Taxation of DAOs may not be what you think it is!

Photo by Scott Graham on Unsplash

Let me preface this by saying I do not intend to attack DAOs, or manipulate the markets through FUD, or alarm people. I do intend for you, the reader, to think! As such, I will not name projects, though I am writing this thinking of several.

Let me also preface this by saying I am not an enrolled agent, CPA, or tax lawyer. This is not tax advice. It is my best interpretation of US tax law, as a layman who perversely enjoys studying it. If you have a question after reading this, I am not the one to ask.

What is a partnership?

To quote the IRS:

Note that this definition (like many tax definitions) is a classification, not a selection. That is, whether or not a given operation calls itself a partnership, or files any legal papers to that effect, is irrelevant, it need merely fall under the definition to be one. If you and I decide to mow lawns together, that is a partnership, even if we do not open a bank account or register a trade name.

Suppose you and I do open a lawn mowing partnership, we agree to split the profits evenly and after expenses we have a profit of $1,000! (It’s a rich neighborhood.) You withdraw $100 from the business bank account, and I withdraw $200. How are we taxed?

Answer: We both get $500 of self-employment income. This translates to $71 of actual self-employment tax. Most of this also gets added to our income for the standard income taxes. The partnership itself pays nothing. This is called pass-through taxation.

But note: how or if we withdrew anything from the business account has nothing to do with how taxation passes through. To quote the IRS again:

What is a DAO? Much virtual ink has been spilled, but it sure does look like partnership. After all, it’s multiple people, contributing capital or skills (in the form of governance) to the operation. More particularly, I can’t see how they wouldn’t be classified under partnership, on the basis that they are clearly a multiple person business and definitely not a corporation. Just because a DAO does not register as a legal entity does not mean it is not one.

Most DAOs on Ethereum do not directly distribute earnings due to gas constraints. Such DAOs either buy back and burn tokens, offer earnings to “stakers”, or voters, or any number of other ingenious mechanisms.

But remember: distributions do not determine the shares of profits and losses.

How is profit and loss shared? By default, if the partnership hasn’t come to an operating agreement, proportional to the ownership. So thereby if you own 1% of the DAO’s tokens, you receive (and owe taxes on) 1% of the DAO’s income.

It doesn’t matter if you actually got 1% of the DAO’s income in actual crypto in your wallet. You get the income (and incur the tax liability) simply by holding the tokens. The mechanism doesn’t matter — your equity does.

Fair? Let’s consider the alternative hypothesis.

Suppose the IRS decided that, no, DAOs are totally not partnerships, and everything’s fine. Suppose DAOs really are a black hole of taxable income, and taxes are not owed on any payments made to a DAO.

Then all you need to dodge income tax is to have a DAO. Hire the DAO out to your employer and don’t distribute the profits unless you absolutely have to. But better yet, why not form a DAO with the other workers, and buy-back-and-burn tokens? Then since you never have a distribution, either, you pay only capital gains when you sell the tokens.

But why stop there? Large businesses could convert to a DAO and pay no corporate income taxes. After all, if it works for small businesses, it works for large ones, too.

In fact, what would happen is that this loophole would be so colossal that it would break the income tax system altogether.

At which point, doubtlessly, the Congress will pass a law to make DAOs officially partnerships, and we return to where we started.

There are four questions I suspect I’ll hear. First, is the sky falling?

Probably not. A quick back-of-the-envelope calculation shows that even the largest DAOs have a income-per-token ratio so slow this matters only to whales. (But it very much does matter to whales.)

But as of this writing, no tax agency has acted. Does that mean they won’t ever act?

Hardly. During the ICO craze, all those who claimed the SEC would crack down on what were clearly violations of security law were mocked and ignored. They were ultimately right.

Ask yourself the following question: Will the IRS, seeing all the YOLOic majesty and high-speed glory that is DeFi, be struck with such awe and wonder that it will consider a DAO to be not taxable in any way, and especially not pass-through taxation like any other partnership?

If the answer is “no” then the sky will fall. Just not, perhaps, today.

Second, is it not true that tax law is different across the world? After all, I have written this as if America is the only nation.

Yes, every nation has different laws. Which makes this even more of a nightmare.

Where is a DAO domiciled? In the country of the creator? Wherever it has members? The IRS has jurisdiction over both money made in America and money made by Americans. Any large DAO will almost certainly have both, and will also by similar laws in other countries get dragged into every nation’s tax laws.

I don’t think any mortal could disentangle that mess.

Third: Isn’t this going to be complex to figure it out?

The good news is, all of a DAO’s transactions are on the blockchain. Any sufficiently tech-savvy accountant could reconstruct who owes what, given enough time and possibly computer power.

The bad news is, this is supposed to someone else’s responsibility to begin with, and that person isn’t doing it (or this article would not exist). Any partnership meeting certain very very low guidelines legally must file a Form 1065 (a form of tax return for partnerships) and send a Schedule K-1 to all partners. Who is this person responsible? One of the partners. To actually do this would be a logistical nightmare — but it is nonetheless legally mandated.

“But why don’t corporations have to put up with this?”

The fourth question touches on an important point. Corporations don’t pass through profits and loss, so if you hold a share of TSLA or AMZN, you don’t have to worry about it. You also don’t have to worry about share buy-backs. Dividends are taxable, but at least you (should) get a form about it.

However, there are two reasons this is of no use to DAOs.

The first is that a corporation pays corporate income tax, which no DAO whatsoever does right now. If a DAO wanted to avoid the above nightmare, it would have to become a corporation and indeed pay corporate income tax.

Which is the second reason: you cannot pretend your way into corporate personhood. You have actually file papers to create an official, registered business entity.

DAOs exist in a weird limbo right now. If they grow big enough, one day the IRS and all the world’s tax authorities will inevitably react, as the SEC eventually caught on to the ICO craze. I don’t know when that day will be, and I don’t know what will happen on it.

But you, dear reader, can research this for yourself. All the above information was found on the IRS’s own website, and if that doesn’t help you can find any number of articles on the internet on how partnerships work.

I plead with you: do the research. Investigate this for yourself. Don’t let complacency and the false security of governmental inaction delude you. Don’t file this away in your brain under FUD.

Find out.

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