Second Life Tax: U.S. Federal Tax Laws Applied To In-World Second Life Activities

Part III.A: Introduction to Two Theories of Taxation: Cash-out Taxation and In-world Taxation

The first question one must answer is whether the activities in Second Life fit into the current tax system. One can begin with the Code and interpretations of §61. Recall that in Comm’r v. Glenshaw Glass, the Supreme Court interpreted gross income to mean “any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has] complete domination.” This properly implicates notions of basis. For the exchange of some piece of property, § 1001 provides that taxpayers should subtract their basis from the amount realized, where “amount realized” is the sum of the cash received plus the fair market value of any property received. That is, when there is a realization event, a taxpayer must pay tax only on the total value that exceeds the original input value. How one measures basis in Second Life is a fundamental question one must answer in order to arrive at the taxable amount of income resulting from Second Life wealth. To reach basis, however, one must first one must establish the proper measure of virtual income. One cannot measure net income in Second Life until one can measure gross income, and since such measurements partially turn on how one defines the property rights, one must examine the property rights in Second Life that gave rise to the income.

It is through this property rights issue that one can divide the taxation of Second Life into two sweeping extremes: (1) taxation upon cashing out (i.e., no in-world taxation) or (2) dynamic taxation as accessions to wealth occur (i.e., some in-world taxation). One end of the spectrum dismisses the benefits derived and would not tax any of the economic activity that takes place in Second Life. That is, the only taxable events that would relate to Second Life are those that ex post involve accessions to wealth that are already taxed, such as receiving U.S. Dollars or receiving out-world services with a fair market value. The other end of the spectrum looks through the novelty at the underlying economic reality and tracks the theoretical framework developed above such that one’s taxes accrue in real-time on all gains that have a fair market value.

Although a detailed analysis of property rights is outside the scope of this paper, recognize that in the context of a cash-out method the legal property rights assigned to anything in Second Life makes no difference, but that in the context of in-world taxation, property rights can make an enormous difference. One can analyze these two methods in turn. First, notice that irrespective of how one defines the property rights or the property exchanged in Second Life, anytime that someone receives U.S. Dollars, either by cashing out their Linden Dollars or by making a trade of in-world goods for out-world benefits, a taxable event has occurred. If a resident has property rights to the goods in question, then upon trading, the individual has realized an economic gain possessing a clear fair market value with a floor equal to the selling price. If the individual lacks property rights to the “good” in question, then payment received is simply payment for the service of transferring access to use the underlying computer software in question. “If the non-tax law concludes that a virtual item is ‘property,’ then its sale is subject to the formula in § 1001.” If the non-tax law concludes that a virtual item is not property, then the transfers of the computer code are still “services paid for in exchange for other services.” But under either formulation, “the transaction produces gross income within the meaning of § 61.” Thus, even without wading through theories of property rights for virtual goods, one can still bound some part of Second Life activity that is subject to a gross income valuation.

If users of Second Life were to be taxed on in-world aspects of Second Life before they cashed-out, there would need to be defined property rights. By analogy, if an individual takes ownership of 100 Euros in payment for some service, that person is taxed on the fair market value of the money at the exchange rate for U.S. Dollars. This holds true even if the money remains in a European bank account and is never actually converted into U.S. or European paper money because there is a recognized property interest in this money and U.S. tax payers are taxed on world wide income. If Linden Dollars operate like Euros, then having 100 Linden Dollars in one’s Second Life account should properly be subject to taxation because there is a floating exchange rate and discernable value in terms of U.S. Dollars. However, in Second Life, Linden places contractual restrictions on Linden Dollars. The Second Life Terms Of Services (“TOS”) agreement provides that users have permission to use the “‘textures’ and/or ‘environment content’ that are both (a) created or owned by Linden Lab and (b) displayed by Linden Lab in-world,” yet it also states that “Second Life does not grant participants intellectual property rights to the items it provides in the virtual environment, such as land and Linden Dollars.” With respect to creations, Second Life’s TOS “expressly states that participants have intellectual property rights in their creations, to the extent provided by law.” “The TOS thus appears implicitly to grant land holders only a limited license to use land in Second Life” creating “multiple tiers of property, one tier in which participants have substantial ownership rights, and additional tiers in which participants are mere licensees of property created by Linden Lab.”

Having established that property rights can divide the taxation of Second Life activities into a cash-out method and in-world method, one can further bound the methods of taxation by examining the operational limitations that exist in the current tax law. Again, recall that in Comm’r v. Glenshaw Glass, the Supreme Court interpreted “income” to mean “any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has] complete domination.” Notice that while this appears to unify the economic and statutory formulations of income, this definition explicitly imports realization as an operational limitation. In fact, the current tax doctrine actually creates three exceptions to gross income which significantly impact the analysis of virtual wealth. These operational restrictions are realization, valuation, and imputation. If either the cashing out method or some in-world taxation method is applicable to Second Life based on property rights alone, then one must examine these additional limitations in turn, to determine whether Second Life activities are otherwise precluded from taxation. As a secondary matter, one can use these operational limitations to explore more deeply the novel property rights issues that Second Life creates. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.