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The Billion Dollar Issue in the NJ Sports Betting Case is Commandeering

February 10th, 2013 3 comments

The last time I wrote about sports betting and New Jersey was last May, and I said the following:

Late last week, New Jersey Governor Chris Christie announced his State will proceed to take the steps necessary to offer sports betting at Atlantic City casinos and the State’s four horse tracks.

New Jersey is far ahead of New York in the process, as Governor Christie signed a bill into law in January 2012 that authorizes professional sports wagering in NJ. New Jersey will likely encounter in the near future efforts by federal authorities challenging such legislation on the basis of the Supremacy Clause. NJ will argue PASPA is unconstitutional.

My prediction held true, sort of.

Last August, the NCAA and the four major professional sports leagues filed suit against NJ Governor Christie, et al., in an effort to prevent the expansion of legalized sports betting in the United States.

Then in December, U.S. District Court Judge Michael Shipp held that the leagues have legal standing to sue NJ over the State’s sports betting law.

About a month later, the U.S. Department of Justice filed papers to intervene as a co-plaintiff in the case and defend the constitutionality of the Professional and Amateur Sports Protection Act of 1992.

Since then, the parties exchanged and filed legal briefs outlining their positions, ahead of this Thursday’s oral argument on the merits before Judge Shipp in federal court in Trenton, NJ.

What will the parties focus on during oral argument?

The leagues and the DOJ will argue that PASPA is constitutional and thus NJ’s sports betting law violates PASPA. NJ, in turn will argue that PASPA is unconstitutional under any of three theories, as articulated in New Jersey’s brief filed on Friday:

  1. PASPA Impermissibly Commandeers The Legislative Authority Of The States
  2. PASPA’s Lack of Uniformity Exceeds Congress’s Commerce Clause Power by Depriving States of Equal Sovereignty
  3. PASPA Violates Due Process and Equal Protection Rights

I find theory #1 the most compelling argument of the three. It’s clear NJ feels the same, as the substantial majority of its brief focuses on the commandeering issue.

What is commandeering? The 10th Amendment to the U.S. Constitution:

The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.

The U.S. Supreme Court has struck down federal laws as unconstitutional for violating the 10th Amendment only a handful of times. The basis for the findings was that the federal statutes in question commandeered the states to enforce them.

The issue narrows to, again: What is commandeering?

Unsurprisingly, the parties fiercely disagree on the answer to this question.

Does the 10th Amendment merely prohibit federal statutes that compel the states to take some affirmative action, as the DOJ argues? Or, as NJ argues, does it also extend to federal statutes that do not necessarily compel the states to do anything, but instead prevent them from taking some action?

In this case, that’s the billion dollar question.

NJ may have a tougher time prevailing on the issue merely because there is no Supreme Court case on point factually to support its interpretation of the 10th Amendment’s reach. But, the 10th Amendment cases decided by the Supreme Court are not even roughly analogous to this case, so that is the opening NJ is seeking to exploit.

In its brief, NJ comes out firing in the opening two paragraphs. Citing New York v. United States, the State emphasizes that under the Constitution, Congress lacks the power directly to compel the States to require or prohibit certain acts pursuant to a federal statute. And of course, argues the State, PASPA prohibits States from offering sports betting.

The entire brief is a worthy read, as the State picks apart the 10th Amendment characterizations presented by the leagues and the DOJ. In short, the State takes the position that the anti-commandeering doctrine has been applied to federal statutes that command the States to maintain a certain state of affairs.

There’s some great additional commentary on the commandeering issue in this Pokerati post and its comments.

No matter how Judge Shipp rules in this case, an eventual appeal to the U.S. Supreme Court seems inevitable. There’s simply too many dollars at stake for either the leagues or New Jersey to back down until the Supreme Court says to do so.

Governor Christie Conditionally Vetoes iGaming Bill: What About Poker?

February 8th, 2013 2 comments

Yesterday, New Jersey Governor Chris Christie acted on the internet gambling bill sitting on his desk during the final moments of his forty-five day time-frame. He could have (i) taken no action, thus allowing the bill to become law, (ii) vetoed the bill, or (iii) conditionally vetoed the bill, recommending changes to the legislation that he would sign off on.

The Governor’s conditional veto has apparently generated little, if any, initial opposition. State legislators and other interested parties believe the proposed changes are non-issues and that internet gambling in New Jersey is going to happen.

For a clear and concise read on the events surrounding the Governor’s conditional veto, be sure to check out this piece at Online Poker Report. The “short answer” on what Governor Christie wants changed:

  • Taxes at 15%, not 10%
  • License fees roughly double
  • NJ Division of Gaming Enforcement takes the reigns of online gambling
  • Online gambling regulation “sunsets” (expires) after 10 years (though nothing prohibits the legislature from renewing)
  • More funding for problem gambling initiatives, including an annual report wrt the impact of online gambling on problem gambling

Online Poker Report also delves into a “longer answer” on the changes. There are a couple in particular that raise some interesting questions.

Authorizing Online Poker in New Jersey

I came across this thread on the TwoPlusTwo forums. The original poster wondered whether online poker would be authorized under the Governor’s proposed changes.

The conditional veto calls for this language to be deleted from the bill:

2. (New section) Any authorized game or authorized gambling game, as defined in section 5 of P.L.1977, c.110 (C.5:12-5), that is authorized to be played in a casino may, with the approval of the division, be offered through Internet gaming.

And to be replaced with:

2. Section 5 of P.L.1977, c.110 (C.5:12-5) is amended to read as follows:

“Authorized Game” or “Authorized Gambling Game” – Roulette, baccarat, blackjack, craps, big six wheel, slot machines, minibaccarat, red dog, paigow, and sic bo; any variations or composites of such games, provided that such variations or composites are found by the division suitable for use after an appropriate test or experimental period under such terms and conditions as the division may deem appropriate; and any other game which is determined by the division to be compatible with the public interest and to be suitable for casino use after such appropriate test or experimental period as the division may deem appropriate.  “Authorized game” or “authorized gambling game” includes gaming tournaments in which 6 players compete against one another in one or more of the games authorized herein or by the division or in approved variations or composites thereof if the tournaments are authorized by the division.  “Authorized game” or “Authorized gambling game” shall also include any game that the division may determine by regulation to be suitable for use for wagering through the Internet.

No, you don’t see the word “poker” anywhere, although other games are listed. What, then, is the authority for permitting online poker under this legislation?

The language proposed in the original bill says the Division of Gaming Enforcement may approve for internet gaming any games only already authorized to be played at New Jersey casinos. Since poker is authorized for play in NJ casinos, then the division may approve it for internet gaming.

The Governor’s proposed language (underlined portion above) takes a different approach. Instead, he wants the Division of Gaming Enforcement to decide pursuant to promulgated regulations the games that are suitable for internet gaming. From my reading, it appears that the division would not be limited to approving for internet gaming those games only already authorized for play in NJ casinos, but instead may approve for internet gaming any game the division so chooses.

The proposed change runs consistent with the Governor’s conditional veto statement, which makes clear his goal to grant the New Jersey Division of Gaming Enforcement “wide latitude and authority to establish a regulatory framework that provides for the most effective controls, monitoring, and supervision” of internet gaming.

What wouldn’t surprise me is if the division takes a cautious approach with poker. Games not against the house (i.e. player-against-player) raise various unique issues, such as collusion, that require special attention and consideration.

Poker will be a part of internet gaming New Jersey. Governor Christie is just giving the division the apparently unilateral power to figure out how to bring the game—any games, for that matter—online in the state.

Pooling Liquidity

Another proposed change pointed out at Online Poker Report:

Page 32, Section 33, Line 47: Delete “an interstate compact” and insert “a reciprocal agreement”

The phrase “interstate compact” is found in section 33 of the bill:

33.  (New section)  Notwithstanding any other provision of P.L.      , c.    (C.      ) (pending before the Legislature as this bill), wagers may be accepted thereunder from persons who are not physically present in this State if the Division of Gaming Enforcement in the Department of Law and Public Safety determines that such wagering is not inconsistent with federal law or the law of the jurisdiction, including any foreign nation, in which any such person is located, or such wagering is conducted pursuant to an interstate compact to which this State is a party that is not inconsistent with federal law.

Interstate compacts are agreements entered into between two or more states. Under the U.S. Constitution, interstate compacts require congressional consent.

Perhaps the Governor is anticipating possible legal challenges to agreements entered into with other states for internet gaming. If the iGaming law acknowledges that the agreement is an “interstate compact,” then the State is essentially admitting that the agreement is subject to Congressional approval under the compact clause. By labeling these possible future agreements as something else, the State at least leaves the question open as to whether the agreement is one subject to the compact clause.

With that said, is there any special significance with using the phrase “reciprocal agreement?” Perhaps. As fellow gaming attorney Bob Crawford noted on Twitter, it’s possible that a reciprocal agreement would require other states to accept NJ players, but an interstate compact might not.

We should continue to think on this issue. As I’ve previously discussed, how states seek to pool virtual liquidity may prove critical on how the internet gaming market thrives in the United States.

In the meantime, NJ Assemblyman John Amodeo said he is working “to get these [proposed amendments] passed by the Legislature as soon as possible and back onto the Governor’s desk for consideration.”

Yesterday’s conditional veto was a very significant step along the path towards regulated internet gambling in the United States.

Intrastate iGaming: Interstate Compacts and Revenue Sharing

January 30th, 2013 No comments

One of the most not only fascinating but also critical issues for state-by-state iGaming legalization is whether states will let their virtual fences down and enter into iGaming compacts with other states. If so, how may states share tax revenue from gaming activity?

Interstate iGaming Compacts

Before evaluating tax revenue sharing possibilities, we must grasp some of the dynamics surrounding interstate compacts.

Look no farther than the State of Nevada, which appears poised to open its doors to intrastate online poker sometime in 2013. But with a population of approximately 2.76 million, Nevada presents profitability concerns for online poker operators offering its product only to customers physically present in the state. This viability issue is compounded many times over as more than a dozen companies have already received preliminary approval to operate in the state.

Sure, some committed poker players may move to Nevada to play online full-time, but it seems unreasonable to expect many recreational players to do so. Certainly not enough to make online poker in Nevada a robust business on its own. And interested parties know this.

In his 2013 State of the State address, Nevada Governor Brian Sandoval urged lawmakers to approve a bill authorizing him to enter into interstate iGaming compacts without first requiring federal legislation authorizing it.

Larger states, however, may not have as strong an incentive to negotiate compacts with smaller states. Consider California, for instance. With a population of over 38 million, the Golden State is larger than every country in Europe but eight.

The Internet Gambling Consumer Protection and Public-Private Partnership Act of 2012 did provide California legislators the alternatives to opt into a federal iGaming system or enter into compacts with other states. The problem with either alternative coming to fruition is that special interest groups in California are mightily struggling to get on the same page for iGaming. That’s why the bill failed to reach committee vote last year. And these groups may hold the belief that if the State reaches compacts for interstate online play, other smaller states would reap the benefits of the pooled liquidity far more than California would.

Another compact concern for California involves losing its residents to partner states. (Note: Expatriation is already a problem for California.) Suppose, however unlikely, that NV presented an attractive proposal to CA for pooling liquidity, such as NV giving CA a significant percentage of gross gaming revenue (“GGR”) generated by the NV players. Once the pooled sites go live, some CA players would move to establish residency in NV and thus avoid paying CA income tax. The analysis of this issue could narrow to whether the additional gaming revenue paid to CA as result of liquidity would exceed the lost income tax revenue from CA expats.

Even if states agree to share revenues based on location of players, as discussed below, there’s likely still an overall benefit to pooling liquidity. By substantially increasing the number of virtual players on a given site, a greater variety and quantity of tables become available for players to choose from. The challenge is figuring out how to distribute the increase in overall benefit so interstate compacting is agreeable to lawmakers and their supporters on all sides of the negotiating table.

With the above in mind, how would states seek to share tax revenues pursuant to interstate iGaming compacts?

Revenue Sharing Pursuant to Interstate Compacts

States that have or are considering legalized online gaming are including their own licensing and taxation regimes in the legislation. We should expect any state’s iGaming legislation to permit an operator to operate in the state only if licensed in the state. In other words, foreign operators in general seem unlikely, at least in the early stages of this emerging industry.

The natural progression to interstate iGaming compacts would seem to involve an operator licensed in more than one state to pool its liquidity among those states. But it’s not necessarily a smooth ride to get there.

New Jersey’s pending iGaming bill, for instance, requires all iGaming servers to be located in Atlantic City in order to comply with the New Jersey State Constitution. If PokerStars is licensed in both NV and NJ and pools its liquidity, for example, then PokerStars would have to ensure all servers running virtual tables with NJ players are located in Atlantic City. If NV players were on these tables as well, would such conduct run afoul of the NV interactive gaming laws? I suspect this type of issue would need to be addressed in the interstate compacts themselves.

As an aside, the notion of requiring operators pursuant to an interstate compact to be licensed in each state it seeks to operate ironically defeats another purpose for compacts: Avoiding paying license fees in multiple states.

With the above considerations in mind, how would states share gaming revenue pursuant to an iGaming compact? Let’s assume, as discussed, that each state will have in place its own gaming taxation model. The result is that operators could be required to apply more than one state’s taxation model to activity taking place on the same online poker table.

Suppose again that PokerStars is licensed in both NV and NJ. NV’s tax is 6.75% of GGR. The pending NJ iGaming bill calls for a 10% tax on GGR. If liquidity is pooled between the states, there could be both NV players and NJ players on the same PokerStars cash game tables. Gaming revenue to PokerStars would be the collected rake for each hand played.

The question then becomes, how do the two state’s gaming taxation models apply to each online poker hand played? A few possible approaches:

  1. The rake is subject to tax in both states;
  2. The rake is subject to tax in the state that the winning player of the hand resides; or
  3. A proportion of rake is subject to tax in state “A” based on the ratio of total wagers made by players in state “A” to total wagers made by players in both states “A” and “B.”

Approach #1 obviously requires modification, otherwise operators would pay GGR tax of the full amount to both states. Operators could be entitled to some tax credit for GGR paid to another jurisdiction. The states would need to negotiate the mechanics of the tax credits as applied to each state.

Approach #2 would seem to be the easiest to implement. Operators would already be required to know the location of all of its players, so the added step of attributing a location to rake collected for each hand does not seem too burdensome. Of course, split pots present more complex situations, but are likely far from insurmountable.

An interesting issue arises with Approach #2, however. States themselves would then be biased with respect to the outcome of each hand in favor of its own residents. The more its own residents win over nonresidents on the pooled tables, the more overall gaming revenue to the state. The bias would be more pronounced with poker tournaments, as the prize distributions are more skewed. Clearly, states themselves should not have preferred winners for quantifiable reasons in games they are regulating.

Approach #3 would be more complicated to implement than #2, but it removes the state bias issue. Let’s try an example for #3 to clarify the mechanics.

Suppose there are three NJ players and three NV players at the same online poker table with a rake of $5 for each hand played. At the conclusion of one hand of Texas Hold’em, player 1 (NJ) wagered $5, player 2 (NJ) wagered $0, player 3 (NJ) wagered $10, player 4 (NV) wagered $25, player 5 (NV) wagered $25, and player 6 (NV) wagered $10. Player 4 won the hand. NJ players wagered a total of $15, and NV players wagered a total of $60. The percentage of rake attributable to NJ would be 15/(15+60), or 20%. Percentage of rake attributable to NV would be 80%. For this hand, $1 of rake would be subject to the 10% GGR tax in NJ, and $4 of rake would be subject to the 6.75% GGR tax in NV.

Any of the three above approaches are viable if each state has a similar GGR model. How would states share revenue if one state taxes gaming revenue based on GGR and another imposes a deposit tax? I will leave that question open for us to think about.

I’m very interested in hearing reactions to this post. Does anyone envision a different path to pooling virtual liquidity in the U.S.? Are there more efficient or agreeable ways that states could seek to share revenue? Consider contributing your thoughts at the LinkedIn group U.S. Internet Gaming: Tax Considerations.

I plan to revisit this topic sooner than later. In about one week, we’ll learn whether iGaming becomes legal in New Jersey. If it does, I’ll cover that next time. If not, I’ll delve into state income tax considerations for both iGaming operators and players.

Intrastate iGaming: State Gaming Taxation Models

January 23rd, 2013 No comments

It’s no secret the chief aim for most—if not all—states to legalize Internet gambling is to generate tax revenues. This “Intrastate iGaming” series now turns to how states may seek to attain that goal.

Gaming Taxation in the United States – Gross Gaming Revenue

A convenient iGaming tax model for states to adopt is that used to collect gaming tax revenues from licensed brick and mortar casinos in their particular state. Among the twenty-two states with commercial casinos, most tax casinos based upon Gross Gaming Revenue (“GGR”).

GGR is characterized as a profit-based model. In general, GGR consists of total wagers made by customers less the winnings paid back to its customers. The GGR base may be further reduced by other expenses. The tax is a percentage of GGR, from a low of 6.75% in Nevada to a high of 55% on slot machines in Pennsylvania.

The GGR model has already been adopted to tax iGaming operators at the state level. In Nevada, the first state to promulgate iGaming regulations, gross revenue received by an interactive gaming operator is subject to the same license fee “as the games and gaming devices of the establishment, unless federal law otherwise provides for a similar fee or tax.” (NV Gaming Comm’n Reg. 5A.170(1)) In other words, the State will generally tax iGaming operators the same as its brick and mortar casinos.

Delaware is the only other state with an iGaming law on the books, titled The Delaware Gaming Competitiveness Act of 2012 (“DGCA”). Delaware’s iGaming framework is different from Nevada’s because it is under the control and operation of the Delaware Lottery. Furthermore, it authorizes not only internet poker like in Nevada, but also traditional lottery games and table games over the internet.

Similar to Nevada, Delaware generally taxes iGaming based on GGR. Under the DGCA, gross revenue from iGaming, less winnings paid to players, are required to be placed in a special account called the “State Internet Lottery Fund.” After an appointed Director pays administrative and operation fees out of the account, the first $3.75 million of proceeds for a given fiscal year must be transferred to the State Lottery Fund for the benefit of the state. Remaining funds from internet lottery and table games are to be distributed pursuant to the provisions under section 4815 of the Delaware Code.

Alternative Model – Deposit Tax

Another iGaming taxation model is the deposit tax. Instead of taxing gross gaming revenues, the deposit tax is imposed on a percentage of funds a player deposits with an operator. A volume-based model, deposit tax rates around the world on iGaming are generally much lower than GGR rates.

It’s notable that of the three federal bills containing tax schemes for regulated iGaming in the U.S. (here, here, and here), all of them called for a deposit tax. The Internet Gambling Regulation and Tax Enforcement Act of 2010, for example, sought to impose a two percent tax on deposits made by customers on licensed iGaming sites.   

Comparing the Models

GGR may be viewed as relatively low-risk for operators since the tax is based on profits from gaming. Plus, it’s the model many future iGaming operators will be most comfortable with at the outset, since GGR is the most common model to tax commercial casino gaming in the United States.

Applied to iGaming, the GGR model has some kinks. When are payouts to customers in the iGaming space deemed to be made? When a winning wager is credited to a customer’s account or when the customer withdraws the funds from the account? The answer impacts the timing of the deduction from the GGR base. In addition, some GGR models have different tax rates depending on the game played. This structure adds complexity to the accounting measures operators must have in place to properly remit the GGR tax to the State.

Licensing jurisdictions would seem to favor a deposit tax for iGaming because the tax is collected up front, when the customer deposits funds on the iGaming site. And unlike GGR, the deposit tax does not depend on the type of game played, so it is game-neutral. An across the board tax would make implementation far easier for iGaming operators.

One issue with the deposit tax is that it may apply regardless of whether an iGaming customer actually uses the deposited funds to engage in wagering activity. Theoretically, customers could deposit funds and then immediately request withdrawal without placing any wagers. Such activity presents no benefit to the operator, who would have to pay a tax without the opportunity to earn revenue.

Finding a Happy Medium

At least initially, states seem keen on carrying gaming taxation models from brick and mortar to iGaming. It’s not a surprise considering operators are already accustomed to GGR. Jurisdictions should bear in mind the deposit tax offers potentially much simpler implementation. But what about the deposit tax issues?

To address the deposit and immediate withdrawal situation, states could permit operators to charge early withdrawal fees. Another idea is to allow operators to take a tax credit for withdrawn funds that are not returned to players, thereby imposing the deposit tax only on wagered funds. Such a credit makes the deposit tax more akin to a profit-model like GGR while maintaining game-neutrality.

The gaming taxation model is crucial for determining how a state will generate revenue from iGaming. Each state must carefully consider the implications of each proposed model for operators and customers and ultimately determine which is in the best interests of the State in order for the iGaming industry to thrive in the United States.

Next time, we will highlight some tax considerations for states entering into interstate iGaming compacts.

Intrastate iGaming: Federal Wagering Tax

January 16th, 2013 No comments

So far, we’ve discussed how federal withholding and reporting obligations and the Bank Secrecy Act may be implicated with intrastate internet gaming activity in the U.S. This time we examine the possible applicability of another type of tax imposed by the Internal Revenue Code (“IRC”), the excise tax on wagers made under section 4401.

The federal wagering excise tax may apply for bets accepted on U.S. internet gambling sites. For accepted wagers authorized under state law, the excise tax is 0.25 percent of the wager amount and is paid by the entity accepting the wager. For all other wagers (i.e. wagers not authorized by state law) the tax jumps to two percent.

To determine whether the tax may apply to intrastate iGaming, the first question we must ask: What is a taxable wager under the statute?

IRC section 4421 provides taxable wagers include those placed:

  1. on a sports event or contest with a person engaged in the business of accepting such wagers;
  2. in a wagering pool on a sports event or contest conducted for profit; or
  3. in a lottery conducted for profit.

As an aside, any wager placed in a sweepstakes, wagering pool, or lottery which is conducted by an agency of a State acting under authority of State law is exempt from the tax. So if a state or an agency of a state operated an iGaming site, then the federal wager tax wouldn’t apply to wagers accepted on the site.

In general, the federal wagering tax applies on wagers accepted by race and sportsbook establishments in the U.S.

Online horse wagering exists today, and operators are required to collect and remit the tax on wagers placed. (Note: Parimutuel horse race wagers pursuant to state law are exempt.) Online sportsbooks at this time are not authorized under any state law, so those accepting wagers would be required to pay the tax at the higher two percent rate.

Does the tax apply to offshore online sportsbooks accepting wagers from U.S. customers? Probably not, unless the party accepting the wager is a U.S. citizen or resident.

IRC section 4404 provides that the tax applies only to wagers:

(1) accepted in the United States, or

(2) placed by a person who is in the United States (A) with a person who is a citizen or resident of the United States, or (B) in a wagering pool or lottery conducted by a person who is a citizen or resident of the United States.

This provision extends the wager tax to cross-border wagers accepted by American bookies. If the bookie located offshore is not a U.S. citizen or resident, then the tax should not apply. If, however, the bookie is located in the U.S., then the wager placed is taxable regardless of where the person placing the wager is located.

What types of bets may fall under the third type of a wager subject to the tax, “a lottery conducted for profit?”

Treas. Reg. 44.4421-1(b)(1) states “lottery” includes the numbers game, policy, and similar types of wagering. A lottery conducted for profit

includes any scheme or method for the distribution of prizes among persons who have paid or promised a consideration for a chance to win such prizes, usually as determined by the numbers or symbols on tickets as drawn from a lottery wheel or other receptacle, or by the outcome of an event.

Poker may be considered a lottery conducted for profit.

The regulation at least implies that the game must be one of chance. In IRS Revenue Ruling 57-521, the Service considered whether a puzzle contest was a lottery conducted for profit. Because “the element of skill rather than that of chance determines the winners” in the puzzle game, the IRS stated, the puzzle contest was not considered a lottery. Applying the skill versus chance analysis to poker, there is at least an argument that poker is not a lottery conducted for profit, especially in light of the recent Dicristina decision.

Even if poker falls within the definition of a lottery conducted for profit, it may nevertheless be exempt from the wager tax.

IRC section 4421(2)(A) provides that the term lottery does not include any game of a type in which usually the wagers are placed, the winners are determined, and the distribution of prizes or other property is made in the presence of all persons placing wagers in such game. Treas. Reg. 44.4421-1(b)(2) applies the exemption to card games and concludes, “no tax would apply in the case of card games.”

It’s clear that in-person poker cash games and tournaments are exempt. It’s far from clear, however, that we can deduce the same conclusion with respect to online poker wagers.

One can argue that the standard for “in the presence of all persons” is not merely physical presence, but also extends to virtual presence on the same online poker table.

Some slightly bad news: In Rev. Rul. 79-146, the IRS applied a physical presence standard to certain types of keno games. We shouldn’t place too much emphasis on this particular revenue ruling, however, because it was written well before virtual poker tables were around.

Another possible argument is online poker wagers are placed in “coin-operated devices,” as the wagering tax does not apply on any wager placed in a coin-operated device. Treas. Reg. 44.4402-1(b)(2)(v) says the following is an example of a coin-operated device:

A coin-operated machine that displays a poker hand or delivers a ticket with a poker hand symbolized on it that entitles the player to a prize if the poker hand displayed by the machine or symbolized on the ticket constitutes a winning hand.

Of course, nobody is putting coins into their computers to play online poker. (Note: Bitcoin enthusiasts may disagree.) But there have been indications the definition of a “coin-operated device” is not strictly construed to require actual insertion of coins to play poker, giving rise to an argument for regulated online poker wagers in the U.S. to fall under the exemption.

As you can see, intrastate iGaming in the U.S. raises more questions than answers for purposes of the federal wagering tax. Next time we will shift the tax discussion from federal to state by examining some gaming taxation models that states may consider adopting.

Intrastate iGaming: Bank Secrecy Act and Player-to-Player Transfers

January 9th, 2013 No comments

Last week we discussed some federal withholding and reporting considerations for intrastate iGaming. The Internal Revenue Code is not the only federal law implicated in this emerging area, of course. This time we examine the applicability of the Bank Secrecy Act (“BSA”).

The BSA is aimed at preventing and detecting money laundering and other financial crimes. Because casinos handle large amounts of cash, they are prone to serving as a vehicle for illicit activity. In order for the government to monitor notable money movement, Congress enacted rules requiring casinos that fall under the definition of a “financial institution” to report certain financial transactions.

A casino or “gaming establishment” (including, for example, a card room) is considered a financial institution if:

  • (a) its gross annual gambling revenue exceeds $1 million; and
  • (b) it is a licensed casino or gaming establishment under federal or state law.

It seems clear iGaming sites regulated pursuant to state law would be considered financial institutions under the BSA. What types of transactions on iGaming sites may operators be required to report? Qualifying financial institutions are required to file with the Financial Crimes Enforcement Network:

  1. Currency Transaction Report by Casinos (FinCEN Form 103); and
  2. Suspicious Activity Reports by Casinos and Card Clubs (FinCEN Form 102).

A casino must file Form 103 for each transaction involving either currency received or currency disbursed of more than $10,000 in a gaming day. Among other things, the form includes the name, address, and social security number of the individual making the transaction. So, if I open an account on a U.S. regulated iGaming site that is a qualifying financial institution and make an initial deposit over $10,000, the site would be required to file Form 103.

Money launderers may seek to avoid triggering the Form 103 filing requirement by making two or more smaller deposits under the $10,000 threshold. This is a no-no.

The practice of conducing financial transactions in a specific pattern with the purpose of avoiding a Form 103 filing is called “structuring,” and is illegal under the BSA. One may go to jail for structuring.

Financial institutions are on the lookout for “structuring” activity. A U.S. iGaming site, for example, must treat multiple transactions as a single transaction if the iGaming site has knowledge that:

  • (a) they are made by or on behalf of the same person, and
  • (b) they result in either Cash In or Cash Out by the casino totaling more than $10,000 during any one gaming day.

If I deposited $6,000 in the beginning of the day and then another $6,000 later in the day on the same site, that iGaming operator would probably have to treat the transactions as a single transaction for purposes of determining whether Form 103 would have to be filed.

A single deposit of $9,999 might seem harmless on its own because Form 103 wouldn’t have to be filed, but such activity may instead require an iGaming operator to file Form 102, Suspicious Activity Reports by Casinos and Card Clubs.

An iGaming site would be required to file Form 102 if a transaction involves or aggregates at least $5,000 in funds or other assets, and the site knows, suspects, or has reason to suspect that the transaction (or a pattern of transactions of which the transaction is a part):

(i) Involves funds derived from illegal activity or is intended or conducted in order to hide or disguise funds or assets derived from illegal activity (including, without limitation, the ownership, nature, source, location, or control of such funds or assets) as part of a plan to violate or evade any federal law or regulation or to avoid any transaction reporting requirement under federal law or regulation;
(ii) Is designed, whether through structuring or other means, to evade any requirements of 31 CFR Chapter X or of any other regulations promulgated under the Bank Secrecy Act, Public Law 91-508, as amended, codified at 12 U.S.C. 1829b, 12 U.S.C. 1951-1959, and 31 U.S.C. 5311-5332;
(iii) Has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage, and the casino knows of no reasonable explanation for the transaction after examining the available facts, including the background and possible purpose of the transaction; or
(iv) Involves use of the casino to facilitate criminal activity.

Institutions must file these forms pursuant to the BSA E-Filing System. With respect to the BSA, the challenge for iGaming operators in the U.S. will be how to implement practices to ensure compliance.

These practice standards may also be required by state gaming commissions before an iGaming operator is approved for accepting real money deposits in a specific state. Nevada, the only state with internet gaming regulations at this time, requires iGaming operators to comply with the BSA pursuant to NV Gaming Comm’n Reg. 5A.080:

Each operator shall implement procedures that are designed to detect and prevent transactions that may be associated with money laundering, fraud and other criminal activities and to ensure compliance with all federal laws related to money laundering.

We should expect similar minimum standards from other states promulgating iGaming regulations in the future.

Player-to-player transfers

A major part of the game of poker that you don’t see on the table: Staking. As I’ve discussed before (here and here), a “staking arrangement” arises when the “staker” backs up, or puts up, the funds for another player, the “stakee.” The staker and stakee share the winnings, if any, by some predetermined agreement. Given the popularity of staking, iGaming operators have strong incentives to explore the feasibility of making staking easy for its players.

The more straightforward aspect to staking in the iGaming space is handling the distribution of winnings among the staker and stakee. The IRS is aware that gamblers sometimes share winnings, and created Form 5754 to allow for allocation of winnings among multiple recipients for reporting and withholding purposes. If I won $20,000 in an online poker tournament and my U.S. resident backer collects $10,000 of the winnings, we could theoretically submit a completed 5754 to instruct the U.S. iGaming operator to issue two W-2Gs for $10,000 each instead of one W-2G for $20,000 to me. Whether the operator actually acknowledges the form is another story.

The more difficult consideration involves how the “staker” could supply the initial funds to the “stakee” to engage in gambling activity on a U.S. iGaming site. The most convenient method, of course, would have the “staker” transfer funds from his online poker account to the account of his “stakee.” Player-to-player transfers are permitted on the most popular online poker site in the world, PokerStars. PokerStars, of course, is not licensed and regulated in the U.S. If it were, would player-to-player transfers take place between U.S. customers?

My guess is probably not at the outset, for various reasons. One major obstacle is how would an iGaming operator adequately monitor whether player-to-player transfers are for a legitimate purpose such as staking or for something illicit?

As discussed above, casinos must file a Suspicious Activity Report (FinCEN Form 102) if it suspects that a transaction involves or aggregates at least $5,000 has no business or apparent lawful purpose. Will iGaming operators put themselves in a position to have to make that determination each time a transfer request of such amount occurs? Perhaps the “business or apparent lawful purpose” standard could be met if the transfer recipient was required to wager a certain amount of the funds on the iGaming site before being permitted to cash out the funds.

In Nevada, player-to-player transfer issues are academic at this time. NV Gaming Comm’n Reg. 5A.120(9) reads, “An operator shall not allow an authorized player to transfer funds to any other authorized player.”

I spoke with a Nevada lawyer regarding this provision. Although regulators and potential operators are well aware of the attractiveness of player-to-player transfers, regulators don’t want to deal with this difficult issue upon opening the State’s doors to iGaming. After some time of successful operations, perhaps Nevada will soften its stance on the issue and begin to permit player-by-player transfers under limited and controlled conditions.

To learn more about financial transaction considerations for iGaming in the U.S., be sure to check out fellow gaming attorney Stuart Hoegner’s draft paper Cash Is Not King: Thoughts on Financial Transactions in Internet Gaming.

Next time we return to the Internal Revenue Code to examine the possible applicability of the federal wagering tax to intrastate iGaming activity.

Intrastate iGaming: Federal Reporting and Withholding Tax Obligations

January 2nd, 2013 No comments

It’s no surprise Senator Harry Reid could not attach his rumored internet poker bill to must-pass legislation during the lame-duck session in Congress. Now “iGaming” in the United States is likely to emerge over the next few years by state-by-state legalization. Delaware and Nevada have already cleared the initial legalization hurdle, and are carefully taking their next steps in an effort to establish industry standards before permitting operators to accept real money deposits. With an iGaming bill merely awaiting Governor Christie’s signature, New Jersey may not be far behind.

Unless federal oversight legislation is passed, states will have to adapt the current federal laws, including the Internal Revenue Code, to their intrastate iGaming operations. Intrastate iGaming in the U.S. presents a variety of interesting tax considerations for operators, consumers, and third-parties. Of course, I cannot adequately address them in one post. Instead, I begin here a series of posts with the minimum goal of raising awareness and ideal goal of exploring possible approaches to the trickier issues. I also plan to analyze new iGaming legislation signed into law in light of these considerations.

I welcome and encourage topic suggestions, questions, comments, constructive criticisms, etc. Do not hesitate to send me an e-mail (brad[at]taxdood[dot]com) or engage me on Twitter @taxdood. If you are on LinkedIn, consider joining the group U.S. Internet Gaming: Tax Considerations to observe or participate in additional discussion.

Federal Reporting and Withholding Tax Obligations

Regardless of state-specific legislation, internet gambling operators will have to comply with the current federal withholding and reporting obligations under the Internal Revenue Code. In general, brick and mortar casinos determine whether a tax information form (usually either a W-2G or 1042-S) must be issued and withholding is required when a winner seeks to cash out chips or redeem a winning ticket.

In the online space, it may not always be as clear when the tax information and withholding determinations should be made. Let’s assume an iGaming operator would have the taxpayer’s identification information (e.g. taxpayer identification number, or “TIN”) upon establishing a consumer’s online account. (Note: How operators will adequately verify the identification of iGaming consumers is beyond the scope of this post.)

Poker Tournaments

“Closed-universe” situations, such as poker tournaments, are more straightforward. When a U.S. resident wins more than $5,000 (less the buy-in) in a poker tournament, the casino is required to issue a W-2G to the winner. Technically, operators are also required to withhold twenty-five percent of the winnings pursuant to Rev. Proc. 2007-57. Section 6 of the Revenue Procedure, however, provides a safe harbor for operators that do not withhold in this situation:

The IRS will not assert any liability for additional tax or additions to tax for violations of any withholding obligation with respect to amounts paid to winners of poker tournaments under section 3402, provided that the poker tournament sponsor meets all of the requirements for information reporting under section 3402(q) and the regulations thereunder.

In other words, if the sponsor reports the winner to the IRS, then the IRS is okay with no withholding. I should note this IRS safe harbor is not binding law. It remains possible for a court to rule that a poker tournament falls within the definition of a “wagering pool” and thus withholding would be required under section 3402(q) of the Internal Revenue Code.

Cash Games

Onto a potentially more problematic situation: Cash games. In general, gambling winnings are reportable on a W-2G if the amount paid with respect to a wager is $600 or more and the proceeds are at least 300 times the wager; withholding is required if the amount paid is $5,000 or more and at least 300 times the wager.

Let’s apply the rules to No Limit Texas Hold’em. Assume a table seats no more than the usual maximum of ten. In general, the most one can win on a given hand is ten (10) times the amount wagered. This outcome occurs when every player at the table bet at least as much as the winner did. As a result, the withholding and reporting obligations thresholds for U.S. residents would not be triggered for poker cash games in the iGaming space. Well, not so fast.

Some casinos pay bad beat jackpots to the highest hand that doesn’t win. For example, Commerce Casino pays a bad beat jackpot under the following circumstances:

If you lose with a hand of aces full of Ten’s (10′s) or better to a four-of-a-kind or better in Hold’em games, you will receive 60% of the posted jackpot; the winning hand will receive 20% and the other players at the table will split the remaining 20%. The jackpot in an average $3-$6 per Hold’em game might amount to as much as $15,000.

One possibility is to bet $30 in a $3-$6 Hold’em game and win 60% of a $15,000 jackpot, or $9,000. The casino would be required to issue a W-2G in that situation because the jackpot amount is 300 times the amount wagered and more than $600. Withholding would be required as well.

Time will tell whether online poker sites in the U.S. pay bad beat jackpots.

What is a wager?

In the Hold’em context, we assume a “wager” is defined by the sum of all bets made by a player during the course of one hand. What if, in the online space, “wager” is interpreted as all bets made with deposited funds by a player while seated at a Hold’em table? Or even more broadly, all bets made with deposited funds by a player while logged into an account? These interpretations give rise to the possibility of a player leaving a Hold’em table or logging out of an account after winning more than 300 times amount wagered. These possible outcomes, however unlikely, mean the iGaming operator’s software may have to be programmed to detect when these situations occur.

In my opinion, wager should be defined by the sum of all bets made by a player during the course of one hand. As a result, winnings of U.S. residents for the substantial majority—if not all—of poker cash games would go unreported to the IRS.

Would Congress take action to change this result? Probably.

H.R. 2230, Internet Gambling Regulation and Tax Enforcement Act of 2011, for example, sought to require “Internet gambling licensees” to report to the IRS, among other things, the “net Internet gambling winnings” for the calendar year of each person placing a bet or wager with the licensee. Such a requirement would maximize the reporting to the IRS. But would it be prohibitively costly for iGaming operators to not only document but also report the net winnings of all persons placing wagers, including nominal amounts (e.g. less than $100)?

Nonresidents

At the outset, intrastate iGaming will likely be offered only to those who are physically present in a state regulating iGaming. This group could include individuals who are not U.S. residents. How are the above considerations different with respect to nonresident aliens?

In general, gambling winnings of nonresident aliens are subject to thirty percent withholding and the payee is issued Form 1042-S. Again the issue is raised: When would the iGaming operator make the reporting and withholding determinations? After each hand played? After each table session? After a player logs out? At year’s end?

iGaming operators must also consider how to handle claims of treaty benefits made by nonresidents. An applicable tax treaty between the U.S. and a treaty partner may reduce the withholding rate or eliminate it altogether. Claimants must provide the operator Form W-8BEN or Form W-8ECI to obtain treaty benefits.

If operators do not put mechanisms in place to accommodate such claims, the nonresident alien’s recourse could be to file Form 1040NR and claim a refund for the withheld funds. This alternative is far from ideal for the player, however, because the 1040NR is not filed until after year’s end. Withholdings from January, for example, would probably not be returned to the player until far more than a year later.

Next time we’ll examine applicability of the Bank Secrecy Act to intrastate iGaming operations, including implications of player-to-player account transfers.

Internet Probability Specialist

October 30th, 2012 No comments

Living in the NYC metropolitan area, I feel extremely fortunate to have survived Hurricane Sandy without losing power or sustaining flood damage. Thoughts and prayers to those less fortunate.

Stuck indoors all day yesterday, I watched the 2012 World Series of Poker Main Event final table reduce from nine to three. Play resumes tonight at 9:00 PM ET on ESPN (on a fifteen minute taping delay) until a champion wins the coveted bracelet. The winner takes home (before taxes) $8,531,853.

The current chip leader, Greg Merson, is a twenty-four year old American from Laurel, MD. According to this article in the Washington Post, Merson’s most recent tax filing stated he is an “internet probability specialist.” The article goes on to describe Merson’s ups and downs as he emerged in the poker world.

I’ve discussed on several occasions that a poker player reports gambling winnings as a professional or amateur gambler. Does filing instead as an “internet probability specialist” raise any issues? Maybe.

Merson began playing poker online while in high school. At 19 years old, he dropped out of college to play poker online full time. After “Black Friday” effectively eliminated the online poker market in the U.S. in April 2011, he moved to Toronto to continue playing online.

Playing live at this year’s World Series of Poker has already paid off big time for Merson. He won $1.1 million and the gold bracelet in the Six Max No-Limit Hold’Em Event in July, and stands to win at least $3,799,073 in the Main Event.

From the little I’ve read, it seems that Merson played minimal to no live poker prior to 2012. Let’s assume he in fact played no live poker prior to 2012. In that case, “internet probability specialist” is merely a euphemism for professional gambler. All of his gambling winnings and losses as an “internet probability specialist” would be reportable on Schedule C and he could deduct ordinary and necessary business expenses associated with the online poker play.

More interestingly, what if Merson also had live poker winnings and losses during a tax year for which he filed as an “internet probability specialist”? Could an ”internet probability specialist” report online poker winnings as a professional and separately report live poker winnings as an amateur on the same return? Or must the live and online winnings be combined?

Because there is no case law or statutory authority to my knowledge that supports a bifurcation of gambling winnings between live and online play, I believe in that case filing as an “internet probability specialist” would be inappropriate.

The Internal Revenue Code does not distinguish between types of gambling for tax purposes. Whether a taxpayer’s winnings are from horse racing, live poker, online poker, etc., all of the gambling winnings are combined together and thus taxable either as a professional or amateur. There is no case law to support the position of a taxpayer claiming to be a “professional blackjack player” but also an amateur poker player at the same time. If the taxpayer is a professional of any type of gambling, then all the gambling should be considered part of the profession.

Of course, if Merson filed as an “internet probability specialist” and combined all his gambling winnings (live and online) on Schedule C anyway, then the tax law would seem to be applied correctly. Instead it’s just a labeling issue.

A final question to consider is whether one who files as an “internet probability specialist” is more likely to trigger an IRS examination. High income taxpayers are already at a high risk of audit, so I suppose not. Lower to moderate income taxpayers, however, may be asking for an examination by using an unfamiliar term for their profession. Then again, “professional gambler” is unfamiliar to many at the IRS anyway, so I’m not so sure the difference would be beyond marginal.

Good luck to the remaining three in tonight’s conclusion of the Main Event!

(Hat tip to @PokerScar for sharing the piece in the Washington Post.)

Reid-Kyl Federal Online Poker Bill

October 19th, 2012 No comments

A draft bill for federal online poker said to come from the offices of Senators Harry Reid and Jon Kyl was leaked to the media earlier today. Read the full text of the bill, titled “Internet Gambling Prohibition, Poker Consumer Protection, and Strengthening UIGEA Act of 2012,” here.

Gaming attorney Ian Imrich has offered his initial comments on the bill. I’ll post some thoughts after combing through its seventy-three pages.

Tweetbag: Withholding Gambling Winnings of U.S. Nonresidents

September 17th, 2012 4 comments

Today I received the following inquiry:

“[L]ooking for some info why 30% was tak[en] out of an $83 winning in poker at a NY state casino when most states tax after 5k.”

The casino in this case was the Seneca Niagara Casino, located in Niagara Falls, NY.

To evaluate the issue, we need to know whether the taxpayer is a U.S. resident. That’s because the rules for withholding and informational reporting of gambling winnings under the Internal Revenue Code depend on the residency status of the taxpayer.

It turns out this taxpayer is a resident of Canada. In general, gambling winnings paid to foreign individuals are subject to 30% withholding, assuming the income is not effectively connected with a U.S. trade or business. Proceeds from a wager placed in blackjack, baccarat, craps, roulette, or big-6 wheel, however, are not amounts subject to reporting.

Here, it seems that Seneca properly withheld thirty percent of the $83 winnings, as poker is not exempt from nonresident withholding.

Note that an applicable tax treaty between the United States and a treaty partner may reduce the amount withheld by Seneca Niagara. The United States-Canada Tax Treaty, however, offers no such relief.

Is there any other relief? Suppose the same taxpayer enters in only one other poker tournament during the year paying an $83 entry fee, and loses. Now the taxpayer has net $0 of gambling winnings for the year, yet approximately $25 was withheld on the $83 win. One shouldn’t pay $25 in U.S. tax on net zero gambling winnings. To possibly obtain a refund, the taxpayer could file a Form 1040NR to claim the winnings and losses for the year and the amount withheld.

Keep in mind that the withholding and informational rules discussed above are pursuant to federal law, not state law. Again, U.S. casinos are required to withhold 30% and issue a Form 1042-S to nonresidents unless an exception applies.

Of course, some states have their own separate informational and withholding rules for state income tax purposes. But they are not in lieu of federal law, which still must be followed, but are in addition.

The comment that “most states tax after 5k” is likely a reference to the federal rule that requires all U.S. casinos to issue a Form W-2G to U.S. residents who win more than $5,000 in a poker tournament, net of the entry fee. Note, however, whether a W-2G is actually issued has no bearing on whether the actual winnings are taxable, as all gambling winnings of U.S. residents are taxable, regardless of the amount.

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