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December 21, 2022

How to Incorporate a DAO

with

David Kerr

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In this episode, we’re joined by David Kerr, principal of Cowrie LLC and a writer for Andreessen Horowitz, to discuss DAOs and their legal framework. It’s important for crypto users to understand DAOs, especially when it comes to governance tokens. If you're going to be holding and trading these tokens, you’ll want to fully understand what you're signing up for in doing so. David gives us the lowdown, including tax and liability considerations and how to incorporate a DAO. 

David Kerr is the principal of Cowrie LLC, which assists clients with risk mitigation strategies for Web3. He is also the Head of Research at the DAO Research Collective and writes for Andreessen Horowitz. David has 10 years of experience in tax strategy, financial accounting, and risk advisory across the tech industry. 

Mark:

Today we're talking about DAOs and incorporation with David Kerr. David, thank you so much for joining us.

David:

Yeah, happy to be here.

Mark:

I am really excited to have you here today for a few reasons. One, we're both DAO nerds, so I'm sure we're going to get into the weeds and learn and debate a lot. But also because understanding DAOs is really important to people navigating crypto every day, especially when it comes to governance tokens, all these governance tokens are in theory a claim on voting rights in a DAO. So if you're going to be holding and trading these tokens, you better well understand how DAOs actually work and what that claim is, and what you're signing up for when you do that.

David:

I would say that's correct. Yes. Yes.

Mark:

And so you are the guy, you're the expert, you are the author of A Legal Framework for DAOs part one and two, which you published with Andreessen Horowitz. I'd love to start by asking you to help give the audience a sense of what makes you such a credible expert in guide on the subject.

David:

It's funny. I had a lot of different marks along my career where I was doing different things that I wasn't necessarily doing as part of a wider strategy. Certainly not this idea that it would all become useful around cryptocurrency in the future, but I had a very fortunate first step when I started with Ernst and Young. I was working in their Las Vegas office working on gaming issues, and there were just a lot of overflow projects around money laundering concerns, regulatory reporting around transactions for the casinos. There had been a lot of influx of money laundering, and so there was a real development around the AMLKYC practices. So that was kind of one of the areas that I had extensive experience in prior to joining the crypto space that was really helpful in coloring in some of the background.

And then I made a transition to the Dallas office 2014 and was fortunate to work on a very large client that had a lot of intangible property issues, a lot of entity structuring issues. That was just part of the work that kind of came through. And so being exposed to quasi regulated industries, both in gaming and the other client was a telecom client, kind of established the part of your experience and background necessary to understand where different sets of rules can come from and where some of the complexity that's not necessarily ... It doesn't come from one place, so you kind of have to develop the part of your brain, like a muscle, that looks for the connections in quasi regulatory issues, and then also in areas that might capture operational risk, liability risk, taxation risk. All of that comes together, and that's not always the case for the businesses that you work on or the roles that you might have within a client. And a lot of that work was done with me being a very junior member of the team, but the exposure to it created a background where I had tangentially or directly worked on a lot of the areas that color the issues facing DAOs and crypto generally. So that was just a huge, fortunate experience.

And it wasn't totally unintentional. I wasn't wandering around just being from project to project. I think a lot of folks could see where technology was heading in terms of where the workforce was going and where opportunity was going to be into the future, and I think a lot of folks grabbed onto projects and skills to develop around an amorphous shape, but I couldn't have teched a better background, and it was mostly unintentional to that degree it was successful to have developed the areas that were necessary to complete the full picture around what issues DAOs would be facing from a structured standpoint all the way through final level taxation, jurisdictional, all of that.

Mark:

Makes sense. Looking back, the dots always connect.

David:

Well, and it's funny, I think you look at all the people who are practicing the space, and if they go past their initial exposure to it, they all have a story on why they had the background necessary to be able to do this. Because the reality is advising in the space is somewhat terrifying, because you're crossing so many areas of specialty that you would typically see specialists vertical ... You would see a collection of vertical specialists, and there's so much ground to cover that I think everyone's forced to stretch a little broader than I think they're comfortable with. But I think a lot of the folks who have found success advising in the space as attorneys are advisors, accountants, operational struck, everyone seems to have some kind of similar, "Oh, I had this client that gave me this one. I had this experience that gave me that." And I think you need to have some kind of exposure to that kind of background, because if you've existed as a single issue specialist, the breadth and the complexity and the risk in the space is going to be something that would be non manageable as a career path, because you wouldn't have had the experience you need to be able to issue spot, protect risk, and pull the package together.

Mark:

Yeah. Well, it seems like a remarkably tough space to operate in as a lawyer, both because it touches a lot of different areas of law, but because a lawyer bears real personal liability for giving incorrect or problematic advice. And when you're in a gray area that's emerging and you're trying to bring order to the chaos, there's not always a right answer. But of course business practicalities demand and answer, so it's a really tough area to operate in.

David:

Well, I went to law school, but I went straight into advisory and at station. So I worked both on advisory projects and then primarily on audit projects around the tax provision for a big chunk of my career. And so I did not open up a legal shop. I am an advisory practice, and so there's a lot of limitations around what advice I can give and what role I can take. But what it does do is I'm more like a connective tissue between certain advisory teams and the legal team. And so I'll work embedded with legal teams occasionally, depending on what they need out of expertise within the space or on taxation issues, and occasionally I will attach under their attorney-client privilege and function as a member of that team, although I'm myself not the attorney. And then a lot of it is, like I said, that connective tissue of organizing multiple specialists and multiple teams, and then issue spotting to make sure we get legal review, issue spotting to make sure ... Someone else's legal opinion goes on top of my advice in almost every situation.

And so that's really helpful from a personal risk perspective, but that also speaks to a fairly large group of well-funded projects that are able to afford multiple levels of legal advice. And so I don't necessarily find myself in that solo practitioner handling all of this by themselves space. That's not how I'm set up. And so a lot of times when I do an advisory call, an introductory call, the very first thing is, well, there's elements this I can help with that I can certainly help educate a little bit, but your first step's to hire an attorney, and that's not me. And I think a lot of folks are confused by that because it's not necessarily a relationship that they've seen professionally. And so I just have to explain that being a lawyer in practice and being a lawyer from having passed the bar are not in any way the same thing. And so that in advisory practices, a lot of times the cherry on top of a pretty robust advisory team, legal team that already exists.

Mark:

And out of curiosity, how did you come to end up writing these two reports, which were so widely circulated?

David:

Miles Jennings played a huge role in that. He's currently the general counsel for A16Z, but at the time he was a partner in Latham's, I think, developing technology practice. And so he had been one of the initial deal attorneys who was part of the big increase in crypto projects over the past five to six years. And so when he had moved back from London to San Francisco, I think during that time period, that was kind of the project group he got in with, and he was doing a lot of public offerings for startups and he was doing a lot of that work. And that was the group at Latham that carried that practice area for that developing space.

And so when I left EY, I did it a little before COVID, which was just great timing, because obviously there really wasn't a whole lot going on during COVID. And I'd moved to New York thinking, "I'll get a job. I'll take the end of my vacation and I'll start up in New York and that'll be fine." And it probably would've been, but then COVID changed, I think, everyone's math on what a career looks like, on what finding a job in the middle of COVID looks like. And so I started doing ad hoc consulting off of my Rolodex of people who I had had relationships with before, but it was kind of broad consulting base. It wasn't necessarily taxation structuring always. Sometimes it was putting process flow mapping together, or RPA integration into project planning.

And it was kind of whatever I had a relationship with to be able to connect on the work, and then one of the people who I'd reached out to for potential work and this kind of quasi-consulting practice during COVID was Miles. He was like, "No, no, no. We have issues." And he took me through the very first I'd been exposed to treasury concerns around token holders having access to what at the time was an extraordinarily valuable treasury, and then the taxation concerns around entity structuring and how the tax obligations could be met in a way that was compliant. Because a lot of these DAOs, the entity list ones really struggle with where they would pay tax if tax was owed. And so-

Mark:

And just for context, the markets have crashed, but there's still about 10 billion locked up in these treasuries.

David:

Oh, no question. Yeah, no question. Yeah, it's not at all. I think the enthusiasm's down, but I think you're absolutely right. It's still a big number on a tax form, if it comes to that.

So yeah. So Miles and I started that paper when he was still at Latham, and actually, I think, finished the first version of it, or primarily finished it by the time he had left. And we started looking at academic journals to publish in. And it's funny, there's these blockchain journals, but they still operated this old world, old school, "Well, it'll be eight months for publication." And it's like, well, eight months for publications a really long time.

Mark:

Yeah. It's a lifetime.

David:

So he brought it to A16Z, and they were super supportive of adding it to their research directives. And so the first article was basically them approving the publication on their website, and then they commissioned the second one and some work surrounding it.

Mark:

Makes sense. Well, a commission but also a major public service. So thank you on behalf of the DAO space.

David:

Yeah, I have to say, you have critics of the VCs, but I think a lot of times I think we want to look past maybe other VCs and other spaces and conflate it all into one, or every VC in this space. And I think the reality is there's not that much in the way of credible research that it requires so much time and it's an investment, because it's not something you can do and turn [inaudible 00:12:20].

Mark:

Yeah, it's real work.

David:

So I have to say, I was definitely impressed with their willingness to not only engage with me as an outside member, I'm not part of their operation at all, but also where they were willing to fund into the space and acquire talent. And it's not just A16Z. It's Paradigm too. There's a lot of development. There's Ethereum foundations, the DAO Research Collective is an organization I'm a part of that certainly encourages publications. And so there's definitely a push to get there. But I think a lot of times the VCs are somewhat driving the research forward in the space. And undeniably, it's self interest. There's obviously been a big bet made that this space is going to work, and I think they would like to cultivate whatever research they can to help along the way.

Mark:

Yeah, but they're creating positive externalities to help everyone, including themselves.

David:

That's right.

Mark:

That is to be admired or appreciated at the least.

David:

For sure. At the least, yes.

Mark:

Yeah. Okay, great. So let's just start from the top. There's a couple simple questions which we have to get out of the way, I think. There's lots of ways to define a DAO. How would you define a DAO?

David:

It's funny. If you had caught me at any time in the past year, I might have a different answer to that. And I think I'm finally at the point where I've thrown in the towel around trying to give it a solid definition. The train has left the station on the colloquial usage of DAO, to basically mean any organization of people that have an affiliation with any form of blockchain technology.

And I don't take any issue with that from the standpoint of enthusiasm. I think in the reality you've got two main forms of DAO and many, many, many variation within that. But I think you have your native DAOs, which are built around a social construct, that are built around a community, that are built around a shared organizational structure, and develop their role and their activities and their operation by direct democracy or whatever experiment is being made into decentralized forms of governance. And I think that's a wonderful thing, because obviously decentralized governance historically has not been a particularly robust mechanism when compared to centralization.

Anytime there's been a direct challenge throughout most of history, centralization tends to be the dominant form. It's more agile, it's more quickly. But through the elements of technology and the developments of technology, there really is an opportunity to build out mechanisms because of the nature of blocks to build a pause to build ... We've been able to go a little bit wider with how we can approach this technology and the cryptography elements that were foundational to it. And I think you have this really strong case to be made for the fact that we finally have a system that supports a modernized form of decentralized governance. Whether we're talking governments themselves, or voting, that's a huge development. But at the same time, for that to share any different definition, that may not be autonomous, that may not even really be decentralized, it's definitely an organization.

On the other side of the extreme from the native DAOs, you have these protocol DAOs, and protocol DAOs typically are built on some degree of investment, whether it's financial investment through investors themselves, or through just the hard work and sweat equity of someone developing an idea on their own. And that's built around a series of smart contracts that actually operates as a protocol from day one. There's day one functionality, and it may come in the form of an airdrop, there may be a distribution amongst people who've used the protocol in a [inaudible 00:16:11] form, but there's some degree of a fully formed operational infrastructure or protocol has now existed, and there's a community around it through the tokens. But the role of that community with those tokens is not necessarily particularly active when you look at it in terms of traditional managerial function, or structure or leadership. It's a group of individuals who have some say in how the value of that operation gets spent in furtherance of that operation.

Mark:

Makes sense.

David:

And that's makes sense a lot of times what the other side is.

Mark:

So it's a great point. There's a full spectrum of DAOs. So let's narrow in on DAOs that ... There's a protocol and a governance token, just for the sake of conversation. And it strikes me that in the paper there's a lot of talk around what is that group of people. From a legal perspective, is it a general partnership? Is it an unincorporated non-profit association? But a lot of what you circle around is this idea of dominion and control.

David:

Yes.

Mark:

And it strikes me that to what degree do these various people involved in this DAO actually have some sort of dominion and control over the DAO, such that the issues that come up around liability and taxation when you're talking about a group of people are actually even relevant?

David:

Yeah, no, I think that's a very strong point. I think it's the right question.

I think to take one quick step back, the dominion and control point in particular is a tax concept. It's the baseline fundamental principle of US taxation for when you have realizable income. And so it's an ascension to wealth, and you have the ability to have hold of it and have control of where it goes. And yes, you're absolutely right that the question posed by a, let's make it absurd, a million person DAO who all have these tokens who are directing, where in a totally decentralized manner are directing where some of these funds can go in support of furtherance of programs. It's all almost an absurd application of that principle to say any one of them is exercising dominion control over that activity. But at the same time, the laws are, and this is kind of where the paper was written from was over the risks and not so much a ...

An application of that kind of dominion and control, that kind of idea that that is being exercised, if there's two people it's very clear. You and I have control over a treasury that for whatever reason's worth a million dollars. Well we have the ability to transfer that to ourselves. Maybe we should make it three people so there's no ties, but we have three people in this, and two people want to distribute it. Now obviously just skipping past the securities problems of having direct distribution for how you came to be a member of this DAO and these treasuries, we could always pass that money back to ourselves. That's one of our choices. Now, the fact that it might be illegal or the fact that it might violate securities law is somewhat irrelevant, because that's the same choice anyone has when they get a dissension of wealth. It's theirs, they control where it goes, and they have a say in whether it goes to themselves or to someone else.

So if we collectively decide that the money that we're, the value that we have control over should transfer funds for someone else, for a good purpose, but not necessarily a tax deductible one because those rules are difficult. For a good purpose, we decide we want to send that money to a grant for someone to build a tool who can help bridge the protocol we're associated with. Something unequivocally good. But what we're doing with that value is we're transferring it from ourselves, from our collective control, to someone else. And so the general argument there is ... When we're talking about three people it's pretty obvious to see where that tax liability comes from. If we're all assuming US jurisdiction and assuming US issues, then that's probably an American treasury.

But then when we take it to the whole other extreme and we have a million, the question that we have, the problem that we have is, well, is any one person truly exercising dominion control at that point? Is any one person actually moving that situation? And we do have a first principle application where we can go to for an analogy, and it's not a great one. There's tons of general partnerships that operate with this same problem in the real estate space, who have hundreds of thousands of members. Well, tens of thousands of members is probably a more supportable one, but a significant amount of general partners. And these same principles apply to them even though in reality they have that same kind of fractured set up. They are essentially decentralized.

And so the risk there is we come to this decentralization concept. The DAOs are the first example of a decentralized organization, and general partnerships are a decentralized organization, and they carry a history in the common law and a history in taxation where they are given a significant amount of negative treatment in this regard. And you have to accept the possibility that merely by being more globalized and even more decentralized, and more easier to get decentralized because we rely on the blockchain for that technology, at the same time we are looking at a bad fact for where we can take our analysis around what laws might apply.

And so while I'm definitely in agreement with you that that decentralized nature does make some of that, especially around the treasury determination, somewhat absurd, it becomes a little bit less so when you start generating revenue and having that revenue be part of the overall picture that that organization is also making decisions around. And so at the end of the day, is there really a legal out for, well this is so decentralized that this is kind of an insane application of principle. And I think what we look for is, that would be a legislative issue, under the current rules, to the best that we have to adopt them, there doesn't seem to be an immediate exception, and so that's a risk we have to factor in.

But philosophically I couldn't agree with you more. You can certainly see how there's an extreme version of that scenario where the application of the principles doesn't seem to align with the intent or even the previous application of such principles.

Mark:

Yeah, so it sounds like there's a tax issue and then there's a liability issue, and then there's a practicality issue of ... The tax issue is is an individual member going to bear some sort of tax? The liability issue is are they going to bear liability for something the group does? And then the practicality issue as, well, the group has to maybe have a bank account, sign contracts, do things.

David:

Yeah. The real world existence is a very real part of all of this.

Mark:

Right. And so sounds like dominion and control is relevant for tax in the US. It sounds like it's probably less relevant with respect to liability. Is that right?

David:

Well yes, because that's not one of the principles, and so at that point you're looking at just pure membership. You're looking at an affiliation or an association, you're looking at the default rules for ... And you can take that back to the common law, and you can figure out why this association rule is done so broadly. We make associations in our daily life that we don't even notice. And in the activities of that, we do share joint liability, potentially personal unlimited liability. More or less, when we operate as individuals, we walk around accountable for our actions from a tort perspective, from a contract perspective, we are one person making one decision, and the responsibility for that decision is usually pretty easy to track to you.

But at a foundational level, when you start looking at theories of liability, well if you and I are walking a dog or if you and I are starting a dog walking business or maybe baking cookies for an organization for charity purposes, or we just agree as a general favorite to our neighbors to watch the playground for a while, well we've now split up that individual concept of liability, to use the Harry Potter metaphor, like a horcrux. We both now have a shared liability over what was a singular operation if one of us was doing it, and as a joint operation if multiple people are doing it. And so the reason why there's that broadness within the history of joint liability is simply a matter of, it's a very hard threshold question to see who should ultimately be responsible for the actions of a group. And so there's a pretty thin test to become a group, to become an association. And it's not to form a business. It's to take on an undertaking, and it may be a business and it may just be for a purpose. A common purpose.

And that's where from the liability standpoint it gets very difficult is once more than one person's doing it, then we've opened up this door for what seems like a very unfair result. It's the democracy is the worst government until you look at all the other ones kind of situation. It's really unfair that these people have this kind of immediate joint problem. But then if you didn't have that, what would be the overall structure you placed on top of that? And that would be something that would be very hard to enforce, and would not be rules that we could bound our society by, and so that's why we evolved into the space. But understanding where that comes from doesn't necessarily make it easier to apply in a lot of situations, because you do have this reality that unlimited liability is a particularly unfair result for a group of people who've come together, especially for an informal purpose, or maybe not a profit. Different factors make it seem even more unfair.

Mark:

Yeah. Why are you responsible for your brother's actions? Not because you should be, but because how could we function together as a society if you weren't a little bit responsible for your brother's or your colleagues' actions?

David:

That's right. And if you go back to the common law-

Mark:

It's practical, not ethical.

David:

Yeah, no, it is. And the general partnership and the common law carries this burden of an absolute mentality towards the application of that principle. Now in modern times, and this was an area we didn't address particularly well in the paper or in depth, but is probably worth discussing, is that the general principles around liability and general partnerships and corporated associations have gone somewhat of an evolution in modern times.

And so if you were to look at the case law and the statutory developments, legislative history, there's been a trend for, in America, previously unlimited liability entities or relationships to have some protection, like a general partnership. If you didn't commit a crime but you didn't participate in it, there may be an exception for you not having to share that burden of everyone else's actions. You weren't involved, or it did something that you didn't ... There are-

Mark:

There's some limitations on it. There are limitations on it. Yeah.

David:

And the problem with it is there's no cohesive answer to that. It turns into the classic legal answer of, well, facts and circumstances, and every situation's different. But that's the reality, because that's a jurisdictional evolution that doesn't have a uniform standard until you start getting into the uniform acts around unincorporated associations. LLCs are unincorporated associations, limited liability partnerships are unincorporated associations, LCAs, UNAs are all unincorporated associations. And so that's one of the areas where you see significant carve out is this idea that we've come to accept as, in our whole lives it's existed, that in the 1970s the LLC was formed and you really started down this path of hybrid entity forms that carried both the benefits of incorporation, while carrying the partnership structure that didn't carry any of those protections in the past. And so that's an even further step forward.

And at the time the IRS put up the biggest fight against the LLC, because they really used to make firm taxation standards between corporations and partnerships. And then in the '90s, after 20 years of fighting whether or not an LLC should be taxed as a partnership or as a C corp, or as a corporation, which we call C corp taxation colloquially, and it's not actually correct, it's just corporate tax. The IRS got tired of dealing with it and opened up the 8832 elections, and allowed for a fairly stress-free method for determining your level of taxation. And that opened the door even further. So there is evolution on this front. This common law, unlimited liability principle around general partnerships has evolved quite a bit, even for general partnerships. But if you just look at corporatization associations generally, it's evolved tremendously. Because the hybrid organizations in the past 50 years would be unimagined 100 years ago.

Mark:

Makes sense. It's so interesting we think of ... Yeah, it is so interesting that we think of these entities, LLCs and C Corps as so static and monolithic. But in actuality they're constantly evolving and changing, and some of them are actually relatively new, and are different in different places in the world. And I guess there's no reason why we shouldn't expect that as DAOs emerged, there isn't going to be a steady evolution of these entities to incorporate the practicalities and corner cases that they present.

David:

Yeah, I think that's right. I think right now it depends how you theorize it. I think a lot of folks in the crypto space are becoming more and more cynical about maybe the motivations behind the lack of governmental support around regulatory evolution of the space. America is certainly following behind the rest of the world. There's multiple examples of the legislation lag. I think one senator of the other day, testimony said it'd be really great if just crypto could just slow down so the regulation could catch up. And it's just not a particularly accurate reflection of the way technology works.

Mark:

What wishful thinking. Right?

David:

Yeah. But at the end of the day, I think where maybe the crypto folks is we do get kind of myopic on our own industry, our own views, and it's exciting and it makes sense as to why. But it's probably worthy of taking a step back and looking at how much stress regulatory form governance, corporate governance, regulations around technology, taxation concerns around technology like technology development, how much stress, what has worked at least relatively well for the past 50 years is under, in response to every single technology is pushing the boundaries on where to be taxed, how to be taxed, lowering the tax bill, how do you even avoid it, privacy.

And it's pushing the same kind of boundaries on employment laws, and where we look for supporting our employees. We have all of these technological carve outs where unions have taken a step back, worker protection has taken a step back, retirement planning is at an all time low, and you start taking all of these things in effect into consideration and you have a pretty good indication that a robust regulatory environment doesn't have the ability to onboard all this information, process all this information in a comprehensive distilled way. And what we're looking at is just the complete bull work of all of these issues slamming up against him at once and no one on that side having a really credible path forward. And I don't blame them, because I don't know anybody who would in their situation. If you think leading by regulations is the necessity, I don't know how you keep up with all these spaces. And crypto's one small part of all of this.

Mark:

They mean well. It's a constant game of catch up, and I think it's hard to fault them too much for that. It's better than acting too fast and getting it wrong. That's also problematic. So tough balance.

Okay, so two buckets of questions I'm curious about. First, from a token holder's perspective, a lot of these issues around tax liability, let's say not tax for transferring your asset and the gains there, but tax on the treasury and the acts of the DAO, of the group and the funds they control. So the issues around tax and the issues around liability, they almost seem like a false worry sometimes, because in most cases there's actually not even a formal tie between the governance token and the actions of that group, which often is a multisig. So in practice, just because you say something's a governance token doesn't make it a governance token in the eyes of the law. And so to what degree do you think the people who are holding these tokens actually have to worry about these issues if the law hasn't even figured out a way to formally tie them to them? Is it really just the multisig holders who have to worry about these issues?

David:

No, I think that one requires a broader view of the history of taxation and what's not written into the code, where risk comes from. There's a number of liability principles. Economic substance doctrine, also called the sham transaction doctrine, and then also the assignment of income problem. And so what you have, and you can see this in ... And this is why I would have, depending on facts and circumstances, I don't think the broad application of the Cayman Foundation structure as broad as it has been utilized is a particularly good idea. Because there are obviously times where it's the appropriate outcome, but I think it's a little bit more narrow than having a foundation hold all the IP and all the operational structure, and having the token holders sit outside of that as an advisory board who provides input, but not necessarily the final decision making, because obviously they're not obligated to do what they say but they more or less do, there's a particular kind of trust that was utilized where that same kind of design was implemented and the IRS is flagged it as a flagrant violation of the principles of assignment and substance over form.

And so I think the reality is if you have ... There's not going to be a great amount of defense from, "Well we were just relaying it and we didn't have any actual control over it." Because if that's true, if your multisigs have that level of discretion to not enact it, and enact decisions on their own accord, then what you're really saying is you have a very, very centralized entity. And if we go back to the, we've kind of glossed over it because I think it's been talked about a lot, but if you have that level of centralization at the core of your project, and you are impacting the US markets in any way, shape, or form, then you have a US securities problem that is ginormous. And so I don't think there's a whole lot of runway in front of a project who wants to make the assessment that really it was the multisig who were making all the decisions and the voting mechanism of the token was holographic, or ceremonial, or that's not going to ... All of these levers need to exist and some of [inaudible 00:37:16]-

Mark:

You can't have your cake and eat it too.

David:

That's right.

Mark:

You can's have a multisig claiming that ownership is decentralized and hence not control the tokens on security, and at the same time say, "Well all these people don't have to file taxes, and don't really have to bear liability because actually this is in practice a very centralized entity.

David:

That's right.

Mark:

There's a little bit of cognitive dissonance there.

David:

Yes. You might be able to get out of your tax problems, but at the end of the day when it comes to this level of risk tax, optimizing for tax shouldn't wag the dog on ... Tax is not the biggest worry in out of all of this. What makes tax so frustrating, I think, is that a lot of projects would just like to conform to tax requirements, whatever structure they're in. And then they have all of these reporting obligations that are somewhat irrelevant. If they could just write a check for whatever the government [inaudible 00:38:09]-

Mark:

They'd be happy to do.

David:

They would write that check tomorrow. But there's all these other reporting standards.

Mark:

Take my money, take my money.

David:

That's what's really frustrating because it doesn't need to be this hard. It's the reporting requirements, and none of these were built in a vacuum. You look at all the behavior that got us here and it's kind of that three person DAO versus the million DAO. There's a really easy answer on why we know that assignment of income's a problem. If I win the lottery, I grip the lottery ticket and I look at it and I know I'm the winner, I've exercised dominion control over ... That's mine now. I can't just give it to you and say, "This is yours now." I have to collect it, pay the tax before I can transfer ... I can't just hand it to the Red Cross or whomever.

And if you look at it from a trust structure, you can see even more ... And this isn't theoretical, this is real harm that's been done by trust forever, is we put this money in a trust and I'm not supposed to have any control over it, but I tell the person what I want to have happen and they decide that's what they want to have happen. And so really what I'm doing is getting full access to my wealth, while avoiding the tax thing. And so that's the risk with this kind of relayed ... And even taking a step back from tax, we get into these beneficial ownership requirements, and a lot of times that sounds wrong because we don't have any ownership in a traditional sense. There's no equity in a traditional sense, but at the same time there's a carve out for control. So a lot of these beneficial ownership rules deal with do you have control over the decisions of the entity?

Mark:

Just for the listeners' benefit, so beneficial ownership is typically, I think, used in a compliance context where if you're doing KYC or KYB for an entity, anyone who has over 10% of control of the entity has to identify themselves, or something like that. That concept of beneficial. And it looks through, so you can't have one person owning six shell companies that each own 5%. It's like no ... The ultimate owner is the beneficial owner [inaudible 00:40:14].

David:

And that speaks to the other problem with DAOs who have to comply with those beneficial ownership testing is a lot of times they don't necessarily have the ability to close the loop. They don't think they have anyone who owns 25% or whichever test is applying. But then they don't actually have the insight into their entire DAO membership to actually be able to say for certain that they don't. So there's a lot of landmines in this regulatory reporting around DAOs. So you speak to another one ... Yeah, exactly. Six people could be aggregating it.

And so these rules, even though they seem so punitive, exist because to anyone who, I feel like, feels that these are just insane and where do they come from, what I suggest is reading the leaked versions of the Pandora papers, the Paradise papers, and the Panama papers. Because what's in there is an insane amount of enterprise level high quality work to obfuscate ownership, to make it such that you can't even tell if a legal activity exists because there's so many legal forms of hiding shell companies, obscure ... You just don't know who's implicated, and you don't have any of the information you would need to be able to identify whether or not the tax treatment is proper, because you can't identify any of it. And that's the level of obscurity that has been weaponized for the money laundering tax evasion business. It's funny-

Mark:

Don't hold your breath, but I'll put those papers on my night table for bedside reading and I'll talk to you in 10 years.

David:

If you at least want to feel the why. If you feel that it's totally insane and then you want to see what the other side looks like just to get a sense of, "Oh sure." Because if there's any crack over time in law, in tax, someone's going to find it and it's going to rip open into a fisher, and that is just how it works.

I don't have a lot of sympathy for the regulators, because what I would say is utilizing the old school methods of intermediated transactions, and the enforcement actions and overregulation, they haven't done their part to keep up with evolving technology, to use technology to better regulate. So I don't have too much sympathy for them. But at the same time, I at least have sympathy for their objectives which are any opportunity turns into a nightmare on every single law at scale against everyone who's up against it. And so they're always on a losing battle on the war of attrition with potential harm, and faced with some really tough choices. Now, obvious solution, integrate better technology, try to get in front of it, maybe we'd have some better outcomes. But that's where there seems to be a cognitive dissonance.

Mark:

So I'd love to ... We've been focusing a lot in the US. I'd love to talk about the global aspects of this, but I just want to ask one more question on this, which is I'm looking at your DAO entity structure features comparison chart, and anonymity of members is one of the dimensions. And in certain ones of these, there's entities with anonymity of ownership. How is it that you can actually create an entity with anonymous ownership? Let's just imagine it's a bad actor for a moment. How would you go about ... I don't even understand how you can do that.

David:

Well, it's not ownership. But it is control, it is voting. So most of them do not allow for anonymous ownership of the entity ... Most of them don't allow for anonymous DAOs. Really we're talking about on the side that does would be general partnerships, some trusts, and the Unincorporated Non-profit Association, the UNA. And that's in a lot of ways-

Mark:

I see. Because you haven't formally incorporated, obviously there's no register.

David:

That's right. And the US, when they contemplated the Corporate Transparency Act as part of the National Defense Act in January of almost two years ago, Trump's veto was overridden, and it was a big [inaudible 00:44:42] over civil war generalship, like civil war bases being named after generals. And hidden within that was this bill that had been trying to get passed. It had no chance of passing by anyone who lays odds on those kinds of things. Almost immediately overnight they passed it. They made it so forward looking, you didn't even realize that it passed in real time. It still hasn't been enacted yet, the provisions of it, even though it's been law for two years.

And it's a slow transition into it, but more or less it's to bring the US kicking and screaming up to the international standard around beneficial ownership reporting. And the test was more or less built on the Bank Secrecies Act for people who are obtaining bank accounts. They more or less tried to use that same language. They had a little bit less authority, so it's a little less strong, and they applied it to corporate forums in general, which is more or less how most of the world does it.

But if you look at the UK, they have found that having general partnerships or corporate associations evade it still allows for you to have this opportunity for harm, that if you don't have everyone disclose their interest in these organizations you can always find your way through harm. Well the CTA contemplated a study, they're going to look at it for two years, but they also wrote into the law they were willing to face the international recrimination by not rising to that standard, because it's kind of an un-American principle to have everyone who has ... To give up your private information for no reason isn't exactly the American ideal.

And so to your point of it's not that they don't incorporate, because a lot of the entities that don't incorporate still have to register with the secretary of state. It's the lack of registration. So the really good high level litmus test is if you don't have to register your entity with the secretary of state's office, or some equivalent, which is where a lot of those Native American plans around corporate entity structures actually go off track is a lot of times tribal registration either requires some kind of secretary of state registration to go wider than tribal members, or the tribal membership council, the business council will meet the test for the secretary of state if they have registered, so they have to meet it.

So yeah, it's a very technical carve out. It's why Miles and I focused on the UNA so far out. We knew about the CTA, we knew about the risks that was going to have for the ability to have anonymous members. And what I would say from a risk standpoint that I'm very comfortable with is I don't see a reason why a tax compliant entity, at the corporate level, who's meeting all of its informational reporting around the transfer of money, the possible payment of 1099s, the issuances of W8Bs to form. If they're following all of those rules, I don't know why you need to know who the members of that organization are.

Now, if they're not following those rules, then you've opened up the risk and maybe there is potential harm, but it's that closing of all of the loops, and if all that's left is then disclosing a membership group who, like you said, has some ancillary voting right but no direct income stream, no direct role, and no direct in the money being distributed besides having some say, and if those rules are followed, then I think you've closed the loop around the potential harm. And that's why I'm comfortable with saying that it'll support anonymous membership.

Mark:

I see. Makes sense. Okay, so that's the UNA, which is Unincorporated Non-profit Association, right?

David:

Yes.

Mark:

Okay. And so that is the driving point behind your paper. But I think this brings us to the US, non-US, right? Because that's a US construct, and these tax issues we're talking about are US oriented. But in practice, most DAOs have a lot of international members. And in particular, if you're an international member ... Let's try it this way. I understand how US projects and majority US members, they're in the US. It doesn't matter where they incorporate really. But if you're a global DAO, or someone outside the US, there's a lot of drawbacks to joining an unincorporated partnership in the US, because it actually creates potential tax liabilities that you as an individual wouldn't have anyways. In particular, even if you don't owe taxes, tax reporting, which is a lot of the reasons why a lot of hedge funds and VC funds and PE funds are domiciled offshore. They don't want to create US tax reporting obligations for their LPs.

So this seems like a good solution for the US, but how practical is it to incorporate in the US when token holders and governance participants are going to be global, and often don't want to be in the US? IS IT inherently limiting, and thus less relevant?

David:

It's an argument that came up a lot early on in my advisory work, and I did a couple tests around it. I think a lot of times there's a lot more US involvement than people are comfortable acknowledging in the space. And I think we have a US ... If you have a project that was invested in by VCs, if you have one of those projects, and that's where most of the funding for DAOs are coming from is the United States, then that has an ancillary effect where it also makes a lot of the work that's done ... It just has a halo effect around the reality of the situation is a lot of the work that's being done on this, a lot of the interest that's being done on it, a lot of the actual development is being done in the United States. Also a lot of the funding is being done in the United States. I do not argue that there is an international answer to this that has nothing to do with the United States. What I would argue is that it's very easy to say it's an international community when you start looking at the areas where you can fine tune that knowledge. It's not as international as an industry as I think a lot of folks would like to believe it is based on [inaudible 00:50:53] levels.

Mark:

Yeah. You're saying if you're looking at the top 100 governance tokens, let's say, most of them have a pretty big US stakeholder base.

David:

Yes, yes. Now I agree with you-

Mark:

So fair-

David:

But when you get past that, you're absolutely right. And so I think we tried very hard-

Mark:

Well hold on. But it's not just the now. It's the aspirational future. So you may be correct now, but in the aspirational future, a lot of those people ... A lot of these projects want to be global, even if they're mostly US now. They're in the process of decentralization. They may not say they're fully decentralized.

David:

Yeah.

Mark:

Ethereum, for example, is a great example. Ethereum, its founders are American, but is it a majority US thing? I don't know. It seems pretty decentralized, globally.

David:

Yeah. And I think if we call Ethereum a DAO, you look at the Ethereum Foundation as maybe part of that. What they chose was a very tax intensive structure. The European equivalent, there's a certain strategic objective to finding a place that has strong tax treaties internationally, and pays tax, for making your problems go away. And it's somewhat cynical because it's not really representative of Web-3, and I will acknowledge that. But at the same time, one of the things that you can do by paying tax in the United States, or paying high tax in Switzerland, is you can take away your international risk, because you have met what has more or less become the international standard for hard to solve taxation.

Mark:

You go to a legit jurisdiction, and other jurisdictions are not going to challenge you. You go to an ... A jurisdiction's not really legit from a tax perspective or compliance perspective, and other jurisdictions are going to want to-

David:

Open season.

Mark:

Yeah. Open season. Yeah, totally makes sense. So like-

David:

But yeah, you're right. It's somewhat a cynical practice tax analysis that makes that, and that is the reality. For the groups that are US, I think it's a really great option. For the groups that have the case that might solve some problems, that is the second group, and that's a pretty big group too. For truly non-US, then you're absolutely right. But if you want to pay tax one place, have the tax treaties on your side, and clear up the tax issue, and all you're doing it for is 21% of your overall treasury activity that has realizable tax event in that year, which if you were strategic about would not necessarily be your full treasury or even close. 20% of your treasury could more or less run your operations from a tax realization event standpoint. So there is a lower tax way of doing that.

The argument ... The question that I have been asked genuinely, and I feel very difficult answering, because I have two thoughts on it, is I've been asked very directly by European people who don't feel ... Or international people. I shouldn't say European. Especially not in this case. The person I was thinking of was Europe. But international communities have said, "We don't want to pay tax we don't have to pay to the US government." There's a political objection to funding the United States operations. And I understand that concern. And my structure, the idea that I propose, that kind of tax planning around a US-centric obligation does not have a good answer for those people. We are paying tax that you may not necessarily owe, and it may not be the most this current construct.

Now I'm a big believer that from a tax standpoint, I would like to see blockchain evolve where we can get fair apportionment amongst all the jurisdictions. That's what I believe in and I'm working for. That's something that's really not present in current levels of international tax. Basically the G7, the G10 run the taxation game. Everyone else gets peanuts. I would like to see a fair ... And that would hurt the US from an economic standpoint, but at the same time, I would like to see a more fair representation of that activity. I think blockchain could ultimately result in that. This plan around the corporate taxation of the UNA doesn't accomplish that. What it does is it solves risk.

The other side of it though, and this is where it gets difficult, is I am fully aware of the negative characteristics of American exceptionalism, of the American history of where we are in terms of someone having a very viable case for feeling that they don't want to support America, both as an external citizen of the world, and both as internal citizens in America. Any number of people can feel that, directionally, maybe the US government isn't the most responsible caretaker of wealth.

I myself don't ... I understand the concerns. I understand why that's of interest to people. I am of the mindset where I think the US government, for all of its harm and for all of its foibles and for everything that it's done wrong, I still view it as the shining light of potential for international governance. I think they play a huge role. And so yeah, I do support the US, and I've talked about the US taxation a lot because I'm a US domestic specialist, but I do think that yes, I have a patriotic alignment with the United States. It's not necessarily why I do the planning that I do, but I do feel that the United States is the responsible party for taking up that kind of extra taxation, and the best place from a strategic standpoint. But I fully acknowledge why many members of DAOs, for various reasons, would feel differently than me and would not want that payment to end up in the hands of the United States any cent more than it has to be.

Mark:

Well, I'm a US national and very much agree with you. I very much support the United States. I think the issue is, for me, it's not so much the payment. There might not even be payment. It's on some levels the creating of an administrative burden for a non-US person who wants to get involved in the US DAO.

David:

Yeah.

Mark:

The question is why would you force people to bear that if you don't have to? Doesn't mean the US people don't still bear it. It's just, why limit your user base?

David:

Yeah. I would reframe that slightly. The tax obligation exists whether or not the entity form exists. The ability to pay it is what the entity form fixes. And this is where it gets really difficult. When you start getting into foreign partnerships, foreign corporations, they themselves may not have a reporting obligation to the United States, but the United States members of that organization still carry the individual reporting requirement on their return.

And so it's somewhat of a theoretical solve, in the sense that if you don't have any insight into this, how is anyone going to know? But you do have this problem where the individuals ... Yes. But you can't take practical likelihood as a tax planning strategy. That's one of the rules. And so yes, if everyone was quiet about having a foreign partnership or a foreign corporation, then the US members could not put it on their tax return. They would have to lie on the reporting at the very front for their self-reporting assets, but as long as they don't check the box and don't claim it, no one's probably going to know with the current information we have.

I would say the one thing to keep in mind is the area where the IRS has thrown their money is in trying to link wallets, trying to link online behavior, and that kind of not reporting, hoping nothing bad happens strategy, I don't think it's likely to continue. And so I think you do have that problem where the tax obligation on the US side exists whether or not you have a US entity, and so how big that number is where I kind of draw the line on whether or not I think it's a good idea to file in the US. And it's not a hard, fast rule, but that's where it gets complicated.

Mark:

I wouldn't be surprised. As with many things in crypto, this may end up looking a lot the solutions that have emerged in TradFi. There's probably going to be master feeder entities, just like there are in hedge funds and PE firms, where there's an international entity and a US entity and [inaudible 00:59:34]-

David:

Oh, I know.

Mark:

A joint entity, so everyone can be compliant and only take the burden on if they have to.

David:

Oh, I hate that. I hope we use the math to go the other way. I really do, I hope we do the math to send the money to jurisdictions based off of activity and user ship, find some fair test forward and actually help the international tax community. Because this problem exists in all forms of the industry right now. Not just crypto, but all forms of international tax have this. And if we could find some relief to where the jurisdictions who don't receive their fair share of tax income were to get their fair share of tax income, I don't have a whole lot of sympathy for the people in the space who feel like governments don't have a role in this and it should all be tax free, but I'm very much an advocate for getting into the right place and actually having a more representative picture of where tax collection comes from. And I do think that if we pushed on that point, we could make developments in that way.

Mark:

Well, you and me both.

David, thank you very much for sharing your wisdom with us today.

David:

Mark, thanks for having me. Pleasure as always.

Mark:

I'm glad to speak with someone else who gets as energized by tax.

David:

Yeah, [inaudible 01:00:47] it's seven.

Mark:

Yeah. So thank you very much again.

David:

No, happy to be here. Thank you.

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