Can My Business be Taxed When it Operates in the Metaverse?

While trying to describe the Metaverse with precision is a bit like trying to nail Jello to the wall, it can be even more challenging to discuss tax issues of the Metaverse. The Internal Revenue Service (IRS) has not yet provided much guidance on the taxation of operating in the Metaverse, but you can bet they will find a way to tax Metaverse transactions, capital gains, and profits.

You need to learn about these issues if you are considering dipping your toe into the Metaverse pool. A Maryland business tax attorney can talk to you about the question, can my business be taxed when it operates in the Metaverse? The short answer is yes.

What Kind of Taxes Are Possible When Doing Business in the Metaverse?

Just as something as simple as sales tax was murky initially on online selling platforms like Amazon and eBay, transactions in the metaverse will involve the possibility of sales tax, income tax, and capital gains.

Many people mistakenly think that because goods, services, and cryptocurrency are virtual as opposed to a physical item one can hold in a hand, there are no tax implications. That way of thinking could lead to a massive tax bill eventually.

Another common mistake is that because it is difficult, if not impossible, to track assets that utilize blockchain technology, the IRS will not be able to calculate the financial values of metaverse transactions. As with previous attempts to avoid taxation, like offshore accounts, one can only fly under the radar temporarily before the IRS figures out away or to find, track, and tax sales, purchases, and other transactions.

Taxable Implications of Cryptocurrency

Buying or using cryptocurrency could have tax implications for people who: 

• Sell or trade in cryptocurrency 

• Who pay for good or services with cryptocurrency

• Who receive cryptocurrency as payment for goods or services

• Buy and hold cryptocurrency as an investment

The IRS says that transactions that use virtual currency are taxable just like any other type of currency or asset transactions. The IRS defines virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” When a type of virtual currency can get used as a substitute for or exchanged into “real currency,” like Euros or U.S. dollars, the IRS considers that cryptocurrency as “convertible” virtual currency. 

Using cryptocurrencies can result in a capital gain or loss. If you sell cryptocurrency at a profit or get paid in a digital asset for a good or service, you have reportable income. People who bought cryptocurrency as an investment years ago have seen the value plummet recently, with some cryptocurrencies losing 75 to 80 percent of their value. These individuals could have a tax loss.

Let’s say you bought cryptocurrency several years ago and then used it to purchase a nonfungible token (NFT) after it gained in value. Imagine buying $1000 of cryptocurrency, holding it until it increased enough in value you used it to buy a $15,000 NFT. You would have a taxable game of $14,000.

Is the IRS Really Going After People for Back Taxes on Cryptocurrency?

Yes. Back in 2019, the IRS started sending letters to taxpayers who the IRS suspected of failing to report income or not reporting the transactions correctly. The IRS notified these taxpayers that they must pay the back taxes as well as penalties and interest. The IRS has increased its attention on virtual currency transactions. They have increased their use of data analytics. The outreach from the IRS concerning non-compliance includes: 

• Trying to educate taxpayers about the taxpayer obligations regarding virtual currency transactions

• Audits

• Criminal prosecution

There does not appear to be a grace period for taxpayers who do not realize the tax consequences of virtual currency transactions. When the IRS discovers that a taxpayer did not properly report and pay the applicable taxes on cryptocurrency transactions, there can be interest and penalties going back to the transactions in question.

General Tax Principles That Apply to Virtual Currency Transactions

Notice 2014-21 from the IRS explains to taxpayers and tax professionals how cryptocurrency transactions fall under already existing tax principles. So far, there does not appear to be a need to write new tax laws to address crypto transactions. The challenges for the IRS are to discover: 

• Who engages in these transactions 

• The dollar amounts involved, and 

• Issues like the taxpayer’s adjusted basis for purposes of capital gains tax

Some things you might want to know about how the IRS views and treats virtual currency and transactions with it include:

• Although your home state might treat it in some other manner, the IRS considers virtual currency as property for purposes of federal tax law.

• The IRS does not treat cryptocurrency as foreign currency that could create foreign currency gains or losses.

• If your business accepts virtual currency as payment for services or goods, you must report that amount in your company’s gross income.

• The amount of the income derived from these transactions will be the fair market value (FMV) of the cryptocurrency on the date you received the virtual currency, and measured in U.S. dollars. The FMV on the date one receives the virtual currency also determines the basis of that cryptocurrency.

• You must report virtual currency transactions in U.S. dollars. If you trade in or accept virtual currency that gets sold on an exchange, you can convert the FMV into U.S. dollars using the exchange rate. 

• If you hold cryptocurrency as a capital asset, you could realize a capital gain or loss when you sell or exchange the virtual currency. Usually, you will realize an ordinary gain or loss if the cryptocurrency you use in transactions is not a capital asset.

• The IRS does not apply a different tax rate to transactions that happen in the metaverse as opposed to the real world or physical world.

When you understand that cryptocurrency is a type of property that is convertible into U.S. dollars and capable of generating income and ordinary or capital gains or losses, you merely need to apply general IRS taxation principles to your business virtual currency transactions to see the tax implications involved with using this currency. Most of the metaverse taxation issues surround the use of virtual currency.

Reporting Payments Made Using Cryptocurrency

In recent years, the IRS has cracked down on “under the table” payments for goods or services. If a business pays $600 or more to an independent contractor during a tax year, they must report that payment to the IRS and issue the legal entity they paid a Form 1099 MISC, Miscellaneous Income. The tax treatment of payments made in virtual is the same as for other forms of legal tender. The recipient must report the income on their income tax return.

The Future of the Metaverse

According to Prager Metis, the metaverse is “a highly immersive virtual world where individuals will be able to come together to socialize, play, work, and trade in virtual (and non-virtual) goods and services.” The metaverse uses blockchain technology and smart contracts. Smart contracts, also called digital contracts, are rules programmed into the metaverse blockchain.

Prager Metis warns people who get involved in any transactions in the metaverse that they should not mistakenly think their economic activities will be invisible to the tax authorities. The IRS and other tax authorities already have or are developing the technology to access information about cryptocurrency holdings and transactions. Some people think that the metaverse is an autonomous virtual space that the IRS and governments across the real world cannot control or regulate, but that is a false assumption.

The IRS can find many digital assets and digital currency transactions and calculate a taxpayer’s back taxes on nonfungible tokens (NFTs), sales, payments, trades, and other metaverse activity. The activity will likely take place in the locations where the taxpayer actually is a resident.

Imagine that Person #1 creates virtual real estate for use as augmented reality in virtual worlds and sells the virtual real estate for $1 million to person #2. The sales tax rates are the same as for any other sale of a good. Person #1 could owe income and sales tax where they live and file their taxes. Person #2 resells the digital item for a profit. Person #2 could owe sales tax and either income or capital gains tax where they live and file their taxes.

Considering the fact that some digital items sell for millions of dollars, that cryptocurrency values can and do fluctuate wildly, and that there is currently no government oversight over the metaverse or transactions in it, there will be questions about taxation and many other issues for years to come. You will want to assess your risks of doing business in the “wild West” that is currently the metaverse.

If your company is considering doing business in the metaverse, educate yourself and talk to a Maryland business attorney about the taxation and other issues that might apply to your industry.