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How DAOs Are Taxed

Key Highlights Regarding DAOs:

✅ As of mid-2022, there are currently over 4,000 active DAOs with a market capitalization of approximately $20 Billion.

✅ There was an early example called ‘The DAO’. Due to a now infamous technical flaw, one or more hackers were able to steal nearly $70M. Although it was a highly controversial move, Ethereum was forced into a hard fork.

✅ In 2022, 40% of all DAOs are focused on decentralized financial systems (DeFi)

DAOs can be applied to all different spaces, including gaming, politics, art and culture and non fungible tokens.

✅ Ethereum is the most popular blockchain for building DAOs, with 83 top 1000 governance tokens by market capitalization.

Over 50% of DAOs hold USD Coin (USDC), with close to 45% of DAOs holding MakerDAO’s stablecoin, and over 40% hold wrapped ethereum (wETH).

The Blockchain industry is maturing rapidly and the space is booming! Over the last few years DAOs, better known as decentralized autonomous organizations, have gained popularity and have captured the attention of the blockchain community. But, through all the hype, a few glaring questions remain…

What are DAOs? How are they taxed? And why should the average crypto enthusiast care?

The concept of DAOs, first explored in 2013 in pieces by Vitalik Buterin and Daniel Larmier, begins with the notion that corporations are merely a way to organize human activity under a set of rules and objectives that are defined in contracts. A DAO, or ‘Decentralized Autonomous Organization’, is defined as ‘a community-driven entity with no appointed central authority.’ DAOs are fully sovereign and transparent, with smart contracts holding primary authority of laying the foundational rules and executing agreed upon decisions. DAOs are run by a group of individuals who collectively vote to decide on organizational proposals and instead of abiding by a traditional hierarchical management structure, with DAOs, software runs the show. Each member’s voting power is determined by their percentage interest that they have in the DAO, which is calculated by dividing the digital assets contributed by a member by the total amount of digital assets in the DAO. With DAOs it is important to note that, at any point, the entity’s proposals, voting, and even code itself can be publicly audited.

In practice, DAOs have the following advantages:

✅ Increased trust amongst all stakeholders due to the radical transparency ensured via the stakeholders

✅ Reduced costs by automating actions through smart contracts

✅ A sense of ownership that makes contributors feel more financially and psychologically incentivized to contribute.

It’s very likely that DAOs will be taxed in the future, however, we have no exact date for when this may happen. The IRS issued Notice 2014-21 in 2014, declaring that all cryptocurrency will be taxed starting from the moment it was used by an individual, which could date back to 2009 (i.e. Bitcoin’s origination). Although there has been a lot of talk surrounding the legal implications of DAOs, little attention has been paid to the tax and reporting considerations for both DAOs and their token holders. While DAOs present a huge opportunity to transform the way current business is conducted, DAOs also present a variety of tax complications. For example, when we look at traditional companies, working capital is understood as the difference between our current assets and current liabilities. For DAOs, the biggest challenge is that there is no accounting standard or financial reporting requirement(s) that clearly categorizes transactions.

In the eyes of the IRS, most DAOs are considered to be taxable entities for reporting purposes. However, DAOs that are formed for purposes other than trade or business and making profit, are likely not viewed as tax entities.

Let’s continue…

Once a DAO is determined to be a separate tax entity, we are then left to figure out how this DAO should be properly classified for tax reporting purposes. Almost all entities either (1) owe U.S. entity-level tax or (2) require their owners pay U.S. tax on a passthrough basis. The only exception to this rule is a foreign corporation that is not in a U.S. trade or business (a USTB) and is not a controlled foreign corporation (CFC) with 10% U.S. shareholders. As I’m sure our readers know, there are two general types of entity classifications, partnerships and corporations. Another factor that needs to be analyzed when looking at the tax implications of DAOs is whether or not the entity is considered to be ‘domestic’ or ‘foreign’.

As we discussed in our prior blogpost ‘Difference between Domestic and Foreign LLC’s’, the term ‘domestic’ refers to any entity or partnership created or organized in the U.S. or under the law of any U.S. state. Following suit, the term “foreign” refers to any entity or partnership that has laws falling outside of this jurisdiction. Two States, Vermont and Wyoming, have allowed DAOs to register in their states as DAO partnerships. Like regular partnerships, DAO LLCs provide a limited liability benefit to DAO members. Looking at things from a tax perspective, a DAO partnership, registered under state law, may be treated as a domestic partnership for tax purposes. Although this set up is better for legal reasons, we find that it may be damaging for the U.S. partners who are required to report their share of the DAO’s income and losses. Please note, it is also possible for a DAO partnership to elect to be treated as a domestic corporation for tax purposes. On one hand, electing to be treated as a domestic corporation prevents passthrough taxation but would subject the DAO’s income to U.S. corporate taxes.

Now, let’s explore DAOs outside of Wyoming and Virginia. Due to the fact that DAOs do not register with state secretaries, as they exist solely on the blockchain, they have the potential to be classified as foreign partnerships for tax purposes. This can even be the case in situations where all DAO members are United States tax residents. Although foreign partnership and domestic partnerships differ in their reporting requirements, both categories of partnerships are required to report their share of the partnership’s gains and losses (even if a distribution has not been made in the taxable year).

A DAO potentially can be classified as a foreign publicly traded partnership (PTP), if a DAO’s tokens are traded on a secondary market. In the case that a DAO is classified as a foreign PTP, the partnership is subject to being taxed as a foreign corporation. The income and losses of foreign corporations are likely not taxable to its shareholders until the corporation pays a dividend. However, if the DAO qualifies as a passive foreign investment company, the U.S. token holders would be subject to items such as ordinary income taxation on gains and dividends. If the DAO’s assets solely consist of tokens, it may be considered to be a passive foreign investment company.

DAOs are an exciting phenomenon and the possibilities for this space are seemingly endless. By no means are we suggesting that the road ahead for DAOs will be smooth but we are certain that as the blockchain industry grows DAO adoption will continue to as well. If you weren’t interested in DAOs and how Blockchain can help restructure communities of interest, crowdfunding, and corporations, you should be after reading this post! If you work with DAOs you should be working with Darien Advisors.

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