The Super Bowl is just around the corner, bringing with it a formal end to the NFL season—and to the fantasy football season. But while everyone will absolutely know which team is the best in the world after Sunday’s game, many fans will still be wondering something else: Just how do I report my fantasy earnings or losses on my taxes?
It’s not a trivial question. The Fantasy Sports Trade Association recently estimated that 56.8 million people in the United States and Canada played fantasy sports in 2015.
Clearly, the popularity of fantasy sports, especially fantasy football, has exploded in the United States. Thanks to an ad blitz at the beginning of the 2015 NFL season, “daily fantasy games,” which allow players to choose different teams much more frequently than in the past, in particular have a much higher profile than they did just a year ago. These sites have relied on an exception in the Unlawful Gambling Enforcement Act of 2006, P.L. 109-347, that specifically excluded fantasy sports from the law’s general prohibition of using the internet to accept payments for wagers.
So what do you need to know about reporting to help all of your fantasy-football-playing clients?
Unfortunately, the IRS has not ruled on the treatment of fantasy sports income and losses, and there is little if any authority for the proper reporting on tax returns: only IRS Letter Ruling 200532025, which discussed the various methods of reporting winnings by a taxpayer that ran a site for online game-playing tournaments. According to the letter ruling, the three possible reporting methods are:
- 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).
- 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.
- 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.
Reporting fantasy sports activities—which method is correct for your client?
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 Regs. Sec. 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 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 Rev. Rul. 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.
Determining how the client’s activities should be characterized will depend on that client’s facts and circumstances.
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 Regs. Sec. 1.183-2(b)—that is, it is a regular activity that the taxpayer engages in with a profit motive.
1. 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 Regs. Sec. 1.183-1, Activities not engaged in for profit. Hobby income is reported on Form 1040, U.S. Individual Income Tax Return, line 21, “Other income.” Expenses that are otherwise allowable under other relevant sections of the Code are allowed subject to Regs. Sec. 1.183-1(b) and are treated as expenses related to the production of income under Sec. 212. This means 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%-of-adjust-gross-income (AGI) floor, and they are disallowed for alternative minimum tax (AMT) purposes. Expenses here 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, since most leagues report amounts in box 3 using the cumulative net method, i.e., winnings less total entry 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.
2. 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. Note that the IRS will consider whether the activity contains “elements of personal pleasure or recreation” (see Regs. Sec. 1.183-2(b)(9)), 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 Sec. 162, the net income from the fantasy sports activity would be subject to self-employment tax. The taxpayer will report the activity as a sole proprietor on Schedule C.
3. 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 are not subject to the 2%-of-AGI floor (and thus, not 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.
4. 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. 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, with regularity, for the production of income for a livelihood, and not as a mere hobby (see Groetzinger, 480 U.S. 23 (1987)).
Of equal importance to most clients will be how their state handles the taxation of fantasy sports income. However, because this is an emerging issue, many states are still grappling with it, and the few that have issued guidance have focused on the fantasy sports operators and not the players.
David Baldwin, CPA/PFS, is the tax partner with Baldwin & Baldwin PLLC in Phoenix. Donald J. Zidik Jr. , CPA, is a director with Marcum LLP in Needham, Mass., and an adjunct professor of taxation at Suffolk University in Boston. Baldwin is a member and Zidik is the vice chair of the AICPA Individual & Self-Employed Tax Technical Resource Panel.