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Crypto Taxes for Your DAO: PART III. Global DAOs: Tax Strategies and Legal Considerations

By

Leo Henkels

In this third part of “Crypto Taxes for Your DAO” series, Cameron Richard and Adam Miller engage in a thought-provoking discussion on the tax implications of DAOs. They explore the complexities surrounding DAO legal structures, the benefits of non-profit status, and the global nature of DAOs. The conversation delves into practical scenarios, offering insights into tax considerations for DAO members and contributors. Donna joins the discussion, raising important questions about tax responsibilities within DAOs and the treatment of staking rewards.

The Viability of DAOs as Non-Profits

Cameron Richard: “In the U.S., forming a DAO as a non-profit involves certain legal implications, but it's a viable option if the DAO's activities serve the public good. This approach eliminates the problems associated with being a general partnership, like avoiding corporate tax. A DAO structured as a non-profit can raise funds, build its treasury, make grants, and engage in other non-profit activities.”

“For instance, if we were to form a DAO to create a library of free tax resources, as long as it's in service to the public good, it would qualify as a non-profit. This principle applies to non-U.S. based non-profits too, whether it's a foundation in Switzerland, the Cayman Islands, or a non-profit in the Marshall Islands. The key is meeting the criteria of a non-profit in the respective jurisdiction. However, if someone, like an executive director of a non-profit, is receiving a salary or contractor fees, they would still be subject to taxes on that income.”

Flexibility of Non-Profits

Adam Miller: “This leads to an interesting point when discussing DAOs potentially registering as non-profits. Often, a DAO project involves multiple legal entities and smart contracts, and there can be financial gains, like rising token values or profits from liquidity providing. I've heard a metaphor from a lawyer that illustrates the flexibility of non-profits.

Consider professional sports associations like the NHL, NBA, or MLB, which are non-profits, yet there's significant financial activity and profit-making within these structures. The teams themselves are for-profit entities, and their value fluctuates. Despite this, the sports leagues themselves are still considered non-profits. This metaphor suggests a similar flexibility could apply to DAOs structured as non-profits.”

Viability of DAOs as Non-Profits

“Another example that parallels this concept is yacht clubs, which are often non-profit organizations. Yacht clubs can be governed by their members, and despite the fluctuating value of yachts and potential profit from club services, they are still considered non-profits. This seems analogous to DAOs that support or govern a DeFi protocol. The members might be involved with the protocol, but the DAO itself is distinct from the protocol, making a non-profit structure potentially suitable. What do you think about these metaphors in relation to classifying an organization as a non-profit?”

Cameron Richard: “I find these metaphors quite apt. They highlight that entities can exist adjacent to profit-generating activities without necessarily being for-profit themselves. Take the NHL and MLB; they are structured as non-profits but are closely tied to for-profit teams and activities. The key distinction is the overarching goal: while individual teams or entities might seek profit, the overarching organization – like a sports league or a yacht club – aims to support a broader mission or community.

This principle applies to private foundations as well. It's not just about making money but about serving a larger purpose that benefits society or a specific community. This is the essence of a non-profit – an entity that exists beyond the immediate interests of individual stakeholders and is meant to serve a broader, long-term mission. So, applying this to DAOs, if they're focused on governance or direction rather than direct profit-making, a non-profit structure could indeed be appropriate.”

How are DAOs Taxed? Tax Considerations in DAOs

Adam Miller: “Let's explore a hypothetical scenario. Suppose I start a non-profit, say a DAO, with the aim of supporting a specific individual, like Cameron. We raise funds and distribute all of it to him. This seems akin to creating a non-profit for a specific area, like South Central LA, where the goal is to raise money and support the local community.

But what if the beneficiaries, like the people of South Central LA, are involved in governing the non-profit that benefits them? That seems reasonable and shouldn't pose an issue. However, if someone like Cameron is on the board of a non-profit designed to financially benefit him, that could lead to tax implications. How do you view these scenarios, especially in the context of DAOs where the purpose is to support a specific community, and those in the community might also be token holders?”

Cameron Richard: “In the scenario where a non-profit directly benefits a specific individual, like myself, and I'm on the board, it could result in taxable benefits. However, when the non-profit aims to benefit a broader community, project, mission, or structure, and those representing or involved in the community are part of the governance, it's entirely acceptable. They might be indirect beneficiaries, but that's different.

For example, if I'm on the board of a non-profit in South Central LA and I'm compensated for services like accounting or marketing, that compensation is taxable. But activities like raising funds to beautify the area, start community gardens, or advocate for rights at the city council are typical non-profit activities and are usually tax-exempt. So, in the context of DAOs, the key is how the funds are used and the relationship between the governance structure and the beneficiaries.”

Tax Considerations in DAO entities

Adam Miller: “It's important to consider the tax implications in different scenarios. For instance, if a non-profit raises funds and then pays someone in South Central LA for services, that individual must recognize and pay taxes on that income. Similarly, if we distribute money directly to individuals, they too are responsible for taxes on that amount. The IRS still receives taxes, just in a different form.

For example, if a non-profit in South Central LA allocates $10,000 to start a community garden, those who are paid for building fences, supplying equipment, or any other service related to the garden will pay income tax on their earnings. The key point is that while a DAO or non-profit may delay or redistribute tax obligations, ultimately, someone is still responsible for paying taxes on the benefits or compensation they receive.”

Cameron Richard: “Exactly, that's a great way to put it. Even in non-profit scenarios, there are tax implications for those receiving payments or benefits. The structure of a DAO or non-profit may alter the timing or distribution of tax liabilities, but it doesn't eliminate them.”

The Global Nature of DAOs and Legal Entities

Adam Miller: “Let’s shift our focus to the global nature of DAOs and their legal entities. One of the unique aspects of DAOs is their inherent global presence from inception. They often include members from all around the world, collaborating on various projects. This international aspect influences how DAOs consider their legal entity formation. Even if we, for instance, start a DAO in California, its purpose and membership could quickly become global, involving people from various parts of the world in its governance and activities.”

“Considering the global aspirations of most DAOs, there's a pivotal question about where to establish their legal entity. Traditionally, we might opt for a California or Delaware entity for a new business, but with DAOs, the situation is different due to their inherently global nature. Many DAOs, unlike local-focused ones like the Austin Texas DAO or Miami Community Radio, aim for a global presence right from the start. Cameron, from your perspective, what does this global marketplace look like in terms of choosing a jurisdiction for a DAO? And what are the implications when most members don't reside in the same jurisdiction as the DAO's legal entity?”

Tax Implications for Foreign Owners

Cameron Richard: “In the global context of DAOs, forming offshore can be simpler, especially for those operating primarily on-chain, since it avoids certain complexities like needing a bank account and registering with the IRS. For an American involved in a UK entity, for instance, there would be a requirement to file taxes with HMRC. However, being part of an offshore-based DAO simplifies this, as the individual's responsibility is limited to what they receive from the DAO, not the overall activities of the DAO.”

“This approach is advantageous as it reduces the burden on participants, especially when starting from scratch. In contrast, forming a corporation or LLC in the U.S. and later shifting control to an offshore DAO can lead to significant tax events due to the transfer of value. Establishing intellectual property in a tax-advantaged or friendly jurisdiction from the beginning can alleviate many of these concerns. It also shifts the tax burden to the jurisdiction where services are performed or where individuals reside, rather than at the entity level. This can greatly simplify the tax situation for global participants of the DAO.”

“Apologies for the lengthy explanation; these matters can get complicated quickly. To summarize, for a part-owner or member in a foreign company, the tax situation is generally not pass-through. You're taxed only on the money the organization actually pays you. If you're part of a foreign-based DAO or corporation, your tax responsibilities are confined to the profits or payments you receive from it. However, if you're part of a DAO or corporation based in the United States, you could have additional tax filing obligations, especially if it's connected to U.S. trade or business.”

“For those with a multi-jurisdictional team, forming an entity in the U.S. can make tax compliance more challenging. If most of your team is offshore and your operations are primarily conducted on-chain, starting offshore might be more advantageous to reduce the initial compliance burdens. Smaller DAOs, in particular, might find it difficult to comply with complex foreign partnership requirements in certain jurisdictions.”

DAOs Tax Implications

Adam Miller: “So, if I understand correctly, there's an added burden for members of foreign companies, but it depends on the structure and location of the entity?”

Cameron Richard: “Yes, exactly. Let's consider a simple example: If I have an LLC partnership based in the U.S. with partners in Canada and the UK, and we generate a small amount of taxable income, the compliance requirements become complex. We'd have to file withholding taxes with the IRS, and then the foreign partners would need to file foreign non-resident returns to possibly get a refund.

For small organizations, maintaining compliance with these requirements can be daunting. This complexity is why many startups might opt for sole proprietorships or domestic corporations to simplify tax matters. However, when transitioning to an offshore structure or DAO, the original onshore entity's value transfer can create significant tax events. The key is understanding the specific tax requirements and implications for foreign token holders or members in various structures.”

Adam Miller: “You've just highlighted a significant point we often discuss: people outside the United States are generally less inclined to be a member or owner of a U.S.-based corporate entity. One major reason, which I wasn't fully aware of before, is the automatic withholding of income for foreign people until they file with the IRS. This clarifies why many DAOs choose to have at least one entity outside the U.S., as foreign persons are more likely to participate in such structures.”

Cameron Richard: “Precisely. Alternatively, paying a flat 21% corporate tax in the U.S. can avoid the complexities of withholding, but issues arise again with dividends or profit-sharing structures. It's challenging for a foreign shareholder or partner to manage the compliance burdens, wait for refunds, and handle filings, especially for less capitalized entities. This complexity underscores why it's often more feasible for DAOs to operate outside the U.S.”

Adam Miller: “Regarding the reverse scenario, what happens when an American or European, for example, is a member of an entity in the Marshall Islands? While there are no filing requirements in the Marshall Islands, does the IRS or their home jurisdiction require them to report or pay anything due to their ownership or membership in a foreign company?”

Cameron Richard: “That's a great question. For an American who is a member of a Marshall Islands-based entity, they're taxed only on income they actually receive or earn in the States. This might include payouts for services or other forms of compensation. Additionally, there could be compliance requirements like reporting to the Financial Crimes Enforcement Network (FinCEN) for foreign accounts holding over $10,000.

However, tax liabilities arise only upon receipt of payment or earnings from the overseas corporation. An important caveat is if the foreign entity is more than 50% American-owned, it could potentially be viewed as a controlled foreign corporation, leading to different tax considerations.”

Adam Miller: “Regarding the 50% American ownership threshold, it seems that if it's less than half-owned by Americans, it won't be treated as a foreign-controlled corporation. But what about LLCs? Is the situation the same for them? Let's discuss the Mida DAO LLC, which operates as a for-profit entity in the Marshall Islands. It's subject to a 3% gross revenue tax, excluding dividends and capital gains. What are the tax implications for a foreign owner or member of such an LLC?”

Cameron Richard: “If an LLC is more than 50% American-owned, it could potentially be treated as a controlled foreign corporation, requiring the filing of Form 1120-F, which is the foreign corporation tax return in the U.S. This applies to income effectively connected with U.S. trade or business.

For instance, if an American, living abroad, owns part of a Marshall Islands-based DAO and isn't selling services to U.S. customers or engaging in business activities in the States, they might not have U.S. income tax liability. However, filing returns could be necessary depending on specific controlled foreign corporation (CFC) rules. The tax situation depends on where the income is generated and the nature of the activities involved. This can get complicated, especially when considering the dynamics of digital assets and wallet addresses in determining tax jurisdiction.”

determining tax jurisdiction

Adam Miller: “Indeed, it sounds like navigating these tax implications can be quite complex, especially with the evolving nature of digital assets and international business structures.

Now, I'd like to invite Donna to join our discussion. She interacts frequently with lawyers, tax advisors, and DAOs, and is familiar with some of the more complex questions that arise. Donna, what's on your mind regarding these topics?”

Donna: “Thanks, guys. This has been a really thought-provoking discussion. I often speak with 30 to 60 DAOs weekly about incorporation. They ask great questions, but one area of concern I've noticed is the lack of clarity about a DAO's legal structure. For instance, I'm a member of Bankless DAO, which has over a thousand members, and often, it's not clear whom to approach for specific legal queries.

My question is about the responsibility and awareness of members or contributors when they join a DAO, especially considering Americans' obligation to worldwide income tax. Should people be asking about the DAO's legal structure and their tax responsibilities right from the start?”

Staking and Taxation

Cameron Richard: “Definitely, these are crucial questions to ask, especially for those significantly involved or receiving tokens. For a general member or minor token holder, personal obligations may not be extensive. However, those receiving staking rewards, participating in yield farming, or receiving capital gains have more individualized tax responsibilities.

The same applies to those compensated in tokens for services. The key is understanding one's stake in the DAO, whether as a shareholder, equity holder, or active contributor. These details dictate the level of responsibility and potential tax obligations. It's vital for participants, particularly those more deeply involved, to inquire about the DAO's structure and their role in it to fully understand their tax liabilities.”

Donna: “That's really helpful information. My next question, if we have time, is about how staking is treated from a tax standpoint. I interact with many DeFi protocols, which often aren't legally structured because they're open-source. Then there's the DAO that manages the treasury and governance, issuing staking rewards and similar incentives. How should this be approached tax-wise for a significant contributor in a DAO? And if this veers too close to specific tax advice, we can table it.”

Cameron Richard: “It's important to note that what I'm sharing is not formal tax advice and everyone should do their research. Regarding staking, there's a lot of debate, and the IRS's current stance is that when you receive something of value in your wallet, like staking rewards, it's considered income. This interpretation suggests such rewards should be treated as ordinary income.

However, the reality is more nuanced. Many in the field, myself included, and some tax attorneys, argue that until the tokens received from staking or similar activities are sold, they shouldn't be considered taxable income. This perspective aligns with some recent cases where money itself is argued as non-taxable until realized. The stance on staking, yield farming, and liquidity pool rewards is still evolving, and until there's clear legislation from Congress, the IRS's position remains advisory. This means if your tax return is audited, and it goes to tax court, the IRS will argue based on their current guidance, and you'll need to be prepared to defend your position.”

“Addressing tax courts, the IRS's position is advisory, and going against it can lead to legal challenges. It's a frustrating area for many, including myself, as the answers aren't always clear-cut. For example, consider staking scenarios where rewards are received and restaked without being converted to fiat or stablecoins. The IRS had a case – the Jarrett case – where they opted to dismiss it, essentially deciding to address the issue later.”

“When it comes to derivatives like liquid staking, where you don't directly receive the token, it strengthens the argument that it might not be ordinary income. The approach to staking isn't black and white, and there are strategies to defend different positions. On a personal level, many of my clients and I tend to treat staking rewards as capital gains, believing it to be a fair stance. However, this is a matter of individual preference and risk tolerance, especially considering potential IRS scrutiny.”

Adam Miller: “It's indeed a complex and evolving area. Interestingly, I met someone at ETH Denver who claimed to be from the IRS, which was quite an eye-opener.”

Tax Considerations for DAO LLCs

Adam Miller: “Let's delve a bit deeper into the staking question. From the perspective of a DAO LLC or a corporate entity providing staking rewards, either from a governed protocol or directly from its treasury, how should this be considered from a tax standpoint?”

Cameron Richard: “The tax implications depend on the structure of the DAO. For a for-profit DAO, providing staking rewards might be analogous to a stock split or dividend. These aren’t typically deductible expenses for the corporation. In contrast, a non-profit DAO issuing more staking rewards would view these as non-deductible but logical expenses in line with its non-profit objectives.

The challenge arises if the IRS classifies these rewards as income for the individual. If so, it could then be a deductible expense for the issuing entity. The situation is complex, and the tax treatment might differ depending on whether the rewards are considered income or a non-taxable event like a stock split.”

Adam Miller: “That's insightful. As we're nearing the end of our podcast, Cameron, I want to thank you for this incredibly deep dive into the world of DAOs and taxation.”

Summing Up

If you're looking to deepen your understanding and keep up with the latest developments in DAO taxation, we invite you to join us on our podcast, "Just DAO It." Here, we offer more detailed insights and expert tips.

In conclusion, the discussion has shed light on the intricate dynamics of tax considerations within the world of DAOs. The evolving nature of these tax matters emphasizes the need for individuals involved in DAOs to seek personalized tax advice. Understanding one's role within a DAO and staying informed about the ever-changing tax landscape is essential for navigating this complex terrain.