Traditional investment firms are getting a run for their money – literally. The continued volatility in the market underscored by chip shortages, transportation issues and supply chain challenges have made uncertainty a reality that investors need to become comfortable with. Concurrently, new investment trends are emerging such as DAOs, or decentralized autonomous organizations, which have been pooling capital and buying everything from rare non-fungible tokens (NFTs) to an original copy of the U.S. Constitution – almost. This has left many wondering what are DAOs, how do they function, and how they can be used to fund investments and new business opportunities. To help clients, prospects, and others, Calvetti Ferguson has provided a summary of the key details below.
A decentralized autonomous network, or DAO is like “an internet community with a shared bank account,” as described by a crypto insider. DAOs can accomplish similar goals as regular companies, charity organizations, or special interest groups, except they don’t have a traditional corporate hierarchy or business structure. Everything is on the blockchain and runs automatically by code. How each DAO operates is determined by the code written into smart contracts and cannot be changed by any one member. Changes to the smart contracts must be approved by a vote.
The blockchain, is a digital ledger associated with cryptocurrency—but it’s more than that. In finance, it’s used for asset tracking, money transfers, recording ownership rights to land or other assets, internal money transfers, regulatory compliance, and more. Relative to DAOs, blockchain maintains the structure and rules of each DAO network. Operations are spread across computer networks and locations without the need for a central authority.
DAOs are most often established on the Ethereum network and usually start out with a small collective of account holders. The account holders pool their resources for a common goal; for example, to acquire a specific and highly valuable non-fungible token (NFT), invest in a business or other digital asset, contribute to a nonprofit organization, and more. DAOs have even been used to buy land to create a new town.
They function like investment firms, and some business leaders claim that DAOs are the LLCs of the future. Though votes are required to change code or governance structures, the DAO can be established so that not everyone is required to vote. Sometimes, votes are weighted according to how much a member contributes. Every DAO is set up different.
The advantages are a level playing field to making investments, acquiring assets, and contributing to a larger collective effort, all on a relatively anonymous basis. DAOs can carry out goals anytime, from anywhere, and the operating structure is completely transparent. Yet, they’re not without risk. DAOs can be risky investments and are subject to the same cybersecurity hacks as any other blockchain. Despite some high-profile DAO headlines, most don’t work out. There’s no regulatory or legal framework for DAOs, and both governance and structure largely depend on member goals.
Types of DAOs
DAO is an umbrella term that encompasses several types of structures. Most fall into two categories: DAOs that make investments and DAOs that manage open source blockchain projects with a specific goal and purpose. In either case, the code and smart contracts powering DAOs are written to carry out tasks autonomously.
As an investment firm, PleasrDAO, pooled together vast member resources to purchase the only remaining original unreleased album Once Upon a Time in Shaolin from the Wu-Tang Clan for $4 million. Then, the group created an NFT so that all members are co-owners of the deed to the digital asset. Despite the asset’s significant value, the average member contribution was relatively small, usually just in the hundreds of dollars.
Recently, DAOs made headlines again after a near-successful attempt to purchase a copy of the U.S. Constitution.
Buying a copy of the Constitution?
It’s true. The collective ConstitutionDAO raised almost $47 million from 17,437 investors, in less than a week, to purchase one of the 13 remaining original copies of the U.S. Constitution. The goal was to donate it afterwards.
It was a groundbreaking experiment in how quickly DAOs can mobilize to accomplish lofty goals. This was a crowdsourcing record and even though it didn’t succeed in securing the Constitution, the process still proved it can work exceedingly well.
Sotheby’s auctioned the copy of the Constitution with a reserve price of up to $20 million, which the DAO could have easily managed. The final transaction price was $41 million and went to an individual billionaire. If the group had won the rights to the asset, automated code would have been deployed to manage how the asset would be stored, accessed, and displayed. Now, autonomous code will instead refund investor money.
It wasn’t as simple as it sounds, though. PleasrDAO’s leaders debated whether to maintain the collective and use the money to acquire another asset. Instead, they opted to refund investors’ money, except that most investors probably lost all or most of their contributions (at an average contribution of about $200) due to fees converting actual currency to cryptocurrency, and then back again.
What’s next for DAOs?
With increased adoption rates, DAOs face increased regulatory scrutiny. Federal cryptocurrency regulations were recently introduced in the Infrastructure Investment and Jobs Act, for example. The SEC has also been paying attention to DAOs and cryptocurrency investing of late. Formal regulations haven’t been issued, but the SEC decided it does have authority over DAOs.
It seems likely that government regulations are forthcoming, so individuals and businesses involved in cryptocurrency and DAOs should stay on top of potential regulatory and tax reporting requirements. For example, cryptocurrency transactions need to be reported on Form 1040 now, regardless of amount. Cryptocurrency investors still need to keep track of basis and capital gains.
The opportunities available through cryptocurrency investments, including those in a DAO, have sparked new interest from investors. While these investments are certainly intriguing, it is essential to carefully consider the state and federal tax issues which can arise from cryptocurrency transactions. If you have questions about the information outlined above or need assistance with a cryptocurrency tax issue, Calvetti Ferguson can help.