Previously, I wrote about whether a taxable event occurs when players of online virtual world games receive in-game currencies that can easily be converted into real-world money. Some people make a living from their online activities, and an argument can be made that they should be taxed on their profits like a real business. But most participate in these virtual worlds to have fun and do not think they should be taxed on their virtual activities. So where can the line between play and profit be drawn?

Today, let’s look at two possible solutions to this tax conundrum. One was implemented by Linden Labs, creators of the virtual world Second Life which has a two-way convertible game currency called the Linden Dollar. The other involves separating players into business users and casual users.

Before we discuss these solutions, it may be helpful to understand why a virtual world developer would even want to have a two-way convertible currency. After all, why would they want to risk putting themselves and their users in a position where they have to comply with tax laws?

The reason is money. The developers will charge a fee for every currency conversion transaction like banks and airports do when they exchange currencies. This can be a viable alternative to either charging a large up-front payment to play a game or using a monthly subscription fee. So this means that some people who play heavily and engage in many transactions will subsidize the casual players who do not engage in many transactions.

In 2019, Linden Labs announced that they would issue Form 1099Ks to U.S. residents who engaged in 200 or more Linden Dollar sale transactions totaling over $20,000 in a calendar year in accordance with the form’s instructions. The income reported on the Form 1099K must then be reported on the player’s income tax return with the appropriate deductions. This seems like a good solution since it is fair to assume that casual players have less than 200 Linden Dollar sale transactions and even if they did, the total of the transactions would not exceed $20,000.

But this system is not perfect. Some players might structure their in-game transactions so that they either do not exceed 200 or do not total more than $20,000 which can result in deliberate underreporting.

Similarly, it might not address the play vs. profit issue for some players. Even though they meet the 200/$20,000 threshold, they may not have cashed out the currency into the real world. This is a common problem for those who engage in online gambling inside these virtual worlds.

The other problem is possible double reporting. To understand this, pretend that a player’s Second Life account is connected to their PayPal account. If the 200/$20,000 transaction threshold has been met through cash-out transactions, it is possible that both Linden Labs and PayPal would issue a Form 1099K to the player since the transactions occurred through their platforms. While this can be addressed when preparing the income tax return, it is not foolproof. Some people will forget to include both income amounts wrongly thinking that they are duplicates which can lead to an automatic audit. Also, it is possible that the tax return may be subject to an audit because the numbers may appear suspicious. While in most cases, these can be resolved favorably, it is a pain for taxpayers to prove their case during an audit.

Perhaps a simpler solution to the play vs. profit conundrum is to require players to identify themselves as either a casual player or a profit player. How? By issuing in-game business licenses for the latter. I am only going to discuss generalities since specific solutions will be different for each virtual world.

Basically, players who do not have business licenses will have severe limitations on what they can do with the game currency. Transfers of currency between two nonlicensed players will either have daily limits or be banned. They may also be subject to limits on how much currency can be converted into real money. But the limits should not be so harsh so that players will not be able to enjoy the game.

Players who want to sell virtual items or provide in-game services for compensation must be required to apply for a business license. To get one, they must submit proper identification and tax information. Once licensed, they will not have the currency transfer limitations that nonlicensed players have. But their activities will be subject to tax reporting requirements including receiving Form 1099s which must then be reported on the player’s real world tax returns.

Issuing a license can be a simple solution to the play vs. profit conundrum instead of studying their in-game activities in order to figure out whether a player is a casual player or a profit-motivated one. The nonlicensed players’ in-game currency transactions will be so minimal that there are likely to be no large scale tax events. While those who engage in large-scale currency activities can be easily identified for tax purposes.

This column is cross posted at Above The Law