Tax considerations for decentralised autonomous organisations

Tax and reporting consequences for DAOs and their token holders have gotten scant attention in the debate over the legal implications of decentralised autonomous organisations (DAOs).

To put it another way, it’s a group of people that collectively vote on organisational proposals in a decentralised autonomous organisation (DAO) administered by a computer programme powered by the blockchain. To compute a DAO’s voting power, divide the quantity of digital assets contributed by a member by the total digital assets in the DAO and multiply that result.

For the most part, a decentralised autonomous organisation (or DAO) functions without the need for a board of directors or other governing body and can serve as an effective and (possibly) safe platform for bringing together people and resources to pursue a common purpose.

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Investing is a common goal of many DAOs. It is common for investors to send their digital assets to a DAO in exchange for DAO tokens, which often represent a share in the company. This is how most DAO transactions begin. If a DAO defines its tokens in a different way than most do, ownership interest in a DAO may not be represented by DAO tokens at all.

In order to select the best investment proposals, token holders vote on them collectively. Profits and losses are shared among token holders in an investment that is either successful or unsuccessful. Computer code known as a “smart contract” may accomplish the aforementioned tasks without the need for human interaction when correctly run.

DAOs and their tax status

An entity, even while virtual, can nonetheless exist for tax purposes, even though a DAO appears to have no formal character. If participants “carry on a trade, business, financial activity, or venture and divide the profits therefrom,” tax regulations in the United States specify that a joint venture or other contractual agreement may constitute a separate corporation. If the property is not maintained, repaired, and rented or leased as a separate entity for tax purposes, the co-ownership is not considered separate.)

DAO’s may be taxed as independent entities when they are founded by investors who want to vote on and choose investment proposals as well as contribute cash for investment and partake in their profits. DAOs formed for non-profit objectives, such as raising money to buy a copy of the United States Constitution, are not likely to be taxed as a corporation.

For tax purposes, how should a DAO be classed once it has been determined to be a separate tax entity? Corporations and partnerships are the two most common groupings. Partnership is the default classification for a business with two or more members who each have unlimited liability.

An additional factor to keep in mind is whether the DAO is domestic or foreign. To say something is “domestic” is to say that it was created or is organised in the United States or under state or federal law. In contrast, “foreign” refers to any non-domestic corporation or partnership. Even if all DAO owners are U.S. tax residents, DAOs may be treated as a foreign partnership for tax purposes if they exist only on the blockchain and are not registered with any state secretary. Even if the partnership doesn’t make a distribution, participants in a foreign partnership must nevertheless disclose their portion of the partnership’s profits and losses on an annual basis, just as in a domestic partnership.

If the DAO’s tokens are exchanged on “a secondary market (or the significant equivalent thereof),” it could be categorised as a foreign publicly traded partnership (PTP). Cryptocurrency exchanges may be regarded secondary markets or the substantial equivalent since the US Internal Revenue Service accepts the use of crypto exchanges for assessing fair market value DAO would be a foreign PTP, which is taxed as a foreign corporation in this situation.

When a foreign corporation delivers a dividend to its shareholders, the corporation’s revenue and losses are generally not taxed to the shareholders. A passive foreign investment business would, however, subject U.S. token holders to punitive effects, such as ordinary income taxation on gains and dividends and an interest penalty, if the DAO is considered to be a passive foreign investment company. As a passive foreign investment corporation, the DAO may be required to file periodical reports with the US holders of its tokens.

A new DAO state law

In addition to tax problems, investors are increasingly concerned about the legal consequences of their investments in DAOs (i.e., their personal assets could be put at risk for any lawsuits or debts of the DAO). DAOs can now register in Vermont and Wyoming as DAO LLCs, which, like ordinary LLCs, offer the benefit of limited liability to the DAO members.

It is possible to classify a DAO LLC as a domestic partnership in tax terms because it is registered under state law. The U.S. partners, who must report their share of the DAO’s profits and losses regardless of whether the DAO makes a distribution, may suffer as a result, even though it is better legally. A DAO LLC might chose to classify itself as a domestic corporation, which would prevent passthrough taxes, but would also impose U.S. corporate tax on the DAO’s income, which is a trade-off.

Contributions from DAOs

If any token is traded for another, the IRS considers it a taxable event that results in either a loss or a gain in value. However, in exchange for a partnership interest or stock in a corporation, property payments may be tax-free. To the degree that a DAO token offers voting rights and a right to share in the DAO’s revenues, it may be termed a partnership interest or a share of corporate stock. As a result, a person in the United States may be able to claim that donating Ether to a DAO in exchange for DAO tokens results in no gain or loss.

DAOs have the potential to fundamentally alter the way businesses operate, but they also bring with them a host of unknown tax implications. An experienced tax professional should be sought out prior to establishing or making an investment in a DAO.

 

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