First published in BanklessDAO’s Decentralized Law, “Decentralized Autonomous Organizations,” July 28, 2022.
Decentralized autonomous organizations represent a new organizational structure that, in form if not always function, allows for decentralized decision making using blockchains and token-voting mechanisms. Where legacy industrial corporations are reliant on the separation of management and ownership, DAOs offer a radically different template for organizational participation where ownership and management are merged — driven by smart contracts, fluid memberships, and transparent transactional channels.
One of the most discussed aspects of DAOs is the ongoing debate surrounding their legal status and structure, and the mechanisms that allow DAOs to interact with the rest of the world. What mechanisms will allow an organization that is intrinsically global to benefit from legal personality and limited liability? Can this occur without being incorporated in a single jurisdiction? What are the ideal jurisdiction and entity structures? Ultimately, can an on-chain organization comply with jurisdictional legal obligations while retaining its sovereignty, and do they even want to?
Incorporating a DAO in any jurisdiction is generally not straightforward due to administrative — more so than substantive — hurdles. Most jurisdictions won’t accept reference to on-chain code as an operating agreement or bylaws, and even incorporation of these fundamental aspects of a DAO by reference can be difficult. Additionally, identifying the members of a largely anonymous or pseudonymous organization can be problematic, for obvious reasons. Incorporating or associating a DAO with a pre-existing legal entity structure is generally analogous to fitting a square peg into a round hole. With enough manipulation or hammering, it may eventually work, but your peg will almost certainly no longer retain its original desired attributes.
A handful of forward-thinking jurisdictions are already making modifications to current entity structures or working to create new structures to support DAO incorporation in their regions:
In the United States, Wyoming, Vermont, and Tennessee have implemented changes to existing limited liability company (LLC) laws, in addition to recently proposed federal legislation regarding DAO recognition.
The Republic of the Marshall Islands (RMI) has already passed legislation implementing a non-profit DAO LLC structure and is working to implement additional for-profit structures.
The Kazakh government is modifying existing structures with the stated ultimate goal of creating bespoke structures that will accommodate for-profit and non-profit DAOs in a special economic zone known as the AIFC.
Additionally, in 2021, the Coalition of Legal Automated Applications (COALA) published a proposed model law that emphasizes recognition by jurisdictions, as opposed to registration, to accommodate the global and transnational nature of DAOs.
Legal uncertainty continues to impede the growth and widespread acceptance of this new form of social organization. However, many may have forgotten that the U.S. LLC only came into existence in the late 1970s. The LLC only then acquired the full taxation and liability protection benefits that have allowed it to become one of the most commonly utilized enterprise structures since the early 1990s. The legislative changes required to reach that point were only brought about due to lobbying efforts by affected businesses and associated interest groups. Similar efforts, likely on an international scale, may be required to facilitate widespread adoption and use of DAOs — in whatever format — as a viable organizational structure or business model.
As mentioned, the U.S. LLC structure was developed in the late 1970s to address the radically different tax regimes imposed on incorporated and partnership structured businesses and the lack of limited liability in unincorporated U.S. entities. Partnership tax provisions impose only one level of taxation at the owner level (i.e. ‘pass-through’) and provide a number of other benefits, including the ability to allocate profits and losses more flexibly. Corporate tax provisions (with limited S corporation exceptions) require corporations to pay two levels of tax, once at the entity level and again at respective shareholder levels.
At the time of the LLC's creation in 1977, partnership classification regulations administered by the Internal Revenue Service (IRS) imposed certain requirements on all unincorporated business organizations seeking the benefits of partnership taxation — and also precluded application of limited liability for non-corporate organizations. In 1988, the IRS issued Revenue Ruling 88-76 allowing the initial Wyoming LLC to be classified as a partnership despite the presence of limited liability protection. Adoption of the LLC as a recognized entity structure ultimately represented a new solution to the limitations imposed by the two-tier corporate tax structure and the preclusion of a limitation on liability by unincorporated organizations.
The 1977 Wyoming Limited Liability Company (LLC) Act established the first unincorporated business entity in the United States to combine statutory limited liability protection with the ability to be taxed as a partnership for federal income tax purposes.
The Wyoming Act was written specifically for Hamilton Brothers Oil Company (Hamilton). Due to the high-risk and speculative nature of their investments, Hamilton needed a flow-through entity to provide one level of taxation and limited liability protection similar to the Panamanian ‘limitada’. In contrast to the U.S. entities available at the time, limitadas provided direct limited liability as well as the opportunity to secure partnership status for U.S. income tax purposes.
However, Hamilton quickly discovered that limitadas faced administrative challenges in the U.S. and, because no analogous company existed, raised doubts about the extent to which U.S. courts would recognize their limited liability feature. Because no feasible domestic entity combining limited liability and partnership taxes existed, Hamilton utilized attorneys and lobbyists to establish an unincorporated domestic entity similar to the foreign limitada in a friendly jurisdiction. The proposed entity would satisfy the literal criteria of a partnership while also offering direct limited liability protection to all participants.
The proposed LLC Act was modeled after the German GmbH Code and the Panamanian LLC Act. These entity structures had four basic characteristics:
The LLC’s name must contain some form of the word ‘limited’.
LLCs are afforded full juristic personality.
LLCs may use the partnership concept of ‘delectus personae’, in which the LLC is given control over the admission of new members.
An LLC will dissolve on the death of one of its members, unless otherwise stated in the articles of association.
The newly developed LLC structure was initially introduced to — and rejected by — the Alaska legislature. Shortly after the rejection of the LLC legislation in Alaska, Hamilton presented an identical LLC bill to the Wyoming legislature, which promptly achieved enactment on March 4, 1977.
Armed with the newly established Wyoming LLC legislation, Hamilton submitted a request for a positive partnership classification ruling from the IRS, the federal agency charged with determining whether unincorporated businesses escape association status. In 1980, following significant lobbying efforts, the IRS issued a favorable private letter ruling to Hamilton Brothers Oil Company regarding its Wyoming LLC. Unfortunately, this form of opinion is only applicable to the soliciting party. In early 1983, the IRS announced that it would review the impact of applying limited liability to organizations classified as unincorporated. During the five-year study, while LLC tax status and limitations on liability remained in limbo, further growth in LLC legislation and businesses employing the structure predictably ground to a halt. The LLC had little prospect of mass adoption as long as its taxation status was in question.
On September 2, 1988, the Internal Revenue Service issued Revenue Ruling 88-76 — a public interpretation of the law on which all taxpayers may depend — allowing the Wyoming LLC to be classified as a partnership despite its limited liability attributes. Following the IRS's landmark decision to recognize the LLC's right to be taxed under the partnership rules, states began to implement legislation adopting the LLC as a business structure. By the end of 1996, all fifty states and the District of Columbia had passed legislation allowing the formation of LLCs within their borders. This new business form rose from obscurity, to be a viable alternative to partnerships and corporations, in less than 20 years, a rate unprecedented in the development of business organizations.
Ultimately, the LLC's battle to emerge as an independent, viable alternative for doing business revolved around convincing the IRS that it met the partnership classification requirements. The LLC’s current viability as an entity structure only came about due to concerted lobbying efforts, and DAO proponents should understand that such targeted efforts will certainly be necessary to craft legislation that will allow DAOs to operate optimally and without sacrificing their inherent attributes.
In 2022, Senators Cynthia Lummis, R-Wyo. and Kirsten Gillibrand, D-N.Y. co-sponsored the Responsible Financial Innovation Act. DAOs were clearly not at the forefront when drafting the bill; one half a page out of the 69 pages of legislation addressed recognition of DAOs. The bill specifies that the default classification for these community-led entities is as business entities for tax purposes. It also requires most DAOs to be properly incorporated in accordance with existing laws of an identifiable jurisdiction, such as an LLC or partnership. The bill allows putative DAOs to avoid business disclosure requirements and not be considered a business entity if they can prove they are sufficiently ‘decentralized’. Ultimately, the legislation leaves a lot to be desired. It is, however, at least a starting point.
At the state level, Wyoming, Vermont, and Tennessee have made efforts to accommodate DAOs by enacting laws that specifically acknowledge the validity of blockchain smart contracts as governing documents. Theoretically, this allows DAOs to simply point to the respective blockchain or contract to legally verify the members of the LLC while concurrently maintaining the benefits of blockchain technology — privacy and immutability.
Jordan Teague and other crypto-native attorneys have discussed some of the inherent limitations and design-choice issues associated with existing U.S. DAO LLCs.
Compared to creation of the Wyoming LLC in the 1970s, legislative efforts to accommodate DAO registration in the U.S. have primarily been related to minor administrative modifications. Where the early Wyoming LLC Act combined attributes from distinct already-existing legal structures, the U.S. LLC acts are simply making administrative concessions. Due to the unique attributes associated with DAOs, a bespoke entity structure — designed specifically to accommodate the unique needs of an on-chain entity while still allowing real-world interactions and limited liability — may ultimately be the ideal way to accommodate DAO registration and activity.
As of 2022, the Republic of the Marshall Islands (RMI) officially recognizes DAOs as legal entities, thanks to the Amended Not-for-Profit Entities Act of 2021 (Act). The act allows DAOs to register as Marshall Islands Non-Profit DAO LLCs and is based on legislation passed by the RMI government with the assistance of the founders of MIDAO Directory Services Inc. (MIDAO). In addition to its legislative efforts, MIDAO is a multinational organization that was formed to act as the registered agent for RMI DAOs and to assist DAOs in registering in the Marshall Islands under the new amendment.
As previously stated, MIDAO led efforts to facilitate pro-DAO legislative changes. Former RMI chief secretary and co-founder of MIDAO, Bobby Muller, has stated that his country recognizes that now is a “unique time to lead” the “blockchain revolution”, and that DAOs will play an important role in creating “more efficient and less hierarchical organizations”. MIDAO's strategy is to provide a competitive cost of incorporation, a supportive government with internationally recognized courts, and an environment open to technological advancement. In addition to the non-profit LLC structure, MIDAO is also currently working on legislation that will allow the registration of a for-profit DAO LLC option that may be particularly useful to investment DAOs.
Poko is a Y Combinator-backed startup that, in addition to on-chain DAO governance tools, is focused on making wrapping or associating DAOs with associated legal-entity frameworks as frictionless and inexpensive as possible. Poko believes that operating in a DAO should not preclude the project or members from taking advantage of the benefits afforded to a governmentally recognized legal entity, including the ability to contract, limitations on liability, tax implications, and other advantages associated with corporate personhood or jurisdictional personality. Poko is approaching its legislative efforts in iterative cycles in order to create a live-model jurisdiction that will allow DAOs to have a legal form that is compatible with on-chain governance.
Poko is working with the Kazakh government to establish a new DAO jurisdiction based in the Astana International Financial Centre (AIFC). The AIFC is a Kazakhstan-based common law special economic zone that is developing innovative and forward-thinking financial regulations. AIFC was created in 2018 to establish a modern financial and legal hub between Asia and Europe. In 2021 it received an influx of bitcoin miners, and other cryptocurrency-related entities, as the result of China’s ‘crypto ban.’ As a result of this exposure, Kazakhstan became interested in developing a dedicated crypto/Web3 industry. To facilitate the initiative, the President endorsed a national crypto strategy.
Cryptocurrency exchanges such as Binance and Bitfinex are set to open operations in the AIFC before the end of 2022. In contrast to other offshore hubs, AIFC and the government are implementing training programs to accommodate more than one hundred thousand information and technology engineers, with the goal of providing value to the crypto economy via a trained pool of workers. To distinguish itself as a well-regulated Web3 jurisdiction, the AIFC has implemented, or is considering, the following legislation:
A national crypto strategy which allows crypto-fiat rails for exchanges.
Introduction of a central bank digital currency.
Implementation of laws recognizing NFTs as a distinct form of IP.
DAO governance structure experimentation and development of public goods.
Poko has been granted exceptions in the AIFC to create an initial limited number of ‘test’ DAOs, associating them with existing legal entity frameworks (foundations and special purpose vehicles (SPVs)). To facilitate the process, certain requirements that DAOs might have difficulty fulfilling have been eliminated for the test DAOs. Poko has already established the first investment DAO SPV in the AIFC and is working with regulators to have the next 100 test DAOs approved by the end of July 2022. Accommodations for the initial SPV-structured DAO included streamlining the overall registration process — and ensuring a fully electronic process, determining the best way to conduct KYC/AML/CFT requirements, issuing tax registration numbers, and establishing crypto-fiat banking rails.
Based on the findings derived from the test DAOs, Poko will develop and introduce proposed DAO-specific legal structures to the AIFC in 2023. Considerations for this bespoke entity would include 1) zero percent corporate, income, capital gains, and dividend distribution tax rate until 2066; 2) the ability to utilize a common law legal regime based on English law for the first time in central Asia; 3) a frictionless corporate e-filing system that can be integrated with Poko’s dashboard; and 4) an independent court with leading British judges and International Arbitration Center for dispute resolution. Poko is also collaborating with the banking authority to establish a pilot crypto-fiat banking facility to accommodate crypto-native transactions.
Poko’s goal is to facilitate decentralized on-chain and off-chain decision making and to allow DAOs and their members to choose their own on-chain and off-chain governance structures. Poko will provide entities in the AIFC — and eventually other jurisdictions — with the resources they need to succeed. Poko has stated that it is working to make Astana the ‘A’ in the ‘ABCD’ (Astana, BVI, Cayman, and Delaware) of the most popular DAO legal entity options.
The DAO Model Law (ML) was published in June 2021 by the Coalition of Legal Automated Applications (COALA). COALA is an international, multidisciplinary research and development initiative that seeks to clarify blockchain technologies, smart contracts, and decentralized applications. The initiative is made up of lawyers, academics, economists, and computer scientists, among others. The ML seeks to strike a balance between the importance of innovation and experimental freedom in technological development.
As previously referenced, DAOs face significant legal uncertainty that arguably limits their development and use. The ML aims to create uniformity and legal certainty while allowing for additional innovation. This is facilitated by not requiring formal registration with a jurisdiction, unlike other regulatory frameworks or entity structures that may accommodate wrapping or association with a DAO. The ML combines autonomy for DAO members with separate legal personality for the DAO in order to encourage pseudonymous participation and to recognize that human-to-machine or machine-to-machine interactions can carry out valid legal acts. Participants in DAOs are also granted limited liability under the ML. The ML is ultimately intended to allow DAOs to retain their underlying characteristics and attributes while providing legal personhood with all of the associated protections and benefits.
Because DAOs are inherently transnational, the ML strives to adopt a consistent set of rules that can be implemented across jurisdictions. DAOs formed in accordance with the ML's formation requirements will be recognized as legal entities separate and distinct from its members. To ensure its broad applicability, the ML provides a minimum set of rights, duties, and protections that are widely recognized in legislation governing analogous corporate entities in major jurisdictions. The ML also includes specific provisions that address the unique characteristics and challenges faced by DAOs, including procedures in the event of adversarial forks in the underlying blockchain, DAO restructuring, or failure events. Although no governmental authority could directly enforce the ML provisions onto a DAO, the baseline of legal certainty is meant to incentivize adoption.
Despite the ongoing and active discourse regarding DAO entity structures in the Web3 community, the ML garnered minimal attention when announced in 2021. It has, similarly, not generated significant discussion. However, this could simply be based on the timing of the announcement or other unknown considerations. Notwithstanding, the ML represents, at the very least, a useful starting point for discourse with regulators and should not be disregarded. It is also worth noting that this is just the first iteration of a proposed model law. The ML’s executive summary references the UNCITRAL Model Law on Electronic Commerce as a loose exemplar for the ML. Legislation based on the Model Law on Electronic Commerce has only been adopted in 85 of the 193 member states of the United Nations in the 25 years since its issuance in 1996.
Proponents of the ML will likely face significant challenges in persuading legislators that the principles of functional and regulatory equivalence on which the ML is based protect the interests of their jurisdiction. As with the development of the U.S. LLC in the 1970s, the development of a viable DAO Model Law necessitates a bottom-up, community-driven approach informed by both legal scholars and policymakers, as well as the experience of people working on the ground and interacting with DAOs on a daily basis.
As more people and money flock to DAOs, it will be important to resolve lingering questions about the legal rights and responsibilities of these entities and their members. In the U.S., states are leading the way. Outside of the U.S., entities like MIDAO and Poko are working to facilitate more significant legislative changes that will allow DAOs to be considered a viable entity structure, appropriate for widespread adoption. And, while slightly more esoteric in format, COALA’s Model Law provides a useful roadmap for DAO proponents attempting to enact legislative changes.
It took nearly twenty years, from 1977 until 1996, for creation and widespread adoption — i.e. adoption by all 50 states and the District of Columbia — of the LLC entity structure in the U.S. Even this seemingly protracted period represented an unprecedented rate of adoption. Wyoming’s DAO LLC legislation was only enacted in August 2021 and does not ultimately represent a significant or groundbreaking modification of the entity structure in comparison to the LLC’s combination of pass-through taxation and limited liability protection.
In the future, there will almost certainly be iterations or combinations of existing entity structures to accommodate ‘wrapping’ or other association of legal entities with DAOs before a more ideal structure is modified or created. Needless to say, it’s still relatively early in the legal lifecycle of DAOs and their associated legal structures and it is likely that existing structures will change or new structures will be developed in ways that have not yet been considered.
lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at email@example.com.