Can the IRS impose an excise tax on Daily Fantasy Sports?

Mark Twain was not wrong when he said that nothing in life is certain except for death and taxes, but shouldn’t Uncle Sam properly define who should be taxed before he comes to collect? This is the issue Daily Fantasy Sports (DFS) companies are facing when the IRS issued a memorandum declaring an excise tax of 0.25% on state-authorized wagers under IRC § 4401. The issue here is with how “wager” is defined; 26 U.S.C. § 4421 (1) states, “The term ‘wager’ means-(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.”

Essentially, a wager means wager. This definition comes especially as an issue as Draftkings’ (a DFS company) CEO Jason Robins states that DFS is not wagering. This issue being challenged on the federal level is concerning to DFS companies like Draftkings who would have to pay millions of dollars in additional taxes. Ultimately, this tax would affect entry fees for DFS, not operating revenue from conducting DFS contests.

The IRS negates to address the novel legal issue of entry fees in Daily Fantasy Sports and avoids the analysis of whether DFS is a game of skill.

The question then rests on whether entry fees in DFS constitute wagering. According to Humphrey v. Viacom, the district court in New Jersey held that entry fees for fantasy sports are outside of the definition of a wager inter alia “[d]efendants do not compete for the prizes.” The third circuit has also differentiated participating in fantasy sports leagues in NCAA v. Christie, where it states, “[w]e note, however, the legal difference between paying fees to participate in fantasy leagues and single-game wagering as contemplated by the Sports Wagering Law.”

The IRS memorandum attempts to circumvent this issue. It notes that several state courts’ and legislatures’ discussions of DFS’s legality turns to whether DFS is a game of skill, and not gambling. Other states have enacted legislation stating that DFS is not gambling, but does not mention any notion of whether it is a game of skill. Regardless, the IRS memorandum states that the statutory language in IRC § 4401 and 26 U.S.C. § 4421 does not differentiate as to whether an activity involves skill, chance, or a combination of the two. “Most importantly,” the memorandum states, “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.”

In essence the IRS negates to address the novel legal issue of entry fees in daily fantasy sports and avoids the analysis of whether DFS is a game of skill. Essentially, what does the IRS state a wager even is then? The IRS uses the Random house Dictionary in accordance with the plain, obvious, and rational meaning found in IRC § 4421. The dictionary states, “something risked or staked on an uncertain event or a bet.” In that case, it must be analyzed whether DFS bears a risk on the bettor and sportsbook.

DFS guarantees a prize pool and loses money if not enough people pay the entry fee to cover the pre-set guaranteed cost of the prize pool. This is unlikely to happen on a continual basis as Daily Fantasy Sports companies can gauge, on average, how many participants are likely to play in a game and can guarantee prize money well below what is earned from entry fees. There is essentially nothing at stake for the DFS companies because their earnings are not contingent on who wins the game. Regardless of the result of the game, players who enter DFS and pay the entry fee ensure that DFS companies are getting paid for the athletic match. For this reason, the house always wins.

The good news for DFS companies is that this memorandum from the IRS is not binding and only serves as internal guidance to the governmental agency. In terms of tax audits, it does provide clarity to DFS companies on the IRS’ position on DFS. Regardless, there are still several questions that arise in how the IRS will plan on pursuing DFS companies going into the future. For now, DFS companies may ignore or spurn the opinion as there is currently no threat towards paying the excise tax.

September 22, 2020 | Eric Calero