Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks
Published: 2013-05-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Recent years have seen the development of virtual economies, such as those within online role-playing games, through which individual participants can own and exchange virtual goods and services. Within some virtual economies, virtual currencies have been created as a medium of exchange for goods and services. Virtual property and currency can be exchanged for real goods, services, and currency, and virtual currencies have been developed outside of virtual economies as alternatives to government-issued currencies, such as dollars. These innovations raise questions about related tax requirements and potential challenges for IRS compliance efforts.
This report (1) describes the tax reporting requirements for virtual economies and currencies, (2) identifies the potential tax compliance risks of virtual economies and currencies, and (3) assesses how IRS has addressed the tax compliance risks of virtual economies and currencies.
To accomplish these objectives, GAO reviewed tax laws, IRS guidance and program documents, federal program internal control guidance, and interviewed IRS officials and knowledgeable experts on the topics.
section_title: What GAO Found
paragraphs: Transactions within virtual economies or using virtual currencies could produce taxable income in various ways, depending on the facts and circumstances of each transaction. For example, transactions within a "closed-flow" virtual currency system do not produce taxable income because a virtual currency can be used only to purchase virtual goods or services. An example of a closed-flow transaction is the purchase of items to use within an online game. In an "openflow" system, a taxpayer who receives virtual currency as payment for real goods or services may have earned taxable income since the virtual currency can be exchanged for real goods or services or readily exchanged for governmentissued currency, such as U.S. dollars.
Virtual economies and currencies pose various tax compliance risks, but the extent of actual tax noncompliance is unknown. Some identified risks include taxpayers not being aware that income earned through virtual economies or currencies is taxable or not knowing how to calculate such income. Because of the limited reliable data available on their size, it is difficult to determine how significant virtual economy and currency markets may be or how much tax revenue is at risk through their usage. Some experts with whom we spoke indicated a potential for growth in the use of virtual currencies.
Beginning in 2007, IRS assessed the tax compliance risks from virtual economies, and in 2009 posted information on its website on the tax consequences of virtual economy transactions. However, IRS has not provided taxpayers with information specific to virtual currencies because of other priorities, resource constraints, and the need to consider the use of these recently-developed currencies, according to IRS officials. By not issuing guidance, IRS may be missing an opportunity to address virtual currency tax compliance risks. Given the uncertain extent of noncompliance with virtual currency transactions, formal guidance, such as regulations, may not be warranted. According to IRS officials, formal guidance requires extensive review, which adds to development time and cost. However, IRS may be able to develop more timely and less costly informal guidance, which, according to IRS officials, requires less extensive review and can be based on other existing guidance. An example is the information IRS provides to taxpayers on its website on the tax consequences of virtual economy transactions. Posting such information would be consistent with IRS's strategy for preventing and minimizing taxpayers' noncompliance by helping them understand and meet their tax responsibilities.
section_title: What GAO Recommends
paragraphs: GAO recommends that IRS find relatively low-cost ways to provide information to taxpayers, such as on its website, on the basic tax reporting requirements for virtual currencies. In commenting on a draft of this report, IRS agreed with our recommendation.

section_title: Letter
paragraphs: Recent years have seen the development of virtual economies, such as  those within online role-playing games, through which individual  participants can earn and exchange virtual goods and services. Within  some virtual economies, virtual currencies have been created as a  medium of exchange for goods and services. Virtual property and  currency can have economic value outside of virtual economies, such as  when individuals trade these virtual goods for dollars or other  government-issued currencies. More recently, virtual currencies have  been developed outside of virtual economies as alternatives to  government-issued currencies to exchange for real-world goods and  services. These innovations raise questions about their related tax  requirements and whether their increased adoption could pose  challenges for the Internal Revenue Service (IRS) in its efforts to ensure  tax compliance.
You asked us to review virtual economies and currencies and IRS’s  approach to addressing their tax implications. This report’s objectives are  to (1) describe the tax reporting requirements for virtual economies and  currencies, (2) identify the potential tax compliance risks of virtual  economies and currencies, and (3) assess how IRS has addressed the  tax compliance risks of virtual economies and currencies.
To describe reporting requirements for virtual economies and currencies,  we reviewed the Internal Revenue Code and applicable IRS regulations,  including relevant sections of the Internal Revenue Manual, and  interviewed IRS officials. We also reviewed academic articles and  interviewed academics whose research focuses on virtual currencies and  taxation of virtual transactions, as well as tax practitioners and  representatives from the American Institute of Certified Public  Accountants. We selected academics to interview based on criteria  including the recognition and citations of their research in the relevant  literature. We selected tax practitioners and representatives based on  their association with an organization with widely-recognized expertise in  federal tax matters.
To identify potential compliance risks associated with virtual currencies  and virtual economies, we reviewed and analyzed legal and academic  literature and government reports, including the National Taxpayer  Advocate’s 2008 Annual Report to Congress and the European Central  Bank’s October 2012 report on virtual currencies. We then discussed  these compliance risks with knowledgeable experts, including the Bitcoin  Foundation, a virtual currency user group; tax professionals, including  members of the American Institute of Certified Public Accountants;  representatives from a company that publishes a virtual economy  platform; and academics who have written about virtual currencies and  taxation of virtual economy transactions. We selected experts based on  criteria including their recognition and citations in the literature, and their  expertise and recognition in representing taxpayers in federal tax matters  or in representing virtual economy or currency concerns. We interviewed  IRS officials knowledgeable on virtual economies and currencies and  overall IRS tax compliance enforcement efforts. We also performed  Internet searches to see what information was circulating for determining  the proper tax treatment of virtual economy and currency transactions.
1GAO, Internal Control Management and Evaluation Tool, GAO-01-1008G (Washington,  D.C.: August 2001). general IRS procedures and plans for providing information to taxpayers  to help them comply with tax requirements included in IRS’s Taxpayer  Assistance Blueprint and related progress reports to Congress.
We conducted this performance audit from September 2012 to May 2013  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: There are no legal definitions for a virtual economy or currency, but  generally, a virtual economy is comprised by the economic activities  among a community of entities that interact within a virtual setting, such  as an online, multi-user game. Virtual economies can be closed, meaning  the economic activities and units of exchange used within the community  do not interact with the real economy outside of the virtual environment  setting, or they can be open, with some economic activity occurring in  both the virtual setting and the real economy. A virtual currency is,  generally, a digital unit of exchange that is not backed by a government- issued legal tender. Virtual currencies can be used entirely within a virtual  economy, or can be used in lieu of a government-issued currency to  purchase goods and services in the real economy. Some virtual  economies may function similarly to barter exchanges, where bartering is  the exchange of goods or services in lieu of monetary payments. For  example, a carpenter may build a desk for a dentist in exchange for  dental work. Barter transactions are taxable transactions, and taxpayers  must report the fair market value of the good or service received on their  tax returns. Some of the variations in virtual currencies and their  interaction with the real economy are shown in figure 1.
2The 2007 Taxpayer Assistance Blueprint—a 5-year strategic plan for improving service to  taxpayers—is a collaborative effort of IRS, the National Taxpayer Advocate, and the IRS  Oversight Board. Congress has received annual update reports on the implementation of  the blueprint.  3The term “barter exchange” means any organization of members providing property or  services who jointly contract to trade or barter such property or services. 26 U.S.C. §  6045.  halve every time the network reaches 210,000 blocks, or approximately every four years.  From inception through November 2012, rewards were 50 bitcoins. In 2016, rewards are  expected to halve again to 12.5 bitcoins.   from the bitcoin network, but are providing some figures to provide context for the possible  size of these markets.  5Given these limitations, we did not test the reliability of data, such as the data generated  6http://blockchain.info. (Date accessed May 1, 2013.)  7Due to data limitations, it is difficult to calculate the velocity, or the rate at which bitcoins  8https://mtgox.com. (Date accessed May 1, 2013.) https://mtgox.com operates the largest  are spent, and the number of transactions between unique users in a given time period.  bitcoin exchange. The site has daily and monthly limits on how many bitcoins may be  exchanged back to U.S. dollars or other virtual or government-issued currencies. These  limits may be raised if users provide additional documentation confirming their identity.
According to Linden Lab, creators of Second Life, residents  exchanged more than US$150 million worth of Linden dollars within  Second Life’s economy in the third quarter of 2010.
IRS is responsible for ensuring taxpayer compliance for all economic  areas, including virtual economies and currencies. One mechanism that  assists IRS in enforcing tax laws is information reporting, through which  third parties report to IRS and taxpayers on certain taxpayer transactions.  For example, subject to certain thresholds, third-party settlement  organizations are required to report on Form 1099-K payments in  settlement of third-party network transactions. A common example of a  third-party settlement organization is an online auction-payment facilitator,  which operates as an intermediary between buyers and sellers by  transferring funds between their accounts in settlement of purchases.  Another type of third-party information reporting is performed by barter  exchanges, which, generally, are organizations that facilitate barter  transactions among exchange members. Such barter exchanges are  required to report on Form 1099-B each member’s barter transactions  proceeds. Third-party information reporting is widely acknowledged to  increase voluntary tax compliance, in part because taxpayers know that  IRS is aware of their income.
Likewise, in its role in administering the tax code, IRS must implement the  laws Congress enacts through detailed guidance. To accomplish this  responsibility, IRS publishes several forms of guidance, such as  regulations, revenue rulings and procedures, and notices. IRS also  provides more informal guidance on its website based on factors such as  perceived need, media coverage, or IRS staff identifying an emerging tax  compliance issue. As outlined in IRS’s Taxpayer Assistance Blueprint and  related reports, a key part of IRS’s strategy for preventing and minimizing  noncompliance is to outreach to taxpayers to help them understand and  meet their tax responsibilities. One of the guiding principles of this  approach is to enhance IRS’s website so that it becomes the first choice  of taxpayers for obtaining the information they need to comply.
9Third-party settlement organizations must file Form 1099-K if gross payments to a payee  exceed $20,000 and there are more than 200 transactions with the payee in a given tax  year.
section_title: Virtual Economy and Currency Transactions May Be Taxable If They Produce Income
paragraphs: 10For federal tax purposes, all income is taxable, although the tax code excludes some  items from income, such as gifts or inheritances, subject to exceptions, while it allows  other items to be deducted to reduce taxable income, subject to limitations and  restrictions, such as trade or business expenses. have no value outside the game and David cannot exchange his  online money for U.S. dollars. David has not engaged in a taxable  transaction.
Ann plays an online game and amasses virtual tools that are valuable  to her avatar. The online game does not allow users to directly  exchange their virtual tools for U.S. dollars, but rather they can do so  using a third-party, making this a hybrid system. Ann uses a third- party exchange not affiliated with the online game to coordinate the  transfer of her virtual tools to another player in exchange for U.S.  dollars. The transfer is conducted by the third-party exchange and  payment is mediated by a third-party payment network. Ann may have  earned taxable income from the sale of these virtual tools.
John is a resident of Second Life. He rents virtual property to other  residents who pay him in Linden dollars. At the end of the year, John  exchanges his Linden dollars for U.S. dollars and realizes a profit.  John may have earned taxable income from his activities in Second  Life.
Bill is a bitcoin miner. He successfully mines 25 bitcoins. Bill may  have earned taxable income from his mining activities.
Carol makes t-shirts and sells them over the Internet. She sells a t- shirt to Bill, who pays her with bitcoins. Carol may have earned  taxable income from the sale of the t-shirt.
section_title: Virtual Economies and Currencies Pose Various Tax Compliance Risks, but the Extent of Noncompliance Is Unknown
paragraphs: IRS, tax experts, academics, and others have identified various tax  compliance risks associated with virtual economies and currencies,  including underreporting, mischaracterization, and evasion. These risks  are not unique to virtual economies and currencies, as they also exist for  other types of transactions, such as cash transactions, where there are  not always clear records or third-party tracking and reporting of  transactions. The tax compliance risks we identified for virtual economies  and currencies are described below.
Taxpayer lack of knowledge of tax requirements. Income is  generally defined as any undeniable accessions to wealth, clearly  realized, and over which the taxpayers have complete dominion.  The unsophisticated taxpayer may not properly identify income  earned through virtual economies or currencies, such as virtual online  game assets exchanged for real word currency, as taxable income. If  taxpayers using virtual currencies turn to the Internet for tax help, they  may find misinformation in the absence of clear guidance from IRS.  For example, when we performed a simple Internet search for  information on taxation of bitcoin transactions, we found a number of  websites, wikis, and blogs that provided differing opinions on the tax  treatment of bitcoins, including some that could lead taxpayers to  believe that transacting in virtual currencies relieves them of their  responsibilities to report and pay taxes.
Uncertainty over how to characterize income. Even if taxpayers  are aware that they may have a tax liability, they may be uncertain  about the proper tax treatment of virtual transactions, according to tax  experts, including academics and tax practitioners with whom we  spoke. For example, characterization depends on whether the virtual  economy activity or virtual currency unit is to be treated as property,  barter, foreign currency, or a financial instrument. According to some  experts with whom we spoke, some virtual currency transactions  could be considered barter transactions, which may not be an obvious  characterization to unsophisticated taxpayers. This characterization  could result in noncompliance with requirements for reporting and  paying tax on barter income.
Uncertainty over how to calculate basis for gains. Income earned  from virtual economy or currency transactions may not be taxable if it  is equivalent to that from an occasional online garage sale, meaning  occasional income from selling goods for less than their original  purchase price. It may be difficult for individuals receiving income from  virtual economies to determine their basis for calculating gains. For  example, some online games require players to pay a monthly fee in  exchange for use of the game and a monthly allowance of virtual  currency. If a player then sells a virtual tool gained in the game for  real money, calculating the basis for any taxable gain may be difficult  for the unsophisticated taxpayer.
Challenges with third-party reporting. Third-party information  reporting requirements do not apply specifically to transactions using  virtual economies or currencies. Virtual economy or currency  transactions may be subject to third-party information reporting to the  extent that these transactions involve the use of a third-party payment  network to mediate the transaction and the taxpayer meets reporting  threshold requirements. Because virtual economy and currency  transactions are inherently difficult to track, including identifying the  true identities of the parties to the transaction, third-party information  reporting may be difficult or prohibitively burdensome for some virtual  economy and currency issuers to administer.
Evasion. Some taxpayers may use virtual economies and currencies  as a way to evade taxes. Because transactions can be difficult to  trace and many virtual economies and currencies offer some level of  anonymity, taxpayers may use them to hide taxable income.
Because of the limited reliable data available on their size, it is difficult to  determine how significant virtual economy and currency markets may be  or how much tax revenue is at risk through their usage. Some experts  with whom we spoke indicated that there is potential for growth in the use  of virtual currencies. Additionally, the European Central Bank recently  issued a report on virtual currencies, acknowledging their potential for  future growth and interaction with the real economy. If the use of virtual  economies and currencies expands, it can be expected that associated  revenue at risk of tax noncompliance will grow.
1326 U.S.C. § 6050W and applicable regulations define third-party payment networks.  14European Central Bank, Virtual Currency Schemes (Frankfurt am Main, Germany:  October 2012).
section_title: IRS Has Provided Some Guidance on Tax Reporting Requirements for Virtual Economies but Not for Virtual Currencies Used Outside of Virtual Economies
paragraphs: IRS has assessed the tax compliance risks from virtual economies and  virtual currencies used within those economies, and developed a plan to  address them in a manner consistent with internal control standards.  Beginning in 2007, IRS’s Electronic Business and Emerging Issues  (EBEI) policy group identified and surveyed internal and external  information sources, gathered data on the industry, and collect trend  information, among other efforts. EBEI determined that virtual economies  presented opportunities for income underreporting and developed (1) a  potential compliance strategy, including initiating a compliance  improvement project to gather research data and analyze compliance  trends, and (2) a potential action plan for specific compliance activities.  According to IRS compliance officials, IRS ultimately decided not to  pursue these actions in light of available IRS resources and other higher  priority needs. Also, IRS did not find strong evidence of the potential for  tax noncompliance related to virtual economies, such as the number of  U.S. taxpayers involved in such activity or the amount of federal tax  revenue at risk.
However, in November 2009, based on EBEI having determined the  need, IRS posted information on its website on the tax consequences of  virtual economy transactions. The web page points out that, in general,  taxpayers can receive income in the form of money, property, or services  from a virtual economy, and that if taxpayers receive more income than  they spend, they may be required to report their gains as taxable income.  The page further states that IRS has provided guidance on the tax  treatment of issues similar to online gaming activities, including bartering,  gambling, business, and hobby income, and provides links to IRS  publications on those topics. IRS officials who were involved in issuing  this guidance reported it cost less to make an online statement pointing  taxpayers to existing guidance than it would have cost to develop and  publish new guidance specific to virtual economies.
IRS has not assessed the tax compliance risks of open-flow virtual  currencies developed and used outside of virtual economies. These types  of currencies, generally, were introduced after IRS’s last review of  compliance related to virtual economy transactions. According to IRS  compliance officials, IRS would learn about tax compliance issues related  to virtual currencies as it would any other tax compliance issue, such as  IRS examiners identifying compliance problems during examinations or  taxpayers requesting guidance on how to comply with certain tax  requirements. To date, these processes have not resulted in IRS  identifying virtual currencies used outside of virtual economies as a  compliance risk that warrants specific attention.
Likewise, IRS has not issued guidance specific to virtual currencies used  outside of virtual economies due to competing priorities and resource  constraints, and because the use of virtual currencies is a relatively  recent development that requires further consideration before guidance  can be issued, according to IRS’s Office of Chief Counsel and compliance  officials. As previously discussed, taxpayers may be unaware that  income from transactions using this type of virtual currency may be  taxable, or if they are aware, uncertain on how to characterize it. By not  issuing guidance, IRS may be missing an opportunity to address these  compliance risks and minimize their impact and the potential for  noncompliance. Given the uncertain extent of noncompliance related to  virtual currency transactions, formal guidance, such as regulations,  revenue rulings, or revenue notices, may not be warranted at this time.  According to officials from IRS’s Office of Chief Counsel, these types of  guidance require extensive review within IRS and the Department of the  Treasury and, in some cases, public comment, which add to the time and  cost of development. However, IRS may be able to develop informal  guidance, which, according to Chief Counsel officials, requires less  extensive agency review and can be based on other existing guidance.  As such, IRS can develop informal guidance in a more timely and less  costly manner than formal guidance, according to the officials. An  example of such informal guidance is the information IRS provides to  taxpayers on its website on the tax consequences of virtual economy  transactions. Posting such information to its website would be consistent  with IRS’s strategy for preventing and minimizing taxpayers’  noncompliance by helping them understand and meet their tax  responsibilities, as outlined in IRS’s Taxpayer Assistance Blueprint.
section_title: Conclusions
paragraphs: in providing taxpayers with information on the tax consequences of virtual  economy transactions, a low-cost step to potentially mitigate some of the  noncompliance risk associated with such transactions. The uncertainty  about the extent virtual currencies are used in taxable transactions and  any associated tax noncompliance means that costly compliance  activities are not merited at this time. However, the fact that  misinformation is circulating and the possibility of growth in the use of  virtual currencies outside virtual economies suggest that it would be  prudent to take low-cost steps, if available, to mitigate potential  compliance risks. The type of information IRS provided about virtual  economy transactions is one model.
section_title: Recommendation for Executive Action
paragraphs: To mitigate the risk of noncompliance from virtual currencies, the  Commissioner of Internal Revenue should find relatively low-cost ways to  provide information to taxpayers, such as the web statement IRS  developed on virtual economies, on the basic tax reporting requirements  for transactions using virtual currencies developed and used outside  virtual economies.
section_title: Agency Comments and Our Evaluation
paragraphs: We sent a draft of this report to the Acting Commissioner of Internal  Revenue for comment. In written comments, reproduced in appendix I,  IRS agreed with our recommendation and stated it would provide  information to taxpayers on the basic tax reporting requirements for  transactions involving virtual currencies by linking to existing relevant  guidance. IRS noted that it was aware of the tax compliance risks  associated with virtual currencies and was taking other steps, such as  developing training resources for agents, to address them. IRS also  provided technical comments on our draft report, which we incorporated,  as appropriate.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to interested congressional  committees, the Secretary of the Treasury, the Acting Commissioner of  Internal Revenue, and other interested parties. In addition, the report also  will be available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made key contributions to this report  are listed in appendix II.
section_title: Appendix I: Comments from the Internal Revenue Service
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Jeff Arkin (Assistant Director),  David Dornisch, Lois Hanshaw, Richard Hung, Ronald W. Jones, Donna  Miller, Ed Nannenhorn, Danielle N. Novak, and Sabrina Streagle made  key contributions to this report.