Thanks to everyone who posted comments on my first post on virtual tax. As promised, this one discusses Second Life. For those who are unfamiliar with it, Second Life is a different type of world from World of Warcraft (WoW) and other game worlds. Second Life provides a virtual environment and basic avatars but leaves it to participants to provide most of its content. Its Terms of Service allows users to retain intellectual property rights in their content. Second Life earns its revenue from selling "premium" memberships that allow "ownership" of land and from monthly land use fees. Basic membership is free.
Second Life can be used as a type of chat room for avatars and for entertainment activities, such as going to a concert. Second Life also facilitates commerce. It provides the LindeX, an in-world exchange for its currency, Lindens (though it purports merely to license Lindens to users). Second Life users can do things like create a line of cool T-shirts for avatars that they sell copies of for Lindens. Real-world business such as Adidas have joined Second Life, selling virtual items for avatars and promoting their real-world products.
How should transactions within Second Life be taxed? My view is that, from a policy perspective, the right result is to tax commercial activity within virtual worlds but not game play. Thus, if Anna is a Second Life entrepreneur raking in the Lindens and Bert uses Second Life to build and furnish a virtual castle to hang out in with his friends, then, as a general matter, Anna should be taxed on her Second Life activities, but Bert shouldn’t be. The problem is how to reach that result.
One possibility would be to provide a "cash-out" rule, along the lines of what I proposed for WoW. The problem I see with this is the extent to which Second Life is a medium for commerce. WoW focuses on a game with a general storyline and goals and prohibits real market trade. Second Life encourages commerce and not only allows but facilitates the exchange of Lindens for dollars. Were sales for Lindens not taxed, that would encourage excessive allocation of resources to virtual businesses. Deferral of taxation would be a larger problem in Second Life than in WoW because of the larger array of business opportunities and the lower risk of deferring cashing out that the legitimacy of exchanging Lindens for dollars provides. Failing to tax sales of virtual items in Second Life could also facilitate tax evasion by sellers who purport to sell a virtual item but actually sell a real one (for Lindens).
Thus, I think the better result is to tax sales within Second Life (for Lindens). That would result in the imposition of tax on commerce such as Anna’s. (Information reporting by Second Life might be required for effective enforcement of the tax.) It would also, at least in theory, tax sales by play-minded users, but the likely outcome for someone such as Bert would not be any actual federal income tax liability because only profit would bear tax. That is, because the expenses of an income-producing "hobby" can be deducted from the income from the hobby under IRC section 183, someone like Bert, who spends more on Second Life than he brings in from it, would not actually owe any federal income tax on his Second Life activities.
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