The IRS has determined that daily fantasy sports (DFS) operators are liable for two federal excise taxes and must register as being “engaged in business of accepting wagers.”
Traditionally, fantasy sports have been typically played among a group of people over the course of a league’s season. Around 2007, companies began offering a new form of fantasy sports, played exclusively on-line, that are now called “daily fantasy sports” (DFS). DFS has many key differences from traditional fantasy games. DFS contests, for example, typically occur daily, and the participants tend to be a much larger group of strangers. Rather than a draft, each DFS participant is given an equal amount of fictitious money known as a “salary cap.” Participants may select the same players for their fantasy teams as other participants so long as the selections do not exceed a participant’s salary cap.
DFS contests take place on a DFS operator’s website and are accessed by DFS participants via computer. Many DFS operators offer various types of DFS contests on their websites, including “guaranteed prize pools,” in which participants pay a set entry fee to compete against large fields for a share of a fixed prize pool. For contests involving guaranteed prize pools, a typical DFS operator will set the prize pool such that it retains a commission ranging from 6% to 14%.
In order to participate in a contest on a DFS operator’s website, a participant must register for an account. When a participant enters a contest, the amount of the entry fee is debited from the participant’s segregated account. The DFS operator, upon debiting a participant’s segregated account, deposits the amount in its own account and records the amount as cash revenue on its books. Upon the completion of a contest, the DFS operator deposits any contest winnings into the winning participants’ segregated accounts and deducts those amounts from its own revenue for book purposes.
In IRS Chief Counsel Memorandum AM 2020-009, released July 23, 2020, the questions presented were:
(1) Is a DFS operator liable for the excise tax on wagers under tax code Section 4401; and
These questions were, surprisingly, answered in the affirmative.
Games of Skill or Chance?
Section 4401 imposes a percentage tax on every wager. The tax is imposed on the person who “is engaged in the business of accepting wagers,” and the percentage amount depends exclusively on whether the wage is authorized by the state in which it is accepted, or whether the wager is un-authorized. Section 4411 imposes an annual occupational tax on each person who is liable for the tax imposed by Section 4401. Section 4412 requires each person required to pay tax under Section 4411 to register with the IRS
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 amount of the wager is the amount risked by the bettor, including any charge or fee incident to the placing of the wager, rather than the amount which the bettor stands to win.
A person is engaged in the business of accepting wagers if the person “makes it a practice to accept wagers with respect to which the person assumes the risk of profit or loss depending on the outcome of the event or the contest with respect to which the wager is accepted.” A wagering pool conducted for profit includes any scheme or method for the distribution of prizes to one or more winning bettors based on the outcome of a sports event or contest provided that such wagering pool is managed and conducted for the purpose of making a profit, the IRS said.
The Unlawful Internet Gambling Enforcement Act of 2006 (UIGEA) generally prohibits gambling businesses from knowingly accepting payments in connection with the participation of another person in a bet or wager that involves the use of the Internet and that is unlawful under any federal or state law.
“The UIGEA defines the term, wager, to include risking something of value on the outcome of a sporting event,” but it embodies a specific carve-out for fantasy sports. The carve-out provides that the term, bet or wager, does not include participation in any fantasy or simulation sports game or educational game or contest in whichno fantasy or simulation sports team is based on the current membership of an actual team that is a member of an amateur or professional sports organization, the IRS said.
In order for DFS activities to be considered taxable wagers, the entry fee must fall into the definition of a “wager” under Section 4421(1). All three definitions of “wager” in Section 4421 start with “the term, wager, means any wager.” When a term is not defined, “we must apply the term’s plain, obvious, and rational meaning.” According to the dictionary, a “wager” is defined as “something risked or staked on an uncertain event” or “a bet.”
A DFS entry fee fits into the definition of wager under both Section 4421(1)(A) and (B). 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 Section 4421(1)(A). A DFS entry fee is also a wager “placed in a wagering pool” as described in Section 4421(1)(B). The DFS entry fee is the wager. The entry fees are placed in a common fund with the other participants’ 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 from every participant who participates, meaning the wagering pool is conducted for profit.
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. The statutory language in Section 4401 and Section 4421 does not differentiate whether an activity involves skill, chance, or some combination of the two. Whether a DFS is a game of skill for state gambling statute purposes is simply not relevant for determining whether DFS is wagering for federal excise tax purposes.
Still, the IRS acknowledged, the presence or absence of skill in a contest “may help determine whether an entry fee constitutes a taxable wager.” In Revenue Ruling 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. Regardless of how “educated” a DFS participant is, their chosen players may perform poorly that day, become injured, not play in a given game, etc. The existence of chance indicates that DFS contests are distinguishable from the type of skill-only contest described in Rev. Rul. 57-521.
A DFS operator may argue that the UIGEA legalized fantasy sports and exempted DFS from the definition of wagering. UIGEA, the IRS observed, was enacted in 2006, prior to the proliferation of DFS, and referred to traditional fantasy sports. UIGEA neither renders legal or illegal any form of gambling within the United States: UIGEA simply provided new mechanisms for enforcing gambling laws on the Internet. Based on the foregoing, the IRS concluded that any entry fee for a DFS contest constitutes a taxable wager under Section 4421. Any DFS operator in the business of accepting taxable wagers is liable to pay the wagering excise taxes on entry fee/wagers it receives.
Because a DFS operator is liable to pay excise taxes on wagers, the IRS concluded that each DFS operator is liable to pay the occupational excise tax under Section 4411; and is required to register under Section 4412 as a person liable for the tax imposed under Section 4401. As for the rate of tax imposed, any DFS operator that accepts wagers is subject to the “authorized rate” (0.25% of the amount of the wager) for each wager that is accepted in a state in which DFS is authorized under state law. If DFS is not so authorized, and a DFS operator accepts a wager in such a state, such wager is subject to the “un-authorized rate” (2% of the amount of the wager).
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.