The Internal Revenue Service plans to develop more guidance and training materials to inform taxpayers and tax preparers of the tax compliance risks associated with using virtual currencies like Bitcoin and “Linden dollars.”

A new report from the Government Accountability Office recommended that the IRS develop additional guidance to reduce the tax compliance risks of virtual economies and currencies, such as the type used in online multiplayer games. The GAO report noted that 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 so-called “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 “open flow” 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 government-issued currency, such as U.S. dollars.

“Virtual economies and currencies pose various tax compliance risks, but the extent of actual tax noncompliance is unknown,” said the GAO. “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.”

Recent years have seen the development of virtual economies, such as those within online role-playing games such as Second Life and World of Warcraft, 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 such as Bitcoin have been developed outside of virtual economies as alternatives to government-issued currencies, such as dollars. In some cases the virtual goods are auctioned off on sites like eBay. These innovations raise questions about the related tax requirements and potential challenges for IRS compliance efforts.

In a closed-flow system, virtual tools amassed by players can be traded in a game for other in-game assets or to advance to higher play levels, but they hold no value outside of the game and cannot be cashed out for dollars or other government-issued currencies. However, in a hybrid system, one or more of the flows between the virtual currency and real dollars or goods and services is closed. For example, participants can purchase virtual currency with real dollars or earn virtual currency by completing tasks, such as taking surveys, and then use the currency to purchase real or virtual goods and services. However, the virtual currency might not be exchangeable back into real dollars. An example of a hybrid system is some massively multiplayer online role-playing games, or MMORPG, the GAO noted.

MMORPGs allow users to create avatars, or graphical representations of themselves, that exist within a digital world and interact with other avatars around the globe to carry out tasks. Some MMORPGs operate as a closed-flow system, but some of these closed- flow systems can leak into the real economy via third-party transactions. Some MMORPGs, like Blizzard Entertainment’s World of Warcraft, have third-party exchanges that allow users to exchange virtual goods for real dollars. This interaction between the virtual and real economies can be limited by the game’s distributor through terms of use agreements.

Second Life and Bitcoin

In an “open-flow” system, virtual currencies can be used to purchase both real and virtual goods and services, as well as be readily exchanged for government-issued currency, such as U.S. dollars. One example of an open-flow currency designed primarily for use in a virtual economy is Second Life’s Linden dollars. Second Life, a product of Linden Lab, is a virtual economy created in 2003 that has its own virtual currency. “Residents” of Second Life create avatars and interact with other avatars in a user-defined and user-created environment. Within Second Life, residents can create virtual assets, such as buildings that they rent or sell to other residents, or operate virtual businesses, such as virtual clothing stores that sell virtual goods to other residents. Transactions taking place within Second Life use Linden Lab’s virtual currency, Linden dollars. Second Life residents can sell their Linden dollars to other residents for U.S. dollars through the LindeX exchange, which uses third-party payment networks to process the payments and allows residents to cash out of the Second Life world.

An open-flow currency can also be developed and designed primarily to be used to purchase real goods and services outside an online game virtual economy. An example is Bitcoin, a decentralized digital currency that uses a peer-to-peer computer network to move Bitcoins around the world. Developed in 2009 by an anonymous programmer or programmers, Bitcoin is a privately issued digital currency that exists only as a long string of numbers and letters in a user’s computer file. Bitcoins use cryptography to secure and safeguard against counterfeiting.

Unlike U.S. dollars and other currencies, Bitcoin is not government issued and does not have a physical coin or bill associated with its circulation, such as a Federal Reserve note. Bitcoin has grown in popularity since its introduction and, according to academics and user groups with whom the GAO spoke, is the most widely circulated virtual currency available. Bitcoins act as a real-world currency in that users pay for real goods and services, such as coffee or web development services, with Bitcoins as opposed to U.S. dollars or other government-issued currencies. Third-party exchanges allow Bitcoin users to exchange their Bitcoins back to government-issued currencies, such as U.S. dollars, euro or yen.

Beginning in 2007, the IRS assessed the tax compliance risks from virtual economies, and in 2009 posted information on its Web site on the tax consequences of virtual economy transactions. However, the 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, the IRS may be missing an opportunity to address the tax compliance risks of virtual currency, the GAO pointed out.

Given the uncertain extent of noncompliance with virtual currency transactions, formal guidance, such as regulations, may not be warranted, the GAO acknowledged. According to IRS officials, formal guidance requires extensive review, which adds to development time and cost.

However, the 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 Web site 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.

The GAO recommended that the IRS find relatively low-cost ways to provide information to taxpayers, such as on its Web site, on the basic tax reporting requirements for virtual currencies. In commenting on a draft of this report, the IRS agreed with the GAO’s recommendation.

“The Service is aware of the potential tax compliance risks posed by off-shore and anonymous electronic payment systems, and we are working to address these risks,” wrote former IRS acting commissioner Steven T. Miller in a May 3 response to the report, which was released Monday. “Our efforts have included discussions with other federal agencies, evaluating our agents’ expertise, developing continuing professional education curricula, proving online and classroom training, and creating lead sheets and questionnaires for agent use during examinations. We agree that providing taxpayers with information on the basic tax reporting requirements for transactions involving virtual currencies could further aid our efforts.”