IRS guidance on fantasy fees could spell major trouble for DraftKings, FanDuel

The IRS, in a July 23 internal memo made public on Aug. 7, issued new guidance that amounts to a major shot across the bow at daily fantasy sports (DFS) operators DraftKings and FanDuel.

The memo, which does not name those companies, concludes that DFS contest entry fees count as wagers, and thus fall under the existing excise tax on sports betting. The tax is 0.25% of the amount of a wager, or for DFS companies, a contest entry fee. In 2018, as an example, the DFS industry brought in $3.2 billion in fees (that’s “handle,” not revenue), which would have meant $8 million in IRS excise taxes—significant for an industry that only generated $335 million in revenue that year.

DraftKings and FanDuel have not previously been paying these taxes, and have long held that their fantasy contests—in which users create a fantasy lineup of real athletes and can win money based on how the athletes perform—do not qualify as gambling contests.

The companies will surely fight the IRS decision in court, a scenario that will reunite the two business rivals that worked together through 2015 and 2016 as they fought various state attorneys general to argue that their contests are “games of skill” rather than chance. They will make the same argument to the IRS, DraftKings CEO Jason Robins made clear on Yahoo Finance Live on Friday morning.

“This isn't the first time that there’s been an education process to help explain the skill-based nature of our games and why DFS entry fees are distinct from wagers,” Robins said. “We do believe that upon embarking on that education process, it will become clear. This is an issue that’s been, for dozens and dozens of state legislatures and courts, already considered over the past several years. And almost unanimously they’ve come out on the side that DFS is clearly not wagering, it is clearly skill-based... We’re looking forward to having the opportunity to make that argument.”

A spokesperson for FanDuel said: “We are aware of the issue and look forward to working with the IRS."

The companies won’t challenge the IRS merely because they want to avoid paying the taxes, but also because they have to challenge it on a reputation basis: agreeing to pay the taxes could amount to a concession that they do accept unauthorized wagers, which could open up the companies to additional legal penalties.

If the IRS prevails, it would cost the two companies tens of millions of dollars—especially if a tax court decides the decision applies retroactively. Even Disney (DIS) has a stake in the outcome, as it owns 6% of DraftKings shares from the 21st Century Fox deal.

It’s unclear why exactly the IRS guidance is coming out now, when FanDuel has been in business since 2009, and DraftKings since 2012. Back in 2015, as ESPN reported, a former assistant U.S. attorney sent the IRS a letter about his belief that DFS companies “are clearly engaged in betting or wagering for purposes of the wagering excise tax.”

DraftKings (DKNG) went public in April by merging with an SPAC (special purpose acquisition company), and FanDuel in 2018 sold to Paddy Power BetFair (PDYPY), which rebranded as Flutter Entertainment last year.

Neither company is profitable yet, though DraftKings has $1.2 billion in cash on its balance sheet.

DraftKings reported its Q2 earnings on Friday, and while its loss of $161 million was worse than expected, its adjusted revenue of $75 million beat expectations, even after a quarter in which most sports didn’t play. Both DraftKings and FanDuel have spent big to ramp up TV advertising in July as soon as sports returned, and both are anxiously awaiting the NFL season, the time at which they sign up the most new users every year. If the NFL season falls through due to COVID-19, Robins says it will have a “short-term impact to our revenues.”

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Daniel Roberts is an editor-at-large at Yahoo Finance and closely covers sports business. Follow him on Twitter at @readDanwrite.

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