How to navigate tax and legal complexity associated with DAOs

In the absence of tax and legal certainty, DAO participants often adopt a pragmatic approach, Lukacs explains, using existing parallels within the wider digital economy as well as further afield to manage risk as best they can.

“As with any emerging technology, commercial DAO use cases have far outpaced tax policy and legislation,” Lukacs says. “DAOs don’t fit neatly into any existing guidelines. So, what the industry has been forced to do, both in the tax and legal sense, is to work by analogy, ensuring DAO governance token holders are in the best position possible to maintain levels of innovation, while mitigating tax exposure in the most manageable way. “

The importance of case-by-case DAO risk mitigation

The ever-increasing range of DAO use cases, each with their own underlying assets and legal and tax considerations, means there is no single templated approach to risk mitigation. For example, some of the most successful DAO use cases include:

• Cryptocurrency exchanges – the largest example has approximately 300,000 token-holding members.
• Metaverse platforms which are governed by DAOs.
• Software development communities, which include developers from across the globe, working simultaneously on coding projects.
• Non-fungible tokens (NFTs) art collectives – collaborating on NFT drops, often for major international brands.
• Decentralized investment funds, which enable anyone to buy a stake in Web3 and decentralized finance (DeFi) start-ups and initiatives. Token holders vote on how capital is spread across projects supported by the fund.

While no internationally recognized tax and legal approach to DAOs exists yet, unilateral steps are being taken by some jurisdictions – a move which Dennis Post, EY Global Blockchain Tax Leader, and Anya Vvedenskaya Tax Manager at Ernst & Young Belastingadviseurs LLP, say can provide DAO participants with a valuable insight into how a jurisdiction’s tax approach may evolve.

For example, in 2017, the US Securities and Exchange Commission (SEC) decided that DAO governance tokens would be treated as securities and would be subject to securities law within the US.¹ This raised the prospect of DAO participants being held legally liable for the actions of the wider DAO. In a recent 2023 case, the US court stated that the unregistered DAOs may be held legally liable for their actions.

“We’re seeing examples of this in case law,” Post points out. “It implies governance token holders should always be aware of their DAO’s activities. If they’re not, and the DAO votes to do something illegal, they may be liable, whether they voted in favor or not. We’ve already seen DAOs move out of the US for this reason.”

In an attempt to create an environment that’s more DAO friendly, some US states (including Vermont, Wyoming and Tennessee) recently allowed DAOs to register as legal entities, giving them the option to act in a form of customized limited liability company, like DAOLLC.² These LLCs are shaped to better embed DAO’s features, so these companies can benefit from associated legal protections and tax certainty. Other jurisdictions that also legally allow a DAO’s registration include Switzerland, the Cayman Islands, Hong Kong, Panama, Bulgaria and the Marshall Islands.

Establishing the legal status of DAOs is essential

According to Post and Vvedenskaya, this ability to define the legal status of a DAO is the essential first step in the process toward determining tax treatment. “It’s a case of deciding what the DAO is legally and then being able to figure out the tax implications on a case-by-case basis, because ultimately all DAOs are different,” Vvedenskaya says.

“Under certain circumstances, the legal frameworks that are emerging define DAOs as a legal partnership, which is a great starting point. In other circumstances they may be considered a legal entity, which has specific rights and obligations as well as protections for legal liability purposes toward the token holders,” she adds.

Country-specific regulation is only a partial solution, however, due to the fact that DAOs routinely include participants from all over the world. A solution to this complexity could eventually come in the form of an Web3 regulation initiative by the Organisation for Economic Cooperation and Development (OECD), suggests Silvan Guler, Digital Tax Leader Switzerland at Ernst & Young AG.

“An internationally agreed approach on tax and regulation through the OECD would increase confidence considerably,” he says, noting the OECD recently produced its framework for cryptocurrency reporting. “It’s entirely possible that DAO regulation could feature as an addendum to future iterations of this framework.”

Navigating the intersection between the blockchain and brick-and-mortar worlds

Without this legal clarity, governance token holders can find even the most straightforward interactions with the physical, non-blockchain world impossible. For example, many commercially focused DAOs may to be subject to sales or business income tax. Without an established legal status for DAOs, however, holders are unable to register as a business or open a bank account, which can make filing a tax return by a DAO impossible.

DAOs become most problematic at this intersection between the physical and virtual worlds. Post says few administrations (if any) are willing to accept payment in digital assets, for example, let alone allow a DAO protocol to collect tax receipts from digital-asset activity and forward those receipts to a tax administration. “So, it’s likely to be difficult for both taxpayers and authorities to determine whether individuals and entities have properly self-reported taxable income,” he says.

Without an internationally agreed-upon legal approach to DAOs, a steadily growing patchwork of country-specific legislation is emerging. This increases the level of complexity faced by DAO participants, with legal status open to various interpretations by courts, creating mismatches and potential double taxation, tax risks and liabilities.

Identifying DAO taxable events

For DAO participants to make the best possible calculation of tax exposure it is first necessary to identify the key taxable events within the DAO value proposition. For example:

• Commercial DAOs often begin their existence with a transfer of tokens from a conventional corporate entity, which established the DAO’s core protocol. This increasingly popular process is known as an “exit to DAO” strategy.
• A DAO and its members may decide to fund the community’s development and hedge against volatility by selling its native governance tokens.
• Depending on the type of DAO, it may realize income or returns from its activities. For example, investment DAOs often see gains or losses on their portfolio, collector DAOs may see the value of their art or NFT holdings appreciate, and DAOs that participate in staking may be deemed to receive income.
• DAOs – and particularly protocol-development DAOs – often establish grant programs to fund teams supporting the general protocol infrastructure. Some even do so as their sole reason for existence.

Calculating the tax liability of holding DAO governance tokens in the same way as any other digital asset and an underlying asset connected to this token for income tax purposes can be a useful default starting position, but may be risky at the same time. Any capital gains and losses may be taxable as well as any income generated by the governance token, for example by sharing DAO profits.

However, as the list above shows, this starting position becomes more complex when an individual earns additional governance tokens, for example in return for improving a DAO’s code. This could be taxed as income resulting from business and or entrepreneurial activity, or as a form of in-kind salary.³

The taxation of governance tokens can also depend on how funds in the DAO treasury are used. A DAO treasury is the total sum of assets the DAO may use at its own discretion. It excludes DAO-managed assets owned by another party, such as staking accounts and reward fees.

If treasury funds are invested and generate taxable income, or if funds are used in crypto staking, mining or lending, token holders may not even know that these potentially taxable events are taking place, let alone be reporting them for tax purposes. These examples once again reiterate the fact that there is no templated approach to DAO tax risk mitigation, with each requiring case-by-case analysis.

Legal wrappers and why DAOs may need to relinquish a level of decentralization

One way to achieve a basic level of legal and tax certainty is to register a legal entity, or legal wrapper, over the DAO structure. A legal wrapper inevitably leads to a degree of centralization, but it also introduces accountability, clarifies tax and reporting obligations for DAO members and the DAO and can improve regulatory compliance.

“I think that in order for DAOs to evolve and achieve wider adoption it will be necessary to accept a certain level of centralization,” says Lukacs. “At the moment DAOs are being championed by evangelists willing to push the envelope; they want to be the first movers and they are willing to live with the risk. This situation is manageable, but it’s not for the faint-hearted.”

Post agrees. He says the DAO model was created by Web3 innovators who believed that organizations can live fully on blockchain. The reality, however, is that all commercial entities ultimately need to interact with the physical world, and that includes paying taxes.