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. 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. 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.