EFTA00598636.pdf

ESTATE PLANNIN By Ivan Taback & Nathaniel Birdsall The Bitcoin GRAT A new funding source—if the grantor has a healthy tolerance for risk 4:0:1 n Jan. 1, 2013, a single bitcoin would have cost and every bitcoin transaction. These nodes, acting by you a little over $13. Presuming you didn't consensus, relay bitcoin transactions to be added to the spend it on a pizza in the meantime, by early block chain. Thereafter, a public record of the transac- December 2013, your bitcoin would have increased in tion is available for all to see, although the identities value by over $1,000, only to fall back to around $400 of the two transacting parties are kept anonymous! by the middle of April 2014 (then shooting back up to Because each transaction is recorded in the block chain, around $650 by early June). it's impossible for any owner to sell the same bitcoin to This volatility imperils the use of bitcoins for pay- multiple purchasers. ment of day-to-day expenses because yesterday's pizza To own bitcoins, one needs at least one bitcoin could be tomorrow's fortune and vice versa. However, address, consisting of a seeming jumble of 30 or so their potential for dramatic gain, along with the ease numbers and letters. The address is roughly akin to a with which they can be transferred, makes bitcoins routing number, and it's how to identify to whom bit- attractive as a funding source for grantor retained annu- coins should be transferred. The addresses participating ity trusts (GRATs), provided the grantor has a healthy in any bitcoin transaction (of which there will be at least tolerance for risk. two—one for each of the transferor and the transferee) On March 25, the Internal Revenue Service issued are made public on the block chain, which allows for Notice 2014-21' (the Notice) which concludes that vir- a determination of how many bitcoins are associated tual currencies, including bitcoins, are to be treated as with each address. This transparency is essential to the property for tax purposes, rather than currency. The integrity of the Bitcoin system and is why, for instance, Notice allows practitioners, with some initial degree of a site like bitcoinrichlist.com can provide a list of the certainty, to begin determining best practices for execut- 100 addresses that hold the largest number of bitcoins. ing and reporting bitcoin estate-planning transactions. Each address has a corresponding "private key" that's known only to the owner, which she must use to Bitcoin Basics authorizethe transfer ofany bitcoins associated with her The Bitcoin system ("Bitcoin" is capitalized when refer- address. ring to the overall network or concept but is left uncapital- A bitcoin owner keeps track of her addresses in a ized when referring to a unit of currency) is maintained 'wallet; which can consist of a program on the owner's by a decentralized, peer-to-peer payment network. personal computer or smartphone or via an online wal- Anyone who installs the requisite software can become let hosted through a third-party company. Because the a "node" on the network and participate in maintaining wallet can contain both public addresses and private the public record (known as the "block chain") of each keys, for security reasons, many people prefer to keep their wallet disconnected from the Internet, such as by using a "paper wallet" (which, at its most basic, is a piece Ivan Taback, far left. is a partner and of paper with an address and private key printed on it). Nathaniel Birdsall is an associate. Anyone who gains access to a private key can transfer both in the New York City office of the associated bitcoins wherever she wishes. A victim Proskauer Rose LLP of a bitcoin theft will be able to see the transfer of the JULY 2014 TRUSTS ti ESTATES / 15 EFTA00598636 bitcoins on the block chain but will most likely have no of financial institutions or the oversight of governments way of determining who took the bitcoins. The irre- and taxing authorities (although those authorities can versibility of bitcoin transactions is an intentional, see transactions on the block chain just like anyone fundamental component of Bitcoin design, and in else). This is even the case if bitcoins are being sold for this respect, bitcoins function exactly like cash. If a cash, but such a transaction would generally require a robber breaks into your house and steals both cash and buyer and seller to meet in person to make the exchange. your paper wallet, in neither case should you have any However, the most common way of converting bit- expectation of easily tracing and recovering your miss- coins to cash is to use an online exchange. Exchanges ing funds. are, generally, for-profit businesses that connect buyers At present, roughly 12.8 million bitcoins have been and sellers, and each exchange has its own continually introduced into circulation. As of early June 2014, each changing buy and sell prices. To date, the largest of these bitcoin was worth approximately $640, representing a exchanges are based overseas, in places such as Japan, total capitalization of around 58.2 billion. The num- Slovenia, Bulgaria and China. To use an exchange for ber of bitcoins in circulation will gradually increase, any substantial transaction, cash will most likely need to be transferred to or from a bank account, which is the point at which bitcoins come most clearly onto the radar of the taxing authorities. Bitcoins actually provide more There's a variance in the prices offered from exchange to exchange. At present, the transaction costs accurate evidence of the date of of moving large sums of hard currency in and out of exchanges (which as likely as not are located in differ- transfer than many other possible ent countries from each other) limit the effectiveness of bitcoin arbitrage looking at the top three exchanges by funding sources. volume, as of early June 2014, it isn't exceptional to see a price variance of up to 2 percent The price of bitcoins has had dramatic ups and downs, particularly over the last five months or so, as reaching a predetermined maximum of 21 million investors look for evidence of whether bitcoins have bitcoins sometime around 2140. However, because long-term viability as a currency. As one might suppose, the number of bitcoins added to circulation decreases prices tend to react negatively to indications that world by half every four years or so, 99 percent of those governments will begin to regulate and tax bitcoins, 21 million bitcoins will be in circulation by around such as in December when China prohibited banks and 2030 (the process by which bitcoins are mined and other financial institutions from participating in bitcoin added to circulation, although fascinating, is beyond transactions. Prices also dropped when the Japan-based the scope of this article). Mt. Gox, at one point the world's largest bitcoin If an owner loses her private key for any reason, exchange, filed for bankruptcy and revealed that it had she'll never again be able to access the coins held in lost control ofover 850,000 bitcoins (due to some as-yet- the corresponding address. Those lost coins are effec- undetermined mixture of negligence and theft), then tively removed from circulation forever. So, although worth hundreds of millions of dollars. It did little to bol- 21 million bitcoins will be released, the number avail- ster the public's confidence when Mt. Gox announced a able for circulation will slowly fall over time. However, few weeks later that it had located 200,000 of the missing because bitcoins can be transacted with up to eight bitcoins in a wallet they had overlooked. decimal places of specificity, they are divisible into an effectively unlimited number of subunits (much the way Best Practices dollars are divisible into cents). As such, proponents If a client decides to fund a trust with bitcoins, there's no argue that the Bitcoin system will remain robust, regard- real authority as to how the transfer should be memo- less of the actual number of bitcoins available for use. rialized for tax purposes. By looking up the transaction Bitcoins may be transferred without the participation on a site that allows searching of the block chain (such TRUSTS & ESTATES / JULY 2014 16 EFTA00598637  FEATURE: ESTATE PLANNING & TAXATION as blodcchain.info), anyone will be able to see the time any reason, such as to make annuity payments. the transaction occurred, the bitcoin addresses of To avoid any argument that the gift is incomplete the sender and the recipient, the number of bitcoins because the grantor retained control over the transferred transferred and any transaction fees involved. bitcoins, the grantor shouldn't have any access to the As an example, we've selected at random one of the trust's private keys (unless the grantor is also acting thousands of bitcoin transactions that took place as as trustee). So if the grantor isn't acting as the initial we wrote this article: 76a9343d668a2b9ac4edfeld70c- trustee of the GRAT, she shouldn't be the one who sets cfd186e839a53099e9b95c5788c7991d95233. Looking up the wallet for the trust. If the grantor is the initial up that transaction on the block chain reveals that at trustee of the GRAT, at the end of the GRAT term, 2:32 pm GMT on April 2, 2014, a bitcoin address hold- she should transfer any remaining bitcoins to a new ing 80.05067484 bitcoins transferred 10 of thosocoins to address created and controlled by the remainderman a different address. This transaction technically consist- (for instance, the trustee of a continuing trust for the ed of three simultaneous transfers: (1) 10 bitcoins were benefit of the grantor's descendants). It isn't sufficient transferred to the recipient, (2) 70.05057484 bitcoins to simply provide the remainderman with the password were returned to the original owner (albeit to a new to the GRAT's digital wallet (or to physically give the address) as change, and (3) .0001 bitcoins were retained remainderman a piece of paper listing the relevant by the Bitcoin system as a transaction fee. addresses and private keys) because in each case, the Because the identity of the owner of each address is grantor could have retained a copy of the private keys, anonymous, it's possible that actually 70 or so bitcoins which she could use at any time thereafter to transfer the are being transferred, and 10 bitcoins are being received bitcoins back to herself. as change. However, this scenario seems unlikely, given that one transfer is for a round number of 10 bitcoins. It's Administering a Bitcoin GRAT also possible that no bitcoins are changing hands at all, Administering a GRAT funded with bitcoins is unde- and that the owner has merely decided to hold her bit- manding, due to the ease with which bitcoins can be coins in two addresses rather than one. However, for our transferred back to the grantor to make annuity pay- purposes, we'll presume that this transaction represents ments. Unlike a GRAT .funded with stock, there's no the funding of a GRAT with 10 bitcoins. need to open brokerage accounts or to issue annual The record of this transaction will exist publicly in instruction letters to transfer shares. The fee for each the block chain for as long as the Bitcoin system exists. bitcoin transfer will be, at most, a few cents, and that fee Thus, bitcoins actually provide more accurate evidence doesn't scale up with the amount transferred. Essentially, of the date of transfer than many other possible funding the trustee can administer the GRAT from her laptop sources (for instance, the transfer of an entity interest with only a few keystrokes. via an unnotarized assignment agreement). However, However, we advise that the GRAT open up a basic additional steps must be taken to prove what parties bank account at the time of funding. This account were involved in the transaction. To that end, in the will be useful for two purposes. First, in the event that transaction above, we would advise the grantor to send the price of bitcoins soars, the grantor can lock in that a contemporaneous email to her attorney (with a copy value by using a power of substitution to exchange cash to the trustee), which provides the transaction ID and for bitcoins. Second, assuming bitcoins are to be valued affirms that the grantor is the owner of both the input for federal gift tax purposes using the mean between the address where the 80 or so bitcoins originated and day's high and low prices (as discussed below), it will be the output address for the 70 or so bitcoins received difficult to transfer bitcoins exactly equal to the annuity as change. As discussed below, we also recommend that amount (because the mean between high and low won't the email provide evidence of the grantors basis in the be known until the end of the day). If the GRAT has a gifted bitcoins. small cash account, it can pay the bulk of the annuity The trustee likewise should respond with an email by bitcoins, and then once the value of the transferred confirming that the trust is the owner of the output coins is determined the next day, it can use cash to pay address that received the 10 bitcoins. Similar emails the balance. should be sent each time the trust transfers bitcoins for If the grantor or trustee doesn't want to hold JULY 2014 TRUSTS & ESTATES / 17 EFTA00598638  FEATURE: ESTATE PLANNING & TAXATION bitcoins directly, there are investment funds that invest plummet in value, any trust that will hold bitcoins in bitcoins (such as the Bitcoin Investment Mist or the should opt out, to the greatest extent possible under forthcoming Winlclevoss Bitcoin Trust). Using such the governing law, of any prudent investor standard a fund takes the burden off of the trustees to make or any fiduciary obligation to diversify trust assets. certain that any bitcoins are held securely, at the cost The trust agreement should also include comprehensive of fund fees and the greater administrative complex- indemnification provisions for the trustee (although this ity of making annuity payments with fund interests. will be of little use if the trust's assets are entirely wiped For instance, as per its website, the Bitcoin Investment out in a major price plunge).In addition, it's advisable to Trust, which is only open to accredited investors mak- include a provision specifically authorizing the trust- ees to hold bitcoins, even to the exclusion of all other assets, along with an acknowledgment by the grantor that this authorization is given with full awareness of Anyone who wishes to may create the speculative nature of bitcoins. If a trust holds bitcoins directly, there's also the risk a bitcoin exchange, without of theft or the loss of the private keys associated with the trust's bitcoin addresses. needing the consent of any central To minimize the possibility of theft, the trustee should be familiar with how bitcoin transactions work and the Bitcoin authority. importance ofkeeping the trust's private keys confidential The trustees should take steps to keep the private keys secure and should research the different wallet options ing a minimum $25,000 investment, has a front-end available. If a paper wallet is used, it should be kept in a fee of 0.5 percent, an annual administrative and safe- safe or other secure location controlled by the trustee.' keeping fee of 2 percent and an early redemption fee While keeping multiple copies of a paper wallet increases of 1.5 percent if shares are redeemed within a year of the likelihood of theft, it may be advisable to avoid the purchase. The added expense of an investment fund possible loss ofa single hard copy of the private keys due may be reasonable in the eyes of the trustees, given to fire, natural disaster or shoddy record keeping. the merest possibility of total loss of trust corpus due There's also the risk that the trustee will simply to lost or stolen private keys. Alternatively, to a grantor transfer the bitcoins to herself, and then claim that the who's technically savvy, a bitcoin investment fund bitcoins were stolen. Because bitcoin addresses are anon- may seem a useless drain on trust assets. So, whether ymous, there would be no immediate way to determine to hold bitcoins directly or through a fund will be a whether the bitcoins had been taken by the trustee or by trust-by-trust decision. In the case of a GRAT, if the some third party. grantor owned bitcoins directly prior to funding the Given these concerns, the grantor must give great GRAT, it's likely she'll continue to be willing to hold consideration as to who will act as trustee of the trust. them directly while acting as trustee. If the grantor At present, it may be difficult to find any bank or trust intends to reacquire, for cash, any bitcoins remaining company that's willing to take on the liability associated in the trust at the end of the GRAT term (to provide with funding a trust with bitcoins. likewise, it may be the remainderman with assets without any built-in difficult to fmd any attorney or law firm that's willing gain), the grantor will never need to rely on any other to take on the responsibility of holding backup copies trustee with respect to any bitcoin transaction. of private keys. So, the grantor will likely need to place great faith in one or more individual trustees. Fiduciary Issues Appointing multiple trustees can minimize the Whether the trust holds bitcoins outright or through a risk of the inadvertent loss of bitcoins, if each trustee fund, there's always the risk of a precipitous plunge retains separate access to the trust's wallet. That way, in bitcoin value (including to zero, in the event the if one trustee dies or becomes incapacitated, there will integrity of the Bitcoin system is someday compro- still be a remaining trustee with access to the trust's mised). To minimize the trustee's liability if bitcoins private keys. If a sole trustee is to act, she should make 18 TRUSTS & ESTATES / JULY 2014 '0+ EFTA00598639  1040 ° certain that the designated successor trustee, or some The trick is in selecting which exchanges to include other trusted individual, knows where the wallet is locat- in the reference group and how many to use. That deci- ed and how to access it in the event of the trustee's death. sion will change from day to day, as exchanges wax and The Bitcoin system also allows "multi-signature wane in reputation and popularity. For instance, up until transactions, meaning a single address can require mul- its ignoble demise, Mt. Gox was one of the largest and tiple private keys to authorize a bitcoin transfer. Using most successful exchange& The safest option is prob- multi-signature transactions would allow, for instance, ably to take into consideration only those exchanges a grantor to require any two of three private keys to be that trade bitcoins for U.S. dollars and have the high- applied to authorize a transaction. Ifthose three keys were est trading volume on the day of transfer. distributed to three trustees, the trustees would de facto In looking at prices across in exchan es one need to operate by majority to effect transactions (mini- may note that the prices offered by are mizing the risk of theft by the trustees), and there would higher than the others. This discrepancy exists because be no total loss in the event one key was mislaid.' The that site connects individuals who want to conduct possibility of theft by an outside party would also be a one-on-one transfer of bitcoins for dollars outside reduced, because any thief would need to steal private of the auspices of an exchange, such as by a face-to- keys from multiple trustees (who may each hold their face meeting between buyer and seller (so, in many key in a different form of wallet). ways, it operates more like a brokerage service than an While multi-signature transactions aren't yet preva- exchange). The average sell prices on lent, they'll likely become more common as Bitcoin tend to be higher than on other exchanges, possibly due evolves. Likewise, an increasing number of online wallet to the increased value to the participants of conducting providers likely offer a multi-signature security protocol. a cash transaction without the necessity of involving any bank, exchange or other financial institution. Given Determining Bitcoin Value the safety and logistical concerns of arranging a one- Because the Notice concludes that bitcoins are property on-one transfer for the large sums with which a trust rather than currency, any gifted bitcoins are valued at the will like) be funded, it may be reasonable to eliminate price at which the bitcoins would change hands between from the list of referenced exchanges. a willing buyer and willing seller as of the date of the gift, A gift of property will only be adequately disclosed as provided in Treasury Regulations Section 25.2512.1. for federal gift tax purposes if it meets the requirements Publicly traded stocks and bonds are probably the of Treas. Regs. Section 30I.6501(c)-1(f), which requires closest analog to bitcoins under the property valua- the grantor's federal gift tax return to include either: tion rules, because each derives its value by reference (1) a detailed description of the method used to deter- to an exchange. Under Treas. Regs. Section 25.2512-2, mine the fair market value (FMV) of the transferred gifts of stocks and bonds that are traded on a public property, or (2) an appraisal prepared by a qualified exchange are valued at the mean between the highest appraiser. If the gift is adequately disclosed, then the and lowest selling prices on the date of the gift. If the filing of the return commences the statute of limitations stocks or bonds are listed on more than one exchange, period during which the IRS can object to the valuation then the value of the exchange where they're principally of the transferred bitcoins. dealt should be used. If no records are available for any Given that there are public exchanges where bitcoins such principal exchange, the value can be based on can be converted into cash at an ascertainable and the public records of a composite listing of combined recorded value, it's not obvious that any particular exchanges. valuation discount should apply when valuing gifted Anyone who wishes to may create a bitcoin exchange, bitcoins (except, conceivably, a blockage discount in without needing the consent of any central Bitcoin the case of a gift of a massive number of bitcoins). authority. So, there's no single or principal exchange A qualified appraisal, then, will likely rely on the same that sets value. Accordingly, the best approach is likely procedure discussed above, namely taking a weighted to take a weighted average of the mean between the average of the mean daily value of a variety of reputable highest and lowest bitcoin prices on a variety of the bitcoin exchanges. The focus of the appraisal might be a most popular exchanges. rationale for analogizing bitcoins to stock and bonds for JULY 2014 TRUSTS & ESTATES / 19 MM. EFTA00598640  ESTATE PLANNING & TAXATION valuation purposes and then a justification of which (and Determining Bitcoin Basis how many) exchanges were selected as the sample group. As per the Notice, an owner has a basis in her bitcoins, Absent the prospect of a valuation discount, there similar to any other property. Because gifted bitcoins may be no need to incur the expense of a qualified will carry over the grantor's basis, it's important that appraisal, because the client can simply provide a detailed the grantor provide a statement to the trustee of what description of the gifted bitcoins under Treas. Regs. Sec- that basis is and how it was calculated. Otherwise, it tion 301.6501(c)-1(f)(2)(iv), setting forth the method may be impossible for the trust to prove its basis on any used to determine FMV. That description should list future disposition, and the IRS may argue that a zero which exchanges were referenced, give their high basis should apply. and low values on the day of the transfer and pro- Calculating basis is easy if the grantor originally vide a brief description of why those exchanges were purchased the bitcoins in a handful of transactions and selected. has held them as a long-term investment. In that case, For example, on April 2, 2014, the date of transfer of the grantor should provide the trustee with the relevant the 10 bitcoins described above,here are the relevant val- transaction IDs by which the bitcoins were originally ues in U.S. dollars of one bitcoin, as per the three largest purchased, along with a statement of what price she exchanges by volume. paid in dollars. If the grantor obtained the transferred bitcoins in a large number of transactions or by min- Exchange High Low Mean ing them, it will prove more difficult to calculate the Bitstamp $494.98 $430.00 $462.49 relevant basis. Bitfinex $496.20 $431.20 $463.70 At present, the federal government has little ability BTC-e $498.70 $420.00 $459.35 to track each individual's bitcoin transactions. As such. $461.85 any bitcoins reported on a gift tax return may be of par- ticular interest to the IRS, because it's one of their few While many bitcoin exchanges provide copious opportunities to receive detailed basis information. For charts and data on historic prices, others don't. And, that reason, it's imperative to be accurate when report- it may be that the historic prices aren't presented in a ing the grantor's basis on Form 709. manner that makes it easy to determine the day's high and low prices. There are numerous third-party sites Final Thoughts that collate the pricing data of various exchanges in Whether Bitcoin, in particular, flourishes in the a searchable format, but often one will have no idea long run, virtual currencies seem poised to become a who runs these sites or how accurate they are. For permanent part of the financial landscape. Eventually, instance, we obtained the information above from there will no doubt be rulings, regulations and MIIMMI, for which we did no due diligence additions to the Internal Revenue Code that provide whatsoever. There are several sites that provide an clear guidance on how such currencies are to be updated bitcoin exchange rate by reference to multiple treated in the context of estate-planniii exchanges (such as or i. but transactions. their methodology should be investigated with care to see how it comports with the property valuation rules Endnotes discussed earlier. I. Available online al wwwirs.gawhvbfws-droph14-21.O. Given the lack of any rulings or cases discussing best 2. More actor-Meet transadicrts are pseudonyncusil a third parry is able to practices for bitcoin valuation in the gift tax context, a cli- conned your one to your address. Meet be able to see all of you transac- ent may wish to fund a trust with bitcoins via a defined tions related to that address, which may lead them loather addresses wider value gift agreement. In the event that the value of the vote control. transferred bitcoins is adjusted on audit (for instance, if 3. Me a safely deoosit box May SeeM like a go:d splutter'.male bark woill the IRS disagrees with the client's or the appraiser's selec- 4kov one lobe held is the name of a bust tion of relevant exchanges), the agreement could provide 4. Multilignatures also allow for escrow tra xactions. n wiikh a third-Oady that any bitcoins transferred in excess of the intended escrow agent onauthorize the completion arcamdationof a tikcii trans- value will be paid to a designated party (for instance, the anion between buyer and seller.deoending on whether the purchased asset grantor) rather than retained by the donee trust. is delisvred as promised. 20 TRUSTS 8 ESTATES / JULY 2014 EFTA00598641