Cryptocurrency is classified as property by the IRS. Property can be a target of legal action, similar to real estate, and you can lose 100% of your property, or in this case, your cryptocurrency, even if it is DEFI.
The blockchain allows the tracing of all transactions involving a given bitcoin address, all the way back to the first transaction. If a crypto investor is involved in litigation or has a creditor, the Court can demand a disclosure of all relevant cryptocurrency assets that a defendant owns.
Bitcoin, Ethereum, and other popular cryptocurrencies, even though they promise full anonymity, it cannot be guaranteed 100 percent as most blockchain transactions are recorded on the public ledger. This makes for the cryptocurrency to be easily tracked by government agencies.
There are many articles about protecting your cryptocurrency from hackers, which is vital to protecting your asset from that point of view. This post will address the key points to protecting your cryptocurrency from lawsuits and probate.
Five Strategies to Protect Your Cryptocurrency from Liability:
1. Understand the difference between protecting your crypto account from hackers vs. liability. Yes, it is vital to protect your crypto account from hackers and theft and be organized, depending on how you set up your account. Protecting your crypto account from hackers includes steps around the type of crypto wallet, whether it’s a paper, cloud-based, or non-custodial online wallet.
Update: Since the FTX bankruptcy filing 11-11-22, many crypto holders are withdrawing their crypto from other exchanges into cold wallets for storage. The crypto industry’s golden rule is “Not your keys, not your coins.” And it comes down to the fact that when you turn your coins over to an exchange to hold and keep secure, you’re giving control over them.
You have given up control when you leave your crypto on an exchange; whether centralized or decentralized, it’s far safer to have custody of your assets. This means keeping them in a physical hardware wallet similar to a USB drive or, alternatively, an online software wallet. In both cases, you are the one who maintains control over the coins, and access to them is protected through private key cryptography.
Your next step is understanding that crypto in a cold storage wallet may be safe from an exchange collapse but not from liability. Protecting your crypto account from personal liability is centered around asset protection of a safe asset. Crypto is similar to an investment (although not according to the IRS) because it is considered a “safe asset.”The asset is not going to cause direct liability to the owner.
The opposite is considered “risk assets,” like real estate, a business, a boat, or a car, that can cause direct liability. Safe assets are typically held in a separate entity that only owns other safe assets, including stock in other companies or investments in the stock market.
Your cryptocurrency is subject to being lost in a personal lawsuit when you own it personally. Most individuals own cryptocurrency in their name, personally. For example, a Coinbase Wallet is a cryptocurrency wallet and DApp browser controlled by you and only you. This means that your wallet’s private keys (representing ownership of the cryptocurrency) are stored directly on your mobile device and not with a centralized exchange like Coinbase.com.
When you open a Coinbase wallet, you can only fund it individually. This means the asset will be titled to your name only.
This is similar to opening an Etrade account and buying stock in Tesla. You have invested in a company’s stock (a safe asset) and directly own it. The critical question is, how could you be personally sued? Let’s assume you have an e-commerce business on Amazon, and you diversify a percentage of your profits into cryptocurrency as a hedge against inflation vs. investing 100% into more inventory.
Your e-commerce business should be established as a separate legal entity. The U.S. is the largest consumer market globally, but the downside is that we have the most lawsuits, especially regarding product liability. Most Amazon sellers know you must obtain product liability insurance once you cross $1 million in sales, but Amazon does not enforce that rule.
Litigation costs small businesses more than $ 100 billion annually in the United States. It’s not a matter of “if” it will happen to your business, but “when.” “By some estimates, over 40 million lawsuits are filed annually. What happens if your company is sued for product liability, loses in court, and doesn’t have any insurance?
Let’s assume you lost the product liability case, and a judgment is filed against your company. If your company did not have the cash to satisfy the judgment, the plaintiff might move to pierce the entity veil and go after you personally. Most form a cheap LLC online and have ZERO protection because there are no corresponding operating agreements and formalities for the LLC. Most likely, if your LLC is sued, you will also be personally sued as the manager or member. Let’s say that aside from the equity in your home that is not protected by a homestead, your most significant personal asset may be the cryptocurrency you have accumulated over the last couple of years.
You might say, “My crypto account is private. No one can access it without a public or private key and a password.” This falls under privacy and asset protection. Yes, it is helpful if no one knows what assets you control and under what entity or name, but if you have a judgment against you and hid personal assets, that is a big problem with a judge.
The best approach is to assume your crypto account can be found. If it is, would it be protected if a personal lawsuit results in a judgment against you? Here are some other ways you could be individually sued and lose control of your crypto assets. Social media posts tear down your competitors. For instance, suppose you personally created an ad campaign for your corporation criticizing a competitor. The competitor views the campaign as malicious and untrue and decides to sue.
They might personally sue your corporation and you as the ad’s creator. While you would not be liable for any settlement the corporation has to pay due to the suit, your assets could be attached to pay off any judgment the competitor won in its case against you, the individual.
What else can be taken in a lawsuit against you? Savings accounts are usually fair game in a lawsuit. However, retirement accounts, such as 401(k) and IRAs, are typically protected from a liability lawsuit.
Although 401(k) retirement plans are protected under the Employee Retirement Income Security Act of 1974, individually held IRAs get only a partial exemption in bankruptcy. You would have to rely on state laws for protection.
Some attorneys will go after everything else when collecting assets to satisfy a judgment, including your crypto account. They ask for all checking and savings accounts, partnership agreements and records of partnerships, real estate (including timeshares), trusts, contents of all safe deposit vaults, titles to all properties, and a complete list of jewelry, art objects, and personal property. A defendant could lose his car, cash, or other assets to satisfy a judgment.
2. How Do the Courts Know What Crypto You Have?
But how does the court know about your assets? A creditor can require your appearance in court for an asset hearing. The creditor can ask you questions under oath about your assets and demand you produce documentation regarding your wealth and ability to pay. Failure to appear at an asset hearing generally results in a bench warrant issued for your arrest. The creditor can then request a cash-only bond in the amount of the judgment. That could cause you to be held in custody until the judgment is paid in full, a new asset hearing can be held, or until the judge lowers the bond.
Do you need liability insurance? Yes. “Without liability insurance, you’re responsible for damages and injuries if you caused them.
3. What amount of crypto in your name is worth protecting with a separate legal entity? Do you need to ask how much you would be willing to lose in a personal lawsuit? If you had $5K in a brokerage account invested in Apple, would you form a separate LLC for only $5K to protect that as your only safe asset?
Probably not. That might be different if you had other safe assets, such as stock in a start-up, plus the $5K. You will want to determine your risk tolerance and the level of protection required for your situation. The other factor with cryptocurrency is very volatile, especially on the upside. If your Bitcoin was at $43K in April 2022, would it be in April 2023? Right now, Bitcoin is way down, and you may buy more in hopes of increasing value over time.
If you have $100K in crypto or other safe assets, which is 20% of your net worth, you will likely want to protect those safe assets using another entity or structure. If the $100K is 5% of your net worth, you still might consider a separate structure to protect your safe crypto-asset due to the potentially explosive upside over the next 1-3 years.
Your age will also be a factor. If you are 21 with $50K in Crypto, you have less risk and the ability to start over, vs. someone at age 65 with the same amount.
4. Why do I need to protect myself if I have insurance? We always recommend the correct entity structure to protect your assets, whether your business, real estate, or safe assets such as cryptocurrency. Besides, we recommend you have business liability insurance, product liability insurance, homeowners and car insurance (of course), and a personal umbrella policy covering any overflow.
Insurance does not cover some things, including breach of contract, defaulted loans, family disputes, fraud, and sexual harassment. Over the years, insurance has developed more and more loopholes, separate from pre-existing conditions, exclusions, incomplete documentation, and including less coverage due to excess claims – for example, in-mold cases, needing to report the gathering of water on your property within 72 hours and reporting it vs. months later, when it won’t be covered, in many cases. Insurance is a great idea but not enough to protect your crypto for all these reasons.
You might ask whether I can buy insurance designed to protect my crypto. In 2020, Gemini Exchange, a regulated cryptocurrency exchange, wallet, and custodian, formed its own insurance company to cover up to $200-million for crypto custody. Lloyd’s Launches Cryptocurrency Wallet Insurance Policy. Lloyd’s did create a space for insurance to protect against your crypto being stolen, https://www.insurancejournal.com/news/international/2020/03/02/559855.htm.
5. What Entity Options or Structures are Available? If you hold your crypto directly in a self-directed IRA, it is protected while in the IRA. Once the money is distributed based on IRA rules, the asset may or may not be protected, depending upon state law. What about using your living trust to protect your cryptocurrency?
A living trust is a good idea for protecting your assets from the probate courts after death, but not against liability. Most people seem to forget all assets held by a living trust are not protected against liability. The key to passing on your crypto assets according to your estate plan is to make sure your estate plan provides for disclosure of your crypto assets and provides for a secure method of transfer of the private key to your heirs (if that is the case) and your passwords on any accounts.
Should you consider an LLC or limited partnership to protect your cryptocurrency? These are traditional tools to protect safe assets, and the key is to know which entity is best and how to transfer your crypto account to an entity. The other key component is assigning your crypto to the legal structure, assuming your account is set up in your own name.
There are situations where an asset protection trust (not a living trust) will provide another level of protection, but that usually involves a two-year or longer statute of limitations.
From a tax point of view, selling, exchanging, or using cryptocurrency triggers capital gains and losses for traders. The IRS treats cryptocurrencies as intangible property. More IRS scrutiny is scheduled for 2022 in the crypto world, and make sure you amend any previous returns where you have not claimed your crypto income or gains or losses before you receive an IRS notice.