"Predictions markets" have surged in popularity, with new and established platforms attracting millions of users trading on everything from election outcomes to the weather. But as predictions market activity grows, so does the question that every participant and platform will eventually face: how will the Internal Revenue Service ("IRS") tax the transaction?
What is a “predictions market” contract?
Predictions markets are online platforms where participants buy and sell binary (yes/no) contracts regarding the outcome of future events. Predictions markets contracts have been framed as the next iteration of futures contracts. A futures contract, as regulated by the Commodity Futures Trading Commission ("CFTC"), is a standardized, legally binding agreement to buy or sell a specific commodity or financial instrument at a predetermined price on a set future date. Traded on regulated exchanges, these derivatives have historically helped to hedge risk or speculate on price movements.
How does a futures contract work?
A futures contract is a contractual agreement between two counterparties – a buyer and a seller – to exchange a particular asset at a predetermined price on a later date. The buyer of the contract is obligated to purchase the underlying asset at the predetermined price and receive the asset once the futures contract has expired. The seller is obligated to sell the underlying asset at the agreed-upon price and to deliver the asset to the buyer as outlined in the contract.
The buyer profits if the underlying asset rises in value above the purchase price set by the contract. The seller profits when the value of the underlying asset decreases below the price set by the parties. Losses on the contracts are recognized by opposite movements in the value of the underlying asset. Futures contracts offer buyers and sellers the ability to lock in purchase (or sale) prices of an asset for a specific date in the future, historically to mitigate the risk of unfavorable price movements from the date of the agreement until the expiration date.
Although futures contracts traditionally were settled by physically delivering the underlying asset (e.g., bushels of corn) to the counterparty, over time the markets have evolved to where cash settlement is the norm – the parties simply exchange the change in the value of the underlying asset on the expiration date of the contract. Moreover, modern futures contracts can be traded on almost any type of asset, for example, commodities like corn and oil, currency, and even the movement of a specific market or index (e.g., the NASDAQ or the S&P 500).
Predictions markets are the latest expansion of what types of assets can be traded – in this case the parties' contractual promises to each other on the unknown outcome of almost any future event. Imagine if you could enter into a contract on what the temperature will be tomorrow in Des Moines at 10 am. Well, if you can find a counterparty to your "prediction," then you can buy a futures contract on one of the new predictions market exchanges.
How is a predictions market contract different from a bet?
Some have described contracting on predictions markets as akin to gambling. But the same could be said for contracting on the cost of a bushel of corn in six months, the price of a barrel of oil in 10 days, the value of the S&P 500 in a week, or the value of the Euro next October. One very real difference between gambling and a futures contract is that the latter is a derivative contract traded on an established and regulated exchange, like the Chicago Mercantile Exchange ("CME") or the London Metal Exchange ("LME"). Contracts traded on these exchanges are subject to agreed-to and standardized terms and conditions. And most importantly, there is no "house" – the exchange's profit does not depend on the outcome of the future event. The exchange only earns a service charge for running the exchange and bringing the parties together. In a casino, the gambler is playing against the house and the odds are set (either by regulation or industry custom) to slightly favor the house. In a futures contract, the buyer and seller are contracting or competing against each other, with the "odds" set through the process of bidding on the price.
How is a predictions market contract taxed?
Well, candidly, we do not yet know. To date, the IRS and the U.S. Treasury have not issued any guidance on how these transactions will be treated for federal income tax purposes. But we do know how they should be taxed if respected as futures contracts. The IRS could, however, view these transactions with a jaundiced eye and try to tax them as an "other" form of gambling.
The Section 1256 question
Some predictions market contracts may qualify as "regulated futures contracts" or "foreign currency contracts" pursuant to Internal Revenue Code ("IRC") Section 1256, which mandates "mark-to-market" treatment and treating any gain in the value of the contract under a 60/40 split – 60 percent long-term and 40 percent short-term capital gains regardless how long a participant has held the position. As such, if a predictions market is established on a CFTC-regulated exchange, the IRS will be hard pressed to treat the transaction as anything other than a "Section 1256 contract."
The IRS could argue for gambling treatment or merely as capital gains
Many predictions market exchanges permit users to trade in contracts that involve sports activities, like who will win the Super Bowl. The IRS could argue that the substance of these transactions is sports gambling, and try to tax the transaction as gambling. The IRS could also argue that non-sports related contracts are gambling in substance. If treated as gambling winnings, gross proceeds would be fully includable in a participant's ordinary income under IRC Section 61, with losses deductible only by those who itemize — and only to the extent of winnings, limited to 90 percent of the putative gambling losses.
If, instead, the IRS treats the gain on these transactions as capital gains (analogous to a financial contract), profits held longer than a year could qualify for preferential capital gains tax rates. Whether the participant is engaging in these transactions as a passive investor or as part of a regular and continual business will also affect how they will be taxed.
Areas of potential IRS dispute
Character of the gains. The IRS could assert that transactions are gambling, subjecting winnings to the less favorable tax treatment as described above. Active participants with large volumes would face significant exposure if losses cannot fully offset gains. Similarly, the IRS could argue for general capital gains treatment subjecting transactions occurring within a calendar year to short term capital gains tax rates (this would also potentially impact participants' ability to use losses to offset gains).
Information reporting. Regardless of how the gains on transactions are characterized, the exchanges (or some other party relevant to the transaction, like a broker) will likely issue some form of information tax return to report the activity to the IRS. For example, participants could receive IRS Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, which summarizes the annual activity for sales of securities and capital gains or losses. A copy of the form will be sent to the IRS as well as the participant. Participants may also have to file IRS Form 6781, Gains and Losses from Section 156 Contracts and Straddles, reporting the activity on their tax returns.
If the IRS considers the transaction as gambling, it could assert that the exchange issued the wrong form and the exchange should have issued an IRS Form W-2G, Certain Gambling Winnings, and propose a civil tax penalty on the exchange for each wrong form issued. These penalties can add up to millions of dollars per year.
Withholding obligations. Platforms may be subject to income tax withholding obligations, and the failure to comply with those obligations will make the platform legally liable for their customers' income tax incurred on each transaction plus interest thereon. The applicability (and rate) of withholding tax will depend, at least in part, on how the IRS characterizes the transaction and even on the status of the participant.
Excise tax. If the IRS believes these transactions are gambling, the platform will be liable for wagering excise taxes.
Self-employment tax. For participants who engage in predictions market transactions regularly, the IRS might argue that market activity constitutes a trade or business, triggering self-employment tax on net profits, and levy an additional tax on participants would not expect. Alternatively, the IRS could argue that the Section 1411 "net investment income tax" applies to profits from these transactions for some high-earning participants.
Crypto-based markets. Platforms settling in cryptocurrency add a further layer of complexity. Each settlement event may constitute a taxable disposition of the cryptocurrency itself, generating gains or losses independent of the underlying contract.
Practice Point
As with all new financial activities, until the IRS and the Treasury issues formal guidance and the tax law is settled, there is uncertainty of how these activities will be treated for tax purposes. In the interim, we suggest taking steps to protect yourself, including:
- Whether you are a participant or a platform, maintain detailed records and data for all transactions (e.g., positions, settlements, and fees paid/incurred) until the period of limitations on assessment has lapsed (note that this period could stay open indefinitely until a tax return or information return is filed);
- Consult a tax advisor to determine the most defensible tax characterization, and get written tax advice to abate any potential civil tax penalties that may be asserted in the future;
- Consult with your state tax professional to determine state and local tax treatment and reporting; and
- Be consistent in how you treat and describe the activity internally and publicly – account, market, and report the activity consistently – so you do not give the IRS or any other governmental agency ammunition to treat it differently and unfavorably.
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.
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