Internal Revenue Service Preparing to Wield “Fiery Sword of Tax Audits” against Diablo III Gamers
We’ve reported before on how technology oftentimes outpaces the law. But for the millions of people currently playing Diablo III™, Activision’s and Blizzard’s newest release, the opposite has occurred. Here we have older income tax laws catching up to technology in new, unexpected ways. In short, there is a serious likelihood that millions of online gamers are about to incur some federal income tax liability, and the vast majority of them seem not to know it yet. Whether you are a gamer yourself or whether you think gamers need a dose of reality, this post has something for you.
Before getting on with the show, we need to get a few tax disclaimers out of the way. Blame our lawyers for this.
This post discusses federal income tax law, but should not be construed as tax advice. IRS CIRCULAR 230 NOTICE: Nothing contained in this website was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the IRS, and it cannot be used by any taxpayer for such purpose.
The backstory is — Diablo III™’s creator, Blizzard Entertainment, is world renown for publishing games that break new ground in their genres. Their titles include the ubiquitous World of Warcraft™ and Starcraft™ franchises. With Diablo III™, Blizzard has yet again done something new — this time by establishing an online market to buy and sell in-game items. For the unassimilated, Diablo III™ is a role-playing game in which your chosen character fights hordes of demons, finding items along the way that make your character more powerful. Using the online marketplace, dubbed the “real money auction house” (“RMAH”), players can buy and sell these items — not for in-game fake currencies, but for real U.S. dollars. Using the RMAH is optional for players, but more than 3.5 million people bought Diablo III in the first 24 hours it was offered for sale, and untold millions more have purchased the game since then. Items on the RMAH can go for as little as $1.25 and as much as $250. This adds up to millions of dollars in economic activity between players. Because Diablo’s RMAH is the first of its kind for any game, only a few players have so far recognized that their online sales may carry tax consequences. Even among those who have, uncertainty pervades.
10. TAXES. You are responsible for taxes incurred when you use the Auction Houses. All auctions are deemed to occur in the United States of America and are subject to all applicable state and federal tax laws and regulations. Proceeds from auction sales may be considered income for tax purposes. You should consult with a tax specialist to determine your tax liability for these transactions.
A number of blogs have already tackled this issue, here, here, and here, but none have tackled the relative merits of different tax strategies. This is probably because the IRS doesn’t have much of a precedent for this scheme. The best example for players might be the IRS’ treatment of PayPal and Ebay sales, which have to be reported by sellers only if they earn more than $20,000 and conduct more than 200 transactions per year. The rationale for this reporting “floor” is that the IRS does not want to tax people for simply cleaning out their garage. The sellers are likely charging less than what they bought the items for, so in most transactions there would be no realized gain on the sale that could be taxed.
However, neither this $20,000/200 transactions floor, nor the policy rationale behind it, will work for the RMAH. Most sales are going to be for “gain.” Some gamers have cleverly reasoned that their earnings should be classified as hobby gains, which are taxable as income but can be offset by hobby losses — e.g., the money spent to purchase the game (and arguably part of the money spent to obtain a computer that meets the game’s minimum hardware requirements). There is a problem with this, however. Hobby losses are considered “miscellaneous deductions,” and therefore can only be deducted to the extent that they exceed 2% of your adjusted gross income (“AGI”). This means that if you make $50,000, you could deduct only those expenses that exceed $1,000! Because most players won’t spend this much on their Diablo III hobby, classifying their RMAH dealings as hobby income won’t alleviate their tax liability.
On the other hand, if they could convince the IRS that their RMAH transactions are part of a legitimate business, they could claim business deductions to offset their business gains. Unlike hobby income, there is no AGI floor for such deductions. The test for whether an activity is a business or a hobby is whether the taxpayer intends to engage in the activity for profit. In this case, players could possibly use their business losses, including the purchase of in-game items and the game itself, to set off their business gains from item sales to arrive at little or no taxable gain. Of course, convincing the IRS that you play Diablo III to make money, not for fun as a game, is probably one hurdle most gamers will never clear.
One more issue to investigate is whether the income from RMAH sales is automatically
“realized” by the player. Income can only be taxed when it is “realized” — i.e., when the taxpayer gains an unqualified right to the money earned. Blizzard employs a distribution scheme whereby players can either take the money as a credit to their PayPal accounts, minus a %15 processing fee, or as Blizzard currency usable for the purchase of other in-game items or Blizzard games, but which cannot be cashed out. It seems fairly obvious that the former situation is immediately taxable, but the latter is less clear. Still, the latter situation looks like the tax payer has an unqualified right to the money, even if he/she can use the money only for certain purposes. It is a principal of income tax law that receiving a gift card as compensation, e.g., from your employer, is a form of taxable income. How is what Blizzard is doing here any different from that?
So, what’s next? The transactions fees on the RMAH are making Blizzard a lot of money, so I would wager that this game mechanism is here to stay, and we’ll see it emulated on other platforms in the future. How the IRS chooses to treat these transactions, either as business income, hobby income, or income subject to a floor (like their treatment of PayPal profits), is yet to be seen.
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 Please disregard the fact that we are, in fact, our own lawyers.
 AGI is just a fancy tax term for “your total income minus any deductions or adjustments.”
 This also assumes that the players would be itemizing deductions on their returns, but for most young people it makes more sense to the take the standard deduction, which does not allow taxpayers to claim additional miscellaneous deductions such as hobby losses.
 The 7th Circuit in 1983 set forth this rule in Nickerson v. Commissioner.