In Legal Advice issued by the Chief Counsel's office in 2020-009 ("Memo"), the IRS has determined that an organization operating daily fantasy sports (DFS) games is liable for the excise tax on wagers and the occupation excise tax on wagering businesses and is required to register as a wagering business with the IRS.
IRC §4401(a) generally imposes a tax on "wagers." A wager is (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 tax on wagers is imposed on the person engaged in the business of accepting wagers ("wagering business"). (IRC §4401(C)).
Each person engaged in the wagering business must pay a $500 annual “occupation tax.” Generally, every person required to pay the tax on wagers is required to register with the IRS.
Generally, traditional fantasy sports are games where participants assemble simulated, “fantasy” teams with rosters of actual players from the real teams in a sports league (such as the National Football League (NFL) or the National Basketball Association (NBA)). The participants accumulate points based on the actual game performances of the selected players. Scoring is based on the selected players’ performance statistics or measures that are converted into points. Each participant then receives a “total fantasy score” that is determined by compiling the individual fantasy scores of each player in the participant’s roster or lineup. The participants compete against one another based on their total fantasy score. (Humphrey v. Viacom, Inc., (DC NJ 2007) 2007 WL 1797648)
A version of fantasy sports, daily fantasy sports (DFS), takes place on a DFS operator’s website and is accessed via computer or mobile software applications. DFS operators’ offerings cover several actual professional sports leagues, as well as college sports, and some e-sports.
DFS has many key differences from traditional fantasy sports games. For example, unlike traditional fantasy sports games, DFS contests are not tied to a specific sporting event, but typically occur daily, and the participants tend to be a much larger group of strangers.
Also, rather than drafting players as they do in traditional fantasy sports games, each DFS participant is given an equal amount of fictitious money known as a “salary cap.” The DFS operator sets each player’s “salary” or “price” commensurate with the player’s perceived value, not unlike how bookmakers set wagering odds in traditional sports gambling. A participant may select the same players for their fantasy team as other participants so long as those selections do not exceed that participant’s salary cap.
Another important distinction between traditional fantasy sports and DFS is the treatment of the entry fee associated with each. Although participants in both types of fantasy sports typically pay a fee to participate, the pool of money generated by entry fees is generally given entirely to the winner or winners of the traditional fantasy league. In contrast, in DFS a portion of the fees collected is not paid out to the winner or winners but is retained by the DFS operator.
The office of Chief Counsel has determined that a DFS operator is liable for (1) the excise tax on wagers; and (2) the wagering occupation excise tax and, therefore, is required to register as a wagering business with the IRS.
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Importantly, the internal IRS memorandum is what the IRS calls a generic legal advice memorandum. Generic legal advice memorandums have limited authoritative value, not only in the courts but also in matters before the IRS.ReplyDelete
It does, nevertheless, reflect a considered judgment within the IRS Office of Chief Counsel and one should not be sanguine that the chief counsel will readily walk it back. Certainly, Wall Street took it seriously: DraftKings' stock dropped about 9% following the memorandum's release.
In light of the memorandum, DFS organizations will need to evaluate how to deal with both the past and the future. For the past, DFS organizations will likely be unable to recoup from their customers any excise taxes they ultimately pay to the IRS. Technically, the tax is imposed on the "person who is engaged in the business of accepting wagers," not on the person placing the bet. In the absence of a contractual arrangement that requires the customers to reimburse the DFS, the DFS is likely stuck with the liability.
But the DFS organizations could contest that Section 4401 applies to its activities. At DraftKings' second quarter earnings call on Aug. 14, the CEO disclosed that they were under audit and were challenging the positions set forth in the IRS memorandum, describing the IRS' analysis as "deeply flawed."
Given the lack of definitional guidance in the tax laws as to the meaning of the word "wager," and arguments that under applicable gaming laws participation in fantasy sports is not considered gambling, the ultimate answer is not cut and dry. It is likely other DFS organizations will similarly challenge the IRS position.
DFS organizations will also need to make a call on whether, prospectively, they pass on the excise tax to their customers, either directly or economically in their pricing model. Given the size of the potential exposures to DFS operators — a Morgan Stanley analyst on the DraftKings earnings call suggested $20 million to $30 million in annual taxes — DFS organizations will need to balance the risk of further adding to their potential excise tax exposure against the downsides of passing the tax burden on to their customers, particularly if they are simultaneously taking the position with the IRS that the Section 4401 taxes do not apply.
Note that in traditional fantasy sports leagues, if a commissioner who runs the league receives a fee from the league participants, it would behoove such person to heed the IRS memorandum discussed herein, even though the memorandum is directed to DFS operators. If a commissioner is raking or earning a commission on the total pot, the IRS could argue that the commissioner is engaged in the business of accepting "wagers" within the meaning of Section 4401.
Given the exposure of DFS operators, and the lack of definitive guidance on whether Section 4401 applies to fantasy sports, this contest between the DFS organizations and the IRS has the makings of a spectator sport. It remains to be seen whether the DFS organizations prevail — or at least cover the spread.