Following my last thread on this subject, several of you have asked me to walk through an example of what a "good" DAO might look like and what the tax consequences would be.
I was early to publicly explore the concern that many DAOs may be tax entities. But now Iâm seeing lots of tax people simply assume all DAOs are tax entities without engaging with the tech or the law or offering counterarguments.
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FACTS. Let's use a hypothetical DAO, CTGdao, which governs a DeFi protocol and follows my 6 guidelines from part 1:
- a. Preprogrammed. CTGdao gov tokens inflate at a constant rate. Inflation goes to the DAO's treasury.
- b. Wide token distribution. Self-explanatory.
c. No JV talk. CTGdao didn't take my suggestion of avoiding "DAO" nomenclature, but otherwise doesn't call itself a JV.
d. No active business. CTGdao does ONLY TWO THINGS:
i. Makes no-strings grants of treasury tokens.
ii. Votes up/down on self-executing scripts.
e. No treasury diversification. CTGdao's treasury includes only inflationary $CTG.
For fun, though, let's also assume Gary has proposed a self-executing script that, if passed, would divert some protocol fees to $CTG.
f. Keep founder ownership small. Self-explanatory.
CONSEQUENCES PRE-FEES. US taxpayers should have capital gain/loss when they swap into or out of $CTG. The IRS doesn't get to tax treasury inflation, bc $CTG was pregnant with it from day 1. (See Part 1.)
Under this approach, US tokenholders are taxed at ordinary rates on the value of those streamed fees when credited to their accounts, just like with aTokens or stETH.
So, no current taxation other than on streamed fees. None of the above should be controversial.
Apparently, though, at least 1 tax lawyer thought my conclusion that CTGdao âis not an entityâ was controversial. (I believe he used the term "fking moron.")
I don't know that lawyer. If he spent more time reading up on crypto tax instead of denigrating fellow tax pros, he'd know I've separately considered what happens if a DeFi protocol DAO is a tax entity.
Basically, it gets you to the same tax result. Letâs dig in to see why!
Start from the premise that CTGdao is a tax entity. The next relevant question is:
DOMESTIC OR FOREIGN?
Entities are domestic if they are created or organized in or under the laws of the United States or any state. Otherwise they're foreign.
Saying CTGdao is created or organized in the US just because US devs coded or deployed the relevant smart contracts would be tantamount to saying a Swiss GmbH is domestic if a US lawyer drafted and e-filed its org docs.
So CTGdao is foreign. The next q is:
PARTNERSHIP OR CORP?
Under the tax code's publicly traded partnership rules, an entity that would otherwise be a partnership is treated as a corp if (i) its interests are regularly tradable and (ii) >10% of its income is active.
CTGdao earns fees from a DeFi protocol. Fees are active under the PTP rules bc they donât fall into any statutorily enumerated passive categories. So CTGdao is a corp under the PTP rules.
Now that we know CTGdao is a foreign corp for US tax purposes, we can ask whether it owes US tax.
Foreign corps owe US tax if they have a US trade or business (USTB). A US agent's actions can be imputed to foreigners, but shareholder governance isn't a USTB.
Per guideline (d), CTGdao only (i) makes grants and (ii) votes on self-executing code. Making grants is just giving away treasury stock. Democratic voting is just shareholder management. Neither is a USTB.
Under my hypothetical, Gary proposed a self-executing script that would divert protocol fees to $CTG. What if Gary is in the US, or the protocol itself (which generates the fees) was coded or deployed from in the US? Could US dev activity cause CTGdao to have a USTB?
I think not. Neither Gary nor the protocol devs acted at the direction of, or otherwise on behalf of, CTGdao. They wrote code without CTGdao's direction, and $CTG holders later used/deployed that code. The devs' actions shouldn't be imputed to CTGdao or its members.
To recap, if CTGdao is a tax entity, itâs a foreign corp that isnât subject to US tax.
Swapping in/out of stock generally is capital gain/loss. Dividends from a foreign corp (i.e., fees streamed to $CTG holders if Gary's proposal passes) are ordinary income. So, weâve gotten to the same US tax result as if CTGdao wasn't an entity.
There are actually two loose ends still to discuss: the anti-deferral rules (also known as the passive foreign investment company or PFIC rules), and BORGs.
ANTI-DEFERRAL. If a foreign corp is a PFIC, US holders are subject to penalties when they sell, unless they elect to be taxed on its income on a pass-through basis. The idea is to prevent Americans from trading through foreign corps and avoiding current taxable gain.
PFICs are foreign corporations with too much foreign personal holding company income (FPHCI). FPHCI includes interest, dividends, & gain. But it doesn't include gain from âdealerâ txns (i.e., regularly buying from or selling to customers in the ordinary course of a biz).
Are US $CTG holders subject to the PFIC rules? Probably not. While I didnât say what the CTG protocol does, most DeFi protocols probably wouldnât be PFICs. To the extent they have gain from sales (e.g., AMMs and LST protocols), that gain likely is from dealer txns.
Meanwhile, L2 and lending protocols donât earn much if any gain from sales, but rather earn fees for performing a service. Service fees aren't FPHCI.
If US $CTG holders were still concerned about the PFIC rules, they could avoid them by electing pass-through tax. Under my facts, fees are streamed to them currently, so there's no mismatch between their tax and their cashflows.
This all begs an interesting question: Could CTGdao ignore my "no treasury diversification" guideline and accrue fees into its treasury instead of streaming them out currently, so that US holders aren't taxed until a sale (and then only at cap gains rates)?
Frankly, I don't have a good answer to this one. If CTGdao is a foreign corp that is not subject to US tax and isn't a PFIC, it should be able to accrue fees without anyone being taxed on them. That's in fact how cTokens, rETH, and wstETH work.
But let's be realists. The IRS is more likely to try to find a taxpayer-unfavorable recharacterization in that scenario. Maybe tax on a current fee stream is a fair price to pay to minimize government scrutiny.
BORGs. Guideline (d) prohibits an active business to strengthen the âno entityâ argument and avoid US tax nexus. That means CTGdao can, e.g., make token grants to devs but canât contract with them. The grants are no-strings-attached. Can we do better than that?
Well, CTGdao canât, but a BORG can. For instance, community members can form a nonstock Cayman foundation whose org docs require it to support the CTG ecosystem. CTGdao can grant tokens to the foundation on a recurring basis.
Under this approach, CTGdao doesnât control the foundation. (If it did, $CTG would be treated, at least in part, as stock in a PFIC, which could be problematic for US holders.) But the foundation is DAO-adjacent and DAO-funded.
Other potential BORG uses include:
- Governance. Hold a qualified veto right over governance proposals, exercisable only if the proposal results in a governance attack.
- Community management. Host/run website and governance portal.
- Security. Pause protocol if hacked.
BORGs need to be constructed carefully to keep them DAO-adjacent instead of DAO-owned while ensuring they donât present attack vectors. I predict âBORG counselâ will be a real thing in cryptolaw in the not-too-distant future.
CONCLUSION. As I warned in Part 1, not all DAOs are the same, and some are just investment vehicles that probably should be wrapped in a legal entity. But many big protocol DAOs either are not legal entities or, at least, arenât subject to entity-level tax.