United States Federal Taxation of DAO Tokens

Daniel Winters
May 18, 2016 · 7 min read

Greetings to The DAO community! This was also posted to the forum on daohub.org.

I’m an American accountant and my firm provides tax & accounting services to the blockchain space. Our clients include high volume Bitcoin/cryptocurrency traders, miners (Bitcoin & Ether), and blockchain software developers. We accept Bitcoin and Ether as payment and have been known to invoice clients in BTC directly from a phone wallet. (Thanks, https://airbitz.co/ !) I’ve also presented on cryptocurrency tax & accounting issues at multiple conferences and have written a course for CPAs about Bitcoin & Taxes.

It’s May 18, 2016 and The DAO token sale has now raised $146,260,000. Seemed like a good time to look into the U.S. tax aspects of those transactions.

DISCLAIMER

The following general comments concern the United States federal tax treatment of DAO tokens. State tax issues will not be addressed and the comments DO NOT APPLY to any country/jurisdiction other than the United States. Tax law is complex, taxpayer circumstances vary widely and The DAO is a new organization, or possibly entity, whose legal status is unclear. These are general comments which are absolutely NOT intended to apply to a particular taxpayer’s situation. Under IRS Circular 230, I have no responsibility for any positions you take on your tax return, unless I have prepared and signed that tax return. For detailed analysis of your tax situation, please consult your tax advisor.

Before we go further, a quick word about terminology. The Internal Revenue Service and the Financial Crimes Enforcement Network (FinCEN) use the term “virtual currency” to describe what everyone else refers to as “cryptocurrency.” Since this is official government terminology, my post will refer to “virtual currency.”

Most countries tax their citizens based on residency. U.S. tax law is unusual in that U.S. citizens and permanent residents are taxed on their worldwide income. This means that income from sources outside the United States is subject to federal taxation. Since The DAO is a batch of software code which exists solely on the Ethereum world computer, many have already raised the question: Where is The DAO?

I have no idea, but for U.S. tax purposes it’s irrelevant. U.S. citizens and permanent residents are taxed on worldwide income, therefore taxable transactions involving DAO tokens would clearly be included in worldwide income.

On March 21, 2014 the IRS issued Notice 2014–21, which describes how Bitcoin and other “virtual currencies” are treated for federal tax purposes. Under the Notice, virtual currency is treated as property, NOT currency. Though Bitcoin and other virtual currencies are a new type of property, the IRS has well established rules for handling property transactions.

For nearly all taxpayers, virtual currency is treated as a capital asset. (Exchanges treat virtual currency as inventory, which is not addressed in this post) The sale and exchange of virtual currency is therefore treated similarly to the sale of other capital assets, such as stocks. The Notice also describes the following:

- Income from receiving virtual currency as payment for goods/services

- Determining fair market value of virtual currency

- Calculating gain/loss when exchanging virtual currency for other property

- Issues for self employed contractors

- 1099 reporting requirements

How does the IRS define virtual currency? Per the Notice, “virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” In addition, “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as ‘convertible’ virtual currency.”

Are DAO tokens a convertible virtual currency? Let’s review the facts.

During the DAO Creation Phase thru May 28, 2016, the DAO Token Sale purchasers are transferring Ether tokens to The DAO. When The DAO receives Ether, new DAO tokens are created. Let’s assume that it’s June 1, 2016, two days after The DAO’s Creation Phase ends.

At this point, The DAO tokens are fully transferable and can be traded peer-to-peer or on an exchange. Some of the exchanges which plan to support trading of DAO tokens are Bittrex, Poloniex and Gatecoin (though since Gatecoin just lost $2,000,000 in BTC & ETH due to a hack, it’s unclear how many DAO users will use Gatecoin).

Undoubtedly, DAO tokens are a digital representation of value and a store of value.

{EDITED following 2 paragraphs 5/19/2016 as I initially thought that Contractors will be paid with DAO tokens, and that DAO contracts are denominated in DAO tokens. Contractors are paid with Ether, and contracts are also denominated in Ether}

Are DAO tokens a medium of exchange? After I realized that Contractors are paid with Ether, not DAO tokens, I had some brief doubts. However, it’s clear that DAO tokens would be a medium of exchange, after the token sale ends and DAO tokens begin trading peer-to-peer and on exchanges. Basically, a medium of exchange is an intermediary which has value and is exchanged for items of value, such as goods or services. Once, we used gold and silver coins. Now, we use Bitcoin, Ether and DAO tokens.

DAO tokens are also a unit of account as they provide a unit of measurement for defining, recording and comparing value. (investorwords.com)

Once the Creation Phase ends, DAO tokens can be digitally traded between users. Since the tokens will also be traded on exchanges, it’s safe to say that DAO tokens will be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.

Therefore, DAO tokens will have an equivalent value in real currency and act as a substitute for real currency.

Conclusion:

DAO tokens are a convertible virtual currency and should be treated as such for U.S. federal tax purposes.

OK, so what does that mean and how ‘bout some examples, please? Here’s the skinny:

1. Transactions in DAO tokens must be reported to the IRS using their fair market value in USD.

2. Since DAO tokens are a capital asset, you must track the cost basis in USD of all DAO tokens. This is because exchanges of DAO tokens for services/other property are taxable, and you need to calculate and report any capital gain or loss.

3. If you exchange DAO tokens for services/property with a value which is more than your cost basis, you have a capital gain which must be reported on your tax return. If you exchange DAO tokens for services/property with a value which is less than your cost basis, you have a capital loss, which must also be reported.

4. If you receive DAO tokens as payments for goods/services, you have income equal to the USD value on day of receipt.

5. The DAO tokens received as payment for goods/services are a capital asset with a cost basis equal to the USD value on day of receipt. If you later exchange those tokens for goods/services/another virtual currency, you must calculate any gain/loss on the transaction and report this to the IRS.

6. Cashing out to fiat currency is irrelevant and does not determine when income should be reported. The taxable event occurs when the DAO transaction occurs, not when DAO tokens are exchanged for USD, EUR or other fiat currency.

7. Bitcoin, Ether and other virtual currencies are property. You need to track and report all exchanges of DAO tokens for ETH, and report those transactions. You also need to track and report all exchanges between different virtual currencies.

8. There is NO minimum transaction threshold. Yeah, that kinda sucks.

Does this seem complicated? Yup, it does. Welcome to the wonderful world of cryptocurrency accounting.

Example 1:

You acquire 10,000 DAO tokens for 1,000 USD on June 1, 2016. On June 3, 2017, you exchange the 10,000 DAO tokens for 1,300 USD. You have a 300 USD long term capital gain.

Example 2:

You acquire 10,000 DAO tokens for 1,000 USD on June 1, 2016. On April 23, 2017, you exchange the 10,000 DAO tokens for 1,200 USD. You have a 200 USD short term capital gain.

{Example 3 EDITED 5/19/2016}

Example 3:

You are a self employed contractor (as defined under US tax law, not The DAO’s term) and provide services to The DAO. You receive 100 Ether tokens on September 4, 2016 when the tokens had a value of 2,000 USD.

You have 2,000 USD of ordinary income. This is subject to ordinary income tax, and self employment tax.

You now own 100 Ether tokens, a capital asset with a cost basis of 2,000 USD.

On September 15, 2016 you exchange the 100 Ether tokens for 2,100 USD. You have a 100 USD short term capital gain and must report this on your tax return.

Note: If instead you were paid with DAO tokens or Bitcoin, the tax treatment would be the same.

Example 4:

On September 30, 2016 you purchase 10,000 DAO tokens for 2,500 USD. Donald J. Chump wins the presidential election and is inaugurated on January 20, 2017. President Chump immediately issues an executive order mandating that DAO tokens replace the US dollar in every casino in the United States.

The DAO price triples overnight! On January 21, 2017 you exchange the 10,000 tokens for 7,500 USD of Bitcoin on a non-US exchange and fall asleep. Next morning on January 22, 2017, you transfer the Bitcoin you acquired the day before to a US exchange and sell for 7,400 USD. Three days later, you receive 7,400 USD in your US bank account.

a. You have short term capital gain of 5,000 USD:

7,500 sale proceeds of January 21, 2017

MINUS 2,500 cost basis of September 30, 2016

= 5,000

b. You have a short term capital loss of 100 USD:

7,400 sale proceeds of January 22, 2017

MINUS 7,500 cost basis of January 21, 2017

= (100)

Practical issues:

1. We need a DAO price index to track the USD exchange rate.

2. We need a method to export DAO transactions occurring within the DAO as a CSV or other file.

3. We need a method to transform ETH and DAO transactions on public addresses into a CSV or file which an accounting program can import.

4. We need accounting software that can track ETH, Bitcoin, and DAO transactions and create standard reports such as a Profit & Loss and Balance Sheet.

If you are a software developer and have demonstrable experience with such issues, let’s talk!

Final thoughts:

Some have argued that exchanging 1 type of virtual currency for another virtual currency is a like-kind exchange and thus any gain is NOT taxable. I call bullshit.

Section 1031 of the Tax Code governs like-kind exchanges, and was enacted in reference to real estate transactions. Occasionally, and very occasionally, like-kind exchanges are used for intangible assets. However, there is zero support for the idea that a like-kind exchange could apply to the exchange of 1 type of virtual currency for another type of virtual currency.

Daniel Winters

Written by

Bitcoin & cryptocurrency tax accountant with strong international experience. Email us at daniel.winters@globaltaxaccountants.com to set up a consultation.

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