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Federal Income Tax

Taxing Online Video Game Earnings

I came across this very interesting article about taxing online video game transactions. This type of issue does show the flaw or challenge presented by a tax system that is dependent upon the concept of “income” and the problem is likely to become a much more serious problem for the US Treasury.

It is now possible to operate a business wholly online in the online game “Second Life.” For example, I could probably operate my law practice online. In that case I (and even scarier, non-attorneys) can provide legal advice and earn compensation in Linden dollars and I can convert those dollars to US dollars. The question then is whether my law practice earnings are not taxable simply because the legal advice or business was conducted wholly online and the compensation therefore was paid online (and remember there is a federal moratorium that prevents states from taxing certain internet activities)?

The answer is clear under traditional US tax laws. Income or accessions to wealth by US citizens or certain residents are subject to tax, no matter where they are earned. But that leaves the question as to how the IRS would track the receipt of online video game income.

The answer is that the IRS would have to audit US taxpayers to obtain their bank records. This would mean that the IRS would have to have IRS employees play the online video games in order to tell who should be audited (or in the case of the Second Life game, the IRS may have to set up an online IRS office). While auditing US taxpayers to locate online video game income could be a possibility now, it may not be in the very near future.

In the very near future these games could allow US taxpayers to stash cash and the records pertaining to that cash in no-tax or low-tax jurisdictions. In that case the IRS would have next to no ability to locate the income if taxpayers did not voluntarily report the income to the IRS (and that doesn’t even get into the tax treaty implications).

There can be little doubt that this issue will continue to diminish the US tax base as online technology and use of that technology increases. This issue may end up being big enough that it forces the US to convert to a consumption-based tax, rather than an income-based tax. But even those tax systems would have some problems addressing online video game earnings.