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Crypto Taxes for Your DAO: PART II. Understanding DAOs and Tax Implications

By

Leo Henkels

Welcome to the second installment of our three-part series, "Crypto Taxes for Your DAO." In this series, we dive deep into the intricacies of taxes concerning Decentralized Autonomous Organizations (DAOs) and the broader world of cryptocurrency. In this second part, we explore the fundamental concepts of DAOs and their tax implications, shedding light on critical considerations for those involved in these decentralized digital entities. Join us as we continue our enlightening journey with Adam Miller and Cameron Richard, uncovering essential insights into the complexities of taxation within the DAO landscape.

Clarification on DAO Legal Structures

Adam Miller: “Let’s now talk about the topic, which many are eager to learn about taxes for DAOs. We'll start with this and, time permitting, delve into taxes for crypto more broadly, and possibly even beyond DAOs. So, Cameron, what's the first thing that comes to mind when you think about taxes for DAOs, especially for someone who's part of a DAO and is beginning to consider their tax obligations?”

Cameron Richard: “The initial consideration is the legal structure of the DAO and how it is viewed by tax authorities. By default, any DAO is essentially a collection of individuals. In real-life terms, if five people come together for a venture, in the absence of a specific legal structure, they form a general partnership. This means each individual's share of the entity is taxable.

For instance, if there are 25 token holders in a DAO without a formal structure, they would each report and pay taxes on their respective share of the profits. However, once a DAO establishes a legal structure, it separates the entity from the individuals, bringing the tax compliance down to individual levels. This doesn't change the fundamental tax obligations but distributes them more manageably among the individual members.”

“When a DAO is based in jurisdictions like the Marshall Islands, Cayman Islands, Switzerland, or similar places, the tax obligations shift to the individual members, based on what they earn or receive from the DAO. This approach reduces the tax burden at the entity level and places it on real-world transactions involving real people. It's important to dispel the myth that DAOs are purely metaphysical entities without tax implications.

In reality, there are humans behind each interaction, whether it's through a keyboard or a smartphone, contributing efforts and receiving compensation or tokens. These individuals are responsible for their income, transitioning the focus from the entity to the individual at a fundamental level.”

DAOs and Tax Implications

Importance of Specific Legal Entities

Adam Miller: “Let me see if I understand correctly. The concept of legal entities versus default legal entities, like a general partnership, is crucial here. Many people consider forming legal entities in places like the Marshall Islands but are hesitant about formalizing a legal structure. I often advise them that not choosing a specific legal entity type results in a default legal entity, often a general partnership, which is not favorable for several reasons, including tax implications. Is that correct?”

Diverse Tax Treatments for Different Entities

Cameron Richard: “Exactly, that's correct. In the past, people have tried to circumvent formal structures, but it's important to recognize that if you're part of a multi-sig wallet or a similar arrangement without a defined legal entity, you're inherently part of a general partnership. This means you're responsible for your proportionate share of any income or assets associated with that partnership. Whether those funds are on-chain or otherwise, each member's tax obligations are determined by their share in the partnership, as dictated by any agreements or even informal arrangements among the participants.”

Deferred Taxation Strategy

Adam Miller: “Let's make this concrete for our listeners. Imagine a DAO or a multi-signature project with ten members, and this project generates a million dollars in income in 2023. If this organization hasn't elected to form a specific legal entity, it's effectively a general partnership. In this scenario, each of the ten members would be liable for taxes on $100,000, which is their share of the earnings, regardless of whether they actually received any money. This default treatment, although not widely litigated yet by the IRS, is crucial for many in the past few years. Is that a correct understanding?”

Cameron Richard: “That's correct. Without a specific legal entity, members of a DAO or similar structure would be treated as part of a general partnership for tax purposes, each bearing responsibility for their share of the earnings.”

Tax Variations Based on Legal Entities

Adam Miller: “Now, let's discuss those who have created legal entities. We know that legal entity types vary globally. For example, an LLC in one jurisdiction may differ from an LLC in another, and the same goes for corporate structures and foundations. Could you help us understand how taxes might differ depending on the type of legal entity created?”

Cameron Richard: “Sure. When you're operating as an individual, without a distinct legal entity, the tax implications are straightforward. However, once you form an entity like 'Cameron LLC' or 'Cameron Inc,' the tax conversation changes. Various entity types can be taxed differently, offering options for optimization. For instance, a Wyoming DAO LLC is still an LLC but can be taxed differently at the IRS level – as a corporation, partnership, S corporation, or even a non-profit LLC if structured correctly.

The tax treatment of a general partnership versus an LLC partnership is similar; the key difference is the legal representation the entity provides. If you have a corporate DAO based in the states, it faces a flat 21% corporate income tax, with additional tax implications for distributions to shareholders, token holders, or DAO members, whether as dividends or compensation. This varies within the U.S. tax regime.”

Tax Variations Based on Legal Entity types

Benefits of Offshore Legal Structures

“If a DAO decides to establish its legal structure offshore in jurisdictions like the Marshall Islands, Cayman Islands, or Switzerland, it moves out of the scope of U.S. income tax on its residual profits. This is advantageous because it delegates tax reporting to the individual level, based on what each person is actually paid for their services. This separation of the DAO's treasury from individual earnings is significant. Depending on the jurisdiction, individuals might owe taxes on gross receipts, licensing fees, or asset taxes, but this approach focuses on the income they actually receive, rather than taxing every transaction or capital appreciation within the DAO's treasury.”

Taxation When Receiving Payments

Adam Miller: “To clarify, if a DAO has a registered legal entity that manages its own taxes, then individual members only pay taxes when they receive distributions, payments for services, or employment income, correct?”

Cameron Richard: “Exactly. If the DAO is taxed like a corporate structure, then tax treatment follows accordingly. However, if it's a DAO LLC based in Wyoming, for example, and doesn't elect a specific tax treatment in the States, it's still essentially treated as a partnership. So, in the case of a Wyoming DAO LLC with ten people, if they haven't chosen a particular tax treatment, each member would be responsible for their share of the profits, just like in a general partnership. This could mean each person is on the hook for 10% of that million dollars, regardless of the legal structure in place.”

Corporate Tax Election and Phantom Income

Adam Miller: “So, it's essential to elect a specific tax treatment, like being taxed as a corporation, whether it's an LLC or another type of legal entity. This is especially relevant in DAOs where many members, often in the thousands, aren't receiving payments. The core team and other contributors might be compensated, but the majority aren't.

Therefore, in these scenarios, it usually makes sense to create a legal entity and elect corporate tax treatment. However, this isn't a one-size-fits-all solution, and complex scenarios require more detailed advice. In essence, a corporate tax election means individuals involved in the DAO won't face tax liabilities unless they receive some form of payment or distribution. Is that accurate?”

Cameron Richard: “Exactly, that's right. When a DAO is taxed as a corporation, it's akin to a deferment strategy. This approach means individual members aren't taxed on 'phantom income' – profits not actually realized – until they receive payments from the DAO or corporation. The corporation pays taxes at its rate in the jurisdiction it's established in, and individuals are taxed on what they actually receive.”

Corporate Tax Election

Non-Profit DAOs and Tax Implications

Adam Miller: “Considering that many DAOs operate as non-profits or have charitable aspects, how does this impact their tax situation?”

Cameron Richard: “In the case of non-profits, the approach in the U.S. involves forming a non-profit corporation and filing form 1023 with the IRS. If a DAO operates with an altruistic mission or provides a public service, incorporating it as a non-profit can be a viable option. It means the DAO can raise funds and operate without being taxed like a general partnership or a for-profit entity, as long as it adheres to the principles of a non-profit organization.”

Conclusion: Stay Tuned for Part III

This concludes the second part of our comprehensive series, "Crypto Taxes for Your DAO." To keep this conversation going and to dive even deeper into the nuances of DAO taxation, we invite you to tune in to our podcast, "Just DAO It." Here, you'll find extended discussions, expert insights, and even more practical advice on navigating the complex tax landscape of Decentralized Autonomous Organizations.

As we continue to explore the complex and ever-evolving landscape of DAO taxation, we invite you to join us in our next installment. In the third part, we will delve even deeper into the intricacies of tax compliance, examining real-world scenarios, challenges, and strategies for DAOs. Stay tuned to gain a comprehensive understanding of how to navigate the tax landscape in the realm of Decentralized Autonomous Organizations.