Asking Questions About Taxation in Virtual Worlds

I caught this one on the feed at SLCN - sorry I missed it in person (though it sounds like getting questions through may have been tough anyway). I really appreciate that Bryan is willing to take questions here too.

I ran a brief piece on this at VB earlier, focusing on one thing that I heard both Bryan and a U.K. tax specialist say in the last two weeks: that we could be looking at classifying virtual worlds profit as income pre-withdrawal/conversion. That seems like a new twist on this -- conventional wisdom as recently as six months ago seemed to be running toward it being taxable only upon withdrawal. I know Bryan came down somewhere in the middle on it, but I wonder if we're even closer to that end of the spectrum than he suggested.

Bryan - your argument seemed to be at least partly that the closer we get to real world transactions that use in-world currency, the closer we get to it being considered taxable gross income pre-withdrawal on the same grounds that "barter credits" are. I'd say we're essentially there already. I, personally, have paid to have code written for my web site using Lindens (and I expect I am not alone) and I keep hearing about real world hard-goods purchases using Lindens coming down the pipe. But here's the elephant in the room: a not insignificant part of the virtual world economy is already derived from the purchase of, well, real world services, hmmm... how to say this delicately... of an adult nature. How does the fact that users can already use Lindens to pay for phone sex -- and by the number of sites and individuals in-world advertising it, appear to do so in droves -- impact that analysis?

Hi Benjamin, great point. When thinking about the breakdown of the "fourth wall" (as I call it) or the "magic circle" (as others refer to it), I try to look at it from the viewpoint of the recipient of the putative income. My basic argument is that so long as the virtual currency is good only for more "play" (i.e. role-play), then it is merely imputed income. That is, the recipient is simply increasing the amount of play he or she is able to engage in. So if I am role-playing as a member of the world's oldest profession, my receipt of Lindens does not represent gross income to me because my skills (at merging vocal and graphic representations in a way the payor finds pleasing) only bring me the opportunity to engage in more role-play---either as a further provider OR a customer. Plenty of opportunity to tax the service provider at the time he or she cashes those Lindens into currency. There is no need to...er...penetrate the fourth wall and call the receipt of those Lindens gross income. That's my current view. That view might change if and when Lindens become either truly like barter club trade credits or become more like property (note that Linden Labs has ALWAYS been careful to characterise the use of Lindens as a "license" to engage in SL activities).

Hope that helps. -bryan

"That view might change if and when Lindens become either truly like barter club trade credits or become more like property (note that Linden Labs has ALWAYS been careful to characterise the use of Lindens as a "license" to engage in SL activities)."

This is probably the reason that Tier fees can't be paid in L$; it makes a clear distinction between play tokens and real money. I have been paid in L$ for some scripting work and, while it would be nice to pay a few months of tier on a sim with it, I now understand why I have to cash out first.

I was advised that the simplest solution was to consider tier fees to be expenses for my business (which is already involved in software development) and any cashed out amounts a simple business income. This seems to indicate that even rank and file tax advisers are looking at L$ in the same way.

However, as I am involved in scripting, it would seem that it would be easy for me to become involved in service for service exchanges in SL. I had planned on simply paying for any subcontracted code in L$ since I have them in world anyway and that would allow me to avoid the income realization on much of it; now I'm feeling less crystal about that. The code I receive may be a SL artifact, but I'm not sure that the I or the coder on the other side view producing LSL code as "role play". Nor is that code "limited" to SL: it can be cut and pasted into my version control system and in that regard is no different from any other text/code.

Looks like my simplest solution is to cash out periodically to ensure that realization of income is an easily traced event. It gets uglier when I contemplate 1099s though; everyone would need to be on the same page as far as declaration of income or some unhappy surprises might await people.

Paying In Lindens for Services

@John, to me it is not so much what services you provide to earn LIndens as what you can use them for. You provide in-world coding services (whether or not linked to the adult service-providers I won't ask ). I think my theater analogy is strong enough to deal with that. Scripts provide the props. In the theater world you would be akin to a scene designer or perhaps a propmaster. You are paid in props. Again, so long as the props remain useful only on the stage, I would argue that they represent, at best, imputed income. You can use them for play and your scripting services enhance your own ability to role-play in SL. If you cash out, of course, now you are transforming your "units of play" (as it were) into units of currency, which can be used to purchase any type of goods or services.

I took my first coding course when a senior in college in 1981. I learned Pascal. I wrote a great blackjack program. Still have the 5 and a quarter inch floppy. Problem is, my code/script cannot work outside the environment it was designed to operate in. That is, I have no compiler! So it has no value. Similarly, your scripting has value only because the programs running SL allow it to work. It certainly cannot be taken off the stage! Or, at least, I don't see how. But I am not an expert in that area.

As for specific tax advice about what you should report or not and whether you are under an obligation under section 6045 to send in a 1099 on your subs, I cannot speak to any of that. My comments should not be taken as giving anyone specific tax advice. Heck, I'm an academic. But I hope I give you some ideas you can take to your tax professional to get advice on how to report this stuff.

Regards, -bryan camp

Scripting Paid For In Lindens

@John, to me it is not so much what services you provide to earn LIndens as what you can use them for. You provide in-world coding services (whether or not linked to the adult service-providers I won't ask ). I think my theater analogy is strong enough to deal with that. Scripts provide the props. In the theater world you would be akin to a scene designer or perhaps a propmaster. You are paid in props. Again, so long as the props remain useful only on the stage, I would argue that they represent, at best, imputed income. You can use them for play and your scripting services enhance your own ability to role-play in SL. If you cash out, of course, now you are transforming your "units of play" (as it were) into units of currency, which can be used to purchase any type of goods or services.

I took my first coding course when a senior in college in 1981. I learned Pascal. I wrote a great blackjack program. Still have the 5 and a quarter inch floppy. Problem is, my code/script cannot work outside the environment it was designed to operate in. That is, I have no compiler! So it has no value. Similarly, your scripting has value only because the programs running SL allow it to work. It certainly cannot be taken off the stage! Or, at least, I don't see how. But I am not an expert in that area.

As for specific tax advice about what you should report or not and whether you are under an obligation under section 6045 to send in a 1099 on your subs, I cannot speak to any of that. My comments should not be taken as giving anyone specific tax advice. Heck, I'm an academic. But I hope I give you some ideas you can take to your tax professional to get advice on how to report this stuff.

Regards, -bryan camp

Hi all, the two posts purportedly from Prof. Camp are indeed from me. I just did not have my account set up. So those posts went through Caleb and one is still pending as I write this. I've emailed him that those were indeed from me. And I have a brand-spanking new account here, username of "MrTallChief." So posts from MrTallChief are, in fact, posts from me.

Regards, -bryan camp

Professor of Law
Texas Tech University School Thereof
1801 Hartford Ave.
Lubbock, TX 79409-0004
806-742-3990 x269 ("not a toll free number")

I caught some of the talk, but I didn't get to ask about my realization theory. The theory that I use to explain why I don't pay income taxes on my in-world income until I transfer the Lindens into dollars is because I don't have control of the Linden dollar balance. If Linden Research got out of Second Life tomorrow, they wouldn't owe me anything on a Linden dollar balance. Additionally, the Lindens aren't responsible for any error regarding my linden dollar balance due to glitches, so again, I don't have total control over my income.

This is also why if the Linden dollar balance becomes portable, I think it would be taxable then, because then it would be in the user's total control.

Am I missing a step in my analysis?

Wanted to say that this was one of the best guests at an inworld event I have listened to in 2 years of bring in second life. The speaker was able to put his descriptions into understandable scenarios that tied in very well with everyday issues that we business owners in second life deal with. The additional feedback through these commenta was a great addition that many speakers dont do. Kudos to all involved and i look forward to attending more of these events.

Control Issues

@Jessica, control is a very important idea in much of tax law. For example, the doctrine of constructive receipt turns on the idea of control. That doctrine (as stated in Treasury Regulation 1.451-2), provides that "income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is NOT constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions." Later, the regulation gives this example: "Generally, the amount of ...interest credited on savings bank deposits...is income to the depositors...for the taxable year when credited. However, if any portion of such...interest is not subject to withdrawal at the time credited, such portion is not constructively received and does not constitute income to the depositor...until the taxable year in which the portion first may be withdrawn."

It is important to note here what the regulation means by "substantial limitations or restrictions." It means legal restrictions and legal limitations, not practical or economic ones. So, on the one hand, the idea that Linden Labs could go bust tomorrow or could decide to simply shut down SL and never reboot is not the sort of "substantial limitation or restriction" that matters. That would be like saying the virtual credits I have in my bank savings account representing the (anemic) interest they pay me are not income because the bank could go bust or just not open for busines one day. All that really says is that I am at risk to lose my wealth, not that I have not accumulated wealth.

So if one analogizes your SL account to a bank account, then to the extent you COULD have cashed out your Lindens but CHOSE NOT to do so is of no nevermind. The Lindens were (as a matter of fact) available to you and there was no legal restriction on your ability to cash them out. Heck, does not LL even run an in-world exchange where you can buy and sell Lindens?

It is true that I have a legal right to demand that the bank had over U.S. currency to me based on the virtual credits reflected in my account balance. And I can order the bank to pay U.S. currency to someone I identify on a check. The bank is legally obligated to do so. And if the bank goes bust or refuses to honor my check, then it will owe me money. In contrast, as you point out, however careless Linden Labs may have been in its PR materials about residents "owning" virtual stuff, it has always been very careful in its EULA and TOS to say that the virtual currency of Lindens represent only a license right. So if they go bust or just close up shop or decide to shut down your account, there is some question of what rights you have against them. That depends on how a court will construe the EULA and TOS.

But the point is that even though Lindens are a "mere" license right, they still have readily identifiable fair market value and there is no legal restriction on your (a) purchasing inworld services with them or (b) converting them to U.S. bucks (through the SL Exchange).

The portability that is important is the cash-out. I don't think that converting Lindens to WoW gold will present the same cash-out issues. Both are units of play, although units of play for different games. So now you are moving props between two different stages and not from the stage to the audience. So I would not see that as a breach of the fourth wall. To quickly refer to one analogy I use in my paper, it's like the fact that you can take casino chips from one casino and use them in another does not make them income before you cash them out.

I'm afraid I've gone on way too long. I cover these and other questions in my paper "The Play's the Thing: A Theory of Taxing Virtual Worlds" which is available on SSRN at the link kindly given above.

Regards, -bryan camp

@ Geuis,

Thanks for the kind words. I quite enjoyed the experience.

I read your paper and would like to commend your clear language and vivid examples. I think the correspondence to casino chips in the D$ example is a strong one and the idea of imputed income a clear line that does make a lot of sense.

My concern would be that the clear line is being blurred by services such as Star Fruit. (There is another that I can't find the link for just now: they sell sculptures in world that are also shipped to the buyer in the real world, again for a L$ payment).

If imputed income is the primary wall, I would argue that allowing goods to be purchased directly in L$ is akin to accepting casino chips at the buffet; a practice that tears that wall down. If this is true, are there any fig leaves left after this becomes a common practice? Or is there a way to prohibit such activity in a meaningful (i.e., in a legal sense) that prevents these endeavors from exposing all L$ transaction to taxation? In your paper, you cover the idea that copyright could be a rent in the fabric, but I find far more cause for concern in services that simply tear down the wall entirely and allow me to spend L$ on real world, tangible goods.

Hi John,

My only thought to mix in with your good observations is that the law will often create fictions to maintain a particular status quo until such time as the disconnect between the fiction and the reality is too great. Then the law shifts. Law tends to formalism and the forms recognized by legal rules generally do not shift easily. There has to be quite some disconnect. I like to think of it as similar to how people remember faces. If you have been around on the planet long enough I suspect you have had the experience where the actual appearance of a old friend, or a family member, has changed incrementally and then, one day, you suddenly notice because your shorthand mental image of that person simply does not jibe with that person's appearance. The mental form no longer accurately reflects the new perceptual reality. That happens in the law a lot.

So I would expect that it would take something larger and more systemic than the occasional pizza or artwork purchase to breach the fourth wall to an extent that the tax law will notice. It does not trouble me that I cannot say with any certainty when that might occur. It might happen sooner, or later. I doubt there will be any one single dramatic cause. To shift metaphors again, it will take quite an accumulation of straws to break the camel's back. Sure, people might get all excited and point to the last straw as "the" cause. But that wll just be the point at which there are too many holes in the fourth wall to maintain the fiction. IMHO, anyway ..

Regards, -bryan camp

Professor of Law
Texas Tech University School Thereof
1802 Hartford Ave.
Lubbock, Texas 79423-0004

My last word

The above will need to be my last comment on this thread. It's been fun. Folks are welcome to contact me at Texas Tech. Regards, -bryan camp