DAOs And Taxes — Unanswered Questions

A decentralized autonomous organization (DAO) is an organization represented by rules encoded as a computer program that is transparent, controlled by the organization members and not influenced by a central government. It’s a software running on a blockchain that offers users a built-in model for the collective management of its code. DAOs differ from traditional organizations by boards, and executives.

Classification

Relative to traditional centralized organisation, how do one classify a DAO? Because when it has features resembling any traditional entity that we know, it would be easy to tax DAOs as those entities are taxed. In that context, DAOs may be classified as any of these two:

1. A partnership
2. A Corporation

1) A partnership

The major characteristics of a partnership is that there must be a form of agreement, a deed which states the terms of the contract. Also profit sharing between partners is a major feature. Now looking at a DAO’s structure, The DAO for example, there is language throughout its documents that describes “THE DAO" to potential investors emphasizing that no “legally binding contract” was created through the investment. The only binding contract in THE DAO was it’s code — the smart contract. Investors of a DAO intends to consult together to decide on investments, to make the investments, and to share in the profits through the smart contract.
But is the smart contract codes and the profit sharing in DAOs enough to call it a partnership? Let’s take a look.
In determining the status of a DAO for tax purposes, classification for local law purposes is not relevant (even assuming that the quoted language about no legally binding contract had its desired effect). In determining whether the agreements entered into in creating THE DAO, or any similar entity, result in an entity for tax purposes, the regulations state:

Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the
organization is recognized as an entity under local law.

The regulations go on to state what makes an organization an entity separate from its owners:

A joint venture or other contractual arrangement may create a separate entity
for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.

From the statements above, we can say a DAO which is established for profit purposes and where the participants carry out trades and financial operations (buying, selling of governance tokens, investing, etc) can be described as a partnership irrespective of its legal status and thus a taxable entity. Lets keep looking.

The regulations exclude from being a partnership “a joint undertaking, merely to share expenses” or “mere co-ownership of property that is maintained, kept in repair, and rented or leased.”

Most DAOs have core principles which fit exactly into to the above description and thus can only be described as a DAO and not a partnership or anything else. An example of this type of Dao is pleasrDAO. PleasrDAO is a collective of DeFi leaders, early NFT collectors and digital artists who have a mission to collect digital art that represents and funds important ideas, movements and causes that have been memorialized on-chain as NFTs. Basically what they do is to buy and fund culturally significant pieces and then create something fundamentally additive to the soul of the piece before sharing it back with the community, in other words,creating shared ownership of the NFT.

If for diversity and the vast space present, some DAOs fall into the first scenario, another question pops up which begs for an answer:

Since DAOs are truly autonomous and decentralized blockchain structure intentionally omitting a central authority playing any role in its ongoing operation and decision making, those who developed it and promoted it no longer have any power to control it. Thus, in a DAO, is there anyone fully responsible for filing the forms and returns needed by the tax system? Is there anyone to file corporate or partnership tax returns with the IRS? If forms are not filed and amounts are not withheld, who will be responsible for making the resulting payments and paying any penalties that the IRS will levy? If any DAO presents persons for these tasks then the true nature and meaning of DAO has be forfeited as those persons will act as a figure head representing the DAOs. If this happens then it’s no longer a DAO.

2) A Corporation

According to investopedia, A corporation is a legal entity that is separate and distinct from its owners. Under law, corporations possess many of the same rights and responsibilities as individuals. They can enter contracts, loan and borrow money, sue and be sued, hire employees, own assets, and pay taxes. The binding factor here is its legal status. As an organisation, you can’t be called a corporation without being fully registered by law. One of the major issues faced by DAOs is issue of its legality. The precise legal status of this type of business organisation is generally unclear, and may vary by jurisdiction.

On July 1, 2021, Wyoming became the first state to recognize DAOs as a legal entity. American CryptoFed DAO became the first business entity so recognized. On April 21, 2021, Wyoming’s governor signed into law a bill sponsored by the state’s Select Committee on Blockchain, Financial Technology and Digital Innovation Technology, the first in the nation to allow decentralized autonomous organizations (DAOs) to obtain legal company status. The legislation becomes effective on July 1, 2021. What does this imply? Lets take a deep dive.

The proposed legislation would allow DAO protocol creators to pursue development and growth post-token launch by registering in Wyoming as a limited liability company (LLC). DAOs would benefit immensely from the ability to incorporate, register, transact, hire employees, and scale like any other LLC can. The legislation would therefore provide legal structure, regulatory clarity, and operational legitimacy for any DAO registered. Hence all tax duties and roles played by a normal LLC will be attributed to all DAOs associated with this legislation.

But the profit model and business routine of these DAOs are very much different for the normal LLC. Unlike traditional LLC, who have a definite product or services that is rendered, hence a clear path for profit expectation, income and expenditure; most DAOs profit from fees which are incurred from participation of members (or anyone) in the protocol (such as swapping, voting, exchange, etc). These fees are undefined and there’s no clear record of how much income is made through these fees, hence an undefined income which can pose a problem for taxing these DAOs. Also the income made by DAOs clearly depends on the number of investors and participants whom are actively involved in the activities of the DAO. This however cannot be fully estimated or predicted owing to the fact that DAOs are free entities opened for all — people of like-minds are free to enter and exit at will, presenting only low barriers to entry. So How do you tax an ever evolving organisation with no fixed path in terms income?
That aside, moving deeper:

The registration as a Wyoming LLC tempers the fundamental “decentralized” aspect of DAOs. That is, does the US Securities and Exchange Commission (SEC) now have an identifiable entity or individuals that involves network development and governance structure called “Active Participants" (APs)? Without registering as an LLC, one can say that all the participants are independent and do not constitute a structured group of APs.

This will eventually leads to a small group of people being elected by the DAO’s decentralized governance protocol to oversee non-critical and off-chain decisions. For instance, the governance protocol could empower the elected individuals to make decisions regarding certain aspects of treasury management and asset allocation. When this happens eventually, the whole aim and core principle of decentralisation of DAOs is defeated. Will it still be called a DAO in this scenario? or FDAO (Fairly Decentralized Autonomous Organisation)?

Pass-through Entity

So How then should a DAO be taxed? What form should it be regarded as for it to be properly taxed? Some speculate that DAOs should be taxed as a pass-through entity which means while the DAO itself won’t be taxed, individual members will pay income taxes on their share of the organization’s profits. This Plies that token holders will be liable to pay income and capital gain tax as the case may be.

Let’s take a look:

DAOs profit and that of its members is entirely different. The DAO as an organisation makes profit from fees and other sources (depending on the type of DAO) while its members make profit from returns on investment, appreciation of governance tokens, and other activities carried out by the members as the case may be for different DAOs. When the individual participants are taxed in place of the DAO itself, then the inherent reason for doing so is not achieved, what is being done is merely punishing the members of the DAO on grounds that the organisation which they’re involved in cannot be grasped in terms of taxation. Don’t get me wrong, taxes can be imposed on any crypto user and when it does it is the crypto user who pays the tax as an individual fulfilling his financial obligations and not in place of those protocol. So was the aim of taxing DAOs achieved by taxing its members?

Closing Thoughts

Currently, there haven’t been any clear way of placing taxes on DAOs due to the nature of it principles and the security and exchange commission (SEC) and other regulatory bodies in diaspora have not revealed any guidelines or outlined plans to do so. This means that right now, there is no clear method for filing taxes on profits DAOs make. Thus currently there is no straight forward path for reporting any money on tax basis.

In the near future, who knows a method could be introduced or a transition of DAO’s principles and meaning from what it is now to suitably fulfil task duties as an organisation.