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Real-money skill-based games are very popular across the world and the United States is no exception. Generally, real-money skill games allow players to compete against others in various games where the outcome is determined by the relative skill of the players (as opposed to chance). In simple terms, it is the same betting your friend $5 on a game of darts or pool at the local pub. Except these games are played online – most frequently on smartphones. Games range from timed solitaire contests (using the same deck), to knife throwing or cup flipping games, to trivia contests. Because chance does not determine the outcome, most states’ anti-gambling laws do not prohibit skill-based games. U.S. based and international companies have been working to invest in this space, using the increasing availability of the internet and smartphone apps to provide entertainment to players seeking to compete against others and win some money in the process.

I have written extensively about legality of skill gaming, as well as the obstacles that developers need to overcome to get their games up and running and advertised.

Besides private company gatekeepers, local law enforcement, and regulatory authorities, there is a new obstacle for skill-based gaming companies. This time it comes from the IRS and could have broad market implications beyond simply paying taxes.

In 2020, the IRS issued two related memoranda regarding Daily Fantasy Sports (“DFS”) wagers. Recall that DFS is an accelerated version of traditional fantasy sports, giving players a chance to set lineups and compete on a daily basis, rather than having just one team for the entire season. DFS is available in 43 states through the two major operators: DraftKings and FanDuel. Similar to pure-skill games, DFS distinguishes itself from gambling by emphasizing that relative skill of the players determines the outcome (as opposed to chance). In some of the 43 states, DFS operates pursuant to government license. In other states, DFS is unregulated and either expressly or implicitly exempt from the statutory definition of “gambling.”

In the first 2020 memo, the IRS considered whether DFS operators (i.e. DraftKings and FanDuel) were required to pay excise tax on wagers pursuant to IRC §§ 4401 et seq. Under federal tax law, each “wager” is subject to excise tax – sportsbooks are very familiar with this provision that requires the bookmaker to pay tax on every bet accepted from a patron. In answering in the affirmative, the IRS defined “wager” without any reference to an element of chance:

“[T]he statutory language in IRC §§ 4401 and 4421 does not differentiate whether an activity involves skill, chance, or some combination of the two. Most importantly, whether DFS is a game of skill for state gambling statute purposes is not relevant for determining whether DFS is wagering for federal excise tax purposes.”
IRS AM 2020-009

At the same time, the IRS did not overturn Revenue Ruling 57-521, which was a 1957 opinion on whether a puzzle contest was a taxable gaming transaction. Rather, the IRS distinguished that in the puzzle contest “the contest participant’s own skill was the only factor involved in winning the puzzle game and there was no chance element at all.” In DFS, the participants use their skill to select a lineup, but then earn points based on the real-world performance of the selected athletes (over which the participants have no control). The IRS emphasized that no matter how educated and skilled a DFS participant may be, there is always a chance that the chosen player or players will perform poorly that particular day, get injured, or suffer adverse effects on their performance from the weather or officiating. Thus, the IRS concluded that the “skill” involved in DFS was similar to the skill involved in traditional sports betting or horse race “handicapping.” Finally, the IRS also explained that that the rate of excise tax (0.25% or 2%) depends on whether DFS is “authorized” under the law of the state where the wager is accepted. The IRS did not explain whether “authorized” means DFS is operating pursuant to express state license or is simply outside of the particular state’s anti-gambling legislation.

Two months after the excise tax memorandum, the IRS relied on essentially the same analysis to conclude that DFS wagers are “wagering transactions” that can be used to offset wagering income during a taxable year under IRC § 165(d). Effectively, DFS wagers are treated the same as gambling losses under the IRC. In its legal analysis, the IRS reiterated:

Any argument a DFS transaction is not wagering because it is based on skill must fail because elements of chance beyond the participant’s control ultimately determine the outcome of the transaction
IRS Memorandum 202042015

Why does the IRS’s DFS analysis matter for skill-based real-money gaming? Two main reasons: (1) The IRS’s interest in DFS transaction could signal increased tax scrutiny for real-money skill-gaming operators; and (2) the IRS’s legal analysis of whether a skill game is actually gambling/wagering could be adopted by states that currently do not regulate skill-based gaming.

1. Do real-money skill-based game companies have to pay federal excise tax?

There is no doubt that pure-skill games are still exempt from the definition of “wager” and “wagering transaction” for tax purposes. However, it is unclear whether there can be “any” chance at all. The first IRS memo cited a 1957 puzzle game ruling to distinguish pure-skill games, noted “there was no chance element at all,” and concluded that “[t]he existence of chance indicates that DFS contests are distinguishable” from the pure-skill puzzle game at issue in the 1957 memo.

In the second memo, IRS revised its position slightly to conclude that “the test is not whether there is an element of chance or skill, but which is the dominating element that determines the result of the game.” Regardless, the IRS took the position that the outcome of a DFS contest is predominantly determined by chance (as opposed to skill). DFS industry leaders have predictably issued statements opposing the ruling, calling it “deeply flawed” and inconsistent with state court decisions that have held that DFS is a game of skill.

If you are a real-money skill game developer, it is critical to determine whether your game has any element of chance at all. In other words, is your game more fantasy sports or pure contest? If there is any element of chance at all, you must determine whether skill “is the dominating element” of the game. Most, if not all, real-money skill games will pass this second test. At the same time, if your game is more like fantasy sports (for example a stock market or cryptocurrency picking game), your game will likely be considered to involve taxable wagering. This obviously subjects you to the excise tax under IRC §§ 4401 et seq. An added wrinkle is whether you owe tax at the 0.25% “authorized” rate or the 2% “unauthorized” rate. Most skill-based operators operate without a license or governmental approval – but at the same time, they only operate in states where their activities are not prohibited by state anti-gambling laws.

2. Will states adopt the IRS definition of “wager” to regulate real-money skill-based gaming?

Additionally, the IRS analysis may be adopted by states seeking to regulate or prohibit real-money skill games. For instance, if you are paying excise taxes to the IRS, a state regulator can easily use that fact to argue that your game is actually “wagering” and therefore constitutes “illegal gambling.” This is especially troubling because the first “excise tax” memo seems to require “chance only. It is also possible that real-money skill games will be considered “wagering” for the purposes of excise tax imposed by IRC §§ 4401 et seq but not “wagering” for the purposes of IRC § 165(d).

Stay tuned for more on this developing area. It is likely that DraftKings and FanDuel are headed for a showdown with the IRS over the excise tax issue. Any resulting Tax Court decision (or even settlement) will have significant repercussions for the skill-based gaming industry.

Have more questions? Contact Dan Artaev today by emailing dan@artaevatlaw.com or by phone or text at (269) 930-0254.

Disclaimer: This guide is not intended to be and does not constitute legal or tax advice. It is for informative and promotional purposes only. Do not take any action or refrain from taking any action based on this guide, and always consult with a qualified professional about the circumstances of your particular case. Each set of facts is unique and different circumstances apply to each individual business.

Skill-based real-money gaming is a growing industry worldwide. Previously, I wrote about the legality of playing casual games like Solitaire and bingo derivatives for real money. But what about console or PC games like FIFA ‘21, NHL ‘21, Madden ‘21, NBA2K21, and PGA2K21? Shooters like Call of Duty, CS:GO, and Fortnite? Strategy card games like Magic the Gathering? Can those be played for real money as well?

We are not talking the official in-game cash cups or periodic tournament that a few games offer. Rather, head-to-head real money competition that makes any game a chance to win (or lose) cash. There is no shortage of websites and apps offering players this very service. The chance to wager real money on head-to-head video game contests or play in cash-prize leagues and tournaments is certainly attractive. But whenever there is any sort of betting or wagering, legal issues may come up. As a player, you want to make sure you are not breaking the law by wagering $5 on a Sunday Madden round robin. As an entrepreneur and app developer, you need to know what you can and cannot offer to your audience or how to plan for and resolve potential legal issues.

There are two distinct problems areas in the real-money gaming sector. First, is playing video games for real money considered illegal gambling?

Each of the 50 U.S. states has its own set of laws that define “gambling” and that definition determines whether real money playing video games for real money. Do not assume that a platform or app is legal just because it is not traditional, casino-style “gambling.”

You may have heard that if a game’s outcome depends on skill rather than chance, then it is not “gambling” and therefore allowed. This is false. Each of the 50 states have their own regulatory scheme for gambling and gaming, and while some states only regulate games where chance is the dominant factor (in other words, casino-style gambling), not all have the same laws. Certain states define gambling independent of whether chance or skill determines the outcome. They simply make it illegal to wager money in exchange for the possibility of winning money. Other states expressly regulate “games of skill,” either independently or as part of recent internet gambling legislation.

Note that even if a state allows participants to wager real money on a game of skill for a chance to win cash prizes, wagering on the gameplay of others is prohibited. Wagering on the play of others is akin to a sportsbook, which are tightly regulated as gambling across the board.

The gambling vs. game of skill analysis also depends on the particular game at issue. Some games are pure skill with no element of chance – such a game that pits two identical soccer squads against each other. Others have some element of chance, but the skill predominates over the outcome. For example, Fortnite has an element of chance (even presuming you are matched with players of equal skill) because the loot is randomized and the bus approaches the map from different directions, giving an element of luck at least at the start. Then there are games like Magic: The Gathering and Hearthstone or any other game that features cards and a random shuffle mechanism. While better players will certainly win over time, the randomness of the shuffle does affect the outcome. Thus, the specific nature of the game played also determines the legality of the wager on a state-by-state basis. Note that official in-game tournaments always have a “void where prohibited” disclaimer and generally do not require a real-money entry fee to participate to avoid legal issues.

The second problem is intellectual property rights – specifically the game copyrights and trademarks owned by studios like EA and Epic.

Game studios generally do not endorse any websites or apps that allow real-money wagering on their games. In fact, such wagering providers may face copyright or trademark infringement lawsuits from the game developer for misusing their intellectual property.

Many third-party wagering sites use the logos or cover art from the games that they support, but not many have the license or permission to do so. From a trademark perspective, the game studios could have a brand confusion claim, as players may assume that the game makers themselves endorse these wagering sites. The fine print (that nobody reads) disclaiming any endorsement is unlikely to prevent a trademark infringement action. Game developers spend millions of dollars on cultivating their image and will not hesitate to file a lawsuit to protect the integrity of their brand.

The game studios also own the copyright to their games, which means they get to control how their products are used, distributed, and portrayed. At least one studio, Epic Games, has publicly stated that any website or app that facilitates wagering on any of its games (including Fortnite) is violating Epic’s IP rights. Video game publishers – especially those that market to the under-18 crowd – do not want to be associated with anything that could be viewed as gambling (even if it is not gambling under the law). It is likely that there are lawsuits coming to protect the games’ “family-friendly” image and reassure parents that video games are a safe and wholesome hobby. It is also unlikely that any game studio – at least any major game studio – will enter into a licensing deal with a wagering website to specifically support real-money wagering on gameplay.

Plus, some studios themselves offer cash and prize competitions. For example, Fortnite hosts its own real money prize events. Call of Duty has league play. Magic: The Gathering periodically does an Arena tournament that awards a cash prize to the top players. “Official” competitions let the studios control their own IP and not have to share revenue and player base with any third parties. Further, most official competitions do not require a real-money buy-in to participate, making them more “family-friendly.”

There is no doubt that real-money skill gaming is a big draw worldwide, especially with the ubiquity of smartphones and fast cellular connections. Potential legal issues are there as well, and the wrong approach will attract the attention of local law enforcement and civil intellectual property lawyers. To add to the uncertainty, the United States is a dual-sovereign system, with regulations both on the federal level (that mainly affect the banking aspect of wagering) and the state level (that are constantly changing). Tread carefully and hire a lawyer.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.