Guide to DAO Taxes in 2023

DAO stands for “Decentralized Autonomous Organization.” A DAO is an entity whose decisions and rules are not enforced by a central authority but rather by smart contracts. We can think of DAOs in crypto as a kind of blockchain co-op. Members hold governance tokens or NFTs that give them the ability to propose and vote on DAO initiatives. 

There has been a rapid growth in the number of DAOs. These range from financial projects to social communities (Friends with Benefits) to geographically oriented organizations (ATX DAO). Amidst this boom of DAOs, the IRS has still not provided clear guidance about how DAO taxes work, so DAO taxes remain an area of speculation.

Decentralized autonomous organizations, or DAOs, pose a problem for the IRS: how do you tax an entity that is, by definition, decentralized? With no fixed address or owner, how does the agency determine where a DAO is taxed and who is liable for its crypto taxes? How can the IRS account for income or governance tokens from such an organization?

At time of writing, two things are certain:

• Direct crypto payments from DAOs for goods or services are taxed as income.

• Profits from the sale of governance tokens are subject to crypto capital gains tax.

However, although there is a reasonable case to be made for DAOs being taxable entities themselves, it has not yet been determined how or where those taxes would be levied. Nevertheless, the possibility of DAOs’ profits being taxed at an entity level is a real one, especially as they become more widespread and popular. 

As crypto tax law specialist David J. Shakow notes, the criteria for being a taxable entity have little to do with local classification as a business. Rather, entities are considered taxable when partners agree to work together and divide their profits. 

DAOs in crypto pretty clearly fit this definition, as participants in a DAO collectively agree to the smart contracts that govern it and in return might receive a share of its income. This situation could reasonably be interpreted by tax agencies as constituting a taxable entity. 

There exists legal precedent for this in the United States. In 2017, when considering the governance token for “The Dao” project, the SEC ruled that the tokens were offered by a ”virtual organization” and therefore subject to securities law.

Furthermore, following President Biden's 2022 crypto executive order, SEC Chair Gary Gensler made remarks suggesting that most crypto tokens fit the criteria of securities and should be classified as such. In June of 2023 the SEC filed lawsuits against Binance and Coinbase declaring numerous cryptos (including Cardano, Solano, and Binance Coin) to be securities.

That noted, there is still no clear method to report crypto taxes on entity-level profits DAOs in crypto make through fees, investment strategies, or other means. 

If a DAO sends you crypto in exchange for goods or services, those assets are taxed as income in the country and state in which the sale was made or the work was performed. 

For example, if a social DAO pays a graphic designer in crypto, they will need to claim those funds as income subject to tax in the region where they performed the work. If this crypto later appreciates and is sold, any realized profit will also be subject to capital gains tax.

International taxpayers will benefit from our helpful country guides for further crypto tax guidance in regions outside the United States.

If you receive governance tokens or NFTs as part of a DAO’s launch or as an incentive or reward, you likely need to report them on your crypto taxes as ordinary income. 

Additionally, if you sell those governance tokens or NFTs, any profit would be subject to crypto capital gains tax.

No one is certain how DAOs in crypto will be taxed going forward, particularly when it comes to identifying who is liable for the entity’s taxes and where those taxes would be levied. Is everyone with a wallet, or sub-address, liable for a share of the entity’s tax burden? If the DAO has participants from across the globe, is the DAO liable to be taxed by dozens of countries?

Some speculate that in the US, pass-through entity tax may serve as a model for any future entity-level DAO tax. A pass-through entity doesn’t generally pay federal taxes at the entity level. Instead, its owners and/or members file 1040s and pay individual income taxes on their share of any profits. Pass-through entities include partnerships (including some limited liability companies ) and S-corporations.

Although DAOs in crypto do not necessarily have the expectation of profit, if the IRS comes to treat them as pass-through entities for tax purposes, members will need to report their share of the DAO’s earnings from fees, investments, etc. on their personal income tax returns, regardless of whether or not that income had been distributed to them.

DAOs as legal entities

As a general rule, establishing a legal entity provides a foundation for operations, liability protection, and tax obligations. In contrast, entities without legal status, whether labeled as DAOs, companies, or communes, face the legal classification of a general partnership, which results in a number of issues.

Firstly, individuals in a general partnership bear personal liability for the organization's actions, leaving them vulnerable to lawsuits and financial repercussions. Secondly, lacking corporate personhood hinders a partnership's ability to engage in essential activities like signing contracts or owning property. Additionally, tax obligations fall on individual partners, a reality often overlooked by many DAOs. 

DAOs have new legal options in 2023. Various jurisdictions, including Wyoming, Tennessee, and the Republic of the Marshall Islands, now offer specialized legal entities like DAO LLCs, designed to cater to the unique needs of DAOs. Some DAOs have also chosen to incorporate as Limited Cooperative Associations or Unincorporated Nonprofit Associations in Colorado or have established foundations offshore. 

The incorporation of DAOs in these jurisdictions not only grants legal recognition but also provides access to banking services, shields members from personal liability, and helps to ensure tax compliance.

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Here are answers to frequently asked questions about DAO taxes and DAOs in crypto.

Do you pay taxes on decentralized crypto?

Yes, decentralized crypto is typically taxed like crypto purchased through centralized exchanges. Some countries have more favorable crypto tax laws than others, and DeFi gas fees can sometimes be tax deductible and included in your cost basis.

How do DAO owners make money?

Crypto DAO owners make money through a variety of methods. Often, they earn income by issuing governance tokens. These tokens can be purchased or distributed among members who actively contribute to the DAO.

Staking and yield farming opportunities also allow DAO owners to lock tokens and receive rewards. Some DAOs also generate revenue from various activities, and owners may receive dividends or a share of profits.

Can a DAO be taxed?

In a sense, yes. While the IRS has not provided clear guidance on entity-level taxation for DAOs, individual participants are currently responsible for reporting their share of earnings on personal income tax returns.

What does DAO stand for?

DAO stands for “Decentralized Autonomous Organization.” A DAO is an entity that enforces decisions and rules through smart contracts rather than a central authority. Participants hold governance tokens or NFTs to collectively shape and vote on DAO initiatives.

What is the full form of DAO in tax?

Tax regulations and guidance for DAOs are still evolving, posing challenges in determining how they are taxed and where tax liabilities are attributed. Currently, the IRS has not provided clear guidelines on the tax treatment of DAOs. When in doubt, consult a crypto tax professional for guidance.

What is the difference between a DAO and an LLC?

The primary distinction between a DAO (Decentralized Autonomous Organization) and an LLC (Limited Liability Company) lies in their structural and governance frameworks. A DAO operates on a decentralized blockchain, utilizing smart contracts and consensus mechanisms for decision-making. In this context, participants hold tokens representing voting and decision-making authority, and the enforcement of rules is carried out through smart contracts. Conversely, an LLC adheres to a traditional legal entity model, featuring a centralized structure governed by members or managers following legal regulations.

The governance dynamics further differentiate the two entities. In a DAO, token holders make decisions collectively through voting, and smart contracts autonomously enforce the rules. This underscores the decentralized nature of DAOs, with no central authority or ownership. On the other hand, an LLC's governance is typically defined by an operating agreement, with decisions made by members or managers, adhering to established legal and regulatory frameworks. The centralization aspect of an LLC is reflected in its structured ownership and management roles.

What is an example of a DAO?

An example of a DAO is "The DAO," which gained prominence in 2016. It was a decentralized crowdfunding project on the Ethereum blockchain, aiming to create a venture capital fund governed by the token holders. Participants could purchase DAO tokens, granting them voting rights on investment proposals.

However, bad actors exploited a vulnerability in the smart contract code, leading to a significant hack and subsequent controversial hard fork in the Ethereum blockchain. While The DAO itself faced challenges, it serves as a historical example of a decentralized autonomous organization.

What is DAO in law?

In legal terms, DAO stands for "Decentralized Autonomous Organization." It represents a novel approach to organizational structure, where decision-making and rule enforcement rely on smart contracts and consensus mechanisms rather than a central authority.

Legally, DAOs pose challenges, as traditional legal frameworks may not easily accommodate decentralized entities. The lack of a central governing body and the reliance on blockchain technology creates unique considerations for legal interpretation and compliance. As the legal landscape evolves, various jurisdictions are exploring and adapting their regulations to address the complexities associated with DAOs.