And these payments are very much subject to backup withholding.
If you pay an independent contractor or service provider more than $600, they must give you their social security number or Taxpayer Identification Number (TIN) so that crypto tax is paid correctly. If you don’t get this number, then the taxpayer – that’s you – must withhold 24%. I’m honestly not sure how you do this using blockchain technology. It’s one of the many current mysteries.
Are there reporting requirements for a person who settles payments made in virtual currency on behalf of merchants who accept it?
Yes. Third-party networks set up to process crypto transactions for merchants, in the manner of Visa or MasterCard, must report these using form 1099-K.
To repeat: Don’t think that just because your Bitcoin is out there in cyberspace, instead of in a bank, it means you don’t have to do your reporting. You do. If you don’t, you’ll be subject to penalties.
Can I use crypto to avoid paying taxes?
No, you cannot use cryptocurrency to avoid paying taxes.
How do I gift or inherit crypto?
If you own crypto and you want to control what happens to the coin in the event of your death, you can transfer your crypto assets to a wallet owned by a third party. Examples include Casa, Exodus, Electrum, Mycelium, Ledger, Trezor, and others. They’re all slightly different, and some research may be required to determine which one best suits your needs. As part of my research, I opened an account with Coinbase, which so far does everything I need it to do.
These wallet services act as third-party intermediaries, similar to banks, that hold your key for you. At the same time, they’re not banks, don’t provide the same protections, and introduce some new risk elements…they only function like banks. Remember that when using these services to secure your asset for a beneficiary.
Can I put crypto in a Living Trust?
Yes, but not directly. Unlike a bank account, you cannot retitle your crypto to your Trust and then have the institution put it under the control of your Trustee after you pass.
Instead, you should clearly list your crypto in your Trust Assets just as you would any piece of personal property that does not carry a legal title—such as a piece of art or a favorite bicycle.
Then you need to figure out how to pass your key securely to your Trustee when you die. You do not, for example, want to list your key in your Estate Planning documents. That would mean literally anyone reading those documents could steal your crypto.
You could write your key on a piece of paper and store it in a vault. You could entrust it to your Trustee ahead of time. But your best bet in accomplishing a secure transfer is probably to set up a third-party wallet and provide that information to your Successor, Executor, or Trustee. This makes it relatively easy to transfer access to your key. If you have significant crypto assets, you should make specific arrangements for this so your key isn’t accidentally thrown away if you have stashed it in a filing cabinet somewhere.
If you don’t trust your Trustee, that’s a different situation, and you should probably set up an appointment to speak with someone like me about it.
Can my crypto be stolen or lost?
Yes. To repeat: you or your heirs can easily lose access to your crypto assets by mistake or by fraud. This includes all the various scams and hacks that have been part of life on the internet since the beginning. It also includes social-engineering schemes and plain, old-fashioned theft—if someone just breaks into your house, finds a piece of paper with your key, and swipes it. Your crypto can also be misplaced forever quite easily. Again and again, we hear stories of people who simply lost track of their private keys, or forgot to tell heirs where they were hidden.
Take these cautions seriously—and fully understand he potential risks of investing in cryptocurrency before you start doing so in earnest.
Conclusion: Some best practices for investing in cryptocurrency
- Never forget that crypto lives outside the jurisdiction of the governments of California and the United States, so you should not expect the same protections associated with more traditional financial instruments.
- Crypto nevertheless intersects with financial and legal systems, and transactions made using crypto have legal and tax implications. Do not imagine that you can use crypto without paying attention to tax issues!
- Use a third-party wallet, and rigorously safeguard your information.
- Do your research and fully understand crypto before getting involved.
What do we do as California Estate Attorney specialists?
The lawyers and staff at Cunningham Legal help people plan for some of the worst and best times in their lives; then we guide them when those times come.
As specialists in advanced tax planning, we regularly work with high net-worth cryptocurrency investors. We have the experience necessary to navigate the complex world of cryptocurrency tax law and Estate Planning.
Make an appointment to meet with CunninghamLegal for California Estate, Trust, and Tax Planning. We have offices throughout California, and we offer in-person, phone, and Zoom appointments. Just call (866) 988-3956 or book a free call online.
Check our practice areas page for more on many of these issues. Please also consider joining or replaying one of our free online webinars.
We look forward to working with you!
Best, Jim
James Cunningham Jr., Esq.
Founder, CunninghamLegal
