I was raised and live in Florida. Outside of the weather, this is the best time to be a Floridian. It is the beginning of football season, when anything is possible for our teams.
Florida and Texas are the football capitals of the world. We take the gridiron seriously here in the Sunshine State. High school football began last week (yes, we closely follow high school football), college football starts this weekend, and the NFL the following weekend. The rivalries are intense in Florida.
In high school football, Central Florida, where I live, is always trying to prove that we are as good as South Florida, where a lot of the young football talent in the state is located. For college football, I am a Miami Hurricanes fan. I detest the Florida Gators and the Florida State Seminoles. The Gators are too scared to play Miami every year, but we will play Florida State midseason. For the NFL, we don’t have a team in Orlando, so my loyalty has always been with the Tampa Bay Buccaneers, even though Orlando is a Miami Dolphins town.
The Rise of Fantasy Football In the past year, fantasy football has gone from leagues that are managed by one person and consist of about 12 teams to daily online fantasy leagues.
Fantasy football is basically played by the managers of each team. They select players from various NFL teams as starters. Each league is a little different, but most leagues allow a player to play one quarterback, three or four wide receivers, two running backs, a tight end, a defense and special teams, and a kicker. Points are scored when a player you have started scores a touchdown, field goal, or gets more than 10 yards rushing or receiving; or when the defense gets a sack, keeps the score below a certain level, or gets an interception, fumble recovery, or safety. Special teams score points by yards gained by a runback of a kickoff or punt and touchdowns.
By the end of Monday, all of the points that each team has made are tallied up, and a winner is determined between each head-to-head matchup. On Tuesday, the next week begins.
Last year in the United States, NFL fans were introduced to, what I refer to as, “fantasy football on steroids.” Draft Kings and other sites introduced us to weekly fantasy games.
How these work is you pay a buy-in and you draft your team weekly. You are given a certain amount of play money, and each player costs you a portion of that money. The best players in the NFL cost the most money, and the other players cost less. This is where your knowledge of everything NFL comes in. Your job is to select a good player who is undervalued within the league, so that you can stay within the salary cap and still win your match.
These new fantasy sites offer cash prizes of up to $10 million in some leagues. If you don’t win the grand prize, there are cash prizes for the different places that you finish in. However, not all places receive cash.
You can’t watch NFL football these days without getting inundated with fantasy football ads. As a consequence, last year, these leagues became extremely popular. The popularity of these leagues drew the attention of several attorneys general of various states. The reason? The attorneys general stated that these new fantasy football leagues were gambling, which is illegal.
As the season went on last year, many states banned their citizens from playing in these leagues. Nevada required these leagues to obtain a gambling license to operate in that state, and New York completely banned these leagues. Eventually, most of the wrinkles were ironed out with these various states, and the leagues were allowed to continue their operations. Football isn’t the only sport that has a fantasy league. There is fantasy baseball, basketball, soccer, hockey, and even golf. However, football is the most popular.
The question is: How does the IRS treat fantasy football winnings?
IRS Letter Ruling Offers Some Clues Unfortunately, the IRS does not have a definitive ruling on the treatment of fantasy sports income and losses, and there is very little, if any, authority for the proper reporting on tax returns. The only thing that can be pointed to would be IRS Letter Ruling 200532025. This letter ruling discussed the various methods of reporting winnings by a taxpayer who ran a site for online game-playing tournaments.
According to the letter ruling, the three possible reporting methods are:
1.The gross method. The site operator reports the total of all winnings for the year on Form 1099-MISC, Miscellaneous Income (if the player wins $600 or more).
2. The net method. The site operator reports the total of all winnings for the year and subtracts the entrance fees from winning contests only. These are also reported on Form 1099-MISC, assuming the net amount the player wins exceeds $600.
3. The cumulative net method. The site operator reports the player’s total winnings less all entry fees for the year, regardless of whether the participant received a prize.
The IRS concluded in the 2005 letter ruling that the net method must be used when entrance fees are only netted against winnings from that particular contest as a return of capital – entrance fees on losing contests are not deductible against winnings from other contests.
Gambling or Not Gambling? A client’s fantasy sports activity could be characterized in several ways. Which method is used affects how the income (or loss) is reported. The threshold question is whether participation in fantasy sports constitutes a gambling activity.
It could be argued that many fantasy sports leagues are wagering pools, governed by Internal Revenue Code Reg. §44.4421-1(c)(1). In Letter Ruling 200532025, the IRS defines a wagering pool as “an arrangement to pool bets into a common fund, which are wagered on a sports event or contest, with the successful bettor (or bettors) receiving the pool proceeds, subject to the pool seller’s commission.” If fantasy sports operations constitute a wagering pool, the players are gambling. Note that while fantasy sports are carved out as an exception from the Unlawful Internet Gambling Enforcement Act, that doesn’t necessarily mean they don’t count as a gambling activity for other purposes.
On the other hand, if the winnings are predetermined and must be awarded regardless of how many participants there are or how much is collected in entrance fees (which appears to be the case with the major online sites), then fantasy sports would not constitute a wagering pool. In Revenue Ruling 57-521, the IRS ruled that if a prize is offered in a contest of mental or physical skill, and the contest must award the prize in any event, the contest is not gambling. Fantasy sports players would no doubt argue that their success depends on skill and, therefore, they are not gambling.
In short, the determination of whether fantasy sports constitutes gambling or another activity is dependent on how the league is set up. So, you would basically have to ask your client a series of questions.
After determining whether the activity constitutes gambling, the question then becomes whether the activity is not engaged in for profit (i.e., a hobby activity, if it is not gambling, or casual gambling, if it is gambling) or if the activity rises to the level of being a trade or business.
The taxpayer’s activity, whether it is considered nongambling or gambling, is a trade or business if the activity qualifies as such under Reg. §1.183-2(b) – that is, it is a regular activity that the taxpayer engages in with a profit motive.
Hobby activity. If the activity is not gambling, then, for most individuals (i.e., those whose fantasy sports activity does not achieve the level of activity required to qualify as a trade or business), reporting would fall under the hobby loss rules of Reg. §1.183-1, Activities not engaged in for profit. Hobby income is reported on Form 1040, line 21, “Other income.”
Expenses that are otherwise allowable under other relevant sections of the tax code are allowed, subject to Reg. §1.183-1(b), and are treated as expenses related to the production of income under Code Section 212. What this means is that deductions are generally allowable only up to the amount of income from the activity and only if the taxpayer itemizes deductions. These expenses are reported as miscellaneous itemized deductions subject to the 2 percent-of-adjusted-gross-income (AGI) floor, and they are disallowed for alternative minimum tax (AMT) purposes. The expenses would include the taxpayer’s entrance fees for losing contests and other substantiated expenses related to the activity.
The Form 1099-MISC received from the daily fantasy sports league would likely be incorrect, under Letter Ruling 200532025, because most leagues report amounts in box 3 using the cumulative net method. Earlier I stated that this is earnings less entrance fees. The tax preparer should consider filing a disclosure under Form 8275, Disclosure Statement, if there is no correction made to income as reported on Form 1099-MISC.
Nongambling activity trade or business. For the activity to qualify as a trade or business, the client would need to keep complete and accurate books and records, and conduct the activity in a businesslike manner. Under Reg. §1.183-2(b)(9), the IRS will consider whether the activity contains “elements of personal pleasure or recreation,” which could indicate that the activity is not engaged in for profit.
If the client’s fantasy sports activity does manage to qualify as a trade or business, although ordinary and necessary expenses could be deducted under Section 162, the net income from the fantasy sports activity would be subject to self-employment tax. The taxpayer would report the activity as a sole proprietor on Schedule C.
Casual gambling activity. If the fantasy sports activity qualifies as gambling, then the usual rules governing gambling activities would apply. Entrance fees for losing contests of the taxpayer should be reported as gambling losses and would be allowable only if the individual itemizes deductions. The losses, to the extent of winnings, are miscellaneous itemized deductions, but they are not subject to the 2 percent-of-AGI floor. Further, they would not be disallowed for AMT purposes.
Excess losses cannot be carried over to another year. No other expenses of engaging in the activity would be deductible. All winnings would be reported as income, even if the taxpayer’s losses exceeded the winnings. Also, all of the client’s gambling winnings and losses should be reported together, not just winnings and losses from fantasy sports.
Professional gambling activity trade or business. Some taxpayers who play fantasy sports may qualify as professional gamblers in the trade or business of gambling, either based on their level of activity in fantasy sports leagues or their overall gambling activities. For these taxpayers, gambling winnings and losses are reported on Schedule C. Gambling losses can only be deducted to the extent of gambling gains, and losses in excess of gains cannot be carried over to another year. However, ordinary and necessary business expenses the taxpayers incur to engage in the gambling activity can be deducted.
From US Supreme Court case Commissioner of Internal Revenue, Petitioner v. Robert P. Groetzinger (1987), as under item 2, the taxpayer must establish that the gambling activity rises to the level of a trade or business, which the Supreme Court has held may be possible if the taxpayer pursues gambling full-time, in good faith and with regularity, for the production of income for a livelihood, not as a hobby.
As you can see, it all depends on how the league is set up, and how many hours your client spends playing fantasy football, as to how it is taxed.
As we open football season, good luck to your favorite teams. We will see how my teams do this season. As with every year, I am hoping for the best, but preparing for the worst.