A decentralized autonomous organization (DAO) is an organization run by a blockchain-based computer program and run by a group of individuals who jointly vote to decide on regulatory proposals. Generally, each member’s voting power is determined by their percentage stake in DAO, which is calculated by dividing the digital assets members contribute by the total amount of digital assets in DAO.
A DAO usually operates (but not always) without a board or other governing body, and can provide an effective (and likely) secure platform for bringing people and resources together to achieve a collective goal.
Many DAOs have been created for investment. A typical DAO activity begins with investors transferring their digital assets, typically Ether (ETH), to DAO in exchange for DAO tokens, which typically represent a stake in DAO. Although in some cases DAO tokens are not an ownership interest, but represent, for example, only the right to dispose of the assets of DAO, depending on how DAO defines its tokens.
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The token holders then vote collectively to select the investment proposals submitted by the applicants. If the investment is successful, the token holders share the profits; If not, they share the losses. When used properly, the above actions can be performed without human intervention using a data code known as a “smart contract”.
DAO tax classification
Although DAO looks like an electronic creation without any formalities, it can still be a legal entity for tax purposes. In the United States, for example, tax rules state that a joint venture or other contractual arrangement may establish a separate entity if the participants “hold and distribute the profits from a trade, business, financial transaction or enterprise.” (On the other hand, only joint ownership of property that is maintained, maintained, refurbished and rented out or leased out does not constitute a separate entity for tax purposes.)
To the extent that a DAO is created by investors who intend to vote and select investment proposals, contribute funds to investments and share profits, a DAO can be a separate tax entity. Some DAOs established for purposes other than trade or business and profit, such as a DAO created to raise funds to purchase a copy of the U.S. Constitution, will most likely not be considered taxable entities.
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When a DAO is defined as a separate tax entity, the next question is: how should the DAO be classified for tax purposes? Two general types of classifications are companies or partnerships. When a business unit has two or more members with unlimited liability, the default classification is “Partnership”.
Another assessment to check is whether DAO is domestic or foreign. The term “internal” means created or organized in the United States or under the laws of the United States or any other country. In contrast, the term “foreign” means any company or partnership that is not domestic. Since DAOs are usually only on the blockchain and are not registered with any Secretary of State, DAOs can oddly enough be classified as a foreign partnership for tax purposes – even in cases where all DAO owners are tax resident in the United States. A foreign partnership may have other reporting obligations than a local partnership, but like a local partnership, partners must annually report their share of the partnership’s income and losses, even if the partnership does not make distributions.
A DAO can be classified as a foreign listed partnership (PTP) if the DAO tokens are traded on a “secondary market (or substantially equivalent)”. Because the IRS allows the use of cryptocurrency exchanges to determine fair market value, these exchanges may be considered as secondary or equivalent markets. In this case, DAO will be classified as a foreign PTP that is already taxed as a foreign company.
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Unlike partnerships, income and losses of foreign companies are usually not taxed to their shareholders until the company pays dividends. However, if DAO is treated as a passive foreign investment company, US token holders will be subject to penalties, including normal withholding tax on profits and dividends, as well as interest costs.