Legal structures and DAO laws
DAOs are a new, rapidly evolving type of organization, and since each one is different, there is no perfect out-of-the-box legal structure. There are several reasons that a DAO should incorporate a legal entity, and usually the main considerations are liability protection, taxes, compliance, and transacting in the real world. This summary of some popular options and should not be taken as legal advice. A lawyer can recommend suitable legal structures depending on the use case, number of members, and the risk tolerance of the organizers.
The main options for incorporating a DAOs are:
Option 1: No entity
Many financial DAOs exist in the crypto-cloud with no formal legal entity. While DAO purists may argue this is ideal and they should not have to interface with the "legacy" legal system, this is the riskiest option for DAO members, since without incorporating, the DAO defaults to being a general partnership where each member carries unlimited liability and a heavy tax burden. Each member is technically responsible for paying taxes in proportion to the DAOs income. Without an entity, a DAO cannot interface with the real world so things like opening a bank account, entering into contracts, buying property, or holding intellectual property are not possible.
Option 2: U.S. LLC
Incorporating an LLC provides protections for DAO members and can reduce tax burdens. It's also usually cheaper and easier than the other incorporation options. Delaware is often the preferred state for incorporation since it has a robust history of case law and a lenient tax regime. With an LLC, a DAO can choose different tax strategies that simplify its members tax responsibilities. After incorporating, an operating agreement can be kept and updated that outlines the governance protocols and rules for membership. There are drawbacks to LLC incorporation, for example adding and removing members manually. LLCs were not designed for the fluid nature of DAOs where members, some of which may be anonymous, can easily join and leave.
Option 3: DAO Law
DAO laws like the new Wyoming LLC DAO statute provide many of the same liability and tax benefits of incorporating as an LLC while offering some regulatory clarity specific to DAOs. They require disclosing the smart contract address where DAO funds are managed voting happens. A DAO can even elect to be "algorithmically managed" and simply point to the smart contract address where decisions are made algorithmically.
Under the Wyoming DAO LLC statute, members do not have a fiduciary duty, or an obligation to work in the best financial interest of the organization. This gives DAO members more freedom and flexibility to explore less financially-motivated outcomes, and reduces the likelihood of DAO members suing each other. For example, DAO members may approve a proposal that is not in the best interest of participants with regards to financial returns, like donating money to charity. In that case, DAO members should not be liable for violating a fiduciary duty since they voted for the proposal.
Critics of the laws say these laws are poorly written and saddle DAOs with additional disclosure burdens. While these laws should be seen as experimental, they provide a better-than-nothing starter kit for getting a DAO off the ground in a relatively light-touch, more compliant way.
Option 4: Foundation
While setting up a Foundation can have optics downsides, it can offer an ideal blend of low taxes, light-touch regulations, and liability protection. Since the U.S. has stringent rules on what types of financial products are allowed, many financial protocols choose to create Foundations. Instead of having shareholders, Foundations can be ownerless, which can set the right tone for a DAO, though they still usually need supervisors with a fiduciary duty to the Foundation. Compared to starting an LLC, which costs around $100, upfront costs to starting a foundation are much more significant, often in the range of $10k-$30k. Both Switzerland and Singapore are known for having friendly regulatory structures and low tax rates. The Cayman Islands is popular for being "tax neutral", meaning it levies no direct taxation, though members will still need to pay taxes in their jurisdiction. Of course, the optics of incorporating a distant legal entity are an important consideration, especially if most DAO members are in the same jurisdiction and blatantly using the Foundation to avoid taxes.
In 2021, your author posted a tweet, half in jest, that I was starting a DAO to buy land in Wyoming. The tweet went viral and a few hours later, thousands of people flocked to the Discord community. In the weeks that followed, we crowdfunded over $5m and purchased 40 acres of land in Wyoming. Ethereum Founder Vitalik Buterin joined, along with Coinbase CEO Brian Armstrong, as well as Mark Cuban. The project, CityDAO, became one of the first projects to use Wyoming's new DAO law to buy and own land as a collective, aspiring to create a crypto-governed city. In fact, Wyoming's new DAO law was the inspiration for the idea, since it meant that an internet collective could, for the first time, own real world assets together.
The Wyoming legislature passed Senate Bill 38 in 2021, providing a mechanism for incorporating an LLC that is managed by a DAO. The act is a supplement to the existing LLC statute, with the addition of requiring the DAO's smart contract address. With legal recognition, DAOs are able to enter into contracts, own assets, and incur liabilities in the same way as traditional business entities. One of the most important aspects of the DAO law is the protection it provides for DAO members, which will be discussed in the next chapter, Unlimited Liability. The law specifies that members are not personally liable for the debts or obligations of the organization, unless they have personally guaranteed such debts or obligations. In addition to these provisions, the Act also outlines the rights and duties of DAO members, including the right to vote on proposals and the duty to act in good faith and in the best interests of the DAO.
DAO laws have both legal and symbolic value. On the legal side, DAO laws can provide liability protection to members, enable ownership of real assets, and streamline legal and tax compliance. Some will argue DAO laws are imperfect and the same legal structures can be created by doing legal jiu-jitsu with more battle-tested Delaware LLCs or Cayman Foundations. But one other factor to consider is that Wyoming and other states that enact DAO laws are flashing a welcoming beacon -- a bat symbol of sorts -- proclaiming they are open-minded towards blockchain technology. We will comprehensively discuss more options for the legal structure of DAOs in a following chapter, but DAO laws are shaping up to be a promising option.