I don't make money in SL, but, I do have a small online business selling photographs. Every year, the site that does the customer fulfillment for me sends me a Federal 1099 form showing my income, which I dutifully declare to the IRS.
If SL does not issue 1099s I'm not sure how the IRS would discover your income, and merely transferring L$ to your Paypal does not necessarily mean it's income.....
I did earn L$500 as a female avie escort back in '05 (don't ask), I wasn't quite sure how to broach the subject with my tax guy *laughs*