Disclaimer: I am neither a lawyer nor a tax advisor. This article is not legal advice. This article is not tax advice. It is solely my research into regulations and information for Non-Profit Decentralized Autonomous Organizations (DAOs). For those unfamiliar with DAOs, we recommend starting with our previous article titled DAOs 101.
One piece of the DAO puzzle is entity formation. When speaking about DAO entities, some questions come to mind: Should a DAO be incorporated or unincorporated? Should a DAO be an LLC, or should it go the LCA (Limited Cooperative Association) route? Does not claiming a jurisdiction mean the DAO and its members could be liable in any jurisdiction? Is forming the DAO outside the United States the right or wrong choice?
The likely answer to these questions is it depends, and those in the legal field would advise you to meet with an attorney. While that is all fine and well, I like to be prepared and do the research. Or at least understand as much as possible before entering those conversations with an attorney.
What led me down this Non-Profit rabbit hole for DAOs was my article, Wrappr: Liability Protection for DAOs. In that article, I spoke about an innovative approach Wrappr.wtf is using to help with legal liability. They have created a “legal NFT minter” that mints a token and provides DAOs “…with limited liability” and allows them “…to own IRL assets by representing legal entities.”
One Wrappr called a UNA particularly caught my attention. According to their site, the UNA Wrappr“…creates an Unincorporated Non-Profit (UNA), which has limited liability and can offer tax benefits.” The UNA or Non-Profit route is one direction a DAO could take. Still, before diving deep into UNA Wrapprs, I needed to refresh my understanding of Non-Profits.
One of the first things people bring up when speaking about Non-Profits is 501(c)(3) organizations. What does 501(c)(3) mean, and where does it come from?
501(c)(3) is just the section within the Code of Federal Regulations (CFRs) that speaks to exemptions of Income taxes for organizations operating under certain parameters. Specifically, it is located within 26 CFR Chapter I Subchapter A. Section 501(c)(3) starts with this description:
§ 1.501(c)(3)-1 Organizations organized and operated for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals.
Organizations that meet these circumstances are usually called “charitable organizations.” Please note that there are different types of Non-Profit organizations and regulations. For example, 501(c)(4)-1 applies to Civic organizations and local associations of employees. In contrast, a different law applies to Social clubs, like 501(c)(7)-1.
Okay, so Non-Profit administrative laws are found in 26 CFR and, with a little digging, section 501(c)(3), but what does a Non-Profit have to do to meet these laws?
For an organization to be exempt under this section, it must meet an exempt purpose. The IRS defines exempt purposes as operating “exclusively for one or more following purposes:”
(d) Testing for public safety,
(f) Educational, or
(g) Prevention of cruelty to children or animals.
The IRS gives examples and definitions for further clarification of these exemptions. For example, the term educational is defined as:
(a) The instruction or training of the individual for the purpose of improving or developing his capabilities; or
(b) The instruction of the public on subjects useful to the individual and beneficial to the community.
An organization may be educational even though it advocates a particular position or viewpoint so long as it presents a sufficiently full and fair exposition of the pertinent facts as to permit an individual or the public to form an independent opinion or conclusion. On the other hand, an organization is not educational if its principal function is the mere presentation of unsupported opinion.
An example of an organization using the educational exemption is below.
An organization whose activities consist of presenting public discussion groups, forums, panels, lectures, or other similar programs. Such programs may be on radio or television.
While many DAOs today do not operate using radio or television, they host open discussions and forums on tools like Discord and Telegram. This leads me to believe that a DAO whose purpose is educational could become a Non-Profit DAO. But wait, there is more, a lot more!
Public Charity vs. Private Foundation
Once an entity qualifies to become a Non-Profit, the IRS makes an assumption and thinks it’s a private foundation. Wait, what? Yes. Let’s say you have done all the hard work to be granted 501(c)(3) status; now you have to prove that you are a public charity. This comes down to a famous phrase “show me the money!”
Public charities generally receive a greater portion of their financial support from the general public or governmental units, and have greater interaction with the public. A private foundation, on the other hand, is typically controlled by members of a family or by a small group of individuals, and derives much of its support from a small number of sources and from investment income. Because they are less open to public scrutiny, private foundations are subject to various operating restrictions and to excise taxes for failure to comply with those restrictions.
Under the tax law, a section 501(c)(3) organization is presumed to be a private foundation unless it requests, and qualifies for, a ruling or determination as a public charity. Organizations that qualify for public charity status include churches, schools, hospitals, medical research organizations, publicly-supported organizations (i.e., organizations that receive a specified portion of their total support from public sources), and certain supporting organizations.
Given that many DAOs are made up of members of the public and not controlled by members of a family, the potential exists that many DAOs could prove to be public charities. To help, two tests are used to determine if a Non-Profit is for a public charity or a private foundation. These tests are described as organizational and operational tests. Essentially, suppose a Non-Profit can show that it dedicates its purpose to the tax-exempt pursuit and refrains from activities against it. In that case, it will be designated a public charity (versus a private foundation).
Fewwww. That was a lot. So to recap, 501(c)(3) is a section of regulations that discusses certain entities being exempt from income tax. There are different types of Non-Profits. Once the status is granted, you are assumed to be a private foundation (like an endowment) until you have proven that you operate as a public charity.
If you have made it this far, congratulations. This is not easy to understand, and I probably need more information, but I hope it has helped. For part 2 of this series, I will dive deeper into taxes and try to identify the required forms for Non-Profit DAOs.
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