Death & Taxes

Death is avoidable -- or, at least, rezzable -- in virtual worlds.  Are taxes?

State of Play / Terra Nova really started talking about what is looking like the big incoming thing: whether trades in virtual worlds are taxable.

Here's why: being a game doesn't make exchanges immune to taxation (see poker); and the fact that the trade concerns electronically-maintained records in a virtual environment doesn't make the exchanges not real (see the stock exchange). 

So the legal experts on the panel agreed: the current law seems to indicate that not only are taxes due if you cash out, or if you pass the assets at death and are above the estate tax limit on non-taxable transfers, but the law may even reach to tax the value of in-world barter.  Responses to the panel seemed to be along some lines we've talked about before: Virtual property isn't really property, they say, so it can't be taxed.   Another pretty common response was that these are just games, so they can't be taxed. 

In a pretty cool moment, Bryan Camp argued that my work on virtual property was at the root of this problem.  /eep.  But the thing is, whether something is property doesn't determine what rule the IRS will choose to tax it.  We tax capital gains when the person cashes out.  We should tax gold farmers by taxing their gains when they cash out of the world.  Saying that something is property doesn't even begin to tell us whether we're in a pretty good world -- gold farmers get taxed -- or in a pretty terrible world in which gamers get form 1099s in the mail requiring them to report their recently-acquired Misplaced Servo Arm.

One way to look at this is as a purely pragmatic matter.  Remember, the IRS is at least as concerned about tax evasion as it is about deep theoretic discussions of what could be taxed and what can't.  They classify some pretty far-out stuff as property, just to stop people from pouring assets into it as tax evasion.  They don't base their theories of what is taxable on deep theoretic distinctions about property or non-property.   If virtual worlds aren't taxable, some enterprising individual is going to open TaxEvasionWorld, and permit parties to convert their assets to tax-exempt virtual assets.  It could be the wave of the future.

Don't Panic.  /Douglas Adams.  Deep breath.  Reach for your towel.   

What we need to do is talk to the people involved, and convince them that a cash-out rule that taxes gold-farmers is the way to go.  I'm pretty convinced this is how this will go, it's just a matter of speaking with a clear voice.

Finally, I gotta say, there is no way the IRS will NOT develop some policy on virtual world assets -- not at the rate of growth virtual worlds are seeing.  We need to influence policy and protect gamers, not stick our heads back in the sand and murmur "but it's just a game!"

Comments on Death & Taxes:

Minivet says:

Just a lurker, but your post made me think -- has anyone looked into what Korea or China's tax authorities are doing in this vein?

Posted Dec 5, 2006 9:15:15 AM | link

Ben says:

Few things come to mind about virtual taxation:

1) Current virtual worlds have no regulatory controls for influx/outgoing of virtual goods and currency. Anyone sitting at a root server or with a GM account could theoretically create their own monetary supply. This is not the case with regulated industries like banking and the stock exchanges.

2) For virtual goods to be taxable, companies such as Blizzard would have to give up their right to ownership of the products (gold/items/characters). How can I as a user be taxed on the sale of something that I don't own?

3) What constitutes a "taxable" sale? There are rules with the IRS about gifting of money from one individual to another -- will we need to start tracking and taxing all trades between guild-members? What about loans between friends? If I buy a very expensive weapon, does the person that sold the weapon assume the tax liability?

Or is this only a discussion when I convert my virtual assets to legal world tender? If so, see question 2.

Posted Dec 5, 2006 9:51:05 AM | link

Douglas Thomas says:

This does seem like a straightforward solution. When people exchange items from virtual worlds for money in the physical world, it seems like the IRS should get involved. Otherwise, it seems that what happens in-world should stay in-world.

Don't most TOSs and EULAs (with the notable exception of SL) say that things in world are the property of the game company anyway? I understand that might not apply when I take an item to Ebay, but certainly while in-world, there seems to be an argument that I can't be taxed on something I don't own (don't I just rent it from Blizzard for $15/mo?)

Posted Dec 5, 2006 9:53:27 AM | link

Tom says:

SL is the spanner in the works when it comes to an overarching VW taxation policy.

With most other VWs, the developers explicitly claim ownership over all virtual assets. Therefore, in-world transactions amount to transfer of data between users, which neither user has more than tenuous claim to. Therefore, it makes sense that gains be taxed only when they are converted to a "real" currency.

With SL, however, the users ostensibly own the IP rights to their own creations. Users are, therefore, effectively performing a transfer of my-IP-for-your-IP with every transaction in the game, using the L$ as an intermediary. That makes the situation sufficiently analogous to real-world barter and "local currency" transactions that all L$ transfers within SL should be taxed at the fair market rate.

Posted Dec 5, 2006 10:41:12 AM | link

Peter Clay says:

Taxing only the cashing out makes sense, and if it reduces currency farming in MMOs so much the better.

Posted Dec 5, 2006 11:07:29 AM | link

Mike Sellers says:

Josh wrote:

the current law seems to indicate that not only are taxes due if you cash out, or if you pass the assets at death and are above the estate tax limit on non-taxable transfers, but the law may even reach to tax the value of in-world barter. ...

We tax capital gains when the person cashes out. We should tax gold farmers by taxing their gains when they cash out of the world.

A few thoughts:

First, if you are a resident of the US, you'll already be taxed by the US government when you cash out of in-world activity (I assume it works similarly elsewhere in the world, but can't really say). If you've generated income that has been translated to US dollars, I don't believe there's any legal way to not declare this as income (isn't that what Julian did?). So the whole "we should tax gains when someone cashes out of the world" seems to be covered by existing tax law.

Second, to my knowledge, US law prevents any taxation on transactions that happen online (absent in-state transactions that happen online). So if I buy or sell something, the government has no authority to tax it. I see no basis in anything other than complete speculation that the government would find a basis for reaching into virtual worlds to tax transactions where no gain is realized.

Third, the whole "virtual property" line of reasoning is a red herring. This whole aspect of the discussion may spring, I think, from a desire to give our odd little creations the imprimatur of being not only real, but important -- perhaps of bolstering our egos against the eye-rolling reaction that we're playing with dolls and toys, if online ones. From a taxation POV, the virtuality of the property is immaterial; what matters is the dollars it becomes, if it ever does.

To my knowledge, no one considers whether barter transactions are "real" or not, or whether the property involved in them is real. And yet such transactions happen often, and are typically untaxed until (as above) some dollar-based gain is realized.

Are there examples from other contexts where taxation occurs (in the US) where no dollar-based transaction has taken place, or where scrip or similar has not been cashed out? (In casinos for example, you may win a million dollars in chips, but I'm pretty sure you're not taxed on it unless and until you cash it out -- so if you lose it all again while in chips, it's "easy come, easy go".)


As to SL and IP rights, note that SL users retain only the IP rights for the use of their creations outside of SL. So within SL there is no difference from any other virtual world -- LL reserves the right to use your creations in world however they wish, including deleting them at their sole discretion. But this is all a sideshow anyway: what matters is when virtual currency returns to real currency. Until then, no gain is realized, and no taxation is possible.

Posted Dec 5, 2006 11:31:21 AM | link

Tom says:

Mike Sellers> "Are there examples from other contexts where taxation occurs (in the US) where no dollar-based transaction has taken place, or where scrip or similar has not been cashed out?"

From The IRS: "Bartering occurs when you exchange goods or services without exchanging money. An example of bartering is a plumber doing repair work for a dentist in exchange for dental services. The fair market value of goods and services exchanged must be included in the income of both parties."

So any time an in-kind non-monetary transaction occurs, it is taxable, regardless of whether or not any money changes hands. The key is that economic value is created by the exchange of services that would otherwise require payment, which is exactly what is happening in SL.

This means that if I trade my piece of digital artwork for your piece of digital artwork in Second Life, we are engaging in a transaction that is taxable at the fair market value of what is exchanged. The fact that there is an intermediary (L$) that can be used to facilitate the trade simply makes it easier to keep track of the aggregated fair value of the many barter transactions a typical user engages in over the course of a year.

Posted Dec 5, 2006 11:46:33 AM | link

Joshua_Fairfield says:

Mike Sellers wrote:

"From a taxation POV, the virtuality of the property is immaterial; what matters is the dollars it becomes, if it ever does."

This is absolutely right.

Posted Dec 5, 2006 11:46:42 AM | link

Wolfe says:

The value of RMT is highly inflated by the fact that it is against most EULA's. Kindof like how drugs would probably be a bit cheaper if they were legal.

RMT must become legal for this type of taxation deal to become reality. The volume of fraud must drop and various authorities must enforce the now highly real world types of laws which govern ownership and properties and so on.

When all these things happen the cold truth of reality will enter our virtual world. This reality says that the actual market value of all this "valuable" stuff is quite low. The reasons why the value is high now is because of lack of supply, the supply of RMT goods is strangled. Its not strangled because people really think its worth more than what some people might want to pay, but the risk of getting banned is too high for all legit players. Most players dont feed supply, if they start the value of a manhour of RMT labor will drop dramatically. Down to the level where the IRS wont even bother with it anymore.

You also have the problem where each hour of labor gets cheaper for every hour that pass. Investments in anything produced by labor is always a loss. The exceptions for this is when the labor was using a cheat which has expired or obtained some "pre-patch" asset, which may gain value over time.

Posted Dec 5, 2006 12:05:42 PM | link

Tom says:

"From a taxation POV, the virtuality of the property is immaterial; what matters is the dollars it becomes, if it ever does."

Not quite. What matters is not the dollars, but rather the value being transferred as a result of the transaction.

If I make a deal that, in exchange for a bit of digital artwork, I will write some software for you, then by IRS (and most country's revenue collection agencies) rules, that transaction is taxable if it occurs when we are sitting at my kitchen table. I have never heard a cogent argument for why that transaction should suddenly become not taxable if it occurs in a virtual world.

Posted Dec 5, 2006 12:16:36 PM | link

Mike Sellers says:

What matters is not the dollars, but rather the value being transferred as a result of the transaction.

Not really. See my example involving gambling chips above. I can win (transfer from you to me) a million dollars and lose (transfer to someone else) a million dollars, and as long as I don't cash out, there is no taxable event.

Barter is sometimes taxed, but the fact of the matter is this is rare. There are entire, official barter networks where goods and services exchanged are never taxed.

Moreover, barter is taxed on the presumption of fair market value -- essentially a reduction to dollars. When no viable FMV exists, or when there is no net value change, no taxation can occur.

Anyway, as I said before, I believe all of this is covered by existing conditions:

  • income in (or cashed out to) dollars is taxed as miscellaneous income no matter where it comes from, and
  • US law does not permit taxing of online transactions. The income derived from the transaction is taxed but not the transaction itself.
Absent some major change in one or both of those, I see no point to worrying about additional taxation. If someone is making actual dollars from in-game activities, terrific. The IRS already has that well covered. The rest is immaterial.

Posted Dec 5, 2006 12:39:46 PM | link

Jessica L. says:

Im back ya!

go to my new webs

yo im back!! Did u 4get me?

Posted Dec 5, 2006 12:40:30 PM | link

Joshua_Fairfield says:

I think that says it all!

Posted Dec 5, 2006 2:04:40 PM | link

Jeff Freeman says:

"They say publicly, 'No, we don't like it,'" Fairfield said of the publishers. "But privately, they support it...Why? Because it makes them money."

How's this?

Posted Dec 5, 2006 2:51:20 PM | link


Mike Sellers said: "There are entire, official barter networks where goods and services exchanged are never taxed."

Not really true anymore. Barter clubs used to operate under the radar in the 60's but the the IRS scoped them out in the 1970's. See the discussion in Robert Keller's excellent article "The Taxation of Barter Transactions" in 67 Minn. L. Rev. 441, 490-512 (1982).

Section 6045 requires Barter Exchanges to file information returns. Third party reporting is the true engine of tax collection. That is why I see the most likely way that taxation of online transactions breaking is some vendor like Sony or Blizzard seeking guidance from the IRS on whether they are a "broker" within the meaning of section 6045 and thus required to file information returns.

I think the treatment of Barter Exchanges and their members actually provides a useful model for taxation of in-world the extent that in-world trades trigger gross income.

Tom's posts get it right, in my view. I think the key concept to keep in mind is that section 61 counts as gross income almost ANY realized increase in a person's economic well-being, whether that increase comes in the FORM of cash, property, or services. The big exception is imputed income.

So if I prepare your will for $500 and you pay me cash, I have $500 gross income. If I prepare your will in exchange for your IBM stock worth $500 I still have $500 income even though you "paid" me in property. If I prepare your will in exchange for you painting my house, we both have $500 income. It's like I prepared someone else's will and got paid the $500 cash and then paid you the $500 cash to paint my house. (We would give the trade a value of $500 per the decision in Philadelphia Park Amusement Co. v. U.S. 126 F. Supp. 184 (Ct.Cl. 1954).

But if I prepare my own will then even though I am demonstrably $500 richer, it's long been held not to fall within the legal definition of gross income. See Helvering v. Independent Life Ins. Co. 292 U.S. 371 (1934).

The other point to remember about section 61 is that an item of value becomes income only when it is realized and reduced to the possession of the taxpayer. That was how the IRS skated around the record-setting baseball caught by the fellow who then gave it back to Mark McGwire. The IRS ruled that he did not "realize" the income. Not true, but a good enough excuse in that case.

The point is that form does not matter nearly as much as economic substance. And once you have economic wealth, avoiding it becoming gross income is pretty hard. Both the imputed income issue and the realization issue are in play in any analysis of in-world transactions, IMHO.

Although I tried to impress folks of the existence of a reasonable argument as to why in-world trades could be gross income, that (as I said at the conference) is not my current thesis.

My current thesis is that in-world trade of in-world items does not generate gross income within the meaning of section 61. This is so for two reasons. First, in-world items are currently best regarded as units of play and not as property. They have value only in world and their value is shaped by the in-world game context. Second, even though they themselves are a form of property both in theory (as a limited license right to play the game) and in practice (hey, they ARE bought and sold), I think they are too contingent (game designer's control) to meet the constructive receipt rule. So their trade cannot produce gross income because of the realization requirement.

I locate the relevant property right at the level of player accounts. Thus viewed, all in-world acitvity simply increases the value of the player account. It's self-created value, which has a long history of not meeting the LEGAL definition of gross income even though an economist would corretly conclude that it meets the ECONOMIC definition of income.

But I am also thinking that to the extent players cease to be players and break the magic circle by using in-world items to pay for real world itesm (such as using Lindens to pay the rent), then you've got a much more powerful case for taxation of inworld transactions because the inworld items now seem to have a life outside the virtual world context and their acquisition now appears not simply to enhance the game play of a particular account but to be a realization of an item of income that is indeed independent of the player's virtual account.

I'm still working through all this and surely appreciate the thoughts and comments I'm reading here and on other places, such as on Fark where there is a quite robust discussion.

Cheers, -bryan

Posted Dec 5, 2006 3:17:14 PM | link

Joshua_Fairfield says:

Although I support your goal, Bryan, I have to say -- eliminating private property is an expensive way to avoid taxes. Not something I'd propose in real life by any means. It also won't work, since, for example, the presence of property in Second Life is undeniable.

I think it's better to understand virtual property as property but, since, as you say, function trumps form, enact a taxation rule that makes sense for that particular kind of property.

Posted Dec 5, 2006 3:35:44 PM | link

Joshua_Fairfield says:

On second thought, I'm not sure I disagree with you at all, Bryan. The idea being, if you cash out the object, it's income. But if you keep it in the account, the value of the account increases and the appreciation isn't taxed. Hmm. That's pretty good. Of course, the EULA says the account isn't your property either. How would your view create the private ownership that we use in the real world to encourage investment and growth?

Posted Dec 5, 2006 3:51:24 PM | link

Ben says:

Out of curiosity, and maybe to assist me in understanding the situation a little better, how would the IRS view the trading of baseball cards between people?

Or, continuing the baseball motif, how about the trade of a "player" from one "owner" to another in a for-money fantasy baseball league.

Posted Dec 5, 2006 3:53:29 PM | link

ron meiners says:

Brian, if I'm understanding correctly, it seems like host worlds would be incentivized to forbid RMT. If there's a tax liability only when a cash value is realized, I would think they would want to do even more to shut down such activity - and thus avoid having to tell their users that their accounts are being reported to the IRS.

Is that right? The IRS as de facto defender of the player experience?

Posted Dec 5, 2006 4:31:15 PM | link

Bryan Camp says:

Hi Josh,

I'm happy for your second thoughts! The EULA is (right now) just a contract. No matter how one-sided the contract is, Linden Labs and Blizzard have obligations to perform under it. Locating the property right at the level of the player account makes intuitive sense to me because although the EULA gives the game owners complete control over the rules of the game, it does not give them equal control over your account. They basically agree that you can play so long as you don't violate the TOS. So let's call you Marc Bragg and say they think you violated the TOS and terminate your account. You sue. You might win or lose, but your RIGHT to sue is the property right. You can even sell your right to sue, you know. There are folks in the business of buying and selling causes of action. And the IRS can seize it through its administrative levy powers under section 6331 and sell it (and has done so in the past).

As you point out in your article, the law is shot through with rules that either trump contract rules or else cannot be altered by contract. I am not familiar (yet) with the law regarding arbitration clauses or how the law would treat a contract clause where one party ostensibly gives up the right to sue. Perhaps someone can help me with that (and cites to specific cases are most welcome). I would expect that such a clause would not be dispositive of the issue, just as a clause that cays "I did not sign under duress" is not dispositive of that condition.

To answer Ben's question, the IRS would treat a baseball card trade as a realization event. That means that the traders would likely have to calculate the amount of their gross income gained from the trade. (Unless both taxpayers were in the business of collecting and selling cards and structured the trade as a like-kind exchange under section 1031 in which case it would be an unrecognized realization your head spinning yet? )

The AMOUNT of income realized from a sale or exchange or other disposition of property (such as a baseball card swap) is goverend by section 1001, which says that the gross income gain from the transaction equals the amount realized from the transaction minus the basis in the property sold, exchanged, or disposed of. So if I bought my baseball card fr $5 and traded it for another card when both were worth $7, then I have a gain of $2 ($7 amount realized minus $5 basis). It's like I sold the card for $7 cash and bought the other card. I now have a basis of $7 in the other card, which protects me from having to pay tax twice on the money I spent on the card. That is the purpose of basis, to track the tax history of a piece of property, to track what you are "into" the property for, in terms of already-taxed dollars.

Notice I'm finessing a couple of practically important issues: valuation and reporting. That is, if you trade 2 cards, how do you know what each of them is worth, even assuming that both are worth the same? I am also finessing the reporting issue. It's up to the taxpayer to report the transaction correctly. Without a robust 3rd party reporting regime, you can imagine that compliance would be much lower than the current compliance rate of approximately 85%.

While those issues are very important practically, they are unimportant to the theoretical problem of whether a transaction produces gross income in the first place.

As for the fantasy baseball, that is another virtual world as far as I can tell. Perhaps more imperfectly rendered than WoW or SL, but virtual nonetheless. The players would be in-world items and their trade might well increase the economic value of the taxpayer's virtual team, but unless the taxpayer is receiving real world cash or property or services in exchange for the player, I'd argue (at this point) that the trade does not trigger gross income under section 61.

Hope that helps, -bryan

Posted Dec 5, 2006 4:52:06 PM | link

John Beety says:

Just a few quick comments from a lurker:

First, Synthetic World : Poker :: Real-Money Trade : Cashing Out?

I see real-money trade (RMT) income as income, no matter which way it is presented. If I should sell a World of Warcraft account for some amount of money, that is income that should be taxable. Of course, then one gets to the question of deductions...would the cost of the game and expansions be deductible? Monthly fees? It is something that would need to be further developed. The question would require more time and finesse than I can expend here.

As for taxing in-game transactions that never leave the game, I believe the long-term negative consequences for another source of tax revenue would more than outweigh any revenues from the synthetic worlds. What would the effect be on corporate profits and the consequent tax revenue?

Corporations such as Blizzard, Sony, Square Enix, etc. that operate synthetic worlds pay taxes on their corporate profits. If a tax is imposed on synthetic-world transactions, then almost every move can be taxed in what is essentially a leisure activity for the vast majority of players. There is a disincentive to choose a synthetic world for entertainment. Players leave synthetic worlds; revenue (and profits) fall for the companies who own them; some synthetic worlds may close completely, depriving the authorities, not only of income from Real-Money Trade activities, but the taxes paid by the corporation who once operated that world. At current tax rates around the world, this is a distinct possibility.

I believe that any nation that rushes to tax, not just Real-Money Trade, but transactions that never leave the game, risks slaughtering the golden goose. Of course, there are other, longer-term implications to taxing in-game synthetic-world transactions. Should a government decide that a particular game generates toxic immersion (a nod to Castronova), that government could impose a sin tax of sorts on the in-world activities of those citizens who play. This power, like any other, could be used negatively...what if the above "toxic immersion" is exposure to concepts like liberty?

I am starting to get tangential and long-winded, so I shall stop there. It is clear, however, that much more is at stake than merely a tax on virtual gold.

Posted Dec 5, 2006 7:23:36 PM | link

Richard Bartle says:

Joshua Fairfield>being a game doesn't make exchanges immune to taxation (see poker)

If I play a hand of poker and win $100, then I play another hand and lose $100, so all in all I'm even, should I be paying income tax on that $100 I won? Can I use the $100 I lost to write off some of that tax? What if I played 50 hands in an evening? Would I be taxed on the turnover or the eventual profit?


Posted Dec 6, 2006 3:18:10 AM | link

Daniel Stengel says:

Richard, you would be taxed on the eventual profit generated within the accounting period.

There is a difference between VAT and income tax. VAT may apply to online transactions, but only if it's either a business to consumer or a business to business transaction. C2C remains free. Thus, if IGM sells you 100g or the purple Icemail Breastplate, the transaction is very likely VATable, regardless of whether they sell it via ebay, a toon or the WoW auction house. Even today, under the current regulations. But if I sell you the same item as a private individual, no VAT should apply. So no reason to worry.

Income tax will only incur if there's a profit at the end of the year (or accounting period). No doubt that the gains of 98% of all online gamers will be eaten up by subsription fees or telecommunication costs. If the remaining 2% do vw trading for a living, it seems fair that they would be taxable.

However, I agree with Bryan that valuation and reporting are the tricky issues here, next to questions like cross-national taxation and (that's fun) whether the game provider could be held liable for any non-paid taxes. The regular gamer, however, does not need to bother.


Posted Dec 6, 2006 5:04:51 AM | link

Detritus says:

Joshua > If virtual worlds aren't taxable, some enterprising individual is going to open TaxEvasionWorld, and permit parties to convert their assets to tax-exempt virtual assets. It could be the wave of the future.

Ahhh I love Academics. They’re so mischievous! You guys really keep the world interesting for the rest of us. You know a fair number of nefarious white collar types are going to seriously calculate the costs of TaxEvasionWorld vs. the taxes they can avoid paying and that this article is going to be pasted all over the Libertarian blogs as their Liberty Dollar 2.0.

Joshua > What we need to do is talk to the people involved, and convince them that a cash-out rule that taxes gold-farmers is the way to go.

I grew up on the edge of the economic ladder that placed me in neighboring territory with individuals that had accounts in the Cayman Islands, so I am personally familiar with the despicable lengths many will go to in avoiding paying for the roads. What you are suggesting is that the IRS would eventually get their cut when the money was transferred out of the Cayman Islands, but that is exactly what doesn’t happen. Perhaps in sales tax, but the income tax is neatly avoided when the IRS has no record of how much money your tax ID has earned. Gold Farmers and such would just use banks that are beyond the scope of the IRS, so that when they “Cash out” from the game the money goes straight over the IRS (or whichever governing tax authority you may be avoiding).

The recent US legislation making it unlawful for banks to make transactions with over-seas gambling sites will only hamper the casual blue collar guy. The white collar crowd has already had, or was planning to get anyway, a bank somewhere else that wouldn’t (or at least won’t be able to) tax their winnings. The end run there means you’re evading paying taxes in the US (which looks and feels legal), and then very clearly neglecting to pay your taxes to the Dominican Republic (which is completely illegal, but doesn’t catch up with you unless you happen to visit the Dominican Republic).

So your suggestion is very much in line with the status-quo, but I feel we will need roads to be maintained and that this is not a healthy solution.

I can’t wait to see the Libertarians and the IRS duke this one out. Keep adding fuel to the fire! If I could legally bet my money would be on the IRS, even if they’d get a cut of my winnings.

Posted Dec 6, 2006 9:01:38 AM | link

Bryan Camp says:

Ricahrd wrote: "If I play a hand of poker and win $100, then I play another hand and lose $100, so all in all I'm even, should I be paying income tax on that $100 I won? Can I use the $100 I lost to write off some of that tax? What if I played 50 hands in an evening? Would I be taxed on the turnover or the eventual profit?"

Daniel's answer is close to mark, but not entirely accurate. Remember, the first question a tax lawyers asks is whether you have GROSS income from a transaction. Only then do you get to applicable deductions, etc.

So the more accurate answer to Richard's poker hypo is that the $100 win is indeed gross income (congratulations!). Now the fact that you then spent that $100 to obtain more pleasure at the table does not change it. What the spent $100 does is give you a possible deduction. If you were a professional gambler, then you'd get to deduct the $100 loss against the $100 gain and you would indeed come out even at the end of the tax period (which is generally a calendar year). But if you were a hobbyist, then you would be allowed only so much of the $100 loss as exceeded 2% of your Adjusted Gross Income for the entire year. So if your AGI was $40,000 for the year, then the first $800 of deductible expenses would not count against your income.

Recreational gamblers get screwed all the time on this. They simply fail to keep receipts of their losses and so when they hit the trifecta or pull the jackpot and get a W-2G they cannot show their losses, much less show that their losses exceed 2% of their AGI.

Now, to track this back to the virtual, suppose you bought $100 in chips in a casino and played poker with them. The 3rd Cir. in a famous case called Zarin v. Commmissioner, 916 F.2d 110 (1990) held that casino chips were neither property nor represented an enforceable debt. Instead, the court thought the chips were best conceived of as markers, or units of play (or, to take Richard's ideas in the first panel at the STate of Play conference, you might call them "units of fun").

So under the Zarin view, we don't know whether you have GROSS income until you cash the chips in.

While the IRS accepts this view for casinos (they do not try to claim that all your interstitial winnings between the time you buy your chips until the time you cash them in are gross income), the IRS has already taken a different view with respect to virtual gaming. In Private Letter Ruling (PLR) 2005532025 (August 12, 2005), the IRS ruled that the taxpayer (who operated online casual games where people bet on their game play) had to report on a 1099-MISC the interstitial winnings of players between the time they bought into the virtual account and the time they cashed out their virtual account.

I think the PLR is wrong. Like casino chips, the vitual prizes "awarded" to winning players were simply markers, or units of fun. But the PLR has serious implications, IMHO, for other types of virtual transactions.

Regards, -bryan

Posted Dec 6, 2006 9:55:05 AM | link

Joshua_Fairfield says:

Another question that came to me. The barter rule is what's at issue here, mostly, since everyone agrees cashouts a la goldfarmer are -- and should -- be taxed.

But is this really barter? If I use dollars to buy Euros, then use Euros to buy a computer, is that barter? Is every cross-border credit card purchase barter? I don't know the answer, but I think it likely isn't.

So, purchases with gold are not really barter, perhaps?

Posted Dec 6, 2006 10:16:25 AM | link

Mike Sellers says:

I don't think they're barter either. The poker chips analogy is the best I've seen so far, though it's not perfect: in-game assets are markers for in-game abilities. They may have external monetary value, but unlike poker chips that is not their primary intent. Thus, I think the Zarin view that Bryan refers to is the relevant piece (and not the gambling-specific PLR, which will likely fall if tested in a court case, I'm guessing). I can't see the IRS attempting to tax someone based on having found a Sword of Ten Large when that sword has not in any way been reduced to something other than a virtual marker.

Posted Dec 6, 2006 10:22:46 AM | link

onetrueping says:

I'd like to point out that the real issue here is more a matter of income from RCEs, and the ability of government to apply inheritance taxes to virtual assets with real world value. The sale of gold or the cashing out of L$ should already technically be taxable, but when someone can have a million US$ in virtual assets in virtual worlds like SL, can the government tax that?

Beyond that, the taxing of in-game achievements where such cannot normally be converted into cash is kind of outside the scope of the IRS, since putting money into the game is no guarantee of getting money out of the game (and by contract, at least, isn't even possible).

Besides which, with the fluctuating values and inherent inflation of most MMOs, taxing their virtual assets evenly would be far more complicated than the potential income would warrant.


Posted Dec 6, 2006 10:44:00 AM | link

Bryan Camp says:

Hi all, Josh puts his finger on a really interesting issue that I have yet to fully explore or figure out. The foreign currency rules in sections 985-988 basically treat foreign currency as a commodity. There's a recent 7th Cir. opinion (recent as in November 2006) by Posner dealing with this issue. The basic rule is this: if you conduct business in a currency other than the currency you normally use in your Trade or Business (T or B), then your use of the currency is a realization event.

For example, let's say I normally do business in US dollars and use $100 to buy $200 pesos. I then use the $200 pesos to buy goods and services in Mexico. At the time of my Mexico transaction, the $200 pesos are worth $110. Section 988 says that I have a $10 gain in my disposition of the pesos. I bought them for $100 and "sold" them for $110.

As virtual currencies start to break out of the magic circle, I am thinking they could be treated as "nonfunctioning currency" within the meaning of section 988.

This is still way preliminary and it may make no difference since if I buy a real world item on Ebay in exchange for Lindens, it is no different than me "selling" Lindens in exchange for the RW item. So I end up in the same place as if I applied the foreign currency rules in 988.

Cheers, -bryan

Posted Dec 6, 2006 12:11:06 PM | link

greglas says:

onetrueping> Besides which, with the fluctuating values and inherent inflation of most MMOs, taxing their virtual assets evenly would be far more complicated than the potential income would warrant.

I'll leave the tax law to Bryan, but let me chime in on the basic facts to agree with the point about how complicated all this is. One of the panelists (not Bryan) made a mistake, I think, by suggesting that there would not be major administrative problems in tracking in-game trades and fixing FMV for barter. It would actually be very complicated.

The very notion of "barter" is strained in the MMORPG setting much more than it is in the poker chip example. Poker chips have a cash equivalence and that's pretty much all they represent to players. But most traded "things" in MMORPGs represent combinations of skills, status, expressions, currency, and narrative progression. Add to that the fact that the vast majority of barter transactions are de minimus trades, auctions prices do very odd things across shards/over time/in response to narrative, and many people play fully within the magic circle (they never anticipate cashing out). I could go on with more reasons, but I think most of us agree that, even if you don't like the logic of Zarin, there are multiple good reasons why it would generally be a mistake to implement a tax on virtual barter.

Posted Dec 6, 2006 12:42:09 PM | link

Ombrone says:

The tax problem is very interesting and probably the key issues of the future development of this kind of virtual worlds. I believe that soon we will have some kind of tax scheme with all the possible difference from country to country.

This will change deeply the game mechanics and as some comments suggest may TOS and EULA limiting the property rights of players should be changed with all the involving legal problem for the games company.

Having had in my youth year some experience, to put in this way, about the Tax Elusion business, I could only wonder the possible application concerning the virtual world: a database glitch will allow to ask for a tax write off? Or (for example) LL will have to pay me the damage? If SL crashes… my MPs will ask for “special government disaster recovery program” to help my tax paying virtual company? And bloody hell are the connection expenses and registration fees loses in my balance account?

Writing this post I am just thinking to have a chat with my old partners to prepare myself, maybe I have the chance to be quoted in Terranova as the founder of the first virtual tax consulting firm…

That’s actually not kidding at all, and I would like to stress a another issues.

Maybe the volume are not enough right now, but they are rocketing up.. and… SL (to quote only one) sounds to me the perfect dreamed paradise if you need to do some money laundering…. Money coming from a Bahamas bank account… you buy land.. you build, you sell, you sell again… you rent.. you re-sell… a couple of ALT in the chain, money coming out in a Channel Island bank account.

Think about that too, there are a lot of smart kids that could think about it.

Posted Dec 7, 2006 3:59:48 AM | link

Peder H Pedersen says:

Just another example of how RMT screws with recreational games. If "virtual currency" of places like WoW, DAoC, EQ - you know, the "gamey" worlds, ever become taxable, then we've lost something very very nice, and why? Because of a minority of people being unable to respect agreements (ToS, EULA), and just having to get that edge, which isn't allowed by the rules. Those people you know who say they do no harm. If this ever happens they have done more than harm - they'll have destroyed online gaming as we know it (and many of it enjoy it).

Posted Dec 7, 2006 6:17:53 AM | link

Ben says:

RMT will exist, with or without taxation.

RMT existed probably before you recognized it existed, yet you still most likely had "fun" playing your "gamey" games.

If you ask most people who play WoW, EQ, DAoC if they have fun playing the game, they will more than likely say yes. If you then ask them if the RMT transactions that exist in their worlds lessen there fun, they may say yes. But if you ask them if it removes it all, I can assure you, the answer will be "no".

RMT won't destroy online gaming any more than subscription fees, lag, or poor programming already have.

This not meant to be a defense of RMT, but as a counter to the vocal minority that are calling for it as the END OF THE WORLD (of warcraft).

Posted Dec 7, 2006 10:30:29 AM | link

Victor Keegan says:

Are there circumstances in which SL could declare itself a separate country as so many bits of Eastern Europe have done? Then it could levy its own taxes to finance vital improvements in infrastructure that need to be done (such as building a decent road near me). Membership of the United Nations could follow bringing a truly international stance to the table.

Posted Dec 7, 2006 3:06:45 PM | link

Andy Havens says:

Wolfe said: "RMT must become legal for this type of taxation deal to become reality."

Nope. At least in the US, you're supposed to declare illegal income, too. That's what got Al Capone; tax evasion on undeclared income. If he'd simply declared it, regardless of source, he'd never have gone to jail (from my limited understanding).

A friend of mine once made the argument to his young (22-ish) daughter that she shouldn't be trading hundreds (or thousands) of MP3s with her friends, because she'd be liable for the income tax on them, even if she'd never paid for them in the first place. They have value, and trading them counts as barter, and is therefore barter income.

He was half-serious, half trying to scare her out of doing something that he finds morally objectionable. And half just being a weiner to his kid, which we all enjoy.

Posted Dec 7, 2006 3:34:37 PM | link

Daniel Stengel says:

For tax purposes, please don't think of virtual worlds in terms of nation or state. Think of servers located in the USA, Germany or Japan and of transactions between real individuals located in these (or third) countries. Then you will be able to decide where these individuals and transactions are subject to tax.

Actually, this applies to all legal matters.


Posted Dec 8, 2006 3:52:38 AM | link


> RMT existed probably before you recognized it existed,
> yet you still most likely had "fun" playing your
> "gamey" games.

Yes, because limited RMT does limited damage, and isn't really a problem.

However, as RMT increases in volume it is my opinion that it does have an increasingly large impact on the game. Coming under the radar of tax authorities is one, potentially very nasty, such effect.

RMT is not the end of any game - but if widespread RMT indirectly causes in-game assets to be taxable "property" then it will mean the end of online gaming as we know. I am not saying this is gonna happen, but pointing out *if* this happens it will be RMT which caused this.

Widespread RMT does have serious impacts on 'gamey' worlds (and sandbox worlds for that matter if the RMT happens outside the 'intended' use of such, if anyone, in the world). It's not, IMHO, a valid argument that because the previously limited RMT traffic has had very little impact on worlds, RMT in general cannot, given a large enough usage, have seriously detrimental effects - even including the end of the world (of whatever game).

Posted Dec 8, 2006 10:05:19 AM | link


Terminology is important --

First, income is taxable regardless of its legality. That said, RMT is a breach of contract, not illegal.

Posted Dec 9, 2006 10:46:34 AM | link

Mark Limardo says:

As more and more businesses discover that MMOs can be powerful marketing and productivity tools, we can expect increasingly complex and sophisticated MMO applications. Given the current rate of change in MMOs, computing power and broadband availability, it is not difficult to envision future MMOs in which media companies will deliver product (e.g., pay-per-view movies, sports and music), professionals (doctors, lawyers, accountants, etc.) will render in-world advice, and bankers will offer financial and investment opportunities as varied as those on Wall Street. Some whiz kid might even offer an in-world currency-denominated derivative tied to a real world security (such as stock market index security) and backed by real life guarantees or insurance. If the in-world economy becomes sufficiently diverse and stable, every one of these transactions will be conducted solely using in-world currency without any need ever to convert into real life currency, and people may even take in-game currency as payment for real life goods and services.

As I started to think about the tax issues, I divided MMOs into three basic categories: (i) MMOs clearly intended and used for recreational purposes ("recreational MMOs"), (ii) MMOs clearly intended and used for commercial purposes ("commercial MMOs") and (iii) MMOs used for both recreational and commercial purposes ("mixed use MMOs"). Based on these MMO categories, MMO-related transactions can occur in several variations: (i) in-world transactions occurring completely inside recreational MMOs (e.g., Ultima Online, the EQs, WoW, Anarchy Online etc.), (ii) real-life transactions involving in-world items in recreational MMOs and (iii) any transactions (in or out of world) involving mixed use MMOs or commercial MMOs. At the recreational MMO extreme, it does not seem fair or right to tax in-game transactions denominated solely and at all times in virtual currency. However, once MMOs move away from the pure recreational paradigm, the tax analysis becomes much more difficult.

There is no getting around that all in-world MMO transactions are exchanges or barters, either of property and/or services (which makes irrelevant whether in-world items rise to the level of "property"). In theory, if not in practice, barter and other exchange transactions are fully taxable in the absence of an applicable deferral, exclusion or exemption. As more and more real life success stories emerge from commercial and mixed use MMOs, the pressure to tax MMO-related transactions will continue to build. The key to MMO taxation is to delineate those circumstances under which an MMO transaction should or should not be taxable and, if taxable, to do so in a manner that is fair, practical and the least burdensome to MMO users and operators.

In-World Transaction and Recreational MMOs. Even though everyone's "gut feeling" is that purely in-game transactions in a recreational MMO should not be taxable, getting to the right answer still requires a high degree of technical analysis. A wholly in-game purchase of a +1 longsword for 10 gold pieces is an exchange, either of property (i.e., the right to use one in-world icon for the right to use another in-world icon) or services (i.e., coin gathering services for loot gathering services). However, the exchange should not be treated as a taxable event, because then every recreational activity involving two or more participants would result in a taxable exchange (based on the value of the exchanged services). To play tennis, at least two players must agree to hit a tennis ball over the net to determine who can score more points. Our tax system does not tax each tennis player on the value of the ball-hitting services provided by the other player. While no one had much reason to think about tennis match taxability before the advent of MMOs, the underlying rationale is probably that each tennis player is making a gift of his ball-hitting services to the opposing tennis player and, because gross income does not include gifts, no tax attaches to the tennis match.

For the same reason, wholly in-game transactions in a recreational MMO should not attract tax. To create the game experience (fantasy, science fiction, etc), players agree to "gift" their in-game services to the other players. Therefore, no player should be subject to tax on purely and wholly in-game transactions. However, because MMOs by their nature involve large numbers of anonymous players with no connection to each other apart from the MMO, the rules defining a what constitutes a "gift" should be clarified to include activities engaged solely and exclusively for recreational purposes. A similar result can be reached under the "unit of fun" theory mentioned already, although again this will probably require some regulatory clarification.

Real Life Transactions and Recreational MMOs. The "pharmer" category is easy to resolve fairly. If a player receives real life cash for an in-world item, then the player owes tax on the net income recognized on the transaction. A real life cash transaction is a clearly-defined realization event, without any accompanying intent or valuation problems.

However, MMO tax theory cannot begin and end with the "pharmers." Reversing the transaction flow shows the hole. What happens if an online economy in any MMO (recreational, commercial or mixed use) develops to the point where people will accept in-world currency for a real life services or property (which is already happening since, despite the best efforts of the MMO companies, people buy and sell character accounts and in-game items for real life cash). In a commercial or mixed use MMO, the issue becomes even more interesting if the in-world currency is used to make an in-world investment tied to real life asset. It is doubtful that the tax authorities will allow people to defer tax on real life transactions in this manner, especially if the phenomenon's real life dollar magnitude becomes significant.

At least to some limited extent, a complete theory of MMO taxation must take into account the real life value of in-world character accounts, currency and other items, where the parties are acting for non-recreational purposes. Thus, for example, both a service provider (on the providing of real life services) and a service recipient (on the sale of the in-game items) will have income when payment for the real life services is made using character accounts, in-world currency or other in-world items. Because it is difficult to value the in-world items (unless there is an established market for in-world items), the amount of income for both parties will be determined by reference to the value of the real life services (e.g., $150 of income for both parties if the going rate for a one-hour plumber visit is $150).

Transactions involving Mixed Use or Commercial MMOs. The current generation of MMOs (including the groundbreaking one discussed below) probably remain sufficiently "gamey" to preserve their non-taxable recreational MMO status. Thus, to some extent, this whole discussion is somewhat premature and largely academic. Nevertheless, when a true commercial or mixed use MMO finally arrives on scene, the MMO "rubber" will hit tax "road."

One groundbreaking MMO provides some insight into the commercial future of MMOs. As officially-sanctioned component of its game system, this MMO maintains a currency exchange under which its in-world currency is directly convertible into real life currency and grants the intellectual property rights to user-created content to the users creating the content. Because of its non-fantasy setting, this MMO is attracting real life businesses for a variety of commercial purposes (such as marketing, working group meetings and seminars). One user recently collected enough in-world currency for in-world services to become a millionaire (based on the prevailing exchange rate) in real life. User-created wealth of such magnitude is sure to draw eventual IRS scrutiny.

As technology and broadband access continue to grow and improve, it is likely that the next generation of commercial and mixed use MMOs will progress beyond these rudimentary beginnings and start to look more and more like real life. If the economic magnitude of the transactions conducted in these virtual worlds becomes significant, we can expect the IRS to tax in-world transactions as they occur, even before they translate into real life currency (especially if there is a currency exchange doing the heavy lifting on the valuation side). And, while there are strong arguments against taxing MMO transactions prior to real life cash-out, there is some risk that IRS could prevail under existing U.S. law.

* * *

So where do we go from here? One clear first step is to prevent any attempt to tax wholly in-game transactions in recreational MMOs. Without all the technical jargon about "gifts" and "units of fun," taxing MOB killing, skill usages and other activities occurring wholly within a recreational MMO is patently absurd and any attempt to do so will only lead to derision of the U.S. tax system in general. If any tax attaches to a transaction relating to a recreational MMO, it is only when the MMO transaction is part of real life transaction (e.g. the gold pharmer) and then only on actual cash-out. And, in any event, it should be made clear that recreational MMO operators never have any withholding, information reporting or other similar obligations. Everyone knows what the right result is; the technicians just need to agree on the supporting tax theory.

As for the MMO future, a "wait and see" approach is probably the best way to go at this point. Rapid technological change makes it difficult to predict whether true commercial or mixed use MMOs will ever appear and, if so, the nature of their economic activities. If commercial and mixed MMOs eventually become operational, then it will be necessary to determine whether there is any legal basis or significant fiscal need for imposing tax on in-world economic activities prior to real life cash-out. Just because something (for example, frequent flyer miles earned on business travel) is capable of being taxed does not mean it must be taxed, particularly if compliance and other economic cost significantly impair the additional tax revenues.

If the sky does fall and the IRS successfully imposes tax on in-world transactions in commercial or mixed use MMOs, then it is important to minimize the resulting compliance costs. MMO operators cannot have any withholding, information reporting or other similar obligations (e.g., 1099s), especially given that, with user-created content (including drops), it would be extremely difficult, if not impossible, for the operator to know what exists in-world at any given moment. Any attempt to do so will simply drive MMO operators to offshore jurisdictions that do not impose such compliance obligations.

In the end, the MMO community must educate the tax regulators about the nature of the MMO beast and why it is inappropriate to tax in-world transactions prior to real life cash-out. If MMO community fails in this regard, then we will probably end up with tax regulations that are overly burdensome, impractical and anti-competitive.

Posted Dec 13, 2006 12:05:37 PM | link

Barry Kearns says:

So would "units of fun" be... funits?

Posted Dec 15, 2006 1:22:21 AM | link

Amarilla says:

Andy : the world out there is much more than the USA laws , you know...and the Reality have this strange habit : we, as gamers, we dont give a squat rat on what you, the devs , or the tax-man , are thinking about it. I have an alt, an avatar, some skills and some items, and i'm selling them. You cannot do anything against this.
I'm living on the Bahamas, sue me.But my guess is that you aint gonna to.You have a Congress Man, a Law-maker , who is playing the game;he earns $ k/month , from an unregulated venture, wich is the SL. I've used to make some nice cash there , but not anymore, due the decreasing number of " investors " ( i wont call them " losers " or the alikle ).

Posted Dec 20, 2006 7:11:28 PM | link