Written by: Athena, TaxDAO
1. What is DAO and why is it important?
DAOs (or Decentralized Autonomous Organizations) represent a new organizational structure that formally allows for decentralized decision-making using blockchain and token voting mechanisms. Where traditional industrial enterprises rely on the separation of management and ownership, DAOs offer a completely different template for organizational participation, where ownership and management are merged - driven by smart contracts, fluid membership, and transparent transaction channels.
The UK Law Commission proposed comprehensive elements of DAOs to help define them and to facilitate discussion around the relationships involved in DAOs and the legal implications arising from them, which are outlined below:
Software Protocol: A digital infrastructure consisting of rules governing how smart contracts work together, and is followed by a network of participants. A protocol will dictate the rules by which a particular system operates, as well as the rules for determining and implementing changes to that system. Protocols can embody a blockchain system, but can also be deployed on top of an existing blockchain system (for example, DeFi protocols deployed on existing blockchains leverage the capabilities of the underlying blockchain system).
Blockchain System: A software protocol that is a distributed ledger that records and transmits data in a structured manner, including the operations of the software protocol deployed on the blockchain system. A blockchain system is typically independent of any DAO associated with the software protocol deployed on it.
Miners and validators: Participants in a blockchain system who follow and run the blockchain protocol, thereby ensuring its operation. Miners and validators are incentivized to follow the rules of the blockchain system protocol through rewards and are relied upon by software protocol developers.
Developer: Software engineers write software code for blockchain systems, software protocols, and the smart contracts that comprise them. Most software written by developers in the cryptoasset ecosystem is provided as open source software. The Legal Committee believes that developers may be closely associated with a DAO, a specific software protocol, or related software (such as a front end), and may act alone or as part of a team or registered company (or other legal entity).
Protocol Token Holders: A protocol token is a unit of account (or nominal unit of account) for a specific software protocol (such as Ether in the Ethereum blockchain system). Some software protocols have tokens that are used for specific functions within the protocol. For example, a governance token may provide holders with specific voting or participation rights, while another token may give holders access to products or services provided through the protocol. Protocol token holders may be closely associated with a DAO, for example, where a DAO issues tokens to developers, investors, or contributors. However, the tokens are likely to be freely transferable and therefore can be sold on the public market to holders who have no connection to any DAO participating in the protocol.
According to the comprehensive elements given by the UK Law Commission, DAO (decentralized autonomous organization) can be defined as a digital infrastructure consisting of software protocols, blockchain systems, miners and validators, developers, and protocol token holders, which aims to achieve decentralized decision-making and operating rules and may involve complex relationships between multiple participants.
As public interest in crypto assets grows and more and more money is invested in crypto asset companies around the world, some issues related to liability are becoming more and more important. If DAOs lack a centralized governance structure, they also lack a central entity or individual who is responsible for the obligations and debts of the DAO and can take enforcement measures against them. The following will explain the legal status of DAOs in various jurisdictions and their corresponding tax rules, tax reporting requirements and tax compliance risks.
2. Legal Status of DAO
Some forward-thinking jurisdictions have already recognized the legal status of DAOs or DAO-like organizational structures by enacting new laws to support the registration of DAOs in their regions.
2.1. Legal status of DAOs and related tax rules in some regions of the United States
Currently, four states in the United States - Vermont, Wyoming, Tennessee, and Utah - recognize DAOs as legal entities. Although Delaware and Colorado do not recognize DAOs as legal entities, the corporate laws of these states are compatible with DAOs being registered as limited liability companies or equivalent limited liability companies.
2.1.1. Vermont
Legal Status
In August 2018, the U.S. State of Vermont legislated a new form of company: the blockchain-based limited liability company (BBLLC). Although the bill does not specifically mention DAOs, it allows any company that "uses blockchain technology for a significant part of its business activities" to register as a BBLLC. The bill allows DAOs to effectively enter into contractual agreements to protect their owners, managers, and blockchain participants from unnecessary liability. Corporate governance can be operated in part or in whole through blockchain technology. At the same time, because BBLLC is stipulated under the limited liability company chapter, the provisions of the limited liability company also apply to BBLLC. Gravel&SHEA, dOrg LLC. (also known as BODDY MAX), registered under the Act, is considered the first legal DAO.
Vermont law requires that a company registered as a BBLLC must state in its articles of organization that it is a BBLLC; and must mention in its operating agreement a summary of its mission or purpose, as well as information about the blockchain technology to be used, voting procedures, protocols for responding to security breaches, procedures for becoming a member, and the rights and obligations of each group of participants. Like other limited liability companies, a BBLLC can limit fiduciary liability and provide for limited liability in its operating agreement.
Tax rules
Under the Internal Revenue Code and Vermont law, a BBLLC can be taxed as either a C Corp or a partnership (pass-through), which is the same taxation rules as a regular LLC.
Partnership or corporate tax
Deciding whether to tax as a partnership or corporation is significant because it will determine whether taxes will be passed through to individual shareholders. Generally, corporations are subject to corporate income taxes. In contrast, shareholders of partnerships are generally subject to state individual income taxes because they are pass-through entities. Pass-through entities, or disregarded entities, are legal business entities that do not pay corporate taxes because they pass all taxable income through to owners, shareholders, and investors. In contrast, corporations are not pass-through entities because both the corporation and individual shareholders must pay taxes on income generated by the BBLLC. Assuming the BBLLC wishes to avoid double taxation, the company can limit its tax liability by choosing to be taxed as a partnership rather than a corporation.
Vermont Corporate Tax
In Vermont, pass-through entities are particularly attractive because the state has one of the highest corporate tax rates in the country. Specifically, Vermont’s top corporate tax rate is 8.5%. In contrast, Vermont’s individual income tax rate can be as low as 3.55%. Therefore, a BBLLC can cut its tax burden in half simply by choosing to be taxed as a partnership rather than a corporation. As a result, Vermont encourages companies to organize their entities as pass-through entities, which include (1) S Corps; (2) Limited Liability Companies, including BBLLCs; and (3) Partnerships. By allowing blockchain companies to register as pass-through entities in the form of BBLLCs, the Vermont government intends to incentivize cryptocurrency companies to register in the state by providing a favorable tax framework for blockchain entrepreneurs.
Related tax
However, one question raised by the new Vermont legislation is whether the bill will create any nexus issues for out-of-state members of a BBLLC. Specifically, the bill declares that because the BBLLC is organized within the state of Vermont, if out-of-state members or managers interact with the BBLLC in a different capacity or role or engage in other business activities, those activities may not be deemed to occur in Vermont. As a result, out-of-state members may be subject to Vermont and other state taxes when their income is passed through to their respective personal income taxes, depending on where their business activities occur. In fact, the tax framework for multi-state corporations is very complex, including how various tax nexus with a particular state is constituted. Therefore, out-of-state members in a Vermont BBLLC should consult a tax professional to ensure that their taxes are reported correctly.
2.1.2. Wyoming
Legal Status
In July 2021, Wyoming became the first state to enact a law specifically allowing the establishment of DAOs. The law allows the creation of DAOs in the form of limited liability companies, supplementing the existing Limited Liability Company Law, and is the first time in the United States that such entities have been given legal status and identity.
As a supplement to the Limited Liability Company Act, the DAO Supplemental Act is considered to provide special coverage for DAOs, but the rest of the Limited Liability Company Act applies to DAOs in the absence of special provisions. Technical requirements include using DAO, LAO, or DAO LLC in the organization's name to distinguish it from the current LLC usage. The articles of organization must include a specific notice alerting all potential members that the DAO can eliminate fiduciary responsibilities, restrict the transfer of ownership interests, exit or resign from the DAO, refund contributions, and dissolve the DAO.
The Articles of Organization or the DAO’s Operating Agreement must state whether the DAO is managed by its members, and at least one person must be a member to conduct the business of the DAO LLC, as management rights belong to its members. The Articles of Organization will regulate a range of activities that are usually conducted by a corporation, including: the rights, obligations, relationships, voting rights of members, DAO activities and how they are conducted, how the Articles of Organization or Operating Agreement may be amended, allocations to members, transferability of membership interests, withdrawal of members and their contributions, dissolution and allocations to members after dissolution, procedures for amending, updating, editing or changing applicable smart contracts, and public identifiers for any smart contacts used to manage, promote or operate the DAO. Much of the information needed to operate a DAO can be found in the white paper of the entity that creates the DAO and promotes its benefits to potential members.
Wyoming law provides that DAO members have no fiduciary responsibilities unless the bylaws provide otherwise; and have no obligation to provide information or inspection rights to members (except for information and inspection rights on the DAO's open blockchain).
Tax rules
Wyoming has no corporate income tax, personal income tax, or capital gains tax, and its property, sales, and estate taxes are among the lowest in the U.S. Wyoming also has no taxes on: Inventory tax; Franchise tax; Business or "per-capita" tax; Gross receipts tax; Excise tax; Intangible Taxes: Wyoming does not tax intangible assets such as stocks and bonds.
Avoiding Double Taxation and Pass-Through Deductions: Standard corporations are generally subject to double income taxation. A corporation's profits are taxed first as income, and shareholders must pay income tax on any dividends. An LLC, on the other hand, can file as a pass-through entity, and distributed profits are taxed only once on each member's individual income tax return. In addition, LLCs that file as C corporations can also deduct 20% of their business income from their taxable income under the 20% "pass-through" deduction provided by the Tax Cuts and Jobs Act.
2.1.3. Tennessee
Legal Status
On April 20, 2022, Tennessee became the second state in the U.S. to create a specialized business entity for decentralized autonomous organizations (DAOs). The new legislation amended Section 48 of the Tennessee Code to allow Tennessee Limited Liability Companies (LLCs) to register as “decentralized organizations” by including new optional language in their articles of organization.
Wyoming and Tennessee laws allow a limited liability company to state in its articles of organization that it is a DAO. Both laws provide that: unless a DAO's articles of association state that it is managed by an algorithm or smart contract, the DAO will be deemed to be managed by its members; the articles of association must contain information about the DAO's smart contracts; and if the DAO does not approve any proposals or take any actions within one year, the DAO will automatically dissolve. Tennessee law provides that DAO members do not have fiduciary duties to the DAO unless there is an implied covenant of good faith and fair dealing.
Tax rules
LLCs operating in Tennessee must register with the state Department of Revenue and pay franchise taxes as required. The franchise tax levied on LLCs is 0.25% of the net value of tangible assets or property in the state of Tennessee, whichever is greater. The minimum state franchise tax payment is $100. Another tax requirement is an excise tax at 6.5% of the net taxable income generated in the state.
2.1.4. Delaware
Legal Status
Another scenario is to form an LLC in Delaware. Although Delaware has not yet recognized DAOs as legal entities, many DAOs have been formed as Delaware LLCs. While this structure compromises the autonomy and decentralized nature of DAOs to some extent, the Delaware LLC form allows for a large degree of adaptation of DAO principles and procedures. As typically structured, the LLC owns the funds raised in the DAO token sale and is the beneficiary of those funds; the LLC operating agreement sets forth many of the functions that will be operated through smart contracts (such as issuing interests, acting as an asset custodian, registering member interests, counting member votes, and providing notices); and the operating agreement sets forth fiduciary liability limitations, liability limitations, and other DAO-oriented functions. While Delaware LLC law and jurisprudence are widely recognized and mature, and its flexibility makes it useful for DAOs, not all DAO principles and objectives can be adapted to this form. (For example, a Delaware LLC may not be able to maintain the anonymity of its members in certain circumstances.)
Tax rules
Corporate income tax is calculated based on a company's net profit, with the state average tax rate being around 8.7% (profits not generated in the state are exempt).
All domestic and foreign LLCs, limited partnerships, and general partnerships formed or registered in Delaware are subject to an annual tax of $300. There is no requirement to file an annual report.
An LLC doing business in Delaware is classified as a partnership for Delaware income tax purposes unless it is classified as a partnership for federal income tax purposes. An LLC is always classified for Delaware income tax purposes the same way it is for federal income tax purposes.
2.1.5. Utah
Legal Status
On March 1, 2023, the Utah state legislature passed HB 357, the Utah Decentralized Autonomous Organization Act (Utah DAO Act), which became the first state to legislate to recognize decentralized autonomous organizations (DAOs). The Utah DAO Act grants DAOs: 1. Legal recognition and limited liability protection, addressing the limitations of the previous "wrapping DAOs into LLC entities" approach; 2. Establishing clear tax treatment; 3. No implicit fiduciary responsibilities for DAO participants; 4. Using "bylaws" to protect the anonymity of DAO participants; 5. Incorporating technical checks to ensure that the DAO is indeed a DAO.
The DAO Act passed by Utah allows decentralized autonomous organizations that are not registered as for-profit corporate entities or non-profit entities to be legally equivalent to domestic limited liability companies.
The Utah DAO Amendment Act provides very detailed provisions on all aspects of DAO, including: DAO Act terminology, laws that DAOs must comply with, DAO legal personality, DAO name, DAO registered agent and fees, DAO documents, DAO formation requirements, DAO limited liability, DAO charter, DAO annual report, DAO membership, DAO voting, DAO assets, DAO reorganization, DAO failure, DAO taxation, etc.
Tax rules
Under the Corporate Franchise and Income Tax Act and the Pass-Through and Pass-Through Taxpayers Act, a DAO can register as a C Corp, which is subject to double taxation, paying corporate taxes at the company level and personal income taxes paid by shareholders; or register as a partnership (pass-through) and not pay corporate taxes.
2.1.6. Colorado Cooperative
Colorado’s Uniform Limited Cooperative Association Act, while not explicitly recognizing DAOs, provides a framework for them that allows for them. The law regulates “limited cooperative associations” (LCAs), which are defined as “autonomous, unincorporated associations of persons united to meet their common needs through a commonly owned enterprise primarily controlled by such persons.” Under the law, LCAs can distribute profits to sponsoring members in proportion to their services and allow members to vote on governance matters, and DAO-based governance principles and liability limitations can be incorporated into the charter and bylaws. In general, cooperatives tend to reward participation rather than just capital commitments—members typically have one vote each, or their voting rights are determined based on their level of activity in governance.
2.2. Legal Status of DAOs and Tax Rules in the Republic of the Marshall Islands (RMI)
2.2.1. Legal status
As of 2022, the Republic of the Marshall Islands (RMI) officially recognizes DAOs as legal entities, thanks to the Amended Not-for-Profit Entities Act of 2021. The Act allows DAOs to register as Marshall Islands non-profit limited liability companies, based on legislation passed by the Marshall Islands government with the assistance of the founders of MIDAO Directory Services, Inc. (MIDAO). In addition to legislative efforts, MIDAO is a multinational organization that was established to serve as the registered agent for Marshall Islands DAOs and assist in registering DAOs in the Marshall Islands under the new amendments.
Under this law, DAO token holders could become members of a limited liability company, and the DAO’s charter could be encoded into the blockchain.
Although the Marshall Islands is a sovereign state and not subject to U.S. jurisdiction, many of its laws, such as corporate law, are based on Delaware law. In the absence of applicable statutes or case law in the Marshall Islands, the Marshall Islands courts may refer to Delaware case law.
As mentioned earlier, MIDAO has taken the lead in pushing for legislative reforms to support DAOs. Bobby Muller, former RMI Chief Secretary and co-founder of MIDAO, said his country recognizes that it is a "unique moment to lead the blockchain revolution" and that DAOs will play an important role in creating "more efficient and less hierarchical organizations." MIDAO's strategy is to provide competitive registration costs, a supportive government with internationally recognized courts, and an environment open to technological advancement. In addition to the non-profit LLC structure, MIDAO is currently working on legislation to allow for-profit DAO LLC options that may be particularly useful for investment DAOs.
2.2.2. Tax rules
The Marshall Islands' non-profit decentralized autonomous organization LLCs, by design, have no economic owners, meaning they cannot distribute earnings to their members. Instead, these entities have beneficial members who participate in the governance of the organization. Non-profit DAO LLCs enjoy tax exemptions, meaning the organization itself is not subject to tax, and its members are not subject to pass-through taxation.
In contrast, for-profit entities operate as income-generating entities. They are subject to a 3% gross revenue tax (GRT) on the income they earn, which includes interest expenses but excludes capital gains and dividends. It is important to note that for-profit entity members may be subject to additional taxes in their local jurisdictions.
2.3. Cayman Islands Foundation
2.3.1. Legal status
The Cayman Islands, Panama, and Switzerland all offer ownerless foundations with separate legal personality that DAOs can use to hold tokens or intellectual property and contract with third parties to provide or receive services. The implementation of these foundations allows token holders to direct the actions of foundation directors without any ownership rights. Foundations can form part of a wider DAO structure where (for example) a limited company is formed to provide software development services to the foundation.
Cayman foundations are used as a “bridge” to facilitate off-chain actions by DAOs. Foundations have limited liability; the foundation’s charter can set specific rules for how the foundation achieves its objectives. The charter can limit the roles and responsibilities of the foundation’s directors and managers; the foundation can select beneficiaries (e.g., token holders of a DAO) who have only the rights and powers specified in the charter. The arrangement between the foundation and the DAO to which it is associated typically provides that the foundation will execute the DAO’s agreements. The Cayman Islands also recently enacted the Virtual Asset Service Providers Act (VASP Act), which provides a regulatory framework that is also useful for many DAOs. However, the foundation “bridge” structure is not perfect because it requires individuals who are not members of the DAO (such as directors or trustees of the foundation) to take off-chain actions, and the trust-like form introduces centralization.
2.3.2. Tax rules
The Cayman Islands has no income tax, capital gains tax, corporate tax or other direct taxes.
3. Tax rules for DAO members’ income
3.1. Tax Rules for DAO Members’ Income in the United States
DAOs in the US are currently taxed at the individual level, with participants reporting their share of the proceeds on their personal income tax returns. The IRS has not yet clarified how profits from DAO entities will be taxed at the federal level, so this is an area that needs to be worked out.
DAO cryptocurrency holders should keep detailed records of their share of the DAO and their profits. If a taxpayer receives cryptocurrency from the DAO in exchange for goods or services, it should be reported as income in the country and state where the sale was made or the work was performed. Profits from the subsequent sale of the cryptocurrency as income are subject to capital gains tax. Cryptocurrency paid directly by the DAO for goods or services is taxed as income.
However, while there are reasonable grounds for treating DAOs themselves as taxable entities, how or where they will be taxed has yet to be determined. As DAOs become more common and popular, the question of whether the profits of DAOs are taxed at the entity level will become increasingly important. As cryptocurrency tax law expert David J. Shakow points out, the criteria for becoming a taxable entity has little to do with local corporate classifications. Instead, an entity is considered a taxable entity when partners agree to work together and split profits.
The DAO in cryptocurrency clearly meets this definition, as the participants of the DAO collectively agree to manage the DAO's smart contract and in return may receive a share of income. Tax authorities can reasonably interpret this as constituting a taxable entity.
There is already legal precedent for this in the United States. In 2017, the SEC ruled in its review of the governance tokens of the "The DAO" project that the tokens were sold by a "virtual organization" and were therefore subject to securities laws. In addition, after President Biden issued the 2022 Executive Order on Cryptocurrencies, SEC Chairman Gary Gensler spoke out, arguing that most crypto tokens meet securities standards and should be classified as securities. In June 2023, the SEC filed a lawsuit against Binance and Coinbase, declaring many cryptocurrencies (including Cardano, Solano, and Binance Coin) to be securities.
3.2. Tax reporting requirements for DAO members in the United States
Members who receive governance tokens or NFTs as part of a DAO launch or as an incentive or reward will need to report them as ordinary income in the member’s crypto taxes. If a member sells these governance tokens or NFTs, any profits will be subject to crypto capital gains taxes.
4. Regulatory compliance risks posed by DAO organizations
Potential for fraud. The more free-wheeling nature of DAOs can easily lead to investors being deceived or misled when raising funds. Because most DAOs to date have focused on raising funds for cryptocurrency projects, some have accused them of being similar to Ponzi schemes whose goal is nothing more than to increase the value of the crypto tokens they issue.
Tax Uncertainty. There remains significant uncertainty regarding the tax treatment of DAOs. Many DAOs may be treated as business entities for tax purposes, meaning that they may have tax filing, reporting, and/or withholding obligations. A maximally decentralized DAO may have no practical way to meet these obligations. In addition, characterizing a DAO as a partnership, a “passive foreign investment company,” or a “controlled foreign corporation” may require taxpayers to pay tax on their share of the DAO’s income on the basis that the DAO was registered as a pass-through entity or be subject to onerous consequences, but many taxpayers may not be able to determine their “pass-through” share of the DAO’s income without a sophisticated nexus analysis.
Regulatory Compliance. A legal analysis should be conducted to determine whether securities laws require registration of the DAO’s tokens and, if so, how the rules related to registration (and ongoing reporting requirements) will be complied with. Founders should also keep in mind that statements made by them or others in marketing the DAO could give rise to securities law liability and/or civil lawsuits for claims based on alleged misinformation. Founders must also consider the impact of the DAO’s design and governance on a variety of other regulatory issues (including antitrust issues) and how to ensure the DAO’s ongoing legal compliance.
How to comply with an Anti-Money Laundering (AML) program. How can a DAO include the following AML content to meet compliance requirements?
(a) policies, procedures, and internal controls that are reasonably designed to comply with the Bank Secrecy Act and its implementing regulations;
(b) independent testing of compliance;
(c) designate one or more persons to be responsible for implementing and monitoring operational and internal controls;
(d) Provide ongoing training to relevant personnel.
In general, regulators must protect investors and consumers, but it is equally important to give equal financial rights to small businesses, the poor, individuals without access to banking services, and anyone who cannot meet the requirements of the existing centralized system. Striking a balance between these competing values will be the real challenge in realizing the promise of DeFi and the cryptocurrency industry. DAOs are more inclusive than most existing organizations, bringing together like-minded individuals to work on projects for the common benefit of the group. The most promising advantage of DAOs is that they lower the financial entry barrier for individuals and small businesses who would otherwise be unable to participate in stock markets, banking and lending, or provide services or goods to the broader market.
references
[1] PANews. (2022). An article exploring the combination of DAO and legal entities.
[2] TaylorWessing.(2022).That'll be the DAO: an overview of the structure and status of decentralised autonomous organisations under English law.
[3] Guanghe Law Firm. (2022). A brief analysis of DAO and its legal nature: Taking SeeDAO as an example.
[4] Harvard Law School Forum on Corporate Governance.(2022).A Primer on DAOs.
[5] FREEMAN.(2022).Vermont Blockchain Legislation Status.
[6] Mondaq.(2022).United States: Legal Issues Confronting Formation And Operation Of A Decentralized Autonomous Organization (DAO).
[7] Cavenwell.(2023).Exploring the Marshall Islands DAO LLC: A Revolutionary DAO Legal Structure.
[8] Utah State Legislature. (2023). DECENTRALIZED AUTONOMOUS ORGANIZATIONS.
