IRS Looks at Virtual Worlds

The IRS office of the National Taxpayer Advocate released on 1/7/09 its 2008 Annual Report to Congress. The report identifies tax issues related to virtual worlds as a "Most Serious Problem" and features a 13-page section entitled "The IRS Should Proactively Address Emerging Issues Such as Those Arising from 'Virtual Worlds'"(starting on page 214 of volume 1). The chief concern for the IRS is summarized as follows:

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.

More specifically:

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. So when counting income for tax purposes, should virtual currency be discounted to reflect that risk?

The report notes the significant economic value of many items and avatars in virtual worlds, even observing that some of the limitations set forth in TOS and EULA contracts "may not be enforceable under state law." The problem, according to the National Taxpayer Advocate, ultimately boils down to economic activity:

The economic activity in virtual worlds is significant.…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.

The report states that one of the biggest obstacles to introducing taxes to virtual worlds is the issue of valuation:

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?

The report also raises a sticky issue that has intrigued me for a while now, and that is the ability of virtual world operators to arbitrarily terminate an account and confiscate its holdings. Although people often talk about their accounts in World of Warcraft or Entropia like they were regular financial possessions, in the real world banks can’t simply decide to confiscate your checking and savings accounts. In the realm of taxation, it would seem to me that this risk permeates all virtual world accounts and diminishes the value of any obtained assets. In certain real world situations, such as divorce proceedings, civil litigation and the federal estate tax, it is common to apply discounts to the market value of assets when another party has ultimate control over that asset or there is a lack of marketability. While not intended to cover virtual assets, there are obvious similarities. The National Taxpayer Advocate’s report picks up on this issue:

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.

I think one of the most remarkable aspects of the NTA’s report is what it does not embrace: the much-discussed distinction between game worlds like World of Warcraft and non-game worlds like Second Life. The NTA report goes into some detail describing structured and unstructured worlds, specifically referencing World of Warcraft and Second Life. However, the report’s analysis and recommendations appear devoid of any reference to the type of world. Gold and armor in World of Warcraft is just as much a taxable item as selling virtual homes and t-shirts are in Second Life. Personally, I do not find the lack of distinction surprising, because it’s always seemed silly to me to try to categorize economic value based on intent or some contrived definition of a “game world” (I previously blogged on this here). Economic value is what it is, and whether you got through selling virtual armor or virtual homes is irrelevant. However, this distinction seems to be awfully important to some observers and researchers addressing issues of virtual worlds and taxation (for instance, see here and here). While certainly not final, I suspect the mindset embraced by the NTA regarding this aspect of virtual worlds will carry over to other divisions of the IRS as well.