Standing on the Shoulders of Llcs: Tax Entity Status and Decentralized Autonomous Organizations

• Publication year: 2023

Standing on the Shoulders of LLCs: Tax Entity Status and Decentralized Autonomous Organizations

Samuel D. Brunson
Loyola University Chicago School of Law, sbrunson@luc.edu

Standing on the Shoulders of LLCs: Tax Entity Status and Decentralized Autonomous Organizations

Cover Page Footnote

* Associate Dean for Faculty Research and Development and Georgia Reithal Professor of Law, Loyola University Chicago School of Law. I would like to thank Jeffrey L. Kwall and Omri Marian for their comments and recommendations and Loyola University Chicago School of Law for its generous research stipend. I would also like to thank Jamie Brunson for her support.

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STANDING ON THE SHOULDERS OF LLCS: TAX ENTITY STATUS AND DECENTRALIZED AUTONOMOUS ORGANIZATIONS

Samuel D. Brunson^*

Since the formation of the first decentralized autonomous organization (DAO) in 2016, their use has exploded. Thousands of DAOs now try to take advantage of smart contracts to solve a problem that plagues business entities: the gulf between ownership and management. Armed with smart contracts and requiring token-holders to vote on any change in strategy, DAOs dispense with the management layer so necessary in traditional business entities. DAOs owe their existence to technology. Without blockchain, without cryptocurrency, and without smart contracts, there would be no DAOs. But they owe their explosiveness to something much more unexpected: Treasury regulations. In the wake of limited liability companies (LLCs), the last major new entity to emerge, Treasury created the check-the-box regulations. Prior to these regulations, a business entity had to determine whether it had more partnership or corporate characteristics to determine whether it would be taxed as a partnership or a corporation. LLCs did not fit comfortably into either category, so businesspeople did not adopt the form. When enacted, the check-the-box regulations allowed most business entities to decide how they wanted to be taxed and file an election with the Internal Revenue Service (IRS) for that treatment. This certainty futureproofed entity taxation. New business forms—including DAOs—no longer have to look like previous forms. They can choose their tax status. And without the impediment of taxes, people can—and did—adopt the DAO structure. Tax entity status comes with obligations, though. And while DAOs do not have to worry about their entity status, they also must

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meet the obligations attendant to the status they choose. This Article discusses several of those obligations—obligations which, at times, run counter to the ethos of DAOs.

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Table of Contents

I. Introduction...................................................................606

II. Decentralized Personhood........................................609

III. Limited Liability Companies and the State of the Art ..............................................................................................616

A. HISTORY OF LLCS...........................................................617
B. HOW THE CHECK-THE-BOX REGULATIONS WORK............626

IV. Check-the-Box and DAOs...........................................630

V. The Burdens of a Tax Status.......................................633

A. DISTRESSINGLY COMPLEX AND CONFUSING....................636
B. ANONYMITY IN THE FACE OF THE TAX LAW.....................641
C. A DOMESTIC OR FOREIGN PARTNERSHIP?........................645

VI. Conclusion....................................................................648

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I. Introduction

In November 2021, SpiceDAO acquired one of the few remaining copies of Alejandro Jodorowsky's pitchbook for a screen adaptation of Dune.¹ (The pitchbook was a book with concept art, costume design, a script, and storyboards for the proposed screen adaptation.² ) The $2.9 million winning bid came from Soban Saqib, a 25-year-old nonfungible token (NFT) and cryptocurrency millionaire in California, who used nearly his whole net worth to acquire the pitchbook.³

A week later, he asked members of SpiceDAO, a decentralized autonomous organization (DAO) for $6 million; after taxes and legal fees, SpiceDAO would acquire the pitchbook from Saqib for $3.8 million.⁴ Thousands of people across the internet—both friends of Saqib and people he did not know—contributed and the next day SpiceDAO had $12 million.⁵

To some extent, the speed of the internet and newly-minted crypto fortunes papered over Saqib's impulsiveness and lack of preparation. From the very beginning, he—and then SpiceDAO—radically overpaid for the pitchbook. Prior to Saqib's bid, appraisers estimated it would sell for $40,000.⁶ While appraisal requires professional judgment and is ultimately more art than science,⁷ paying 7,500 percent of the estimate suggests a breakdown in pricing somewhere.

And that breakdown is likely at the buyer side. SpiceDAO appears to have misunderstood what rights ownership of the

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pitchbook granted to it. In January 2022, SpiceDAO made waves when it announced it had three plans for the pitchbook: to "[m]ake the book public (to the extent permitted by law)[,] [p]roduce an original animated limited series inspired by the book and sell it to a streaming service[, and] [s]upport derivative projects from the community."⁸

SpiceDAO's announcement "was quickly and widely ridiculed."⁹ While Saqib and SpiceDAO acquired the physical pitchbook, they did not acquire the underlying intellectual property that would allow them to bring Jodorowsky's vision to fruition or create derivative works based in the pitchbook.¹⁰ Copyright rights "are separate and distinct from rights in the material object in which the copyrighted work is embodied."¹¹ In its successful bid, SpiceDAO acquired the material object, not the copyright rights, though it proved unaware of these legal niceties.¹²

While SpiceDAO was not the first decentralized autonomous organization, its success in achieving its short-term goal of acquiring the pitchbook, combined with its naiveté in proceedings after it acquired the pitchbook, helped launch DAOs into the public consciousness.¹³ That naiveté about legal uses of property it acquired likely extends into other legal regimes as well. Questions of the entity and tax status of DAOs will be increasingly important going forward, and in some cases, will require affirmative actions by DAOs of which DAO founders and investors—especially those

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who, on a whim, are moving fast and breaking things¹⁴ —are unaware.¹⁵

This Article proceeds as follows: Part II discusses various innovations in business entity law, especially in LLCs and DAOs. It describes where DAOs fit in the constellation of business entities and how they differ from traditional entities like corporations and partnerships.

Part III then compares the development and adoption of LLCs, a type of spiritual precursor to the DAO. In contrast to the rapid adoption of the DAO form, LLCs took decades to find general acceptance.¹⁶ One significant reason was tax uncertainty.¹⁷ Part III explains how, in response to the creation of LLCs, the Treasury Department promulgated truly elective tax entity status.

While this elective model of tax entity status was created in response to LLC pressures, Part IV demonstrates that in effect, the check-the-box election futureproofed the tax system. Because it is largely agnostic to the characteristics of an entity, the check-the-box regime allows for entity innovation and the adoption of new entities, including DAOs, because investors can know in advance how an entity will be treated for tax purposes.

Finally, Part V demonstrates that this futureproofing does not mean that DAOs have a free hand to do whatever they wish. Even an elective tax regime imposes obligations on taxpayers and business entities.¹⁸ DAOs must comply with these tax obligations, even where the obligations are inconsistent with the DAO's ethos and goals.

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II. Decentralized Personhood

The emergence of DAOs represents only the latest innovation in the world of business organizations. In 2010, Maryland and Vermont enacted the first legislation authorizing benefit corporations.¹⁹ Two years earlier, Vermont became the first state to authorize the creation of low-profit limited liability companies (L3Cs).²⁰ The L3C itself is just an iteration of the LLC,²¹ which is itself a relatively new form of business organization, authorized for the first time in Wyoming in 1977.²² Within twenty years, all fifty states had enacted legislation authorizing LLCs.²³ As these new types of entities entered into the state law, they did not supplant older entities like corporations and partnerships; instead, they added more nuance to the world of business organizations.²⁴

There are at least two reasons for this explosion of business organization types. The first is technological²⁵ : business organizations come with legal personhood.²⁶ Professor Shawn Bayern describes this legal personhood as a legal technology.²⁷ Legal personhood, he explains, allows a legal entity "to be recognized by law sufficiently to perform basic legal functions."²⁸ In

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spite of not being a natural person, a legal person can own property, enter into contracts, act as a principal and an agent, and can sue and be sued.²⁹ With the overlay of these rights, business organizations have the ability to operate in the broader economy.³⁰

Endowed with the legal technology of personhood, business organizations provide an excellent vessel for allowing disparate people to pool their assets.³¹ With this larger asset base, business entities can engage in endeavors that individuals could not do on their own.³² It also allows individuals without the requisite knowledge or skills to engage in a particular business to nonetheless invest in and have financial exposure to that business.³³

DAOs share critical similarities with more-traditional business entities such as corporations, partnerships, and limited liability companies...