Ever wish you could live a double life?  Growing numbers of people do every day.  At least, virtually, courtesy of a San Francisco-based Linden Lab which has introduced a virtual world called Second Life in 1999.

Second Life describes itself on its website as: “a 3-D virtual world entirely built and owned by its residents. Since opening to the public in 2003, it has grown explosively and today is inhabited by a total of 1,110,224 people from around the globe.”

I’ll admit that I’ve never participated in a virtual world (if you don’t count law school). And I’ll bet that most of the agents and policy-makers at the Internal Revenue Service or Congress haven’t either. That hasn’t stopped them, however, for investigating whether it makes sense to consider taxing Second Life’s virtual economy.

Confused? Yes, I was, too. How can you tax something that doesn’t really exist?

Well, I guess that’s easy to answer. The IRS does it all of the time. It taxes imputed income, for example, which isn’t altogether tangible. When I started thinking about it, I realized that there are a number of taxable transactions that aren’t “real” in terms of money changing hands. So, I thought I would check out Second Life and see how it works, and what goes on that has grabbed the attention of the IRS and Congress.

I paid Second Life a visit this morning and was greeted with these statistics:
Second Life Time: 7:41 AM
Total Residents: 1,110,224
Logged In Last 60 Days: 459,062
Online Now: 8,136
US$ Spent Last 24 Hrs: 525,432

Yes, that’s US dollars, not Linden dollars (the virtual currency of Second Life).  While the residents of Second Life deal in Linden dollars, the currency can easily be converted to American dollars (the exchange rate is approximately 400 Linden dollars to $1 US as of today). Transactions worth half a million US dollars take place every day online at the site. Assuming a level amount of activity each day, that translates into more than $182 million per year changing hands – and that’s just through Second Life.

Other companies (as many as thirty) are creating virtual worlds every day.

I decided that, in order to understand this whole scenario more, I needed to get some firsthand experience. So, this morning, I created an account, where I was allowed to choose a name and persona. At check-in, I was offered free Linden dollars for signing up for various plans, including the receipt of a weekly allowance for creating a premium account. Premium accounts cost between $6.00 and $10.00 per month. I decided not to sign up for the extras.

I poked around on the site for a bit and once I mastered walking and flying (yes, flying), I struck out to make some money. I didn’t succeed.

I never made it to any of the shops from retailers like Reebok or Amazon to buy any virtual products. I didn’t see any virtual concerts or buy any virtual albums (I actually disabled the music feature because I found it annoying since it interfered with my iTunes). I didn’t buy or sell any real estate. In fact, for most of my trial run, I had zero dollars in my account (note to IRS: don’t come looking for me).

I did find myself among a crush of newbies, all checking out the virtual world. It was clear that this new world was attracting users – and if those were users with money, the more than $180 million virtual economy could quickly become billions.  Ad agencies see it. Big companies like Nissan see it. It was only a matter of time before Congress and the IRS caught up.

Taxing these virtual transactions could be tricky.  I’m not sure, really, how IRS would anticipate tracking such activities.  Would they require the founding company to issue forms 1099 for users that “make” more than $600 in one year?  Or would the virtual employer or seller be responsible for the form 1099? Would the dollars have to be realized (in this instance, cashed in) to be taxable, or would the income be imputed whether actually realized or not? And, if it’s considered to be entertainment, such as gambling, would users be allowed to deduct losses up to income thresholds?

Even more complicated, would the income be considered US-sourced?  Would the source of the income depend on the user or the content provider? And if it’s the latter, would that serve as an incentive for US companies to relocate (imagine the consequences if a US-based company like Linden Labs was forced to report income paid to foreign users, thus likely making it taxable in the US, when a non-US based company did not have the same requirements).

While Congress has indicated that it is “looking into” how to monitor the economic consequences of these virtual transactions, I wouldn’t hold my breath. I can’t imagine a scenario where enough members of Congress actually “got” what these virtual worlds are all about since many clearly can’t “get” what the real world is about. I envision committee meetings with projected screens of virtual worlds… with some giddy Congressional officials yelling “Look at me, I’m flying!” while other members go in search of virtual sex clubs.

I don’t think we’ll see virtual tax audits any time soon, but I do think that this opens up a number of questions about how the IRS treats internet businesses and online presence – an issue that has yet to be satisfactorily resolved. It’s a much different world than ever before.

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Kelly Phillips Erb is a tax attorney, tax writer, and podcaster.

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