Navigating the Maze: Choosing a Legal Entity Structure for a DAO
Navigating the Maze: Choosing a Legal Entity Structure for a DAO
Evaluating the existing limited structures and their pros and cons
There’s a lot of uncertainty in the legal structuring of Decentralized Autonomous Organizations (DAOs) inside and outside the US. Globally, regulators have taken an aggressive approach to DAOs and their activities. Developers must be cautious when choosing an entity structure to avoid class action lawsuits, penalizing taxes, and overbearing censorship against themselves and their organizations. There are countless areas to consider when choosing a legal structure, so this article will only cover the basics.
Whether you are considering launching a DAO, in the process of launching a DAO, or have already established one and are exploring legal entity (LE) structure options, questions regarding the most suitable framework inevitably arise. What are the advantages and disadvantages associated with each available option? Which entity structure is the most aligned with your DAO's objectives? And even after selecting a structure, what potential risks still need to be considered?
In this article, we dig into these crucial questions, providing insights and analysis to help guide DAOs through the decision-making process and set them on a path towards success. Drawing from Miles Jennings and David Kerr's comprehensive analysis, 'A Legal Framework for Decentralized Autonomous Organizations,' we raise key considerations when evaluating entity structures. A simple breakdown is shown in the chart below.
A DAO Venture: To Form, or Not to Form?
This question should be considered carefully. There are several restrictions and complex regulatory aspects of decentralization. Depending on the purpose of your project, it may not benefit at all from becoming a DAO. For example, if it’s not associated with a blockchain infrastructure or it doesn’t have a need of decentralization for its members or the service it’s providing, there is no benefit to forming a DAO.
DAOs do have several benefits including full transparency, no central authority or hierarchy, community involvement and collaboration, and automated efficiency.
One Size Does Not Fit All: Pros and Cons of Available Entity Structures
If you believe your project would benefit from forming a DAO, the next step is to decide on whether or not your DAO should utilize an LE structure and if so, which one would fit best. As the header says, one size does not fit all, or any really. No matter which entity structure you choose, issues still arise. Due to the complexity and infrastructure of the technology, it’s difficult for DAOs to fit into the available outdated LE structures.
Determining whether an LE structure is necessary all comes down to the purpose of your DAO. There are numerous differing concepts that fall into the following categories we’ll be shedding light on: Network DAOs, Protocol DAOs, Social DAOs, Collector DAOs, Investment DAOs, Cooperative DAOs, Collective DAOs, and Charity DAOs.
I. Network and Protocol DAOs
Network and Protocol DAOs use tokens as ownership for voting rights to implement any decisions or changes in the applicable protocol or network.
Depending on the nature of your Network or Protocol DAO, you could choose one of the following structures: a non-legal entity, an Unincorporated Non-profit Association, or a Foreign Foundation.
Many people believe DAOs should operate without adhering to governments and their regulators since DAOs primarily exist in the virtual world. This concept can be achieved if certain requirements are met. Network or Protocol DAOs whose principal trait is autonomy (meaning little to no human control over the DAO, no physical operating location, and execution is done simply with code), do not generate or distribute revenue, do not issue governance tokens, and exhibit proper decentralization, can get by without forming an LE structure.
The benefits of a non-legal entity structure are pretty clear, that your DAO doesn’t have to answer to any governing body and gets to be truly decentralized. Its members do not have to reveal their identity and taxes can be avoided. On the other hand, not having an LE structure in place leaves DAOs with the potential of unlimited liability, without any power to hold real property (unless a member can be individually responsible), and the inability to sue if needed. Not paying taxes is great until relevant jurisdictions assert claims on the DAO’s activities. As the space evolves, a non-legal entity structure may not be a viable solution, especially since regulators near and far are cracking down on digital assets.
To solve these issues, a DAO can utilize an Unincorporated Non-profit Association (UNA) entity structure which is offered in several states. UNAs are the most straightforward and flexible LE structure by offering a robust combination of features including sustainable censorship resistance and decentralization, the ability to own real property, limited liability protection, the capability to obtain tax-exempt status or pay taxes as a corporation (depending on the nature of activities), and DAO members can be represented by token ownership without being required to reveal their identity. UNAs are also not required to register within the state in which it was formed. This all-encompassing structure ends up being less costly than alternative structures and can even be tailored to wrap certain DAO activities such as treasury management or a protocol itself.
Yet, there are some disadvantages to this structure that may cause DAOs to look elsewhere. There are limitations on profit distribution to its members; if members receive profits exceeding the allowable amount, it will void the protections gained from this structure. UNAs are also not recognized by all states, but this risk can be mitigated through contractual protections.
The other option Network and Protocol DAOs can utilize is a Foreign Foundation, which is the most common structure used by Network and Protocol DAOs. DAOs utilize this structure to ensure the entity itself holds the fiduciary obligation and not its members. Like a UNA, this structure solves the issues that a non-legal entity structure brings including member token ownership, identity revelation, liability, and operating flexibility. Additionally, it enables DAOs to manage international ownership and control, particularly in cases involving foreign-sourced income, and does not restrict DAOs from generating and distributing profits, subject to applicable securities laws.
However, Foreign Foundations come with many disadvantages. It’s complicated, time consuming, costly, has strict compliance requirements, and forces international transfer of intellectual property. One of the strenuous compliance requirements is the appointment of a board, restricting member direction, which contradicts the core principle of decentralization. Even though people believe Foreign Foundations offer less stringent regulation and control than US structures, they are actually more susceptible to worldwide regulatory attack. And if DAOs have significant US activity, they may not benefit at all from foreign structures, as this creates additional reporting obligations, cost, and potential tax complexities.
II. Social and Collector DAOs
A Social DAO’s purpose typically is to establish a community that is capable of trustless coordination and share the costs associated with DAO activities. Collector DAOs pool various resources together, usually including art (often in the form of NFTs), to own and display them.
Like Network and Protocol DAOs, Social and Collector DAOs can benefit from utilizing a UNA or Foreign Foundation (discussed in section I). Another potentially advantageous structure for Social and Collector DAOs is the implementation of a Limited Liability Company (LLC).
LLCs are flexible US structures that offer the benefits of a corporation while operating more like a partnership. Some states, such as Tennessee and Wyoming have recently introduced DAO-specific laws within their state’s LLC frameworks. By adopting LLCs, DAOs can address the issues associated with non-legal entity structures (see section I). LLCs promote decentralized governance with limited liability protection that extends to on-chain activities, ensure tax treatment certainty and flexibility, and are cost effective. Moreover, they can facilitate member token ownership and transferability, and avoid legal agreement signatures by members. Similar to Foreign Foundations, LLCs allow for profit generation and distribution, subject to applicable securities laws.
Nonetheless, LLCs are not the perfect structure. For instance, LLCs restrict the autonomy of DAO members and require the maintenance of a member list. If DAOs fail to meet the structure's requirements, such as exceeding the member limit, they could lose limited liability protections causing increased regulatory control. Furthermore, if governance tokens represent membership ownership, they may be subject to securities regulations. This introduces greater restrictions, making a UNA structure more appealing.
III. Investment DAOs
Investment DAOs, a very common type of DAO, are usually compromised of a group of people that pool their money into a vehicle to invest together, often executed on a member vote.
Similar to Social and Collector DAOs, Investment DAOs can benefit from utilizing an LLC structure (see section II) with flow-through taxation to their members. However, Investment DAOs must follow certain requirements like using a traditional bank and disclosing smart contract details including location. To qualify for SEC exemption, Investment DAOs need to meet certain criteria: maintain a membership count below 100, refrain from publicly advertising membership, ensure every member votes before reaching a decision, and avoid member ownership in the form of securities. The disadvantages of LLCs are discussed in section II.
IV. Cooperative and Collective DAOs
A Cooperative DAO is an organization where operations are fairly controlled and owned by its members while a Collective DAO (not be confused with Collector DAOs) is an organization that is managed without hierarchy. These two types of DAOs are more general structures.
Cooperative and Collective DAOs can leverage an LE structure that we haven’t discussed yet, a Limited Cooperative Association (LCA). LCAs are usually incorporated in Colorado, which has adopted the Uniform Limited Cooperative Association Act.
The LCA structure effectively addresses the challenges encountered by a non-legal entity (see section I). DAOs have effectively used this structure to handle member benefits such as payroll and healthcare, add flexibility to member voting activities and ownership transferability, and obtain limited liability. Additionally, LCAs permit profit generation and distribution, potentially allowing for tax-free financial distributions based on contributions. As long as Cooperative DAOs adhere to the applicable securities laws, they can establish a clear pathway for distributing profits to their members.
Conversely, these benefits come with some drawbacks. LCAs necessitate compliance with both federal and state regulations, which can cause hurdles for certain DAO activities. Moreover, there are securities limitations and tax obligations to consider such as the risk of member identities being revealed if electing corporate taxation. Nevertheless, engaging legal counsel can help navigate the abundance of compliance requirements.
V. Charity DAOs
A Charitable DAO’s purpose is to perform charitable acts, promote social welfare, and operate with a non-profit objective.
Charitable DAOs can obtain tax-exempt status, if all requirements are met, by utilizing a UNA (see section I) or a non-profit corporation structure.
The benefits for a DAO obtaining tax-exempt status include tax savings and exemptions (federal income tax), fundraising appeal, grant eligibility, enhanced credibility, and long-term sustainability.
However, if a Charitable DAO cannot comply with the legal requirements, it will be considered a taxable entity. Under US law, members are not allowed to receive profit of a certain threshold. Awarding DAO members for doing charitable work is a great concept but awarding them would disqualify the DAO for tax-exempt status. To maintain tax-exempt status and avoid penalties, you are required to include significant disclosures to demonstrate compliance with the legal requirements, and proficient record keeping and reporting. Tax-exempt status also compromises the DAO's ability to be decentralized and anonymous, the main points of a DAO. If a treasury is involved, it must only be for a charitable purpose which requires significant off-chain control to operate. One should only choose to utilize a non-profit corporation if able to comply with the abundance of rules.
Conclusion
Navigating the legal structuring of DAOs is a complex task that requires careful consideration. The aggressive approach taken by global regulators towards DAOs has created uncertainties and risks that developers must address. Choosing the most appropriate entity structure is crucial to mitigate potential legal issues and ensure alignment with your DAO's objectives. Whether you are considering launching, establishing, or are already running a DAO, the decision-making process revolves around understanding your project's purpose and needs.
Each available entity structure varies in its advantages and disadvantages and comes with its own set of considerations including compliance requirements, liability protection, tax obligations, and governance limitations. By thoroughly analyzing their specific needs and seeking legal counsel, DAOs can make informed decisions when selecting an entity structure.
To avoid additional stringent regulation, developers must band together with regulators to develop legal structures, laws, and guidance that do not hinder functionality and that add certainty and flexibility for DAOs. In the meantime, DAOs must step up to the challenge and adhere to these limited LE structures as a means to mitigate risks for their members and pave the way for the DAO’s success.
We are not providing legal advice. It is always recommended to seek legal advice when considering the appropriate structure for your project or DAO to ensure compliance with applicable laws and regulations.
References
Jennings, Miles and Kerr, David. Dao Entity Features & Entity Selection, 1 Dec. 2022, a16z.com/2022/05/23/dao-legal-frameworks-entity-features-selection/.
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