Welcome to the unknown.
DAO
First of all, DAO stands for a Decentralized Autonomous Organization. It is a structure that allows stakeholders to make governing decisions over a protocol such as a Digital Token without the need for a centralized authority. This protocol can be used to fund and operate a for profit business.
In essence, instead of a small Board of Directors in a corporate format or a manager in a LLC format making decisions about the company, DAOs enable the community of token holders to vote on the future of the protocol.
Right now, Wyoming leads the way on recognizing DAO’s as LLC’s under a filing process called a DAO LLC. This is important because it protects the token holders from liability much the same as a regular LLC does. Without this LLC format the token holders bear the brunt of a legal proceeding. Other counties such as Switzerland and the Cayman Islands have similar versions of this structure.
Taxation
Ok, here is the tricky part that tax professionals and the IRS are trying to reconcile as they deal with this new entity format.
Let us take the case of a DAO created without the benefit of a legal structure in the US or elsewhere. The natural default position from the IRS viewpoint would be more than likely that the net earnings of the protocol, whether or not distributed, would be taxed as a partnership interest. That is simplifying things a bit but the net earnings would pass through to the token holders as if they were partners. How that gets administered is anyone’s guess and it would seem that the protocol would need to hold back on decentralizing a part of the operation so that some compliance administration would be possible.
In the case of a DAO created as a DAO LLC, the LLC would have certain reporting options as an LLC. It could be taxed as a C Corporation or a Partnership depending on the election made. See https://acullytax.com/startup-tip-entity-selection-and-some-tax-implications
Under the C Corporation structure it would be taxed at 21% and the token holders would be taxed on the value of any form of distribution to them at their respective rates. The token holders would report a capital gain or loss on the sale or transference of their interest much the same as any cryptocurrency.
Under a partnership structure the partnership income will be taxed at the token holder level as mentioned above.
And then there is more . . .
If the concept of a DAO is tough to grasp and the taxation issue even tougher. Let’s look at the special compliance issues by example.
Let’s say there is a C Corporation structure elected for a DAO LLC formed in the US. However, >25% of the tokens are held by a foreign individual or entity. There then needs to be a Form 5472 filed to report that ownership and in the digital environment how are the details of the token holder going to make it onto this tax form. I bring up the Form 5472 because of the $25,000 automatic penalty for non compliance.
A similar situation exists where >10% US stakeholders in foreign enterprises are required to file a Form 5471 and test the taxes paid abroad comply with IRS rules. Who is going to file this and where will the information come from to avoid the $10,000 non compliance penalty.
Under the new BOI rules struck by the US Department of Treasury >20% owners the LLC must report their holding along with a abundance of personal information about their beneficial interest in the LLC.
Then there comes to the mechanics of withholding and reporting of payments to foreign stakeholders as well as US holders.
As you can see the digitized world meets the real world and compliance will require a second look at this emerging area.
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