DRAGONS, ORCS, THE IRS AND CONGRESS
By Ryan K. Carnes, J.D., LL.M. 1
Massively Multiplayer Online Role-Playing Games (“MMORPG’s”) provide users with
an outlet to escape reality where they slay dragons, create alliances, and define fantasy heroes.
As the battle escalates in the world of Azeroth, Congress and the Internal Revenue Service
(“IRS”) continue to take an incorrect approach towards taxing transactions involving virtual asset
acquisitions.
This article looks at the different methods of virtual asset acquisitions in World of
Warcraft (“WoW”) and analyzes these methods to determine whether or not these asset
acquisitions are taxable as a matter of law. In addition, the article discusses the current approach
that the IRS is taking with regards to taxing virtual asset acquisitions and provides a critique of
the current approach.
WoW is one of the most popular MMORPG’s with more than 9.6 million subscribers
worldwide. The main objective in WoW is to develop and improve your character. This process
of development and improvement encompasses the acquisition of virtual assets such as swords,
shields and in game currency. In WoW, virtual assets can be acquired in one of three ways, two
of which are permissible and one of which is impermissible. 2 The first permissible approach is
through what is known as a “loot drop.” 3 A loot drop occurs once a user acquires a virtual asset
after he kills a creature or discovers a secret passageway. The second permissible approach is
known as a “loot trade.” 4 A loot trade occurs once a user trades virtual assets with another user.
The third method of virtual asset acquisition is known as a “real money transfer” (“RMT”), 5 and
stands as the one impermissible approach to virtual asset acquisition. RMT’s occur when a user
sells his virtual asset for real money outside of the game. WoW’s usage agreement strictly
forbids the latter method of virtual asset acquisition. 6 With regards to ownership rights, WoW’s
usage agreement clearly states that the user has no ownership or other property rights in his
virtual assets. 7
To determine whether any of the above methods of virtual asset acquisition can result in a
taxable transaction as a matter of law, it is necessary to determine how the Internal Revenue
Code (“Code”) defines income. The catchall provision of Section 61 states that gross income is
all income from whatever source derived. 8 Section 63 of the Code defines taxable income as
gross income minus allowable deductions. 9 Congressional intent is clear: when in doubt as to
1
Copyright 2014 by Ryan K. Carnes, J.D., LL.M.
Scott Wisniewski, Taxation of Virtual Assets, 2008 Duke L. & Tech. Rev. 5, 6 (2008).
3
Id. at 8.
4
Id.
5
Id. at 11.
6
Us.blizzard.com
7
Us.blizzard.com
8
26 U.S.C. §61.
9
Id. §63.
2
whether something should or should not be included in gross income, it should be included in
gross income.
In 1955, the Supreme Court stated, in Commissioner v. Glenshaw Glass, that if a situation
created an “undeniable accession to wealth, clearly realized, and over which the taxpayers have
complete dominion,” there is gross income. 10 Herein lies a few limitations on gross income.
First, to be considered gross income, there must first be a gain, or some accession to wealth. In
order to have a gain, there must be some measurement of the taxpayer’s wealth and the change
therein from one point in time to another. 11 This measurement of wealth is generally represented
by the fair market value of the good or service received. Section 61(a) of the Code provides
examples of ways in which one could receive a gain. These examples include interest, rent,
pensions and gains derived from dealings in property. 12
Secondly, there must be realization. According to the Supreme Court’s 1991 decision in
Cottage Savings v. Commissioner, “Section 1001(a) provides a straightforward test for
realization: to realize a gain or loss in the value of property, the taxpayer must engage in a “sale
or other disposition of [the] property.”” 13 The Court further stated that the sale or exchange of
property gives rise to realization only if the properties are “materially different.” 14 “So long as
their respective possessors enjoy legal entitlements that are different in kind or extent,” the sale
or exchange is materially different. 15
It naturally follows that the taxpayer must have property rights in that asset for the
recognition requirement. Property is often described as “a bundle of rights.” 16 Those rights
generally include the right to exclude, use, possess and/or alienate with respect to that property. 17
The first method of virtual asset acquisition discussed above was a loot drop. A loot drop
occurs when a user defeats an enemy or provides some service in exchange for a virtual asset
such as in game currency or a new weapon.
The first obstacle for determining taxability focuses on the concept of gain. In order for
there to be a gain, there must be some accession to wealth. Whether or not there is an accession
to wealth is determined by a positive change in position by the taxpayer, which is generally
measured by fair market value.
In the case of a loot drop, there seems to be a clear gain. Assume that on day one an Orc
has, at his disposal, two bronze shields, one silver sword and nine gold coins. After taking part in
a quest on day two, the Orc has three bronze shields, one silver sword, one wooden sword and 15
gold coins. A simple online search reveals that each bronze shield can be sold for $1 U.S., each
silver sword can be sold for $2 U.S., each wooden sword can be sold for $6 U.S. and each gold
10
Marvin A. Chirelstein, Federal Income Taxation, 11 (15th ed. 2009).
Id.
12
26 U.S.C. §61(a).
13
Chirelstein, Federal Income Taxation, at 237.
14
Id. at 240.
15
Id.
16
Adam Chodorow, Ability to Pay and the Taxation of Virtual Income, 75 Tenn. L. Rev. 695, 713 (2008).
17
Id.
11
9
coin can be sold for $.50 U.S. The Orc’s gain can be determined by measuring his position after
the quest ($18.50) against his position before the quest ($8.50). Due to the loot drops gathered on
his quest, the Orc had an accession to wealth equal to $10.00 U.S.
The second limitation to taxation is the realization requirement. Although there is no
unitary acceptance of one single definition of realization among scholars, “federal income tax
law states that a realization event occurs when there is a sale or exchange of property that is
materially different in kind.” 18 According to the IRS, gains resulting from the ownership of
property are often taxable. As noted above, Section 61(a) of the code states that gross income
means all income including, but not limited to, gains “derived from dealings in property.”
Many scholars believe that the essential factor in determining whether virtual assets can
be taxed depends on whether the IRS determines that an individual has property rights in his
virtual asset. 19 As noted above, WoW’s usage agreement clearly states that the user has no
ownership or other property rights in his virtual assets. 20 However, the discussion does not end
here. As in contract law generally, courts will often apply the concept of “substance over form”
when analyzing a contractual agreement between parties. This principle revolves around the idea
that a court will likely analyze a contract as it reflects reality as opposed to adhering to its strict
legal form. 21
Viewing loot drops in light of the “bundle of rights” theory of property law discussed
above and which, in conjunction with the substance over form doctrine, it appears that loot drops
likely constitute property. 22 Under the bundle of rights theory, one possesses property rights in
that which he possesses the rights to exclude, use, possess, and or alienate relative to that piece
of property. In WoW, these property rights exist regardless of what the usage agreement states.
Take for example the Orc and his gold coins. The Orc excludes others from using his gold coins
by holding onto them, he uses them to purchase other goods, he possesses them because they are
part of his game account and he alienates them when he gives them to another user. Although
WoW’s usage agreement clearly states that the user has no ownership or other property rights in
his virtual assets, viewing the agreement, or contract, through the lens of substance over form
suggests that the property rights actually belong to the user. As one scholar noted, more property
rights creates a stronger argument for realization. 23
The next step in the realization analysis involves the concept of materially different. To
be materially different, the taxpayer must simply enjoy a legal entitlement in the property that is
different in kind or extent. As long as the user is said to have property rights in his virtual asset,
this requirement is easily fulfilled because once WoW credits the users account with the virtual
asset, his legal entitlement in the asset is different than it was before. 24 He now has a legal right
to exchange that asset, for example, which is a right that did not exist before the acquisition. 25
18
Id.
Camp, The Play’s The Thing, at 48.
20
Us.blizzard.com
21
Chung, Real Taxation, at 756.
22
Id.
23
Camp, The Play’s The Thing, at 47.
24
Id. at 55.
25
Id.
19
10
The second method of virtual asset acquisition referred to above was a loot trade. A loot
trade occurs when a user trades virtual assets with another user. As noted above, owning
property can produce income through the exchange or alienation of property. It is a wellestablished principle that money need not be received in exchange for property in order for a
taxable event to occur. 26 For example, a surgeon who provides dental work for a client in
exchange for a shotgun must include the value of the shotgun in his gross income. According to
the IRS, the dentist is required to act as though he sold the shotgun for cash and deposited the
cash into his bank account. This type of transaction commonly referred to as “bartering” results
in a taxable event. Just as bartering requires the surgeon to recognize gain when he exchanges
dental work for a shotgun, so too does it require the Orc to recognize gain when he exchanges his
shield for gold coins.
Currently, IRS treatment regarding the taxation of transactions involving virtual asset
acquisitions is limited to what is known as the “cash out” rule. 27 Under the cash out rule, virtual
gain is not taxed so long as it stays “in world”; it becomes taxable when it is turned into profit in
real currency and transferred out of the game. 28 Applying the cash out rule, the only method of
virtual asset acquisition discussed above that is taxable is the RMT.
Although the IRS’s current approach to the taxation of transactions (virtual asset
acquisitions) should be applauded for its simplicity, the cash out rule is the incorrect approach to
apply. As exhibited above, valid arguments exist to support the position that transactions
involving virtual assets are subject to taxation regardless of whether the user converts his virtual
income into U.S. dollars. Not taxing transactions that are taxable as a matter of law results in
noncompliance. Noncompliance negatively impacts the reputation of the IRS.
Further, real tax receipts are being left on the table by adhering to the cash out rule.
According to one economist, “the time spent in one of the many virtual worlds generated about
$3.42 per hour, which represented a gross national product (“GNP”) of about $135 million and
per capita GNP of about $2,266 - roughly equivalent to Russia and higher than in many
developing countries.” 29 “In 2006, one person was reported to have become a millionaire by
developing and selling virtual real estate in Second Life, and about 3,100 residents of Second
Life who earned a net profit were reported to have generated average annual revenues of $20,000
in U.S. dollars.” 30 Failure on the part of the IRS to exercise its power to the fullest extent is
resulting in lost revenue.
Lastly, failure to tax transactions involving virtual asset acquisitions to the fullest extent
opens the door for tax evasion. MMORPG’s provide a level of anonymity to the user and virtual
asset transactions are difficult to trace. It naturally follows that a refusal on the part of the IRS to
26
G. Martin Bingisser, Federal Tax Consequences of Virtual World Transactions, 5 Shidler J. L. Com. & Tech. 7, 9
(2008).
27
Chung, Real Taxation, at 749.
28
U.S. Gov. Accountability Office, Virtual Economies and Currencies, (May 2013).
29
National Taxpayer Advocate, 2008 Annual Report to Congress, 216-217.
30
Id. at 217.
11
monitor and tax virtual asset transactions fully only encourages individuals to engage in such
transactions to evade tax.
On May 15, 2013, the U.S. Government Accountability Office (“GOA”) submitted a
report to the Committee on Finance in response to a request by the IRS to review virtual
economies and currencies and the IRS’s approach to addressing tax implications related thereto.
In its response, the GOA recommended that the IRS not make costly compliance adjustments to
the IRS’s current approach due to the uncertainty about the extent that virtual currencies are used
in taxable transactions and any associated noncompliance. 31 In conclusion, the GOA encouraged
the IRS to provide further information to taxpayers on virtual currencies and taxable transaction
via the IRS website as opposed to providing formal guidance through the Code or Treasury
Regulations. 32 The IRS agreed with the GOA recommendation. 33
By all indications, virtual worlds are here to stay and will likely continue to grow in both
membership and generated revenue. Based upon the GOA’s report and the IRS’s response
thereto, it seems as though Congress and the IRS will maintain the status quo. Until Congress
and the IRS make adjustments to their approach towards taxing transactions involving virtual
asset acquisitions, a strong revenue stream will go untapped and negative tax policy implications
will likely follow.
31
U.S. Gov. Accountability Office, Virtual Economies and Currencies, (May 2013).
Id.
33
Id. at 17.
32
12