The Virtual Taxman Cometh?

In South Park's 147^th episode, 'Make Love, Not Warcraft,' Stan, Kyle, Cartman and Kenny dedicate weeks of their lives playing World of Warcraft, determined to defeat a rogue player who keeps killing their online characters. Just when it appears that the boys will be defeated by this online evildoer, World of Warcraft executives rush in and deliver the Sword of a Thousand Truths, a superpowerful magical weapon that allows the boys to win their battle and carry the day.

But, wait, was that a taxable event?

It appears that the Joint Economic Committee (JEC) of Congress is going to find out. The JEC staff has begun examining policy issues related to virtual economies; that is, the universe of transactions that occur within massively multiplayer role-playing online games (or MMPORGs), such as the World of Warcraft, Second Life and their kind. This is undiscovered country for the JEC and the Internal Revenue Service ' as well as the operators of virtual worlds. Although the JEC has promised to reach a reasonable conclusion, a poorly conceived taxation of virtual economies could quite quickly take the joy, if not the incentive, out of these online gaming experiences, and stifle the very creativity that has made them so compelling and vibrant ' not to mention the possible impact on that segment of e-commerce.

A Virtual Goldmine

There's no denying that these virtual worlds are the source of significant economic transactions. Games like Second Life (which in early October signed up its one-millionth 'resident'), the World of Warcraft, EverQuest, Ultima Online, The Sims Online and others have an estimated 10 million users worldwide. To the JEC, a virtual economy is defined as the universe of transactions that occur within an online community, and may include the goods and services that take place entirely within virtual economies. There need be no real-world or physical exchange, but at the same time, a real-world value often can be assigned to those transactions using exchange rates or other methods.

In Second Life, for example, up to $500,000 in user-to-user transactions take place every day, and its economy is growing by 10% to 15% a month. EverQuest's annual gross domestic product (GDP) is about $135 million, or roughly half the GDP of the Caribbean island nation of Dominica. In fact, virtual players spend an estimated total of $880 million to $3 billion in real-world dollars for virtual goods and services produced in online games, not counting sales of the games themselves and monthly subscription fees.

Many of these virtual economies are also extremely sophisticated, and growing more so every day. For example, Second Life allows players to own virtual real estate, and several entrepreneurs own enough land to rent space to virtual retailers, who, in turn, earn virtual money selling everything from jewelry to clothing to art, all virtual and non-existent in the real world. Second Life also recognizes intellectual property rights for assets created in-world, in this realm's jargon, by Second Life residents, and Entropia (Entropia Universe) is allowing players to withdraw virtual funds into real world currency using ATMs. (For a discussion of the potential for laundering of real money gained through virtual games and accounts, see, 'New Kinds of e-Commerce: Asset Creation, Seclusion And Money Laundering in The Virtual World: It's a Real Problem That Could Easily Get Worse' in the August edition of e-Commerce Law & Strategy.)

As these facts and other data demonstrate, there's a tremendous amount of economic activity springing from these virtual economies. The difficulty comes in determining whether to tax, and if so, what and when to tax. There's probably little debate that cashing out should be taxed. That is, real income earned from virtual, or in-world, economies ' such as cash earned through eBay sales of virtual gaming items, or the exchange of virtual currency to real currency ' is reportable as income.

Realizing Virtual Income

But the more challenging issue arises from transactions that are not cashed out of their virtual economies. And, because these transactions take place in a virtual world, do the taxable events even take place within the United States for tax purposes? Where, in other words, should one be reporting this income if a person physically resides in another country?

Whether these virtual transactions can be considered reportable income under existing law is uncertain. Generally, income means 'any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has] complete dominion.' Comm'n v. Glenshaw Glass, 348 U.S. 426 (1955). That definition covers cash, cash equivalents, property or services. It would seem that this broad definition would include virtual-world transfers of virtual castles for virtual gold coins, or virtual T-shirts for virtual Linden dollars, as they're called in Second Life. The holder of that virtual currency, after all, has acceded to some form of wealth.

But the question, then, is when is it realized?

Of course, there's no specific guidance or ruling on this issue from the IRS, but there is certainly some guidance to be gleaned from the IRS' positions on analogous matters. In its Publication 525, Taxable and Non-Taxable Income, the IRS discusses the reporting of income sources that have some strong parallels to virtual economic transactions. For example, after they developed into a substantial economic source in the late 1970s and early '80s, barter clubs drew the IRS' attention. These clubs took a variety of forms, but generally produced directories that listed their members and the services they provided. Members can buy those services using 'barter' dollars that, in turn, were earned with the members' own services. In 1980, the Service ruled that barter-club transactions produced taxable income, even though no cash changed hands. In 1982, Congress passed a law requiring these clubs to provide the IRS with information about every barter transaction.

Hence, Publication 525 now defines bartering as an exchange of property or services, and it instructs taxpayers to include the fair market value of property or services they receive in bartering at the time it is received in their income.

The illustrative examples employed by the IRS to explain bartering to taxpayers are quite enlightening. According to the IRS, a self-employed attorney who performs legal services for a client, and receives shares of that client's stock as payment for his services, is obligated to include the fair market value of the shares in his or her income in the year received. Likewise, a self-employed person who is a member of a barter club that uses credit units as a means of exchange, must include as income the value of the credit units that are added to his or her account, even though he or she may not actually receive goods or services from other members until a later taxable year.

In both instances, analogous situations to virtual economies can be seen. Just as a lawyer receiving a client's stock must report it upon receipt, not sale, so perhaps the World of Warcraft player who obtains the Sword of a Thousand Truths must report that as income, even though he sells it years later on eBay. And likewise, if a player accumulates Linden dollars in Second Life for use in buying and trading within that virtual economy, shouldn't that be reported just like credit units in barter exchanges?

Publication 525 also clarifies that winnings ' meaning cash, bonds, cars, houses and other non-cash prizes ' from lotteries and raffles are gambling winnings, which must be recorded as income. Similarly, a person winning a prize in a lucky-number drawing, television- or radio-quiz program, beauty contest or other event must include it in his or her reported income.

So, if a person participates in the World of Warcraft, and wins the Sword of a Thousand Truths, has that person won a prize? Must it be converted into cash for redemption to receive that income?

Burden on Operators

For the owners and operators of these virtual online economies, the IRS barter rules have other implications. Publication 525 makes clear that, as to persons swapping property or services through a barter exchange, the barter exchange must deliver them a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, or a similar statement before January 31 of the following year. That statement must show the value of cash, property, services, credits or script that the barter-exchange member received from all exchanges during the prior year. The IRS must also receive a copy of its form.

Worse, although backup income tax withholding is generally not necessary in barter situations, it will apply if a barter participant does not give the barter exchange his or her taxpayer-identification number, or gives it the wrong number. To avoid this, the IRS requires a person joining a barter exchange to certify under penalty of perjury that his or her taxpayer-identification number is correct, and that he or she is not subject to backup withholding, usually in a Form W-9 that the exchange provides to the participant. Without this certification and the disclosure of the taxpayer-identification number, the barter exchange may be forced to withhold up to 28% of income.

Implications for Online Communities

As the JEC noted, virtual economies represent an area where technology has outpaced law. The full implications of imposing a tax regime on virtual economies is certainly beyond the scope of this article; nonetheless, a few critical issues come to the forefront.

When does a taxable event occur? As indicated in the review above, it's not too controversial to state that income is realized and must be reported when virtual items, be they mythological swords or imaginary ocean-front property, are sold for real-world cash. A critical determination, then, is at what point will income be deemed 'earned' before that 'foreign currency' exchange takes place?

Where is income earned? Perhaps less of an issue for gamers who are residents of the United States, there are legions of players in Third World countries who 'gold farm.' In other words, these players toil at low wages to earn virtual items that can then be sold to other gamers for cash. If the companies hosting these online communities are based in the United States, then will these offshore virtual residents be subject to U.S. taxes for their virtual transactions?

The burden of recordkeeping. Just as the IRS put the burden on barter exchanges to track and report transactions between their members, so too could the IRS place the same burden on the operators of online communities. But consider that barter exchange membership is dwarfed by nearly 10 million current members of virtual worlds and their 'economies' in MMPORGs. Certainly, this added expense would, in turn, add to potential participants' costs. Will this drive online communications offshore, like gambling Web sites?

Virtual taxman. Along the same lines, will Congress or the IRS ultimately forsake the whole issue and just make operators of these virtual economies the 'virtual taxman?' In effect, Congress could require them to impose and collect a kind of virtual sales tax on every transaction.

Fun and games, or fun and business? Should a distinction be made between virtual worlds that exist purely for gaming, like World of Warcraft, and those like Second Life? For instance, World of Warcraft actively discourages players from realizing any real-money profit from playing the game when using the service. At the other extreme, Second Life actively encourages its users to capitalize on the intellectual and other property they create in that virtual world.

The buzz-kill factor. As a more general proposition, if the taxman will be looking over players' virtual shoulder, it is certain to have some chilling effects on participants, and their creativity. Before a World of Warcraft gamer picks up that Sword of a Thousand Truths, will he or she have to ask, 'Can I afford the taxes on this?'

Conclusion

Perhaps virtual residents should be heartened by the title of the JEC's press release on this issue, 'Virtual Economies Need Clarification, Not More Taxes.' And likewise, the JEC's distinction that the issues raised in this article and by virtual economies will generally be addressed and resolved in a common-sense manner might give virtual-world 'residents' and the businesses behind those worlds some hope that a rational and sensible system for addressing these virtual economic transactions will be developed. Nonetheless, Linden Labs, the creator of Second Life, is not taking any chances and is working with the JEC to help it examine this issue. A report is expected by the end of this year.

In South Park's 147^th episode, 'Make Love, Not Warcraft,' Stan, Kyle, Cartman and Kenny dedicate weeks of their lives playing World of Warcraft, determined to defeat a rogue player who keeps killing their online characters. Just when it appears that the boys will be defeated by this online evildoer, World of Warcraft executives rush in and deliver the Sword of a Thousand Truths, a superpowerful magical weapon that allows the boys to win their battle and carry the day.

But, wait, was that a taxable event?

It appears that the Joint Economic Committee (JEC) of Congress is going to find out. The JEC staff has begun examining policy issues related to virtual economies; that is, the universe of transactions that occur within massively multiplayer role-playing online games (or MMPORGs), such as the World of Warcraft, Second Life and their kind. This is undiscovered country for the JEC and the Internal Revenue Service ' as well as the operators of virtual worlds. Although the JEC has promised to reach a reasonable conclusion, a poorly conceived taxation of virtual economies could quite quickly take the joy, if not the incentive, out of these online gaming experiences, and stifle the very creativity that has made them so compelling and vibrant ' not to mention the possible impact on that segment of e-commerce.

A Virtual Goldmine

There's no denying that these virtual worlds are the source of significant economic transactions. Games like Second Life (which in early October signed up its one-millionth 'resident'), the World of Warcraft, EverQuest, Ultima Online, The Sims Online and others have an estimated 10 million users worldwide. To the JEC, a virtual economy is defined as the universe of transactions that occur within an online community, and may include the goods and services that take place entirely within virtual economies. There need be no real-world or physical exchange, but at the same time, a real-world value often can be assigned to those transactions using exchange rates or other methods.

In Second Life, for example, up to $500,000 in user-to-user transactions take place every day, and its economy is growing by 10% to 15% a month. EverQuest's annual gross domestic product (GDP) is about $135 million, or roughly half the GDP of the Caribbean island nation of Dominica. In fact, virtual players spend an estimated total of $880 million to $3 billion in real-world dollars for virtual goods and services produced in online games, not counting sales of the games themselves and monthly subscription fees.

Many of these virtual economies are also extremely sophisticated, and growing more so every day. For example, Second Life allows players to own virtual real estate, and several entrepreneurs own enough land to rent space to virtual retailers, who, in turn, earn virtual money selling everything from jewelry to clothing to art, all virtual and non-existent in the real world. Second Life also recognizes intellectual property rights for assets created in-world, in this realm's jargon, by Second Life residents, and Entropia (Entropia Universe) is allowing players to withdraw virtual funds into real world currency using ATMs. (For a discussion of the potential for laundering of real money gained through virtual games and accounts, see, 'New Kinds of e-Commerce: Asset Creation, Seclusion And Money Laundering in The Virtual World: It's a Real Problem That Could Easily Get Worse' in the August edition of e-Commerce Law & Strategy.)

As these facts and other data demonstrate, there's a tremendous amount of economic activity springing from these virtual economies. The difficulty comes in determining whether to tax, and if so, what and when to tax. There's probably little debate that cashing out should be taxed. That is, real income earned from virtual, or in-world, economies ' such as cash earned through eBay sales of virtual gaming items, or the exchange of virtual currency to real currency ' is reportable as income.

Realizing Virtual Income

But the more challenging issue arises from transactions that are not cashed out of their virtual economies. And, because these transactions take place in a virtual world, do the taxable events even take place within the United States for tax purposes? Where, in other words, should one be reporting this income if a person physically resides in another country?

Whether these virtual transactions can be considered reportable income under existing law is uncertain. Generally, income means 'any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has] complete dominion.' Comm'n v. Glenshaw Glass, 348 U.S. 426 (1955). That definition covers cash, cash equivalents, property or services. It would seem that this broad definition would include virtual-world transfers of virtual castles for virtual gold coins, or virtual T-shirts for virtual Linden dollars, as they're called in Second Life. The holder of that virtual currency, after all, has acceded to some form of wealth.

But the question, then, is when is it realized?

Of course, there's no specific guidance or ruling on this issue from the IRS, but there is certainly some guidance to be gleaned from the IRS' positions on analogous matters. In its Publication 525, Taxable and Non-Taxable Income, the IRS discusses the reporting of income sources that have some strong parallels to virtual economic transactions. For example, after they developed into a substantial economic source in the late 1970s and early '80s, barter clubs drew the IRS' attention. These clubs took a variety of forms, but generally produced directories that listed their members and the services they provided. Members can buy those services using 'barter' dollars that, in turn, were earned with the members' own services. In 1980, the Service ruled that barter-club transactions produced taxable income, even though no cash changed hands. In 1982, Congress passed a law requiring these clubs to provide the IRS with information about every barter transaction.

Hence, Publication 525 now defines bartering as an exchange of property or services, and it instructs taxpayers to include the fair market value of property or services they receive in bartering at the time it is received in their income.

The illustrative examples employed by the IRS to explain bartering to taxpayers are quite enlightening. According to the IRS, a self-employed attorney who performs legal services for a client, and receives shares of that client's stock as payment for his services, is obligated to include the fair market value of the shares in his or her income in the year received. Likewise, a self-employed person who is a member of a barter club that uses credit units as a means of exchange, must include as income the value of the credit units that are added to his or her account, even though he or she may not actually receive goods or services from other members until a later taxable year.

In both instances, analogous situations to virtual economies can be seen. Just as a lawyer receiving a client's stock must report it upon receipt, not sale, so perhaps the World of Warcraft player who obtains the Sword of a Thousand Truths must report that as income, even though he sells it years later on eBay. And likewise, if a player accumulates Linden dollars in Second Life for use in buying and trading within that virtual economy, shouldn't that be reported just like credit units in barter exchanges?

Publication 525 also clarifies that winnings ' meaning cash, bonds, cars, houses and other non-cash prizes ' from lotteries and raffles are gambling winnings, which must be recorded as income. Similarly, a person winning a prize in a lucky-number drawing, television- or radio-quiz program, beauty contest or other event must include it in his or her reported income.

So, if a person participates in the World of Warcraft, and wins the Sword of a Thousand Truths, has that person won a prize? Must it be converted into cash for redemption to receive that income?

Burden on Operators

For the owners and operators of these virtual online economies, the IRS barter rules have other implications. Publication 525 makes clear that, as to persons swapping property or services through a barter exchange, the barter exchange must deliver them a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, or a similar statement before January 31 of the following year. That statement must show the value of cash, property, services, credits or script that the barter-exchange member received from all exchanges during the prior year. The IRS must also receive a copy of its form.

Worse, although backup income tax withholding is generally not necessary in barter situations, it will apply if a barter participant does not give the barter exchange his or her taxpayer-identification number, or gives it the wrong number. To avoid this, the IRS requires a person joining a barter exchange to certify under penalty of perjury that his or her taxpayer-identification number is correct, and that he or she is not subject to backup withholding, usually in a Form W-9 that the exchange provides to the participant. Without this certification and the disclosure of the taxpayer-identification number, the barter exchange may be forced to withhold up to 28% of income.

Implications for Online Communities

As the JEC noted, virtual economies represent an area where technology has outpaced law. The full implications of imposing a tax regime on virtual economies is certainly beyond the scope of this article; nonetheless, a few critical issues come to the forefront.

When does a taxable event occur? As indicated in the review above, it's not too controversial to state that income is realized and must be reported when virtual items, be they mythological swords or imaginary ocean-front property, are sold for real-world cash. A critical determination, then, is at what point will income be deemed 'earned' before that 'foreign currency' exchange takes place?

Where is income earned? Perhaps less of an issue for gamers who are residents of the United States, there are legions of players in Third World countries who 'gold farm.' In other words, these players toil at low wages to earn virtual items that can then be sold to other gamers for cash. If the companies hosting these online communities are based in the United States, then will these offshore virtual residents be subject to U.S. taxes for their virtual transactions?

The burden of recordkeeping. Just as the IRS put the burden on barter exchanges to track and report transactions between their members, so too could the IRS place the same burden on the operators of online communities. But consider that barter exchange membership is dwarfed by nearly 10 million current members of virtual worlds and their 'economies' in MMPORGs. Certainly, this added expense would, in turn, add to potential participants' costs. Will this drive online communications offshore, like gambling Web sites?

Virtual taxman. Along the same lines, will Congress or the IRS ultimately forsake the whole issue and just make operators of these virtual economies the 'virtual taxman?' In effect, Congress could require them to impose and collect a kind of virtual sales tax on every transaction.

Fun and games, or fun and business? Should a distinction be made between virtual worlds that exist purely for gaming, like World of Warcraft, and those like Second Life? For instance, World of Warcraft actively discourages players from realizing any real-money profit from playing the game when using the service. At the other extreme, Second Life actively encourages its users to capitalize on the intellectual and other property they create in that virtual world.

The buzz-kill factor. As a more general proposition, if the taxman will be looking over players' virtual shoulder, it is certain to have some chilling effects on participants, and their creativity. Before a World of Warcraft gamer picks up that Sword of a Thousand Truths, will he or she have to ask, 'Can I afford the taxes on this?'

Conclusion

Perhaps virtual residents should be heartened by the title of the JEC's press release on this issue, 'Virtual Economies Need Clarification, Not More Taxes.' And likewise, the JEC's distinction that the issues raised in this article and by virtual economies will generally be addressed and resolved in a common-sense manner might give virtual-world 'residents' and the businesses behind those worlds some hope that a rational and sensible system for addressing these virtual economic transactions will be developed. Nonetheless, Linden Labs, the creator of Second Life, is not taking any chances and is working with the JEC to help it examine this issue. A report is expected by the end of this year.