Decentralized autonomous organizations, or DAOs, pose a problem for tax agencies: how do you tax an entity that is, by definition, decentralized? With no fixed address or owner, how does one determine where a DAO is taxed and who is liable for its crypto taxes? How does one account for income or governance tokens from such an organization?
The crypto tax community has been asking such questions since the 2016 launch of The DAO, the original (but ultimately hacked) DAO that prompted a hard fork on the Ethereum blockchain. However, years later, many of these questions still lack definitive answers, as the IRS has not issued guidance on the subject.
At this time, two things are certain. Direct payments from DAOs for goods or services are taxable, as are capital gains/losses from the sale of governance tokens. 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 is a real one, especially as they become more popular.
In this piece, we’ll use Radicle — a peer-to-peer code collaboration network — as a demonstrative case of what is taxable now and what could be taxed in the future. While we can’t offer comprehensive or definitive answers on future tax treatment of DAOs and their governance tokens, we’ll point to pass-through entities as a possible “real world” model for potential DAO tax treatment.
Radicle: A DAO case study
Radicle is a peer-to-peer stack for social coding that integrated with Ethereum in February 2021 and introduced RAD, a native governance token. Essentially, Radicle’s projects work like a decentralized Github. Leveraging Radicle’s integration with Ethereum, software projects within the network can be governed by Radicle Orgs, which are Ethereum smart contracts that allow for DAO-controlled software projects. These can be pre-existing DAOs that join the Radicle network, or they can be newly deployed DAOs.
The ETH integration will allow users to send crypto to Radicle Orgs, which in turn send payments to contributing developers. DAI (or other crypto stablecoins) received through Radicle's funding protocols, for example Token Streams, will be subject to a withdrawal fee held by the Radicle DAO’s treasury. In addition to direct payments for contributions, users may also receive RAD tokens for participation in the community. Some 50 percent of RAD tokens are slated for distribution via the community treasury over the next four years. Finally, anyone can become a member of Radicle by purchasing and holding RAD tokens.
Are payments from DAOs taxable?
Cryptocurrency paid from a DAO’s ETH address for goods or services is subject to income tax in the country where the sale was made or the work was performed. For example, when a Radicle user funds a project, the associated DAO deposits that payment into the contributing developer’s wallet. The developer would need to claim that cryptocurrency as income subject to tax in the state and/or country where they performed the work.
Are governance tokens taxable?
Yes. Receiving governance tokens as part of a launch or as an incentive for activity on the protocol is likely taxable income. Also, profit made from selling or otherwise disposing of governance tokens would be subject to capital gains tax. Let’s say a user receives 1,000 RAD from the community treasury when RAD is valued at $5 and then exits the position two years later when RAD is selling for $10. They would need to report $5,000 of capital gains.
Are DAOs taxable entities?
As pointed out by crypto tax law specialist David J. Shakow, 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 pretty clearly fit this definition; 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’s already some legal precedent for this in the United States. In 2017, when considering The Dao’s governance tokens, the SEC ruled that the tokens were offered by a ”virtual organization,” and therefore subject to securities law.
However, as stated above, although there seems to be a relatively clear argument that DAOs could be taxed, no country has outlined a plan to do so. This means that right now, there is no clear method for filing taxes on profits DAOs make through fees, investment strategies, or other means. This means, for example, that currently there is no straightforward path for reporting any money Radicle makes from the fees it collects on each user payment.
How will DAOs be taxed in the future?
The answer: No one’s sure, 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 and dozens of countries?
Some speculate that the IRS’s treatment of pass-through entities may serve as a model for any future U.S. taxation of DAOs as an entity. A pass-through entity doesn’t generally pay federal taxes at the entity level; rather 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 Radicle doesn’t necessarily have the expectation of profit, if DAOs became treated as pass-through entities for tax purposes, members would need to report their share of the DAO’s earnings from fees on their personal income tax returns, regardless of whether or not that income had been distributed to them.
What’s the takeaway for DAO participants?
At this time, you should be reporting governance tokens distributed to you by a DAO as part of a launch or incentive, as well as capital gains/losses on the sale or other disposal of them. Additionally, if you receive crypto from the DAO for goods or services, you should report these transactions on your income tax returns.
Although there is no current method for reporting your share of a DAO’s entity-level profits, there could be in the future. For this reason, you should keep detailed records on your share of the DAO and its profits.
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