That might seem like an absurd question, especially for readers in the United States, where the First Amendment protects the freedom of the press. How can a news website be illegal?

Well, while the First Amendment protects freedom of the press, plenty of other federal, state and local legislation regulates the conduct of business. And the First Amendment doesn’t give news publishers a free pass to ignore that. So you’d better be paying taxes on your business income. And abiding by legal hiring and employment practices if you’re bringing on help.

“No sweat,” I can hear some of you saying to yourselves. “I pay my state and federal income taxes and work by myself at home. I don’t need to worry about employment law or all that other stuff.”

Ah, you work at home, you say? Then you might not be running a legal business after all.

Have you checked your local zoning code to see what it says about running a business out of your home? You might surprised by what you learn. Even if all you do in running your business is to type on your home computer, the fact that you’re earning income that’s not coming from an employer is enough in some jurisdictions to cover you under local home-business zoning and tax rules.

Every few years, the City of Pasadena (California) sends me a letter asking me to pay up for a city business license and tax. The same letter goes to everyone with a Pasadena mailing address who reported Schedule C income on his or her federal tax return who hasn’t obtained a license yet. (Schedule C is the form through which you report all 1099 or miscellaneous income. It’s the form that home business owners who do not incorporate use to report their business income.)

Pasadena’s hardly alone. New York City, for example, levies a unincorporated business tax that hits many freelance writers and website publishers. The City of Los Angeles also hits freelancers and writers (among others) with a city business tax, but exempts the first $100,000 in income. Fail to pay these local taxes and license fees, and you’re running an illegal business.

Now, even through the U.S. postal service assigns me a Pasadena mailing address, I actually live in unincorporated Los Angeles County. So whenever I get that letter, I just reply with a written note that I live outside the city limits, and they leave me alone. But I always wonder how many less-informed LA County residents don’t realize that, and send in the money anyway. It must be enough to make it worth the city’s postage costs in sending out those extra letters.

But even in unincorporated LA County, I’m subject to residential zoning code addressing home-based businesses. (Writing and publishing don’t fall on the long list of home businesses required to obtain an LA County business license, so that’s not an issue for me.) Now, before I go any further, let me acknowledge that busting writers making money on work they’re creating at home is pretty far down the priority list for most communities. Getting money from unpaid taxes is one thing, but zoning enforcement’s rarely an issue for home businesses that don’t generate excess noise, garbage or foot or vehicle traffic.

That said, if you’re writing stuff that might, uh, tick off the powers-that-be in your community, it’s just smart business to make sure that you’re not breaking any rules a vindictive local official might use against you.

So take a look at your local residential zoning code. Here are a few interesting things I discovered about unincorporated Los Angeles County:

The safest thing to do as a publisher is to rent yourself some office space in a legally-zoned commercial office building. That also can help make your emerging business look more legitimate in the eyes of potential customers and clients. But if the numbers don’t work for you paying that extra rent each month, don’t forget to give your local residential zoning code a look before you get too far down the road with your publishing business.

Because even if all you’re doing is writing, you don’t want a local commissioner you’ve just busted in an exclusive expose using that zoning code to bust you in retaliation.

Cover yourselves.

P.S. And LA County? Please, let’s revisit that whole no “video production” thing soon, please?

But let’s not dismiss too quickly the federal government’s potential role in promoting good news coverage. Here are 10 steps that the US government *could* take that would significantly help entrepreneurs trying expand the news coverage of their local communities. And none of them involve direct subsidies or payments to the news industry.

1. Protect Net Neutrality

The Internet has nearly eliminated the barriers to entry for start-up publishers, enabling the explosion of new information sources across the Internet. If we need better sources of local information, the solution is not to allow telecom companies to extract tolls and demand payments from publishers to allow access from readers. That will merely reduce the number of voices available to consumers while further enriching telcos. Corporate media was cutting local news coverage before the Internet. Silencing websites won’t bring back that coverage. It will only reduce the possibility of finding replacements.

2. Expand broadband coverage

The smaller the market, the harder it becomes for a local publication to earn the income it needs to operate as a viable business. The digital divide makes small communities even smaller. Universal access to broadband would make every household part of its local digital marketplace, expanding opportunities for publishers and helping increase the possibility that a professional, responsible news publication in that community could be a financial success. The government can help expand broadband coverage not by caving to the demands of telecos (who are holding broadband expansion hostage to kill net neutrality, for example), but by laying its own fiber lines, establishing public WiFi networks, and by demanding more from companies bidding for broadcast spectrum.

3. Digitize public records and put them online in open formats

You might have noticed that we have millions of un- and underemployed workers in America today, many with digital skills. We also have decades of public records that remain available only in printed form, or in archaic electronic formats. Why not create a WPA-style computer workforce to digitize the nation’s public records and to publish them online, in open formats? Not only would this effort put many thousands of Americans to work, it would create a repository of more easily retrievable public information, allowing citizens (and reporters) easier access to our government.

4. Pass a national shield law, with explicit protection for online publishers

The First Amendment belongs to everyone, not just to print and broadcast reporters. Unfortunately, the shield laws that provide legislative support to the First Amendment vary from state to state, and some courts are unwilling to apply their protections to anyone other than old-school print and broadcast reporters. A federal shield law, with an explicit protection for online publishers, could help create a more hospitable legal environment for start-up news publishers.

5. Regulate transaction fees

Like many retailers, I lose a chunk of every payment made by my customers who use debit and credit cards. While it’s reasonable to expect to pay a bit for the convenience of these forms of payment, given the small number of megabanks that now control the credit card industry, we need government oversight to keep fees reasonable. Congress is taking steps to help this happen, which will reduce operating costs for all small businesses, including start-up news publishers.

6. Revisit COPPA

The Children’s Online Privacy Protection Act sounds like a worthy piece of legislation – no online service can collect personal information from someone under age 13 without that the explicit consent of that child’s parent or guardian (and an email or Web form consent doesn’t count). In practice today, however this act is violated so often as to make the drinking age look like a widely respected law. And it’s not the publishers undermining the law. It’s the kids. Many online community publishers spend way too much time finding and deleting user accounts from kids who lied about their age to register on a website. Creating digital media has become a normal part of life for kids under 13. It’s time to revisit this law and create a new solution that protects kids, parents and publishers. The law should mean something. When this many people violate it, the law is reduced to charade and farce.

7. Ditch the FTC’s “blogger endorsement” rule

This attempt to force truth in advertising is a confusing mess and its inconsistent enforcement has become a joke. If payola disclosure’s important, let Congress pass a law mandating it for everyone – bloggers, newspaper reporters, celebrities and anyone else who publishes. But good online publishers shouldn’t have to worry themselves with jumping through legal hoops that less considerate people get away with ignoring.

8. Model zoning reform

Continuing on the topic of widely ignored laws, zoning laws in many communities make running a business from your home (even a remotely hosted website) illegal. With telecommunity becoming more popular, the lines dividing home from work are becoming more blurred. While zoning remains a local issue, the federal government could encourage local communities to revisit their zoning regulations to encourage the development of online businesses. The first step would be to eliminate restrictions against running from one’s home office a business that employs no one from outside the family on site.

9. Remove payroll tax cap and reduce rate

My last two recommendations would help create a more viable environment for all job creation, not just in online news. Too many digital entrepreneurs are caught by surprise their first year, when they’re hit with the bill for the “self employment tax” – the share of Medicare and Social Security taxes typically paid by employers. When you’re self-employed, you’re on the hook for that share, as well as your regular share as an “employee.”

These so-called payroll taxes are regressive, as they are charged only on the first $106,800 of income. Eliminating the cap would raise additional money to fund these programs, potentially allowing an overall reduction in the payroll tax rate. That would reduce the self-employment tax, making digital entrepreneurship more attraction to journalists thinking about starting up, just trying to make a middle-class income for themselves and their family.

10. National health care

Even more than payroll taxes, the biggest non-income expense for many start-up businesses is health care. I personally know many journalists who’ve stuck with unsatisfying newsroom jobs rather than starting out on their own because of the health benefits. Ever-increasing health insurance premiums effectively serve as a private industry “tax” on job creation in the United States. A national health care plan that divorces health insurance from employment would encourage people and businesses to create jobs by eliminating health insurance as a direct expense of creating (or maintaining) a job. At the very least, opening Medicare to all who wanted to enroll and pay the premiums would create some much needed competition for companies such as Wellpoint, which enjoy near-monopolies in many communities on health policies for the self-employed.

Plenty.

Now, before the libertarians within online news community fire up their torches for my march to the stake, hear me out.

OJR’s David Westphal last week detailed the many ways that government has, uh, helped the news business in the past. Perhaps subsidies of that sort can continue in the future. But I see two, much larger, steps that the government can take that would help ensure a more stable and diverse journalism industry, one that would have the financial ability to fund more in-depth reporting over a longer period of time that today’s newspapers and emerging website can support.

Ready? Here goes.

#1: Raise taxes on the rich. A lot

I’ve insisted for some time now that the problem facing the news industry isn’t the Internet, and the competition that this new medium has unleashed upon newspapers and broadcasters. Plenty of businesses have found ways to profit online, even ones that provide news and community information.

Nor did the Internet catch newsrooms by surprise. News organizations a decade ago saw a more competitive future approaching, and they have employed over the years many visionaries who tried to show them the way to build websites and services that would have allowed them to retain both their audience [the people who read or watch] and their customers [the people who pay, e.g. advertisers].

So why didn’t they? That tragic phrase: “We have a fiduciary responsibility to our shareholders.” In English: “We can’t spend any money on anything that might pay off tomorrow. We have to maximize our income today. Even if that means putting the company’s future at risk.”

Why are investors so myopic? Take a look at this table, which lists the highest marginal federal income tax rates over the years, and the income level at which they applied. There’s a nice graphical representation of this data at fivethirtyeight.com, as well.

(Don’t forget the effect of inflation on those threshold numbers. That $400,000 in 1960 is the same as an income of $2,921,311 in 2009, according to the U.S. Bureau of Labor Statistics. The $200,000 threshold from 1976 would be the same as one of $759,849 today.)

Punitive tax rates change the calculus of investing and income management. Why maximize short-term gains if the government’s just gonna take it all in taxes?

So people don’t. Instead, they start looking for investments that will provide stable (though lower) income over a longer term. Throw in a transaction tax on every stock trade, as well as restoring a punitive tax bracket for earners netting more than a million a year, and the government could sharply reduce the pump-’n-dump speculation that cripples managers’ attempts to build anything for the long haul.

Take another look at those tax rates. The so-called glory days of U.S. journalism, with Watergate and full-funded newsrooms, correlates with the higher tax rates of the 60s and 70s. When the government did away with top tax rates in the 1980s, that’s when we began to see short-term attitudes reach a tipping point in the industry, leading to frequent layoffs and cutbacks (which predated the Web, by the way, for those of us with longer memories.)

On the broadcast side, couple the change in income tax rates with FCC decisions not to hold stations’ feet to the fire on public service programming, and network newsrooms became profit centers, expected to add to the corporate bottom line, not detract from it.

Even today, I’ve spoken privately with many would-be news entrepreneurs who fear soliciting outside investment in their projects, for fear that they would lose control to short-term investors who would gut their efforts for an immediate payday, instead of having the patience to grow a community over time. (I’ll fess up that I share this attitude toward my projects, as well.)

Jack up the tax rates and watch attitudes change. (Bear in mind that I am not advocating a tax increase on lower- and middle-class incomes, anything under $250,000 a year for a married couple filing jointly. In fact, I’d prefer to see payroll taxes folded into the income tax, with a cap on payroll taxes permanently lifted, which could effectively reduce tax rates for many self-employed middle-income individuals.)

Even with a more long-term focus, there will remain plenty of investors and managers who above the punitive tax rate threshold. They will be looking for places to take a loss, to ensure that their money goes where they want it to go, rather than to the U.S. Treasury.

Let’s put it this way: In which environment would you rather be trying to enlist supporters who would fund a new local online newsroom, one that would employ a handful of potentially expensive investigative reporters, with tight local advertising margins making it difficult for the project to stay in the black?

One where investors, enjoying no increase in marginal tax rates as their incomes reache seven figures, were looking for projects that returned immediate large profits off their investment? Or one where investors, trying to avoid crippling marginal tax rates on high income, were looking for places to dump profits from their other investments – the bigger the loss the better?

I thought so.

#2: End employer-provided health insurance

Again, in speaking privately with the many potential news entrepreneurs I’ve met with over the past several years, I’ve heard one reason cited more than any other why they don’t make the jump into starting their own news business.

They don’t want to lose their employer-provided health insurance. Trust me, I feel this pain. Buying health insurance as an individual, you have none of the protection that subscribers to group plans enjoy, including protection against being dropped for undisclosed or even undiscovered pre-existing conditions. I haven’t seen a doctor in two years, in part due to fear that if a physician finds something wrong with me, even if trifling, it might lead our insurer to drop my family’s plan, leaving my kids without coverage.

Most companies selling individual policies also enjoy near monopolies in their local markets [PDF], allowing them to increase rates at will. My provider increased our premiums 36 percent this year, even before it had paid a penny in benefits to us.

Health insurance are the “golden handcuffs” that bind journalists to corporate newsrooms, depriving the industry of a richer diversity of journalist-led publications. Worse, the need to hold on to those health benefits makes journalists risk-averse, afraid of doing anything innovative that might make them a target in the next, inevitable round of lay-offs, should their initiative fail.

From a corporate perspective, paying for health benefits becomes an effective tax on each job created or maintained. Health insurance premiums tip the scales away from hiring (or retaining) full-time employees in the United States to do the work the business needs done. Not having to pay for health benefits makes it that much easier for a business to justify outsourcing or automating work, even if it doesn’t rise to the same level of quality as that done by local employees.

Change the system and take employer benefits off the table, and, again, the calculus of employment changes. Someone would still need to pay for health care – whether it be the government, through a single-payer system paid for by general taxes, or individuals, through privately purchased insurance. But it wouldn’t be employers paying for each job they created or maintained, potentially encouraging them to create (or at least, maintain) additional positions. More reporters = more coverage of their communities.

Benefits would be decoupled from employment, as well, allowing employees to leave or change jobs without having to think about health insurance. That would enable many more frustrated newsroom employees to make the jump into entrepreneurship, increasing the number of new, innovative approaches to the journalism business being tried in the field.

By now, you’ve likely figured out that neither of my suggestions has anything to do, specifically, with journalism. They’re general suggestions to improve the quality of long-term business investment, and hiring, throughout the economy.

That there lies my point. The government should quit worrying about saving specific industries and, especially, companies – whether they be Goldman Sachs, Bank of America, Gannett or News Corp.

Instead, the government should devote its attention to saving the economy, creating a more healthy environment in which forward-thinking companies can grow and would-be entrepreneurs can have a chance to succeed without having to resort to pump-’n-dump tactics.

Do those things, and journalism will find its own way.

Consider your legal exposure when choosing a structure for your business. Mark Anderson, an intellectual property attorney at Masur & Associates, says that, “Especially in terms of copyright infringement claims, damages can be very high, and if you’re not insulated by a corporate entity… then, your personal assets are potentially at stake. If somebody sues you for something that you wrote on your website, they’d be suing you personally, then you could lose your house; you could lose your car. But if you’ve got a business set up, that’s separate from you, it’s the business that would be sued, and the most you could lose from that is what you put into the business.”

According to Anderson, many small publishers find that a limited liability company, or LLC, provides the right combination of tax and legal advantages. Because an LLC is a corporation, its assets and liabilities are separate from those of its principals. However, some corporate structures have a disadvantage, because both the corporation and the individuals deriving income from them pay taxes. Owners of LLCs, along with S Corporations, can avoid this double taxation when their revenues are small, but they can change the way they are taxed if they start to make more money. LLCs have other additional advantages – for example, the ownership rules are more flexible.

An ethics policy or code of conduct may help protect you from libel or defamation charges. Ethics codes have their own virtues, and they don’t protect a publisher from legal action by themselves, but they can help to set the tone for an online community and clarify the publishers’ intent.

The debate over codes of conduct has become more intense because of the recent controversy surrounding threatening comments and pictures posted about prominent technology blogger Kathy Sierra. Sierra told readers that safety concerns led her to cancel speaking engagements and hide out in her home, awaiting the results of a police investigation. What followed was a vigorous, ongoing debate including efforts to create a bloggers’ code of conduct. [Full disclosure: I am a contributing editor for BlogHer one of the groups that figures prominently in both the Sierra controversy and the debate over blogging guidelines. BlogHer’s community guidelines inspired a proposed code of conduct proposed by well-known web writer Tim O’Reilly. Both codes pledge that online publishers will ban “unacceptable content” — content that might be libelous, abusive, or that might infringe on a copyright or trademark.

Anderson says it’s “tough to say” how a bloggers’ code of conduct might affect a legal proceeding. “There are certain protections under the law for journalists, and now it’s getting tougher and tougher to define who, exactly is a journalist. Potentially, adhering to one of these codes might be a factor that weighs in favor of somebody being treated as a journalist under certain laws.”

Small publishers doing journalism have to think carefully about the risks they are willing to take, especially since the legal definition of a journalist is subject to debate. Of course, freelancers and small publishers who commit acts of journalism have to understand that courts may not be willing, for example, to extend state shield laws protections to them. It’s also important to understand that federal prosecutors have broad subpoena powers when it comes to forcing the disclosure of information they deem important for a criminal investigation.

Nothing better illustrates the risks small publishers take than the case of videoblogger Josh Wolf, who was released from federal prison in early April after serving 8 months for refusing to turn over video outtakes from a July 2005 demonstration to a grand jury. Wolf claimed that, as a journalist, he was entitled to withhold the information under California’s shield law. However, the court rejected his claim because Wolf was not employed by a news organization at the time that he shot the video.

Be clear about your purpose. It’s because of Wolf and other citizen-journalists that Christine Tatum, president of the Society of Professional Journalists, thinks that the definition of a journalist should be expanded beyond those who are paid to report the news. “We want to define journalists as people who are gathering information with the purposes of distributing it,” Tatum says. “Rather than question for me being, ‘was that person a journalist?’ the question for me is, ‘was that person practicing journalism?’”

That view of journalists was part of the reason SPJ donated $31,000 to Wolf’s legal defense and helped him obtain the services of top-notch legal counsel. But Tatum acknowledges that the law has not embraced that definition, and neither do many bloggers. Noting that many bloggers say they aren’t journalists but want the legal protections afforded to journalists, she said, “I encourage people to really take a long and hard look at what is it you are, really?”

Take advantage of the growing number of educational resources and training opportunities made available by advocacy groups and professional organizations. Small business attorney Nina Kaufman notes that the Electronic Frontiers Foundation has a plethora of free resources, including legal guides for bloggers. The Media Bloggers Association is just one of several organizations that offers training in journalistic practices and legal issues. They have also taken the lead in advocating for press credentials for its members, most notably in the recent trial of Lewis “Scooter” Libby.

The MBA’s success echoes Anderson’s argument that, “the more professionally you run your blog site, the more you act like a traditional journalist, the more you are going to be treated as a real journalist. That would include adhering to a code of ethics.”

Be smart about copyrights. Anderson quips, “For starters, don’t use anything that belongs to any one else.” Seriously, Anderson urges publishers to educate themselves about fair use guidelines, which permit the use of small portions of copyrighted material for comment, criticism, parody or educational purposes. It’s a serious matter: Anderson warns that copyright judgments come with statutory damages that can be as high as $150,000 per violation. For that reason, Anderson urges publishers to think carefully before choosing to defy a request to remove material that someone claims is infringing on a copyright or trademark.

EFF maintains that major copyright holders such as entertainment companies often make abusive use of copyright laws — combating that abuse is one of their major areas of advocacy.

But online publishers are also copyright holders, and sometimes they, too, have to take action to protect themselves. Blogger Elise Bauer warns that there are some people who use RSS feeds to aggregate others’ content without their permission, forming their own revenue-generating website. Bauer urges using the Digital Millennium Copyright Act against them, either by filing a complaint with Google for content scrapers who use its AdSense program, or by complaining directly to the DMCA office itself.

When in doubt, ask a lawyer Anderson said the published guides and training workshops are great for general knowledge, but it’s best to consult an attorney for really specific questions. And EFF spokeswoman Rebecca Jesschke says that their attorneys have found that some media lawyers are willing to consult with small publishers for a reduced fee, assuming that the matter in question isn’t too involved.

Bottom line: choosing to publish online is an enormous responsibility, and it carries risks. But a professional attitude, self-education and a few proactive steps can go a long way.

Consider liability insurance Anderson says media liability insurance can offer “peace of mind” for online publishers. One leading provider, Media/Professional/Insurance, says the right policy offers much more. M/PI is one of two companies specializing in policies tailored for cyberspace-based businesses.

* * *
In addition: The SPJ, EFF and MBA are just a few of the professional organizations and advocacy groups that offer legal advice and support. Others include:

• American Society of Journalists and Authors: A free list of resources for authors on contracts, protecting copyrights, along with information about the Creators’ Network, a group dedicated to protecting authors’ rights.
• Online News Association: Provides legal resources for its members.
• National Writer’s Union: Has sample contracts, a system for resolving contract disputes between writers and editors, and educational resources for writers and editors.
• Reporters’ Committee for Freedom of the Press

OJR: Are bloggers legally required to report donations to a Paypal account, Amazon wishlist, or other similar fundraising vehicles?

Kushner: I imagine that what your talking about there is that someone has an online magazine in the public domain, and they ask that if people like it, maybe they’d like to contribute money to it to help sustain the publication.

OJR: Right.

Kushner: In that regard, the first issue is, is the person publishing that site doing it for profit motive? If there’s a profit motive, then yeah, of course, any money that they collect would be income.

Now, why do I say a profit motive? What do I mean by that? What I mean is that people sometimes make their hobbies their business. So there’s some tests for when a hobby becomes a business or when a business is really a hobby. If someone is doing this for profit, of course any money they collect – they’re a US person, of course it’s taxable, no matter where it’s contributed from. When I say US people, I don’t [just] mean individuals, I mean a US corporation, partnership, individual trust – whatever it is. A US entity is taxed on its worldwide income.

OJR: For an individual blogger, what is the test to distinguish between a hobby and a business?

Kushner: The way the tax rules are set up is that if your income exceeds your expenses, it’s generally considered a business. Here’s the problem — a lot of people will take their hobby and say it’s a business.

Let’s say I have horses. I own horses, I breed them sometimes, I have a lot of horse expenses. Clearly I like to ride them a lot, but I say I’m in the horse business because I breed them, and whatever it is. I collect a little bit in fees, and I have huge expenses, huge losses in my horse business. It’s almost like a tax shelter, right? If I’m going to do the horses, whether I say I’m in business or not, why not take advantage of the tax deductions and say I’m in the business? So a lot of people will take their hobbies and actually say they’re businesses.

Well, in different types of activities… you have to show a profit in a certain number of years. You can’t show losses every year. Either two out of seven or three out of seven years, you have to have a profit. And there are a lot of other tests. If somebody says it’s a hobby and they’re profiting, the government is going to say it’s a business! The government gets the best of every rule. They have the ability because they have the hindsight. They know what has occurred, and they’ll make the determination based on what has occurred.

OJR: So that means you really have to keep accurate records.

Kushner: That’s the thing. If somebody has a hobby, and they really keep accurate records, and treat in a businesslike manner, the government may agree that it was an attempt at a business, even if you have losses. So, if you’re going to have a business and have losses, you’re going to have to keep really good records.

OJR: When should owners of blog sites file 1099 forms for contributing writers?

Kushner: The rules are the rules. Whenever you pay somebody more than $600 in a calendar year, you’re supposed to give them a 1099. In theory, what you should be doing is before you pay them the first time, you should request a certification of their [tax] ID number. There’s a form, W-9. Keep that on file, in case the payments go over $600.

OJR: In recent years, news organizations have been setting up shop in virtual worlds such as Second Life. Some of these news outlets sell advertising and other products on the web and in-world. They spend money creating offices in world and sometimes stage special events. There has been some discussion about whether assets created and sold in virtual worlds should be taxable. [One journalist, Julian Dibbell, chronicled his failed effort to get an answer to the question in this 2006 article for Legal Affairs magazine.] Given the interest in Congress in taxing revenues generated in virtual worlds, are there things that people who start businesses in those sites should be doing?

Kushner: We have a definition in the tax code of what gross income is. Any time gross income is realized, it’s taxable. Whether or not it’s a profit that you also pay tax on is a different issue, but anytime there’s gross income, it’s reportable gross income. So if somebody receives something of value, or they had an increase in their wealth as a result of a transaction, then it’s considered taxable income.

OJR: Dan Miller, a senior economist for the House joint economic committee, told Reuters last year. that, “you can have a virtual asset and virtual capital gains, but there’s no mechanism by which you’re taxed on this stuff.” Your thoughts?

Kushner: Certainly, if a US person has created virtual wealth which they can exchange for any product or service, or exchange it back into some currency, then it’s reportable income. Under our tax laws, I don’t care what [Miller] says, that happens to be the definition of income, and it’s reportable.

OJR: They have a virtual currency, called Lindens, that can be exchanged for US dollars.

Kushner: If you can convert it back to US dollars, or to Italian lira, or to any country’s currency, at any time, then, all they’ve done is created another medium of exchange. And to the extent that your increase in net worth exists as a result of your exchanges, you have income.

OJR: Is it taxable at the point when you convert it to dollars, or when you acquire it?

Kushner: It’s taxable when the transactions occur. It’s no different than if I convert my money into British pounds, and I put into a British stock brokerage account, and I trade stock in the United Kingdom, and I make money in that account, trading stock. Just because I’m trading it in sterling, doesn’t mean that I don’t have income.

Now, if you buy assets in those currencies, it’s when you sell the assets [that it’s taxable.] It’s what you realize in terms of US dollars Let’s say I buy an asset for £1 million, and the equivalent in US dollars is $750,000. Then I sell it at a £1 million. But when I sell it, the equivalent is $850,000 US because the exchange rate [fluctuates]. I’d have $100,000 of income, even though the sales price and the purchase price was the same.

Now, let’s say I make $1000 in a virtual transaction. If I use that $1000 to pay my office rent and telephone expense and my internet hosting costs – I’m using it for business expenses, I get to deduct those.

OJR: The tricky thing here, is that if you don’t convert your Linden dollars, what you’re buying and selling are virtual assets, which in the real world are just 1s and 0s.

Kushner: But it’s whatever the conversion rate is for those dollars after your own currency. So if it’s dollar for dollar, when you have a closed transaction, you have to measure the value of the transaction in US currency.

[As of Jan. 26, 2007, one US dollar was worth 267 Lindens, according to Reuters’ Second Life bureau.

OJR: You seem to have a very clear position, but it doesn’t seem to be something that is settled in the eyes of the IRS. So what should people who are active in places like Second Life be doing?

Kushner: We have to talk about the difference between US people and non-US people. The issues would most likely be – and I’m only guessing because I haven’t read much about this - transactions [by non-US people] that are occurring within the United States, and whether they should be taxed because they’re occurring in the United States. But they’re not getting taxed because the participants might be somebody sitting at a keyboard in another country.

OJR: It has to do with people in the United States, too.

Kushner: I think the difficulty there is that they probably have no way of tracing those transactions, and they’re probably trying to figure out how to set up some excise tax or something like that. That’s the only thing I can think of, because income tax rules are clear. You have income when you realize the accession to wealth. What that means is that if you sold something for more than you bought it for, no matter what the currency, no matter what the medium of exchange, you have income.

I think people have to aware that what they transact online with virtual dollars, they have to consider just as they would consider transacting business a real bank account. They have to account for the income, and account for the withdrawals for personal use

OJR: Do independent writers who are given equipment and software for review have to report it? (Last year, for example, Microsoft gave laptops with their new Vista operating system to several bloggers.)

Kushner: There are rules that cover that. They’re called the barter rules. If Microsoft sends a computer to somebody and says, “We’d like you write a review of this computer for us, and you can keep it for your trouble,” they’ve bartered that person’s services in exchange for providing them a piece of equipment. A person has income to the extent of the fair value of the piece of equipment that they’ve received.

OJR: Suppose they don’t put it that way. Suppose they say, “We hope you’ll consider writing a review?” But you don’t have to agree to do it.

Kushner: And if they don’t agree to do it, they can just keep the computer?

OJR: Right.

Kushner: And it’s unsolicited? That’s a good question. That depends on the existing relationship between the parties. There’s a couple of different things here.

Let’s pull apart the transaction where somebody gives you a book and says, “We’d like you to review the book.” What they could have done is say, “Here’s $25, go out and buy our book and please do a review for it.” You have $25 income that they’re paying you, then you have $25 expense for buying the book. You’re at zero for that.

A piece of equipment is a little bit different. On my books, when I receive this piece of equipment, I’m going to record “equipment: $500,” and I’m going to credit “income: $500.” Now, I can depreciate that equipment, I can expense that equipment under certain expensing elections. So, to a certain degree, I can come out at zero on that, as well.

The question is, do they have something they’re supposed to report? The answer to that is, “Yes.” They have bartering income.

They should probably be recording the value of that piece of equipment on one side [of the ledger] and either the expense of acquiring that equipment, to do the work that they had to do, value it a capital asset, probably. But somehow, it would become something that they ultimately would get a tax deduction for, in most circumstances.

OJR: I suppose your advice to any one who has questions would be to talk to their accountant.

Kushner: Yes. That’s absolutely necessary. We’ve had clients with Internet businesses, and let me tell you, some of them make substantial amounts of money, and the reason we to them as clients is because in their initial planning, they never thought they were going to make the money that they’re making. So their initial planning was off, in terms of the type of entity selected. There are consequences to entity selection in terms of self-employment taxes and things like that. So planning is key, especially if you are really doing it for profit and you have the potential to make a large profit.