What GAO Found
Transactions within virtual economies or using virtual currencies could produce taxable income in various ways, depending on the facts and circumstances of each transaction. For example, transactions within a "closed-flow" virtual currency system do not produce taxable income because a 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. In an "openflow" 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 governmentissued currency, such as U.S. dollars.
Virtual economies and currencies pose various tax compliance risks, but the extent of actual tax noncompliance is unknown. Some identified risks include taxpayers not being aware that income earned through virtual economies or currencies is taxable or not knowing 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 we spoke indicated a potential for growth in the use of virtual currencies.
Beginning in 2007, IRS assessed the tax compliance risks from virtual economies, and in 2009 posted information on its website on the tax consequences of virtual economy transactions. However, IRS 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 IRS officials. By not issuing guidance, 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. According to IRS officials, formal guidance requires extensive review, which adds to development time and cost. However, IRS may be able to develop more timely and less costly informal guidance, which, according to IRS officials, requires less extensive review and can be based on other existing guidance. An example is the information IRS provides to taxpayers on its website on the tax consequences of virtual economy transactions. Posting such information would be consistent with IRS's strategy for preventing and minimizing taxpayers' noncompliance by helping them understand and meet their tax responsibilities.
Why GAO Did This Study
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. Virtual property and currency can be exchanged for real goods, services, and currency, and virtual currencies have been developed outside of virtual economies as alternatives to government-issued currencies, such as dollars. These innovations raise questions about related tax requirements and potential challenges for IRS compliance efforts.
This report (1) describes the tax reporting requirements for virtual economies and currencies, (2) identifies the potential tax compliance risks of virtual economies and currencies, and (3) assesses how IRS has addressed the tax compliance risks of virtual economies and currencies.
To accomplish these objectives, GAO reviewed tax laws, IRS guidance and program documents, federal program internal control guidance, and interviewed IRS officials and knowledgeable experts on the topics.
What GAO Recommends
GAO recommends that IRS find relatively low-cost ways to provide information to taxpayers, such as on its website, on the basic tax reporting requirements for virtual currencies. In commenting on a draft of this report, IRS agreed with our recommendation.
For more information, contact James R. White at (202) 512-9110 or firstname.lastname@example.org.
Beware BitCoin Users: The Tax Man Cometh! Paul with the SecurityLedger writes: Beware you barrons of BitCoin – you World of Warcraft one-percenters: the long arm of the Internal Revenue Service may soon be reaching into your treasure hoard to extract Uncle Sam’s fair share of your virtual treasure.
That’s the conclusion of a new Government Accountability Office (GAO) report on virtual economies, which found that many types of transactions in virtual economies – including bitcoin mining and virtual currency transactions that result in real-world profit – are likely taxable under current U.S. law, but that the IRS does a poor job of tracking such business activity and informing buyers and sellers of their duty to pay taxes on virtual earnings.
The report, “Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks” (GAO-13-516) was released this week. It was prepared in response to a request from the U.S. Senate Committee on Finance, which asked GAO to look into virtual currencies and the IRS’s approach to addressing their tax implications. The GAO said that the IRS’s tax treatment of virtual currency transactions is lax, and that the growing use of virtual currencies like BitCoin and virtual game currencies warrants the U.S.’s tax collection agency to mitigate the risks. Those include efforts to educate taxpayers and the publication of basic tax reporting requirements for transactions using virtual currencies.
Virtual currencies have gained favor in recent years, as the sophistication and complexity of virtual economies have grown. In-game currencies for virtual environments like Second Life (Linden Dollars), The Sims (Simoleons) and World of Warcraft (WoW Gold) have sprung up as a way for players to buy and sell virtual goods. While the currency is often earned in exchange for in-game activity and labor, many virtual currencies can also be purchased with real-world currency through in-game or third party exchanges. The exchanges have attracted the attention of law enforcement, who recently cracked down on Liberty Reserve, a Costa Rica-based virtual currency firm popular among cyber criminal groups.
GAO said that strict virtual (or “closed flow”) transactions in which virtual currency is used only within a game or virtual environment to purchase virtual goods and services were not taxable. However, so called “hybrid” and “open flow” virtual currency systems, in which real world currency is used to buy virtual currency, which is then used to buy or sell virtual- or real world goods and services are subject to U.S. taxes.
Some virtual economies in massively multiplayer online role-playing games (MMORPG) like World of Warcraft are “hybrid” systems in which in-game economic activity can spill into the real world via third-party transactions in which virtual goods are exchanged for real money, GAO said.
Virtual currencies like BitCoin and the Linden Dollars of used-to-be-cool virtual environment Second Life are examples of open flow systems in which virtual currencies can be used to purchase both real and virtual goods and services, then exchanged for real world currencies like the U.S. dollar.
GAO provides a number of examples of virtual transactions that are subject to taxation that, in all likelihood are not taxed. They include “John,” a resident of Second Life, who rents a virtual property to other residents who pay him in Linden dollars. “At the end of the year, John exchanges his Linden dollars for U.S. dollars and realizes a profit. John may have earned taxable income from his activities in Second Life,” GAO said.
There is also the example of “Bill” the Bitcoin miner who successfully mines 25 bitcoins. “Bill may have earned taxable income from his mining activities,” GAO said.
The problem with virtual currencies is similar to the challenges the IRS has in capturing other kinds of economic activity, such as cash transactions and barter, where records and third party reporting is lax or non-existent, GAO said. Still, the growing popularity of virtual currencies and exchanges pose unique risks, including lost tax revenue and tax evasion by way of virtual currencies like Bitcoin.
While the extent of the virtual currency problem isn’t known, and in light of the IRS’s sequester-based staffing issues, GAO recommended that IRS take mostly low-cost steps to address it, rather than mounting a large and expansive campaign to crack down. IRS should publish clear guidance of what kinds of online transactions are taxable and clarify third party reporting requirements to counter misinformation that is circulating. However, as the extent of virtual currencies and economies grow, IRS may find it needs to take bolder steps to bring virtual economic activity into line with other kinds of transactions, GAO said.