A digital inheritance – cryptocurrency, death & divorce - Boodle Hatfield

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24 Oct 2023

A digital inheritance – cryptocurrency, death & divorce

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Digital assets are an example of how the perception of what might constitute a good investment can vary significantly between generations.

Some owners of digital assets including cryptocurrencies and NFTs take a long-term view and believe the real value may only really be known after their lifetime.  More and more owners of digital assets are therefore starting to consider how they can pass the assets on as part of their succession planning.

Succession planning for digital assets raises a range of identification and ownership issues because assets held on a blockchain protocol are, by their nature, decentralised with no central register of ownership evidencing title, as is the case with land or shares for example. Ownership of a crypto asset relies upon possession of the 256-character-long binary or 64-digit hexadecimal codes, known as the digital ‘keys’ that are needed to unlock a digital wallet and access the assets. From a legal perspective, this creates difficulties in identifying and tracing the legal and beneficial ownership, particularly on death.

Problems proving ownership

Whoever holds the key to the wallet controls the asset – and to that extent it is similar to cash or other bearer instruments. HMRC take the view that the holder of the keys is the owner, and the tax status of the asset is based on the tax residence of the key-holder. HMRC consider that blockchain tokens, be that cryptocurrency or non-fungible tokens such as digital artwork, are intangible assets that HMRC confirm can be held as taxable investments.  Governments and tax authorities seeking international transparency of ownership, have therefore struggled with how to effectively regulate the trading of digital assets. They cannot rely upon large financial institutions to enforce international reporting standards, as financial institutions are not required in blockchain transactions. Indeed ‘removal of the middleman’ has been heralded as one of the advantages of blockchain technology and the decentralised economy.

When someone dies, their executors have a legal duty to collect in and make an account of the deceased’s assets.  The majority of elderly people dying today will never have held digital assets. However, it is estimated that around 5 million people in the UK now own some form of crypto asset, and owners are principally the younger generations.  On death, the crypto assets can only be accessed by having the digital keys. The potential for executors to be unaware of these assets being held, and indeed never finding them is very real.  For beneficiaries of deceased estates, large sums could be lost as a result, without any intentional wrongdoing by the executors.

What are the tax implications?

The legal issues quickly become complicated.  Consider a situation where digital keys are recovered several years after death.  The executors may have long since finalised the estate administration and distributed the assets. When the assets are recovered, the executors must ascertain the value of the crypto assets at the value immediately before death. Inheritance Tax at 40% is due on the value at the time of death, and that tax will have been due 6 months after the end of the month of death.  A corrective account must be sent to HMRC and the tax paid, together with interest and any late filing penalties.  Given the volatility of the crypto markets, it is entirely possible that the value of the crypto asset might be a fraction of the value at death.  In that case the amount of inheritance tax will not change, as there is no loss on sale relief for crypto assets. The executors will need to find a way to sell the remaining crypto to pay the inheritance tax.

The executors may find it difficult for the law firm acting in the administration to accept the sale proceeds of the cryptocurrency, or for an executors account at a bank to be opened to hold the funds.  Banks will request source of wealth information which the executors may not be able to provide, given the time that has passed since death. There may be no bank record of the original purchase or how the private key came to be in the possession of the deceased. Worse, a beneficiary of the estate might be incentivised to bring a claim against the executors for not ascertaining details of the assets or for the potential loss by not selling them. The executors may find themselves asking beneficiaries for the return of distributed funds to meet inheritance tax charges. Conversely if values have increased since death, the executors may find themselves faced with a large capital tax liability on the estate for a sale of the assets, when the income tax affairs of the deceased and estate have long been closed.

Inclusion in wills

It is not necessary to include details of all assets in a will for it to be valid, and most wills refer to ‘my estate’ as catch all to include all assets owned at death, which can change over time.  To that extent it is unlikely that the will document can helps to evidence any digital asset holding.  If the will does refer to the asset then this will alert the executors to its existence.  A will becomes a public document after probate and so it is not advisable to include private keys in a will for all to see.  A statement in a will saying ‘I leave all of my cryptocurrency to my children’ creates a range of difficulties in terms of the definition of the asset, as not all digital assets are cryptocurrencies, and the gift is not clear whether it is subject to inheritance tax or whether tax is payable from the residual assets of the estate. If tax is payable from the residue of the estate, the tax bill could in theory be so substantial that it requires all other assets to be sold to meet the tax, including perhaps the family home.  Including a reference in a will could also lead to wasted time and costs in searching for the assets after death, only to find they had perhaps been long since liquidated or the keys lost.   Executors could incur high costs and delays attempting to locate old hard drives looking for details of holdings.

Accessing crypto after death

It is suggested by many digital asset wallet providers that steps should be taken to ensure that private keys are not lost.  Writing the keys down on a piece of paper, or placing part of the key with your estate planning lawyer have all been suggestions.  The potential for tax to be avoided by transferring private keys to heirs without disclosure is a risk, but is perhaps no different to issues around artwork or cash.  Ultimately the law has to rely upon the deceased and the executors to comply with their duties and ensure a clear inventory of assets is presented as accurately as possible.  In the UK, as in many other countries, governments have come to recognise these inherent issues, and a consultation is open on measures to ensure robust, transparent and fair standards across the cryptocurrency industry.

While proposals have yet to be made, any steps to stabilise the industry are likely to have a net positive effect for those wishing to include crypto assets in their estate. As change continues apace for the crypto landscape, time will tell whether the law is able to keep pace as more and more digital assets find their way into estates.

But what if the event is not death, but divorce?

Given the intractability of cryptocurrency, there is much interest as to how the asset would, or could, be divided following a divorce. It is important to remember that the family court will take into account all assets of the parties, whatever form they may take. In this way, cryptocurrency is treated no differently to cash or property and the court may make orders for such assets to be transferred or sold and the proceeds divided between the parties accordingly. The only way in which cryptocurrency can be protected in the event of a divorce is via a prenuptial agreement, but even these are not immune to the wide-ranging powers of the family courts in England and Wales and the overarching power to ensure financial awards are “fair”.  For those on the other side who suspect their spouse may be concealing assets in cryptocurrency, it can be difficult to get to the bottom of whether any such assets exist and, if so, how much is held at any one time. The key is to find the threads to pull on which lead to the point of entry into or exit out of cryptocurrencies – bank statements and tax returns can both provide evidence of crypto being exchanged for fiat currency. Given the opacity of crypto-wallets, parties may find themselves reliant on inferences drawn from wider evidence, which can form the basis of a distribution of more accessible assets.  Parties are obliged to make a full and frank disclosure of all their assets. Non-disclosure is punished severely by the family court, including (in rare cases) imprisonment. The court also has the power to reopen divorce settlements if it can be proven that either party failed to disclose his or her assets. Using cryptocurrency as a means of concealment is therefore risky and ill advised.

This article was first written for the FT advisor in October 2023.

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