Beware BitCoin Users: The Tax Man Cometh!

Beware you barrons of BitCoin – you World of Warcraft one-percenters: the long arm of the Internal Revenue Service may soon be reaching into your treasure hoard to extract Uncle Sam’s fair share of your virtual treasure.

Services for buying and exchanging virtual currencies and goods abound online. GAO found that many are likely taxable under current U.S. tax law.

That’s the conclusion of a new Government Accountability Office (GAO) report on virtual economies, which found that many types of transactions in virtual economies – including bitcoin mining and virtual currency transactions that result in real-world profit – are likely taxable under current U.S. law, but that the IRS does a poor job of tracking such business activity and informing buyers and sellers of their duty to pay taxes on virtual earnings.
The report, “Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks” (GAO-13-516) was released this week. It was prepared in response to a request from the U.S. Senate Committee on Finance, which asked GAO to look into virtual currencies and the IRS’s approach to addressing their tax implications. The GAO said that the IRS’s tax treatment of virtual currency transactions is lax, and that the growing use of virtual currencies like BitCoin and virtual game currencies warrants the U.S.’s tax collection agency to mitigate the risks. Those include efforts to educate taxpayers and the publication of basic tax reporting requirements for transactions using virtual currencies. 
Virtual currencies have gained favor in recent years, as the sophistication and complexity of virtual economies have grown. In-game currencies for virtual environments like Second Life (Linden Dollars), The Sims (Simoleons) and World of Warcraft (WoW Gold) have sprung up as a way for players to buy and sell virtual goods. While the currency is often earned in exchange for in-game activity and labor, many virtual currencies can also be purchased with real-world currency through in-game or third party exchanges. The exchanges have attracted the attention of law enforcement, who recently cracked down on Liberty Reserve, a Costa Rica-based virtual currency firm popular among cyber criminal groups.
GAO said that strict virtual (or “closed flow”) transactions in which virtual currency is used only within a game or virtual environment to purchase virtual goods and services were not taxable. However, so called “hybrid” and “open flow” virtual currency systems, in which real world currency is used to buy virtual currency, which is then used to buy or sell virtual- or real world goods and services are subject to U.S. taxes.

Many types of virtual currency systems generate taxable revenue, GAO said.

Some virtual economies in massively multiplayer online role-playing games (MMORPG) like World of Warcraft are “hybrid” systems in which in-game economic activity can spill into the real world via third-party transactions in which virtual goods are exchanged for real money, GAO said.
Virtual currencies like BitCoin and the Linden Dollars of used-to-be-cool virtual environment Second Life  are examples of open flow systems in which virtual currencies can be used to purchase both real and virtual goods and services, then exchanged for real world currencies like the U.S. dollar.
GAO provides a number of examples of virtual transactions that are subject to taxation that, in all likelihood are not taxed. They include “John,” a resident of Second Life, who rents a 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,” GAO said. 
There is also the example of “Bill” the Bitcoin miner who successfully mines 25 bitcoins. “Bill may have earned taxable income from his mining activities,” GAO said.

BitCoin mining and exchanges are taxable under most scenarios, GAO said.

The problem with virtual currencies is similar to the challenges the IRS has in capturing other kinds of economic activity, such as cash transactions and barter, where records and third party reporting is lax or non-existent, GAO said. Still, the growing popularity of virtual currencies and exchanges pose unique risks, including lost tax revenue and tax evasion by way of virtual currencies like Bitcoin.
While the extent of the virtual currency problem isn’t known, and in light of the IRS’s sequester-based staffing issues, GAO recommended that IRS take mostly low-cost steps to address it, rather than mounting a large and expansive campaign to crack down. IRS should publish clear guidance of what kinds of online transactions are taxable and clarify third party reporting requirements to counter misinformation that is circulating. However, as the extent of virtual currencies and economies grow, IRS may find it needs to take bolder steps to bring virtual economic activity into line with other kinds of transactions, GAO said.