Beanie Baby Billions? A Look at Internet Tax Evasion

Until the explosion in Internet auctions, probable income tax evasion on private transactions was limited to the relatively minor market of garage sales and swap meets.

However, it seems as if everyone knows someone making money on eBay and other Internet auction sites. Currently, reporting a net gain is the individual seller's responsibility - the auction sites are not responsible for any income tax owed by the sellers. In fact, an eBay disclaimer recommends that sellers consult their tax advisers.

Assuming that these sellers do not report any tax on the gains, Lillian Mills, assistant professor of accounting in the Eller College of Business and Public Administration at the University of Arizona in Tucson, conservatively estimates this unreported tax at more than $100 million on an annualized basis. Professor Mills became curious about Internet income tax evasion because it has received little attention in the Internet tax debate. Most popular press and research articles on Internet taxation focus only on the sales and use tax.

"Beanie Baby Billions?: Unpaid Tax on Internet Auctions," by Mills and co-authors Susan Albring, a doctoral candidate in accounting at the University of Arizona, and Marlene Plumlee, assistant professor at the University of Utah, was published in Tax Notes. All three researchers have prior tax compliance experience as certified public accountants.

The authors estimate the gain on auction sales of collectibles and the related tax. eBay provides a rolling 30-day auction history. This allows anyone to observe private transactions that were previously hidden in the underground economy. The authors sampled completed auctions for a variety of categories, including plush toys (Beanies), coins, stamps, trading cards and others. From these completed auctions, they estimated the total sales of collectibles at approximately $1 billion per year.

Net gains on sales of collectibles are generally subject to a 28 percent capital gains tax rate (although low-income taxpayers would pay the lower 15 percent ordinary rate). Net losses, however, may not be deductible if the IRS deems the trading activity to be a hobby.

Potential unpaid tax is computed at 28 percent of taxable gain, which is calculated as the difference between the auction price and the estimated tax basis. Since none of the information on eBay indicates what the seller originally paid for the item, it is impossible for an outsider to know the seller's tax basis. If sellers sold the collectibles for twice what they paid for them, the annualized estimate of the potential unreported tax on sales of collectibles is $134 million from eBay auctions alone.

The growth in participation in auctions suggests that more taxpayers have the opportunity to evade taxes. "If the Internet increases the number of people engaging in small-scale income tax evasion, such behavior could undermine voluntary tax compliance in the United States," says Mills. The authors suggest that either education be coupled with enforcement to collect such taxes, or that laws be changed to exempt small gains from taxation. In the meantime, Mills recommends that profitable sellers consult their tax advisers about possible tax liabilities.