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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.[1]

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.

Here at IBL, we think some basic tax 101 is in order for many of these players.  The bottom line is that the IRS defines income very broadly.  Section 61 of the IRS Code provides that “income” is taxable regardless of the source, and that income includes “[c]ompensation for services, including fees, commissions, fringe benefits, and similar items.”  Money received in exchange for in-game items will probably always qualify under this loose definition.  Even Blizzard recognizes this in their posted Terms of Use for the RMAH:

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”).[2]  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,[3] 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.[4]   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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[1] Please disregard the fact that we are, in fact, our own lawyers.

[2] AGI is just a fancy tax term for “your total income minus any deductions or adjustments.”

[3] 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.

[4] The 7th Circuit in 1983 set forth this rule in Nickerson v. Commissioner.

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25 Comments Post a comment
  1. Kevin #

    Yeah, tax the 10 people who still play 😀

    Of course I arbitrarily picked a low number, but there is a really low playerbase.

    July 2, 2012
  2. Anonymous #

    I would still argue that “Blizzard credits” cannot be considered realized money, why? Because unlike gift cards, Blizzard credit is tied to you 100%; you can’t take it anywhere, you can’t use it for anything, etc. Gift cards are basically money earmarked to a certain company, regardless of who spends it. Since Blizzard credit is non-transferrable, it is not really a currency.

    Tl;DR; you can sell gift cards, you can’t sell Blizz-cred

    July 3, 2012
  3. I would still argue that Blizzard credit is not “realized” money. Gift cards are basically money… that is just earmarked to be used by a certain company (I wonder if the court the article referenced is talking about the “Visa” gift cards or ANY gift cards, like to certain stores or restaurants). Blizzard credit, on the other hand, is non-transferrable AND more important, there is no direct way to transfer money into Blizz-cred or Blizz-cred back to real money. Since this is possible with gift cards, its logical to say that gift cards are real money, but not that Blizz-cred is

    July 3, 2012
    • steveramaley #

      This is a good point, though I think I ultimately disagree with you. The answer to your question is that I was talking about any gift cards. The IRS views income as any form of compensation, technically, so the fact that it isn’t 100% liquid doesn’t make it nontaxable; it just makes it harder to value (which in turns makes it harder to tax). So, I think the letter of the law is against you here, but if you are going to seriously make the argument that the IRS *shouldn’t* tax you, I think this is a good route to go.

      July 3, 2012
      • Acemac #

        wait a min! so by that logic you could say that selling an in game item for in game gold on the GAH (gold auction house) is also taxable? now that they have released the sale of gold in the RMAH gold has a monetary value. so do I need to claim every million gold I make as a $1.25 income?

        so if what your saying is true this could kill video game currency altogether?

        July 18, 2012
      • steveramaley #

        Hey Acemac,

        You’ve touched on an issue that I skirted in the original post but is, I think, technically correct and really interesting.

        All forms of compensation are taxable, with the only real limit being the IRS’ ability to determine fair market value of the compensation. Now that we have a FMV for gold, it would seem that the receipt of gold may be taxable too.

        Perhaps even more interesting is that gold trading prior to the RMAH may also have been, technically, taxable. A tenet of income tax law is that even black market or illegal income is taxable. There are famous tax cases that say that embezzled money is taxable income, and when you get caught and have to give it back you actually get a tax deduction. (Hey, at least they are being fair here.)

        This raises three issues for me —

        (1) The IRS hasn’t gone after gold transactions yet, as far as I know. This means they probably don’t care, or don’t consider the loads of microtransactions involving gold to be worth the time and effort. The same could be true for the new RMAH item sales. However, the point of my original post was that selling “items” for “dollars” looks a lot more like “ordinary commerce” than other game transactions and seems to be a growing trend with larger dollar values. If the IRS wants to go after this stuff, they could.

        (2) There is some potential that the IRS would view buying/selling gold for U.S. dollars as a form of currency exchange. There are IRS rules that you don’t need to report the sale of foreign currency as income unless you make more than $200 on the exchange (and even then it’s typically capital gains). Not sure that the IRS would let game gold fall under this exception, but it’s at least plausible.

        (3) There is a larger issue here for foreign sellers. Among other legal and logistical hurdles, tax judgments in the U.S. are typically unenforceable abroad. I’ll digress here but just be aware that the IRS is unlikely to come after players anywhere other than the U.S.

        (Edit: forgot to sign in before I posted!)

        July 18, 2012
  4. Anonymous #

    Article has it wrong, for Paypal its 20k usd AND 200 transactions; not OR.

    July 3, 2012
    • steveramaley #

      You are right, great catch. Making that update now.

      July 3, 2012
      • Anonymous #

        Sorry, that came off as a bit angry; too early to process things yet. Good article though ;D

        July 3, 2012
  5. hi Steve, I wrote one of the blog posts you linked from here (http://blog.tusharnene.com/2012/06/death-taxes-and-diablo-iii.html) and I’m glad I got to read this. I’m not a tax pro by any stretch but from my personal experience I guessed that the most relevant part of what is taxable would be the profits realized as opposed to a digital balance in a Blizzard account which I’m glad to see I wasn’t wholly off on.

    Deducting hobby expenses for most people will likely be nothing based on the 2% rule (by my understanding). But I have doubts as to whether or not using the RMAH can ever be classified as a business as opposed to a hobby from the IRS guidelines. As the IRS puts it, “Does the time and effort put into the activity indicate an intention to make a profit?” It would be easy to say yes, but a player’s only evidence is that they put more effort into the game, which is the same action of someone who is just playing for fun and wants to play more.

    And if such a case was successfully made, would Blizzard have recourse to charge extra royalties or fees to that user beyond their 15% cut?

    There’s a few people commenting on what I wrote – I’ll link them here for some more insights.

    Thanks,
    Tushar

    July 3, 2012
    • steveramaley #

      Hey Tushar, thanks for the comment. I enjoyed your post as well.

      You raise all good points here and in your blog. We agree about the Hobby income and business loss parts of the Code not being much help here. The only thing I would add to your commentary is that it probably doesn’t matter for income realization whether you collect your RMAH sales as U.S. Dollars via PayPal or as “Blizzard Dollars” only redeemable for the purchase of other Diablo III items or Blizzard products. While the latter is less obviously taxable, it’s still income under how I understand the IRS to define it. “Blizzard Dollars” are valid only for the purchase of Blizzard products because your agreement with Blizzard says so, and you even had the option to take a 15% pay cut to make those funds fully transferable. So, just like how the IRS would tax you for being paid in gift cards to Starbucks, for example, the IRS probably wouldn’t care about how you can or can’t use your “Blizzard Dollars” — you are being compensated (and even in a manner that you consented to).

      Here’s a thought, though —- if you do take “Blizzard Dollars,” you maybe could claim that the amount of your taxable income should be reduced by 15% to reflect the “fair market value” of the “Blizzard Dollars.” The IRS might buy this argument, but this is pure speculation.

      July 3, 2012
  6. Anonymous #

    Entropia Universe by MindArc (2003), look it up before dubbing Blizzard the great innovator of game development.

    July 5, 2012
    • Anonymous #

      So true, Blizzard have barely done anything original in all the years I’ve been playing their games. What they do is take the better features of other games that came before them and mash them together into a highly polished title WoW being the best example of that, Its 20 games and themes rolled into 1 and polished like a mirror.

      July 18, 2012
  7. Acemac #

    So at what point will the IRS look at the collection of gold in a game that gives gold a RMV a valid place to make revenue for the state/ country?

    What kind of profit would the IRS need to produce from this until they decided it was worth pursuing? Seems to me that if they taxed the collection of in game gold they could possibly make millions.

    FYI my wife will never let me play another video game again if it increases what I have to pay to the government in April…

    July 18, 2012
    • does she not realize she might get more revenue to spend? #Romney2012

      July 19, 2012
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