Two Wyoming Wrappers, One Federal Question

Somewhere in your DAO's smart contract is probably a function that pays out protocol fees, pro rata, to a few thousand wallets holding your governance token. Nobody drafted a partnership agreement. Nobody filed an election. Most of the wallet holders have never spoken to one another, let alone agreed to go into business together. Under federal tax law, none of that may matter.

This piece covers four things: how the tax code can find a partnership without anyone intending to form one; what that exposure actually looks like for a DAO's members; how Wyoming's two purpose-built wrappers sort founders onto different paths depending on a single question; and why both paths arrive at the same federal form.

The Code Does Not Wait for an Invitation

The Internal Revenue Code defines "partnership" expansively. The term "includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate." That is not a definition built around paperwork. It is built around conduct.

The regulations reach further still. Treasury Regulation § 301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may itself create a separate entity for federal tax purposes where the participants carry on a business, financial operation, or venture and divide the profits from it. A joint undertaking merely to share expenses does not. Carrying on a venture and dividing its proceeds can.

The Supreme Court's controlling test, from Commissioner v. Culbertson, asks whether the parties—considering the agreement, their conduct, their control over income, and the purposes for which it is used—in good faith and with a business purpose, intended to join together in the present conduct of an enterprise. It is a facts-and-circumstances inquiry, and no arrangement is foreordained. But a DAO that distributes fee revenue pro rata to token holders who vote on how that revenue is used supplies most of the facts Culbertson treats as significant. It looks like joint conduct of a financial venture because, functionally, it is one.

Two clarifications before going further. First, this is a federal question. An arrangement can be treated as a partnership for federal tax purposes without being a partnership under the law of any state; the Code reaches unincorporated organizations that no state statute would recognize as such, and the analysis does not turn on state-law form.

Second, the state-law exposure exists separately and is arguably worse. Regulators and plaintiffs' firms have advanced the theory that an unwrapped DAO is a general partnership, with unlimited joint and several liability running to its members. That is a different problem from this one, and a favorable answer here does not dispose of it.

What the Exposure Actually Looks Like

Where a DAO's fact pattern satisfies § 761(a), the default federal regime is Subchapter K. Each "partner" is allocated a share of income and is required to report it (typically via Schedule K-1) whether or not anyone issued one or intended to be a partner in the first place.

For a DAO with pseudonymous, rotating, globally distributed holders, the resulting obligations compound into something close to unworkable:

• Identification. A K-1 requires a name and a taxpayer identification number. A wallet address is neither, and nothing in a permissionless system produces one.

• Varying interests. Tokens change hands continuously. Subchapter K requires income to be allocated by reference to partners' varying interests over the year, which presupposes a record of who held what and when, again, expressed in partners, not addresses.

• Foreign partners. Withholding attaches to effectively connected income allocable to foreign partners under § 1446(a), and separately, under § 1446(f), to a foreign person's transfer of a partnership interest where gain would be effectively connected under § 864(c)(8). Applied to a freely traded governance token, the second implies a withholding analysis sitting on top of ordinary secondary trading.

• International reporting. Schedules K-2 and K-3 call for partner-level detail on foreign activity, for partners nobody can identify.

• Audit representation. The centralized partnership audit regime requires designation of a partnership representative with substantial presence in the United States, whose actions bind every partner. An organization built so that no one speaks for it has difficulty producing that person; if the partnership does not designate one, the Service may.

  
  

These issues are not solvable after the fact.

The Fork: Do You Pay Holders?

Wyoming offers two purpose-built wrappers, and the choice between them is usually settled by a question that has nothing to do with tax: does value flow to the people holding the token?

A Wyoming DAO LLC, formed under the Decentralized Autonomous Organization Supplement at W.S. §§ 17-31-101 through 17-31-116, is exactly what its name says. A DAO under that chapter is a limited liability company; the Supplement operates as an election made within Wyoming LLC law, and the LLC Act governs whatever the Supplement does not displace. It carries no restriction on distributions. If your protocol pays fees out to holders, this is the branch you are on, and the DUNA is not available to you on any terms you would accept.

A Wyoming DUNA, formed under W.S. §§ 17-32-101 through 17-32-129, cannot pay holders for holding. Section 17-32-104(a) permits profit-making activity but requires profits to be used in furtherance of, or set aside for, the association's common nonprofit purpose. Section 17-32-104(b) then prohibits paying dividends or distributing any part of income or profits to members, administrators, or persons outside the association.

The exceptions in § 17-32-104(c) are broader than that prohibition suggests, and they are where most of the practical work happens. A DUNA may pay reasonable compensation or reimburse reasonable expenses for services rendered—expressly including for "voting or participation in the nonprofit association's operations and activities"; confer benefits on members in conformity with the nonprofit purpose; repurchase membership interests to the extent its governing principles authorize; and distribute property to members on winding up. The line the Act draws is between paying members for what they do and paying them for what they hold. It is a real line. It is also drawn in the word "reasonable," which means it is drawn by facts, case by case.

That is the fork. Nearly everything else about the entity choice either follows from it or is secondary to it.

What the fork does not do is answer the federal question.

Both Branches Default to Partnership

Under the check-the-box regulations, an entity that is not a per se corporation is an "eligible entity" free to elect its classification, and a domestic eligible entity with two or more members that makes no election is classified as a partnership. Neither Wyoming wrapper escapes that default.

The DAO LLC is an LLC. It is not on the per se corporation list, it is a domestic eligible entity, and with more than one member it defaults to partnership. Forming one does not eliminate the classification the founders were worried about. It formalizes it. What the wrapper buys is limited liability, an entity that can contract and sue and hold an account, and governance rules a court can actually read. What it does not buy is relief from a single Subchapter K obligation. The K-1s are still owed, to the same people still nobody can identify.

The DUNA reaches the same default by a different road and lands somewhere worse. It is unincorporated and not a per se corporation, so it is an eligible entity. And it necessarily has two or more members, because § 17-32-102(a)(iii)(A) requires at least one hundred. In other words, a predicate for the multi-member default is written into the definition. Now pair that default with the anti-distribution rule. Subchapter K allocates income to partners whether or not the partnership distributes anything; a partner's distributive share is taken into account when the entity earns it, and distributions are a separate event entirely. A DUNA classified as a partnership would therefore allocate net income to members the statute forbids it to pay. Amounts genuinely spent on the nonprofit purpose may reduce that net income, but amounts set aside  (which § 17-32-104(a) expressly contemplates) will not. Treasury accumulation becomes phantom income to the membership, not as an edge case but as the structural consequence of pairing a nonprofit distribution rule with a pass-through classification.

Wyoming also declines to help with the paperwork. Section 17-32-124(e) provides that a DUNA is not obligated to collect and maintain a list of members or individual member information, including names or addresses. That is a sensible rule for a decentralized association. It is a difficult one for an entity whose default federal classification arrives with a hundred-plus K-1s attached.

Both Branches End at Form 8832

The exit from the default, on either branch, is the same instrument: an affirmative election under Treasury Regulation § 301.7701-3(c) to be classified as an association taxable as a corporation, filed on Form 8832.

For the DAO LLC that distributes, the election is a trade. You surrender pass-through and accept entity-level tax. In exchange, reporting collapses from a K-1 per holder to a corporate return, and payments to holders become a distribution question rather than an allocation question. For a protocol with thousands of pseudonymous wallets that trade is frequently not close, because the pass-through benefit is worth less than the compliance obligation is worth avoiding, particularly where the compliance obligation cannot actually be performed.

One wrinkle deserves mention on this branch. Section 7704 treats a publicly traded partnership as a corporation, and defines the term to include interests readily tradable on a secondary market or the substantial equivalent. A governance token quoted continuously on decentralized exchanges is not an obvious fit for the fact pattern Congress had in mind, but it is not an obvious non-fit either, and the qualifying-income exception in § 7704(c) is unlikely to rescue a protocol whose revenue is service fees. Founders who decline to elect may find they have been treated as a corporation regardless, on timing and terms they did not choose.

For the DUNA, there are two routes to the same destination. The first is the same Form 8832 election. The second is exemption: under Treasury Regulation § 301.7701-3(c)(1)(v)(A), an eligible entity that has been determined to be, or that claims to be, exempt from taxation under § 501(a) is treated as having made an election to be classified as an association, effective as of the first day for which exemption is claimed.

That second route is where founders should slow down. "Nonprofit" under Wyoming law and "tax-exempt" under federal law are different concepts that happen to share a word. Wyoming nonprofit status is a constraint on what the association may do with its money. Federal exemption requires qualifying under a § 501(c) category on the merits, and most protocol DAOs are not charitable in any sense § 501(c)(3) recognizes, while the analysis under the other subsections is harder than the marketing around DUNAs generally suggests. The deemed election is available on a claim rather than only a determination, but a claim that fails returns the entity to its default, with the phantom income problem intact.

The Two Questions

The state-law question ("what kind of entity is this") and the federal question ("how is this entity classified") are related but not identical, and the DAO founders who get an unpleasant letter tend to be the ones who assumed answering the first also answered the second.

Both Wyoming wrappers do something genuinely valuable. Each converts an amorphous, potentially accidental partnership arising from conduct into a defined entity whose federal classification can be determined deliberately, in advance, by filing an election. That is a change of problem rather than a solution to one, and it is still a substantial improvement, because the new problem has a form number.

But neither wrapper is that form.

References

Cases

Commissioner v. Culbertson, 337 U.S. 733 (1949).

Internal Revenue Code

I.R.C. § 501(a), (c). I.R.C. § 702(a). I.R.C. § 704. I.R.C. § 761(a). I.R.C. § 864(c)(8). I.R.C. § 1446(a), (f). I.R.C. §§ 6221–6241 (centralized partnership audit regime); § 6223(a). I.R.C. § 7701(a)(2). I.R.C. § 7704.

Treasury Regulations

Treas. Reg. § 301.7701-1(a)(2). Treas. Reg. § 301.7701-2(b). Treas. Reg. § 301.7701-3(a), (b)(1). Treas. Reg. § 301.7701-3(c). Treas. Reg. § 301.7701-3(c)(1)(v)(A).

Wyoming Statutes

Wyoming Decentralized Autonomous Organization Supplement, W.S. §§ 17-31-101 through 17-31-116. W.S. § 17-31-102(a)(ii) (DAO defined as a limited liability company). W.S. § 17-31-103 (application of the Wyoming Limited Liability Company Act). Wyoming Decentralized Unincorporated Nonprofit Association Act, W.S. §§ 17-32-101 through 17-32-129. W.S. § 17-32-102(a)(iii)(A) (one-hundred-member minimum). W.S. § 17-32-104 (profits; prohibitions on distributions and dividends; permitted payments). W.S. § 17-32-107(a) (separate legal entity for contract and tort purposes). W.S. § 17-32-119 (membership interests freely transferable). W.S. § 17-32-124(e) (no obligation to maintain a member list).

Forms

IRS Form 8832, Entity Classification Election.