IRS: Daily Fantasy Sports Companies Are Subject To Federal Sports Betting Tax

New guidance from the Internal Revenue Service says that the federal excise tax on sports betting also applies to daily fantasy sports.

The excise tax, sports betting and DFS

The excise tax is applied as a tax of .25% of all sports wagers; as applied to DFS this would be each entry fee for a contest. Estimating the DFS industry handles roughly $4 billion annually, this would equate to $10 million of federal tax annually. It’s also possible this tax could be applied retroactively, or at an even higher tax rate, depending on how the IRS uses this guidance.

That tax has long been known to apply to sports wagering, as Nevada sportsbooks have been responsible for paying it for years. Sportsbooks in states with legal sports betting that has cropped up since 2018 are also subject to the tax.

But it was unknown if it applied to the DFS industry — which is dominated by DraftKings and FanDuel — or if any DFS company was paying it. (DFS companies likely were not, as they have long held that anything applied to gambling does not apply to DFS.)

An interesting part of the equation is that DFS is being treated like gambling in this instance at the federal level. While the memo clearly does not mean that the federal government writ large considers DFS to be a form of gambling, the IRS is attempting to treat DFS entries as “wagers.” The DFS industry was created, grew and still exists based on the Unlawful Internet Gambling Enforcement Act and on DFS-specific laws or existing laws pertaining to gambling and games of skill at the state level.

It’s not clear why this issue is just coming out now, as daily fantasy sports has been around for more than a decade. The IRS memo was written in July and was recently made public in August. The impetus for the memo appears to be an internal question about the application of the excise tax. The memo is internal guidance and does not carry the force of law.

You can see the IRS memo here.

Legal Sports Report has reached out to both DraftKings and FanDuel on the matter. Both said they are aware of the IRS memo but had no comment on the record. DraftKings CEO Jason Robins talked with Yahoo Finance about it after Friday’s earnings call.

What’s in the IRS memo on DFS

The memo is 10 pages of why the author — Holly Porter, associate chief counsel for the IRS — says the excise applies to DFS.

Here are the top-level conclusions of the memo:

1. A DFS operator is liable for the excise tax on wagers under IRC § 4401.

Here is the applicable part of US code about taxes on sports wagering:

(1) State authorized wagers

There shall be imposed on any wager authorized under the law of the State in which accepted an excise tax equal to 0.25 percent of the amount of such wager.

The memo goes on to outline why DFS is subject to these taxes. The IRS says the amount of skill involved in DFS is immaterial to whether the tax is owed. From the memo (emphasis added):

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.

Could DFS face an even higher tax rate or retroactive application of the law?

The IRS guidance leaves some questions without clear answers, at least from reading the memo.

Could DFS handle be taxed at a rate of 2%?

Here’s another conclusion from the memo:

The rate of tax IRC §4401(a) imposes on wagers accepted by a DFS operator depends on whether the wager is accepted in a state in which the wager is authorized.

The excise tax on sports betting is generally known to be .25%, but as § 4401 and the memo point out, “unauthorized” wagers are taxed at a higher rate of two percent.

From the memo:

Because we have determined that DFS entry fees are taxable wagers under IRC §§ 4401 and 4421, we must evaluate whether the authorized or unauthorized rate of tax applies. IRC § 4401(a)(1) imposes an excise tax of 0.25 percent of the amount of the wager on any wager authorized under the law of the state in which accepted. IRC § 4401(a)(2) imposes an excise tax of 2 percent of the amount of any other wager (any unauthorized wager).

Generally, the person who is engaged in the business of accepting wagers is liable for the tax. We conclude that any DFS operator that accepts wagers is subject to the authorized rate under IRC § 4401(a)(1) for each wager that is accepted in a state in which DFS is authorized under state law. If DFS is not authorized under state law and a DFS operator accepts a wager in such a state, such wager is subject to the unauthorized rate under IRC § 4401(a)(2).

This seemingly leaves a lot of room for what “authorized” entails. DraftKings and FanDuel obviously maintain that they operate legally in all but a handful of US states, and could say that game of skill and gambling laws “authorize” them to take entry fees in those states.

But does that amount to “authorization” according to the IRS? Likely not, but there does seem to be some wiggle room in arguing the interpretation.

Could DFS handle be retroactively taxed?

This is another big question out of the guidance. The IRS seemingly asserts that the DFS industry should have always been subject to the excise tax. DraftKings and FanDuel have handled tens of billions of entry fees over the years.

Could the IRS go to any DFS company and demand back taxes be paid? Such an effort would almost certainly land in court.

DFS is gambling to the IRS, but not elsewhere

The IRS memo certainly does not hold the force of law to say that the federal government considers DFS to be a form of gambling.

The 2006 Unlawful Internet Gambling Enforcement Act — which the DFS industry used as the backbone of its legality — specifically carves paid-entry fantasy sports as a game of skill and not gambling. The federal Wire Act applies to conducting sports betting on an interstate basis but has never been applied to DFS. No law other than the UIGEA at the federal level deals with fantasy sports in particular.

In recent years, nearly two dozen states have passed laws dealing with the legality and/or regulation of fantasy sports.

Still, it’s fair to wonder how this guidance would have been received several years ago, when DraftKings and FanDuel found themselves at the center of controversies around the US concerning their legality. Circa 2015 and 2016, the DFS industry found itself with a number of attorneys general saying that the companies were violating state law.

What does all this mean?

Right now, the memo is just that. It’s not entirely clear how and if this is being applied to DraftKings, FanDuel and other companies in the DFS space. LSR has no insight into any actions the IRS is taking or plans in regards to this memo.

Should the IRS demand payment of the taxes — either for the future, retroactively or both — it seems likely that the companies would challenge that assertion, perhaps in court.

There is a new piece of legislation that looks to repeal the federal excise tax, although that faces uncertain prospects as well.

The guidance might give pause to smaller DFS operators that occupy the space. And if DraftKings and FanDuel collectively find themselves on the hook for tens of millions of dollars in back taxes, the guidance starts to matter a bit more.