The Legal Conundrum of Decentralized Autonomous Organization


DAOs are the next generation of financial and business innovation that are conquering the world. Overall, DAOs provide many benefits over conventional organizations, including decentralization ,member-empowered voting and decision-making, automated code execution through smart contracts, and resource and capital pooling.

As they are not yet recognized as legal entities, DAOs face several legal obstacles. Due to its lack of legal standing, a DAO defaults to a general partnership, subjecting each member to limitless responsibility. In addition, the many countries that may be involved, together with the anonymity of DAO participants, make compliance efforts very difficult for DAOs. Only a uniform regulatory framework can give the legal confidence necessary for DAOs to grow, unimpeded by regulatory inconsistency and gaps.

Is DAO backed by a Legal Entity?

Since most governments do not recognize the DAO as a legal entity, public awareness and recognition of DAOs face significant challenges. In the United States, courts will be expected to assess the consequences of a network of contracts emulating an organization instead of a legally established business.

Since most jurisdictions do not recognize the DAO as a legal entity, DAOs face considerable public visibility and recognition barriers. Without legal recognition, a DAO is not required to comply with the state's registration requirements and hence does not enjoy any business rights offered to ordinary enterprises, such as limited liability. In addition to the prospect of infinite liability, a DAO may be unable to engage in some business arrangements with other companies or the government due to its lack of legal standing. This restricts the kind of businesses a DAO may engage in and can prohibit DAOs from maximizing their earning potential.

In other words, the current legal landscape is just unprepared for DAOs. On the other hand, given the structure of the DAO, it is expected that the US Securities and Exchange Commission (SEC)would view tokens acquired by investors as securities or investment contracts subject to its jurisdiction.

Furthermore, the DAO's voting system is particularly problematic due to its ability to reduce the value of ETH and its own tokens and its conflicting motivations. Due to the potentially dangerous nature of its investments and the prospect of SEC jurisdiction, the DAO may be subject to a regulatory investigation.

In contrast to corporations, limited partnerships, and limited liability companies, DAOs do not have a code of conduct (although, ironically, they are creatures of code). Consequently, there is no corresponding "Model DAO Act" to the "Model Business Corporation Act." In the absence of such laws and regulations, however, it is the community's responsibility to maintain technological and financial openness to continue the development of these decentralized systems.

Who Pays the Taxes & Who handles the Reporting?

Although it may be argued that DAOs are themselves taxable entities, it is still unknown how or where these taxes would be collected. However, the risk of DAO revenues being taxed at the entity level is real, particularly if DAOs grow in popularity.

Decentralized autonomous organizations, or DAOs, offer the Internal Revenue Service a conundrum: how can you tax a decentralized business by definition? How can one establish where a DAO is taxed and who is responsible for its crypto taxes without a defined addressor owner? How are revenue or governance tokens from such a corporation accounted for?

In the United States, there is already a legal precedent for this situation. The SEC determined in 2017that The Dao's governance tokens were issued by a "virtual company" and were thus subject to securities legislation. In addition, after Biden's 2022crypto executive order, SEC Chairman Gary Gensler said that most crypto tokens meet the threshold for securities and should be categorized as such.

No government has implemented legislation despite the seeming clarity of the argument that DAOs might be taxed. This implies that there is currently no clear way to declare crypto taxes on the entity-level gains DAOs earn via fees, investment strategies, or other ways.

In addition, it is unknown if DAOs will be taxed as foreign corporations if one or more of its members reside outside the United States. Some believe DAOs might be taxed as pass-through entities. Thus, although the DAO itself will not be taxed, members will be required to pay income taxes on their portion of the organization's revenues.

Uncovering the Profit Dilemma in the Web 3.0 Domain

Since then, companies that offer meaningful products or services have adhered to a single principle: creating and maintaining cash flow. In the Web2.0 financing model, the inexperience of the founders is compensated for by Investors and Auditors who need continuous reporting on the performance of the project or product. This is a grave error in the Web 3.0 community, which may result in project failure and investor losses when combined with a founder's lack of expertise.

Although we have only started to explore the possibilities of Web 3.0 applications, it is apparent that they have the power to disrupt the status quo. How decentralized initiatives functioning in established businesses may disrupt conventional revenue patterns greatly concern many. Using decentralized peer-to-peer systems, several businesses have started investigating alternative financing sources.

Well, how do web 3.0 firms stay afloat? Numerous models are now based on tokenomics. The ICO bubble and subsequent crisis rested on the issuance of tokens. But there was no way to get it into the hands of users; the token's worth was inherent. In most instances, it was never made apparent how they intended to harvest the produced value.

Furthermore, there are various Web 3.0 arrangements that support the functioning of DAOs:

Revenue Split

The revenue-sharing model utilizes profits to allow distinct players to build efficiency or innovate in mutually advantageous ways by dividing profits.

Percentage Charge

A portion of each transaction conducted on your platform is retained in this arrangement. It continues to be a prevalent paradigm for exchanges and markets. Typically, the seller pays the charge, since they are the ones who gain from a successful transaction on the platform.

Split Income

Using this strategy, consumers participate in the profits of a third party. A non-digital example might be a restaurant where the cashier distributes the tips to everyone. With the framework of Web 3.0, a dollar tip in a coffee shop might be divided with low transaction costs across all actors in the coffee value chain.

Will the sale of tokens to investors be treated as revenue or equity?

STOs (Security Token Offerings) is the latest fundraising mechanism. STOs resemble ICOs in their organizational structure. They entail the selling of crypto tokens developed on a block chain and are backed by something of value (such as shares, dividends, bonds, other assets, or corporate earnings), which may be exchanged, sold, or kept by investors.

Security tokens issued during an STO may be regarded as assets that guarantee ownership rights, dividend payments, or future profit sharing. Consequently, security tokens will establish a contractual duty for the issuing corporation to return cash to the token holders (investors). Therefore, it is arguable that security tokens maybe categorized as financial instruments.

Overall, the features of debt instruments outweigh those of equity instruments, therefore, tokens may be categorized and managed as debt instruments.

Will the tokens be treated as Inventory or Investments?

IFRIC maintains that cryptocurrencies are typically intangible assets according to IAS 38 Intangible Assets, i.e. non-monetary things with no physical existence that transfer economic advantages to the bearer.

Nevertheless, if the cryptocurrency is kept for sale in the ordinary course of business – for instance, if you are a broker-trader (see below) – then IAS 38 does not qualify, and IFRIC suggests that the cryptocurrency be recognized as inventory under IAS2 Inventory.

Moving forward, accounting bodies 'traditional GAAP (Generally Accepted Accounting Practices) will not apply to these decentralized organizations. Moving forward, GAAP might adapt and issue novel practices to suit the unique circumstances represented by DAOs

Bottom Line

Considering their innovation and relatively novel characteristics, DAOs pose significant legal dilemmas. Taxation, reporting, and profit-revenue models in the Web 3.0 realm are still quite hard to comprehend by the public and largely disregarded by official authorities. Still, we will most likely witness how DAOs will acquire more attention in the following years, especially in the legal arena.

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