Selling Virtual Items in an Online Game

Good question. The legalities of virtual transactions have yet to fully sorted out, as per usual, the technology is ahead of the law, so I doubt anyone can give you any definitive answers on these issues, but here are my best guesses.

I know that the IRS's policy is to treat Second Life's transactions as taxable income. Second Life features lots of shopping with Linden currency, and refers to their transactions as purchases, but the IRS doesn't rely on what something's labeled, rather, they look at the practical effect of what's being done because they know that elusive taxpayers are looking for loopholes to avoid tax. So I'd expect they would treat those in your world who purchase things as purchasers even if you call them donors, and call the money you get income, even if you name those transactions redemptions.

Below is a link to a recent IRS report that discusses (at pp. 213 et seq) some of the issues in virtual transactions from a tax perspective.

As for a business license, yes, every business needs one, at least in Los Angeles, and the City expects income taxes to be paid and the County expects property taxes to be paid. If you form an LLC or corporation for this business, Calfiornia's Franchise Tax Board will expect to be paid.

Disclaimer: Please note that this answer does not constitute legal advice, and should not be relied on, since each state has different laws, each situation is fact specific, and it is impossible to evaluate a legal problem without a comprehensive consultation and review of all the facts and documents at issue. This answer does not create an attorney-client relationship.

I agree that the donations would definitely be treated as income since you are not a tax exempt entity. However, you can definitely file taxes as an individual and treat the income, if any after deducting expenses, as self employment income.