Decentralized Autonomous Organizations: Tax Considerations

One Decentralized Autonomous Organization (DAO) is an organization governed by a blockchain-powered computer program, run by a group of individuals who collectively vote on organizational proposals. Typically, each member’s voting power is determined by their percentage stake in the DAO, which is calculated by dividing the member’s contribution of digital assets by the total amount of digital assets in the DAO.

DAOs often (but not always) operate without the need for a board of directors or other governing body, and can provide an efficient and (possibly) secure platform to bring together individuals and resources to achieve collective goals.

Many DAOs were formed to make investments. A typical DAO activity starts with investors transferring their digital assets, usually ether (Ethereum) in exchange for DAO tokens, which typically represent an ownership interest in the DAO. Although in some cases the DAO Token does not equate to an ownership interest, but merely represents, for example, the right to manage the DAO’s assets, depending on how the DAO defines its token.

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Token holders then collectively vote on investment proposals submitted by applicants. If the investment is successful, token holders share the resulting profits; if not, they share the losses. If done properly, the above activities can be achieved through computer code called “smart contracts” without human intervention.

Tax classification of DAOs

Although a DAO looks like a web creation without any formal features, it can still be a taxing entity.For example, in the United States, tax regulations state that a joint venture or other contractual arrangement can create A separate entity if a participant “carries on and distributes profits from a trade, business, financial operation or venture capital investment”. (By contrast, joint ownership of property that is merely maintained, repaired, rented, or leased does not constitute a separate entity for tax purposes.)

Therefore, if the DAO is created by investors who intend to vote and select investment proposals, fund the investment, and share the profits, the DAO may be a separate tax entity. Some DAOs formed for purposes other than conducting trade or business and profit, such as those created to raise funds to purchase a copy of the U.S. Constitution, may not be considered tax entities.

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Once a DAO has been identified as a separate tax entity, the next question is: how should this DAO be classified for tax purposes? Two general types of classification are corporations or partnerships. When a business entity has two or more members with unlimited liability, it is classified as a partnership by default.

Another factor to consider is whether the DAO is domestic or foreign. The term “domestic” means created or organized in the United States or under the laws of the United States or any state. By contrast, the term “foreign” refers to any non-domestic corporation or partnership.Since DAOs generally exist only on the blockchain and are not registered with any Secretary of State, it is surprising that DAOs might be classified as foreign partnership For tax purposes – even if all DAO owners are US tax residents. Foreign partnerships may have different reporting obligations than domestic partnerships, but like domestic partnerships, partners must report their share of partnership income and losses annually—even if the partnership does not make distributions.

If the DAO token is trade On the “secondary market (or its substantial equivalent)”. Because the IRS allows the use of cryptocurrency exchanges to determine fair market value, such exchanges may be considered secondary or substantially equivalent markets.In this case, the DAO would be classified as a foreign PTP, in effect as a foreign company.

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Unlike partnerships, foreign corporations’ income and losses are generally not taxed to their shareholders until the corporation pays dividends. However, if the DAO qualifies as a passive foreign investment company, U.S. token holders will be subject to punitive consequences, including ordinary income tax on gains and dividends, as well as interest charges.If the DAO’s only asset consists of tokens, it could be Passive foreign investment company, requiring regular reporting to U.S. holders.

New DAO State Legislation

In addition to taxes, investors are increasingly concerned about their legal liability for investing in DAOs (ie, that their personal assets may be at risk from any lawsuits or debts from DAOs).As a result, two states Vermont and Wyoming, has allowed DAOs to register as DAO LLCs in their states, and like regular LLCs, DAO members provide limited liability benefits.

From a tax perspective, a DAO LLC, as it is registered under state law, may be considered domestic partnership for tax purposes. While better for legal reasons, this could be detrimental to U.S. partners, who must report their share of the DAO’s revenue and losses—regardless of whether the DAO makes distributions.However, DAO LLC may choose to be treated as domestic corporation For tax purposes, on the one hand it prevents tax pass-through, but on the other hand makes the DAO’s income subject to US corporate tax.

DAO contributions

The IRS view is that when any token is exchanged for another token, it is a taxable event that results in a gain or loss. However, offering property to a partnership or corporation, respectively, in exchange for partnership interests or company stock may be tax-exempt. DAO tokens can represent what is considered a partnership interest or a share of company stock, as long as it confers voting rights and the right to share in the DAO’s profits. Therefore, based on token attributes and DAO classification, it might be said that Americans do not acknowledge the contribution of ether to the DAO in exchange for DAO tokens without any gain or loss.

While DAOs present a huge opportunity to revolutionize the way business is conducted, they also present unexamined tax issues. We strongly recommend consulting a tax advisor before forming or investing in a DAO.

This article was co-authored by Chris Cotaba and Qiaoqi (Jo) Li.

This article is for general informational purposes only and is not intended and should not be considered legal advice.

The views, thoughts and opinions expressed here are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.