While success in crypto-currency investing is far from assured, death, sadly, is.  Accordingly, it is vital that investors in Bitcoin and other crypto-currencies are prepared for the unique estate planning factors that apply to digital assets.  The following are five estate planning factors that should be addressed immediately by crypto-currency investors to ensure that their digital assets are effectively passed on to their heirs or beneficiaries.

  1. Custody of Private Keys and Other Information to Access Digital Assets

Unlike bank accounts which can be accessed post-mortem, digital assets typically require a variety of private information to be accessed.  This information (and an investor’s digital assets) may be lost forever if an investor fails to record it or share it with a trusted third party before they die.  To avoid this, it is crucial that investors physically record the following private access information and provide for custody of this information in their will:

  • Private Key: Most crypto-currencies use a public-private key system to ensure that transactions are valid.  While the public key is made public every time the investor buys or sells crypto-currency, only the investor knows the private key.  Private keys are essential to verify ownership and access digital assets, and should be recorded.  Gaining access to a private key is similar to gaining ownership of a bank account, so it is vital that private keys are kept safe.  Creating a physical copy of your private key and securing it in a bank safety deposit box insulates your private key from hacking and may provide the safest means to protect it.
  • Passwords: Crypto-currencies are traded on online platforms commonly known as exchanges.  Investors that fail to secure their digital assets in hardware wallets (see below) typically have their crypto-currencies stored on default digital wallets provided by an exchange.  It is important that the username, password, and security question information for exchanges be recorded to retrieve digital assets from exchange wallets.
  • Two-Factor Authentication: Many crypto-currency exchanges also require that investors use two-factor authentication to authenticate their identity when accessing their account and transferring digital assets.  Two-factor authentication is typically accomplished via a mobile application that provides a unique code to be entered into the exchange.  Investors who use two-factor authentication should record their username, password, and security question information.
  1. Custody of Hardware Wallets

Once Bitcoin and other crypto-currencies are purchased on an exchange, they are automatically stored on that exchange’s default wallet where they can be accessed electronically by the investor.  Digital wallets, especially those used by exchanges, are susceptible to hacking. Investors should transfer their digital assets to a hardware wallet.  Hardware wallets can be purchased online and are, generally, encrypted flash drives that require a password to be accessed.  Investors and their heirs may lose their digital assets if their hardware wallet is lost or damaged.  Investors should record the password and other access information for their hardware wallets, and provide for custody of the information and the wallet itself in their will.

  1. New Jersey Uniform Fiduciary Access to Digital Assets Act

In 2017, New Jersey enacted the Uniform Fiduciary Access to Digital Assets Act (the “Act”).  The Act generally enables individuals to appoint a fiduciary to manage their “digital assets”, broadly defined as electronic records.  Under the Act, electronic records include account information for online exchanges.  Unfortunately, while the Act authorizes a fiduciary to access a deceased investor’s exchange account, it fails to consider that the private key – the essential information to remove digital assets from a digital wallet – is not available to exchanges.  Moreover, the Act’s limited applicability to electronic records may exclude its applicability to hardware wallets.

  1. Fiduciaries under Power of Attorney and Will

Under a well drafted Power of Attorney, an agent, appointed by the principal, is given the power to manage the principal’s assets and make investment decisions on behalf of the principal.  Depending on how the document is drafted, the powers granted under the Power of Attorney can either be effective immediately upon execution or only effective upon the disability or incapacity of the principal.  Having such a document avoids the necessity of asking the court to appoint someone as the principal’s guardian if he or she cannot manage his or her own affairs.

Among other things, the executor of an estate is tasked with distributing the property of the decedent in accordance with the decedent’s will.

In the context of Bitcoin and other crypto-currencies, it may be necessary for the agent under a Power of Attorney or the executor of an estate to have control over these assets.  As such, it is critical that an owner of crypto-currency have a well drafted Power of Attorney and Will, specifically providing the agent with authority over the crypto-currency assets and the necessary information to access such assets.

  1. Estate Planning with Crypto-Currencies

The federal estate tax is based on the value of one’s assets less liabilities at one’s date of death and is imposed at a rate of 40%.  One important exception that is critical to understanding how the federal estate tax works involves the estate and gift tax exemption.  This exemption is the amount that one can transfer to anyone during one’s lifetime or at death without incurring a gift or estate tax.  In 2018, the exemption is $11.18 and this amount will be indexed annually for inflation until 2026, when the exemption amount is scheduled to revert to $5.49 million, with an adjustment for inflation.

For wealthier owners of crypto-currency assets, implementing certain estate planning techniques in order to remove the value of these assets from his or her estate could be highly beneficial.  One such technique would be the creation of a limited liability company (“LLC”), funding the LLC with crypto-currency assets, and then gifting most of the economic value of the LLC to a family trust.

The gift would use a portion of the owner’s federal gift tax exemptions and thus no federal gift tax would be due.  Additionally, if the LLC is created with voting and non-voting membership interests and only the non-voting interests are transferred to the family trust, the value of the gift could be discounted for gift and estate tax purposes.  Moreover, all future appreciation on the value of the LLC interests gifted would accrue outside of the transferor’s taxable estate.

Investors in crypto-currencies are at risk of losing their assets at death unless they plan ahead.  Following these five factors and speaking to an estate planning attorney versed in crypto-currencies will help ensure that digital assets are effectively passed to heirs or beneficiaries.

On March 13, 2018, the IRS announced that the Offshore Voluntary Disclosure Program (OVDP) will be closing on September 28, 2018. This program has been in place since 2009.

In general, US persons, that is, citizens and residents of the US, must report their worldwide income on their US income tax returns. They also must report their financial accounts held outside the US on an annual FBAR (FinCEN Form 114) if the aggregate balance of their accounts exceeds $10,000.

The OVDP offers a structured program for taxpayers to amend income tax returns to report any unreported foreign income, submit any unfiled international tax filings, and disclose the existence of financial accounts outside the United States.

To participate in the OVDP, taxpayers have had to pay a substantial civil penalty based on the value of the unreported accounts, in addition to paying back taxes with a 20% penalty and interest.

The incentive to participating in the OVDP is that the IRS will not criminally prosecute the taxpayer for the failure to report his or her accounts and that all other potential civil penalties will not be assessed in lieu of the one OVDP penalty.

The OVDP is intended for those taxpayers who knew that the law required reporting of their foreign accounts but who decided to not report such accounts on an FBAR or on other international tax filings. These taxpayers have the most to gain from participating in the OVDP and remain exposed if they choose to not come into compliance.

The OVDP requires eight years of amended return filings, six years of FBAR filings, as well as several other items to be submitted to the IRS. The IRS requires a complete OVDP submission by the September 28 deadline. These submissions require time to compile the necessary documentation and to prepare amended returns. It is important for those not in compliance to decide on participating now – well before the September deadline – or you will not be able to complete the OVDP.

What options do taxpayers have if they didn’t file FBAR’s or report their foreign income but their mistakes were inadvertent? This is referred to as a “non-willful” case and is common for many taxpayers who have accounts from their home country that were opened before moving to the US or for those whose tax return preparer did not advise them as to what the tax law requires. The IRS is continuing a program known as “Streamlined Filing Compliance Procedures,” for non-willful violations. These procedures, which may also require a penalty, will continue past September. There are also other ways to return to compliance.

What will IRS enforcement in this area look like once the OVDP is ended? We believe that examinations in this area will only increase. The IRS has gathered a decade’s worth of material on foreign institutions and bankers through the OVDP. This data, along with the information that the IRS now receives from many foreign countries pursuant to a law known as FATCA, allows the IRS to identify non-compliant taxpayers much more easily today than in the past. These international audits are quite intrusive and can expose taxpayers to substantial penalty. We expect the number of these audits to increase.

Once the OVDP option has ended, taxpayers will still be able to voluntarily come forward to disclose past misdeeds. (The IRS has stated that the precise details how to do so will be forthcoming.) It is clear, though, that as onerous as the OVDP penalty is now, the toll to come into compliance in the future will only be greater.

The recently enacted 2017 tax act (originally called the Tax Cuts and Jobs Act – “Tax Reform Act”) contains sweeping changes to US international tax rules that will affect international  businesses and cross border investments.   A review of how to take advantage of these new rules can reap significant benefits or avoid tax pitfalls, as discussed below.

New Territorial Tax System

The Tax Reform Act adopts a new territorial system of taxation (also known as a participation exemption system), which may eliminate or reduce US income taxes on income earned outside the US by US C corporations (“C corps”).  If a C corp owns 10% or more of a foreign corporation that pays a dividend, then the C corp receives a 100% dividends received deduction (“DRD”) for the foreign source portion of the dividend, which will eliminate or reduce the US tax imposed on the dividend.  This DRD is only available for C corps and not for S corporations or individuals.

A DRD will not apply if the foreign corporation is a passive foreign investment company (“PFIC”) unless the foreign corporation is also a controlled foreign corporation (“CFC”) as discussed below.  A PFIC is a foreign company whose income predominantly comes from passive investments (such as marketable securities).

The new territorial system does not apply to income earned by a C corp from a foreign branch.  Income from a foreign branch is subject to US tax, although if foreign tax is imposed on that income, then a foreign tax credit may reduce or eliminate US tax.  As a result, businesses that operate as C corps may want to incorporate their foreign branches to eliminate US tax on branch income.

This system also can reduce the taxable gain realized when a C corp (but not an S corporation or an individual) sells the stock of a foreign corporation.  If the C corp owns the stock of a foreign corporation for one year or more, pre-2017 law recharacterizes any amount realized by the C corp on the sale as a deemed dividend to the extent of the accumulated earnings and profits of the foreign corporation.  The Tax Reform Act provides that such deemed dividend is eligible for the participation exemption system and thus, is not subject to tax.  As a result, a US C corp can eliminate part or all of the taxable gain on the sale of stock of a foreign subsidiary.

New Global Intangible Low-Taxed Income (“GILTI”) Tax

While labeled a tax on intangible income, the GILTI tax is actually a current tax imposed on US shareholders of CFCs on their share of any income earned by the CFC that exceeds a 10% return on investment.  A CFC is any foreign corporation if US shareholders own more than 50% of its stock; for this purpose, a US shareholder is any US person who owns 10% or more of the voting stock or value of the stock of the foreign corporation.  If a CFC has certain types of passive income known as Subpart F income, then US shareholders must include in their income their share of the Subpart F income even though no dividend is paid to them.

The Tax Reform Act provides that a US shareholder of any CFC must include in gross income, for a taxable year, its GILTI in a manner generally similar to the inclusion of Subpart F income.  GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return in that CFC.  The shareholder’s net deemed tangible income return is an amount equal to the excess of 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) in that CFC over certain interest expense of each CFC with respect to which it is a US shareholder.  The QBAI is essentially a book value concept since it is based on the tax basis of the CFC’s assets and not their fair market value.  As a result, the 10% threshold can easily be exceeded.

US shareholders who are C corps are given special tax benefits that can eliminate the GILTI tax.  First, under the new law, a C corp can deduct 50% of the GILTI inclusion amount, which reduces the potential corporate tax from 21% to 10.5%.  Second, for any amount of GILTI included in the gross income of a C corp, the C corp would be deemed to have paid foreign income taxes equal to 80% of the foreign taxes paid by the CFC with respect to such income.  If the CFC pays foreign taxes of 13.125% or more, then this special foreign tax credit will eliminate any GILTI tax.  Individuals and S corporations get no similar treatment and pay full US tax on any GILTI inclusion amount.

Conclusion

US taxpayers should carefully review the structure of their foreign entities with their advisors to determine if the new territorial tax system may apply to them, and whether any foreign corporations may qualify as CFCs, which will subject their US shareholders to the new GILTI tax as well as numerous other rules affecting CFC shareholders.  Since the Tax Reform Act limits the benefits of the new territorial tax system to C corps and also only allows C corps benefits to eliminate the GILTI tax, US taxpayers should consider owning foreign stock in a C corp.  Individuals who own foreign corporate stock may want to transfer such stock to C corps; S corporations owning foreign corporate stock also may want to restructure to take advantage of these new rules.  While this task may not be simple, the tax benefits may significant.

The recently enacted 2017 Tax Act (originally called the Tax Cuts and Jobs Act – “Tax Reform”) made major changes to the US tax system.  Because C corporations (“C corps”) are now taxed at a flat 21% federal income tax rate, many business owners are asking whether they should structure their businesses as C corps.  The answer, unfortunately, is not simple.  Business owners should discuss the various considerations of this decision with their tax advisors.  Here are some of the pros and cons of using a C corp after Tax Reform:

1. Benefits.  C corp income is taxed at a flat 21% rate whereas partnership income flowing through to an individual partner is subject to tax at a maximum 37% rate.  In addition, C corps can fully deduct state and local taxes whereas an individual’s deduction is limited to a maximum of $10,000.

2. Pass-through income (eg, S corporation or partnership) may be eligible for a 20% deduction for qualified business income (QBI), but that still leaves the effective tax rate at 29.6% (ie, higher than the C corp 21% tax rate).  Furthermore, the 20% QBI deduction is not allowed for most service businesses (except for partners or S corp shareholders whose taxable income is less than $315,000 ($157,500 if not married filing jointly), with the benefit phased out over that amount so it is totally lost once the partner’s taxable income equals $415,000 ($207,500 if not married filing jointly).  There are also other limitations that only generally allow the QBI deduction to be claimed if the business employs many people or owns depreciable tangible property (such as real estate).  Bottom line – you have to run the numbers.

3. The drawback to C corps, of course, is that they are subject to two levels of taxation, one at the corporate level on earnings and one at the shareholder level, for example, on dividends.  Dividends usually are taxed at the qualified dividend rate of 20%, though there is usually no preferential tax rate at the state and local level.  Dividends also may be subject to the 3.8% net investment income tax.  If only federal taxes are considered, the effective federal double tax rate is 39.8%.

This may be the deciding factor for many businesses.  If a business does not make distributions to its owners (for example, the owners generally take only salary and perks and profits are reinvested), then a C corp structure may result in income tax savings.  On the other hand, if the business distributes all of its profit out to its owners annually, then the double tax resulting from a C corp structure will be disadvantageous.

4. If the C corp accumulates cash, it can be subject to one of two penalty tax regimes – accumulated earnings tax and personal holding company tax.

Closely held C corps are subject to the personal holding company tax if 60% or more of their income is passive income, which they retain in the C Corp and do not distribute to their shareholders, though the personal holding company tax often can be avoided.  In addition, a C corp is subject to the accumulated earnings tax if it accumulates earnings beyond the reasonable needs of the business.

5. Sale of company.  If a company is sold, it is most often structured as an asset sale, which results in two levels of tax for a C corp – one tax to the corporation when it sells its assets in exchange for cash (or a note, etc.) and a second tax if the corporation is liquidated and the stockholders exchange their (low basis) shares for the sale proceeds.  For a company that may be sold in the near future, C corp status would be disadvantageous.  On the other hand, if there are no plans to sell the company (eg, children in the business), this may not be a concern.

The owner may consider whether he or she can own goodwill, client lists or other intangible assets in his or her own name rather than in the corporation to avoid double tax.  See Martins Ice Cream, Norwalk, and related tax cases on “personal goodwill.”

6. Step-up at death.  If an owner dies owning C corp stock, the stock will receive a step-up in basis to its fair market value.  This will avoid a shareholder level tax if the C corp liquidates.  However, it does not avoid a tax to the corporation on any appreciated assets that are distributed in liquidation or later sold by the C corp.

7. Losses.  If a partnership has losses that flow through to its partners, those losses would not flow through if the entity becomes a C corp, so C corp status would be disadvantageous.

8. Timing and related issues.  A company that is an LLC can elect to be treated as a corporation for tax purposes.  If a decision is made to terminate S corp or partnership status, then termination would have to be completed by March 15 to be effective this year.  Also, an S corporation that terminates its S status has a five year waiting period to convert back to S status.  If the C corp converts to S corp status in the future, then it may be subject to a built-in gain tax and other concerns if it later converts to an S corp and has accumulated earnings and profits.

If an S corp converts to a C corp, there is a two-year post termination period to take out AAA.  The Tax Reform bill provides that distiributions within this period will be partly treated as AAA (tax-free) and partly treated as previous C corp E&P (taxable 23.8 dividend).

Also, given the uncertainty surrounding the Tax Reform bill and the possibility that the rules could be changed again, some business owners may be reluctant to convert to C corp status and then get “stuck” if the rates or rules change.

9. Outbound foreign.  Under the new international tax rules, ownership of foreign corporations by a C corp rather than an individual has several advantages.  Dividends paid by a foreign corporation to a C corp can escape any tax while dividends paid to an individual are fully taxable.  If a foreign corporation has income that exceeds a base threshold amount (generally, 10% of the book value of its assets) and the foreign corporation does not distribute those excess earnings to its US shareholder, then the new “GILTI” tax applies to treat the US shareholder as receiving a deemed taxable dividend of that excess amount.  But C corps pay a lower tax rate on this income or may not pay any tax at all.

If you, as a business owner, are asking yourself, “Should I be a C corp?” note that there is not a “one size fits all” answer.  Have your CPA run the numbers using the new tax rules and rates.  Speak to your tax attorney to review the specifics of your situation.  Revisit this decision periodically.

The new tax bill passed by Congress is expected to be signed into law by President Trump in the next few days.  Based on the changes that will take place as of January 1, 2018, there are several items that taxpayers should consider implementing prior to December 31, 2017.

Please note that each taxpayer’s situation is different and each suggestion below should be discussed with the taxpayer’s tax and financial advisors to determine what steps, if any, should be implemented now or deferred until next year or whether it should be implemented at all depending on the taxpayer’s business and tax attributes.

Items to consider:

  • Prepay real estate property taxes if you have amounts due for 2018 (cannot prepay NJ or NY state income taxes)
  • Prepay home equity interest (no deduction after this year)
  • Make charitable contributions this year, especially if not itemizing deductions in 2018
  • Accelerate business deductions
  • Medical expense deduction floor reduction to 7.5% only lasts through 12/31/18, so incur medical expenses if possible before then
  • Delay or accelerate Roth conversion
  • Defer or accelerate income*
  • If you are a US person with foreign businesses, potentially converting to an S corporation before year end could be beneficial due to a “deemed repatriation” of profits in the new bill
  • If you have children in private elementary, junior high or high schools and have not already been funding 529 plans, consider use of 2017 annual exclusions not otherwise exhausted to fund 529 plans

 

*Deferral of income until 2018 could save taxes for some taxpayers because of the lower marginal rates, while acceleration of income could save taxes for others due to the limitation on deductions of state and local taxes.  Whether or not a taxpayer is subject to AMT also plays a role.  Again, each taxpayer should consult his or her own tax and financial advisors for specific advice.