Call in the Bean Counters - Some Tax Considerations Concerning DAOs

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First Thoughts

A DAO (Decentralized Autonomous Organization) is an entity represented by encoded rules within a computer program that is transparent, controlled by the organization's members, and is free from central government influences [See, e.g., Chohan, U. The Decentralized Autonomous Organization and Governance Issues. (Accessed February 7, 2022)]. A DAO's operational program rules as well as financial transaction records are maintained upon a blockchain [See, e.g., Hodson, H. Bitcoin moves beyond mere money. (Accessed February 7, 2022).

The precise legal status of a DAO type entity is extremely clouded and in fact may vary from jurisdiction to jurisdiction. Given this uncertainty, a DAO could be viewed from a functional basis as a corporation but without a corporation's legal standing. In other words, a sort of general partnership [Levine, M. Blockchain Company Wants to Reinvent Companies. (Accessed February 7, 2022)]. This view sure is preferable to the prior SEC approach of regarding blockchain organizations as illegal offers of unregistered securities [See, e.g. U.S. Securities and Exchange Commission. SEC Charges Bitcoin Entrepreneur With Offering Unregistered Securities. (Accessed February 7, 2022)].

Nonetheless, the inability to precisely peg the legal status of a DAO, is the genesis factor for a host of other problems surrounding this type of entity. For the purpose of this article, the question must be asked: how can you properly tax an entity (and/or it's participants) when the entities legal status remains undefined?

Tax and Reporting Considerations for Decentralized Autonomous Organizations and the Holders of DAO tokens

Separate Entities

While it is true that a DAO is a creation from the cyberuniverse lacking in a formal character, it may still qualify as an entity for tax purposes under the current U.S. Tax Laws. Presently in the U.S. joint ventures or any other recognized contractual arrangement may form a separate entity if its participants 'carry on a trade, business, financial operation, or venture and divide the profits therefrom' [26 CFR 301.7701-1 (1997)]. But, note this curious distinction by way of contrast. Merely co-owning property which is kept in repair, maintained and leased or rented does not elevate to a separate entity for tax purposes.

As such, a DAO created by investors who aim to vote and opt for investment proposals, contribute funds, and share profits may be a separate entity for tax purposes under U.S. law. But a DAO created for purposes beyond carrying out a business or turning a profit (think about the DAO formed recently to purchase a copy of the U.S. Constitution) will most likely not be considered separate entities for tax purposes.

Classification for Tax Purposes

Once the issue of being a separate entity or not has been determined, the next question to be addressed is: how is the DAO to be classified for tax purposes? In general, there are two types of classifications: partnership and corporate. When there are two or more participants in a business entity who have unlimited liability, the default classification of partnership is assigned.

Another consideration in this area must include whether the DAO is 'foreign' or 'domestic'. In this context, the term 'domestic' refers to any entity created or organized within the US, or under the laws of the US, or under the law of any state within the US. In contraposition, the term 'foreign' simply means any corporation or partnership entity which is not 'domestic'.

This raises an interesting possibility. By nature of a DAO being a creature of the blockchain, the DAO does not perform an 'entity registration' with any US state secretary. As such, every DAO, by strict definition, could be potentially classified as a 'foreign partnership' for tax purposes (even where all DAO investors are US residents and US tax residents). While a foreign partnership may have differing reporting requirements from that of a domestic partnership, a foreign partnership will be required (as is the case with domestic partnerships) to annually report their share of partnership income and/or losses - notwithstanding as to whether or not the partnership made a distribution.

If a DAOs tokens are traded on a secondary market or the substantial equivalent of such secondary market, the DAO could potentially be treated as a foreign publicly traded partnership (PTP) [See 26 CFR 1.7704-1 (1995)]. In that the US Internal Revenue Service permits the use of cryptocurrency exchanges to determine fair market value, the crypto exchange satisfies the 'secondary market' requirement and the DAO could be treated as a PTP which would be treated as a foreign corporation for US tax purposes.

The income or loss attributable to a foreign corporation are not taxable to shareholders until there is a payment of a dividend by the corporation. But should the DAO be qualified as a passive foreign investment company, DAO token holders in the US would be subject to punitive consequences including having tax on gains and dividends treated as ordinary income together with substantial interest charges. Should this qualification apply, the DAO would be required to make regular reports to its US token holders.

Two US states have allowed DAOs to register as DAO LLC's (Vermont and Wyoming), thereby extending the benefit of limited liability to DAO members. From the perspective of taxation, as the DAO LLC is registered under the laws of a US state, for tax purposes it can be treated as a domestic partnership. While the DAO LLC is better for legal reasons, it tends to be detrimental tax wise as US partners would be required to report their pro rata share of the DAO's profit/loss irrespective of whether or not the DAO made a distribution. To solve this, it may be possible to have a DAO LLC elect to be treated for tax purposes as a domestic corporation. While this solution solves the passthrough taxation dilemma it then subjects the DAO's income to US corporate taxation.

Final Thoughts

If you have gleaned from this article that the tax considerations surrounding DAOs is somewhat convoluted, you are not far from the truth. This is an extremely undefined area of the law that requires attention as the use of the DAO entity grows.

With all due respect to the 'bean counters' out there, much of the inherent confusion does not enter the picture by way of the various applicable tax laws. No, it is, in fact, the system's failure to precisely define the legal status of the DAO as an entity that prevents a clear application of the existing tax laws in this area

It is definitely time for the legal community to catch up with the daily innovations in the cryptosphere. DAOs are here to stay. The use of a DAO structure emits a huge opportunity to remake and revolutionize the way business is presently conducted. But nontheless, the untested tax considerations herein identified exist and accordingly, it is highly recommended that a tax advisor be consulted before forming or participating in a DAO.

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