The popularity of digital assets has grown exponentially over the last decade. Unsurprisingly, the value of many cryptocurrencies has followed suit, gaining enormous market capitalization over a relatively short period of time. What was once a fringe asset owned by relatively few tech-savvy investors has quickly become a commonplace investment, particularly for a new generation of taxpayers.
Part I of this series discussed the history and IRS tax treatment of cryptocurrency. This article, Part II, will cover the various planned giving methods that may be well-suited for donations of digital assets. Part III will discuss the practical considerations for organizations considering receiving digital assets.
Potential Charitable Giving Vehicles
When digital assets such as cryptocurrencies are held as long-term capital assets, they may be a good fit for a variety of charitable gift types. The appropriate gift type will depend in part on the value of the asset that the donor wishes to transfer and also the likelihood of price volatility during the period of time when the asset will be transferred. Another important consideration, which will be addressed in more detail in the next article in this series, is the gift's potential to give rise to liability for the nonprofit or other transferee as well as the organization's ability and willingness to take on the asset. Any nonprofit organization looking to accept gifts of cryptocurrency must perform its due diligence to determine whether it can handle the risks involved. The nonprofit would do well to implement a thorough gift acceptance policy that covers the types of digital assets that it will accept and place boundaries around which types of planned gifts involving cryptocurrency are acceptable.
Outright Donation During Life
The simplest and most straightforward donation of digital assets to a nonprofit is an outright gift. The donor transfers the asset to a nonprofit and receives a charitable income tax deduction. The amount of the deduction will depend on whether the asset is a capital asset or an ordinary income asset. If it is a capital asset that has been held for more than one year, the donor will be entitled to a full fair market value deduction. Note that if the value of the donated asset is over $5,000 in value, the donor will need a qualified appraisal to substantiate the deduction. (See Part I of this series for a discussion of qualified appraisals.)
If the asset is treated as an ordinary income asset in the hands of the donor or has been held for less than one year, the donor's deduction will be based on the donor's cost basis in the asset. The digital asset is likely to be treated as an ordinary income asset if it was generated by the donor through mining or farming.
Donor Advised Fund
A donor who wishes to receive a charitable deduction now, but is unsure which charitable organization to benefit, may choose to donate cryptocurrency to a donor advised fund (DAF). If the DAF's sponsoring organization accepts gifts of cryptocurrency, this can be a great way for a donor to lock in a sizeable deduction without having to immediately select the charitable beneficiary.
In addition to an outright donation, a digital asset owner may consider a bequest of cryptocurrency to a nonprofit. As with many other types of assets, the donor may leave digital assets to family members, friends or charitable organizations through the donor's will or trust.
If the executor of the estate does not have access to all the necessary information, it is quite possible for the digital asset to be lost. Therefore, it is important for the bequest to clearly state where and how the digital asset is stored and to be specific as to which digital assets are to be transferred to different individuals or organizations. The donor should also make sure that it is possible for the executor to gain access to the passwords and the private key required to access the assets. This will likely take the form of a description of an external document containing this sensitive information. Given the inherent security risks, it is essential that the passwords are not included in the estate plan document.
Amy met with her estate planning attorney to update her last will and testament. Over the last five years, Amy has substantially increased her holdings of digital assets. Amy currently owns a variety of cryptocurrencies including 5 Bitcoin, 10 Bitcoin Cash, 1,000 Ripple and 50 Chia. She also owns three nonfungible tokens (NFTs). One of the NFTs is a digital painting worth $10,000. The second NFT is a limited-edition album by her favorite band, currently valued at $5,000 and the third is a pair of sneakers valued at $250.
Charitable Gift Annuities
The attorney drafts a will that includes instructions to leave the 5 Bitcoin to her local faith-based nonprofit, the 10 Bitcoin Cash to her favorite animal rescue organization and the NFT of the digital painting to the art museum in the state capital. Amy's will states the specific wallet where the Bitcoin and Bitcoin Cash can be found, along with instructions regarding where the passcode to access the wallet is located. The will notes that the NFT is held in a separate wallet and provides additional instructions for accessing it. Depending on the value of these assets when Amy passes away, her estate may be able to claim a substantial estate tax deduction with these bequests of digital assets, which hold an estimated value of $207,000. Thanks to Amy's attorney's attention to detail and Amy keeping her passcode document updated, the charitable recipients of these bequests are able to access and take possession of these unique assets when the time comes.
Many nonprofits around the country offer charitable gift annuities (CGAs). These contracts between donors and nonprofits can be an excellent arrangement for both parties. With a CGA, a donor gives a certain amount of cash or appreciated assets to the nonprofit in exchange for a promise to pay a set percentage of the initial funding amount to one or two annuitants for life. The charitable deduction for a CGA is based on the present value of the remainder interest at the time of the gift. Most nonprofits that issue CGAs rely on the American Council on Gift Annuities' (ACGA) suggested maximum payout rates. These rates are set using assumptions that target a 50% residuum to the nonprofit.
Oftentimes, donors who fund CGAs will use appreciated assets, allowing the donor to bypass capital gains. With the right timing, a donation of cryptocurrency has the potential to capture large gains. A donor may fund a gift annuity with highly-appreciated cryptocurrency and receive a guaranteed annual payout for life. If instead that donor were to sell the digital asset, there would be a sizeable taxable capital gain in the year of the sale. With a gift annuity, however, there is a bypass of a portion of the gain attributed to the charitable gift. For donors who are also the annuitants, the remaining portion of the gain is taxed over life expectancy, rather than all at once.
Jim, age 75, recently had a discussion with the gift planning officer at his alma mater. He told the gift planner that he would love to make a charitable gift to the university, but he also wants to make sure he has enough income during his retirement years. While discussing possible assets to use for a charitable gift, Jim mentions that his tech-savvy son convinced him to buy into cryptocurrency a few years ago. Specifically, in January of 2019, Jim purchased 100 Ether at a price of $115 each. By May of 2021, Ethereum reached an all-time high of $3,500. As Jim reaches his mid-70s, he has three goals. First, he is looking for a way to make a charitable impact. Second, he wants to find a way to supplement his annual income during his retirement years. Third, although Jim has enjoyed watching the explosive growth of his digital assets, his risk tolerance is much lower than it used to be. Looking at his Ethereum balance, Jim decides now is the right time to put these high gains to use benefitting his alma mater while also generating payouts for his lifetime.
Charitable Remainder Trusts
Jim transfers 75 Ether to the university in exchange for a gift annuity with a 5.4% payout. Based on his age and the current applicable federal rate, Jim is entitled to claim a charitable income tax deduction of $118,346. He will receive annual payouts of $14,175. Of that amount, $2,552 will be taxed as ordinary income, $11,243 will be taxed as capital gains and $380 will be tax-free. If he had sold the 75 Ether, he would have received proceeds of $262,500, with $253,875 of taxable capital gain. Jim is happy to spread out the taxable gain over life expectancy rather than receiving a huge tax bill in the year of sale. He is also thrilled to be able to make such a large charitable gift based on his original investment of $8,625.
Another option that may benefit both the donor and the nonprofit is a charitable remainder trust. There are two types of charitable remainder trusts, charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs). A CRAT pays out a fixed percentage of the initial funding amount each year. The dollar amount of the CRAT payout never changes. A CRUT pays out a percentage of the trust's value, revalued each year. In other words, the dollar amount of the CRUT payout depends on the value of the CRUT on January 1.
Charitable remainder trusts must meet a variety of requirements to qualify as tax-exempt trusts. The present value of the remainder interest, usually the same as the charitable deduction value, is required to be at least 10% of the initial funding value. CRTs must have a minimum income payout of 5%. For CRATs, there must be less than a 5% probability of the trust exhausting before the end of the trust's duration. A CRAT's ability to pass the 10% minimum deduction test and the 5% probability of exhaustion test is influenced by two important factors — the applicable federal rate (AFR) and the age of the beneficiaries.
The AFR is released each month by the IRS. Higher AFRs lead to higher charitable deductions for charitable remainder trusts. Older donors will generally receive higher deductions than younger donors. The CRAT's 5% probability test factors in the AFR and the age of the annuitant(s). With lower AFRs, only relatively senior annuitants will pass the 5% probability test.
Digital assets tend to be held by younger investors. These investors tend to be more tech savvy and have a higher risk tolerance than older investors. However, their age may work against them when it comes time to fund a split interest gift like a charitable gift annuity or a charitable remainder trust.
Dana is a software engineer who decided to diversify her investment portfolio at age 35 to include digital assets. In January of 2015, she invested $100,000 into Bitcoin, purchasing 500 coins for $200 each. Six years later, in April 2021, Bitcoin reached a high of $63,000. Dana felt that Bitcoin had hit a plateau for a while and desired to lock in her gains while her investment hovered around $31,500,000 in value.
Dana met with her advisor to explore her options for locking in her substantial gain while limiting the tax consequences. When planned gifts came up, Dana was intrigued. She liked the idea of receiving annual payouts while also using her cryptocurrency to benefit her favorite nonprofit. She asked the advisor whether the annual payment amount would be fixed or subject to market fluctuation.
Dana's advisor explained that there are a few life income gift options, but that it was unlikely that she would qualify for one that would provide fixed annual payments. Dana may qualify for a charitable gift annuity, but many CGA issuers have a minimum age requirement between 60 and 70 years old. A charitable remainder annuity trust also provides fixed payments, but with a currently-low AFR and her relatively young age, Dana would not qualify for a CRAT. Therefore, the only life-income gift option likely to work in Dana's circumstances is a CRUT, which will not provide annuity-type payouts. Instead, the CRUT payouts are a fixed percentage of the trust's annual value. While this means the trust payout is subject to market uncertainty, it also leaves the door open to a higher payout amount if the trust grows in value.
The volatility in cryptocurrency value can have a huge impact on the value of the CRUT. The trustee will prefer to sell the cryptocurrency and reinvest in a portfolio of stocks and bonds to stabilize the value of the trust and meet prudent investor standards. The trustee should consider reinvesting as soon as possible due to the volatility in the cryptocurrency market. If the trustee holds onto the cryptocurrency for several days, there is a chance that the trust will lose significant value during that time. However, there is also the possibility of a dramatic increase in value. Therefore, the trustee may choose to retain a portion of the original funding asset if it appears to have strong growth potential.
Dana decided to take some time to consider whether she wanted to go forward with the CRUT idea. By early May, with the value of Bitcoin holding near $55,000, she decided it was time to move forward with the CRUT. Dana's attorney put together the trust document, Dana executed the trust and transferred 400 Bitcoin to the trust. The total trust value at the time of the donation was $22,000,000. She retained 100 Bitcoin outside the trust, valued at $5,500,000. Dana was able to take a charitable income tax deduction of $4,014,340. She will receive a payout of 5% of the trust's value, which will begin around $1,100,000 per year, depending on the trust's value each year.
Charitable Lead Trusts
After the trust was funded, the trustee sold the 400 Bitcoin the next day at $52,000 each and invested in a balanced portfolio of stocks and bonds. By that point, the value of the trust corpus had dropped slightly to $20,800,000. Several days later, Bitcoin fell to $38,000 in value. Had the trustee waited another several days to sell and reinvest, the trust corpus would have been $15,200,000, a decrease in value of $6,800,000 in less than a week. Although slightly disappointed that she was not able to capture the value of her Bitcoin at its peak, Dana is thankful that her trustee reinvested quickly, saving her and the charitable beneficiary millions of dollars.
The charitable lead trust is another popular planned giving vehicle. However, for the reasons discussed below, lead trusts may not be the best fit for cryptocurrency donations. While CGAs and CRTs both provide payouts to noncharitable beneficiaries for a period of time, charitable lead trusts pay out to charity first and then the remainder goes to either the donor or the donor's family. Rather than providing the donor an income stream, the benefit of the lead trust is that it allows the donor to take a deduction. Depending on whether the donor or a family member will receive the final distribution, the donor may receive an income tax, gift tax or estate tax deduction.
A charitable income tax deduction is available for grantor lead trusts, where the trust corpus returns to the grantor upon termination. With a nongrantor lead trust, the corpus is distributed to the donor's family at the end of the trust term. This will generate either a gift or estate tax deduction. Finally, the donor may also set up an intentionally defective lead trust – known as a super lead trust – which will allow both income and estate tax deductions.
Unlike charitable remainder trusts, lead trusts are taxable. Therefore, they may not be an ideal fit for a cryptocurrency donation. With a grantor lead trust, the grantor is taxed on the trust's income and gains. Therefore, it is generally not advisable to fund the grantor lead trust with highly appreciated assets that will be liquidated, such as cryptocurrency.
Family lead trusts, on the other hand, are often funded with securities. The trustee will make the annual payment to the charitable beneficiary using income and dividends generated by the securities. If the annual payout amount exceeds the trust's income, the trustee may sell some of the securities to generate the balance. The income and growth realized in the trust are taxable, but the trust may take a 100% deduction for the charitable distribution each year (so long as there is no unrelated business taxable income). Therefore, if the income and growth realized do not exceed the annual payout, the trust will have no taxation. This also means that if the trustee were to sell a large portion of the trust's assets and reinvest, it will pay tax on the realized gain.
Unlike securities, cryptocurrency generally does not generate dividends. Therefore, the lead trust would be dependent upon the growth of the cryptocurrency to outpace the shrinking quantity of cryptocurrency in the trust each year. The trustee would need to sell enough cryptocurrency to make the payment to a nonprofit. The trust would need to have strong, dependable growth or the trust risks passing along a very depleted trust corpus at the end of the trust term. While it is possible that the trust will post strong growth over time, the volatile nature of cryptocurrency makes it far from a certainty. Distributions in-kind from a lead trust will generate recognition of the gain in the asset distribution, as though it was sold prior to the distribution.
Due to the high volatility of cryptocurrency, trustees are very unlikely to accept this type of asset for a charitable lead trust. Trustees are subject to the prudent investor rule. While the prudent investor rules may vary slightly from one state to the next, the general overall principle is that the trustee has a fiduciary duty to avoid unnecessary risk with regard to the trust's investments. The history of cryptocurrency is filled with sharp, swift turns in the market. While great gains are possible, equally rapid declines in value are just as likely. The lead trust's inability to effectively liquidate its assets and reinvest in a tax-favored way, therefore, makes it a disfavored charitable giving vehicle for cryptocurrency.
With the right gift plan—and some fortuitous timing—cryptocurrency owners may be able to contribute substantial sums to their favorite nonprofit organizations. Depending on the gift, the donor may also benefit from substantial income, gift or estate tax savings. Additionally, life-income gifts provide donors the ability to receive payouts over their lives or for a term of years while spreading out taxation over that period of time. With wild fluctuations in the value of cryptocurrencies, many investors will be ready to strike quickly during a bull market. Therefore, it is important for advisors and gift planners to consider the possibilities ahead of time, so they are ready to move forward when the timing is right.