Does the DAO pay taxes? Research on legal status and tax obligation of DAO and its internal members

1. The connotation and importance of DAO

DAOs (Decentralized Autonomous Organizations) represent a new organizational structure that formally allows for decentralized decision-making using blockchain and token voting mechanisms. In the case of traditional industrial firms rely on the separation of franchise and ownership, DAOs provide an entirely different template for organizational engagement, where ownership and franchise are combined - driven by smart contracts, fluid membership, and transparent transaction channels.

The UK Law Commission has proposed a comprehensive set of elements of the DAO to help define it and to open up discussions around the relationships involved in the DAO，and these elements are outlined below:

·Software Protocol: A digital infrastructure consisting of rules governing how smart contracts work together, followed by a network of participants. The agreement will specify rules for the operation of a particular system, as well as rules for identifying and implementing changes to that system. The protocol can embody a blockchain system, and it can also be deployed on an existing blockchain system (for example, the DeFi protocol deployed on an existing blockchain takes advantage of the capabilities of the underlying blockchain system).

·Blockchain system: A software protocol for a distributed ledger that records and transmits data in a structured manner, including the operation of software protocols deployed on a blockchain system. Blockchain systems are typically independent of any DAOs associated with the software protocols deployed on them.

·Miners and validators: Participants in the blockchain system who comply with and run the blockchain protocol, thus ensuring its operation. Miners and validators are incentivized to comply with the blockchain system protocol rules through rewards and are relied upon by software protocol developers.

·Developers: Software engineers write software code for blockchain systems, software protocols, and the smart contracts that make them up. Most of the software written by developers in the crypto asset ecosystem is offered as open source software. The Legal Committee believes that developers may be closely associated with DAOs, specific software protocols, related software (such as front ends), and may act alone or as part of a team or registered company (or other legal entity).

·Protocol Token Holders: Protocol tokens are units of account (or notional units of account) used for specific software protocols, such as Ether in the Ethereum blockchain system. There are software protocol tokens that are used for specific functions in the protocol. For example, a governance token can provide holders with specific voting or participation rights, while another token can give holders access to products or services offered through the protocol. Protocol token holders may have a close relationship with the DAO, for example, when the DAO issues tokens to developers, investors, or contributors. But tokens are likely to be freely transferable and therefore can be sold on the public market to holders who have no connection to any of the DAOs participating in the protocol.

According to the comprehensive elements given by the UK Law Commission, a 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, designed to implement decentralized decision-making and operational rules, and may involve complex relationships between multiple actors.

With the growing public interest in cryptoassets and more money investing in cryptoasset businesses around the world, a number of liability-related issues are becoming increasingly important. If DAOs lack a centralized governance structure, they also lack a central entity or individual that is accountable to and enforceable against the DAO's obligations and debts. The following will explain the legal status of DAOs in each jurisdiction and their corresponding tax rules, tax reporting requirements and tax compliance risks.

2. Legal status of DAO

Some forward-thinking jurisdictions have supported the registration of DAOs in their territories by enacting new laws recognizing the legal status of DAOs or DAO-like organizational structures.

2.1. Legal status and related tax rules of DAO in some regions of the United States

Currently, four U.S. states - Vermont, Wyoming, Tennessee, and Utah - recognize DAOs as legal entities. While the states of Delaware and Codorado do not recognize DAO as a legal entity, the corporate laws of these states are compatible with the incorporation of DAO as a limited liability company or equivalent.

2.1.1. Vermont

Legal status

In August 2018, the U.S. State of Vermont enacted legislation that added a new form of corporation: the block chain-based limited liability company (BBLLC). The bill does not specifically mention the DAO, but 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 that protect their owners, managers, and blockchain participants from unnecessary liability. Corporate governance can be run partly or entirely through blockchain technology. At the same time, because the BBLLC provisions are under the limited liability company section, the provisions concerning limited companies also apply to the 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 association that it is a BBLLC; And it 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, BBLLC can limit fiduciary liability and provide for limited liability in its operating agreement.

Tax rules

Under the Internal Revenue Code and Vermont law, BBLLC can be taxed either as a C Corp or as a partnership (through-body), which is the same tax rules as a general LLC.

Partnership tax or corporation tax

Deciding whether to pay taxes as a partnership or corporation is significant because it will determine whether taxes will be passed on to individual shareholders. Generally speaking, companies are subject to corporate income tax. In contrast, shareholders in partnerships are typically subject to state personal income tax because they are penetrators. Disregarded entities are legal business entities that do not pay corporation tax because they pass on all taxable income to owners, shareholders and investors. In contrast, corporations are not penetrators because both corporations and individual shareholders must pay taxes on the income generated by BBLLC. Assuming the BBLLC wants to avoid double taxation, the company can limit its tax liability by choosing to pay taxes as a partnership rather than a corporation.

Vermont corporation tax

In Vermont, passing 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 percent. In contrast, Vermont's personal income tax rate can be as low as 3.55 percent. As a result, BBLLC can cut its tax burden in half simply by choosing to be taxed as a partnership instead of a corporation. As a result, Vermont encourages companies to organize their entities as penetrators, which include (1) S Corp; (2) Limited liability companies, including BBLLC; (3) Partnership company. By allowing blockchain companies to register as pass-through entities in the form of BBLLC, the Vermont government intends to incentivize cryptocurrency companies to register in the state by providing a favorable tax framework for blockchain entrepreneurs.

Related tax

One question raised by Vermont's new legislation, however, is whether the bill will create any relevance issues for out-of-state members of the BBLLC. Specifically, the bill declares that because BBLLC is organized within the state of Vermont, if members or managers outside the state interact with BBLLC or engage in other business activities in a different capacity or role, then those activities may not be considered to occur in Vermont. As a result, out-of-state members may be subject to Vermont and other state taxes when their income is transferred to their respective personal income taxes, depending on where their business activities take place. In fact, the tax framework for multi-state businesses is very complex, including how various tax relationships with a given state are structured. Therefore, out-of-state members in the Vermont BBLLC should consult a tax professional to ensure proper filing.

2.1.2. Wyoming

·Legal status

In July 2021, Wyoming became the first state to enact a law specifically permitting the creation of the DAO. The law, which allows for the creation of DAOs as limited liability companies, complements the existing Limited Liability Companies Act, giving legal status and identity to such entities for the first time in the United States.

As a supplement to the Limited Liability Companies Act, the DAO Supplement Act is considered to provide special coverage for DAOs, but without special provisions, the rest of the Limited Liability Companies Act also applies to DAOs. Technical requirements include the use of DAO, LAO, or DAO LLC in the organization's name to distinguish it from the current usage of LLC. The Articles of association must include a specific notice alerting all potential members that the DAO may cancel fiduciary duties, restrict the transfer of ownership interests, withdraw or resign from the DAO, return contributions, and dissolve the DAO.

The Articles of Association or the DAO's Operating Agreement must state whether the DAO is managed by a member, and that at least one person is a member to conduct the business of the DAO LLC, as management is vested in its members. The Articles of association will regulate a range of activities normally carried out by a company, including: Members' rights, obligations, relationships, voting rights, DAO activities and the manner in which they are carried out, the manner in which articles of association or operating agreements are amended, the allocation of members, the transferability of members' interests, the withdrawal of members and their contributions, the dissolution and post-dissolution allocation of members, the modification, updating, editing or alteration of the procedures applicable to smart contracts, And public identifiers for any intelligent contacts used to manage, facilitate, or operate the DAO. Much of the information needed to operate a DAO can be found in the whitepapers of the entities that created the DAO and promoted its benefits to potential members.

Wyoming law provides that DAO members have no fiduciary responsibility unless the bylaws provide otherwise; And there is no obligation to provide information to members or provide inspection rights (except for information and inspection rights on the DAO open blockchain).

·Tax rules

Wyoming has no corporate, personal, or capital gains taxes, and property, sales, and estate taxes are among the lowest in the United States. Wyoming also has no 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.

Avoid double taxation and pass-through deductions: Standard companies are typically subject to double income tax. A company's profits are taxed first as income, and shareholders must pay income tax on any dividends. A limited liability company, on the other hand, can be reported as a pass-through, and the distributed profits are taxed only once on each member's individual income tax return. In addition, owners of LLCS filing as a Type C corporation can also deduct 20 percent of their business income from their taxable income under the 20 percent "flip" deduction under the Tax Cuts and Jobs Act.

2.1.3. Tennessee

·Legal status

On April 20, 2022, Tennessee became the second U.S. state to create a dedicated business entity for decentralized autonomous organizations (DAOs). The new legislation amends Section 48 of the Tennessee Code to allow Tennessee limited liability companies (LLCS) to register as "decentralized organizations" by adding new selective language to their bylaws.

Wyoming and Tennessee laws allow an LLC to state in its articles of association that it is a DAO. Both laws state that a DAO will be deemed to be managed by a member unless the DAO's charter states that it is managed by an algorithm or smart contract; The charter must contain information about DAO smart contracts; If the DAO does not approve any proposal or take any action within one year, the DAO will automatically be dissolved. Tennessee law states that DAO members have no fiduciary responsibility to the DAO unless there is an implied covenant of good faith and fair dealing.

·Tax rules

Limited liability companies 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 worth of tangible assets or property in Tennessee, whichever is higher. The minimum state franchise tax payment is $100. Another tax requirement is the excise tax, which is taxed at 6.5 percent of the taxable net income generated by the state.

2.1.4. Delaware

·Legal status

Another option is to establish a limited liability company in Delaware. Although the state of Delaware has not recognized DAOs as legal entities, many DAOs are incorporated as Delaware limited liability companies. While this structure influenced the autonomous and decentralized nature of the DAO to some extent, the Delaware LLC form allowed for a large degree of adaptation of DAO principles and procedures. According to the usual structure, the limited liability company owns the funds raised in the DAO token sale and is the beneficiary of those funds; The LLC operating agreement specifies many of the functions that will be operated through smart contracts (such as issuing interests, acting as custodians of assets, registering member interests, counting member votes, and providing notices); The operating agreement specifies fiduciary limits, limits of liability, and other DAO-oriented features. While the law and jurisprudence of Delaware LLCS are widely recognized and mature, and their flexibility makes them 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 some cases.)

·Tax rules

Corporate income tax is calculated based on the company's net profit, and the state average tax rate is about 8.7% (profits derived from non-in-state operations are exempt).

All domestic and foreign limited liability companies, limited partnerships, and general partnerships incorporated or incorporated in Delaware are subject to an annual tax of $300. There is no requirement to submit annual reports.

A limited liability company 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. LLCS are always classified in Delaware income tax the same way they are classified in federal income tax.

2.1.5. Utah

·Legal status

On March 1, 2023, the Utah Legislature passed HB 357 (effective January 1, 2024), the Utah Decentralized Autonomous Organizations Act (Utah DAO Act), making Utah the first state to pass legislation recognizing decentralized autonomous organizations (DAO). The Utah DAO Act grants DAO: 1. Legal recognition and limited liability protection, addressing the limitations of the previous "packaging DAO into an LLC entity" approach; 2. Established a clear tax treatment; 3. There is no implied fiduciary duty to DAO participants; 4. Use "fine print" to protect the anonymity of DAO participants; 5. Include technical checks to ensure that the DAO is indeed a DAO.

The DAO Act passed in Utah allows decentralized autonomous organizations that are not registered as for-profit corporate entities or nonprofit entities to be legally equivalent to domestic limited liability companies.

The Utah DAO Amendment covers all aspects of the DAO in great detail, including: DAO Act terminology, laws to be followed by DAO, DAO legal personality, DAO name, DAO Registration agent and fees, DAO documents, DAO formation requirements, DAO limited liability, DAO Bylaws, DAO Annual Report, DAO membership, DAO voting, DAO assets, DAO reorganization, DAO failure, DAO taxation, and more.

·Tax rules

Under the Corporate Franchise and Income Tax Act and the Penetrator and Penetrator Taxpayers Act, the DAO may be registered as C Corp, double taxed, subject to company-level corporate tax and shareholders subject to individual income tax; Or register as a partnership (through body) and do not pay corporate tax.

2.1.6. Colorado Cooperatives

Colorado's Uniform Limited Cooperative Association Act, while not explicitly recognizing DAOs, provides a framework for them to allow them. The Act provides for a "limited cooperative association" [hereinafter referred to as "LCA", which is a hybrid of a limited liability company and a corporation. An LCA differs from an LLC in that it can have two types of members: (a) an investor who makes a contribution and (b) a sponsor who carries out business for the company.] It is defined as "autonomous, unincorporated associations that join together to meet their common needs through jointly owned enterprises primarily controlled by such persons." By law, the LCA can distribute profits to sponsoring members in proportion to its services and allow members to vote on governance matters, and DAo-based governance principles and liability limits can be incorporated into the Charter and bylaws. In general, cooperatives tend to reward participation, not just capital commitments - members usually have one vote each, or their voting power is determined based on their level of activity in governance.

2.2. The legal status of DAO and its 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 recognized the DAO as a legal entity, thanks to the Amended Not-for-Profit Entities Act of 2021 (Non-profit Limited Liability Companies Act). The bill allows the DAO to be registered as a Marshall Islands non-profit limited liability company based on legislation passed by the Marshall Islands Government with the assistance of the founders of MIDAO Directory Services (MIDAO). In addition to legislative efforts, MIDAO is a multinational organization established to act as a registration agent for the DAO in the Marshall Islands and to assist in the registration of the DAO in the Marshall Islands under the new amendment.

Under this law, token holders of the DAO can become members of a limited liability company, and the charter of the DAO can be encoded into the blockchain.

Although the Marshall Islands is a sovereign nation and not subject to the jurisdiction of the United States, 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, Marshall Islands courts may refer to Delaware case law.

As mentioned earlier, MIDAO led the push for legislative changes in support of the DAO. Bobby Muller, former chief secretary of the RMI and co-founder of MIDAO, said that his country recognizes that now is a "unique moment to lead the blockchain revolution" and that the DAO 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 that is open to technological advances. In addition to the non-profit LLC structure, MIDAO is currently working on legislation that would allow the registration of for-profit DAO LLC options that might be particularly useful for investing in DAO.

2.2.2. Tax rules

The Marshall Islands' non-profit decentralized autonomous organization limited liability companies are not designed to have economic owners, which means they cannot distribute earnings to their members. Instead, these entities have beneficial members who participate in the governance of the organization. The non-profit DAO LLC enjoys tax-exempt status, the organization itself is not subject to taxes, and its members are not subject to pass-through taxes.

In contrast, for-profit entities operate as revenue-generating entities. They are subject to a 3% gross income 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 required to pay additional taxes in their local jurisdiction.

2.3. Cayman Islands Foundation

2.3.1. Legal status

The Cayman Islands, Panama, and Switzerland all offer unowned foundations with independent legal status 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. The foundation could form part of a broader DAO structure in which (for example) a limited company is formed to provide software development services to the Foundation.

The Cayman Foundation was used as a "bridge" to facilitate off-chain action by the DAO. The foundation shall bear limited liability; A foundation's charter may set specific rules for how the foundation can achieve its goals. The charter may limit the roles and responsibilities of the directors and managers of the Foundation; The Foundation may select beneficiaries (for example, token holders of the DAO) who have only the rights and powers specified in the charter. The arrangement between the foundation and the DAO associated with it typically states that the foundation will enforce the agreement of the DAO. 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 structure of the foundation "bridge" is not perfect, as 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 invites centralization.

2.3.2. Tax rules

The Cayman Islands has no income tax, capital gains tax, corporate tax and other direct taxes.

3. Tax rules for income of DAO members

3.1. Tax rules for income earned by DAO members in the United States

Daos in the United States are currently taxed at the individual level, and participants are required to report their share of the proceeds on their individual income tax returns. The IRS has yet to specify how profits at the entity level of DAOs will be taxed at the federal level, so this area is open to scrutiny.

DAO cryptocurrency holders should keep detailed records of their share of the DAO and their profits. If a taxpayer receives cryptocurrency from a 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 performed. Profits from the sale of cryptocurrencies as income thereafter are subject to capital gains tax. The DAO taxes cryptocurrencies paid directly for goods or services as income.

However, while there are legitimate reasons to treat DAOs as taxable entities in their own right, how or where to tax them has yet to be determined. As DAOs become more common and popular, the issue of taxing profits on DAOs 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 have little to do with local business classification. Instead, the entity is considered taxable when the partners agree to work together and distribute the profits.

The DAO in cryptocurrency clearly fits this definition, as the participants in the DAO collectively agree to manage the DAO's smart contract and, in return, may receive a share of the income. Tax authorities can reasonably interpret this situation as constituting a taxable entity.

There is legal precedent for this in the United States. In 2017, The U.S. Securities and Exchange Commission ruled during its review of governance tokens for "The DAO" project that the tokens were offered by "virtual organizations" and were therefore subject to securities laws. In addition, after President Biden issued the 2022 Cryptocurrency Executive Order, SEC Chairman Gary Gensler gave a speech arguing that most crypto tokens meet the criteria for securities and should be classified as securities. In June 2023, the U.S. Securities and Exchange Commission 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 NFT as part of the DAO launch or as an incentive or reward need to report them as ordinary income in the member's crypto tax. If members sell these governance tokens or NFTS, any profits will be subject to crypto capital gains tax.

4. Regulatory compliance risks brought by DAO organizations

Potential fraud. The more liberal nature of DAOs makes it easy for investors to be deceived or misled when raising funds. Since most DAOs to date have focused on raising funds for cryptocurrency projects, there have been accusations that these DAOs are akin to Ponzi schemes whose goal is nothing more than to increase the value of the crypto tokens they issue.

Tax uncertainty. There is still considerable uncertainty about the tax treatment of DAOs. Many DAOs may be considered business entities for tax purposes, which means they may have tax filing, reporting, and/or withholding obligations. The most decentralized DAO may not have a practical way to fulfill these obligations. In addition, the designation of DAOs as partnerships, "passive foreign investment companies," or "controlled foreign companies" may require taxpayers to pay taxes on their share of DAO income on the basis that DAO is registered as a penetrator, otherwise subject to onerous consequences, but without a complex correlation analysis, the DAO is not subject to tax. Many taxpayers may not be able to determine their share of "penetration" in DAO revenue.

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 they or others make while marketing the DAO may give rise to securities law liabilities and/or civil lawsuits for claims arising from alleged misinformation, and must also consider the impact of the DAO's design and governance on a variety of other regulatory issues, including antitrust concerns, and how to ensure continued legal compliance with the DAO.

How to comply with anti-Money Laundering (AML) programs. How can a DAO include the following anti-money laundering content to meet compliance requirements?

(a) Policies, procedures and internal controls reasonably designed to comply with the provisions of the Bank Secrecy Act and its implementing regulations;

(b) Independent testing for compliance;

(c) Designate one or more persons responsible for implementing and overseeing operational and internal controls;

(d) Ongoing training of relevant personnel.

Regulators must protect investors and consumers in general, 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 achieving DeFi and the future of the cryptocurrency industry. Compared to most existing organizations, DAOs are more inclusive, bringing together like-minded individuals to undertake projects for the common good of the group. The most promising advantage of the DAO is that it lowers the financial barriers to entry for individuals and small businesses who would otherwise be unable to participate in the stock market, banking, and lending, or provide services or goods to the broader market.

reference

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[4] Harvard Law School Forum on Corporate Governance.(2022).A Primer on DAOs.

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[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.