Cryptocurrency and Trusts

The effectiveness of a trustee is measured by the extent to which its administration of the trust is consistent with settlor intent, protects beneficial interest, and reflects the appropriate levels of knowledge and professionalism. In giving effect to all three of these components, the trustee must adhere to a specialized set of duties known as fiduciary duties. By definition, a fiduciary duty is one exercised by someone in a trusted relationship, and someone who accepts legal responsibility for protecting something for someone for a period of time on behalf of others. In the trust relationship, it is a trustee who owes a fiduciary duty, illustrated by the manner in which it safeguards trust assets on behalf of trust beneficiaries and generally administers the trust in a manner consistent with the terms of the trust instrument. A fiduciary duty is the highest level of duty that one can owe to another person. 

Although specific definitions may vary, fiduciary duties typically include the same core elements, such as: 

• Duty of care: a duty to diligently review all relevant information before making a decision that could impact the beneficiary, using reasonable prudence.
• Duty of good faith: a duty to make all decisions affecting the trust in a manner that reflects the best interest of the beneficiaries and avoiding conflicts of interest.
• Duty of prudence: a duty to make all decisions with the highest degree of care, caution, and skill.
• Duty of disclosure: a duty to disclose all information that could impact the beneficiaries or the trustee’s ability to uphold their fiduciary duties as trustee to those parties designated in the trust instrument.

The unique nature of cryptocurrency presents new challenges for trustees in adhering to their fiduciary duties. As an asset class, cryptocurrency is notoriously difficult to secure, and subject to limited documentation and account records. In a world of strict fiduciary duties and responsibilities owed to those for whom the trust is established, trustees are finding it difficult to meet the historical standards imposed on them as a fiduciary while permitting investments in cryptocurrency. While the ultimate path forward is yet to be developed, this article will discuss the unique issues that trustees are wrestling with an eye towards developing a common understanding. 

Cryptocurrency’s Challenges

Cryptocurrency has presented several challenges for trustees in adapting the asset class to traditional fiduciary standards. With rapidly changing technology and laws, it can be difficult to properly educate both bankers and regulators on this ever-evolving asset class. Regulators are looking at (1) whether a trustee can adequately exercise control over cryptocurrency or custody it, (2) whether a trustee can obtain sufficient information regarding transactions and activity from cryptocurrency accounts to meet their duties of record keeping and disclosure, and (3) whether a trustee can adequately safeguard cryptocurrency and protect the asset from loss. 

Custody

The world of cryptocurrency has historically utilized either hot or cold wallets to custody assets. Hot wallets refer to accounts accessed on the internet, either cloud based or through mobile apps. Because they are stored on the internet, they are subject to hacking and malware attacks; however, they are also most similar to standard banking relationships. Cold wallets are stored offline, making them safe from hacking and malware; however, they are also difficult to secure due to the physical nature of the USB drive or physical computer on which their keys must be stored. If the key is lost, so is the asset.

For trustees, it is difficult to say what the best option would be for holding cryptocurrency in trusts. If using a hot wallet, it is more like a standard bank account to access, but the risk is significant if the account is hacked making cyber security a key area of concern. If using a cold wallet, the USB drive can be stored in a safe location but is still subject to loss along with wear and tear of the device, and normal software obsolescence. While it is possible to shift some of the liability for the choice of assets through a directed trust structure, the duty to secure the asset remains with the trustee.

Reporting

Trustees are responsible for maintaining complete and accurate principal and income accountings of all trust assets for the trusts they administer. This accounting is used to report trust activity to taxing authorities, co-fiduciaries, and beneficiaries alike. As an asset class, cryptocurrency is known for the flexibility of trading and lack of documentation, relying on individual owners to track their transactions and cost basis. 

Tax reporting for cryptocurrency has led to additional challenges for trustees. According to IRS Notice 2014-21, the Internal Revenue Service considers cryptocurrency (or virtual currency as it is referred to in the Notice) to be property and not cash, meaning that capital gains and losses must be reported annually. As property, cryptocurrency is subject to (1) gains or loss which may be either short-term or long-term, and (2) income which is taxed as ordinary income. If there is no regulatory authority requiring the reporting of this information to owners, the record keeping is once again left to individual owners who may or may not be knowledgeable enough to understand the information and issues that are present. Trustees, while knowledgeable, may not be able to access this type of information independently or from reliable sources.

Safeguarding

Trustees are under an obligation to safeguard all trust assets under their control. This means having the ability to prove ownership of each asset, custody of the assets included to ensure that others are not able to access the assets, and finally to invest the assets prudently so that they will be available for the purposes intended by the trust. We have already raised the difficulties with both custody and record keeping of cryptocurrency above, but the question of how to properly safeguard the asset while allowing access by those who need it remains a concern. 

Development of procedures specific to cryptocurrency around access is essential, especially in the area of cold wallets. How should cold keys be stored? What is the proper procedure for ensuring that the cold wallets storage does not become obsolete over time? How can you prevent fraud with hot wallets? Trustees are responsible for the security, safekeeping and overall avoidance of loss for all assets under their control. Shared control of cold wallets and security issues of hot wallets had left many trustees cautious about accepting such assets into a trust. 

In addition, unless directed with regard to investments, trustees must be concerned with the prudence of trust investment choices. Cryptocurrency as an asset class is traded aggressively. It is unknown at this time if waivers of the Prudent Investment Rule will be sufficient to allay trustee concerns about concentrated positions and investment stability, let alone the outcome of any such litigation involving a concentration of such assets. Again, making trustees very cautious holding cryptocurrency as a trust asset.

Thoughts on the Path Forward for Trustees

Keeping in mind the fiduciary duties at the beginning of this article, the path forward must include an approach that utilizes diligence, high degrees of care, and maximizes the trustee’s ability to timely and accurately disclose the activity of the trust to the necessary parties. This path must be guided by advice from regulators and informed by best practices within the industry. More recently, cryptocurrency custodians such as Coinbase, Gemini and Ethereum have entered the market offering qualified, regulated U.S. platform exchanges as an alternative to cold and hot wallets. These custodians permit peer to peer transactions on a registered currency exchange and are regulated by FinCEN in the U.S. The registration of these custodians allows owners to buy, sell and trade cryptocurrencies in a manner similar to traditional brokerage and stock market accounts and the custodian maintains control over the accounts and is able to track transactions within their account.

In June of 2024, the IRS issued final regulations requiring custodial brokers to report the sale or exchange of digital assets in an effort to ensure accurate tax reporting with respect to digital asset transactions. This means that new qualified cryptocurrency custodians such as Coinbase, are now required to provide customers with annual reporting such as Form 1099 DA which reports digital asset broker transactions.

These new qualified custodians may be the path forward for cryptocurrency in trusts, combining custody, safekeeping and mandatory reporting, while allowing families the freedom to invest in this new asset class. Only time and best practices will inform the proper application of fiduciary duties to cryptocurrency. In the interim, families should know that trustees are working towards solutions and protection equally in accordance with their fiduciary duties.

Commonwealth Trust Company is pleased to provide this article as a guide. Commonwealth Trust Company is not engaged in the practice of law and is not providing legal advice by the provision of these materials. Commonwealth Trust Company recommends that clients seek the opinion of their attorney regarding the specific legal and tax issues addressed in this article.