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May 27, 2016 - Phil Hodgen

Double-Dog Dare DAO Token Taxation Discussion (DDDDTTD)

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This episode is different. It is the Double-Dog Dare DAO Token Tax Discussion. DDDDTTD.1

After a dare – a double-dog dare – to do so from Edmund at flagtheory.com, I took a look at the tax treatment of DAO tokens. Hey, Edmund. I ain’t a-scaired o’ nuthin’ and I don’t back down from no double-dog dare.

Before I Begin … Help!

Plea for help – tell me where I’m wrong in my understanding of cryptocurrencies, The DAO, and even (especially) in the realm of tax. This is strange territory.

Pro-Tip: Avoid Wikipedia

First things first. If this topic is interesting to you, avoid Wikipedia. The relevant pages appear to be in the midst of a fierce editing war, and should therefore be considered unreliable.

What is Ethereum/Ether/ETH?

First things first again. We are dealing with a digital currency. You will see the words “Ethereum”, Ether (initial cap), “ether” (lower case), and the TLA ETH.

  • Ethereum is a software platform.
  • Ether is a digital currency issued using the Ethereum software platform. Confusingly, many people refer to the currency as Ethereum even though the official website makes a distinction between Ethereum and ether. The correct usage seems to be all lower case: ether.
  • ETH is a commonly-used abbreviation for ether, used on online currency exchanges.

From now on, I will mostly refer to the digital currency as ETH in order to sidestep the semantic mess that is Ethereum/Ether/ether. Alternatively, maybe someone will enlighten me on the correct way of referring to this particular the digital currency.

What is a DAO?

The acronym “DAO” is a reference to a category of organizations – “decentralized autonomous organizations”.

Here is my attempt at an explanation.

A decentralized autonomous organization is a multi-owner organization that has its business operating rules hardwired into computer code. The business operating rules are implemented or can be changed by a voting process.

The “decentralized” part of the phrase means that there are no directors, officers, etc. Decisions are made by “the community” meaning the multiple owners. I’m not sure what the “autonomous” word is intended to mean. The organization is not autonomous. It has owners, and the owners operate the organization by voting. The organization does not operate itself.

As a result of this voting process by the people who have voting rights, the organization does stuff (somehow) and with luck and skill the organization’s digital currency will be somehow converted into more digital currency than it had before.

I confess that when I read the articles (and I have read countless articles on this topic) I get the feeling that someone has had a few too many bong hits, and I know it isn’t me.

You are on your own here. Vaya con Díos.

What is “The DAO”?

The DAO is this week’s latest shiny internet thing.2 It self-describes as a decentralized business/investment organization. Look at the website (gorgeous) and read the prose (WTF?) to figure out what it is and what does for yourself.

As near as I can tell, The DAO sells shares “tokens” to individuals, who are then shareholders members of the DAO community. The individuals pay for the tokens with a specified digital currency: ETH. The organizers of The DAO want it to have a pot of ETH to play with.3

The idea is that you acquire DAO tokens using ETH, a digital currency. The DAO is, at the moment, in the Creation Phase,4 where sending 1 ETH to The DAO’s wallet from your Ethereum wallet will get you a predetermined number of DAO tokens.

The DAO holds the ETH for investment and business opportunities. The shareholders token owners vote on investment and business proposals. If a proposal is approved, then The DAO gives some ETH to the outside person/firm whose proposal is accepted.

Stuff is done by the outside person whose proposal was approved by a vote of the DAO token owners. The done stuff is delivered to The DAO on completion … where? to whom? how? The DAO then … does what with the stuff that the outside person made?

Never mind. With hope and a favorable wind from the southwest, The DAO makes a profit.

OK. So far let’s review what we know. There is this genus called “decentralized autonomous organization” and The DAO is its first prominent species.

Tax Only

I’m a U.S. international tax lawyer, so this discussion is only about U.S. tax.

  • I will not talk about the metaphysics of digital currencies. I own less than $20 of BTC in a wallet,5 if by “$20 of BTC in a wallet” you mean that I have an app on my phone that displays some numbers.6
  • I will not talk about whether DAO tokens are a “security” within the definition of securities law.7
  • I will not talk about DAOs generally or The DAO in particular and whether this is a sound way to conduct business or make investments.8
  • I will not talk about what happens after The DAO receives the ETH in exchange for issuing DAO tokens. Operating activities and profits do not matter for this discussion.9

All I care about is how the U.S. tax system will behave when a U.S. person who acquires DAO tokens and later gets rid of them.

Channeling the Ghost of Lou Reed

In order to figure out the tax treatment of DAO tokens, let’s walk through the process of becoming the proud owner of a DAO token, savoring the moment, becoming disillusioned, going through the de-ownership phase, and the (tax) aftermath.

  1. There you stand, government-issued paper money in your hand.10
  2. Through the magic of the internet,11 you exchange that paper money for some ETH.12
  3. You wander over to daohub.org and read some stuff on that website. You don’t understand it, but … blockchain. Smart contracts. I’m not sure what it all means, but … I want to be in on the ground floor. You can’t win if you don’t play. Etc.
  4. Again through the magic of the internet,13 you give your ETH to daohub.org and get DAO tokens in return.
  5. Time flies like an arrow.14
  6. You are bored.
  7. Through the magic of the internet, you exchange your DAO token for some ETH.
  8. You are still bored.
  9. Through the magic of the internet and the equivalent of localbitcoins.com for ETH,15 you meet someone at Starbucks somewhere and end up with green rectangles of paper that have small portraits of dead people on them. Your new friend has your ETH.
  10. You leave Starbucks and go next door, where you exchange those green rectangles of paper for several adult beverages.
  11. You are drunk.

Or, stripped of the charm, footnotes, and hyperlinks, your life looks like this:

Dollars —> Ether —> DAO tokens —> Ether —> Dollars —> Alcohol

Admire My Poker Face

Again, I repeat. I don’t care at all about cryptocurrency/smart contract/this is the future bullshit and jellybeans.16 I have my personal opinion about all of that stuff, but I will keep my opinion to myself. I do not judge.

Step 1: Dollars to ETH

Let’s start with certainty. The IRS looks at bitcoins (indeed, all virtual currency) as property.

Go read Notice 2014-21.

This is hardly novel. The U.S. tax system treats foreign currency (meaning currency issued by a government) as personal property. Thus, for tax purposes converting a U.S. dollar into ETH is the functional equivalent of converting a U.S. dollar into EUR.

Example 01

You have $12.59 in your pocket.

You buy ETH.

You receive 1 ETH. (This is based on prices on 25 May 2016.)

You are the proud owner of personal property.

Your Tax Basis in ETH

Tax law has a concept called “basis”.

Basis is computed in U.S. dollars, because, well, we all live in The Big Casino and Congress is the pit boss.

When you buy things (shares of stock, bulldozers, real estate, or ETH), your “basis” is what you paid for the thing.17

You might pay for something by handing over U.S. currency. Or you might pay for something by handing over something other than U.S. currency. Basis matters later when you sell the thing: broadly speaking, the sale price minus basis equals your gain. It will be taxable unless you can find a way to make it not taxable.

For now, though, life is simple: you gave dollars, got ETH. You have basis in the ether equal to the dollars you spent to acquire the ether.18

Example 02

You paid $12.59 for 1 ETH.

Your basis in 1 ETH is $12.59.

Step 2: ETH to DAO Tokens

The next step is important. You take your 1 ETH and do internet stuff and in return you get DAO tokens. Let’s analyze how that transaction from the perspective of the U.S. income tax system.

What does this look like, in the eyes of the IRS? Well, you start with a thing (ether), and you exchange it for another thing (DAO tokens).

The Transaction

The first step in the analysis is to look at the fact that you no longer own the 1 ETH. You now own DAO tokens.

Example 03

1.5 ETH = 100 DAO tokens, according to The DAO’s home page on 25 May 2016.

You have 1 ETH. It has a basis of $12.59.

You send 1 ETH to The DAO’s address from your Ethereum Wallet.

The DAO immediately issues 66.667 DAO tokens to you.

Gain is Included in Your Income

You disposed of 1 ETH in a taxable transaction, and acquired 66.667 DAO tokens. Here is how the transaction is taxed.

  • Gross income includes gains from dealings in property.19
  • Cryptocurrencies are property.20
  • Therefore, gains from dealings in cryptocurrencies will be included in gross income.
  • Let’s just agree amongst ourselves that ETH is a cryptocurrency.
  • Therefore, gains from dealings in ETH will be included in gross income.
  • Disposing of ETH (property) – i.e., no longer owning it – is “dealing in property”.
  • Therefore, gains from disposing of your 1 ETH (when you simultaneously acquired 66.667 DAO tokens) will be included in gross income.

The difference between amount realized and adjusted basis of the property that you disposed of will be gain.21

Let’s compute that gain.

Amount Realized

The amount realized is what you receive when you dispose of the property:

The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.22

Since you received only DAO tokens when you disposed of the ETH by sending it to The DAO’s wallet, your amount realized is the fair market value of the DAO tokens you received.

The units in which you express fair market value? Dollars.23

So what is the fair market value of the DAO tokens, expressed in dollars? That’s not too hard to figure out. At the moment I do not see a direct DAO <—> USD exchange but I’m sure it is coming. For the moment, you can back into the dollar value of DAO tokens as follows:

Example 04: Calculating Amount Realized

1.5 ETH = 100 DAO tokens, according to The DAO’s home page on 25 May 2016.

1 ETH * (100 DAO tokens / 1.5 ETH) = x. This is the number of DAO tokens you own after converting your ETH to DAO tokens.

First, cancel out the ETH units in the numerator and denominator. Restate the formula.

1 * 100 DAO tokens / 1.5 = x

The 1 is useless. Restate the formula.

100 DAO tokens / 1.5 = x

100 / 1.5 = 66.667. Ignore the repeating decimal.

After converting your ETH to DAO tokens to ETH, you own 66.667 DAO tokens.

1 ETH = $12.59 on 25 May 2016, according to some random online exchange I visited. Trust me.

Just by eyeballing this whole exercise in 8th grade algebra, we can say 66.667 DAO tokens = 1 ETH = $12.59.

You, when you exchanged your ETH for DAO tokens, received property (DAO tokens) with a value of $12.59. That is your amount realized on the disposition of your 1 ETH.

Basis

Basis for the ETH you disposed of is easy. We calculated it before: $12.59 is what you paid when you bought your 1 ETH

Taxable Gain

Finally we come to the calculation of the gain from disposition of your 1 ETH:

Amount realized ($12.59) minus basis ($12.59) = $0 gain.

This $0 gain is recognized as income.24

This probably seems like a trivial exercise for no payoff, but the important thing is to understand the concept and the methodology. If you had bought your 1 ETH at $8 and converted it to DAO tokens when the value of ETH was $12.59, you would have had a $4.59 taxable gain.

Character of the Gain

The gain is capital gain, earned on the sale of property. It is short term capital gain, because you held the 1 ETH for less than one year.

Reporting

You will report the disposition of 1 ETH on Schedule D.

Step 3: While You Own DAO Tokens

I am skipping over the stage where you are the owner of DAO tokens. This is when proposals are made and votes are taken to decide whether to accept and fund the proposal. Presumably The DAO is making itself rich by doing stuff.

This article is long enough already. Some other day, maybe, I will write a followup.

Step 4: DAO Tokens to Ether

Now we reverse the transaction. You want to dump the DAO tokens and get dollars so you can go get drunk.

DAO tokens are personal property. You dispose of the DAO tokens and receive ETH in return.

Gain

The amount of taxable gain is the amount realized minus the tax basis in the DAO tokens. We know your basis in the DAO tokens: $12.59, because that is what you paid (in ETH) to acquire them.

Remember the rule: amount realized on the disposition of the DAO tokens will be the sum of cash plus the fair market value of property received upon disposition of the property.

Since you receive no cash when you dispose of the DAO tokens, you look at the fair market value of the ETH you receive in the transaction. There is a thriving market for ether. It is easy to get an exchange rate for ETH/USD. Now you know your amount realized.

Reporting

This transaction goes onto Schedule D of your Form 1040.

Step 5: Ether to Dollars

We come to the penultimate step: you have ETH (received when you disposed of the DAO tokens) and want dollars. You are disposing of personal property in exchange for U.S. currency.

The amount realized is the total cash received plus total fair market value of property received. In this case, you sell your ETH for dollars. You get all cash, no property. The amount of cash received is the amount realized.

The amount recognized is the amount realized minus your tax basis in the ETH.

This transaction goes on Schedule D, too.

Step 6: Dollars to Alcohol

I leave the taxation of this transaction to your imagination.

In Case You Want More

Here is the only discussion of taxation in the context of DAO tokens that I could find:

  • United States Federal Taxation of DAO tokens, a reasoned discussion of tax issues on The DAO’s forum, by a CPA. I do not say whether he is right or wrong and I am not going to spend my time debugging his analysis, but it appears to me he is not a member of the Bong Hit Brigade. 🙂

Disclaimer

Let’s get straight to the disclaimer.

There are no tax rules in this area.

Everything in this article is WILDLY wrong, and my reasoning from known principles is tainted by my bemused skepticism about the whole topic.

Let me say it again. There are no tax rules. How can you expect the IRS to write tax rules about bullshit?25

See you in a couple of weeks. I’m going to take my meds now.

Phil.

  1. That is oddly satisfying. DDDDTTD. Feels good. ↩
  2. In fact, I think the truth about The DAO – if we were to discover it – is probably depressingly ordinary. Reality is usually much simpler than the facade presented to us, and even seemingly novel effects have entirely prosaic and familiar causes. Cui bono? ↩
  3. It is telling that ETH and only ETH is used by The DAO. Cui bono? ↩
  4. It looks kind of like an IPO to me. ↩
  5. 4223b3da-15d6-405d-8b20-3fd19cdb2697 because, well, why not. ↩
  6. The experience of apparently “owning” a tiny fraction of a bitcoin has renewed my bemused skepticism of those green paper rectangles that I get from a machine at Chase Bank. And it makes me laugh at the vainglory that asserts that I “own” some dirt and a house on it. In the scope of this universe, who am I to assert “ownership” over some molecules? So bitcoin ownership has accomplished something of value – a little humility, in the best sense of the word. A sense of scale. Am I not enlightened? ↩
  7. FFS why wouldn’t it be a security? Disclaimer: I have deliberately avoided securities law since the mid-1980s, when I got sick of hearing the TLA PPM. ↩
  8. If you want to make money, align yourself with smart, hardworking people. Avoid working with people who are hiding in a Post Office Box in Panama. I say this as someone who knows a fair amount about how to hide things and what happens when secrecy fails. Hint: secrecy fails. ↩
  9. The DAO accepts proposals and the DAO community votes on them. Approved proposals are funded. ↩
  10. I’m waiting for my man, Twenty six dollars in my hand. Up to Lexington, 125. Feel sick and dirty, more dead than alive. I’m waiting for my man. ↩
  11. Precise details are below. ↩
  12. Many fine establishments of good repute seek to earnestly assist you in the conversion of paper rectangles into the finest of digital provisions. Through diligence, honesty, and hard work they endeavor to procure your continued patronage. Or you can meet a guy in a McDonalds parking lot. ↩
  13. Handy-dandy instructions, courtesy of Reddit. ↩
  14. Fruit flies like a banana. Yeah, I know. Dad joke. ↩
  15. I have not seen a website where you can do a meetup and exchange ETH for dollars, but I’m sure sooner or later it will happen. Or use shapeshift.io to exchange your ETH for BTC and then use localbitcoins.com to do that meetup at Starbucks or the McDonalds parking lot and exchange your BTC for dollars. ↩
  16. I spent a year between high school and college working and traveling in New Zealand. I remember reading the book, but mostly I remember the title. ↩
  17. 26 U.S.C. §1012(a). ↩
  18. Because 26 U.S.C. §1012(a). Selah. ↩
  19. 26 U.S.C. §61(a)(3). ↩
  20. Notice 2014-21. ↩
  21. 26 U.S.C. §1001(a). ↩
  22. 26 U.S.C. §1001(b). ↩
  23. Casino. Pit boss. Remember? ↩
  24. 26 U.S.C. §1001(b). ↩
  25. But I do not judge. ↩
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