A California Federal Court Makes a DAO Ruling with Potentially Game-Changing Implications

Apr 18, 2023
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By: Matthew E. Rappaport, Esq., LL.M. and Michelle S. Kabel, Esq.

On March 27, 2023, the U.S. District Court for the Southern District of California ruled that plaintiffs in Sarcuni v. bZx DAO may plausibly allege that bZx DAO, a decentralized autonomous organization, is a general partnership, and that holders of its governance tokens are legally general partners. As general partners, bZx token holders would be fully liable for the damages caused by the multi-million-dollar phishing attack of November 2021. The Court was unpersuaded by the defendants’ argument that recognition of bZx DAO as a general partnership would be a “radical expansion and alteration of long-standing principles of partnership law.”[1] The Court cited the defendants’ decision to not register the DAO as an LLC or other legal entity with limited liability[2] when transitioning control of the bZx Protocol because of their belief that not placing the Protocol in an LLC or other limited liability legal entity would “insulate the bZx Protocol from regulatory oversight and accountability for compliance with U.S. law.”[3]

While this lawsuit is based on a negligence claim, it may provide insight into how federal regulatory bodies may treat and characterize DAOs in the future. As our Firm has previously cautioned in publications, CLE presentations, and on other platforms, many DAOs appear to fit the definition of a partnership under current federal income tax law. The seemingly neat application of Section 761 of the Internal Revenue Code – along with the administrative and judicial interpretations already in existence – makes this legal principle different from other issues presented by blockchain technology, where guidance is much tougher to apply or even nonexistent.

For federal income tax purposes, Section 761 defines a partnership as “a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate.”[4] Many well-known DAOs probably satisfy these conditions because they are typically unincorporated organizations that carry on a business or financial operation, and are governed by members who hold governance tokens and participate in decision-making by proposing and voting on proposals. Proposals that receive the necessary number of votes to authorize a transaction cause the DAO to execute it as a matter of protocol. The nature of these transactions varies depending on the DAO’s mission or shared goal and will ultimately factor into whether the DAO is considered a partnership for tax purposes.

Not all DAOs are the same and may govern across a spectrum of industries and sectors. Common use cases for DAOs include governing social clubs, charities, virtual worlds, decentralized finance (DeFi) protocols, and venture funds. Some DAO activities may not be seen as business or financial operations, but pooling resources to invest in new projects or buying unique assets like original historical documents can be categorized as conducting a business or venture. This may lead to tax partnership treatment and potential risks for the DAO.

Additionally, if a DAO is characterized as a tax partnership, there are specific legal responsibilities that must be satisfied for compliance with existing partnership tax rules and regulations. For example, as a tax partnership, a DAO would have to file an annual information return (i.e., IRS Form 1065 at the federal level), which reports the DAO’s income, deductions, gains, losses, etc. from its activities during the applicable tax year. It must also provide copies of Schedule K-1 to each partner to report on their respective income tax returns. At present, however, many DAOs are neither filing a return nor issuing the necessary tax paperwork to their members. This indicates that, by extension, DAO members are not reporting their tax items from the DAO properly, which could have consequences for those members as well.

Another important consideration is that as a tax partnership, DAOs are required to designate a partnership representative for each applicable tax year under the new partnership audit rules set forth in the Bipartisan Budget Act of 2015. These rules provide that partnerships are audited through centralized procedures at the partnership level, and the audit is unilaterally controlled by a partnership representative.[5] Failure to designate a partnership representative gives the IRS the authority to appoint any eligible person or entity, except for an employee or agent of the IRS, to function as the partnership representative during an audit.[6] The partnership representative carries significant authority and can bind the DAO without the consent of a single one of its members.[7] To avoid this risk, DAOs should seek individualized tax advice regarding compliance obligations.

The tax professionals at Falcon Rappaport & Berkman are here to help you navigate any cryptocurrency- or blockchain-related taxation questions. To contact any one of our tax professionals, please call (516) 599-0888 or submit the contact form below.

[1] Sarcuni v. bZx DAO, No. 22-cv-618-LAB-DEB, 2023 BL 100757 (S.D. Cal. Mar. 27, 2023).

[2] Id.

[3] Id.

[4] IRC § 761(a).

[5] IRC § 6221(a); Treas. Reg. § 301.6221(a)-1.

[6] Treas. Reg. §301.6223-1(f)(1).

[7] IRC § 6223; Treas. Reg. §301.6223-2.

DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship.  This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm.  Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.

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