Hi Fantasy Sports Owners! I know it can be tough to pull yourself away from the all-important decision of whether to start Dalton Schultz or Jace Sternberger at tight end this week, but if you’ll lend me a few minutes, I’ve got some tax news that might just interest you.
MANCHESTER, NH – SEPTEMBER 13: Tim Dent, chief compliance officer at DraftKings, from left, New … [+]
Getty Images for DraftKings
For the second time in four months, the IRS has addressed the world of daily fantasy sports (or DFS, for short), and if you’re scoring at home — and you are; in fact, it’s really all you do — it’s now IRS 2, DFS 0.
At first blush, the latest round of IRS guidance appears to be good news for DFS enthusiasts. After all, the Service concluded that a DFS player may (eventually) deduct entry fees against any fantasy winnings when preparing his or her tax return.
And while that may make those who play DFS happy, how the IRS reached that conclusion will set off a panic among DFS operators.
Let’s take a look…
Section 165(d), In General
Section 165(d) allows a taxpayer to deduct losses from “wagering transactions,” but only to the extent of the taxpayer’s gains from such transactions. For all but professional bettors, however, the deduction — along with all other so-called “miscellaneous itemized deductions” — is disallowed from January 1, 2018 through December 31, 2025.
Last Friday, the IRS published PLR 202042015, in which the Service determined that amounts paid to participate in a DFS contest — such as those made popular by DraftKings and FanDuel — constitute an amount paid for a “wagering transaction” under the meaning of Section 165(d). And while that may strike you as nothing more than a logical conclusion, the ruling may have far-reaching implications for the daily fantasy industry.
Daily Fantasy Sports, In General
During the simpler era of the early aughts, if you wanted to participate in fantasy sports, there were long-term consequences for your incompetence. If you drafted a quarterback with a penchant for bad weeks or a running back prone to twisted ankles, your decisions would plague you for a full 17 weeks.
But some time around 2007, daily fantasy sports were born, allowing participants to escape their own ineptitude and get a fresh start each and every Sunday. No longer must you be saddled with Ryan Fitzpatrick’s maddening inconsistency or Miles Sanders’ porcelain exoskeleton for more than 24 hours. Instead, each Sunday your challenge begins anew: armed with a “salary cap,” you pay an entry fee, fill out a roster, and then based on the combined efforts of your drafted players, compete against millions of others for cash prizes.
In the ruling issued last week, the IRS concluded that DFS entry fees are gambling expenses. This is bad news for the industry, because in many states, the very existence of sites like DraftKings and FanDuel is predicated on the premise that playing DFS is NOT gambling, but rather a “game of skill.”
State Law Treatment: Contest of Chance or Game of Skill?
The distinction is a nuanced one, but one that, long before it drew the attention of the IRS, has been debated in numerous states around the country. Individual states vary in their regulation of DFS: some have determined that DFS is illegal gambling under state law, while others have enacted legislation based on the premise that DFS is indeed a game of skill, not gambling, in order to decriminalize the activity under state law. Still other states enacted legislation simply stating that DFS is not gambling (without opining on whether DFS is a game of skill), while others have taken no position specifically relating to DFS. And some states have seemingly done all of the above; as evidence, look no further than the epicenter of the legal battle surrounding DFS: New York.
Gambling, as a general rule, is illegal in New York pursuant to its state constitution. In order to receive an exemption from that general rule as certain institutions like the state lottery and limited casinos have, a measure must be placed on a ballot and passed by the voters.
When DFS operators began doing business in New York, they did so without following these formal procedures for an exemption, relying instead on the position that DFS was not gambling, but rather a game of skill. In 2015, however, Attorney General Eric Schneiderman issued a cease-and-desist order to DraftKings and FanDuel, arguing that DFS was illegal under state law, which specified at that time that games where players “risk something of value” and do not have “control or influence” over the outcome, are gambling.
In response, DraftKings and FanDuel filed lawsuits against the state, arguing that their games were one of skill rather than “contests of chance.” Under New York law, a contest of chance is defined as a game where the outcome depends to a “material degree” on an element of chance. In turn, gambling is roughly defined as staking or risking something of value upon the outcome of a contest of chance.
In their defense, DraftKings and FanDuel once again argued that DFS are indeed games of skill. They claimed that a player’s success is dependent on their skill in research, analysis, and investigation. In addition, contestants must monitor and assess other conditions such as the opposing team’s defense in the real life game, which may play a factor in an athlete’s production. Finally, contestants may monitor an athlete’s strengths and weaknesses and a player’s production-per-minute of gameplay.
During hearings, the judge disputed assertions by the services that a player’s choice of athletes represents “control or influence” over the outcome, stating that players are ultimately “relying on someone else’s skill” to determine an outcome. As a result, on December 11, 2015, a temporary injunction was granted, forbidding DraftKings and FanDuel from accepting entry fees, wagers or bets from residents of New York.
Just one year later, however, New York changed its tune. On June 18, 2016, the state senate approved legislation to legalize daily fantasy sports. It did so, however, without putting the bill on the ballot for a vote by the general public.
As a result, a group of private citizens immediately filed suit, alleging that the state legislature had violated the constitution. The group was victorious in 2018 when the court held that DFS was, in fact, gambling, and thus violated the state constitution’s ban on such activities. That decision was upheld by an appeals court last February, and is now heading to the state’s top court — the Court of Appeals. In the meantime, DFS operations are free to collect entry fees in New York.
The IRS Has its Say
In PLR 202042015, the IRS for the first time shared its thoughts on whether DFS constitutes “gambling;” in this case, for the taxpayer-friendly reason of allowing a deduction for entry fees. In concluding that DFS is indeed gambling, the Service relied on the “plain, obvious and rational” definition of gambling, as discussed in Tschetschot v. Commissioner, T.C. Memo 2007-38. In that decision, for purposes of applying Section 165(d), the Tax Court examined dictionary definitions of “wager”, including Random House College Dictionary’s definition of “something risked or staked on an uncertain event; bet; the act of betting,” in ultimately holding a poker tournament is a wagering activity.
The Court also considered the following definition of “wager” from Black’s Law Dictionary:
Money or other consideration risked on an uncertain event; a bet or gamble. 2. A promise to pay money or other consideration on the occurrence of an uncertain event.
In its PLR, the IRS went on to cite numerous state courts that have held that the definition of wager “requires two or more parties, having mutual rights in respect to the money wagered, having a chance to win or lose upon the outcome of an uncertain event.” In this way, the IRS stated, a wager is distinguishable from a prize. Unlike a wager, state courts have found that a prize or reward is compensation for an act done. For example, in Las Vegas Hacienda, 77 Nev. 21, the court held that an offer to pay $5,000 for shooting a hole in one to any golfer paying a small fee was a prize, not a wager.
Next, the IRS looked specifically at how DFS fit within the wager/prize paradigm, stating:
DFS transactions meet the definition of wager as interpreted by the Tax Court and state courts because there is an uncertain event (such as the live performance of individual players), winnings if the event resolves in participant’s favor, and consideration is lost if the event does not resolve in participant’s favor. Each DFS transaction is a pay to play competition with predetermined winnings for a certain number of participants. The outcome of the competition turns on the overall statistical performance of live professional players assembled into the fantasy team. The winning participant receives a return of his or her initial bet along with wagering gains, while the losing participant walks away empty handed. This is consistent with the courts’ interpretation of the term “wager.”
Having concluded that a DFS entry fee is a “wager,” the IRS next took issue with the characterization of DFS as a game of skill for tax purposes by looking to the relevant history:
As a general rule, a contest in which a prize is offered based on the mental or physical skill of the contestant is not considered gaming. Revenue Ruling 57-521 examined a puzzle contest in which contestants submitted solutions with a fee per submission to play and concluded that the puzzle game was not a wagering pool or lottery under the excise tax provisions of Sections 4421 because the outcome relied entirely on the contestant’s skill in completing the puzzle. The Service later distinguished this type of contest as a game of skill from poker tournaments which are considered wagering. DFS transactions are similar to poker and other wagers in which a player’s skill is a component of the game but it does not dictate the outcome. As such, the argument that DFS transactions are excluded from wagering as a game of skill are unpersuasive. It may also be argued that the DFS pay to play transactions are entrance fees for their team, comprised of players selected by the taxpayer based on knowledge and skill, to compete. However, the test is not whether there is an element of chance or skill, but which is the dominating element that determines the result of the game. While skill may be involved in drafting the players of a team, the taxpayer’s skill has no impact on the players’ live performances. Although skill may be an element of the transaction, chance dominates the outcome of the transactions. Any argument a DFS transaction is not wagering because it is based on skill must fail because elements of chance beyond the participant’s control ultimately determine the outcome of the transaction.
Because the IRS concluded that DFS entries are contests of chance, rather than games of skill, the DFS entry fees represent wagers, and are deductible under Section 165(d). Or, as stated earlier, for nonprofessional bettors, the fees WILL be deductible again in 2026, when Section 67(g) of the Tax Cuts and Jobs Act expires, allowing for the deductibility of other miscellaneous itemized deductions.
All of this, of course, raises an interesting question. Why would the IRS bother to rule on the deductibility of DFS entry fees at a time when the overwhelming majority of players will not be permitted to deduct the fees anyway?
The answer may relate to a previous internal memo by the IRS on DFS; one that created a stir within the industry and could potentially end its existence.
IRS Memo 2020-009
Earlier this summer, the IRS sent shockwaves throughout the DFS world by publishing an internal memo suggesting that DFS entry fees are subject to an excise tax under Section 4401. The tax ranges from 0.25% to 2% per wager depending on whether or not the wager is authorized under the law of the state in which the wager was accepted.
These excise taxes are well known to conventional sportsbooks, as they apply to all “wagers.” By applying the tax to DFS fees, however, the IRS for the first time concluded that such fees represent wagers for these purposes. In reaching its conclusion, the IRS followed nearly the same logic as it did in PLR 202042015. Which makes one wonder, of course, if PLR 202042015 was used to strengthen the Service’s previous — and much more impactful — position in Memo 2020-009.
In the memo, the IRS referenced many of the same authorities —- in some cases, using identical language to last week’s PLR — to build the case that DFS entry fees are wagers.
The IRS first noted that Section 4421(1) defines wager as (A) any wager with respect to a sports event or a contest placed with a person engaged in the business of accepting such wagers, (B) any wager placed in a wagering pool with respect to a sports event or a contest, if such pool is conducted for profit, and (C) any wager placed in a lottery conducted for profit.
The IRS concluded that a DFS entry meets the definition of wagers in both A and B, above:
A DFS entry fee is a wager of money by the participant with respect to a sports event or contest placed with a person engaged in the business of accepting such wagers (the DFS operator) as described in IRC § 4421(1)(A). A DFS entry fee is also a wager placed in a wagering pool as described in IRC § 4421(1)(B) and Treas. Reg. § 44.4421-1(c)(1). The DFS entry fee is the wager. The entry fees are placed in a common fund with the other participants’ DFS entry fees – this is the wagering pool. The successful bettor (or bettors) receive the pool proceeds, subject to the DFS operator’s commission. The game involves each selected fantasy player’s performance in a real sports event. Finally, the DFS operators derive profit from their operation of DFS by retaining a commission or taking a fee (the rake) from every participant who participates, meaning the wagering pool is conducted for profit.
Next, the IRS referenced DFS operators’ ongoing battles with state legislatures over whether their business is a game of chance or a test of skills, and decided that for excise tax purposes, well…the distinction doesn’t really matter:
A DFS operator may try to differentiate taxable wagers from non-taxable entry fees into skill-based contests. In state courts and state legislature discussions of DFS, the issue of DFS’s legality within each state typically turns on whether DFS is a game of skill or a game of chance (that is, gambling) under the state’s laws. While these state rules are helpful context, the statutory language in IRC §§ 4401 and 4421 does not differentiate whether an activity involves skill, chance, or some combination of the two. Most importantly, whether DFS is a game of skill for state gambling statute purposes is not relevant for determining whether DFS is wagering for federal excise tax purposes. Still, the presence or absence of skill in a contest may help determine whether an entry fee constitutes a taxable wager, or not.
The IRS then compared and contrasted a DFS entry to a puzzle prize that was the focus of a 70-year old Revenue Ruling that was also discussed in the PLR:
In Rev. Rul. 57-521 a puzzle contest, in which the element of skill rather than that of chance determined the winners, was not a wagering pool or lottery. The ruling noted that skill is a component of determining whether a contest is a “gaming transaction.” In the puzzle contest described by Rev. Rul. 57-521, there was only one correct answer to each puzzle. Additionally, the contest participant solved the puzzles. This is not like DFS. If the puzzle in the revenue ruling was similar to DFS, the contestant would choose a person or persons from a field of puzzle solvers who the contestant believed had the greatest chance of solving the most puzzles and would be wagering based on that person or persons’ expected performance. In the revenue ruling, the contest participant’s own skill was the only factor involved in winning the puzzle game and there was no chance element at all. In contrast, DFS participants merely select a lineup for their simulated teams and have no ability to exercise control or influence over the actions of the players participating in the game and who earn the participants their fantasy points. DFS participants may be educated on the sports games, players, expected weather conditions, and other factors. Regardless of how educated a DFS participant is, their chosen player(s) may perform poorly that day, become injured, not play in a given game, or be affected by uncontrollable circumstances such as weather and officiating. The existence of chance indicates that DFS contests are distinguishable from the type of contest described in Rev. Rul. 57-521. We conclude that the “skill” involved in selecting fantasy players is similar to the skill involved in selecting winners of individual professional sports games, horse races, or other traditional sports gambling activities.
Should the Service begin enforcing the position in Memo 2020-009 and imposing the excise taxes in full, it would create an annual liability in the tens of millions of dollars for the larger operators, and could potentially push smaller businesses into extinction. As a result, industry leaders have spoken out against the IRS, with DraftKings CEO Jason Robins calling the memo “deeply flawed in its analysis.” He continued, “Our position continues to be, which we believe has been reaffirmed through state legislatures and courts throughout the country, that DFS is not wagering,” he said. “We believe that the arguments at the federal level are incredibly strong.”
While the arguments for DFS as a game of skill may indeed be strong, the IRS has now twice held to the contrary. If you’re a betting man — and if you’ve read this far, you are — you’ve got to like the Service’s chances to come out on top.