The IRS vs. Daily Fantasy Sports - Part III

What About Them Puzzles?

If this case is litigated, here is a preview of what DFS will likely say. “The IRS position does not make sense. It conflicts with its own revenue ruling, where a skill-based scheme was concluded to be not subject to the excise tax.”

The IRS must know this challenge is coming. How do we know? We know because they allocate quite a bit of real estate to this issue in their July 23, 2020 memo

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.

Critically, the word “contest” is a defined term in the regulations. This has two important implications. First, the word “sporting” does NOT modify the word “contest”, and that may be critical for the purposes of the Wire Act, but that’s for another day. For the purposes of the excise tax provision, the relevant implication is that the IRS might have a difficult path in distinguishing DFS from the ruling on puzzles if they decide to stick with the argument that DFS is a game.

What was the purpose of the excise tax wagering laws? Is it a revenue measure, or an anti-gambling law enforcement tool? 

This was one of the key questions in front of the Supreme Court almost 70 years ago, In United States v. Kahriger, 345 U.S. 22 (1953), the Supreme Court held:

The tax is a valid exercise of the federal taxing power, and is not unconstitutional as an infringement by the Federal Government on the police powers reserved to the states by the Tenth Amendment.

The Supreme Court offered a more balanced view 15 years later. In Grosso v. United States, 390 U.S. 62 (1968), the Supreme Court stated:

The principal interest of the United States must be assumed to be the collection of revenue, and not the prosecution of gamblers, United States v. Calamaro, 354 U. S. 351, 358; but we cannot ignore either the characteristics of the activities about which information is sought or the composition of the group to which the inquiries are made.

The idea of excise tax primarily being a law enforcement tool is being advanced by others as well. For example:

The excise tax on sports betting contributes nothing to the national treasury and was never intended to do so. Rather, Congress included this excise tax in the Revenue Act of 1951 “to facilitate the enforcement of state criminal laws against gambling.”

If this issue is litigated, the narrative around the purpose of the excise tax will be a critical first step.  DFS operators and pro-DFS commentators will surely label the IRS measure as an antiquated tool that doesn’t match today’s reality. That point of view is already being presented, here is an example. “The purpose of the excise tax provision is to prevent gambling,” they will say, and “DFS is a skill-based game, therefore not gambling, so why does the excise tax apply to DFS?” 

The IRS, as expected, is taking the position that they are not bound by the state treatment. The July 23, 2020 memo states:

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.

The IRS has a point. How can the federal treatment follow the state treatment when the states themselves disagree on what DFS is? Consider this:

  • We have a court ruling in Illinois that concluded that DFS is a game of skill (we believe that was the wrong conclusion - DFS can’t be a game of skill if it is not a game in the first place,  a post on this one is coming). 

  • In New York, two courts held that DFS is gambling because it involves a material degree of chance, and therefore the passage of the Interactive Fantasy Sports law was a constitutional violation at the state level (correct conclusion, incorrect reasoning in our opinion - we’ll publish a post on that one as well). 

  • In some other states, like Arizona (where DFS operators are not operating), skill games are not allowed.  

Yet, at the 30,000 feet level, one would ponder whether our laws are failing us. If the purpose of the excise tax is to enforce gambling laws, and if DFS is considered not to be gambling in at least the majority of the states, then how would it be fair that a “non-gambling” operator is penalized? It is quite predictable that DFS operators will work hard to advance this narrative. 

What gives? Well… The proper resolution of these competing narratives can be found neither in the IRS memo nor in the pro-DFS commentary. As we stated in Part I, the resolution is simple. DFS is not a game. It has never been a game. DFS is gambling, not because it is a game of chance, but because it is an entertainment claim on future contingent events that serves no valid economic purpose. 

Once one assumes DFS is a game and assesses there is sufficient skill, the natural conclusion is to characterize DFS as non-gambling. Games of skill and gambling do not coexist. That is the definition of gambling, well, at least half of it. The problem is that this reasoning starts on the wrong promise that DFS is a game. DFS is a claim, not a game, so the other half of the gambling definition kicks in, where the relevant test becomes entertainment vs. purpose. On that spectrum, DFS sits at the wrong edge. 

Bottom line: Games of skill and gambling do not coexist but skill and gambling might. The jury is out on how much skill is involved with DFS, but regardless, DFS is gambling because it is an entertainment claim on future contingent events that serves no valid economic purpose. As such, there is no contradiction between the IRS’s puzzle ruling and its excise tax position on DFS.