How bad tax policy is driving the DAOs out of the United States

It has been more than a year since Wyoming passed the first US law recognizing DAOs (or Decentralized Autonomous Organizations) as legal partnerships. But demand for this recording remains muted.

The reality is that most DAOs will likely continue to incorporate overseas (if they incorporate at all). It’s not because of U.S. Securities and Exchange Commission (SEC) regulation, but because of the same tax considerations that venture capital and hedge fund managers have faced for decades.

Mark Lurie is the CEO of Shipyard Software Inc, a decentralized retail crypto trader exchange. This article is part of CoinDesk tax week.

Around the world, DAOs are increasingly integrating as legitimate businesses to protect their members from liability. In a first lawsuit filed earlier this year, a group of plaintiffs accused bZx DAO members of negligence in protecting funds deposited in their protocol, which left it exposed to a hack costing $55 million. users.

A few months later, the Commodity Futures Trading Commission (CFTC) sued Ooki DAO members for offering financial products traded on margin without registering as an official trader. Events like these are undoubtedly causing more DAOs to consider incorporation or some other type of entity formation in an effort to limit members’ personal liability.

These messy disputes fuel the prevailing understanding that DAOs prefer to incorporate overseas to avoid regulatory headaches in the United States. This is a partial factor. However, at the end of the day, the biggest deterrent to DAO incorporation in the United States actually comes down to how the Internal Revenue Service (IRS) classifies and taxes business entities.

US DAO Incorporation Triggers Extreme Tax Obligations

In the United States, the most common types of business entities are LLCs and corporations, or more specifically C-corporations. C-corps are legally separate from their owners and responsible for paying their own taxes, except when they issue dividends, which often triggers tax liability to shareholders.

In contrast, LLCs are considered “flow-through entities”, which means that income is passed through the business to the owners, who then report it on their personal tax returns as individual income. Many entrepreneurs choose to form an LLC because income is taxed only once at the individual level, rather than “double taxed” at the corporate level and on dividends.

Still, there’s a major downside to going for an LLC – unlike corporations, all LLC owners must pay taxes on their share of the LLC’s income. Even though the LLC does not distribute profits, income tax allocations are automatic.

Read more: What’s wrong with Delaware? How Joe Biden’s Home State Became a Global Tax Dodging Hub / Opinion

For example, if a DAO LLC with five equal owners earns $40 million in 2022, the five owners would be individually responsible for filing taxes on $8 million in income, regardless of the profits distributed.

US citizens must pay these taxes even if they live outside the country since they must pay income taxes no matter where in the world they live – a policy unique to the United States. Meanwhile, non-US citizens might be able to avoid paying taxes on that income, but would likely still have to file an IRS tax return to report it.

Even without coughing up funds, the pain and expense of filing a US tax return would likely be a deal breaker for many non-US citizens, especially those with financial assets and income streams. complex. And DAOs, like crypto in general, are a global phenomenon with contributors all over the world.

If DAO members decide not to comply, the US could soon sanction them under anti-corruption and fraud monitoring regulations, preventing them from using US-related banks or financial institutions. . This step is typically reserved for criminal activity, but could be used in response to a tax compliance violation, particularly if the DAO has significant revenue.

Traditional workarounds are not feasible for DAOs

Hedge funds have navigated this problem for decades, often relying on what is called a master-feeder fund. Those who must file U.S. tax returns put their investment in a domestic fund, while those who are tax-exempt in the U.S. put their money in a foreign fund, perhaps in the Caymans or the islands. British virgins.

These feeder funds then deposit investors’ capital into the hedge fund’s offshore main account, which then makes investments. Profits would then be distributed to US investors through the domestic feeder fund and to non-US investors through the foreign feeder fund, thus circumventing US taxes.

Given these hurdles, you can begin to see how a DAO that chooses to become a US LLC will create a Kafkaesque maze of tax problems and potential financial liabilities for its members. And this byzantine structure would be further complicated if the DAO issued a governance token, triggering tax reporting obligations for hundreds, if not thousands, of token holders.

Read more: Use Your Crypto Losses to Turn the Tide Against the IRS

As a result, most DAOs who are seriously considering setting up a business entity in the United States are either unaware of their impending tax liabilities or are 100% confident that they will never have a non-US citizen member. The former will soon awaken from their reverie; the latter will always have a limited talent pool.

This likely explains why only a handful of DAOs have formed entities in Wyoming in the year since the law was passed, while foreign jurisdictions with similar DAO-friendly laws, such as the Marshall Islands, saw DAOs arriving en masse.

This is why legal advice on how to incorporate DAOs as an LLC in the United States largely misses the point. Andreessen Horowitz, for example, recently published a DAO Business Entity Flowchart, guiding concerned members through the decision-making process to ultimately form a Limited Liability Company (LLC), Foreign Foundation, Cooperative Association in limited liability (LCA) or remain entityless.

But until US tax regulations make it impossible or too expensive for DAOs to execute this in practice, any US-based approach is unlikely to gain traction.

US tax laws are unambiguous and unforgiving

Unlike securities regulation and financial regulation, US tax policy is mostly black and white when it comes to crypto. Applying existing laws to this new form of money is relatively simple, as it is more about people, assets and income than about innovative financial instruments and complex technologies.

Moreover, it is an open secret that the IRS has perhaps the most shrewd and sophisticated crypto team of any government agency.

The number of DAO members who still believe that decentralization provides comprehensive practical protections from regulation and legal liability is rapidly diminishing. In particular, the DeFi community is increasingly aware that the longer it operates without registering its DAO as a business entity, the more likely it is to be held legally and financially liable for any potential stumbles.

But taxes are the biggest practical barrier to incorporating the US-based DAO, and that problem needs to be addressed to make DAO members more receptive to policies like the one adopted in Wyoming. Under the current tax regime, it would be foolish to expect San Francisco, Boston or Miami to become the Silicon Valley of DAOs. That is, unless the United States changes its existing tax code to be more lenient to DAO members (which it won’t).

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