Creating a foreign foundation company is a difficult task that necessitates careful consideration of legal issues that could expose the foundation to government scrutiny from regulatory agencies like the Department of Justice (DOJ), the Securities and Exchange Commission (SEC), and the Internal Revenue Service (IRS) (IRS).
Furthermore, establishing a foreign foundation entity is becoming a more popular method of resolving DAO structure issues: the foundation provides an extremely flexible framework for off-chain functions tied to executing a DAO’s governance protocols; and, the favorable tax regimes of foreign jurisdictions reduce the DAOs’ burden of tax expenses otherwise required to be paid under US tax laws.
Despite the allure of forming a foreign foundation, offshoring governance tokens to jurisdictions with favorable tax regimes — such as the Cayman Islands, BVI, Panama, Singapore, Ireland, and Switzerland — and wrapping the Decentralized Autonomous Organization (DAO) in a foundation entity formed in such jurisdiction poses a wide range of legal risks that developers, investors, administrators, and other DAO members must consider.
The most widely publicized breakthrough in the digital revolution of the economy and society is distributed-ledger technology. It allows up a wide range of novel applications and completely new kinds of cooperation because of features like decentralization, dependability, and anti-counterfeiting. Even though most advances focus on payment systems and other financial instruments, big blockchain-based ecosystems and projects indicate a future in which online communities coordinate at eye level and possibly anonymously, relying wholly or almost entirely on software. The phrase “decentralized autonomous organizations” refers to the creation of solely digitally existing decentralized groups that run independently without traditional leadership and hierarchy (DAOs). The basic goal of constructing a DAO is to build a virtual entity that will take the role of earlier forms’ central management.
Many of today’s standard legal corporations and other business associations operate under different conditions than these DAOs. DAOs will be controlled by democratic or highly participative methods or algorithms, rather than by boards or managers. Rather than functioning in just one or a few nations, DAOs aims to connect thousands of people from all over the world, regardless of their physical location, cultural background, or financial situation. Members of DAOs generally agree to conduct their business through software and the laws of the code, rather than through written agreements or other formalities. Because of the various ways in which a DAO can be organized, a singular definition has yet to emerge. DAOs can be explained in terms of the definition given above.
DAOs have the potential to enhance the core benefits of organizational structures, such as market access and cost efficiency, by doing so. DAOs also established new benchmarks for operating more effectively and transparently by allowing organizations to autonomously regulate and coordinate particular activities and behaviors through the use of smart contracts. Furthermore, they fundamentally challenge basic corporate concerns and definitions, such as the hierarchical organizational structure, the separation of company members from market participants, and member cultural or technical homogeneity.
The majority of currently capital-managing DAOs are focused on crowdsourcing cash and voting to fund new projects, as well as decentralizing the development of existing enterprises to benefit the community. DAOs are gaining a lot of attention and popularity as a result of their ease of involvement in projects, and continued exponential growth is projected.
Legal Structure of DAOs
The decentralized structure and automated operations of a DAO, on the other hand, present complicated concerns concerning determining applicable law, corporation status, and external activities that classical theories cannot effectively address. The imminent designation of DAOs as some form of general partnership in most jurisdictions due to their structure, according to the existing legal situation, is one of the largest threats. As a result, all participants are personally liable and have infinite liability.
In theory, every network begins with a single founder or team; as a result, when transitioning from a centralized network, it is common practice to establish non-profit foundations to oversee the network’s operations and to split the founders into separate entities so that their influence is equal to that of the other network participants.
The process of becoming fully decentralized is difficult and takes time; as a result, network creators should avoid taking shortcuts by establishing foundation entities that do not genuinely satisfy the goals of DAOs when pursuing decentralization.
Given the large number of consumers who participate in DAOs, a legally sound framework should be developed solely for consumer protection purposes, removing this often-unknown liability risk. For example, the state of Wyoming in the United States passed legislation allowing DAOs to be incorporated as limited liability companies with legal personalities, known as DAO LLCs. The Cayman Islands Foundation Companies Law (Foundation Law) of 2017 provides a novel corporate vehicle that can serve two purposes: it can function as a separate legal personality and limited liability company, or it can act as a trust.
Importantly, a foundation might cease to have members (i.e., shareholders) in the context of DAOs, making it appear ownerless; nevertheless, to achieve true decentralization, the DAO network must be trustless and regulated by community governance. When DAO developers understand how difficult it is to create a fully decentralized entity, they create foreign foundations that look like a standard corporation.
Create DAOs without a legal entity
The lack of a legal body for the DAO raises major risks. DAOs that do not have a registered legal entity are breaking the law. In most jurisdictions, they will be treated as general partnerships, with all of the legal ramifications that entail. The danger of personal culpability for each individual is the most significant. However, this also means that the DAO has a legal personality and can lawfully own assets and employ individuals in most states. Even though the DAO was not registered, the participants created a fully recognized legal entity that can sue and be sued in most states. This is frequently misinterpreted.
In some cases, this structure also takes advantage of regulatory arbitrage. When there is no central body engaged and the project is decentralized and launched, anonymous legal enforcement becomes a challenge. Even the Securities and Exchange Commission admitted that the higher the decentralization of a project, the less likely the underlying coins will be regarded as securities.
Create a US-based LLC/S-Corp
This is probably the best option for DAOs with a large number of members based in the United States. After all, the US government is the most important regulatory factor for most teams. Within the US, you have a few options for which state to incorporate in.
Wyoming’s formal acceptance of DAOs has attracted a lot of attention in the media. There is no need to include it there. According to the attorneys I’ve spoken with, it has the same benefits as forming an LLC in another state, but there are a few added drawbacks. You’ll have to fill out more paperwork, publicly file a smart contract address (which limits your future flexibility), dissolve under certain scenarios that don’t apply to an LLC, and so on.
Setting up a Delaware LLC is a superior alternative. This is not only inexpensive (a few hundred bucks) and quick (usually a few days), but it also gives you the most freedom. If your DAO changes, you may quickly adjust your operating agreement as an LLC.
If a US corporation establishes an offshore foundation that is treated as an incorporated trust, the foreign trust is subject to US tax filing obligations.
Create an Offshore Foundation
The establishment of an offshore foundation transfers ownership from the real beneficial owner to another legal organization. Furthermore, DAO Developers who choose to establish an offshore foundation corporation in foreign jurisdictions such as the Cayman Islands, Panama, or the British Virgin Islands (BVI) do so with the understanding that these jurisdictions require a person or group to act as the DAO foundation’s owner.
Both a secretary (a person qualified to perform business management services in the Cayman Islands) and a supervisor are required by the Foundation Law (a person, other than a member, who has a right to attend and vote at general meetings). It is incorrect to say that these supervisors have no ownership or economic rights in the foundation firm; rather, they serve as consultants to the foundation’s directors and ultimately have influence over the DAO’s governing documents. This alone suggests that a foundation firm is run by a controlling body; as a result, it is not fully decentralized and is likely to be influenced by the government.
The three major options here are Panama, the British Virgin Islands, and the Cayman Islands. Offshore foundations appear to cost about the same to set up as onshore foundations and are likely to be just as safe from a legal liability standpoint. DAO Developers with a protocol formed in the United States must carefully assess whether related actions undertaken in foreign countries create a taxable presence in the United States for federal and state income tax purposes, regardless of any international structuring.
This entails establishing a Foundation to serve as the “DAO’s” official legal wrapper, as well as a distinct, unconnected “Development Agency” (DA) onshore somewhere. This DA is registered as a regular non-crypto entity and is incorporated as an LLC or local equivalent. Many projects combine this with the formation of an LLC or equivalent legal company in a business-friendly jurisdiction that employs the developers and team, if one exists, as this might be challenging with just the foundation.
Typically, the foundation will hold the treasury and will have a contract with the LLC stating that the DAO Treasury will cover the LLC’s expenses. Although this option can profit from the advantages of alternatives two and three, it also has additional requirements and specific centralized aspects that must be considered in terms of structure.
The Cayman Foundation plus a Singapore corporation is a popular path. Singapore is frequently chosen because of its low tax rate (17%), business-friendly regulations, and ease of incorporation for non-Singaporeans. The federal government is increasingly coming under fire for dividing a network into different foreign foundation corporations for the sole purpose of generating the illusion of decentralization.
For DAOs, there is no “ideal” or “one-size-fits-all” solution. Until a proper legal framework for DAOs is created, which allows them to operate fully decentralized with limited liability legal recognition, and simple taxation, each current legal setup has its own set of advantages and disadvantages, and each DAO should seek individual legal advice to determine which option best suits its needs.
The legal structure can get much more problematic when a DAO Token is involved, as a Token can sometimes be classified as a security, triggering additional legal procedures such as prospectus or registration with the appropriate authorities. Finally, you must decide what legal liability and tax protection risks you are willing to accept and go from there.