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January 19, 2007
Taxing Ones and Zeros: Can the IRS Ignore Virtual Economies?
by Dustin Stamper

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
on January 15, 2007.

You've just smote a horde of goblins and obtained Gnorbl's Flayed Skinbands. It's midnight; you're in your underpants; and you're playing EverQuest online in your den. And maybe, just maybe, it's a taxable event.

The rise in massive multiplayer online games may present the IRS with its thorniest pop culture tax issue since Mark McGwire was pelting million-dollar home-run balls at baseball fans -- only with much broader consequences. While only a handful of lucky baseball aficionados ended up with home-run windfalls, staggering sums of money are traded in virtual economies every day. And as Joint Economic Committee senior economist Dan Miller told Tax Analysts in a recent interview: When, how, and if those sums are taxed "brings up a whole constellation of issues."

Think the whole discussion is silly? An exercise for stodgy law professors and alarmist tax journalists? Think again.

The JEC began an examination of the tax issues associated with virtual economies in October. The report, due out in the first quarter of 2007, likely won't contain any surprise conclusions. Last year's chair of the committee, Rep. Jim Saxton, R-N.J., began the study warning that IRS taxation of virtual economies would be a mistake.

"Although we continue to research the issue, there does not appear to be a compelling case in favor of taxing virtual income," Miller told Tax Analysts. "In other words, what happens in the virtual world, stays in the virtual world untaxed."

The stance is no surprise given the committee's antitax history under GOP stewardship, but it is not likely to be the last word. The JEC is not responsible for tax law. But the report may go a long way in defining virtual economies and setting limits for the debate.

Essentially, participants in massive multiplayer games such as EverQuest, Ultima Online, World of Warcraft, and Second Life meet in online universes where they can interact through "avatars," trade goods and services, or participate in games. (An avatar is a gamer's online alter ego.)

The differences between the sites can be substantial. Games like EverQuest and World of Warcraft are more structured, with players meeting and participating in scenarios set up by game designers. An online universe such as Second Life is unstructured. Its maker, Linden Lab, does not consider it a game at all. The world is built and maintained by its residents, who are granted intellectual property rights by Linden Lab for anything they create. Residents can write programs that create new clothes, make rain storms, or do just about anything.

What all the universes have in common is a thriving marketplace of virtual goods that are often bought and sold for hundreds or even thousands of real U.S. dollars. Property on Second Life starts in the thousands of dollars and is often leased to other entrepreneurs. Anshe Chung has declared herself the first Second Life millionaire with virtual assets worth over U.S. $1 million built through an online real estate empire.

There is no question that when virtual goods are sold for American currency on an auction site like eBay, the income is taxable. The trickier question is whether the goods are taxable long before that.

Running a Barter Exchange

Writer Julian Dibbell spent much of 2003 on Ultima Online, eventually reporting $11,000 to the IRS from selling the fruits of his "labor." In his book "Play Money," Dibbell explains that he did little actual playing but instead swindled other players out of their goods cheaply in the virtual market and then sold them later for a markup in the real world.

Texas Tech Law Prof. Bryan T. Camp, a Tax Notes columnist, who left the IRS Office of Chief Counsel in 2001, said the trade of virtual goods could be considered a taxable realization event if the goods traded have readily ascertainable fair market values. It is possible to argue that those trades are as taxable as a dentist performing a root canal for a Laundromat owner in exchange for his dry cleaning, Camp said.

Sure, players aren't actually exchanging anything tangible. The goods or services being exchanged are only a series of ones and zeros on a server somewhere. But those goods are just as real as the tax return preparation software that costs $50 to download. That software is also just ones and zeros downloaded from a server to a home computer. And auction sites like eBay provide a testament to the value of virtual goods.

"We know the value of these imaginary assets," Dibbell said.

The potential tax consequences of virtual trades could pose major problems for game makers. Most of the games have their own currency to allow players to buy and sell goods. In essence, the game makers could be running a barter exchange, Camp said.

Trading goods or services for a barter currency that can be used to purchase other goods and services doesn't erase tax liability. In 1982 Congress passed a tax bill that required all trade and barter exchanges to issue Form 1099B information returns for all their members at the end of each year.

According to Tim McDowell, executive director of the National Association of Trade Exchanges, there are more than 400 U.S. retail barter exchanges trading goods as varied as college educations and funerals to the tune of more than $3 billion every year.

"It's a very diverse industry," he told Tax Analysts in an interview. "Anything you can buy for cash you can probably trade for."

McDowell conceded that he is no tax expert, but said he could not see any reason why trades of virtual goods would provide any exception to reporting requirements.

"If it's a barter deal, its taxable," he said. "A lot of people doing this online don't want to hear it."

Camp, who is a tax expert, said his position remains that the trading or acquiring of virtual goods in virtual economic universes is imputed income and not taxable until sold for U.S. currency. Most game makers have helped his argument by trying to thwart what gamers call real money trade, or RMT. The most valuable items are now bound to the avatars that find them and cannot be traded. That means most internet sales now consist of the sale of whole accounts containing any avatars that have acquired valuable items. According to Camp, it is the account that is growing in value so the income is imputed to the account's owner.

The position holds up less well for a virtual economy like Second Life, with a thriving real estate market and a currency that is directly exchangeable for U.S. dollars through Linden Lab itself. Camp conceded that it is becoming increasingly difficult to argue that Second Life transactions are not taxable.

"Activity within Second Life looks a lot like barter exchange," he said.

Miller said he was surprised that people at Linden Lab seemed resigned to the eventual intervention of the IRS into their company's activities. When contacted by Tax Analysts, a spokesman for Linden Lab said the company maintains that it has no reporting requirements and acts merely as an entrepreneurial platform.

"At the time and place you realize profit, it's your responsibility to declare that income," he said.

When pressed on the details of what separates Second Life from other barter exchanges, the spokesman said the company's chief counsel was currently preparing a paper on the matter.

What to Do?

Requiring Linden Lab and other game makers to file information returns for all the residents of their virtual universes could cripple the industry, most observers said.

As Miller points out, declaring virtual economies barter exchanges wouldn't be simple either. He said it would be difficult to determine whether the income was taxable in the location of the player, the servers, or the company. The tax consequences could also hinge on whether virtual assets were considered property, services, or game winnings.

Dibbell took his tax questions straight to the IRS. As he details in his book, the answers were ambiguous at best. Clearly no one at the IRS was even considering online economies, he said.

"What really surprised me is that they still don't seem to be thinking about it," he said. "I suspect they'd rather not think about it [at] all."

The IRS has been known to get in trouble when it applies the letter of the tax law too rigidly. An initial assertion in 1997 that a fan returning a valuable home-run ball to a player would run into gift taxes created a firestorm of bad press for the agency. Although most tax experts agreed that catching a home-run ball is a taxable event even before a ball is sold, enforcing gift taxes just didn't pass the smell test.

"Clearly these are games and clearly it would be problematic to be very logical to apply these barter rules to these games and economies," Dibbell said. The IRS "has proven to be a little smell-deaf on some of these things before. Where the money starts to smell better than the stink is hard to know."

The IRS may not be able to ignore virtual economies much longer. According to Second Life's running online tab, the equivalent of more than $1 million was exchanged in the virtual world over the 24 hours before the writing of this article. Almost 100 people had a positive Linden dollar cash flow of $5,000 in the month of December, and there were 228 transactions of more than $500,000 Linden dollars (about U.S. $2,000, at current Linden Lab exchange rates). Many major companies have opened up shops in Second Life, and Reuters has opened up a virtual news bureau.

At press time, there was a "Level 60 Rogue" for the World of Warcraft for sale on eBay at $700. A prime piece of Ultima Online real estate was up for $300, and an EverQuest "Level 75 Warrior" was going for $800.

Despite the growing economies and increased scrutiny of virtual worlds, the IRS still seems relatively unconcerned. Inquiries to the IRS by Tax Analysts about the application of barter exchange rules to online economies and the level of interest in the issue returned the following written response:

      Any time someone wins a tangible prize or award, the value is reportable as taxable income. An accumulation of "points" would not result in tax consequences, but redeeming or selling them for money, goods, or services would.
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