Lawyer. Web3. International CryptoPlanning. Private Corporate. Trust Funds. Member of: ONE BIG LAB AMA: fortunata@1biglab.com
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Please be noted that no legal or financial advice is being given.
Dealing with crypto from a legal perspective can be hard.
Usually, lawyers, whenever required to solve a problem or to find a solution, immediately go to either a) existing legislation or b) case law.
Now, we can't.
Either regulations on the matters don't exist, are too new, are still flawed projects or those who have to make the proper interpretations don't even fully understand what they are talking about (but who does anyways?) or rather shut doors off instead of opening them.
Several dots have to be connected, therefore, for a proper and coherent legal compliant structure for crypto related projects to thrive. The legal, tax and financial dots are just a few of them.
It makes sense, DAOs ought to manage off-chain operations as well, like having a tax ID number for declaring and paying taxes, opening a bank account, have one voice represent all members, ensuring limited liability for members and a base that enables legally compliant token issuance when required. They require corporate personhood to do these. Specially for limited liability. This means that, for example, if a DAO is hacked and loses all of its treasury, members can each of them, individually, be sued for all their personal assets. They are not protected.
Even if the DAOs exist on the blockchain, members do exist in the physical world, and are obligated to comply with the -scarce and somewhat ambiguous- existing law and regulations.
A legal analysis, financial analysis, tax analysis and technological development + audit must be set into place.
But from where do we start planning?
Let’s not go as far back as 2009 with Satoshi Nakamoto’s Whitepaper on Blockchain and Bitcoin.
Already in 2022 we are trying to put together pieces in a puzzle, to properly deliver coherent legal structures. These structures will need to figure out several aspects of a DAO.
First of: do we DAO?
Level of decentralization
For or non profit?
Incorporation
Liability.
Token issuance. By whom, from where, with what perks. (Careful: SEC)
Taxes.
Ownership of assets (let's get physical too). Fiduciaries?
I know what you're going to say now: “Oh, but incorporating a DAO as an entity in any jurisdiction goes against EVERYTHING THEY ARE MEANT TO BE”.
Well, yes.
And no.
It is true that incorporating as a US entity, for example, can go against the decentralized nature that the whole blockchain ecosystem stands for. On the other hand, DAOs need to be able to interact with the physical world, too. And existing legislation is still very poor on the subject for the mission of DAOs to align with the provided legal structures.
Hopefully, sooner than later, flexible regulations on the matter will provide a decent base for DAOs to develop here (on-chain) and out there (off-chain).
Having said that, we can keep complaining on how having individuals represent or have control of the legally wrapped DAO could be a knife to the heart of decentralization and a warm hug to bureaucracy (i mean, who doesn't hate bureaucracy?) … and a SEC invitation to bring trouble (for purposes of the Howew test).
A step before considering how or where to incorporate a DAO (and if to), we need to create/develop the Decentralized Autonomous Organization in the first place. And, if so, how, by whom, for what, why? Amongst other questions. This is when the planning starts.
DAO definition and terminology can be confusing, as it’s actually still in the making. Are we talking about a DAO (Decentralized Autonomous Organization) or about a DAC (Decentralized Autonomous Corporation)? The term DAO will be used as a generality, encompassing Decentralized Autonomous Organizations in the overall, as DAOs can be conceptualized to reflect foundations or civil associations and DACs to reflect corporations. A DAC can therefore be seen as a subgenre in the genre of DAOs.
They can, but not necessarily become a full analogy of a Corporation on Blockchain. In words of Laila Metjahic, a “decentralized organization involves a set of users interacting with each other and making decisions according to protocol specified in code and enforced on the blockchain (...)”. In these, and unlike traditional corporations, for example, “the contract is coded in the blockchain and maintains a record of each shareholder’s holding and allows for shareholders to vote on various items through blockchain”. So, what makes the big difference between the first and the later, is its autonomous capability, solely controlled by code (or at least fully decentralized ones).
On Aaron Batchelder’s report on DAO Planning Canvas, 12 sections are put to take into account when creating a DAO from moment 0, so it can successfully thrive the whole journey until deployment. Be noted that not every section will be applicable to every DAO, but we can say that at least we will find a Mission (1), a Treasury (6), Governance (8) and Coordination between the mentioned.
These sections are:
“Mission: Why does this DAO exist?
Unique Niche: How is it different from other similar communities?
Key Metrics: How will you know if the DAO is succeeding?
Community Planning: What type of community are you building?
Community Experience: What are the values and the CX of the community?
Treasury: How will you finance and collectively manage the DAO’s war chest?
Revenue Streams: How will you maintain financial health over time?
Governance: How will the community gather consensus?
Organizational Structure: Will it be fully decentralized or have some hierarchy?
Building Hype: How will you find and connect with the right community members?
Operational Costs: What’s the expected run rate to sustain operations?
Content Management: Where will you house content for the community?”
Aaron has made available a DAO Planning Canvas on Figma for everyone to start using when planning their own structure.
It is important to point out how there is a constant interconnection between all points of the structure, as the mission of the DAO itself should be with the chosen figure of incorporation and the choice of perks of the NFTs to issue, or member alliance, for example.
After determining the main points to conceive the main sections of the organization in its core, and in the words of Geoff Costeloe at ETHDenver 2022, DAOS should be encouraged to figure out the following things:
What legal structure should be used? and
How should finance be organized?
So many aspects play a role to give a proper answer, and yes, while we analyze each one all we can say is: “it depends”.
It depends on: what the DAO does, where are the founders based, where is the main trade of business, where was it developed mainly, what type of model is it running, what kind of tokens does it issue (governance, treasury tokens), with what perks, issued by whom, transferability, what voting power do members have, tokenomics, funding, marketing, community, RWA, multisig, and others.
So, yes, it depends on many things.
Going back to Geoff, there are a few things that DAOs can do before physically incorporating their structure to have everything into place and help limit liability for legal issues in the future.
Planning through contingencies
Liability check
Siloing and layering your organization
CONTINGENCY PLANNING:
Core members should think about every single contingency that may or may not happen with the DAO. The good and the bad, especially the bad. What is the plan if: plan/multisig/leadership fails?, loss of funds? What happens when we do token release? How about actually making money?
This way, DAOs can plan in advance how to react to different situations and pay less legal fees when trying to fix whatever mess they failed to anticipate.
LIABILITY CHECK:
Uncomfortable conversations keep healthy relationships. So yes, be clear who pays for broken glasses and how. Who holds liability in the DAO?
Contingency funds could be an option to precede any problem to take care of these possible liabilities. DAOs could put aside a part of their treasury as an internal legal liability insurance so members can be protected in case of liability.
Token holders can also self protect by creating an LLC or Corporation with the sole purpose of being that LLC, for example, the holder of the token, so the multisig holder is the entity and not the person. This could be a way for members to avoid the risk of direct liability on everything they are worth.
1. SILOING AND LAYERING:
During the development of this paper we will continue to analyze the different jurisdictions and ways of incorporating DAOs and the many aspects to bear into account when doing so.It is also good to remember that not only one single entity has to “cover it all” and therefore it can be useful to set up a legal structure that has many entities to take care of different aspects of the Parent DAO. Like one to hold IP, others to silo payments for accounting ease (on work fees, capital fees, insurance/tax), which can be helpfull with liability, taxes and accounting.
Then, David Kerr shared: “DAOs are not legal entities - they are a tool to bring individuals together for a common purpose. The nature of the individuals and the common purpose creates a relationship that might default to an existing entity structure or may require forming an entity to execute the common purpose.”
“ALL THE COMPLEXITY AROUND DAOS NEED TO BE PLANNED FOR BEFORE SELECTING AN ENTITY STRUCTURE”.
Where can DAOs incorporate as legal entities?
Unincorporated DAOs can potentially expose their members to a number of risks and liabilities with both the SEC and the IRS and/or analogue entities of different jurisdictions, depending on place of incorporation and others. Operationally and logistically this can also bring issues on how to interact with other figures and individuals existing on and off blockchain (like not offering protection for potential consequences on the operation of the DAO and therefore being considered a general partnership, for example, so partners wouldn't have the liability limitations that an LLC could provide). Therefore, deciding not to incorporate in a given regime that allows them to, makes members, users and developers: more liability for the harms and consequences of the DAO operations (the concept of joint responsibility rings a bell?), restricted from off-chain operations (like having a traditional bank account to its name, sign legal contracts, owning registrable assets and IP - and protecting that valuable IP) and exponentiating their tax obligations.
There are few jurisdictions in the world that give recognition to DAOs as legal entities in the form of different Institutions, with different benefits and challenges. But there are so many circumstances to weight, there is no singular solution on where is best to go.
Up to date, we can mention:
USA: Vermont, Wyoming, Delaware, Colorado or file to be a UNA (Careful again, there's no recognition at a Federal level) + Marshall Islands.
Offshore Foundations in Switzerland, Cayman Islands, BVI, Panama, Singapore, Ireland + combining other entities.
Let's see what it means to incorporate as a DAO on each, and how to.
USA
Innovation precedes law.
And it is to law to keep up with it by regulating with different approaching criterias.
In the US, regulation is still in the making to provide a complete and safe environment for Blockchain related projects to be born and succeed.
UNA: Unincorporated Nonprofit Associations
We emphasize that this is a nonprofit option, depending on the mission or purpose given to the DAO (usually defined as charitable - as the concept of non profit is more or less defined in each US State and could be flexible enough to host more than one DAO-) under the Uniform Unincorporated Nonprofit Association Act (UUNAA).
Determining if a DAO is going to be a for-profit or non-profit organization helps us frame what structure suits the most from the beginning. In case of being non profit (or of making it fit as one), it can be wrapped up as a Foundation (an UNA).
Another option, and well explained by David Kerr, is having an entity, non profit foundation too, manage the treasury of the DAO (ideally with a separate protocol), and an unincorporated protocol regarding governance (“siloed” structure) or wrapped as a different entity depending on the case. These options can be seen as risky to justify (using two different entities and putting at risk the limit liability of members as well). The UNA becomes a legal entity separate from the members of the DAO in different aspects, like enforcing rights, duties, liabilities and tort.
In other words, options in this case are either “wrapping” a DAO as a single UNA or “siloing” DAO activity between treasury and protocol. This is possible because governance tokens of most DAOs are either delineated by user interaction with the protocol and/or with the treasury (more enabled if the DAO counts with a separate code for each).
Still, giving a DAO this kind of legal wrapper enables the entity to organize itself closer to a traditional type of association. A tax ID number is provided so declaring and paying taxes becomes possible, as well as applying for tax-exempt status under Section 501(c)(3) of the US tax code, for example.
WYOMING DAO LLC
LLC stands for Limited Liability Company, for a kind of figure that creates a distinct entity from its members, and helps prevent double taxation.
By mid 2021 Bill 38 was signed in Wyoming, allowing the State to recognize decentralized autonomous organizations (DAOs) as limited liability companies, adopting the same tax regime as regular LLCs in the state.
Any DAO may incorporate in the form of a DAO LLC in the mentioned state by signing and delivering one exact or confirmed copy of the Articles of Organization (defining if the DAO is member or algorithmically managed) to the secretary for filing. The bill specifies that an algorithmically managed DAO may only be formed "if the underlying smart contracts can be updated, modified, or otherwise upgraded". If the type of decentralized autonomous organization is not otherwise provided for, the limited liability company will be presumed to be a member managed decentralized autonomous organization.
Another requirement is including in the mentioned articles a publicly available identifier of the smart contracts that the DAO uses to manage, facilitate or operate itself.
The articles of organization and the smart contracts for a WY DAO LLC govern all of the following:
i. Relations among the members and between the members and the decentralized autonomous organization;
ii. Rights and duties under this chapter of a person in their capacity as a member;
iii. Activities of the decentralized autonomous organization and the conduct of those activities;
iv. Means and conditions for amending the operating agreement;
v. Rights and voting rights of members;
vi. Transferability of membership interests;
vii. Withdrawal of membership;
viii. Distributions to members prior to dissolution;
ix. Amendment of the articles of organization;
x. Procedures for amending, updating, editing or changing applicable smart contracts;
xi. All other aspects of the decentralized autonomous organization.
Even though regular LLCs can choose to be manager-managed, it is particularly prohibited for DAO LLCs to do so and will be automatically dissolved if it doesn't approve proposals or take actions for over a year.
A regular Wyoming LLC can also convert into a DAO by amending its Articles of Organization.
Founders of the DAO do not require to be residents in the US but each DAO must have and maintain a registered agent in the state for the incorporation.
The Bill is unclear on DAO members acting on behalf of the DAO and legally binding it, so clarifying the bylaws becomes necessary. It is also unclear whether governance tokens will be classified as securities in future regulations or not.
CityDAO is a clear example of a WY DAO LLC (also the first DAO to buy land), the first DAO to incorporate was The American CryptoFED.
DELAWARE LLC ACT
Delaware also provides the option for DAOs to incorporate as LLCs, but in this case with their normal LLC Act. The set up of this structure can be faster and cheaper in comparison with Wyoming, that requires more paperwork and information, but it requires that every member of the DAO becomes member of the LLC and to update everytime this changes, which can go against the flexibility that tradable governance tokens provide.
WY DAO LLCs lack Federal recognition, so incorporating in Delaware as an LLC can make members feel more secure.
With the Delaware form, DAOs can incorporate as a legal entity and handle off chain operations and on chain operations, voting rights and governance. MetaCartel Ventures DAO LLC is a clear example of a DW LLC that is also a DAO.
The LAO is another DAO organized as a Delaware Limited Liability Company that openly shares their process of incorporation and the way they deal with member voting, transferring voting rights and investing.
COLORADO:
When I started my research on DAOs, i wasn’t able to fully comprehend what DAOs were until a dear friend said to me: “look, a DAO is like a cooperative. Imagine a cooperative. People with a common mission and purpose working together and voting on the paths to take by such cooperative, as a community”.
Similar values and principles, they are formed by members, for members.
Then it clicked.
The State of Colorado created the Limited Cooperative Association (LCA), a hybrid between a cooperative and a corporation, to provide DAOs with a legal framework in the US.
Resembling an LLC, “it allows for investor members, returns on investment to patrons and non-patrons, and voting rights for investors, while adhering to cooperative principles” and differences from it in “the distribution of financial returns based on patronage activity, voting based on membership (one-member, one vote) or based on patronage, which allows for the integration of DAO based governance principles, such as rage quitting and quadratic voting”.
To form it, it is not necessary to be a resident in Colorado nor the US.
Jacqueline Radebaugh and Yev Muchnik provide a couple of examples of how DAOs can exploit this model to their benefit, regarding the business model they seek, so different traditional cooperative categories can be adapted to a DAO and therefore DAO Co-op: consumer cooperatives, producer cooperatives, worker cooperatives, purchasing or shared services cooperatives, multi-stakeholder cooperatives, amongst others.
SongADAO Co-op LCA is an example of an already LCA incorporated DAO (consumer cooperative).
VERMONT
dOrg LLC was the first Blockchain-Based Limited Liability Company (BBLLC) in Vermont.
Vermont admits corporate organizations to register using DLTs, if the Statute:
i. describes the purpose of the company,
ii. specifies whether the DLT is fully or partially decentralized, and public or private, including the rights of the members in each protocol
iii. adopts forms of voting, which may include smart contracts, to decide (a) upgrades/updates of the protocol used (b) changes to the statute (c) any matter included in the corporate purpose,
iv. adopts a protocol to respond to security breaches,
v. establishes how to become a member and how to represent your participation (units, tocks, ownership or profit interests); and
vi. establishes the rights and obligations of each member (or class of members) and of the administrators.
dOrg LLCs Operating agreement shows how its purpose, beyond the fact of being incorporated, aligns with the decentralized values of DAOs, and how governance, company funds and distributions can be managed as well.
“Section 1. Purpose. The purpose of the Company is to operate a Decentralized Autonomous Organization (a "DAO") through which the Company can accept requests to perform services for third parties, solicit bids on such requests from Members and non-Members, and permit Members to allocate responsibility and remuneration of Members and others for completion of related tasks. The Company may transact such other lawful business as the Members may determine in accordance with this Agreement.”
“The Company intends to govern itself and conduct all of its activities through the use of blockchain technology, software-enabled governance procedures and protocols, and associated voting protocols.”
“Company funds may consist of traditional currency or of digital assets, including, but not limited to, cryptocurrencies and digital tokens. All Company funds consisting of traditional currency shall be deposited in such bank accounts or invested as designated by vote of the Members. Company funds consisting of digital assets shall be held in such a manner as may be designated by a vote of the Members. In whatever form, such funds shall not be commingled with funds of any other entity managed, controlled, owned or advised by any of the Members. All withdrawals from any traditional currency accounts shall be made only by an Administrative Member or by other persons duly authorized by the Company to make such withdrawals. Transfers of digital assets may be made by duly authorized persons or through duly authorized "smart contracts" or other automatic means approved by the Members.”
“The Members will make all decisions related to distributions of cash or any form of currency (including, but not limited to, cryptocurrencies and digital tokens).”
MARSHALL ISLANDS:
The newest option on the map appeared only a few days ago, February 15th 2022.
The Republic of Marshall Islands or RMI is a small country in the South Pacific that used to be part of the US, but are now an Associate State supported by US Institutions, like the military. A recent amendment to their Non-Profit LLC Statute offers clear DAO treatment. Thanks to it, the bylaws of the LLCs can be in the blockchain and token holders can be members. All this with the same level of corporate personhood and limited liability as a US corporation.
With the intention of becoming an international Hub for DAOs to go and incorporate, the MIDAO were created (Marshall Island Directory Services) as a domestic company whose purpose is to work as a concierge to help DAOs easily incorporate in the Island.
Why? => Flexible and tax positive treasury framework that allows DAOs make decisions through the DAOs governance protocols and execute them off chain.
Sounds too good to be true. Why? => Expensive. 6 figure legal fees.
This means that an existing option to legally wrap a DAO is by creating a Foundation at one of these places and from them offshore governance tokens. Legal and international tax experts advice is necessary for such a structure to be set up.
Even though tax benefits can come from these kinds of structures, the IRS might still subject US income tax to a portion of the income gained if there’s a connection between the US and the trade or business. “If a foreign operation’s intellectual property was developed in the United States, or key employees or directors were present in the United States for significant periods of time, the IRS can attribute the portion of business being conducted in the United States as taxable and require the necessary tax filings, tax reporting and payments to resolve”. This is something that should be taken into account by DAOs whose developers are from the US or if their protocol was developed in the US, both for federal and state income tax.
Switzerland (or Zug, the so called “Crypto Valley”) is one of the most “token regulated” countries in the world at the moment, becoming one of the most chosen destinations for crypto projects to develop.
Switzerland provides the following crypto related structures for Web3 projects to incorporate in its jurisdiction, providing favourable tax regimes and limited liability for their members:
The Swiss Foundation
The Ethereum Foundation was created through this Institution, which works best for long term infrastructure projects, like for software development.
Swiss Association An association provides more flexibility than the figure mentioned above, governance and incorporation-wise. Non Swiss projects can find this attractive as board members are not required to be residents and members can be individuals or legal entities. If the association is for-profit, then it must be registered, but in case is not, there is no filing requirements in Switzerland (so a business organization can incorporate as an association operating globally under one brand whilst maintaining separate profit pools and ring-fencing liability in each country in which they operate - without the need of being a Swiss resident).
Decentralized Autonomous Association (DAA) A Decentralized Autonomous Association is a mix between the legal and the Web3 world of DAOs, aiming to create a DAO with limited liability for its members. MME, a Swiss Legal Services Firm, explains how on their example structure, and before providing with a Model Articles of AssociationThe DAA's bodies are: the DAA Assembly (Governing body),DAA Delegates (Board), DAA Member Community and DAA Whitelisters.
Private International Act (PILA) This new legal construct or theory has not yet been adopted by a DAO, but bases its premise in that DAOs are internet native and should be treated in the legal Swiss order in the same way that foreign entities are treated, in the eyes of the Private International Law, therefore recognizing existence of an online jurisdiction governed by its own code (and the digital space as the State from which this law originates).
Why was this added if we still don’t know if it would actually work on the matter? Honestly, because I say so.
But on a more serious note, I haven't seen enough debate in the industry on the philosophical and psychological implications that, not only DAOs, but the Metaverse, have to play on our society. This will be left for a soon to come article.
Cayman Islands have been a destination for “Foundation Companies” for a couple of years now. For the DAOs convenience, this kind of entity can be structured without shareholders and are able to carry on off-chain operations on command as long as the commanded action is not a VASP Activity nor other regulated activity, adopting the role of a service provider for the DAO.
“A virtual asset service is: the issuance of a virtual asset; or the business of conducting one or more of the following activities or operations for or on behalf of another person: exchanging between virtual assets and fiat currencies; exchanging between one or more other forms of convertible virtual assets; transferring virtual assets; safekeeping or administrating virtual assets or instruments enabling control over virtual assets; and participating in and providing financial services related to an issuers offer or sale of a virtual asset.”
Beyond the fact that it can be structured without shareholders, the foundation company can also designate beneficiaries without maintaining a register of them with their legal names, but class them as “token holders”, for example, adapting even better to the DAO structure and token tradeability. The reason is, that the starting position under the Law is that a designated beneficiary has no rights or powers against the foundation company, only those expressly stated by the foundation company.
This means that DAOs can use this type of foundation companies as legal wrapper and, in case of carrying out VASP activities, creating a subsidiary in a jurisdiction that's friendly with virtual assets, like BVI, to carry on such activities. This vehicle can be very flexible as it operates like an incorporated trust while retaining the separate legal personality and limited liability of a company and tax neutrality. Taking into account that the general public reaction to setting up a structure in the Cayman Islands tends to be seen as “sketchy” or “shady”, and some DAOs prefer to start clean reputation-wise.
Liechtenstein. Options to use a Foundation also apply to Liechtenstein (with the purpose to promote the development of a decentralized network of the DAO), who after the approval of their Blockchain Act, a number of token regulations made the country a very attractive destination for blockchain projects to incorporate and issue their tokens. Be noted, we are talking about blockchain companies, not DAOs.
At the end of 2021, the consulting firm PwC published the Annual Crypto Tax Report, where Liechtenstein was ranked to have the clearest crypto tax regulations.
In Liechtenstein, for the legal recognition of DAOs as entities, we do not find specific Institutions like in Wyoming or Vermont, but can consider the creation of a Foundation, as mentioned before in other jurisdictions, or of a Cooperative (it's easy to become a member and transfer your token to stop being a member as well, beyond the fact of adapting better to the community spirit of DAOs). The last one also provides more flexibility regarding governance protocols, more compatible to DAOs than LLCs, and does share the limited liability for members. Then, if the DAO wants to launch a token, a separate company can be set up to do so (similar to an LLC) and afterwards liquidated.
A Private Trust Company is also an option in Liechtenstein.
If the company takes over the administration of the assets (tokens) of the Protocol ( and only its treasury, without providing fiduciary services to third parties),a Private Trust Company can be established (PTC). The PTC holds the trust property in its own name and administers it as trustee for the benefit of the beneficiaries.
After a meeting with NÄGELE Attorneys at Law for a very enriching consultation on the matter, Liechtenstein's advantages on DAO structuring became both clear and attractive.
And I quote:
“The shareholders register in Liechtenstein is not publicly available, which means that the shareholders have a maximum of privacy in this respect.
Liechtenstein only has bilateral enforcement conventions with Austria and Switzerland and only in relation to certain titles. This means that any judgements or other decisions rendered in other countries will not be directly enforced by Liechtenstein courts. This provides for a proper asset protection of assets located in Liechtenstein. Foreign plaintiffs must, if they are not from Austria or Switzerland, post a deposit with the court to secure the presumed legal costs of the Liechtenstein company for the law suit, otherwise their action will be declared withdrawn.
A prospectus (for a capital markets transaction) which is made in Liechtenstein and passed by the Liechtenstein Financial Markets Authority can be passported to the EU and the EEA. This provides for, inter alia, the possibility of making a token offering to the public in the EU and the EEA.
Liechtenstein is – to our knowledge – the first jurisdiction which has introduced a legal regime for the issuance of tokens (including security-tokens). It is therefore possible to issue e.g. a participation certificate in form of a token in Liechtenstein relatively easily and on clear legal grounds, whereas this could cause serious issues in other jurisdictions. Furthermore, the Liechtenstein Financial Markets Authority has experience with the issuance of tokens and passes prospectuses in relation to tokens on a regular basis.”
There is not one perfect solution when wrapping up a DAO, every option that we look up has its ups and downs. We do know that we are asking ourselves these questions because we are trying to provide DAOs and their members and users with limited liability, tax certainty, decentralization at heart, and regulation compliance of all kinds. Still, we also acknowledge that regulation is scare and sometimes/mostly unclear, and each DAO has differents aspects to take into account on legal, tax and financial basis. This doesn’t mean that the task is impossible, but that it does require immense thought and analysis from different professionals in the mentioned areas, and much patience.
Alrighty, I have successfully incorporated my DAO as a recognized legal entity in XYZ jurisdiction (or chose to set up a Web2 structure to give my DAO training wheels before it can fully drive on Web3 stick), can i go play with the big boys, start issuing NFTs and whatnot, take a good look at my white-list, airdropping and the like?
Hold your horses, Cowboy. Don't go riding before asking an important question: Are my NFTs securities?
Howdy, SEC.
Actually not only the US SEC, but the analysis on token issuance by a DAO can be a global financial topic, beyond the USA. Still, we will use this country as main reference.
The key laws to take into account if you want to know if your token is a security: The Securities Act of 1933, The Exchange Act of 1934 and The Investment Companies act of 1940).
I recently read an article by Brady Neal, “Token Offerings and the SEC”, where he made a clear distinction between the overly-compliant viewpoint of “EVERYTHING IS A SECURITY AND YOUR HOUSE SHOULD BE ON FIRE” and the Chad stand of “TRY TO STOP ME. RATHER SAY SORRY THAN ASK FOR PERMISSION, BRUH” (or at least that’s the dialogue that played in my mind, more or less).
Let’s try to be coherent with a careful middle point here, as Brady quotes Brian Brooks: “The SEC’s view [is] that certain tokens may constitute securities''. DAOs will therefore plan on how to issue, offer, sell their tokens - be it governance tokens regarding interaction with the treasury or with the protocol, and others (like an NFT collection for instance).-
I first started writing this section on the paper to address NFT regulations, then I remembered that we ought to be consistent with concepts.
An NFT is a type of token, and the SEC looks upon the different kinds of token offerings as whether they can rule over them or not. We are talking about Airdrops (yes! Airdrops can be considered token offerings too!), ICOs (Initial Coin Offerings), IEOs (Initial Exchange Offerings), IDOs (Initial Decentralized Exchange Offerings), INOs (Initial NFT Offerings - Here they are! -) and STOs (Securities Token Offerings).
Even if you want to hide your ICO, NFTs of whatever as an STO offering, putting on it all the makeup and sprinkles you want, the SEC will look at the intrinsic nature of the token to know if we are talking about a financial instrument that might make you want to flee the country and change your name (try to avoid picking Chad for the new one). If the token is considered a security then members of the DAO could need to be considered accredited investors or comply with KYC plus other rules.
For this, they use the well known “Howey Test” (U.S. Supreme Court case SEC v. Howey Co., 328 U.S. 293 (1946)) and four factors to determine if the token offering is a security (and any kind of investment that might imply being one):
#1. Is there an investment in money?
#2. In a common enterprise?
#3. Is there an expectation of profit?
#4. Is the profit expected to be derived from the efforts of a promoter or third party?
With cryptocurrencies and tokens the main aspects to identify whether registration is required, lies in whether the cryptocurrencies or tokens are acquired by holders to obtain a benefit for the activity of a third party (basically the issuing company) or if said tokens will give the right to acquire a good or service (not necessarily to obtain a capital gain). That is, it must be purchased to receive the good or service, not to resell the token later at a higher price on a secondary market.
The SEC has two categories of enforcement actions if it considers that the Token offering is a security, these are: taking most of the ICO funding a single-digit percentage of the ICO funding.
As you can see, there's a marked difference between one and the other. Beyond this, what they do have in common are potentially excessive legal fees.
According to Cornerstone Research, from 2013 on, the SEC has fined over 2,350 million USD of crypto related security breaches (97 enforcements - 20 of them only in 2021, 70% of those were ICO related). The appointment of Gary Gensler as SEC Chairman in April of the same year might be a sensible explanation to the SEC’s hardening of treatment unto the subject. More of these harsh measures are expected for the short and middle term time to come.
Or not.
If Commissioner Hester Peirce “Token Safe Harbor Proposal 2.0” is approved, the US might become a “safe harbor” for crypto projects for three years, without needing SEC registration, even if we talk about tokens that are effectively securities. Hey, this could happen.
Going back to our sad ambiguous reality:
Yes, we get it. One can have a lot more freedom when you can publicly offer tokens that do not follow applying SEC regulations/approval: its a bigger market when you don't have to limit yourself to accredited investors (allowing them to laterly trade the token) and when you don't have to inicialy worry about having sufficient funding capital, among other things.
In effect, if your token is a security (and no exceptions -sadly- apply to it) then its offering must strictly comply with the US Securities and Exchange Commission (SEC) regulations.
This means that many more restrictions would have to be taken into account regarding: who they can be offered to (accredited investors) and if they can be traded by them or not, funding capital, SEC approval (and how long it takes to get it), whether it can publicly be advertised or not, if its exempt from state laws or not, amongst others, depending on its type and other perks.
Decentralization on a project doesn't mean that the issued token will not be considered a security. Let's avoid this misconception.
Any project that includes the issuance of any type of digital asset that is later offered to the general public in exchange for funds by the buyer, and said digital asset is subject to future benefits coming from the managerial efforts or activities carried out by the original issuer, is very likely to be considered a security on American legislation.
When NFTs are issued with the option of being transferable and then listed on an open market, it is debatable whether there is no intention of the buyer to obtain future profits from the efforts of others and it is very likely that the SEC will make, at least, the attempt to regulate it (regardless of whether it succeeds or not). As mentioned before this is a grey area, not yet clear. Therefore it is a risk and a potential high legal cost of defense and penalties that those who want to go along with the projects must accept.
To avoid running this type of risk in a country with high penalties and high costs associated with litigation, it can be suggested (and then again this is not financial nor legal advice) setting up legal a vehicle in other offshore jurisdictions to carry out such activities (without US tax residents among its members). We saw how foundations could be used ut supra.
Experts on international tax planning should be consulted on the matter. As an example, to create an offshore entity to act as a holding company and be a shareholder of an American C Corp, injecting the gains of its activities as a capital contribution. Or for the offshore entity to inject the funds through loans to avoid tax withholdings for future profit withdrawals.
If founders, investors, or whoever is in charge of making the call, chooses to assume the "USA risk", a possible option is to make as clear as possible that the NFT is a utility token (and not a security). For example by establishing a fixed price for the token and issuing it in such a way that is non-transferable, where its value resides in the utility/function and not in the possibility of obtaining profits through its negotiation.
The SECs definition of a security is not the only one that counts. The criteria to determine an asset as a security can be wider tax wise, therefore having assets considered securities for tax purposes.
As mentioned above, when trying to set up a legal base and structure for a DAO, and considering doing so out of the US in the form of a foreign Foundation for example, taxation might still be present to the IRS if intellectual property was developed in the US, or key employees or directors were present there for significant periods of time, or if the developers are Americans/the protocol developed there. This means that the IRS can attribute the portion of business being conducted in the US, and therefore be considered taxable.
Member/dev nationality and place of development are factors that change the tax analysis to be made, beyond only considered the US.
In the eyes of the IRS, virtual currencies should be treated as property for US income tax purposes which results in a capital gain or loss coming from the sale or exchange of such virtual currency. This can be found in the IRS 2014 Notice 2014-21, relying in the 2013 FinCEN guidance stating that “virtual currency that has equivalent value in real currency, or that acts as a substitute for real currency is referred to as “convertible” virtual currency”
On the other hand, the receipt of virtual currency as payment for goods or services results in ordinary income.
So in case it wasn't clear, yes, DAOs ought to become responsible of filing returns and paying taxes, especially regarding taxation of governance tokens and DAO treasury activities.
Why would governance tokens be taxed though? Because even though they are born as a mechanism for DAO members to make decisions regarding the DAO - and its treasury - and therefore interact with the protocol in a decentralized manner, as most governance tokens are transferable and have or gain market value as the DAO grows, they are subject to income tax.
DAO treasury activities are also taxed, we are talking about their “patrimony”.
Through their treasury, DAOs can generate income -and engage their community even more- in different ways, like staking/liquidity mining, funding grants or lobbying and/or portfolio diversification, and therefore become taxable.
Then again, as DAOs grow and their treasuries thrive, the bigger the need to file and pay taxes becomes.
Usually, lawyer’s don’t “create” or “innovate”, so to speak.
Now we get to. And we need to keep up with an industry that doesn’t sleep. Lawyer’s need to reinvent themselves beyond just providing bureaucratic legal services and provide holistic strategies from point A to Z.
It’s a moment where both worlds can collide, creating legal structures that converge with the core values that crypto brought from its founding: decentralization, community, buidling together.
I dare say that lawyers need to start thinking in a less traditional centralized way and think more like the future that Web3 is already creating. Out of the box.
In future publications, token offering and crypto taxing will be addressed in depth. As well as MotherDAO.
MotherDAO is a fiduciary platform that will enable DAOs to own and manage physical assets, reconnecting them with Mother Earth.
We will soon share the legal structure that is being set up so DAOs can interact with jurisdictions that not necessarily provide them direct legal recognition as entities (and no, we are done talking about Foundations).
If you’d like to discuss, ask questions about DAOs and/or learn about One Big Lab and the MotherDAO Project, feel free to contact me on Twitter or send an email to: fortunata@1biglab.com
This Research is part of One Big Lab.
Please be noted that no legal or financial advice is being given.
Dealing with crypto from a legal perspective can be hard.
Usually, lawyers, whenever required to solve a problem or to find a solution, immediately go to either a) existing legislation or b) case law.
Now, we can't.
Either regulations on the matters don't exist, are too new, are still flawed projects or those who have to make the proper interpretations don't even fully understand what they are talking about (but who does anyways?) or rather shut doors off instead of opening them.
Several dots have to be connected, therefore, for a proper and coherent legal compliant structure for crypto related projects to thrive. The legal, tax and financial dots are just a few of them.
It makes sense, DAOs ought to manage off-chain operations as well, like having a tax ID number for declaring and paying taxes, opening a bank account, have one voice represent all members, ensuring limited liability for members and a base that enables legally compliant token issuance when required. They require corporate personhood to do these. Specially for limited liability. This means that, for example, if a DAO is hacked and loses all of its treasury, members can each of them, individually, be sued for all their personal assets. They are not protected.
Even if the DAOs exist on the blockchain, members do exist in the physical world, and are obligated to comply with the -scarce and somewhat ambiguous- existing law and regulations.
A legal analysis, financial analysis, tax analysis and technological development + audit must be set into place.
But from where do we start planning?
Let’s not go as far back as 2009 with Satoshi Nakamoto’s Whitepaper on Blockchain and Bitcoin.
Already in 2022 we are trying to put together pieces in a puzzle, to properly deliver coherent legal structures. These structures will need to figure out several aspects of a DAO.
First of: do we DAO?
Level of decentralization
For or non profit?
Incorporation
Liability.
Token issuance. By whom, from where, with what perks. (Careful: SEC)
Taxes.
Ownership of assets (let's get physical too). Fiduciaries?
I know what you're going to say now: “Oh, but incorporating a DAO as an entity in any jurisdiction goes against EVERYTHING THEY ARE MEANT TO BE”.
Well, yes.
And no.
It is true that incorporating as a US entity, for example, can go against the decentralized nature that the whole blockchain ecosystem stands for. On the other hand, DAOs need to be able to interact with the physical world, too. And existing legislation is still very poor on the subject for the mission of DAOs to align with the provided legal structures.
Hopefully, sooner than later, flexible regulations on the matter will provide a decent base for DAOs to develop here (on-chain) and out there (off-chain).
Having said that, we can keep complaining on how having individuals represent or have control of the legally wrapped DAO could be a knife to the heart of decentralization and a warm hug to bureaucracy (i mean, who doesn't hate bureaucracy?) … and a SEC invitation to bring trouble (for purposes of the Howew test).
A step before considering how or where to incorporate a DAO (and if to), we need to create/develop the Decentralized Autonomous Organization in the first place. And, if so, how, by whom, for what, why? Amongst other questions. This is when the planning starts.
DAO definition and terminology can be confusing, as it’s actually still in the making. Are we talking about a DAO (Decentralized Autonomous Organization) or about a DAC (Decentralized Autonomous Corporation)? The term DAO will be used as a generality, encompassing Decentralized Autonomous Organizations in the overall, as DAOs can be conceptualized to reflect foundations or civil associations and DACs to reflect corporations. A DAC can therefore be seen as a subgenre in the genre of DAOs.
They can, but not necessarily become a full analogy of a Corporation on Blockchain. In words of Laila Metjahic, a “decentralized organization involves a set of users interacting with each other and making decisions according to protocol specified in code and enforced on the blockchain (...)”. In these, and unlike traditional corporations, for example, “the contract is coded in the blockchain and maintains a record of each shareholder’s holding and allows for shareholders to vote on various items through blockchain”. So, what makes the big difference between the first and the later, is its autonomous capability, solely controlled by code (or at least fully decentralized ones).
On Aaron Batchelder’s report on DAO Planning Canvas, 12 sections are put to take into account when creating a DAO from moment 0, so it can successfully thrive the whole journey until deployment. Be noted that not every section will be applicable to every DAO, but we can say that at least we will find a Mission (1), a Treasury (6), Governance (8) and Coordination between the mentioned.
These sections are:
“Mission: Why does this DAO exist?
Unique Niche: How is it different from other similar communities?
Key Metrics: How will you know if the DAO is succeeding?
Community Planning: What type of community are you building?
Community Experience: What are the values and the CX of the community?
Treasury: How will you finance and collectively manage the DAO’s war chest?
Revenue Streams: How will you maintain financial health over time?
Governance: How will the community gather consensus?
Organizational Structure: Will it be fully decentralized or have some hierarchy?
Building Hype: How will you find and connect with the right community members?
Operational Costs: What’s the expected run rate to sustain operations?
Content Management: Where will you house content for the community?”
Aaron has made available a DAO Planning Canvas on Figma for everyone to start using when planning their own structure.
It is important to point out how there is a constant interconnection between all points of the structure, as the mission of the DAO itself should be with the chosen figure of incorporation and the choice of perks of the NFTs to issue, or member alliance, for example.
After determining the main points to conceive the main sections of the organization in its core, and in the words of Geoff Costeloe at ETHDenver 2022, DAOS should be encouraged to figure out the following things:
What legal structure should be used? and
How should finance be organized?
So many aspects play a role to give a proper answer, and yes, while we analyze each one all we can say is: “it depends”.
It depends on: what the DAO does, where are the founders based, where is the main trade of business, where was it developed mainly, what type of model is it running, what kind of tokens does it issue (governance, treasury tokens), with what perks, issued by whom, transferability, what voting power do members have, tokenomics, funding, marketing, community, RWA, multisig, and others.
So, yes, it depends on many things.
Going back to Geoff, there are a few things that DAOs can do before physically incorporating their structure to have everything into place and help limit liability for legal issues in the future.
Planning through contingencies
Liability check
Siloing and layering your organization
CONTINGENCY PLANNING:
Core members should think about every single contingency that may or may not happen with the DAO. The good and the bad, especially the bad. What is the plan if: plan/multisig/leadership fails?, loss of funds? What happens when we do token release? How about actually making money?
This way, DAOs can plan in advance how to react to different situations and pay less legal fees when trying to fix whatever mess they failed to anticipate.
LIABILITY CHECK:
Uncomfortable conversations keep healthy relationships. So yes, be clear who pays for broken glasses and how. Who holds liability in the DAO?
Contingency funds could be an option to precede any problem to take care of these possible liabilities. DAOs could put aside a part of their treasury as an internal legal liability insurance so members can be protected in case of liability.
Token holders can also self protect by creating an LLC or Corporation with the sole purpose of being that LLC, for example, the holder of the token, so the multisig holder is the entity and not the person. This could be a way for members to avoid the risk of direct liability on everything they are worth.
1. SILOING AND LAYERING:
During the development of this paper we will continue to analyze the different jurisdictions and ways of incorporating DAOs and the many aspects to bear into account when doing so.It is also good to remember that not only one single entity has to “cover it all” and therefore it can be useful to set up a legal structure that has many entities to take care of different aspects of the Parent DAO. Like one to hold IP, others to silo payments for accounting ease (on work fees, capital fees, insurance/tax), which can be helpfull with liability, taxes and accounting.
Then, David Kerr shared: “DAOs are not legal entities - they are a tool to bring individuals together for a common purpose. The nature of the individuals and the common purpose creates a relationship that might default to an existing entity structure or may require forming an entity to execute the common purpose.”
“ALL THE COMPLEXITY AROUND DAOS NEED TO BE PLANNED FOR BEFORE SELECTING AN ENTITY STRUCTURE”.
Where can DAOs incorporate as legal entities?
Unincorporated DAOs can potentially expose their members to a number of risks and liabilities with both the SEC and the IRS and/or analogue entities of different jurisdictions, depending on place of incorporation and others. Operationally and logistically this can also bring issues on how to interact with other figures and individuals existing on and off blockchain (like not offering protection for potential consequences on the operation of the DAO and therefore being considered a general partnership, for example, so partners wouldn't have the liability limitations that an LLC could provide). Therefore, deciding not to incorporate in a given regime that allows them to, makes members, users and developers: more liability for the harms and consequences of the DAO operations (the concept of joint responsibility rings a bell?), restricted from off-chain operations (like having a traditional bank account to its name, sign legal contracts, owning registrable assets and IP - and protecting that valuable IP) and exponentiating their tax obligations.
There are few jurisdictions in the world that give recognition to DAOs as legal entities in the form of different Institutions, with different benefits and challenges. But there are so many circumstances to weight, there is no singular solution on where is best to go.
Up to date, we can mention:
USA: Vermont, Wyoming, Delaware, Colorado or file to be a UNA (Careful again, there's no recognition at a Federal level) + Marshall Islands.
Offshore Foundations in Switzerland, Cayman Islands, BVI, Panama, Singapore, Ireland + combining other entities.
Let's see what it means to incorporate as a DAO on each, and how to.
USA
Innovation precedes law.
And it is to law to keep up with it by regulating with different approaching criterias.
In the US, regulation is still in the making to provide a complete and safe environment for Blockchain related projects to be born and succeed.
UNA: Unincorporated Nonprofit Associations
We emphasize that this is a nonprofit option, depending on the mission or purpose given to the DAO (usually defined as charitable - as the concept of non profit is more or less defined in each US State and could be flexible enough to host more than one DAO-) under the Uniform Unincorporated Nonprofit Association Act (UUNAA).
Determining if a DAO is going to be a for-profit or non-profit organization helps us frame what structure suits the most from the beginning. In case of being non profit (or of making it fit as one), it can be wrapped up as a Foundation (an UNA).
Another option, and well explained by David Kerr, is having an entity, non profit foundation too, manage the treasury of the DAO (ideally with a separate protocol), and an unincorporated protocol regarding governance (“siloed” structure) or wrapped as a different entity depending on the case. These options can be seen as risky to justify (using two different entities and putting at risk the limit liability of members as well). The UNA becomes a legal entity separate from the members of the DAO in different aspects, like enforcing rights, duties, liabilities and tort.
In other words, options in this case are either “wrapping” a DAO as a single UNA or “siloing” DAO activity between treasury and protocol. This is possible because governance tokens of most DAOs are either delineated by user interaction with the protocol and/or with the treasury (more enabled if the DAO counts with a separate code for each).
Still, giving a DAO this kind of legal wrapper enables the entity to organize itself closer to a traditional type of association. A tax ID number is provided so declaring and paying taxes becomes possible, as well as applying for tax-exempt status under Section 501(c)(3) of the US tax code, for example.
WYOMING DAO LLC
LLC stands for Limited Liability Company, for a kind of figure that creates a distinct entity from its members, and helps prevent double taxation.
By mid 2021 Bill 38 was signed in Wyoming, allowing the State to recognize decentralized autonomous organizations (DAOs) as limited liability companies, adopting the same tax regime as regular LLCs in the state.
Any DAO may incorporate in the form of a DAO LLC in the mentioned state by signing and delivering one exact or confirmed copy of the Articles of Organization (defining if the DAO is member or algorithmically managed) to the secretary for filing. The bill specifies that an algorithmically managed DAO may only be formed "if the underlying smart contracts can be updated, modified, or otherwise upgraded". If the type of decentralized autonomous organization is not otherwise provided for, the limited liability company will be presumed to be a member managed decentralized autonomous organization.
Another requirement is including in the mentioned articles a publicly available identifier of the smart contracts that the DAO uses to manage, facilitate or operate itself.
The articles of organization and the smart contracts for a WY DAO LLC govern all of the following:
i. Relations among the members and between the members and the decentralized autonomous organization;
ii. Rights and duties under this chapter of a person in their capacity as a member;
iii. Activities of the decentralized autonomous organization and the conduct of those activities;
iv. Means and conditions for amending the operating agreement;
v. Rights and voting rights of members;
vi. Transferability of membership interests;
vii. Withdrawal of membership;
viii. Distributions to members prior to dissolution;
ix. Amendment of the articles of organization;
x. Procedures for amending, updating, editing or changing applicable smart contracts;
xi. All other aspects of the decentralized autonomous organization.
Even though regular LLCs can choose to be manager-managed, it is particularly prohibited for DAO LLCs to do so and will be automatically dissolved if it doesn't approve proposals or take actions for over a year.
A regular Wyoming LLC can also convert into a DAO by amending its Articles of Organization.
Founders of the DAO do not require to be residents in the US but each DAO must have and maintain a registered agent in the state for the incorporation.
The Bill is unclear on DAO members acting on behalf of the DAO and legally binding it, so clarifying the bylaws becomes necessary. It is also unclear whether governance tokens will be classified as securities in future regulations or not.
CityDAO is a clear example of a WY DAO LLC (also the first DAO to buy land), the first DAO to incorporate was The American CryptoFED.
DELAWARE LLC ACT
Delaware also provides the option for DAOs to incorporate as LLCs, but in this case with their normal LLC Act. The set up of this structure can be faster and cheaper in comparison with Wyoming, that requires more paperwork and information, but it requires that every member of the DAO becomes member of the LLC and to update everytime this changes, which can go against the flexibility that tradable governance tokens provide.
WY DAO LLCs lack Federal recognition, so incorporating in Delaware as an LLC can make members feel more secure.
With the Delaware form, DAOs can incorporate as a legal entity and handle off chain operations and on chain operations, voting rights and governance. MetaCartel Ventures DAO LLC is a clear example of a DW LLC that is also a DAO.
The LAO is another DAO organized as a Delaware Limited Liability Company that openly shares their process of incorporation and the way they deal with member voting, transferring voting rights and investing.
COLORADO:
When I started my research on DAOs, i wasn’t able to fully comprehend what DAOs were until a dear friend said to me: “look, a DAO is like a cooperative. Imagine a cooperative. People with a common mission and purpose working together and voting on the paths to take by such cooperative, as a community”.
Similar values and principles, they are formed by members, for members.
Then it clicked.
The State of Colorado created the Limited Cooperative Association (LCA), a hybrid between a cooperative and a corporation, to provide DAOs with a legal framework in the US.
Resembling an LLC, “it allows for investor members, returns on investment to patrons and non-patrons, and voting rights for investors, while adhering to cooperative principles” and differences from it in “the distribution of financial returns based on patronage activity, voting based on membership (one-member, one vote) or based on patronage, which allows for the integration of DAO based governance principles, such as rage quitting and quadratic voting”.
To form it, it is not necessary to be a resident in Colorado nor the US.
Jacqueline Radebaugh and Yev Muchnik provide a couple of examples of how DAOs can exploit this model to their benefit, regarding the business model they seek, so different traditional cooperative categories can be adapted to a DAO and therefore DAO Co-op: consumer cooperatives, producer cooperatives, worker cooperatives, purchasing or shared services cooperatives, multi-stakeholder cooperatives, amongst others.
SongADAO Co-op LCA is an example of an already LCA incorporated DAO (consumer cooperative).
VERMONT
dOrg LLC was the first Blockchain-Based Limited Liability Company (BBLLC) in Vermont.
Vermont admits corporate organizations to register using DLTs, if the Statute:
i. describes the purpose of the company,
ii. specifies whether the DLT is fully or partially decentralized, and public or private, including the rights of the members in each protocol
iii. adopts forms of voting, which may include smart contracts, to decide (a) upgrades/updates of the protocol used (b) changes to the statute (c) any matter included in the corporate purpose,
iv. adopts a protocol to respond to security breaches,
v. establishes how to become a member and how to represent your participation (units, tocks, ownership or profit interests); and
vi. establishes the rights and obligations of each member (or class of members) and of the administrators.
dOrg LLCs Operating agreement shows how its purpose, beyond the fact of being incorporated, aligns with the decentralized values of DAOs, and how governance, company funds and distributions can be managed as well.
“Section 1. Purpose. The purpose of the Company is to operate a Decentralized Autonomous Organization (a "DAO") through which the Company can accept requests to perform services for third parties, solicit bids on such requests from Members and non-Members, and permit Members to allocate responsibility and remuneration of Members and others for completion of related tasks. The Company may transact such other lawful business as the Members may determine in accordance with this Agreement.”
“The Company intends to govern itself and conduct all of its activities through the use of blockchain technology, software-enabled governance procedures and protocols, and associated voting protocols.”
“Company funds may consist of traditional currency or of digital assets, including, but not limited to, cryptocurrencies and digital tokens. All Company funds consisting of traditional currency shall be deposited in such bank accounts or invested as designated by vote of the Members. Company funds consisting of digital assets shall be held in such a manner as may be designated by a vote of the Members. In whatever form, such funds shall not be commingled with funds of any other entity managed, controlled, owned or advised by any of the Members. All withdrawals from any traditional currency accounts shall be made only by an Administrative Member or by other persons duly authorized by the Company to make such withdrawals. Transfers of digital assets may be made by duly authorized persons or through duly authorized "smart contracts" or other automatic means approved by the Members.”
“The Members will make all decisions related to distributions of cash or any form of currency (including, but not limited to, cryptocurrencies and digital tokens).”
MARSHALL ISLANDS:
The newest option on the map appeared only a few days ago, February 15th 2022.
The Republic of Marshall Islands or RMI is a small country in the South Pacific that used to be part of the US, but are now an Associate State supported by US Institutions, like the military. A recent amendment to their Non-Profit LLC Statute offers clear DAO treatment. Thanks to it, the bylaws of the LLCs can be in the blockchain and token holders can be members. All this with the same level of corporate personhood and limited liability as a US corporation.
With the intention of becoming an international Hub for DAOs to go and incorporate, the MIDAO were created (Marshall Island Directory Services) as a domestic company whose purpose is to work as a concierge to help DAOs easily incorporate in the Island.
Why? => Flexible and tax positive treasury framework that allows DAOs make decisions through the DAOs governance protocols and execute them off chain.
Sounds too good to be true. Why? => Expensive. 6 figure legal fees.
This means that an existing option to legally wrap a DAO is by creating a Foundation at one of these places and from them offshore governance tokens. Legal and international tax experts advice is necessary for such a structure to be set up.
Even though tax benefits can come from these kinds of structures, the IRS might still subject US income tax to a portion of the income gained if there’s a connection between the US and the trade or business. “If a foreign operation’s intellectual property was developed in the United States, or key employees or directors were present in the United States for significant periods of time, the IRS can attribute the portion of business being conducted in the United States as taxable and require the necessary tax filings, tax reporting and payments to resolve”. This is something that should be taken into account by DAOs whose developers are from the US or if their protocol was developed in the US, both for federal and state income tax.
Switzerland (or Zug, the so called “Crypto Valley”) is one of the most “token regulated” countries in the world at the moment, becoming one of the most chosen destinations for crypto projects to develop.
Switzerland provides the following crypto related structures for Web3 projects to incorporate in its jurisdiction, providing favourable tax regimes and limited liability for their members:
The Swiss Foundation
The Ethereum Foundation was created through this Institution, which works best for long term infrastructure projects, like for software development.
Swiss Association An association provides more flexibility than the figure mentioned above, governance and incorporation-wise. Non Swiss projects can find this attractive as board members are not required to be residents and members can be individuals or legal entities. If the association is for-profit, then it must be registered, but in case is not, there is no filing requirements in Switzerland (so a business organization can incorporate as an association operating globally under one brand whilst maintaining separate profit pools and ring-fencing liability in each country in which they operate - without the need of being a Swiss resident).
Decentralized Autonomous Association (DAA) A Decentralized Autonomous Association is a mix between the legal and the Web3 world of DAOs, aiming to create a DAO with limited liability for its members. MME, a Swiss Legal Services Firm, explains how on their example structure, and before providing with a Model Articles of AssociationThe DAA's bodies are: the DAA Assembly (Governing body),DAA Delegates (Board), DAA Member Community and DAA Whitelisters.
Private International Act (PILA) This new legal construct or theory has not yet been adopted by a DAO, but bases its premise in that DAOs are internet native and should be treated in the legal Swiss order in the same way that foreign entities are treated, in the eyes of the Private International Law, therefore recognizing existence of an online jurisdiction governed by its own code (and the digital space as the State from which this law originates).
Why was this added if we still don’t know if it would actually work on the matter? Honestly, because I say so.
But on a more serious note, I haven't seen enough debate in the industry on the philosophical and psychological implications that, not only DAOs, but the Metaverse, have to play on our society. This will be left for a soon to come article.
Cayman Islands have been a destination for “Foundation Companies” for a couple of years now. For the DAOs convenience, this kind of entity can be structured without shareholders and are able to carry on off-chain operations on command as long as the commanded action is not a VASP Activity nor other regulated activity, adopting the role of a service provider for the DAO.
“A virtual asset service is: the issuance of a virtual asset; or the business of conducting one or more of the following activities or operations for or on behalf of another person: exchanging between virtual assets and fiat currencies; exchanging between one or more other forms of convertible virtual assets; transferring virtual assets; safekeeping or administrating virtual assets or instruments enabling control over virtual assets; and participating in and providing financial services related to an issuers offer or sale of a virtual asset.”
Beyond the fact that it can be structured without shareholders, the foundation company can also designate beneficiaries without maintaining a register of them with their legal names, but class them as “token holders”, for example, adapting even better to the DAO structure and token tradeability. The reason is, that the starting position under the Law is that a designated beneficiary has no rights or powers against the foundation company, only those expressly stated by the foundation company.
This means that DAOs can use this type of foundation companies as legal wrapper and, in case of carrying out VASP activities, creating a subsidiary in a jurisdiction that's friendly with virtual assets, like BVI, to carry on such activities. This vehicle can be very flexible as it operates like an incorporated trust while retaining the separate legal personality and limited liability of a company and tax neutrality. Taking into account that the general public reaction to setting up a structure in the Cayman Islands tends to be seen as “sketchy” or “shady”, and some DAOs prefer to start clean reputation-wise.
Liechtenstein. Options to use a Foundation also apply to Liechtenstein (with the purpose to promote the development of a decentralized network of the DAO), who after the approval of their Blockchain Act, a number of token regulations made the country a very attractive destination for blockchain projects to incorporate and issue their tokens. Be noted, we are talking about blockchain companies, not DAOs.
At the end of 2021, the consulting firm PwC published the Annual Crypto Tax Report, where Liechtenstein was ranked to have the clearest crypto tax regulations.
In Liechtenstein, for the legal recognition of DAOs as entities, we do not find specific Institutions like in Wyoming or Vermont, but can consider the creation of a Foundation, as mentioned before in other jurisdictions, or of a Cooperative (it's easy to become a member and transfer your token to stop being a member as well, beyond the fact of adapting better to the community spirit of DAOs). The last one also provides more flexibility regarding governance protocols, more compatible to DAOs than LLCs, and does share the limited liability for members. Then, if the DAO wants to launch a token, a separate company can be set up to do so (similar to an LLC) and afterwards liquidated.
A Private Trust Company is also an option in Liechtenstein.
If the company takes over the administration of the assets (tokens) of the Protocol ( and only its treasury, without providing fiduciary services to third parties),a Private Trust Company can be established (PTC). The PTC holds the trust property in its own name and administers it as trustee for the benefit of the beneficiaries.
After a meeting with NÄGELE Attorneys at Law for a very enriching consultation on the matter, Liechtenstein's advantages on DAO structuring became both clear and attractive.
And I quote:
“The shareholders register in Liechtenstein is not publicly available, which means that the shareholders have a maximum of privacy in this respect.
Liechtenstein only has bilateral enforcement conventions with Austria and Switzerland and only in relation to certain titles. This means that any judgements or other decisions rendered in other countries will not be directly enforced by Liechtenstein courts. This provides for a proper asset protection of assets located in Liechtenstein. Foreign plaintiffs must, if they are not from Austria or Switzerland, post a deposit with the court to secure the presumed legal costs of the Liechtenstein company for the law suit, otherwise their action will be declared withdrawn.
A prospectus (for a capital markets transaction) which is made in Liechtenstein and passed by the Liechtenstein Financial Markets Authority can be passported to the EU and the EEA. This provides for, inter alia, the possibility of making a token offering to the public in the EU and the EEA.
Liechtenstein is – to our knowledge – the first jurisdiction which has introduced a legal regime for the issuance of tokens (including security-tokens). It is therefore possible to issue e.g. a participation certificate in form of a token in Liechtenstein relatively easily and on clear legal grounds, whereas this could cause serious issues in other jurisdictions. Furthermore, the Liechtenstein Financial Markets Authority has experience with the issuance of tokens and passes prospectuses in relation to tokens on a regular basis.”
There is not one perfect solution when wrapping up a DAO, every option that we look up has its ups and downs. We do know that we are asking ourselves these questions because we are trying to provide DAOs and their members and users with limited liability, tax certainty, decentralization at heart, and regulation compliance of all kinds. Still, we also acknowledge that regulation is scare and sometimes/mostly unclear, and each DAO has differents aspects to take into account on legal, tax and financial basis. This doesn’t mean that the task is impossible, but that it does require immense thought and analysis from different professionals in the mentioned areas, and much patience.
Alrighty, I have successfully incorporated my DAO as a recognized legal entity in XYZ jurisdiction (or chose to set up a Web2 structure to give my DAO training wheels before it can fully drive on Web3 stick), can i go play with the big boys, start issuing NFTs and whatnot, take a good look at my white-list, airdropping and the like?
Hold your horses, Cowboy. Don't go riding before asking an important question: Are my NFTs securities?
Howdy, SEC.
Actually not only the US SEC, but the analysis on token issuance by a DAO can be a global financial topic, beyond the USA. Still, we will use this country as main reference.
The key laws to take into account if you want to know if your token is a security: The Securities Act of 1933, The Exchange Act of 1934 and The Investment Companies act of 1940).
I recently read an article by Brady Neal, “Token Offerings and the SEC”, where he made a clear distinction between the overly-compliant viewpoint of “EVERYTHING IS A SECURITY AND YOUR HOUSE SHOULD BE ON FIRE” and the Chad stand of “TRY TO STOP ME. RATHER SAY SORRY THAN ASK FOR PERMISSION, BRUH” (or at least that’s the dialogue that played in my mind, more or less).
Let’s try to be coherent with a careful middle point here, as Brady quotes Brian Brooks: “The SEC’s view [is] that certain tokens may constitute securities''. DAOs will therefore plan on how to issue, offer, sell their tokens - be it governance tokens regarding interaction with the treasury or with the protocol, and others (like an NFT collection for instance).-
I first started writing this section on the paper to address NFT regulations, then I remembered that we ought to be consistent with concepts.
An NFT is a type of token, and the SEC looks upon the different kinds of token offerings as whether they can rule over them or not. We are talking about Airdrops (yes! Airdrops can be considered token offerings too!), ICOs (Initial Coin Offerings), IEOs (Initial Exchange Offerings), IDOs (Initial Decentralized Exchange Offerings), INOs (Initial NFT Offerings - Here they are! -) and STOs (Securities Token Offerings).
Even if you want to hide your ICO, NFTs of whatever as an STO offering, putting on it all the makeup and sprinkles you want, the SEC will look at the intrinsic nature of the token to know if we are talking about a financial instrument that might make you want to flee the country and change your name (try to avoid picking Chad for the new one). If the token is considered a security then members of the DAO could need to be considered accredited investors or comply with KYC plus other rules.
For this, they use the well known “Howey Test” (U.S. Supreme Court case SEC v. Howey Co., 328 U.S. 293 (1946)) and four factors to determine if the token offering is a security (and any kind of investment that might imply being one):
#1. Is there an investment in money?
#2. In a common enterprise?
#3. Is there an expectation of profit?
#4. Is the profit expected to be derived from the efforts of a promoter or third party?
With cryptocurrencies and tokens the main aspects to identify whether registration is required, lies in whether the cryptocurrencies or tokens are acquired by holders to obtain a benefit for the activity of a third party (basically the issuing company) or if said tokens will give the right to acquire a good or service (not necessarily to obtain a capital gain). That is, it must be purchased to receive the good or service, not to resell the token later at a higher price on a secondary market.
The SEC has two categories of enforcement actions if it considers that the Token offering is a security, these are: taking most of the ICO funding a single-digit percentage of the ICO funding.
As you can see, there's a marked difference between one and the other. Beyond this, what they do have in common are potentially excessive legal fees.
According to Cornerstone Research, from 2013 on, the SEC has fined over 2,350 million USD of crypto related security breaches (97 enforcements - 20 of them only in 2021, 70% of those were ICO related). The appointment of Gary Gensler as SEC Chairman in April of the same year might be a sensible explanation to the SEC’s hardening of treatment unto the subject. More of these harsh measures are expected for the short and middle term time to come.
Or not.
If Commissioner Hester Peirce “Token Safe Harbor Proposal 2.0” is approved, the US might become a “safe harbor” for crypto projects for three years, without needing SEC registration, even if we talk about tokens that are effectively securities. Hey, this could happen.
Going back to our sad ambiguous reality:
Yes, we get it. One can have a lot more freedom when you can publicly offer tokens that do not follow applying SEC regulations/approval: its a bigger market when you don't have to limit yourself to accredited investors (allowing them to laterly trade the token) and when you don't have to inicialy worry about having sufficient funding capital, among other things.
In effect, if your token is a security (and no exceptions -sadly- apply to it) then its offering must strictly comply with the US Securities and Exchange Commission (SEC) regulations.
This means that many more restrictions would have to be taken into account regarding: who they can be offered to (accredited investors) and if they can be traded by them or not, funding capital, SEC approval (and how long it takes to get it), whether it can publicly be advertised or not, if its exempt from state laws or not, amongst others, depending on its type and other perks.
Decentralization on a project doesn't mean that the issued token will not be considered a security. Let's avoid this misconception.
Any project that includes the issuance of any type of digital asset that is later offered to the general public in exchange for funds by the buyer, and said digital asset is subject to future benefits coming from the managerial efforts or activities carried out by the original issuer, is very likely to be considered a security on American legislation.
When NFTs are issued with the option of being transferable and then listed on an open market, it is debatable whether there is no intention of the buyer to obtain future profits from the efforts of others and it is very likely that the SEC will make, at least, the attempt to regulate it (regardless of whether it succeeds or not). As mentioned before this is a grey area, not yet clear. Therefore it is a risk and a potential high legal cost of defense and penalties that those who want to go along with the projects must accept.
To avoid running this type of risk in a country with high penalties and high costs associated with litigation, it can be suggested (and then again this is not financial nor legal advice) setting up legal a vehicle in other offshore jurisdictions to carry out such activities (without US tax residents among its members). We saw how foundations could be used ut supra.
Experts on international tax planning should be consulted on the matter. As an example, to create an offshore entity to act as a holding company and be a shareholder of an American C Corp, injecting the gains of its activities as a capital contribution. Or for the offshore entity to inject the funds through loans to avoid tax withholdings for future profit withdrawals.
If founders, investors, or whoever is in charge of making the call, chooses to assume the "USA risk", a possible option is to make as clear as possible that the NFT is a utility token (and not a security). For example by establishing a fixed price for the token and issuing it in such a way that is non-transferable, where its value resides in the utility/function and not in the possibility of obtaining profits through its negotiation.
The SECs definition of a security is not the only one that counts. The criteria to determine an asset as a security can be wider tax wise, therefore having assets considered securities for tax purposes.
As mentioned above, when trying to set up a legal base and structure for a DAO, and considering doing so out of the US in the form of a foreign Foundation for example, taxation might still be present to the IRS if intellectual property was developed in the US, or key employees or directors were present there for significant periods of time, or if the developers are Americans/the protocol developed there. This means that the IRS can attribute the portion of business being conducted in the US, and therefore be considered taxable.
Member/dev nationality and place of development are factors that change the tax analysis to be made, beyond only considered the US.
In the eyes of the IRS, virtual currencies should be treated as property for US income tax purposes which results in a capital gain or loss coming from the sale or exchange of such virtual currency. This can be found in the IRS 2014 Notice 2014-21, relying in the 2013 FinCEN guidance stating that “virtual currency that has equivalent value in real currency, or that acts as a substitute for real currency is referred to as “convertible” virtual currency”
On the other hand, the receipt of virtual currency as payment for goods or services results in ordinary income.
So in case it wasn't clear, yes, DAOs ought to become responsible of filing returns and paying taxes, especially regarding taxation of governance tokens and DAO treasury activities.
Why would governance tokens be taxed though? Because even though they are born as a mechanism for DAO members to make decisions regarding the DAO - and its treasury - and therefore interact with the protocol in a decentralized manner, as most governance tokens are transferable and have or gain market value as the DAO grows, they are subject to income tax.
DAO treasury activities are also taxed, we are talking about their “patrimony”.
Through their treasury, DAOs can generate income -and engage their community even more- in different ways, like staking/liquidity mining, funding grants or lobbying and/or portfolio diversification, and therefore become taxable.
Then again, as DAOs grow and their treasuries thrive, the bigger the need to file and pay taxes becomes.
Usually, lawyer’s don’t “create” or “innovate”, so to speak.
Now we get to. And we need to keep up with an industry that doesn’t sleep. Lawyer’s need to reinvent themselves beyond just providing bureaucratic legal services and provide holistic strategies from point A to Z.
It’s a moment where both worlds can collide, creating legal structures that converge with the core values that crypto brought from its founding: decentralization, community, buidling together.
I dare say that lawyers need to start thinking in a less traditional centralized way and think more like the future that Web3 is already creating. Out of the box.
In future publications, token offering and crypto taxing will be addressed in depth. As well as MotherDAO.
MotherDAO is a fiduciary platform that will enable DAOs to own and manage physical assets, reconnecting them with Mother Earth.
We will soon share the legal structure that is being set up so DAOs can interact with jurisdictions that not necessarily provide them direct legal recognition as entities (and no, we are done talking about Foundations).
If you’d like to discuss, ask questions about DAOs and/or learn about One Big Lab and the MotherDAO Project, feel free to contact me on Twitter or send an email to: fortunata@1biglab.com
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