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Virtual Economy Found To Need IRS Guidance

by Mike Godfrey,, Washington

24 June 2013

Given that transactions within virtual economies could produce taxable income in various ways, the United States Government Accountability Office (GAO) has recommended that the Internal Revenue Service (IRS) should find ways to provide information to taxpayers, such as on its website, on the basic tax reporting requirements for virtual currencies.

Recent years have seen the development of virtual economies, such as those within online role-playing games, through which individual participants can own and exchange virtual goods and services. Within some virtual economies, virtual currencies have been created as a medium of exchange for goods and services.

Transactions within virtual economies, or using virtual currencies, can therefore produce taxable income, depending on the facts and circumstances of each transaction. Transactions within a "closed-flow" virtual currency system do not produce taxable income because the virtual currency can be used only to purchase virtual goods or services. An example of a closed-flow transaction is the purchase of items to use within an online game.

However, in an "open-flow" system, a taxpayer who receives virtual currency as payment for real goods or services may have earned taxable income since the virtual currency can be exchanged for real goods or services, or readily exchanged for government-issued currency, such as US dollars.

Some virtual economies may function similarly to barter exchanges, where bartering is the exchange of goods or services in lieu of monetary payments. For example, a carpenter may build a desk for a dentist in exchange for dental work. Barter transactions are taxable transactions, and taxpayers must report the fair market value of the good or service received on their tax returns.

These innovations raise questions about related tax requirements and potential challenges for IRS compliance efforts, but the extent of actual tax noncompliance is unknown. Taxpayers may well not be aware that income earned through virtual economies or currencies is taxable, or not know how to calculate such income.

Because of the limited reliable data available on their size, it is difficult to determine how significant virtual economy and currency markets may be, or how much tax revenue is at risk through their usage. Some experts with whom the GAO spoke indicated a potential for growth in the use of virtual currencies.

The IRS has assessed the tax compliance risks from virtual economies since 2007, and in 2009 posted information on its website on the tax consequences of virtual economy transactions. The web page points out that, in general, taxpayers can receive income in the form of money, property or services from a virtual economy, and that if taxpayers receive more income than they spend, they may be required to report their gains as taxable income.

The page further states that the IRS has provided guidance on the tax treatment of issues similar to online gaming activities, including bartering, gambling, business, and hobby income, and provides links to IRS publications on those topics.

However, according to IRS officials, the agency has not provided taxpayers with information specific to virtual currencies because of other priorities, resource constraints, and the need to consider the use of these recently-developed currencies.

According to the GAO, by not issuing guidance, the IRS may be missing an opportunity to address virtual currency tax compliance risks. Given the uncertain extent of noncompliance with virtual currency transactions, formal guidance, such as regulations, may not be warranted, but the GAO recommended that the IRS should, instead, develop more timely and less costly informal guidance.

That guidance could be based on the information IRS already provides to taxpayers on its website on the tax consequences of virtual economy transactions, and would be consistent with IRS's strategy for preventing and minimizing taxpayers' noncompliance by helping them understand and meet their tax responsibilities.

TAGS: individuals | compliance | tax | business | tax compliance | commerce | law | Internal Revenue Service (IRS) | tax authority | internet | e-commerce | United States | currency | regulation | services

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