Within a week, the group created the ConstitutionDAO, organized its followers on Discord (a messaging and community platform), and raised roughly $47 million in virtual currency.⁴ Armed with their new war chest, the group bid on, but ultimately failed to win, the Sotheby’s auction, losing out to a hedge fund billionaire who purchased the copy of the Constitution for $43.2 million (the Constitution DAO had withheld some funds to cover costs associated with winning the auction).⁵

Following their loss, the creators of the group were faced with what to do with the virtual currency sitting in the DAO’s treasury. Many of the community members sought refunds, only to learn that the transaction costs (also known as gas fees) would eat up much of their original contribution.⁶ Ultimately, the ConstitutionDAO’s founders decided to shut it down.⁷ The token issued in connection with the project, originally intended to be used to allow holders to vote on what the DAO would do in the future, lives on, with some holders still hoping to profit.⁸

What if the ConstitutionDAO had succeeded? Who would have “owned” the copy of the Constitution the group would have purchased? In a later interview one of the founders of ConstitutionDAO, Jonah Erlich, disclosed that the group had partnered with a traditional nonprofit organization that would have had legal custody of the Constitution.⁹ The fact that this new type of organization would be reliant on a traditional nonprofit provides excellent insight into the emerging world of DAOs. It also gives us an entry point to examine this new structure.

WHAT ARE DAOS?

In a traditional corporation or limited liability company, the organization is formed by filing paperwork with a government office, typically a state’s Department of State. By creating a legal entity, the people behind the organization are protected from liability. When someone sues a corporation over a contract dispute or other liability, the directors, officers, employees, members, and volunteers are not liable individually. Rather, it’s the corporation that must answer for its liabilities.

In a DAO, however, there is no formal legal entity. Built using the same blockchain technologies that underly the virtual currency ecosystem, DAOs are organizations that are never incorporated in any state (with limited exceptions). The founders create the DAO, and it simply exists.

While DAOs actual structures vary, most DAOs issue a token that gives members of the DAO voting rights. Once tokens are issued, in order to make decisions, all token holders are allowed to vote. The idea, touted by DAO supporters, is that this new structure democratizes organizational decision-making, placing it in the hands of the members. An oversimplified comparison would be a for-profit company that has no paid executives or board of directors, making every decision by allowing all shareholders to vote.

Although the ConstitutionDAO is a well-known example, DAOs are proliferating in the nonprofit community. Here are a few interesting examples: DiatomDAO is raising support to protect the oceans;¹⁰ KlimaDAO hopes to speed up solutions for climate change by increasing the price of carbon assets;¹¹ Bloomeria is using NFTs to increase biodiversity; ¹² and The Regen Network is issuing a token as part of a group of entities to realign the agricultural economy with ecological health.¹³

While each of the foregoing organizations uses the language of the DAO and decentralization, they also demonstrate how the DAO community encompasses many different structures. For instance, the Regen Network is comprised of a traditional C-Corporation, a traditional 501(c)(3) public charity, and a decentralized DAO program.¹⁴ The DiatomDAO is purely a decentralized entity, “owned and directed” by its token holders (see more on this below). The ConstitutionDAO, while operated as a decentralized DAO, would have relied on a traditional 501(c)(3) public charity (one named EnDAOment¹⁵) had it won the Sotheby’s auction and needed a legal entity with which to hold the copy of the Constitution. As you can see, while many groups use the mantle of “DAO”, the term encompasses many different structures.

WHAT ARE THE BENEFITS OF DAOS?

Now that we’ve discussed what DAOs are, and seen some examples, let’s step back to consider what DAO proponents like about the structure. In theory, a pure DAO offers each supporter the opportunity to participate in the group’s decision-making. If a member of a charitable DAO wants to make a grant, they would propose it to the rest of the DAO community. The members then hold a vote. Using this structure, a DAO represents a more direct form of organizational decision-making and, for donors, more direct-action philanthropy.

Further, by avoiding any legal structure, some DAO proponents believe this new structure will give DAOs greater flexibility. Without a state’s laws dictating how decisions have to be made or how boards have to be structured, a DAO might be nimbler. Some libertarians believe that DAOs, who have no real jurisdictional nexus to any state, might even be able to avoid generally applicable laws.¹⁶

WHAT ARE THE DRAWBACKS OF DAOS?

While there is a lot to be excited about by DAOs, they use an organizational structure in its infancy, with many more questions than answers. One critique is that the voting structure adopted by most DAOs (1 token = 1 vote) replicates existing problems with shareholder structures, namely, that the larger shareholders control organizational decision-making, alienating smaller shareholders. If one person holds 60% of the DAO’s tokens and the DAO implements a 50+1% vote threshold decision-making could be even more centralized than it would be in a traditional organization with a board and executives who can counterbalance a large shareholder’s interests. The DAO community has proposed some possible solutions to this problem, such as limiting votes to one per token holder, or creating non-transferable tokens to limit token holder hoarding. Each of these solutions have drawbacks, but they could drive decision-making closer to the idealized notion of the DAO.

Another issue is the legal uncertainty of DAOs. Assume that the libertarian notion that DAOs are legally unaccountable as organizations, since they are not organized in any state nor do they have any other jurisdictional nexus with any local, state, or federal government. That might put the DAO beyond the reach of regulators and law enforcement, but it would not exempt the individuals participating in or working for the DAO, all of whom are real people subject to normal laws. Actually, the idea of a group of people running an unincorporated organization isn’t new. In New York, for instance, such an entity would be deemed an “unincorporated association.” Under longstanding common law, an unincorporated association is not legally separate from the members who comprise it.¹⁷ That means that members of a DAO could be taking on direct legal risk from their participation in the DAO. If the DAO were to breach a contract, discriminate against an employee, or cause other real-world harm, the DAO’s members might be jointly and severally liable.

It’s also an open question whether regulators will share the libertarian view that DAOs are not subject to local, state, or federal laws. It wouldn’t be surprising to see the Securities and Exchange Commission (SEC) bring an enforcement action against a DAO, given that it has already notified the Decentralized Finance (DeFi) community that it considers many DeFI products analogous to products regulated by the Commission.¹⁸ The SEC has already brought an enforcement action against a Wyoming organization operating under the guise of a DAO, albeit only after the entity sought SEC approval to register two tokens as securities.¹⁹

Finally, DAOs in the philanthropic sector face the additional hurdle of providing tax-deductibility to donors. In general, a contribution to a non-charitable intermediary doesn’t allow a donor to take a tax-deduction. The answer to that question isn’t clear²⁰ as it depends on how the entity is treated for tax-purposes, whether its distributions would otherwise qualify for a tax-deductions, and whether it is considered an agent for the donors or beneficiary charities. A person hoping for a tax-deduction should contact a tax professional to examine the particular DAO’s structure and the taxpayer’s circumstances. To date, I’m unaware of any DAO specifically advertising the deductibility of contributions to its treasury, nor having considered tax-deductibility as part of their DAO structure (except, of course, for DAOs like Endaoment and Regen Network that operate using a traditional 501(c)(3) corporate structure).

WHAT’S NEXT FOR DAOS?

Despite the novelty of and the uncertainty surrounding DAOs, their popularity is undeniable. This was exemplified by the incredible enthusiasm around ConstitutionDAO. Taking advantage of the late 2021 surge in the value of many cryptocurrencies, DAOs provide an opportunity for the crypto community to put its assets to work in novel ways, including philanthropy. While they are evolving, DAOs will likely persevere, barring regulator intervention to shut them down.  Donors and charities looking to participate in the DAO community should do so carefully, and with the benefits of advisors familiar with the DeFi and DAO space.

1 https://www.sothebys.com/en/digital-catalogues/the-constitution-of-the-united-states

2 Id.

3 https://www.theverge.com/22820563/constitution-meme-47-million-crypto-crowdfunding-blockchain-ethereum-constitution

4 https://www.constitutiondao.com/

5 https://www.vice.com/en/article/qjb8xv/hedge-fund-ceo-who-bailed-out-gamestop-short-seller-bought-the-constitution

6 https://www.theverge.com/2021/11/24/22800995/constitutiondao-refund-progress-steep-gas-fees-cryptocurrency

7 https://www.theverge.com/2021/11/23/22799192/constitutiondao-shutting-down-lost-auction-refunds

8 The latest price quote for the PEOPLE token can be found at  https://coinmarketcap.com/currencies/constitutiondao/.

9 https://www.theverge.com/22820563/constitution-meme-47-million-crypto-crowdfunding-blockchain-ethereum-constitution.

10 https://diatom.fund/

11 https://www.klimadao.finance/

12 https://bloomeria.org/

13 https://www.regen.network/

14 https://www.regen.network/faq/organization

15 https://endaoment.org/

16 For instance, in his conversation on the Deep Background podcast, Erik Voorhees argued that a DAO could avoid the difficulties of employment law because no states employment laws would apply. https://www.pushkin.fm/episode/whats-the-deal-with-decentralized-autonomous-organizations/

17 See, generally, New York Elec. C. Assn. v. Local Union No. 3, (NY Sup. Ct. 1941), available at https://casetext.com/case/new-york-elec-c-assn-v-local-union-no-3

18 https://www.sec.gov/news/statement/crenshaw-defi-20211109

19 https://www.sec.gov/news/press-release/2021-231; https://www.coindesk.com/policy/2021/11/11/sec-stops-wyoming-based-dao-from-registering-2-digital-tokens/.

20 For an excellent discussion, see Prof. Samuel Brunson’s blog post https://lawprofessors.typepad.com/nonprofit/2021/11/charitable-daos-revisited.html.

The post DAOs and the Nonprofit Sector – How Can they Work Together? appeared first on Perlman & Perlman.

Virtual currency is gaining mainstream attention with each passing day. Nonprofits such as the American Red Cross, UNICEF, and American Cancer Society leverage platforms including The Giving Block and other services to accept a wide range of virtual currencies, as part of their overall fundraising strategies.

At our firm, we continue to work with nonprofit clients as they consider whether and how to fundraise using cryptocurrency. Here are a few questions we have been asked and other questions charities should be asking of potential fundraising platform partners.

Frequently Asked Questions

Should we accept virtual currency?

For many organizations, this is an easy answer – yes. There are few risks to accepting donations of virtual currency, especially if nonprofits immediately liquidate those donations.  Donors of virtual currency typically skew younger, possibly opening up a new demographic of supporters for the organization. The board should consider including virtual currency in its Gift Acceptance Policy, a document every organization should have to guide its board, executives, and staff in their development work.

Should we immediately liquidate donations of virtual currency, or hold onto them?

This is more difficult to answer, as it is based on how much risk the organization can tolerate. Virtual currency is highly volatile – its value can skyrocket or plummet within a matter of hours or days, making it a risky asset to hold onto. Whether to hold onto virtual currency is a decision that should be made with the input of a nonprofit’s board and executive team. If virtual currency is held as part of the organization’s investments, or if a donor asks the organization to hold the virtual currency as an endowment or long-term investment, the organization should consider how that fits within the organization’s overall investment strategy and portfolio, and the applicability of state laws governing the prudent management of institutional funds/assets.

One concern is volatility – few organizations want to see their donations halve in value. For many organizations, the potential upside isn’t worth the potential risk.

A second concern is regulatory risk. As the Chinese central bank, SEC, FINCEN, IRS, and other domestic and international regulators grapple with how to regulate virtual currency, the liquidity and accessibility of virtual currency markets is up in the air. Even major players like Coinbase and Ripple have been subject to or threatened by regulatory action.

Charities are often cautious when holding virtual currency, concerned that the regulatory environment could shift in a way that devalues or freezes their holdings. If a nonprofit is using a virtual currency account on a platform that is subject to an SEC action, for instance, the platform might be forced to freeze transactions until such time as the SEC allows it to continue operations.

Organizations that are highly diversified and have the financial cushion to absorb a zeroing out of their virtual currency donations, taking into account the diversification of risk across the organization’s entire investment portfolio,  might be comfortable with the risks of virtual currency. The potential upside of assets like Bitcoin are hard to ignore – despite volatility, Bitcoin’s value has been on a consistent march upward. Other coins, like Ethereum, have not been far behind. If your organization is willing to take the risk, and has considered the prudent investment regulatory considerations, you can create a wallet at a prominent, legally-compliant platform, and park your virtual currency there and “Hold On for Dear Life” (HODL, as some in crypto-world like to say).

Fortunately, the major virtual currency fundraising platforms allow immediate liquidation of donations. Again, this is the option chosen by most nonprofit organizations. As I mentioned above, nonprofits should include virtual currency in their Gift Acceptance Policy and Investment Policy to help guide their development professionals as they consider whether and how to accept virtual currency donations.

How do we treat virtual currency for accounting purposes?

Despite continued regulatory action in other parts of the crypto market, IRS rules around donations of virtual currency have been relatively stable. Since 2014, the IRS has been clear that virtual currency should be treated as property. A taxpayer donating virtual currency they have held for more than a year may deduct the fair market value of the currency at the time of its donation, similar to other forms of property, such as publicly-traded stocks. This provides a tax benefit to donors who invested in virtual currency in its infancy – they can support their favorite charities without being taxed on the gains they’ve enjoyed on paper.

This consistent treatment from the IRS means that charities can rest assured that they can accept virtual currency in the same way that they can accept donations of appreciated stock or other forms of property. The accounting department or external accountants should be able to handle booking donations of virtual currency without much trouble. A caveat is that, in a nonbinding FAQ, the IRS has said that nonprofits must fill out Form 8282 whenever the nonprofit sells, exchanges, or otherwise disposes of its virtual currency. This is a departure from the IRS’s treatment of virtual currency as akin to stocks, which a nonprofit can sell without filing Form 8282. While not insurmountable, nonprofits and their fundraising platforms should discuss how to operationalize capturing the information required for filing Form 8282.

Questions to Ask a Fundraising Platform

Now that we have considered some of the frequent questions nonprofits ask their advisers, let’s consider questions nonprofits should ask a prospective fundraising platform as part of their due diligence.

Are you registered as a professional fundraiser?

Fundraising is regulated in most states, with each state using its own regulatory regime. Individuals and organizations that support charities are often subject to laws regulating charitable solicitation (here’s an excellent overview from my colleague Tracy Boak). Charities are affected by these regulations and are obliged to make sure they only partner with organizations that are properly registered and licensed, if required.

Many fundraising platforms (both traditional and those dealing with virtual currency) take the position that they are not professional fundraisers, due to the way they structure their platforms and services, e.g., because they don’t affirmatively solicit donations on behalf of any charity and don’t take custody of donations. Regardless, a platform should be able to tell you why it isn’t subject to fundraising registration requirements. By asking the question, nonprofits can rest assured their fundraising platform partner is on top of its compliance obligations.

Are you registered as a Money Service Business or Money Transmitter?

Money Service Business (MSB) and Money Transmitter (MT) regulations are implemented at the federal and state levels. Their purpose is to weed out fraud and money laundering in the money transmission business. Generally speaking, MSB and MT laws create licensing structures that require licensed entities to do some due diligence on their customers, including “KYC” (know your customer) and “AML” (anti-money laundering) requirements.

Since 2013, the Financial Crimes Enforcement Network (FinCEN) has applied money transmitter regulations to some entities within the virtual currency ecosystem. According to FinCEN, if a person or organization accepts money or another instrument with monetary value from one person and transmits it to another person, that person may be classified as a money transmitter under federal regulations. (A comprehensive rundown of FinCEN’s guidance is found here). This means that any entity that accepts virtual currency from one party and transmits it to another party could be considered a money transmitter subject to the federal rules. The same rules apply if the entity accepts virtual currency, converts it to fiat currency (i.e., U.S. dollars), and transmits the fiat currency to another person or entity.

FinCEN does provide some exceptions, including those entities that only provide network access or serve as payment processors, exceptions which largely do not apply to crypto-fundraising. Whether a person or entity will be treated as a money transmitter is a facts-and-circumstances determination, but FINCEN clearly intends to define money transmission broadly and interpret its exceptions narrowly (see the discussion on pages 12-22 of the guidance linked above).

Nonprofits considering crypto-fundraising options should ask the potential partner whether it is registered as a money transmitter. If not, ask how they ensure that their services aren’t used inappropriately – do they work with a partner that is a licensed entity? Who does their KYC and AML compliance work?

Do you accept anonymous donations?

Anonymous donations are nothing new – charities have received anonymous donations large and small since long before the birth of cryptocurrency. But many charities are wary of the “dark side” of cryptocurrency and its reputation (rightly or wrongly earned) for facilitating illicit activity. Nonprofits should check with their potential fundraising platform to confirm whether they allow anonymous donations. If so, ask whether the donations are anonymous to the platform, or only to the charity. If the donation is anonymous to the platform, ask whether and how the platform ensures the anonymous donations aren’t connected with illicit activity. The answer may be that the platform does not, or cannot, do anything else to ascertain the identity of donors who wish to remain anonymous. If that is the case, the nonprofit should consider whether it is comfortable with the risks of accepting anonymous donations.

Those risks are generally the same as accepting any other high-value anonymous donation – that a donation of virtual currency could be traced back to illicit activity or a potential clawback, if the virtual currency that is donated doesn’t belong to the donor.  One difference with anonymous donations of cash or other types of property is that the virtual currency environment is highly transparent, even if it may be highly anonymized. Bitcoin transactions are viewable on the blockchain, even if the participants in the transactions may remain anonymous.

Do you issue donation receipts? Do you fill out Form 8282? Will we get a donor list?

One of the core tasks in charitable fundraising is issuing receipts to donors. Donors need to keep those receipts on file, in case they want to claim a charitable deduction. Many platforms will create automatic receipts. Nonprofits should confirm that the receipts issued by its platform partners are compliant with IRS requirements, and ask for copies for your records.

Nonprofits should also ensure that the fundraising platform will provide you with a list of your donors, to make sure you can build out your donor base.

The post What Nonprofits Should Be Asking About Virtual Currency Regulation and Fundraising appeared first on Perlman & Perlman.