By Anthony Diosdi
Federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest or inheritance. This transfer tax takes the form of a gift tax in the case of completed lifetime gifts and an estate tax in the case of property owned by the decedent at the time of death. Since the Internal Revenue Service (“IRS”) treats cryptocurrency as property for federal tax purposes, the federal estate and gift tax is imposed on any cryptocurrency transferred by gift or bequest.
Gift and estate taxes are computed on the progressive unified rate schedule set forth in Section 2001 of the Internal Revenue Code with rates as high as 40 percent. As of 2022, the lifetime estate and gift tax exemption for U.S. domiciled single filers is $12.06 million and $24.12 million for married couples U.S. domiciliaries filing jointly. For U.S. domiciliaries with taxable estates above the aforementioned thresholds, there are a number of planning techniques available to cryptocurrency holders to reduce or eliminate the estate and gift tax on their crypto assets may substantially appreciate in value during their lifetime. First, if a cryptocurrency trader that acquires newly circulated coins with a low value can give the crypto assets to a preferred donee. The gifted coin is valued at its fair market value on the date of the gift. Fair market value is the “price at which [gifted] * * * property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”
If the cryptocurrency transfer’s gifts his or her crypto assets when the fair market value of the coins is still low, any appreciation after the gift transfer will not be taxed to his or her estate. In the alternative, a crypto trader may avoid or reduce the estate tax by donating his or her cryptocurrency to a qualified charity. Donating crypto assets to a qualified charity will not only reduce or eliminate the estate and gift tax, it may also generate a valuable charitable income tax deduction.
Planning for the estate and gift tax becomes more complicated for nonresidents of the United States. For U.S. federal estate and gift tax purposes, the term “residency” means “domicile.” For U.S. federal estate tax purposes, a person can have only one place of domicile. (However, a number of U.S. estate tax treaties vary these rules). A nonresident’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit.
For nonresident aliens, an estate tax is imposed on any U.S. situs property at the time of death. Situs is determined by the physical location of the nonresident alien decedent’s property. For nonresident aliens a U.S. federal gift applies to transfers of tangible property (real property tangible personal property), including currency physically located in the United States at the time of the gift.
Situs is generally considered to be the place an asset belongs to for purposes of legal jurisdiction or taxation. While this definition seems clear on its surface, its practical application to crypto assets is not, which is particularly troublesome given the dramatic effect that the situs of crypto assets can have on estate tax liability for nonresident aliens.
The problem is that the Internal Revenue Service (“IRS”) has not provided any guidance for determining the situs of crypoassets. With the lack of guidance, it is extremely difficult to determine the situs of cryptocurrency for purposes of the U.S. estate and gift tax. With that said, there are approaches that can be taken to determine the situs of a crypto asset. Holding cryptocurrency on a U.S. exchange such as Coinbase will likely be deemed U.S. situs property for purposes of the federal estate and gift tax. The location of a crypto exchange’s headquarters or server where accounts are held could also establish U.S. situs for purposes of the federal estate and gift tax. In addition, if a nonresident where to hold crypto currency in a based “wallet” could be indicative of U.S. situs for purposes of the federal estate and gift tax. There are two kinds of wallets used to store cryptocurrency.
The first kind of wallet used to store cryptocurrency are often called software wallets. With software wallets, the owner of cryptocurrency downloads the assets to computers or smartphones. The second type of wallet is known as hardware wallets. With hardware wallets, owners transfer private keys to access cryptocurrency to a separate hardware device, such as a USB drive. The hardware device is not corrected to the internet or a computer. In either case, if a software or hardware wallet were to be physically located in the United States, the crypto assets stored on the wallet could be subject to the federal estate and gift tax.
In determining whether cryptocurrency may be U.S. situs property for purposes of the estate and gift tax, the following factors should be carefully analyzed:
1) The location of the owner of the crypto assets;
2) The physical location of the exchange account;
3) The physical location of the servers;
4) The physical location of the digital wallet.
Conclusion
Overall, cryptocurrency is still an emerging asset class with a largely undefined tax framework. U.S. and foreign investors with cryptocurrency with a U.S. nexus should seek guidance from an experienced tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony Diosdi focuses a part of his practice on criminal tax enforcement, broad-based civil tax compliance and white collar matters generally. He also advises clients on the IRS voluntary disclosure program, with particular focus on disclosure related to offshore banking accounts.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.