The Internet has become ubiquitous for much of the population, but your clients may not be aware that their Web activities could produce tax liabilities and some may change in their individual tax status (for example, to sole proprietor). As a practitioner, you need to remind your clients to ensure that all of their Internet-related income is reported and that they are compliant with all relevant taxes. This article provides a set of questions to aid in this endeavor.

Why Ask?

Internet applications, from shopping to investing to game playing, continue to grow in size and variety. About 70 percent of individuals in the U.S. use the Internet (The Progress & Freedom Foundation, The Digital Economy Fact Book (PDF)).

The U.S. Department of Commerce reports that e-commerce sales for the third quarter of 2007 were 3.6 percent higher than for the second quarter, totaling almost $35 billion. While that represents only 3.4 percent of total retail sales, it is a significant increase over 1999, when e-commerce sales accounted for less than one percent of retail sales.

eBay reports that over $1,800 of items are traded worldwide on its site each second and about six million listings are added every day. A 2005 ACNielsen survey found that over 700,000 people in the U.S. use eBay as a key income source, while about 1.5 million use it to supplement their income.

It is estimated that in 2007, $700 million of goods and services were sold in Second Life’s virtual world (The Digital Economy Fact Book (PDF)). Internet gambling, a $13 billion industry worldwide (per H.R. 2046), likely generates over half of that revenue from the estimated 12 million to 20 million players in the U.S. (MarketWatch).

Questions to Ask Your Clients

1. Did you make purchases from online stores or auction Web sites?
Relevance: Many online purchases are likely from out-of-state vendors who are not required to collect sales tax in the client’s state. However, unless the client lives in a state without a sales tax or the item is exempt in the state, the client owes use tax. States vary on how and when use tax is remitted and the state tax agency Web site can be consulted for guidance. Clients can find details of past purchases from credit card statements or the “my account” link at the vendor’s Web site.

2. Did you sell anything online (new or used goods, intangibles, information or services) using an auction Web site or your own Web site?
   Relevance: There are many online sites where people can sell used books, collectibles, inventory, online game features, URLs and much more. A client’s selling activities should be reviewed to determine whether they constitute a trade or business, a hobby with reportable income (IRC §183) or non-business selling but with an occasional item sold at a gain. Trade or business-level selling requires filing of a Schedule C, identification of related expenses and payment (and perhaps registration) of various taxes including self-employment tax, state income tax, business license tax, sales tax and property tax. A client may also need guidance on recordkeeping and sales tax rules. Sales tax registration rules should be reviewed for any client with sales. For a client with numerous online securities trading transactions, consider whether the activities have moved beyond investor status to trader or dealer with different tax treatment.

   Example: In 2007, Henry sold, via an auction Web site, two personal possessions:

i. Used coat generating a $100 loss.
ii. Signed Ansel Adams poster generating a $325 gain.

Henry’s activities do not rise to the level of a trade or business. The loss is not allowed for tax purposes. However, the $325 gain is a taxable capital gain.

Example: Mai had over 200 transactions on eBay in 2007 selling items acquired at garage sales. Mai spends about 20 hours each week on this profit-generating activity. Mai has not obtained a business license or registered in her state for sales tax. Mai’s tax adviser should determine in what states Mai has sales tax collection obligations (where she has the requisite physical presence). Assistance is also needed regarding other taxes owed and recordkeeping.

3. Did you generate income from online games, gambling, raffles or cashing out virtual money for real money?
   Relevance: Individuals might engage in transactions where their virtual money is profitably converted to real money. Clients may have engaged in online gambling or betting, whether legal or illegal, and generated income. Should a client admit to illegal gambling, the practitioner should proceed cautiously and consult an attorney. Clients should also be made aware, perhaps with a reminder on the tax organizer, that there is no privilege for communications beyond those covered by IRC § 7525.

4. Did you generate income from links on your Web site?
   Relevance: Client Web sites may have ads or links to online sellers who pay a commission for sales generated after linking from the client’s Web site. The client might not keep adequate records of amounts earned, however online records might exist at the seller’s Web site. The Web site activities should also be reviewed to determine if a trade or business exists.

Example: Sarah home-schools her children. In 2007, she decided to share some of her lessons and techniques by creating a Web site. The site turned out to be quite popular. Sarah was approached by companies wanting to place ads on the site. Sarah spends about 10 hours per week maintaining the site and generated over $7,000 in 2007 from advertising and referral fees or commissions from click-throughs. Sarah has started a business for which she needs to consider quarterly estimated taxes, self-employment tax and business license tax. She also needs assistance with recordkeeping and tax and business planning.

5. Did you loan or borrow money through an online site that matches borrowers and lenders?
   Relevance: Several Web sites allow lenders (investors) and borrowers to connect, usually indirectly through the operator of the Web site. Check for a Form 1099-INT. Also, consider the foregone interest rules of IRC §7872 if the rate was below market.

6. Did you have any other Internet transactions that generated income or a deduction?
   Relevance: Your client may have found some other way to generate income online that is not covered by earlier questions. This client may have deductions from online activities, such as by making donations without keeping records or may have donated virtual money or points that have real value.

Looking Ahead

Lawmakers and tax agencies are still working to understand and address the tax treatment of some Internet activities. Tax gap solutions may include 1099s for online auction sellers. Lawmakers continue to look at the appropriate legal status of Internet gambling, as well as its tax-generating potential (for example, H.R. 2607, 110th Congress). The Joint Economic Committee is studying how tax rules apply to virtual economies and a report is expected (Virtual Worlds News, 8/22/07 and Tax Notes, 1/15/07). In the meantime, practitioners must not only keep abreast of tax law changes, but also new and emerging Internet activities that may affect a client’s tax situation.

Annette Nellen, CPA/ Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.