LGJ: Virtual Taxation

Each week Mark Methenitis contributes Law of the Game on Joystiq ("LGJ"), a column on legal issues as they relate to video games:

It seems around this time every year, with W2s and 1099s filling mailboxes, that someone thinks it's a good idea to bring up the idea of taxing the virtual world. The irony really is that most of these discussions are far from complete and often only address one potential viewpoint that could be taken.

The latest commentary comes from the Washington Post (via GamePolitics) with further follow up on New World Notes based on a recent publication by the IRS. Their basic contention is that the essential difference in the Terms of Service between the Second Life model and the more traditional MMO model (i.e. World of Warcraft, Ultima Online, Everquest) would mean different tax treatment. I don't think it's nearly so cut and dry.

To get to the basic theory of the IRS in the US, the short version is 'all income is taxable.' This is the baseline that the entire income tax system is based on. Keep in mind, however, there are other taxes that exist in the US that are not part of this system: sales taxes, property taxes, import duties, etc. are all taxes, but not necessarily what we're talking about. To that point, there could be, for example, a transaction tax imposed on virtual goods that would have no bearing on an income tax discussion. That is to say, they could say 'For every transaction in virtual goods, the government gets 1%' or something to that effect, and while that is taxation of virtual worlds, it isn't an application of income tax to virtual worlds. Similarly, an additional tax could be imposed on the monthly fee you pay to play, but that isn't an income tax. Most of the debate stems from income tax, which is what this column will discuss.

Going back to the baseline of 'all income is taxable,' there are, of course, exceptions. These are the deductions and credits that most people are familiar with to some degree by virtue of paying taxes on an annual basis. And it's at this point we reach the first reason many of these discussions are moot: Virtual income is already taxed, or the seller is committing tax fraud.

Say I have a t-shirt store in the real world. When I sell a t-shirt, that income is taxable, subject to ordinary deductions. If I have a t-shirt store in Second Life and I sell a t-shirt, what has changed? The short answer from a tax perspective is nothing. The second I take the Lindens and convert them back to dollars, I have real world income, still subject to ordinary business deductions. I may make more or less per shirt in the real world or Second Life, but the basic mechanics are the same. To that end, the virtual income is already taxed at the point it is realized, presuming the seller is actually following the rules.

The IRS publication also goes into a second point, about whether trades between online goods needs to be treated as a barter transaction rather than on the cash out model I've just stated. While I can see the merits, that virtual goods do have 'value' and to the extent they are traded it is like trading goods, but that introduces needless complexity and, more importantly, would start down the path of other 'real good' applications to virtual goods, like depreciation and basis, which would again complicate the system.

I imagine not a lot of readers are familiar with basis, so I will explain briefly. Let's say I bought a sealed copy of Chrono Trigger for $70 when it came out. My basis would be $70 in the game. Let's also say there were some rebate on the game when I bought it, for $10. That would lower my basis in the game to $60. Then let's say I sold it on eBay a year ago. If I sold it for $100, I would theoretically have to report an income of $40. On the other hand, if it sold for $50, then I wouldn't be able to report the loss of $10. This theoretically applies to everything you buy and resell. Now imagine how much complexity that would add to items in virtual worlds. And that's just one element of the system.

There's a final point in the publication that I disagree with. They analogize items in a World of Warcraft model to chairs on a cruise ship to state that a sale of an in-game item isn't necessarily a taxable event because no property rights change hands. This is like if someone sold you the right to their chair on a cruise ship; because they don't own the chair and the cruise ship grants the right to use chairs to all patrons, there wasn't a taxable event. On the contrary, I don't think either is a transaction in goods at all, but rather the sale of a service. On the criuse ship, you're not buying the chair, you're basically paying someone for the time and effort it took them to get the chair and for them to give up use of it. Maybe it's the best spot on the deck, and that person was up at the crack of dawn to secure the spot. Similarly, if you're buying a character or an item in World of Warcraft, I'd argue you're basically paying for an already complete service, the act of leveling up the character or securing the item you want.

If the IRS wants to publish guidelines on virtual transactions, then that is their decision. However, in doing so it is my firm belief that they need to focus on uniformity and simplicity. In short, they need to produce guidelines that apply to all virtual worlds regardless of the structure of the ToS or the property rights the users have. To the same end, leaving it to a simplified 'on recepit of cash' system would make it easiest for the taxpayer. Yes, that means that potentially people could avoid cashing out virtual goods to defray a tax payment to a following year, but they will still incur a taxable event. A cash out system is the easiest to follow and the easiest to monitor, should that become necessary. I'm sure you'll be hearing plenty more about virtual taxation before anything actually happens, but given the budget crisis, it may happen sooner than I would have originally anticipated to help pay for yet another bailout.

Mark Methenitis is the Editor in Chief of the Law of the Game blog, which discusses legal issues in video games. Mr. Methenitis is also a licensed attorney in the state of Texas with The Vernon Law Group, PLLC and a member of the Texas Bar Assoc., American Bar Assoc., and the International Game Developers Assoc., where he is a board member of the Dallas chapter. Opinions expressed in this column are his own. Reach him at: lawofthegame [AAT] gmail [DAWT] com.

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