IRS Report Recommends Self-Reporting Virtual World Income; Second Life Singled Out Due To IP Rights Policy

In the latest annual report to Congress from Nina Olson, the IRS Taxpayer Advocate, a whole section is devoted to the taxation of income in virtual worlds.  You can read the .pdf file on the IRS site here, the pertinent portion beginning on page 213.  As the Washington Post notes, the general conclusion is that the US government should explicitly clarify its policies on such income, in order to encourage people to voluntarily report earnings from real money trading.  (Julian Dibbell will be pleased to know that his stunt in a regional IRS office is specifically cited as a case in point.)  The author does a pretty good job laying out the background, though some of the claims are questionable-- I'm not sure, for example, that 3,100 Residents "had average revenues of $20,000 in real U.S. dollars" in 2006, and in any case, according to more recent stats (reg. req.), only 606 are earning anything close to that.  (558 earn $2000/month or more.) 

For all Second Life users, however, this, I think, is the key point:

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... [Footnote comment:] 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.

In other words, if I read this correctly, it's less likely that income gained from traditional MMORPGs like World of Warcraft is clearly taxable.  Whereas Second Life earnings, due to Linden Lab's intellectual property rights policies, is a far more likely candidate for taxation.  Olson cites the analogy of a busy cruise ship: if one passenger sells the right to sit in his deck chair to another passenger, that's not clearly a taxable transaction, since the chair wasn't really the passenger's to sell.  On that view, World of Warcraft gold and valuable items are more like deck chairs.  Due to Second Life's IP rights policies, however, user-created content in Second Life is owned by its users.  And therefore, different.  It's more like, say, cartoons a passenger draws on the cruise ship's stationery and pencils, and then sells to other passengers.  (If you sold a drawing to a drunk oil tycoon for $10,000, I'm sure the IRS would like to be told.)

This seems like a fair reading of the situation; thus, it's also more likely a policy on Second Life income will eventually be drafted.  (Especially with two SLers on Obama's FCC transition team.)  There are actually advantages to declaring SL income on your tax form, of course-- you could then write off the cost of your computer, your broadband fees, Photoshop and other software you buy for content creation, etc. 

For that matter, you could probably print up a copy of your L$-to-US$ transactions, and declare that on your 1040 tax form now.  Will you be more likely to do so, if and when a policy was actually put in place? Hat tip: Kotaku.

Comments

[Ann Otoole]

At the rate things are going I seriously doubt there will be much income from SL for the IRS to worry about beyond 2009. Content theft is pretty much putting the idea of business in Second Life to bed permanently. Most people I know are giving up. They reason that there is no longer much incentive to create content in Second Life since it will land in a ripper's flea market the next day and Linden Lab does not stop people from putting the stolen content back out the moment it gets taken down.

It was a nice dream. But it is over. Maybe a serious company that does not use open source ideology will make a replacement in the next few years and we can start all over again.

[rbl]

That's just plain dumb, Ann. You might have noticed that the software industry, then the music industry, then the movie industry have all tried to protect digital content. They've spent hundreds of billions of dollars trying. And yet, I can go download the new Narnia DVD in less than 15 minutes.

Linden Lab doesn't have hundreds of billions of dollars to waste trying to fix the unfixable.

[Ciaran Laval]

Any report that tries to say there's a value to WoW gold when it's explicitly against the terms of service to sell Gold always strikes me as being uninformed.

Virtual world taxation is a messy business, for example the UK tax office have told me that transactions made entirely within a virtual world are not considered services for the purposes of VAT, therefore an inworld only business really shouldn't be exempt from paying VAT on their tier.

Then you get to the sticky situation of when is the currency actually taxable, in Linden dollar form it surely can't be as we don't really own it. Do we own it when we sell Linden dollars and it sits in our US dollar balance or do we only own it when we cash out?

The worry really is that the tax authorities deem the Linden dollar to be something of value, that would open a huge can of worms.

[Doubledown Tandino]

I'll be happy to begin paying US taxes again once the money the government stole from it's people (the bail-out money) is accounted for.

[Ann Otoole]

rbl, whoever you are since you will not post a recognizable name and be accountable for your comments, exactly how would Linden Lab removing stolen content from the asset system as well as in world and deletion of the account permanently if they reimport stolen content cost billions? The solution is policy and enforcement. Not magic code arms races. In addition if they did not have open source viewers then there would not be such a proliferation of rippers. Simple math really. It is a matter of management and accountability. But even with open source it would not cost billions for Linden Lab to enforce DMCA take downs properly and to deal with the repeat abusers. the point is that under the existing management Linden Lab is not doing anything to protect their most valuable assets: The actual content creators. If the real content creators stop then what is left is what RightAsRain and other LL business partners like to point out... piles of crummy prims and shoddy content or something like that. And bad content is not going to compel new accounts to reach one million concurrency. Linden Lab is the only people that can take the actions necessary to change the current downward spiral that a new fancy client viewer and web page cannot stop. It is all administrative overhead around policy creation and enforcement. And it will not cost billions lol.

Linden Lab is the shepherd of Second Life. There is no one else that can step up.

As for Ciaran's point... The day the L$ is declared a global currency is the day we start charging sales tax. And that is another interesting conversation that will one day play out.

[Seven Shikami]

Content theft has not deterred the 7Seas Fishing Game, or any of our other various fiascos, from pulling in five figures this year.

The key is to make something that doesn't rely entirely on selling textures in various forms, since anything can be cache ripped, screencapped, proxy-intercepted, etc. Instead, sell a service, sell a concept, sell scripting, and you'll be fine.

(Oh, and don't sell Naruto avatars and such. One of these days copyright holders are gonna look up and notice us and go scuz me wut r u doin' in thar, and then the lawsuits will hit the fan.)

As for taxes, this is nothing new. We're paying taxes on our income and even have an accountant to help us wrangle it all. The key is that it's not taxable until you "cash out" Linden funnymoney into real money -- at that point you've gained profit for whatever reason (selling virtual goods, cartoons to oil tycoons, lemonade stands, whatever) and it is taxable under current law.

[rbl]

"In addition if they did not have open source viewers then there would not be such a proliferation of rippers."

And dumb again. Sony didn't make an open source version of Blue-Ray, and yet it was hacked almost immediately (despite they're claim that it would last AT LEAST 10 years.)

"But even with open source it would not cost billions for Linden Lab to enforce DMCA take downs properly and to deal with the repeat abusers."

And then the rippers would find some new way to get around the enforcement, and LL would have to spend more to contain them. Repeat ad infinitum. It's EXACTLY the same fight as the big media companies. Except the big media companies are SERIOUS about winning (they're not just a bunch of whiny kids with photoshop) and they still can't win.

Yes, Ann, it would be nice if Santa Clause really existed. But seeing as he doesn't, can we please move on and stopping hoping he does?

-RBL

[Jane2 McMahon]

Income's income...and if Linden dollars are transferred into US cash, there are codes that cover it.

@RBL: IMO, "dumb", "stupid" and words of that ilk belong in a Yahoo chatroom, not in any reasonable discussion.

[Seven Shikami]

I gotta agree with RBL here. You can't beat copyright thieves with technology. Open and closed source systems have both been subject to content theft; it's irrelevant which one you roll with. No matter how much encryption you slap up, no matter how much money you pour into it, you can't get around someone reproducing your work even if they have to do it by hand or by analog hole -- screenshots or hell, even pointing a digital camera at the screen if somehow you found a way to secure a computer against screenshots, etc. It's all pointless.

Okay, so how about chasing them down with policy and law? That's good for after-the-fact punishment but it's not going to stop the content from getting lifted in the first place, and the gears of policy are slow things no matter how much money and manpower you throw at them.

Instead, you need to endeavor to be Better Than Free. Go read this.
http://www.edge.org/3rd_culture/kelly08/kelly08_index.html

We are no longer in a world where creation alone is a sacred and unalienable act. Adapt or perish. My businesses have adapted just fine and we're doing quite well.

[Hamlet Au]

Keep it civil, please.

[radar]

I do agree that Ann Otoole is misstating things by being overly dramatic. This really is the same tack the RIAA goes for, and DRM doesn't work well for anyone. I'm sure there is some content theft, but not to the level you think, Ann. I've never once bought anything that turned out to be a ripoff of someone else's stuff in SL, and I quite typically contact the creators of stuff I like and chat with them about their products.

Is there theft? Sure. Is it rampant? Is it the end of the world? Is everyone really quitting. No.

[Sigmund Leominster]

Oh that I could earn enough money in SL to be an IRS target! My guess is that the cost to the IRS of policing whether folks are making untaxed income from SL would be higher than the possible revenue generated.

And now I suppose I not only have to keep an eye out in Second Life for (a) women who are men, (b) men who are women, (c) men or women who are pedophiles, (d) terrorists, (e) CIA agents, but also (f) IRS investigators.

Henceforth, i think I'll stop talking to people.

[Annyka Bekkers]

I don't think content theft is nearly the boogieman many people make it out to be, and I don't think theft alone is putting anybody out of business. For example, Naughty Designs probably holds the title for Most Ripped-off Business in SL, and yet they still seem to make enough to pay tier and pay for an expensive classified ad every week, despite not releasing any new content in over a year. If Naughty, whose ripped skins turn up in every pirate chopshop around the grid, can still survive, I think others can too.

None of that has any bearing on the issue of taxes though (unless if by some feat of accounting wizardry, you could get away with writing off content theft as a business loss!)

Myself, I'm not going to start worrying about the IRS trying to tax inworld transactions and assets anytime soon. The difficulty of keeping track of it will make it virtually impossible to enforce. If they tried, it would shut down business and any hopes of collecting money, which isn't the IRS's intention, and it would cause a surge in inworld linden-laundering through multiple alts.

I still think the fairest way to tax virtual business is the simplest way. You pay tax on anything you cash out through Paypal into the real world, which is easy enough to report and track. I seriously doubt that the IRS is going to try to get more involved in virtual world business, other than define some terms around it.

[Ciaran Laval]

I agree largely with Annyka regarding the practical aspects of keeping track of transactions and that the common sense approach is the most sensible.

However my views on tax authorities are somewhat clouded after speaking to them, the UK government and the European Union on the VAT issue where the best they could come up with to justify the tax being applied to Second Life was that taxes are a sign of a civilised society.

I'm sure they'd love to get their noses deeper into the trough, hopefully common sense will prevail, it would be very costly to track inworld transactions, alas common sense isn't something that tax authorities always engage in, especially when they don't understand the comlexities of a product.

[Taxed]

US taxation laws have never stopped applying, regardless of source. Any LL income over $600/year is reportable for that tax year, *from the moment it's cashed in*. Similarly to real world money, tax is only due as soon as it is made available to you in a useable form. So for example, I'm not taxed on money that a vendor owes me, until the vendor actually makes that available to me, either as a check or by deposit. Similarly, no tax is due on LL account credit, but you're liable the moment you cash it in. I don't know why anyone would think this is a gray area... it's not.

[Taxed]

And, I should mention while I'm at it... all the IRS has to do is compel LL to record the SSN of anyone getting more than $600 in a calendar year, and then issue 1099 forms. If the IRS thinks too much money is sloshing around, they will compel LL to do so. Many other entities like Paypal/Ebay, Cafepress, and so on, have been forced to for years. We really don't need to reinvent the wheel here.

[Iggy O]

I need to study the IRS document, not because I make any money from SL, but because it interests me as an evolutionary change in how the government regards this unreal spaces.

@Annyka--your suggestion seems reasonable. If one never cashes out, but keeps the virtual currencies in circulation, is it "income" according to the IRS definition?

Meanwhile, I'm going to design a virtual eye-shade (the old accounting ones with the clear green visor) for the virtual IRS auditors who will be coming in-world. I'll report my income from this venture. But only when I cash out.

[HatHead Rickenbacker]

Since there is no law in the US that says you must pay federal income tax and, in fact, that taxing the labor of private citizens is unconstitutional (taxes must be either direct nor apportioned - income tax in neither), tax on virtual income is still exempt.

[Caliburn Susanto]

@HatHead -- Uh huh. I totally agree with you. (Really, I really do!)

And so does Wesley Snipes.

[Tabliopa Underwood]

I think would be absolutely wonderful for me if the taxman wanted to cut himself in for a piece of my inworld activity.

I be able to create a inworld company and channel everything through it and then write off all my losses against my realworld income. And when I come out ahead inworld then I only have to give the taxman some of it.

The great thing about this cunning plan is that I always have losses =)

[Annyka Bekkers]

@Iggy O. The gray area is that the IRS hasn't decided anything on inworld money yet. There's a chance that they might rule that its reportable and we have to pay taxes on inworld earnings *before we cash them out*.

[Dedric Mauriac]

Printing out L$ to US$ transactions may not be enough. Although Linden Lab's states that you now have a credit of US$, you still do not "own" that money until it is sent to a bank. I believe there are legalities here that go with this idea, but I need clarification. I think the only thing we could report is how much US$ we pay to Linden Lab (for L$/Tier), and how much US$ we transfer back to our bank accounts from Linden Lab. I am assuming that if I sell my L$ to pay for tier, but I never transfer US$ from Linden Lab to my bank, then I am in the clear. Linden Lab has had "ownership" of my funds the whole time.

[Melanie]

Ooh... I guess I'd best start hanging onto receipts and stuff more carefully! I'm planning on buying a new system later this year; it'd be nice to write it off!

[Arcadian Vanalten]

Actually, yes, Melanie, if you make RL income off of SL, you should be able to deduct the cost of your PC as a business expense against the income it generates.

God, I'm glad I quit private practice. Wrangling with the tax code is such a headache.

[FLeeF]

I know this is an old article and sorry for resurrecting it, but I'm in need of a U.S. tax preparer who's knowledgeable with virtual world businesses specifically in SL. I want to find out how can I deduct the yearly rent on a sim and all of the overhead I've devoted profits to in-world.

And about LL ever issuing me a 1099? Heck I am seriously thinking about submitting one to them for the services rendered to me! I don't work for LL, and am not an independent contractor of theirs. They have profited from my business by taking transaction fees, exchange fees and tier costs, etc. off the top of my creations totaling way over $600 this last year.