Virtual Income

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Can the IRS tax virtual money?

Virtual currency can be really profitable. As of Dec. 31, 2020, there were 9.6 million active users of “World of Warcraft,” a massively multiplayer online role-playing game (MMORPG) in which players can earn virtual “gold” that can be exchanged for virtual goods like suits of armor and magic potions. Using third-party currency exchanges, some “World of Warcraft” users buy and sell virtual goods and gold using real U.S. dollars. In “Second Life,” another popular MMORPG, players paid each other $150 million worth of Linden dollars, the game’s virtual currency, in the third quarter of 2020 alone [source: GAO]. The question is, if people are making real income from virtual currency, should the Internal Revenue Service (IRS) be able to tax it?

It all started in 2001 when economist Edward Castronova published an analysis of the burgeoning virtual economy of online game worlds, which he calculated to have a gross domestic product of about $135 million. It gained national attention in early 2006 when writer and gamer Julian Dibbell posed a fascinating question — are my virtual assets taxable? — and put his money where his mouth his: Dibbell sold a collection of his own virtual assets from the MMORPG “Ultima Online” on eBay and reported the income to the IRS [source: Dibbell].

Dibbell claimed income in the amount of $11,000 earned from the sale of assets that don’t actually exist in any concrete way. But the more intriguing part came next: After filing with the IRS, he tried to find out from various IRS employees if he was supposed to claim his castles and gold and other online assets that he hadn’t converted to real-world dollars — items that had never left the virtual world of “Ultima Online.” Some of the IRS representatives found the question amusing; others gave it serious thought and could not offer Dibbell a definite response.

Dibbell’s story and other reports of people making their living auctioning off “World of Warcraft” and “EverQuest” characters and assets for real money spread like wildfire through online news sites and the blogosphere. And now, the once-laughable question of taxing virtual transactions that never even leave the virtual world has landed right in middle of a real-life, real-money tax debate. Where does the virtual economy meet the real-world one? And gamers with a theoretical treasure trove of online assets aren’t chuckling anymore. The U.S. Congress is actually looking into the taxability of Mighty Rage Potion and Shrouds of Provocation.

The issue of taxing virtual assets is a complicated one, but the primary point of justification offered by many economists, even if they’re only talking “in theory,” is the fact that these virtual assets have an established real-world value. When gamers started selling their virtual armor and horses and castles for real-world cash, they established an exchange rate. For instance, if we know what a suit of armor sells for in “EverQuest” or “World of Warcraft” gold, and we know what the same type of suit of armor sells for on eBay in U.S. dollars, we have a way to establish an exchange rate between game dollars and U.S. dollars. And theoretically speaking, for tax purposes, anything that has a real dollar value is taxable once it changes hands. So if you sell a suit of armor to another player for a certain amount of gold, it’s possible for the IRS to tax that transaction as income earned in the converted U.S. dollar amount of that gold. The MMORPG “Second Life” has established the exchange rate of Linden dollars to U.S. dollars within the game world itself. In August 2020, one U.S. dollar bought 253 Linden dollars.

In 2007, the IRS began to seriously assess the risk of losing tax revenue to unreported virtual income. The issue of taxing virtual currency drew the attention of the Congressional Joint Economic Committee, which asked the Government Accountability Office (GAO) to make recommendations to the IRS on how to proceed. We’ll take a look at the GAO’s recommendations on the next page.

IRS reminds taxpayers to report virtual currency transactions

More In News

IR-2020-71, March 23, 2020

WASHINGTON — The Internal Revenue Service today reminded taxpayers that income from virtual currency transactions is reportable on their income tax returns.

Virtual currency transactions are taxable by law just like transactions in any other property. The IRS has issued guidance in IRS Notice 2020-21 for use by taxpayers and their return preparers that addresses transactions in virtual currency, also known as digital currency.

Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest.

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In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return. Anyone convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000.

Virtual currency, as generally defined, is a digital representation of value that functions in the same manner as a country’s traditional currency. There are currently more than 1,500 known virtual currencies. Because transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, some taxpayers may be tempted to hide taxable income from the IRS.

Notice 2020-21 provides that virtual currency is treated as property for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means that:

  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
  • Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply. Normally, payers must issue Form 1099-MISC.
  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
  • Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payments to those merchants on Form 1099-K, Payment Card and Third Party Network Transactions.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.

Ability to Pay and the Taxation of Virtual Income

58 Pages Posted: 28 Sep 2008 Last revised: 9 Aug 2020

Adam Chodorow

Arizona State University (ASU) – Sandra Day O’Connor College of Law

Date Written: September 27, 2008

Abstract

Should virtual income be subject to real world taxes? For most people, intuition suggests that the answer to this question is no, at least if the income is left in-world. However, virtual income can have significant real-world value, making it difficult to square intuition with existing tax doctrine and policy. Those who have attempted to do so have justified exclusion by classifying virtual income as falling either outside the theoretical definition of income or into an existing tax category that is excluded from the real-world tax base. In this Article, I argue that the analysis to date and the proposals they produce are not fully satisfactory.

Instead, I offer a new approach that focuses on virtual income’s impact on a taxpayer’s ability to pay real-world taxes. The ability to pay is a core tax concept, and using it yields results consistent with intuitions, existing doctrine and tax policy. Relying on ability to pay, I argue that the taxation of virtual income should be a function of a taxpayer’s ability to cash out. Virtual income from worlds that preclude participants from cashing out should be excluded from the tax base, as the receipt of virtual income does not increase their ability to pay real-world taxes. Virtual income from worlds that permit participants to cash out should be taxed.

However, practical concerns regarding tax evasion and costs may warrant overriding these initial conclusions. To account for these concerns, I propose that Congress empower the IRS to issue world-specific rulings on the taxability of virtual income and adopt a de minimis threshold based on the $600 reporting threshold found in the code. Taxpayers whose virtual income in a taxable world exceeds the threshold would owe tax on all their virtual income from that world.

Keywords: tax, taxation, federal income tax, virtual worlds, virtual reality

JEL Classification: H20, H24, H29, K34

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