IRS Taxpayer Advocate’s Remarks on Virtual Worlds
The following text liberates pages 213-226 of the National Taxpayer Advocate’s 2008 Annual Report to Congress from the PDF file in which they were delivered to the public like bugs frozen in amber. My only contribution to the text, just so we’re clear, was to effect said liberation, which involved a certain amount of cutting, pasting, and mucking around with HTML, but little else. If you think you can make it prettier (and I don’t doubt you can), please feel free to grab this version and go to town. (My own thoughts about this document can be found here.)
Did You Know?
- As early as 2004, the tax gap attributable to small businesses doing business over the Internet was estimated to be as high as $1 billion per year and rising.
- According to one poll, 38 percent of American adults play computer or console games, and among those, 44 percent play games over the Internet.
- Over 16 million people are estimated to have active subscriptions to Internet-based multiplayer environments called “virtual worlds,” many of which have their own economies and currencies.
- As early as 2001, an economist estimated that time spent by “players” in one of the many virtual worlds generated about $3.42 per hour, which represented a gross national product (GNP) of about $135 million and a per capita GNP of about $2,266 – roughly equivalent to Russia and higher than in many developing countries.
- In 2005, about one billion real dollars changed hands in virtual worlds.
- In 2006, about 3,100 “residents” of one of the smaller virtual worlds, called “Second Life,” who generated a net profit in virtual transactions had average revenues of $20,000 in real U.S. dollars.
- Some businesses now accept virtual dollars in exchange for real property or services.
- Second Life charges a value added tax (VAT) on certain transactions between European Union residents and Second Life.
The IRS Should Proactively Address Emerging Issues Such as Those Arising from “Virtual Worlds”
Chris Wagner, Commissioner, Small Business/Self-Employed Division
Clarissa Potter, Acting Chief Counsel
Definition of Problem
A “virtual world” is a computer-based simulated environment, which allows multiple users to interact using graphical representations of themselves (called “avatars”), typically over the Internet. Economic activities associated with virtual worlds may present an emerging area of noncompliance, in part, because the IRS has not issued guidance about whether and how taxpayers should report such activities. To proactively address the tax gap and improve voluntary compliance, when the IRS learns of an emerging economic activity that receives no clear tax treatment under existing guidance, it should quickly promulgate clear rules and enforce them consistently.
The remainder of this discussion illustrates some of the confusion taxpayers may face in reporting economic activities associated with virtual worlds. However, the broader challenge for the IRS is to identify any emerging economic activities with tax implications that taxpayers, especially unsophisticated ones, are likely to misreport without additional guidance, and to issue clarifying guidance quickly.
Analysis of Problem
What is a virtual world?
As noted above, we use the term “virtual world” to refer to a computer generated environment that people can access simultaneously and remotely to interact with each other as well as other features of the environment, generally for a monthly subscription. Participants are represented graphically as “avatars,” and may “own” virtual property, such as clothing, tools, weapons, or real estate, which is also graphically represented in the environment. Virtual worlds operate continuously and retain the location of an avatar and other items, even if the person represented by the avatar has shut off his or her computer.
One category of virtual world, exemplified by the World of Warcraft (WoW), is game-like, has defined objectives, and a significant amount of operator-developed content. WoW describes itself as follows:
World of Warcraft enables thousands of players from across the globe to come together online – undertaking grand quests and heroic exploits in a land of fantastic adventure…. Like most other role-playing games, World of Warcraft lets you advance in level as you gain experience. Experience can be gathered by killing monsters, exploring new destinations, and completing quests.… Nearly all quests give sizeable experience rewards. Many quests also provide material rewards, such as cash, potions, food, magic items, armor, and weapons.
Another category of virtual world, exemplified by Second Life, is unstructured, utilizes more user-created content, and is more geared toward commercial and social interaction. Second Life describes itself as follows:
Second Life is a 3-D virtual world entirely created by its Residents… [p]erhaps you’ll find a perfect parcel of land to build your house or business. You’ll also be surrounded by the Creations of your fellow Residents. Because Residents retain the rights to their digital creations, they can buy, sell and trade with other Residents. The Marketplace currently supports millions of U.S. dollars in monthly transactions. This commerce is handled with the in-world unit-of-trade, the Linden dollar, which can be converted to U.S. dollars at several thriving online Linden Dollar exchanges.
Google is also reportedly planning to launch a virtual world based on its extensive satellite photos and maps of the real world. Any such platform could greatly expand the economic activity associated with these worlds.
What type of economic activity goes on in virtual worlds?
In addition to buying virtual property, such as clothing or tools, a person’s avatar can “steal,” “make,” or “find” it, or pick it up after defeating the prior owner. In some worlds, he or she can gamble for virtual money. Users can sell or exchange virtual property with other players for different property or in-world currency – gold in WoW or Linden Dollars in Second Life. The “terms of service” (TOS) or “end user license agreement” (EULA) contract typically states that the operator may turn off the virtual world or cancel a participant’s account without compensation at any time and for any reason, retains ownership of all accounts and virtual property (i.e., the participant is merely licensing use of the game and has no property interest in virtual items or accounts), and may prohibit the transfer of accounts or virtual property for “real” money. However, at least some of these limitations may not be enforceable under state law.
Even if virtual property and avatars are not determined to be “property” under state law, they are valuable and can be sold for real dollars or in-world currencies, which can often be converted into real dollars. For example, in early 2008 a person could sell 1,000 WoW gold pieces for between $12 and $22 (an exchange rate of between 83.33 and 45.45 gold pieces per U.S. dollar). A person could also sell 1,000 Linden Dollars on an in-world currency exchange for about $3.75 (an exchange rate of 266 Linden Dollars per U.S. dollar).
You’ve got to be kidding: Is this economic activity significant?
The economic activity in virtual worlds is significant. As early as 2001, an economist estimated that time spent in one of the many “virtual worlds” generated about $3.42 per hour, which represented a gross national product (GNP) of about $135 million and a per capita GNP of about $2,266 – roughly equivalent to Russia and higher than in many developing countries. Since $3.42 is a decent wage in some developing countries, people in such countries reportedly spend long hours in a virtual world to acquire virtual property and create avatars with favorable attributes that the entrepreneur can sell for real dollars. In 2006, one person was reported to have become a millionaire by developing and selling virtual real estate in Second Life, and about 3,100 “residents” of Second Life who earned a net profit were reported to have generated average annual revenues of $20,000 in real U.S. dollars. Real world businesses such as Dell, Mazda, Adidas, Coca Cola, CNET, Major League Baseball, Harvard University, American Apparel, H&R Block, and Reuters have established a presence in Second Life. The American Cancer Society reportedly raised about $118,000 via a virtual “Relay for Life” in which over 1,000 avatars participated by “walking” through representations of real-life places. In other words, by participating in these worlds, a significant number of people are creating real economic income. Where there is economic income, there is likely to be tax due from someone.
When people generate virtual income and property, whose property is it?
The federal income tax consequences of a transaction generally depend on what property rights are created or transferred under local law. As noted above, most virtual world contracts provide that players obtain no property rights by playing the game, but since players or residents are creating significant value, scholars have speculated that such agreements might not be upheld. Even if someone else owns the virtual property under state law, however, a person who creates valuable virtual property or turns it into “real” property or value is likely to wonder if he or she is nonetheless subject to tax on income from services, prizes, or winnings.
What are some of the tax issues that virtual worlds raise?
Virtual world transactions raise a number of tax questions. For example, is a person subject to tax each time he or she acquires virtual property? How about when the person exchanges one virtual property for another, or for virtual currency? How about when the user sells the virtual property or his or her account (and avatar) for real money? What, if any, information reporting, withholding, backup withholding, and recordkeeping requirements apply to these transactions? Similarly, difficult questions may arise in connection with the tax obligations of virtual world operators.
Why might a taxpayer be confused about whether transactions involving virtual property should be reported as taxable income?
Income, broadly defined, is subject to tax.
Although the IRS has not issued any guidance directly addressing these difficult questions, a person is generally taxed immediately upon “all income from whatever source derived.” Income is defined broadly as any “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Moreover, a person is generally subject to tax upon finding or earning money or treasure, winning a lottery, prize or award, stealing property, or trading one piece of property for another, potentially leading some to conclude that transactions involving virtual property are or should be subject to tax.
The receipt of prizes, winnings, and barter exchange “trade credits” are all subject to tax, information reporting, and withholding.
If the in-world sale or exchange of virtual property for other virtual property or in-world currency is analogous to barter (i.e., trading), which generates taxable income, then each transfer of virtual property could also generate taxable income. In a barter exchange, one member provides goods or services to another in exchange for other goods or services or for trade credits, which can be used to acquire goods or services from other members. Since barter exchange operators are obligated to issue information returns (Form 1099-B, Proceeds From Broker and Barter Exchange Transactions) to each of their members, reporting each transaction in excess of $1, some virtual world operators may be concerned that the IRS might assert they should be sending these information returns to their customers each year, as certain commentators have suggested.
Taxpayers have a similar duty to report any prizes or awards in excess of $600. Virtual world operators may also be concerned that if the virtual property “paid” to participants in virtual worlds is sufficiently analogous to taxable prizes (e.g., a prize for completing a quest), then the IRS could assert the operators need to report the prizes on information returns. In such cases, the virtual world operator might also be required to withhold against the prize if the player was either a foreign person or failed to provide a tax identification number. Such withholding would be difficult since the prize – the virtual property – is not paid in cash.
However, many taxpayers may not be certain that virtual worlds are analogous enough to barter exchanges or that virtual currency is sufficiently analogous to prizes to be subject to such rules, at least before a taxpayer cashes out his or her virtual items for real dollars. Pursuant to various technical rules, tax is often deferred until after an item is transferred for value, as further described below.
The production of property is not subject to tax.
A person is not immediately subject to tax when he or she creates property. For example, a farmer is not taxed on the crops he grows and harvests before selling or exchanging them. A taxpayer may wonder if creating virtual items or setting out to obtain them is similar enough to farming and harvesting crops that such acquisitions are not taxable.
The receipt of property that is difficult to value is not always subject to tax.
A person is not immediately subject to tax when he or she acquires property that has no reasonably ascertainable fair market value. This is so even if the property could easily be valued if it were not subject to a contingency that affects its value. For example, if a taxpayer sells stock in exchange for a right to receive an amount of money that is contingent on the outcome of pending litigation, the taxpayer might not be taxed until the litigation is resolved. Such “open transaction” treatment also applies to payments for services in the form of nonqualified stock options that have no reasonably ascertainable fair market value. Such payments are not taxable until the options are exercised or transferred. Similarly, payments for services made in the form of stock are not taxable even if the stock is easy to value, provided the stock is subject to a substantial risk of forfeiture (e.g., the taxpayer forfeits the stock if he or she terminates employment before it “vests”) until the stock is transferred or the risk of forfeiture (i.e., the contingency) lapses.
Although some virtual property is relatively easy to value because it is listed for sale on virtual property auction websites, other virtual property is not so easy to value. Some virtual property is not transferable under the TOS. Moreover, all virtual property is arguably subject to forfeiture at the discretion of the virtual world operator. The virtual world operator could cancel the taxpayer’s account, shut down the virtual world, or change the world in a way that eliminates the value of the virtual item. Thus, a taxpayer may wonder if such contingencies make the in-world acquisition and sale or exchange of virtual property nontaxable.
Merely exercising the right to use someone else’s property is not subject to tax.
In certain circumstances, we do not tax the acquisition of the right to use another person’s property even if the use itself is valuable. For example, one academic has observed that when vacationers on a cruise ship reallocate deck chairs which are all owned by the cruise operator, they are not subject to tax. Each vacationer has purchased a right to use any of the chairs in the public areas of the cruise ship. So redistributing actual possession of the chairs among passengers who have the right to use them does not result in taxable income, even though there may be such a shortage of a given type of chair that one passenger may be willing to pay another to use it. Similarly, by paying to play the game, a taxpayer has the legal right to use any virtual property or virtual dollars that he or she could acquire inside the virtual world. Thus, a taxpayer may wonder if the acquisition and sale of virtual property for virtual dollars is nontaxable because it is similar to acquiring and trading the right to use a deck chair – a right that he or she acquired by paying to play the game.
Winnings are not always taxed immediately.
A gambler is generally not taxed after each winning hand of poker provided he or she does not leave the table or cash in his or her chips. Thus, a taxpayer may wonder if the acquisition and sale of virtual property for virtual dollars is nontaxable because it is similar to winning a hand of poker before leaving the table or cashing out.
The IRS sometimes decides not to tax certain transactions.
In some cases, the IRS does not tax transactions that fall into a grey area, especially if the public widely believes they are not taxable and a contrary result might be difficult to administer. For example, academics have suggested the IRS’s policy of not taxing the receipt of frequent flier miles was more a product of political pressure than of technical analysis. Commentators have said the same thing about the IRS’s decision not to tax a baseball fan who catches a record-breaking ball and immediately returns it. Similarly, many Internet users and virtual world operators believe that in-world transactions are not and should not be subject to tax, in part because of the administrative difficulties that taxation would present. Thus, a taxpayer may conclude that when the IRS gets around to providing guidance on the taxation of in-world transactions, it will likely reach the same conclusion, especially since it has not issued any guidance to the contrary even though the tax issues presented by virtual worlds have received significant publicity.
Why would it be difficult to administer the taxation of in-world transactions?
Aside from possibly having to analyze and litigate each of the questions described above, administering the taxation of in-world transactions would present significant challenges for taxpayers and the IRS, such as those described below.
Tracking and reconstructing many small transactions would be burdensome.
Most in-world sales or exchanges involve low value items of virtual property. For example, according to Second Life, in February 2008, its residents engaged in about 16 million transactions, 85 percent of which were for 199 Linden Dollars or less. Since the exchange rate at that time was about 265 to 266 Linden Dollars to the U.S. dollar, these statistics suggest that most transactions on Second Life are for less than $1 and would not be subject to information reporting, even if the IRS treated Second Life as a barter exchange. Thus, residents and the IRS might need to track and document millions of small transactions without the benefit of information reporting.
Valuing virtual transactions would present challenges.
A related and potentially more serious problem would be valuing each of the virtual transactions. Although it might be relatively easy to value in-world currency (assuming we ignore any discount to account for the possibility the virtual world operator may take action that would reduce its value) if the currency is readily convertible into real dollars on an organized exchange, many virtual currencies are not traded that way. Moreover, the value of a virtual currency on any given day could be very difficult for the IRS or a taxpayer to reconstruct years later in connection with an IRS audit. While valuing in-world transactions conducted in virtual currency would be burdensome, especially in light of the small dollar amounts typically involved, valuing in-world trades of other types of virtual property might be nearly impossible. For example, how would we value a trade of virtual armor for a virtual sword or the income from picking up a virtual sword?
IRS guidance could improve taxpayer compliance even if it simply clarified that in-world transactions are not taxable.
Internet-based transactions are a potential area of noncompliance, particularly when they are not subject to information reporting. Yet, the IRS sometimes responds to questions from taxpayers who want to comply with the rules, which the IRS has not adequately explained or written down, by asking the taxpayer to request a private letter ruling at significant personal expense. In 2005, for example, when a taxpayer asked the IRS how to report the acquisition, exchange, and sale of virtual property, IRS employees gave him two different answers and one advised him to submit a private letter ruling request. The taxpayer later published a book describing the situation, as well as his discussion with the IRS.
Some people are likely to conclude that if the rules are so complicated that the IRS cannot even figure them out, it is unreasonable for the government to expect taxpayers to do so. They might also use such reasoning to justify noncompliance in other areas. Moreover, our system of voluntary compliance will break down if it demands that taxpayers report income that is impossible to report, pay tax on “virtual” income that cannot be used to pay real taxes, or makes taxpayers feel like “chumps” if, perhaps mistakenly, they do pay tax on such virtual income. Thus, promulgating guidance would likely promote voluntary compliance even if it exempts in-world transactions from tax.
To its credit, the IRS has recently identified a number of issues presented by Internet auctions of virtual property and other aspects of virtual worlds. However, the IRS should consider doing more to help taxpayers comply with their tax obligations by quickly issuing guidance addressing how to report economic activities in virtual worlds, as well as in other emerging areas of economic activity.
The IRS recognizes the need to address the tax aspects of new e-business activities. For example, the IRS formed the E-Business and Emerging Issues (EBEI) policy group in 2003 to address emerging issues resulting from the growth and expansion of business activities, advances in computer technology, and new developments in the use of e-business technology. This technology includes the advent of Internet-based “virtual world” games that may involve a “virtual economy” for game participants.
The EBEI group has partnered with IRS business units to provide a consistent strategy to address e-business tax issues. The IRS is engaged in the identification of tax issues resulting from new Internet-related activities and recommendation of appropriate strategies to address those issues. Such strategies include internal and external communications such as issuance of interim guidance memoranda, updates to the Internal Revenue Manual (IRM), IRS publications, and website postings. We also had specific workforce training, research projects, proposals for published guidance, and IRS compliance initiative projects.
The IRS has issued guidance in the past on other activities that raise similar issues to those of “virtual world” game activities. For example, guidance related to online auctions, bartering, and electronic businesses states that if a taxpayer spends more money on an activity than received, the taxpayer cannot claim a loss on an income tax return. If a taxpayer receives more money from an activity than spent, then the taxpayer may be required to report taxable income. This guidance should be helpful in assisting taxpayers who have questions about the tax consequences of their online “virtual world” game activities.
The IRS will continue to prioritize our guidance to meet taxpayer needs. Virtual world e-business issues and implementation of communication and compliance strategies will continue to be addressed through the EBEI policy group.
Taxpayer Advocate Service Comments
While the National Taxpayer Advocate is pleased the IRS has formed an E-Business and Emerging Issues policy group, provided guidance, and initiated training, research projects, and compliance initiative projects, she finds the IRS comments largely unresponsive to the concerns outlined above. The IRS guidance on barter, online auction sellers, gambling income, found property, etc. described in the IRS comments is helpful. However, this guidance mostly restates existing rules, addressing the relatively easy questions for which clear answers already exist.
As the tax administrator, the IRS has a duty to answer all of the basic questions about transactions undertaken regularly by significant numbers of taxpayers, such as those involving virtual items (described above), especially if the questions are difficult for taxpayers to answer on their own. It may be unfair to expect the IRS to answer these questions before state property and contract laws have evolved far enough to provide clear guidance about when a transfer of virtual items is a transfer of property rights. These very difficulties, however, support the conclusion that the IRS should issue guidance. If the tax experts at the IRS cannot figure out what the rules are or should be, unsophisticated taxpayers who participate in the virtual economy have little hope of doing so. The IRS could at least make an administrative pronouncement about how taxpayers should treat these transactions in the interim as it studies the issue and the state law rules evolve.
More broadly, the IRS needs to produce specific early guidance on difficult issues confronted by taxpayers on a regular basis in emerging areas of economic activity. Otherwise, it risks turning these taxpayers into unintentional tax cheats, establishing noncompliance norms in the industry, and leaving IRS employees without clear guidance about how to do their jobs.
The National Taxpayer Advocate recommends the IRS:
- Work with the Office of Chief Counsel and the Treasury Department to issue guidance addressing how taxpayers should report economic activities in virtual worlds (or at least ask the Office of Chief Counsel to put it on the priority guidance plan) along with other emerging issues; and
- Invite the Taxpayer Advocate Service to appoint a representative to the E-Business and Emerging Issues policy group.
1 The “tax gap” is the amount of tax on legal transactions for a given year that is not paid voluntarily and timely.
2 Treasury Inspector General for Tax Administration (TIGTA), Ref. No. 2005-30-010, The Internal Revenue Service Is Making Progress in Addressing Compliance Among Small Businesses Engaged in Electronic Commerce (Nov. 2004).
3 The Associated Press/America Online Poll, Gaming Study, Conducted by IPSOS Public Affairs, Project No. 81-5139-64, at http://surveys.ap.org/data/ Ipsos/national/2007-10-22%20Gaming%20Study.pdf (Nov. 12, 2007).
4 A “virtual world,” described in greater detail below, is a computer-based simulated environment, which allows multiple users to interact using graphical representations of themselves (called “avatars”), typically over the Internet.
5 See Bruce Sterling Woodcock, Total MMOG Active Subscriptions, Version 22.0, at http://www.mmogchart.com/Chart4.html (Feb. 12, 2008).
6 See Edward Castronova, Virtual Worlds: A First-Hand Account of Market and Society on the class=SpellE>Cyberian Frontier, CESifo Working Paper No. 618, 33, at http://papers.ssrn.com/abstract=294828 (Dec. 2001).
7 Heather M. Rothman, As Congress Considers Online Game Taxes, Linden Lab Contends Law Already Clear, 210 DTR G-2 (Oct. 31, 2006).
8 Robert D. Hof, My Virtual Life, Business Week, at http://www.businessweek.com/print/magazine/content/06_18/b3982001.htm?chan=g1 (May 1, 2006). According to Second Life, about 531 unique users had positive monthly in-world cash flow worth more than $2,000 in the month of April 2008. See Second Life, Economic Statistics http://secondlife.com/whatis/economy_stats.php (last visited May 12, 2008). Although still one of the smaller worlds, Second Life was recently estimated to have 93,219 “active subscriptions” and more than 12 million “registered users,” the vast majority of whom are in the United States. See Bruce Sterling Woodcock, Total MMOG Active Subscriptions, Version 22.0, at http://www.mmogchart.com/Subscriptions.xls (Feb. 12, 2008) (showing active subscriptions on sheet 4); Robin Sidel, Cheer Up, Ben: Your Economy Isn’t As Bad as This One, Wall Street Journal, page A1, Jan. 23, 2008 (reporting registered users).
9 See Fistpitch, Pizza Enters the Virtual World of Second Life, at http://www.fastpitchnetworking.com/pressrelease.cfm?PRID=8734 (Apr. 21, 2007).
10 See Second Life, Value Added Tax, at http://secondlife.com/corporate/vat.php (last visited May 12, 2008).
11 Heather M. Rothman, As Congress Considers Online Game Taxes, Linden Lab Contends Law Already Clear, 210 DTR G-2 (Oct. 31, 2006) (quoting an IRS spokesman as acknowledging that “we have recognized it as an emerging area of noncompliance.”).
12 Some virtual worlds generate income primarily from advertising revenue.
13 Because virtual worlds were first developed as games, they are sometimes called “massive multiplayer online games” or “ class=SpellE>MMOGs.”
14 See http://www.worldofwarcraft.com/info/basics/guide.html (last visited May 12, 2008).
15 See http://secondlife.com/whatis/ (last visited May 12, 2008).
16 See, e.g., Chris Taylor, Google Moves into Virtual Worlds, by Combining Satellite Maps and 3-D Software, Google Earth Is Turning into a Virtual Online Playground, CNNMoney.com, at http://money.cnn.com/2006/05/11/technology/business2_futureboy_0511/ (Dec. 14, 2006); Tom Smith, Google’s Virtual World Could Be Business Answer To Second Life, the Information Week, at http://www.informationweek.com/blog/main/archives/2007/09/googles_virtual.html (Sept. 25, 2007).
17 Linden Labs, the operator of Second Life, recently banned gambling and unlicensed banking activities. See, e.g., Eric Reuters, UPDATE 3 – Linden Bans Second Life Banks, Reuters Second Life News Center, at http://secondlife.reuters.com/stories/2008/01/08/breaking-linden-bans-second-life-banks/ (Jan. 8, 2008).
18 For example, WoW’s TOS provides: BLIZZARD MAY SUSPEND, TERMINATE, MODIFY, OR DELETE THE ACCOUNT AT ANY TIME WITH ANY REASON OR NO REASON, WITH OR WITHOUT NOTICE.… Blizzard does not recognize the transfer of Accounts. You may not purchase, sell, gift or trade any Account, or offer to purchase, sell, gift or trade any Account, and any such attempt shall be null and void. Blizzard owns, has licensed, or otherwise has rights to all of the content that appears in the Program. You agree that you have no right or title in or to any such content, including the virtual goods or currency appearing or originating in the Game, or any other attributes associated with the Account or stored on the Service. Blizzard does not recognize any virtual property transfers executed outside of the Game or the purported sale, gift or trade in the “real world” of anything related to the Game. Accordingly, you may not sell items for “real” money or otherwise exchange items for value outside of the Game. See WoW TOS § 7-8, at http://www.worldofwarcraft.com/legal/termsofuse.html (last visited May 12, 2008). Second Life’s TOS allows participants to “retain… intellectual property rights with respect to Content you create in Second Life.” Second Life, TOS § 3, at http://secondlife.com/corporate/tos.php (last visited May 12, 2008). However, the TOS also grants Linden Labs a “perpetual, irrevocable, non-exclusive right and license” in any creations and provides that Linden Labs retains ownership of a person’s account and related data. Id.
19 See, e.g., Joshua Fairfield, Virtual Property, Indiana Law No. 50, at http://ssrn.com/abstract=807966 (Oct. 2005); Erez Reuveni, On Virtual Worlds: Copyrights and Contract Law at the Dawn of the Virtual Age, 82 Ind. L.J. 261, 290-294 (2007) (discussing various arguments that could result in virtual property rights, notwithstanding the terms of the EULA or TOS). When Linden Labs exercised its right to deny a person access to virtual property, a court found the TOS arbitration clause to be unenforceable. See Bragg v. Linden Research, Inc., 487 F. Supp. 2d 593 (E.D. Pa. 2007).
20 See, e.g., http://www.mmopawn.com/sell-1.html (last visited Feb. 28, 2008). The actual price may depend on supply and demand conditions on the particular server hosting the part of the virtual world where the transaction will take place as well as the number of WoW gold pieces you are attempting to sell. An online chat on February 28, 2008, revealed that www.mmopawn.com would have paid $14 for 1,000 WoW gold pieces on the “Aegwynn US – A” server.
21 See http://secondlife.com/whatis/economy-market.php (last visited Mar. 5, 2008).
22 See Edward Castronova, Virtual Worlds: A First-Hand Account of Market and Society on the Cyberian Frontier, CESifo Working Paper No. 618, 33, at http:// papers.ssrn.com/abstract=294828 (Dec. 2001).
23 Eli Shayotovich, Taxing Virtual Earnings – Seriously, at http://www.businessweek.com/print/innovate/content/may2006/id20060502_832540.htm (May 2, 2006).
24 See Daniel Terdiman, Big-shot Economist to Advise Teen Virtual World, CNET News.com, Sept. 17, 2007. See also http://acs.anshechung.com/ (last visited May 12, 2008).
25 Robert D. Hof, My Virtual Life, Business Week, at http://www.businessweek.com/print/magazine/content/06_18/b3982001.htm?chan=g1 (May 1, 2006).
26 See www.secondlife.com; Second Life, Brand Promotion, at http://secondlifegrid.net/how/brand_promotion (last visited Mar. 10, 2008). See also, Tim Beyers, IRS to Tax Your Second Life? The Motley Fool, at http://www.fool.com/server/printarticle.aspx?file=/investing/high-growth/2006/10/16/irs-to-taxyour-second-life.aspx?terms=IRS%20to%20Tax%20Your%20Second%20Life (Oct. 16, 2006). H&R Block has started to offer tax advice in Second Life and is accepting Linden Dollars in exchange for a new tax preparation product. See H&R Block Launches First Virtual Tax Experience in Second Life, at http:// www.hrblock.com/presscenter/articles/secondrelease.jsp (last visited Mar. 10, 2008). It is also paying “residents” in Linden Dollars for helping to market its product on their own virtual property. Even the IRS has studied the utility of virtual worlds as a communication and training tool, concluding the IRS could use them to recruit new employees and provide taxpayer service, for example, through “Virtual Tax Days” where the IRS answers tax questions inside a virtual world. Wage and Investment, Strategy and Finance, Program Evaluation and Risk Analysis (PERA), Virtual Worlds, Project No. 7-03-16-2-024 (Apr. 2003).
27 American Cancer Society, Second Life Relay for Life, at http://www.cancer.org/docroot/GI/content/GI_1_8_Second_Life_Relay.asp (last visited May 12, 2008) and Second Life, Philanthropy and Fundraising, at http://secondlifegrid.net/how/philanthropy_and_fundraising (last visited Mar. 10, 2008).
28 The European Union subjects Second Life transactions between the operator and EU residents to VAT taxes. See Second Life, Value Added Tax, at http:// secondlife.com/corporate/vat.php (last visited Mar. 10, 2008).
29 See, e.g., Morgan v. Comm’r, 309 U.S. 78, 80 (1940) (“State law creates legal interests and rights. The federal revenue acts designate what interests or rights, so created, shall be taxed.”). The EULA or TOS typically provides that a specific jurisdiction’s laws will apply. For example, the Second Life TOS provides: “This Agreement and the relationship between you and Linden Lab shall be governed in all respects by the laws of the State of California without regard to conflict of law principles or the United Nations Convention on the International Sale of Goods.” Second Life, TOS § 7.1, at http://secondlife.com/corporate/tos.php (last visited May 12, 2008).
30 See, e.g., Joshua Fairfield, Virtual Property, Indiana Law No. 50, at http://ssrn.com/abstract=807966 (Oct. 2005); Erez Reuveni, On Virtual Worlds: Copyrights and Contract Law at the Dawn of the Virtual Age, 82 Ind. L.J. 261, 290-294 (2007) (discussing various arguments that could result in virtual property rights, notwithstanding the terms of the EULA or TOS). As noted above, when Linden Labs exercised its right to deny a person access to virtual property, a court found the TOS arbitration clause to be unenforceable. See Bragg v. Linden Research, Inc., 487 F. Supp. 2d 593 (E.D. Pa. 2007).
31 At least for foreign persons, there is also a question about whether the person may be subject to tax in the United States, especially if the server is located in the United States. See generally, Richard L. Reinhold, Some Things That Multilateral Tax Treaties Might Usefully Do, 57 TAXL 661 (Spring 2004) (discussing the role of server location in determining if a corporation has a “permanent establishment” in the U.S.); Richard L. Doernberg, Electronic Commerce: Changing Income Tax Treaty Principles A Bit?, 89 Tax Notes 1625 (Dec. 18, 2000) (same). In addition, the location of the parties and the computer server may affect a state’s authority to require the parties to an online-transaction to collect or pay sales or use tax. See, e.g., Paula K. Royalty, Tax Implications of Using Out-of-State Computer Servers, 1 Shidler L.J. Com. & Tech. 5 (Feb. 2, 2005).
32 IRC § 61 (defining gross income). Some taxpayers are not even aware that Internet transactions are subject to tax. The press surrounding the “Internet Tax Moratorium,” which temporarily prohibits local governments from levying taxes on Internet connections may contribute to this misperception. See, e.g., Internet Tax Freedom Act Amendments Act of 2007, Pub. L. No. 110–108, 121 Stat. 1024 (Oct. 31, 2007).
33 Comm’r. v. Glenshaw Glass Co., 348 U.S. 426 (1955). Cottage Sav. Ass’n v. Comm’r, 499 U.S. 554 (1991) further clarified that the exchange of substantially similar mortgages gave rise to “realization” under IRC § 1001 of any gain or loss because the mortgages embodied “legally distinct entitlements.” Thus, some may conclude that the exchange of one virtual item for another or for virtual currency triggers a “realization,” which they may also conclude is taxable in the absence of a clearly applicable nonrecognition provision.
34 See, e.g., IRC § 74 (including in income prizes and awards); IRC § 83 (including in income property transferred in connection with the performance of services); Treas. Reg. § 1.61-14(a) (noting: “Illegal gains constitute gross income. Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession”); Rev. Rul. 80-52, 1980-1 C.B. 100 (noting members of a barter club had income from services in “the taxable year in which the [barter] credit units are credited to their accounts”); Cesarini v. U.S., 428 F.2d 812 (6th Cir. 1970) (holding that cash discovered inside a piano purchased at auction is gross income in the year of the discovery).
35 See, e.g., Rev. Rul. 80-52, 1980-1 C.B. 100.
36 See generally Treas. Reg. §§ 1.6045-1(a)(4); 1.6045-1(e), 1.6045-1(f); IRS Publication 525, Taxable and Nontaxable Income (2007). The barter exchange regulations notably tax the receipt of barter exchange credits or scrip at its face value (unless the Commissioner determines another value), even though pursuant to the regulations, “property does not include a credit or scrip.” Treas. Reg. § 1.6045-1(f)(5)(iii).
37 Notice 2000-6, 2000-1 C.B. 315 (providing a de minimis $1 exception).
38 See Dustin Stamper, Taxing Ones and Zeros: Can the IRS Ignore Virtual Economies?, 114 Tax Notes 149 (Jan. 15, 2007) (reporting that Professor Bryan Camp and Tim McDowel, executive director of the National Association of Trade Exchanges, both indicated that virtual world operators could be subject to the barter exchange reporting requirements).
39 IRC §§ 6041(a), 6041(d); IRC § 6041A(a), 6041A(e); Instructions for Form 1099-MISC (2008) (box 7); Instructions to Form W-2 G (2008). Although “brokers” are subject to similar information reporting rules under IRC § 6045, Internet auction sites such as eBay contend they are not brokers. See, e.g., E-mail from Margaret M. Richardson to Eric Soloman and Michael Desmond (Apr. 16, 2007), reprinted as, Margaret M. Richardson, Individual Comments on Third-Party Information Reporting for Online Commerce, 2007 TNT 80-24 (Apr. 25, 2007).
40 See generally IRC §§ 3406(a)(1), 3406(h)(2), 1441(a), 1442(a).
41 For a detailed discussion of why certain income is not taxed, see generally, Lawrence Zenenak and Martin McMahon, Professors Look at Taxing Baseballs and Other Found Property, 84 Tax Notes 1299 (Aug. 30, 1999); Joseph M. Dodge, Accessions to Wealth, Realization of Gross Income, and Dominion and Control: Applying the “Claim of Right Doctrine” to Found Objects, Including Record-Setting Baseballs, 4 Fla. Tax. Rev. 685 (2000); Bryan T. Camp, The Play’s the Thing: A Theory of Taxing Virtual Worlds, 59 Hastings L. J. 1 (Nov. 2007); Leandra Lederman, “Stranger than Fiction:” Taxing Virtual Worlds, 82 NYU L. Rev. 1620 (Mar. 2007).
42 See Morris v. Comm’r, 9 B.T.A. 1273, 1277-1278 (1928), acq., C.B. VII-2, 28 (1928); Tatum v. Comm’r, 46 T.C. 736, 739 (1966), aff’d, 400 F.2d 242 (5th Cir. 1968) (describing crops as representing an “unrealized appreciation” ); Strong v. Comm’r, 91 T.C. 627 (explaining the general rule). See also Rev. Rul. 56-496; 1956-2 C.B. 17; IRC § 631; Treas. Reg. § 1.631-1(d) and (e). Scholars have distinguished a farmer’s harvest, a fisherman’s catch, and a miner’s diamonds, which a person sets out to obtain with the investment of labor or capital, from similar items that a taxpayer may find unexpectedly. See Joseph M. Dodge, Accessions to Wealth, Realization of Gross Income, and Dominion and Control: Applying the “Claim of Right Doctrine” to Found Objects, Including Record-Setting Baseballs, 4 Fla. Tax. Rev. 685, 696-697 (2000) (observing that no similar deferral applies to income from found items, which are generally taxable upon receipt).
43 See generally Burnet v. Logan, 283 U.S. 404, 51 S. Ct. 550 (1931).
44 See, e.g., Rev. Rul. 58-402, 1958-2 C.B. 15; In re Steen, 509 F.2d 1398, 1403-1405 (9th Cir. 1975); Treas. Reg. § 1.1001-1(g)(2).
45 See Treas. Reg. § 1.83-7.
46 See IRC § 83(a); Treas. Reg. § 1.83-1.
47 The tax treatment of transactions on Second Life could differ from the treatment of transactions on other virtual worlds because according to the TOS Second Life Residents retain certain intellectual property rights to their virtual creations. Second Life, TOS § 3, at http://secondlife.com/corporate/tos.php (last visited May 12, 2008).
48 See Leandra Lederman, “Stranger than Fiction:” Taxing Virtual Worlds, 82 NYU L. Rev. 1620, 1654 (Mar. 2007).
49 See Rev. Proc. 77-29, 1977-2 C.B. 538 (suggesting that to properly substantiate gains and losses in “table games,” which are typically played using chips, a taxpayer should record the gambling results at a given table rather than after each hand). See also Zarin v. Commissioner, 916 F.2d 110, 114 (3rd Cir. 1990) (holding, in part, that casino chips were not “property” in the hands of a gambler, but rather “nothing more than an accounting mechanism… designed to facilitate gambling in casinos where the use of actual money was forbidden”). But see PLR 200532025 (May 3, 2005) (concluding an online gaming site operator must report online credits to a taxpayer’s gaming account, where the credits performed the same function as casino chips even if the taxpayer had not exchanged the credits for cash or property).
50 Compare Ann. 2002-18, 2002-1 C.B. 621 (declaring “[T]he IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel…. The relief provided by this announcement does not apply to travel or other promotional benefits that are converted to cash”) with Dominic L. Daher, The Proposed Federal Taxation of Frequent Flyer Miles Received from Employers: Good Tax Policy But Bad Politics, 16 Akron Tax J. 1 (2001) (suggesting that the receipt of frequent flyer miles is taxable under current law and that the IRS’s announcement was the result of political pressure).
51 Compare IR-98-56 (Sept. 8, 1998) with Darren Heil, The Tax Implications of Catching Mark McGwire’s 62nd Home Run Ball, 52 Tax. Law 871 (Summer 1999) (arguing that a taxpayer should be taxed even if he or she returns the ball because he or she exercises dominion and control over it and suggesting that because the IRS’s press release was the product of political pressure it may not reflect the correct interpretation of existing law).
52 See, e.g., Heather M. Rothman, Tax Policy: As Congress Considers Online Game Taxes, Linden Lab Contends Law Already Clear, 210 DTR G-2 (Oct. 31, 2006).
53 Commentators have pointed out a number of policy arguments for and against the taxation of in-world transactions. See, e.g., Bryan T. Camp, The Play’s the Thing: A Theory of Taxing Virtual Worlds, 59 Hastings L. J. 1, 44-71 (Nov. 2007); Leandra Lederman, “Stranger than Fiction:” Taxing Virtual Worlds, 82 NYU L. Rev. 1620, 1641-1672 (Mar. 2007); Steven Chung, Real Taxation of Virtual Commerce: Has Second Life Crossed the Line?, Spring 2007 (unpublished manuscript, on file with Hastings LJ). However, our discussion is limited to administrative considerations.
54 Second Life, Economic Statistics, at http://secondlife.com/whatis/economy_stats.php (last visited Mar. 10, 2008).
55 Second Life, LindeX Market Data, at http://secondlife.com/whatis/economy-market.php (last visited Mar. 10, 2008).
56 For example, there is no currency exchange for WoW gold. Different Internet vendors buy and sell WoW gold at different rates which are not always publicly disclosed. The value of WoW gold depends on the size of the transaction and its location (e.g., the server on which it is located).
57 The greatest expense associated with a private letter ruling request is likely to be the cost of hiring a tax practitioner to submit the request. However, the IRS’s fee for a private letter ruling is: $625 for taxpayers with gross income less than $250,000, $2,100 for those with gross income between $250,000 and $1 million, and $11,500 for those with gross income of $1 million or more. Rev. Proc. 2008-1, 2008-1 I.R.B. 1. For a discussion of the IRS’s difficulty in evaluating the impact of potential user fees on its ability to achieve its mission, see National Taxpayer Advocate 2007 Annual Report to Congress 66 (Most Serious Problem, IRS User Fees: Taxpayer Service for Sale).
58 See Julian Dibbell, Play Money, or, How I Quit My Day Job and Made Millions Trading Virtual Loot, 303-311 (2006) (describing discussions with one IRS employee at a Taxpayer Assistance Center and his conclusion that in-game transactions involving virtual property are not taxable, and a follow up call to an IRS business assistance line where the IRS employee expressed the opinion that such transactions are taxable, but recommended that the taxpayer obtain a private letter ruling, for a fee, to get a more authoritative answer).
59 See generally David J. Mack, ITAX: An Analysis of the Laws and Policies Behind the Taxation of Property Transactions in a Virtual World, 60 Admin. L. Rev. 749, 759 (Summer 2008) (urging the IRS to issue guidance on the taxation of virtual transactions, in part, to avoid creating “a society of unintentional tax cheats”).
60 Imposing unreasonable recordkeeping burdens on taxpayers, as taxing in-world transactions might do, has long been thought to decrease voluntary compliance. See, e.g., Deborah H. Schenk, Simplification for Individual Taxpayers: Problems and Proposals, 45 Tax L. Rev. 121, 166–67 (1989).
61 Some commentators have suggested that from a tax policy perspective in-world transactions in Second Life should be subject to tax, but in-world transactions in other worlds should not. See, e.g., Leandra Lederman, “Stranger than Fiction:” Taxing Virtual Worlds, 82 NYU L. Rev. 1620, 1625 (Mar. 2007) (concluding “transactions in game worlds, such as WoW, should not be taxed unless the player engages in a real-market trade (a cash-out rule)… [and] that in intentionally commodified virtual worlds, such as Second Life, federal income tax law and policy counsel that in-world sales of virtual items be taxed”); and Steven Chung, Real Taxation of virtual Commerce: Has Second Life Crossed the Line? 14, 20 (Spring 2007) (unpublished manuscript, on file with Hastings LJ) (concluding that “imposing a taxable event at the in-world level would be fairer, would not create excess burdens and is not complex” but later clarifying “this article does not advocate taxing in-world transactions within Second Life”).
62 SB/SE Examination Policy, Reporting Compliance, Internet Online Gaming an E-Business & Emerging Issues (DRAFT) Discussion Paper on the Compliance Impact of Internet Online Gaming (May 2007). As early as 2004, the IRS conducted a Compliance Initiative Project to address noncompliance by Internet auction sellers. SB/SE Reporting Compliance, Compliance Improvement Project, Internet Auction Sellers & Auction Brokers (Feb. 25, 2004). By contrast, according to SB/SE Compliance it “has not identified any known examinations involving Internet Online Gaming and the sale of virtual game items.” SB/SE Examination Policy, Reporting Compliance, Internet Online Gaming an E-Business & Emerging Issues (DRAFT) Discussion Paper on the Compliance Impact of Internet Online Gaming 4 (May 2007).
63 TIGTA also recently found that the IRS could improve the accountability of its guidance process. See TIGTA, Ref. No. 2008-10-075, The Published Guidance Program Needs Additional Controls to Minimize Risks and Increase Public Awareness (Mar. 4, 2008).
64 Communications include: IRS, Retail Industry ATG – Chapter 3: Examination Techniques for Specific Industries (Electronic Business, Online Retail), at http://www.irs.gov/businesses/small/article/0,,id=141491,00.html (Aug. 2005); IRS, Online Auction Sellers, at http://www.irs.gov/businesses/ small/industries/article/0,,id=163622,00.html (last visited Dec. 8, 2008); IRS, Bartering Income, at http://www.irs.gov/businesses/small/ article/0,,id=187904,00.html (last visited Dec. 8, 2008); IRS, Electronic Business, at http://www.irs.gov/businesses/small/article/0,,id=108188,00.html (last visited Dec. 8, 2008); IRS, Tax Responsibilities of Bartering Participants, at http://www.irs.gov/businesses/small/article/0,,id=188095,00.html (last visited Dec. 8, 2008).
65 Guidance includes: IRS, Tax Tip 2008-02, Gambling Winnings and Losses, at http://www.irs.gov/newsroom/article/0,,id=172190,00.html (last visited Dec. 8, 2008); IRS, Tax Topic 419, Gambling Income and Expenses, at http://www.irs.gov/taxtopics/tc419.html (last visited Dec. 8,. 2008); Transcript for Business or Hobby, at http://www.irs.gov/businesses/small/article/0,,id=187331,00.html; IRS Pub. 525, Taxable and Nontaxable Income, at http://www. rs.gov/pub/irs-pdf/p525.pdf (2007) (analogous to gambling, found property, prizes & awards, bartering, hobbies, etc.).
66 For one of the most recent suggestions by a commentator regarding how the IRS could answer some of the difficult questions, see Theodore P. Seto, When is a Game Only a Game?: The Taxation of Virtual Worlds, Loyola-LA Legal Studies Paper No. 2008-24, at http://ssrn.com/abstract=1220923 (Aug., 12 2008).
67 The South Korea and Swedish tax agencies have issued some guidance in this area. See, e.g., Flora Graham, Slapping a Tax on Playtime, BBC News, at http://news.bbc.co.uk/2/hi/technology/7746094.stm (Nov. 25, 2008). Although the Swedish pronouncement was not promulgated in English, it reportedly stated that “in-game transactions may incur liability for both value-added tax as well as income tax under Swedish law.” Vili Lehdonvirta, Sweden Moves to Tax In-Game Transactions, Virtual Economy Research Network, at http://virtual-economy.org/blog/sweden_moves_tax_-game_transactions (Apr. 16, 2008).