An organization’s very structure is being penetrated by blockchain technology. Traditional organizations are organizations that perform for-profit or not-for-profit activities according to state law. A sole proprietorship, general partnership, limited partnership, publicly traded partnership, corporation or limited liability company is just some examples of the types of businesses that exist under state law. As a result of its flexibility for legal and tax purposes, the latter is most popular.
What is a DAO?
Decentralized autonomous organizations (DAO) are essentially a group of individuals who use blockchain technology (also referred to as Web3) to form a group whereby each member contributes virtual assets (tokens) to obtain an ownership interest or right to have a voice in the governing of the assets purchased by the DAO. The ownership interest or right is represented by a token(s) in the DAO (i.e., token for token). Hence, the DAO has no formal legal structure under state law because it exists only virtually.
Many DAOs are formed by persons for purposes of investment activities much like an investment fund. Token holders collectively vote to pick investment proposals submitted by DAO members. Like an investment fund, the members (i.e., token holders of the DAO) share in the profits or losses of the investment(s). If properly operated the DAO can perform the investment activities solely by computer code known as “smart code”, i.e., human interaction is not required.
How are DAOs Classified Under U.S. Law?
So, if the DAO is not formed under U.S. federal or U.S. state law, is it then a domestic or foreign partnership, LLC, or corporation? This is an interesting question and one in which the U.S. tax law is well-prepared to deal with the changing times.
The preparedness is due to the overarching principle of “substance over form,” which undergirds the U.S. tax system. Unlike Civil Law systems, the U.S. system, based on the British court system, allows for legal interpretation as to the substance of the transaction rather than the legal form of the arrangement itself to determine intention and therefore, liability.
So no matter how a group might structure their DAO, there is no structure that is a bulletproof shield against tax reporting and collection.
What’s more, the principle of taxation by citizenship ensures that if there is an American citizen involved in a DAO, whether their business transactions and investments take place on U.S. soil, foreign soil or cyberspace, they are obligated to, at the very least, report their activities to the IRS.
The Interplay of Federal and State Regulations
When determining if a group of individuals constitute a partnership, LLC or corporation, one can look to U.S. tax law and state law. If an organized group is not formalized under state law, it will not be recognized by any state as either a LLC, LP or PTP but may be treated as a general partnership under state law. Of course, the issue would be which state law applies if the members of the group live in different states, or even abroad.
The U.S. Treasury regulations define a corporation as an entity which is organized under U.S. federal or state law or recognized Native American nation, designated as a corporation, association, insurance company or state-chartered bank. The Treasury also lists specific types of entities formed under foreign law as being treated as a corporation. These same regulations declare that a partnership is an entity with two or more members which are not a corporation, and a sole proprietor is an individual conducting a trade or business which is not a corporation.
U.S. tax law does not define a LLC because a LLC is not a corporation under any state law and therefore by default is classified as either a sole proprietor or partnership according to the above mentioned Treasury Regulations, unless said entity makes a special tax election under the Treasury regulations to be treated as a corporation.
U.S. tax law (IRC § 7701(a)(4) and (5)) defines any corporation or partnership which is not formed under the laws of the U.S. or any state as a foreign corporation or foreign partnership.
Hence, if the DAO is formed under any state law, its tax classification will be determined by the IRC and Treasury Regulations.
How Does U.S. Tax Law Classify a DAO?
As previously noted, currently, most DAOs are used for the purpose of a group of individuals to make collective investments. In this case the likely tax classification of the DAO would be a foreign partnership because it can’t be treated as a corporation unless formed under state law as a corporation. For the same reason it would be difficult to classify the DAO as a U.S. entity even if all members were U.S. persons. The use of a DAO for other purposes would require a review of the substance of the activities and intentions of the group to determine its U.S. tax classification – substance over form.
If a DAO would prefer to eliminate the unknown there are two states that allow a DAO to register as a LLC under their state law: Wyoming and Vermont. As mentioned above, unless a special election is made, the entity would likely be treated for U.S. tax purposes as a U.S. partnership.
What are the Potential Tax Liabilities for Investments in a Foreign Entity DAO?
What is the significant difference in the IRS’ treatment of a foreign versus domestic entity? If a DAO is treated as a foreign entity there are special reporting and tax liability implications. For instance, if an interest in a foreign entity by a U.S. person is not properly disclosed on their income tax returns, the IRS levies significant penalties, ranging from $10,000 to $50,000 or higher., Moreover, depending on the entity’s classification as a partnership or corporation, the entity itself can incur additional penalties – for example, if it meets foreign financial account reporting requirements. These penalties are regardless of any income or gain from transacting by way of a DAO.