In this edition of our client alert series on DAOs (decentralized autonomous organizations), we turn our attention to taxes.
Even as the digital asset economy has evolved at lightning speed, the tax law has not. This has left investors and creators, and their advisors, with questions, lots of them, including how to apply the existing tax framework to DAOs. (Remember: DAOs are investment or business organizations that use blockchain technology to record and determine the ownership and governance of the DAO’s assets. See What the DAO).
In terms of taxes, what kind of entity is a DAO?
The token-holders of a DAO are not anonymous: Even though a party’s personal details may not be visible, the public key associated with any transaction is permanently baked into the blockchain. And token-holders, like any other U.S. citizens, need to report income to the IRS, no matter whether that payment occurred through a blockchain or in a casino or as a stock dividend.
Which U.S. tax rules apply to a business, investment fund, or other commercial venture largely depends on the type of entity that conducts the arrangement. U.S. tax law is complex, but well-developed when it comes to such familiar structures as corporations, partnerships, limited liability companies (LLCs) and trusts, but there is limited guidance about how tax law will treat cryptocurrency, non-fungible tokens (NFTs), or other assets existing on a blockchain, including DAOs. Until the government releases more specific guidance, DAOs will need to look to the existing legal framework as it applies to entities similar to DAOs and extrapolate from there.
Some DAOs have organized themselves through a traditional structure, often through U.S. LLCs. The U.S. federal income tax treatment of LLCs is well understood. By default, domestic LLCs are not subject to income tax directly. Instead, their owners are taxed on their proportionate share of the LLC’s income. If the LLC has more than one owner, the LLC is treated as a partnership; if it has a single owner, as a disregarded entity. Domestic LLCs can also elect to be classified as corporations for U.S. tax purposes. In that case, the LLC would be subject to U.S. federal corporate income tax on its worldwide income and its owners would be subject to tax on distributions treated as a dividend or on those that exceed their basis in their equity interest. Let’s assume that DAOs operating through domestic LLCs would be treated for tax purposes the same way as any other LLC. If a DAO chooses to operate through another form of U.S. or non-U.S. legal entity, the DAO would be taxed according to the rules that apply to such entities generally.
A DAO that exists only through a contractual arrangement among the owners on the blockchain and does not operate through any legal entity may, nevertheless, be treated as an entity for U.S. tax purposes. Applicable tax regulations state that a contractual joint venture will be considered a partnership for tax purposes if “participants carry on a trade, business, financial operation, or venture and divide the profits.” This definition is quite broad and would appear to include many DAOs that intend to carry out traditional investment activities or operate using a traditional business structure. Ultimately, the determination will need to be made on a case-by-case basis considering the facts and circumstances of a DAO’s particular activities.
Future client alerts will consider the implications of a DAO being treated either as a business entity or a contractual arrangement that does not constitute a tax entity, including whether the entity can be considered domestic or foreign and the resulting U.S. tax compliance obligations for the organization and its owners.
What financial instruments do the owners of a DAO hold?
The tax consequences to the owners of a DAO will also depend on what they actually “own.”
Equity. If a DAO is formed as an actual legal entity or if it operates through a contractual arrangement that is treated as an entity for U.S. tax purposes, someone will presumably be treated as “owning the equity.” The determination of whether an instrument or other group of contractual rights constitutes an equity instrument for tax purposes is based on an examination of facts informed by a long history of tax laws and guidance. Recorded owners of a DAO could be considered equity-holders if they have the right to participate in the profits and losses of the DAO and if they participate in the management of the entity.
Debt. For an arrangement to constitute debt for U.S. tax purposes, it generally has to include many of the traditional features of a debt instrument—a maturity date, a right to a fixed payment, an interest rate, and the ability for the holder to demand payment as a creditor rather than as an equity-holder. Debt instruments are also distinguished from equity instruments by lacking the characteristics of an equity described in the previous paragraph. The economic arrangement among the owners of a DAO could be designed to resemble debt for tax purposes; but, more often than not, the owners of a DAO have the right to an equity-like return on the DAO’s assets and the ability to participate in the decentralized management and governance of the DAO, which will tend to cause their interest in the DAO to constitute equity rather than debt.
Derivatives or Other Instruments. It is possible that a DAO’s recorded owners could be treated as holding only a contractual right to certain of the DAO’s economics. For example, one could design an arrangement where blockchain hold-rights resemble a forward contract with respect to the DAO’s assets. The flexibility of a DAO would provide many other opportunities for its economics to reflect contractual arrangements or derivatives seen in traditional investment and business contexts.
Determining the U.S. tax treatment of the DAO’s owners and its other economic beneficiaries can be as complex as determining whether it is an entity for tax purposes, and it will require the same kind of extensive analysis.
We’ll guide you and assist you
In recent years, the IRS has been aggressive in ensuring that digital-asset holders comply with their tax obligations. As a result, the creators and recorded owners of a DAO should get proper advice on how they should comply with tax obligations as the IRS expands its scrutiny to DAOs. But, as DAOs become more common, the Treasury Dept. and the IRS may address issues specific to DAOs as part of their evolving guidance on the issues raised by the digital-asset economy.
Each client alert in this series includes some crypto-lingo at the end to help you navigate the cryptoverse. Here are some terms:
Whale—an entity with a large position in a specific cryptocurrency. For instance, a whale might own 50,000 bitcoins, so it could move the market with a single trade.
When Lambo?—somehow Lamborghinis became associated with crypto culture. If someone asks, “When Lambo?” they are asking when will the asset gain enough value so he or she can buy a Lamborghini.
Flippening—the moment when the value of Ethereum overtakes the value of Bitcoin.