Earning Real Income from Fantasy Sports: Tax Opportunities and Pitfalls under the TCJA.
Fantasy Sports: Gambling or Hobby?
There is currently an ongoing debate as to whether fantasy sports can be classified as gambling under tax rules (David Baldwin and Donald J. Zidik, "How to Report Clients' Fantasy Football Winnings," Journal ofAccountancy, Fcbaiary 1,2016, https://bit.ly/2RGv3B4). The FSTA strongly argues that fantasy sports are games of skill rather than luck; this is consistent with the special carve-out that fantasy sports have under the Unlawful Internet Gambling Enforcement Act of 2006. The fact that fantasy sports were not targeted by this act, however, does not necessarily mean these activities are not considered gambling for tax purposes. In fact, other, more traditional gambling activities such as horse racing were also specifically excluded from the Unlawful Internet Gambling Enforcement Act and are still considered gambling activities for tax purposes. The TCJA does not clarify the definition of gambling, and without additional guidance, there is uncertainty as to how fantasy income and expenses should be reported.
If fantasy sports are not treated as gambling, the hobby loss rules apply for fantasy players [assuming the player does meet the requirements to be a professional player under Internal Revenue Code (TRC) section 183]. In that case, the TCJA eliminates taxpayers' ability to deduct fantasy expenses even if fantasy income is reported. Prior to 2018, hobby losses were deductible as miscellaneous deductions subject to the 2% adjusted gross income (AGI) floor. Under the TCJA, which eliminated these deductions for tax years 2018-2025, income from hobbies is still included in income, but hobby losses are no longer deductible.
Many people have argued that fantasy sports are wagering transactions and therefore, consistent with IRC section 165(d), fantasy sports losses should be deductible to the extent of fantasy players' winnings. While the TCJA was detrimental to taxpayers with income from hobbies, its treatment of gambling income and losses is more favorable. Gambling losses were previously assumed to be the actual cost of wagers placed; in the TCJA, however, Congress clarified the meaning of what constitutes gambling expenses and expanded gambling costs to include other costs associated with generating gambling income. According to IRC section 165(d), "losses from wagering transactions shall be allowed only to the extent of the gains from such transactions. For purposes of the preceding sentence, in the case of taxable years beginning after December 31,2017, and before January 1, 2026, the term 'losses from wagering transactions' includes any deduction otherwise allowable under this chapter incurred in carrying on any wagering transaction."
This suggests that, consistent with other sections in the IRC, other expenses that are ordinary and necessary to execute wagering transactions are deductible as gambling losses. IRC section 162 indicates that any expenses that are "ordinary and necessary" in carrying on any trade or business are deductible. For professional gamblers, these expenses are deducted on schedule C as wagering losses; for those not meeting the criteria to be considered professional gamblers, the new language in section 165 indicates that these would be wagering losses and reported on Schedule A as "other itemized deductions" (on the 2018 IRS Schedule A). For more traditional nonprofessional gamblers, this includes the ability to deduct expenses related to travel, lodging, and meals for gambling tournaments as other itemized deductions, to the extent of gambling winnings.
For fantasy players, potential ordinary and necessary expenses may be different. According to the FTSA, there are over 150 companies in the fantasy sports industry sell ing services to fantasy players. The mean expenditure per player for fantasy sports is $556, including $54 for online subscriptions, magazines, and other fantasy-related informational materials that would not have traditionally been thought of as gambling deductions prior to the TCJA (https://fstaorg/research/industry-demographics/). The amount spent per person varies greatly depending upon the fantasy sport service provider utilized, frequency of use, and utilization of supplemental informational materials; premium online analysis subscriptions can cost several hundred dollars.
Beyond online subscriptions, magazines, and other fantasy-related materials, taxpayers who have fantasy winnings may be able to deduct 50% of the cost associated with the food and drink at their draft parties. Fantasy players may even be able to set up a home office used exclusively for their fantasy activities and deduct those related expenses. Furthermore, losses from other gambling activities, such as casinos, horse racing, or regular sports betting, could also offset fantasy sports winnings.
To date, the IRS has not weighed in as to whether fantasy sports winnings are gambling or hobby income. Without guidance, an argument could be made for either position. In reality, it is likely that most fantasy players will want to be more aggressive and claim the activities are gambling for tax purposes. Exhibit 1 presents a comparison of potentially deductible costs and expenses under the old and new rules. Exhibit 2 compares treatments of fantasy sports under the new and old rules, as well as the treatment for professional fantasy players.
The Increased Standard Deduction
For casual fantasy players, the only fantasy-related deductions allowed are classified as "other itemized deductions" of wagering losses and related deductions. The increase in the standard deduction under the TCJA will cause many taxpayers to stop itemizing thereby eliminating any potential benefit of fantasy-related expenses. Taxpayers with fantasy winnings in a particular year may want to bunch other itemized deductions such as real estate taxes or charitable contributions in that year in order to utilize fantasy-related losses.
The Professional Player
This article has thus far focused on the treatment of winnings and losses for the casual fantasy player who does not qualify as a business under IRC section 183. For the serious fantasy player, however, treating gambling as a trade or business may be appropriate. As in the case of professional gamblers, income and expenses are recorded on schedule C; this bypasses the need to itemize in order to take advantage of the tax-related deductions and may qualify players for a new 20% qualified business income deduction on Form 1040. Taxpayers who recognize profits on schedule C will be subject to both income and self-employment taxes; therefore, it is not always beneficial to be considered a professional.
The TCJA does have a downside for professional sports players. Prior to 2018, other gambling expenses such as travel and lodging were not considered wagering losses and therefore not limited to gambling winnings as specified in IRC section 165(d) [Mayo v. Comm'r, 136 T.C. 81 (2011)]. This allowed gamblers to have a net loss on gambling activities up to the amount of these other expenses. The TCJA defined wagering losses to include other related expenses, thereby limiting all gambling expenses to the extent of gambling winnings. Therefore, professional gamblers will no longer be able to claim net losses related to gambling activities on schedule C.
Being considered a professional player takes more than just a profit motive. Professional gamblers have the burden to prove that their activity is "pursued full time, and with regularity, to the production of income for a livelihood and not merely a hobby" ([Comm V v. Groetzinger, 59 AFTR 2d 87-532 (107 S. Ct. 980) (1987)]. Whether a fantasy player meets this test is based on nine relevant factors:
* The manner in which the taxpayer carries on the activities
* The expertise of the taxpayer and his advisors
* The time and effort expended by the taxpayer in carrying on the activity
* The expectation that assets used in activity may appreciate in value
* The success of the taxpayer in carrying on other similar or dissimilar activities
* The taxpayer's history of income or losses with respect to the activity
* The amount of occasional profits, if any, that are earned
* The financial status of the taxpayer
* Elements of personal pleasure or recreation.
Despite the provision of these nine factors, "no one factor is determinative in making this determination" [IRC section 183-2(b)]. Determining whether activities truly constitute a business is not always clear cut, and each individual taxpayer's circumstances are unique. Taxpayers can expect a fair amount of scrutiny from the IRS when claiming to be a professional fantasy player, particularly when the taxpayer benefits from taking that position. Some taxpayers with gambling losses as a result of gaming have been able to sustain gambling activities as a business based upon documentation maintained by the casinos they visited, the time and effort they expended, their previous profits, lack of personal pleasure, and success attained in other profitable businesses (Myers v. Comm V, TC Summary Opinion 2007-194)--while others have not (Ferguson v. Comm 'r, TC Summary Opinion 2007-30).
The Importance of Documentation
Regardless of whether a taxpayer is a professional player or just trying to take an itemized deduction for wagering losses, documentation is very important. IRC section 6001 places the burden of keeping records on the taxpayer, and the courts have routinely thrown out gambling and other losses that cannot be substantiated. For the professional, not only is it important to have receipts and documentation for deductions, but it is also important to document the efforts made to demonstrate the intent to make a profit The burden of proof rests on the taxpayer to prove that the activity was conducted in a businesslike manner, and failure to keep contemporaneous records can be an indication that gambling is not being conducted in such a manner (Boneparte Jr. v. Comm'r, TC Memo 2017-193).
Understanding the documentation is also important. While most gambling is reported on form W-2G, fantasy sports operators typically issue Form 1099-Misc to fantasy players winning more than $600. Under IRS Notice 2015-21, a taxpayer determines wagering gain or loss from electronically tracked slot machines at the end of a single "session" of play, rather than on a bet-by-bet basis. In fact, a 2015 Chief Counsel memorandum (CCM 20153601F) concluded that a taxpayer's multiple buy-ins for the same poker tournament could not be aggregated for purposes of W2-G, as each buy-in was a separate session because the tournament circumstances were different each time. A private letter ruling (PLR 200532035) by the IRS identified three potential methods for calculating winnings:
* The gross method, which reports total winnings
* The net method, which reports winnings from contests less the entry fees for any contest won
* The cumulative net method, which reports winnings less total entry fees paid.
In PLR 200532035, the IRS advised that the net method was appropriate. Not every fantasy sports site follows that guidance, however, and it is important to know how winnings are reported for Form 1099 purposes. For example, Fan Duel calculates the 1099 amount as prize winnings--total entry fees + any bonuses + any entries into paid contests using earned fan duel points (Brad Polizzano, "Daily Fantasy Sports and Taxes: Dissecting the 1099s," Legal Sports Report, Feb. 11, 2016, http://bit.ly/2BvOjd9). Therefore, the 1099 issued would already include the cost of losing contests, and thus would not be allowable as an other itemized deduction from gambling for tax reporting purposes. This is because these sites do not view fantasy sports as gambling and therefore justify not breaking down sessions of play in accordance with IRS Notice 2015-21. This deviation from other reporting could be problematic in the event of an IRS audit.
Individuals using PayPal, credit cards, or similar third-party vendors to withdraw winnings from fantasy sports sites may also receive a 1099-K from those organizations (Polizzano). To the extent that this occurs, it may appear as though taxpayers have more winnings than actually exist.
The Game Has New Rules
Under the TCJA, gambling losses are still deductible, but the deductibility of hobby related expenses has been eliminated. Furthermore, the definition of gambling losses has been expanded to include other expenses incurred as part of wagering. As such, fantasy players may benefit by treating their fantasy sports as gambling and claiming additional fantasy-related expenses that were not previously deductible.
Andrew D. Gross, PhD, CPA, is an associate professor, and Jamie Hoelscher, PhD, CFE, CIA, and Marc Ortegren, PhD, are assistant professors, at Southern Illinois University Edwardsville. William E. Maas, JD, CPA, is an associate professor at University of Wisconsin-La Crosse.
Exhibit 1 Potentially Deductible Fantasy Sports Expenses under Old and New Rules Expense Old Rules Entry fee not already deducted from winnings * Losses from other gambling and betting activities * Fantasy sports-related magazine subscriptions Fantasy sports website subscriptions 50% of food costs at fantasy sports draft parties Cost of any office equipment or office space exclusively dedicated to fantasy sports Cost of any punishments (e.g., tattoos) for losing in a fantasy sports league Expense New Rules Entry fee not already deducted from winnings * Losses from other gambling and betting activities * Fantasy sports-related magazine subscriptions * Fantasy sports website subscriptions * 50% of food costs at fantasy sports draft parties * Cost of any office equipment or office space exclusively dedicated to fantasy sports * Cost of any punishments (e.g., tattoos) for losing in a fantasy sports league * Exhibit 2 Example of the Tax Impact of Different Classifications of Fantasy Sports Hobby Treatment Old Rules New Rules Increase in AGI $10,000 $10,000 Itemized deductions $7,5001 $0 Increase in taxable income (2) $2,500 $10,000 Gambling Treatment Old Rules New Rules Increase in AGI $10,000 $10,000 Itemized deductions $6,000 $7,500 Increase in taxable income (2) $4,000 $2,500 Professional Player Increase in AGI $2,500 Itemized deductions $0 Increase in taxable income (2) $2,5003 Note: Taxpayer is an avid fantasy sports player. During a single tax year, Taxpayer won $10,000 on Fantasy Site A, but incurred a loss of $6,000 on Fantasy Site B. Taxpayer spent $1,500 on subscriptions and other costs associated with fantasy play. The impact of these fantasy activities varies depending on how fantasy sports are treated as illustrated above. 1. Subject to 2% of AGI floor 2. Assuming that the taxpayer does not take the standard deduction 3. Subject to self-employment tax and 20% qualified business income deduction
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||DEPARTMENTS: Federal Taxation; Tax Cuts and Jobs Act of 2017|
|Author:||Gross, Andrew D.; Hoelscher, Jamie; Ortegren, Marc; Maas, William E.|
|Publication:||The CPA Journal|
|Date:||May 1, 2019|
|Previous Article:||Using Ratio Analysis to Manage Not-for-Profit Organizations.|
|Next Article:||JCJA Clarifies Wagering Loss Deduction Rules.|