Taxing Online Video Game Earnings

Published Categorized as Federal Income Tax, Tax
Taxing Online Video Game Earnings, Houston Tax Attorney

The advent of virtual worlds like Second Life and online video games has created a new form of commerce that raises a complex issue for tax professionals: should online earnings from virtual businesses be taxed?

The compensation for these businesses is paid in virtual currency, which can be converted to U.S. dollars. While traditional U.S. tax laws state that income or wealth earned by U.S. citizens or certain residents are taxable, the challenge lies in how the IRS can track and audit such income given the online nature of these businesses. The situation is further complicated by the fact that these games may allow taxpayers to stash cash and related records in no-tax or low-tax jurisdictions, making them difficult to track.

As online technology continues to advance, this problem is only set to worsen, and it may eventually force the U.S. to switch to a consumption-based tax system. The difficulties faced by the IRS in tracking foreign-issued credit card transactions highlight the challenges in addressing online video game earnings, making it clear that this issue will continue to pose challenges to the U.S. tax system.

Tax on Virtual Income

The question that arises is whether online earnings from virtual businesses should be taxed, given that compensation is paid in virtual currency that can be converted to U.S. dollars.

According to traditional U.S. tax laws, income or wealth accruing to U.S. citizens or certain residents are taxable, regardless of where they are earned. But the real issue lies in how the IRS would track such income, which is increasingly difficult given the online nature of these businesses.

The IRS would have to audit U.S. taxpayers to obtain their online records, which in turn would require IRS employees to access or play the online video games to identify those who should be audited. While this may be possible currently, it may not be a viable option in the near future as these games may allow taxpayers to stash cash and related records in no-tax or low-tax jurisdictions, which the IRS would be unable to locate without voluntary disclosure by the taxpayers.

The Size of the Problem

The problem is only set to get worse as online technology continues to advance, and the issue of taxing online video game earnings may eventually become big enough to force the U.S. to switch to a consumption-based tax system instead of the current income-based one. However, even these tax systems would face challenges in addressing online video game earnings.

One only has to consider the IRS’s recent challenges with foreign-issued credit cards. The IRS has not been able to even identify and track transactions, yet alone assign tax consequences to these transactions. The IRS’s primary method for doing so is relying on information-sharing agreements with foreign governments and financial institutions, as well as using data analytics and other technological tools.

The Foreign Account Tax Compliance Act (“FATCA”) does help in this regard. FATCA aims to prevent tax evasion by U.S. citizens and residents who hold assets in foreign financial institutions. FATCA requires foreign financial institutions (“FFIs”) to report certain information about their U.S. account holders to the IRS. This information includes the name, address, and taxpayer identification number (“TIN”) of each U.S. account holder, as well as the account balance, gross receipts, and gross withdrawals or payments from the account.

Given these laws, if a U.S. taxpayer has a bank account or investment account in a foreign country, that financial institution is required to report certain information about the account to the IRS. This helps the IRS track the taxpayer’s foreign assets and ensure that they are properly reporting any income earned on those assets on their U.S. tax returns. FATCA also requires U.S. taxpayers to report their foreign assets on a separate form called the Foreign Bank Account Report (“FBAR”) if the total value of their foreign assets exceeds certain thresholds.

Suffice it to say that it is not clear whether online video games or software are FFIs or whether this type of earnings would even trigger FBAR filing requirements.

Therefore, FATCA helps the IRS track and identify U.S. taxpayers who have assets in foreign financial institutions, which can include online video game earnings that are held in foreign virtual currency accounts.

These questions and problems are only exacerbated by online worlds and alternative methods used to store and transfer value.

The Takeaway

The rise of virtual worlds and online video games has brought up the issue of taxing online transactions, particularly when it comes to virtual income earned through these platforms. While traditional U.S. tax laws dictate that income or wealth earned by U.S. citizens or certain residents are taxable, the challenge lies in how the IRS can track and audit such income given the online nature of these businesses. As online technology continues to advance, this problem is only set to worsen, and it may eventually force the U.S. to switch to a consumption-based tax system. However, even these tax systems would face challenges in addressing online video game earnings. The IRS’s recent challenges with foreign-issued credit cards highlight the difficulties in tracking and assigning tax consequences to such transactions. Therefore, it is clear that the issue of taxing online video game earnings is a complex one that will continue to pose challenges to the U.S. tax system.

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