What I Wish I Knew Before Talking to Lawyers about DAOs

0x9548
October 25th, 2021

Disclaimer: In no way should this be construed as legal or tax advice. Unless you enjoy being subpoenaed, you should definitely talk to a real lawyer ASAP.

Over the past few weeks, I’ve spent dozens of hours talking to lawyers and getting actual legal advice, and the only thing they all agree on is this: DAOs are a legal grey zone. There is no playbook for creating a legally compliant DAO, and there probably won’t be for some time yet. Token issuance is itself a murky subject, but when you combine it with decentralized governance an extra dose of murkiness is added. Everyone is just experimenting and waiting to see how regulators react. So take everything mentioned here with a heavy dose of salt.

Two core concepts to mention going into this are Legal Liability and Tax Protection. The first is obvious - if you are setting up a DAO, neither you nor the actual members of the DAO should be putting themselves in any legal jeopardy. The second is more nuanced - your DAO should pay taxes somewhere. If you don’t, your local jurisdiction may come after the DAO itself. If you’re looking to avoid paying taxes altogether, you can stop reading right now.

With the disclaimer and the basic concepts out of the way, here’s what I wish I knew before talking to lawyers about setting up a DAO:

There are five general options for how to legally structure your DAO:

  1. Don’t set up an entity at all.
  2. US based LLC.
  3. Offshore Foundation.
  4. Onshore Foundation.
  5. Some combination of the above.

Option #1: Don’t Set up an Entity at all.

This is almost certainly a bad idea. Not having an entity at all for the DAO creates three massive risk factors:

  1. No incorporation = unlimited liability. entities default to being structured as a general partnership. That means that any Members - literally anyone who has ever voted in a governance proposal - can be held fully liable in the event of a lawsuit.
  2. No incorporation = crazy tax burdens. Without a formal entity, the members of the DAO have no tax shield. That means, technically, anyone who is involved in the DAO should pay taxes on a proportionate share of the DAO’s income, whether they actually receive any money themselves or not.
  3. No incorporation = no interaction with the real world. Without an entity of some kind, the DAO cannot sign contracts (e.g. SAFTs for investments), pay out 3rd party suppliers off chain, own IP, or hold assets. This may be less or more important depending on what the DAO does, but in most cases it’ll end up biting you at some point.

Many DAOs are currently unincorporated, and maybe that’ll end up being fine? But if and when governments decide to investigate, those DAOs are going to create massive headaches for their leadership teams and their members alike. There are actions you can take to protect individual members (e.g. the DAO is unincorporated, but each core member has their own LLC that interacts with the DAO), but this is a hack and unlikely to be considered an effective liability shield should a lawsuit come. 

Option #2: Create a US based LLC/S-Corp

This is probably the best option for DAOs with a majority of their members in the US. After all, for most teams the US government is the number one regulatory consideration. As the old saying goes, “keep your friends close, but your regulatory considerations closer.”

Within the US, you have a few options for which state to incorporate in.

Wyoming has gotten a lot of press attention for their formal recognition of DAOs. Do not actually incorporate there. According to the lawyers I’ve spoken with, it has the same exact upsides as starting an LLC in another state, but with a number of additional downsides. You’ll have to enter additional paperwork, publicly file a smart contract address (reducing your flexibility in the future), dissolve under certain conditions that don’t apply to an LLC, ensure you’re member managed, etc.

The better option is to set up a Delaware LLC. Not only is this incredibly cheap (few hundred dollars) and fast (typically a few days), but it provides maximum flexibility. As an LLC, you can easily update your operating agreement as your DAO changes. You can also operate as either an LLC or as a C Corp for tax purposes. Many of the most popular DAOs (e.g. Metacartel) are incorporated as Delaware LLCs.

However, the Delaware LLC is not without its drawbacks. First, paid staff of the DAO need to be “Members” of the LLC, creating additional friction for your DAO’s growth. Of course, you don’t have to update your LLC each time you add a Member, but legally you’d be required to do so. Second, you’re fully subject to the vague and maddening US regulatory regime. If you’re a US person creating the DAO, you’d likely be subject to it anyway, but once you incorporate in the US there’s no escaping this fact.

The alternative to Delaware is Nevada, which offers many of the same benefits. Since our project won’t be incorporating in the US, I didn’t dive too deeply into the distinction, but it’s probably worth asking about if you’re US-based.

Option #3: Create an Onshore Foundation

The Foundation structure offers a number of benefits over LLCs. You have the obvious optics benefits - a DAO-as-Foundation just makes sense. You also have the benefit of better tax status in some jurisdictions. And perhaps most importantly, an onshore Foundation can be “ownerless”, which will reduce the founding team’s legal liability if things go sideways.

“Onshore” in my usage refers to a jurisdiction that is not tax neutral. That means your Foundation will have it’s own taxes to pay, in addition to any taxes paid by its members.

The primary countries to look at for Onshore foundations are Switzerland (where they are technically called “Associations”) and Singapore. Both have friendly regulatory structures, and both have relatively low tax rates. If you go the Swiss route, you have the additional benefit of being able to personally negotiate - in advance - your tax rate with the local tax authority. On a legal liability ranking, Onshore Foundations score very highly.

The downside is on tax protection. If you issue a token, there’s a chance you will have to pay taxes on the liquidity you receive which may be detrimental to the DAO’s early operations. Additionally, the Foundation structure also is more expensive to set up. Quotes I’ve been getting are in the $10k-$30k range, though your mileage may vary.

Option #4: Create an Offshore Foundation

“Offshore” here refers to the opposite of Onshore, in that you create a Foundation somewhere that is tax neutral.

The three major options here are Panama, the British Virgin Islands, and the Cayman Islands.

Panama is the cheapest and easiest to set up. They have no VASP (Virtual Asset Service Provider) regime in place. In other words, it’s the wild west. This may sound good, but sometimes the devil you know is better than the one you don’t. There’s no way of knowing what their VASP regime will end up looking like, and it could be quite tricky. Not to mention Panama is just inherently kind of shady. The optics kind of scream “I’m trying to avoid taxes!”.

The British Virgin Islands are second cheapest and second easiest. At the time of this writing, they do not have a VASP regime in place, but they have announced they will have a VASP regime at some point in the near future. From the lawyers I’ve spoken with, the rumors are that it will be relatively stringent. But creating a DAO in a jurisdiction that is just about to create new regulations can create risk that is ideally avoidable.

Based on my initial research, the Caymans appear to be the best option. They do have a VASP regime, but it’s relatively light touch. There are some reporting requirements, and registration with the Cayman Islands Monetary Authority is required if you issue a token, but it’s generally quite friendly. The Cayman also relies on established British common law, so if you do face legal trouble, you’ll have some sense of what to expect.

Offshore foundations seem to cost roughly the same as onshore foundations to set up and are likely just as good from a legal liability perspective. They are, of course, worse on optics.

Option #5: Combinations

So far, the most common approach I’ve seen is actually to mix and match. Typically this means creating a Foundation that is the official legal wrapper of the “DAO” and a separate, wholly unrelated, “Development Agency” (DA) onshore somewhere. This DA is incorporated as an LLC or local equivalent and is registered as a normal non-crypto entity.

A common path is the Cayman Foundation + a Singapore entity. Singapore is often chosen because of it’s relatively low tax rate (~17%), business-friendly regulation, and ease of set up for non-Singaporean residents.

Here’s how it works: the DAO has the treasury. Typically, the treasury is held in a multi-sig wallet that “belongs” to the DAO. The DAO/Foundation should also have a business account with an exchange like FTX to provide a fiat off-ramp should you need to pay lawyers, accountants, etc in meatspace.

The DA pays the leadership team and all associated expenses for the DAO. The Foundation has a Service agreement with the DA and pays accordingly. If, for example, there were $100,000 in expenses, the Foundation may send $120,000 to the DA. The DA then pays taxes on the $20k of profit, ensuring that you are paying taxes somewhere as mentioned at the beginning of this essay. In this fashion, the dual structure seems to provide the ideal balance of Legal Liability and Tax Protection.

Have I mentioned that I’m not a lawyer? Now is probably a good time to repeat that fact.

Getting into the Weeds of the Combo Approach

Before I get into the weeds, I need to first explain the Roles in a Cayman Foundation.

Every Foundation must have at least one Director, Supervisor, and Secretary. These can be human beings or corporate entities, and the same entity can be both Director and Secretary if desired.

The Director literally manages the Foundation. They have a fiduciary duty to act in the best interest of the Foundation’s mission. The Supervisor, well, supervises the Director(s) and ensures they fulfill their duties. The Secretary is an administrative role, and is almost always handled by a local third party.

So here’s the weeds-y question: what roles will your founding team give itself? One option is to make your team the Directors of the Foundation. This means you will have full control of the Foundation and its spending. You can, of course, write language into the Constitution of the Foundation that the Directors will follow the desires of the community, such that there is still a measure of decentralized governance. However, it is not possible - that I’m aware of - to literally tie the on-chain governance outcomes to the actions of the Foundation beyond this. In theory, this means the Directors could go rogue and go against the wishes of the community. On the bright side, this also means that the Directors serve as an emergency backstop in case your DAO’s governance is attacked by bad actors.

The upside of making your founding team the Directors is obvious: you will retain control over the DAO in the face of bad actors.

There are two downsides. First, there’s a potential issue on the tax protection. If a majority of your Directors are from the same jurisdiction, tax authorities there may claim that your offshore foundation isn’t so offshore. In other words, if 3 of your 5 directors are in India, the Indian government may decide to tax your foundation as an Indian foundation. This can be easily remedied by padding your board of directors with local Cayman 3rd parties until no single nationality has a majority. Second, there’s a highly unlikely, but possible, legal liability issue. If you personally are a Director of the Foundation, it may be harder to argue for personal liability protection in worst-case scenarios. This risk is particularly acute if the same people are Directors and owners of the onshore DA. For example, if the US gov wants to claim that you are personally profiting from the DAO in unseemly ways, it may be difficult to argue back. In other words, appointing yourself as a Director creates an individual tie to the DAO.

The alternative is to make the Directors a group of 3rd party people and set your DA (which your founding team owns/operates) as the Supervisor.

The upside though is you create an additional layer of legal liability protection between your founding team and the DAO itself. This may be more important if you are a US citizen or if you otherwise want to keep your personal involvement in the DAO private for whatever reason.

This has the disadvantage of giving power (potentially) to a group of strangers. In practice, these 3rd parties are typically lawyers in the Caymans, so the risk is low, but it does exist. It is also more expensive to go this DA-as-Supervisor route, since you’ll need to pay the 3rd party Directors every year for their services.

Token Issuance

There’s another 381 pages waiting to be written about how to issue a token, but fortunately there are a number of resources online that put it better than I ever could. In short, the best approach is to create a separate entity to issue the token to bottle up some of the legal liability. This is typically achieved by creating an offshore private company that is entirely owned by your offshore Foundation. You should also probably not allow US investors or any investors from your local jurisdictions to access the token sale itself to be extra safe. And lastly, if you issue a token, make sure to register the sale with your entity’s local monetary authority (e.g. CIMA) to avoid any headaches down the line.

Not Satisfied? Me Either

The honest truth is that there are no perfect options for legally setting up a DAO right now. Every option has its own downsides, and every option is complicated. Ultimately, you need to decide on what risks you’re willing to take on the Legal Liability and Tax Protection side and go from there.

Arweave TX
evA-ANnRG0cg6nEQJUOGDnE3lik7ibCSVkc0wsBmppQ
Ethereum Address
0x954888B7a5C6736F4955dF18B556D8328FD02f61
Content Digest
5K9llACK4tzu5WHL68CM3bBsmSleL_XxJ2kRGYnwp7A