A Decentralized Autonomous Organization (DAO) token can act like a paycheck, a share certificate, and a voting ballot all at once. That flexibility is what makes decentralized organizations powerful, but it also makes their tax treatment confusing. The IRS and state tax authorities are trying to fit these tokens into categories built for traditional businesses, and the result is a system that often taxes innovation through outdated definitions.
The question of whether DAO tokens are property, income, or services is not academic. It determines when tax is owed, how much, and to whom. Because most states build their tax systems on top of federal law, the way each state defines its State and Local Tax (SALT) base can dramatically change the outcome for DAO participants.
The IRS set the baseline in Notice 2014‑21, declaring that convertible virtual currencies are property, not currency. That single decision drives every subsequent rule. It means that every transfer, payment, or exchange of a token can trigger gain or loss, just as if you sold stock.
For DAOs, that default creates friction. Tokens often serve governance or coordination functions rather than investment ones. Yet under current guidance, the IRS does not distinguish between a governance token used to vote and a speculative token traded for profit. Both are property.
Governance tokens grant voting rights and influence over protocol decisions. Many have no market value or transferability. Still, if a DAO distributes them as rewards for participation, the IRS could treat that distribution as a taxable event. Members may owe tax on tokens they cannot sell, creating a mismatch between liquidity and liability that frustrates compliance.
Tokens representing ownership in pooled assets or DAO treasuries fit more comfortably within the property framework. They behave like equity interests. Gains are recognized upon sale or distribution, and losses can offset other capital income. The challenge is valuation. When a DAO holds a mix of crypto assets, NFTs, and yield‑bearing tokens, determining fair market value becomes an exercise in forensic accounting.
Contributor tokens are the clearest case of income. When a DAO issues tokens to compensate developers, marketers, or community managers, those tokens are treated as payment for services. The fair market value at the time of receipt is ordinary income, even if the tokens are illiquid. Later appreciation is capital gain. For U.S. taxpayers, that means two layers of taxation: income when earned and capital gain when sold.
Legal scholars Avi‑Yonah and Salaimi have proposed a use‑based model that classifies tokens by function rather than form. Under their approach:
Such a framework would align tax treatment with economic reality. A token used to vote on a proposal should not trigger the same tax consequences as one sold on an exchange. The IRS has not adopted this model, but it offers a roadmap for reform.
Token classification is only half the story. The entity itself must also be classified. Under Treasury Regulations §§301.7701‑1 through 301.7701‑3, an unincorporated group that shares profits is a partnership by default. Most DAOs fit that description.
That classification brings obligations few decentralized communities are prepared to meet: filing Form 1065, issuing Schedule K‑1s, and appointing a partnership representative. If the DAO’s tokens are freely tradable and it earns active income, it may be treated as a Publicly Traded Partnership and taxed as a corporation at 21 percent.
Foreign DAOs add another twist. If U.S. persons own more than half of the voting or value interests, the DAO may be a Controlled Foreign Corporation (CFC), triggering Subpart F and GILTI inclusions. Where ownership is diffuse or anonymous, the IRS may apply Passive Foreign Investment Company (PFIC) rules, which penalize passive income.
Classification drives compliance. A DAO that operates like a business will be taxed like one, regardless of its code‑based structure.
State and Local Tax (SALT) systems begin with the federal definition of taxable income, but conformity is far from uniform. Some states automatically adopt federal changes, others freeze the Internal Revenue Code at a specific date, and a few selectively incorporate only certain provisions. This patchwork determines how DAO‑related income flows into state returns.
These differences shape the SALT tax base, which is the starting point for calculating state income tax. If a state includes GILTI or Subpart F income, a DAO participant may owe state tax on undistributed foreign earnings. If the state excludes those items, the same taxpayer may owe nothing.
A California resident receiving contributor tokens from a Cayman‑based DAO could face state tax on phantom income, while a Florida resident in the same DAO would not. Some states do not allow foreign tax credits or basis adjustments, compounding the inequity.
For DAOs with members across multiple states, this creates a compliance nightmare. The same token distribution can produce different tax outcomes depending on where each participant lives. Understanding how each state defines its SALT base is critical for accurate reporting and planning.
For practitioners and DAO participants, the most reliable approach is functional. Ask what the token does, not what it’s called.
Document these functions carefully. Keep records of token distributions, valuations, and vesting terms. If a DAO issues multiple token types, maintain clear distinctions among them. Function drives tax treatment, and documentation proves intent.
The current system forces DAOs into categories built for corporations and partnerships. Reform will likely move toward functional taxation, where classification follows use. A de minimis exemption for small transactions and liquidity‑based timing rules would reduce phantom income and align obligations with the ability to pay.
States could coordinate through a multistate DAO tax compact, standardizing definitions and safe harbors for pseudonymous participants. Wyoming’s DAO LLC model already offers a glimpse of how legal recognition can coexist with decentralization.
DAO tokens blur the line between property, income, and services because they embody all three. The law has not yet caught up, but the principle is clear: taxation should follow function, liquidity, and benefit. At the same time, how each state defines its SALT tax base determines whether that principle is applied fairly or inconsistently.
Until regulators harmonize these systems, DAO participants must plan carefully, document thoroughly, and understand both federal and state implications.
If your DAO or blockchain-based entity faces uncertainty under federal or state tax rules, Allegis Law can help evaluate classification, structure compliance frameworks, and reduce exposure. Our team works at the intersection of blockchain governance and tax law to align innovation with regulation. Schedule a consultation to discuss how your organization can navigate emerging tax obligations while preserving operational flexibility.
This publication is for informational purposes only and does not constitute legal advice.
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