Cryptocurrency is a taxable asset, according to the IRS Notice 2014-21, 2014-16 I.R.B. 938. Crypto is, for tax purposes, treated as property. The classification allows the asset to be part of legal action meaning that if you are involved in a lawsuit, your digital currency can be subject to seizure.
Documenting Cryptocurrency Transactions
Cryptocurrency, whether it be Bitcoin, Ethereum, Ripple, Litecoin or other digital currencies, are decentralized, meaning that government agencies and banks are taken out of the transaction process.
Blockchain is the underlying technology that acts as a digital ledger that verifies transactions.
Example of a Bitcoin Transaction
Blockchain holds blocks of data that are chained together. A traditional transaction process for cryptocurrency works as follows:
- Transactions are entered
- The transaction is spread across a network of peer-to-peer computers called nodes
- The transaction is confirmed by the nodes
- Transactions are clustered into blocks and entered into the ledger once verified
- A history of the transaction is made by adding the new blocks to the existing blockchain
- The transaction is complete
Multiple things are happening during this process. Digital wallets are in use, allowing for a public and private key to exist to determine where the bitcoin is being sent. While the wallet is anonymous, there is a digital signature for both the public and private keys that allow one person to send and one to receive cryptocurrency.
Blockchain can be even more beneficial, with the option to have triggers where transactions are only complete when certain criteria are met using smart contracts. In fact, financial institutes
believe that blockchain will have many applications outside of Bitcoin or other cryptocurrency transactions.
Can You Reverse Transactions?
No. Once a cryptocurrency transaction is initiated, it cannot be stopped. Due to the nature of blockchain, it’s impossible to slow or stop the transaction from occurring. The person that receives the funds can refund the transaction.
Cryptocurrency values fluctuate, leading prices to often be volatile.
Supply and demand determine the price of Bitcoin. Today, one Bitcoin may be worth $40,000 and tomorrow, it can be worth $50,000. Due to these changes in prices, it’s best to agree on a refund rate if refunds are allowed.
Garnishment and Cryptocurrency
Since the IRS defines cryptocurrency as property, crypto cannot be garnished like money can. The definition doesn’t allow the government or private persons to garnish a person’s cryptocurrency.
Bitcoin, and other crypto, is not considered a form of income, which makes it hard to target in lawsuits, although they do hold value.
If a court did order someone to pay a debt using their digital currency, that individual would need to provide their private and public key to access the asset. Judges have ordered payments to be made using cryptocurrency when the individual is known to own digital currency.
As the laws around cryptocurrency continue to evolve, there’s a chance that the classification of crypto can change. If this is the case, it’s important to put crypto into a trust or other form of asset protection to keep the asset from being a target in a lawsuit.
Crypto Property Types
Since the IRS defines virtual currency, for federal tax purposes, as being property, it’s vital to understand that there are multiple types of potential property classifications. You can classify your currency as one of the following types of property:
If you’re a business that allows Bitcoin to be used for your goods or services, the currency would be considered a business property.
Crypto Assets, Safety and Anonymity
Cryptocurrency has grown in popularity, primarily due to the assets being anonymous. While a wallet has a public key, the blockchain makes transactions anonymous. You cannot trace a transaction to an individual easily, although tracing has occurred in cases of fraud.
For example, a public key is broadcasted, allowing a person to know that crypto was sent to a specific wallet.
Fingerprint technology can be used to identify certain blockchain services used by an account. Ownership analysis can then occur, which may lead to the crypto being tied to a certain individual, but the process is very intensive and often doesn’t result in determining the owner of a certain wallet.
For tax purposes, however, the IRS does require assets to be disclosed, which is why many people choose to put their crypto in an Asset Protection Trust.
If you store a lot of crypto in online or mobile digital wallets, there is a risk that the wallet can be hacked. In fact, there are reports of the “unhackable” digital wallet being hacked multiple times.
To further protect your cryptocurrency is to use cold wallet, or a non-Internet connected storage device, such as an SD card. If you want to secure your cryptocurrency so that it’s the most secure possible, a cold wallet is your best option.
Additionally, an Asset Protection Trust can help you further protect your cryptocurrency.
Asset Protection Trusts and Cryptocurrency
Asset protection is a strategy that you can use to protect your wealth. When you use a trust, you’ll protect your asset from the threat of a lawsuit. Businesses and individuals can create an Asset Protection Trust that is completely legal and a smart choice for a financial portfolio.
Proper estate planning can help you understand how asset protection works and what the best opportunity to protect your cryptocurrencies is based on your situation.
Note: Trusts do not eliminate the need to pay taxes on your crypto. Instead, they allow you to avoid potential lawsuits and protect these assets from business liability.
Domestic Asset Protection
An asset protection attorney can help you create a legal structure that protects your assets from lawsuits. When a domestic trust is created, there are multiple benefits:
- Easy access to the trust
- Beneficiaries of the trust can be the trust’s creator
Properly structuring the trust will make it so that creditors cannot reach the assets in the trust. A domestic asset protection trust (DAPT) is irrevocable and offers additional benefits, including state income tax savings.
The trust can be funded with a variety of assets, including but not limited to:
- Business assets
- Real estate
In some cases, placing cryptocurrency inside of an LLC in a state that has favorable laws that offer even more protection for your assets. Substantial relationships may play a role in DAPT, too.
If a legal battle arises, the location of the trust may play a big role in how the case ends.
Offshore Asset Protection
Offshore trusts can offer even better asset protection compared to domestic trusts because they’re subject to laws of other countries, which can be extremely beneficial. The Cook Islands, which is in the South Pacific, is one of the locations where offshore trusts are extremely beneficial.
When creating an offshore asset protection trust, it’s important that:
- The country of choice is beneficial for your asset protection needs
- The trust management company has no presence or ties with the US
Opening a foreign limited liability company offers a lot of protections, too. A limited liability company is a separate legal entity that separates the owner’s liability from the company as long as the corporate veil is not pierced.
Ideally, the LLC would be formed offshore in a country that does not recognize foreign judgments.
For example, if a judge in the United States ruled that you needed to pay a judgment to a creditor, an offshore trust that doesn’t recognize foreign judgments wouldn’t be obligated to turn over the assets in the trust.
Offshore trusts offer the utmost in asset protection and outperform DAPTs.
Claims made against a foreign trust have to be made in the jurisdiction of the trust, which is equally deterring. The case will then need to be heard in a local court, which is a massive expense that many creditors or people filing a lawsuit will not want to incur.
Combining Domestic and Offshore Trusts
An Asset Protection Attorney can also create a domestic and offshore trust that can be used to move assets through a network of trusts that all work to safeguard your cryptocurrency. When using more than one trust, you can easily access the assets in a trust when needed and easily move them offshore when the assets need more protection.
Cryptocurrency is a rising asset, or a form of property, according to the IRS, that should be protected in a form of asset protection. The proper asset protection strategies allow you to keep your assets in a trust that is protected from judgements and lawsuits.
While cryptocurrency is currently considered property, it’s still a relatively new financial investment that will continue to evolve.
An Asset Protection Attorney can help you protect your cryptocurrency so that if you’re ever ordered to pay a debt or a judgment is passed against you, your crypto is protected.