by Jacqueline Radebaugh

What is the legal treatment of payments to DAO contributors?

If you have been active on Twitter this past year, you probably came across a reference to DAOs and maybe you saw statistics about developers and other folks quitting their jobs to become full-time web3 and DAO contributors. In my work, I have received many questions about DAOs’ legal status and distributions of tokens, and whether they are securities, or need to follow any securities regulations. I don’t pretend to have it all figured out, but I’d like to start the dialogue.

While operating as a bedrock of web3, DAOs[1] suffer from legal uncertainty in a variety of areas: legal status regarding their entity format, securities concerns regarding tokenization and tokenomics, multi-national nature of contributors and members, anonymity of members, taxation of tokens in the various contexts where they are used, etc.

Our team has been working with DAO’s since 2020 and many of them have adopted the Colorado limited cooperative association (LCA) to formalize their legal existence, protect members from personal liability, for tax compliance, and to create more certainty about real-world interactions and provide guardrails over mission protection. We wrote about our experience working with these DAO-coops here.

The tax treatment of payments made by the DAOs to its contributors (and community members?) is one of the aspects I have not heard much about. These payments are called rewards, patronage, bounties, and others, and are often made in the form of tokens – ERC20, utility, stablecoins and other cryptocurrencies. Generally, the IRS has treated cryptocurrency as property with a fair market value[2], and therefore, these sums can be taxed. (Patronage has a specific definition and treatment in cooperative practice and our team has several blog posts about it[3].)

However, I am often asked whether the DAO needs to comply with KYC when formally admitting members and making payments to their members, and generally, as an entity operating online, and sometimes in real life. While there may be uncertainty about the specific tax treatment of each type of payment a DAO makes (what are they for and in what form the payment is made are relevant factors), there is a rule of thumb to keep in mind.

Payments Made

Per the IRS, if, as part of your trade or business, an entity made any of the following types of payments, it will need to file a form 1099 (-MISC, -NEC, or both) for each person to whom it has paid during the year:

  • At least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest.
  • For each person to whom it has paid at least $600 for the following during the year[4] (Form 1099-MISC):
    • Services performed by someone who is not your employee (including parts and materials)
    • Cash payments for fish (or other aquatic life) you purchase from anyone engaged in the trade or business of catching fish
    • Payments to attorneys (including law firms or other providers of legal services)
  • For each person to whom you paid the following during the year (Form 1099-MISC):
  • rents (box 1);
  • Prizes and awards (box 3);
  • Other income payments (box 3);
  • Generally, the cash paid from a notional principal contract to an individual, partnership, or estate (box 3);
  • Any fishing boat proceeds (box 5);
  • Medical and health care payments (box 6);
  • Crop insurance proceeds (box 9);
  • Payments to an attorney (box 10) (see Payments to attorneys, later);
  • Section 409A deferrals (box 12); or
  • Nonqualified deferred compensation (box 14).

 

Not required to file information Returns

You are not required to file information return(s) if any of the following situations apply:

  • You are not engaged in a trade or business*.
  • You are engaged in a trade or business and
    • the payment was made to another business that is incorporated, but was not for medical or legal services or
    • the sum of all payments made to the person or unincorporated business is less than $600 in one tax year
  • Some payments do not have to be reported on Form 1099-MISC, although they may be taxable to the recipient, for example, payments to a corporation (including a limited liability company (LLC) that is treated as a C or S corporation).

The payments that must be reported on Form 1099-MISC are only those that are made in the course of a trade or business. Personal payments (from person-to-person) are not reportable. You are engaged in a trade or business if you operate for gain or profit. And while I can see an argument that operating for gain or profit is not the goal of DAOs as entities, you must know that nonprofit organizations are considered to be engaged in a trade or business and are subject to these reporting requirements, so DAOS are likely subject to reporting as well in similar scenarios.

Now, it is true that the rules refer to payments typically made in the form of cash; and DAOs don’t often do so – as I mentioned, compensation in the DAO context may be made in a variety of forms which may or may not have market value. The concept of barter may then play a role here. Bartering is the exchange of goods or services usually without the exchange of cash, and it doesn’t include arrangements that provide solely for the informal exchange of similar services on a noncommercial basis (the IRS’ example is a babysitting cooperative run by the neighborhood parents).

Barter transactions must be reported in a 1099-B by what is known as barter exchanges – platforms where people offer their goods or services to be exchanged. When the barter does not pass through an exchange, it does not need to be reported in a 1099-B, however, if the payment falls within the payments that required a 1099-MISC, then the 1099-MISC might be required.

If the payor (you, the DAO) fails to issue and report a 1099-MISC, the payee still can report those amounts on their end…but failure to file the 1099 on the issuer side will result in penalties varying between $50-$580.

As I mentioned, I’d like to start a dialog on this topic, so send your questions on Twitter at @jacR and @MuchnikYev to guide our team’s research for answers!

[1] The first references to Decentralized Autonomous Organizations seem to date back to 2005, with the first one being formed in 2016. Since then, they’ve operated under the radar, but I’ve come to believe that their “reappearance” in 2021 and explosion in 2022 is just the result of the many very successful projects that they have brewed between the formation of The DAO in 2016 and now. See this legal paper for some references.

[2] Recently confirmed also in the context of a Tezos staking set of transactions; see https://www.coindesk.com/policy/2022/02/03/irs-offers-tezos-staker-refund-on-rewards-tax-in-break-from-current-policy/.

[3] See this one, and this one, and this one.

[4] You must also file Form 1099-NEC for each person from whom you withheld any federal income tax (Box 4) under the backup withholding rules regardless of the amount of the payment.