2012 may very well prove to be the year that Internet gaming (i-gaming) legally arrives in the United States. Whether by act of Congress or through state-level authorization, it appears that some form of i-gaming will be authorized in the U.S. The universe of authorized i-gaming in the U.S. will likely be limited to Internet poker. Poker is an American pastime and likely the only form of i-gaming that is politically feasible in the U.S. Several states have introduced measures to permit i-gaming. Thus, the focus of this article is on Internet poker and the federal tax implications to intrastate Internet poker operations.
Legislative chambers in California, Florida, Iowa and New Jersey have all considered authorizing intrastate i-gaming. Several other states are actively examining the legal barriers for entry to the intrastate i-gaming marketplace. Nevada, ever the gaming industry leader, is on the precipice of i-gaming coming online. Nevada, which enacted a law authorizing interactive gaming several years ago, enacted legislation in 2011 directing the Nevada Gaming Commission to adopt rules for the regulation of i-gaming. The Nevada Gaming Commission has issued final regulations and may soon start issuing licenses to conduct interactive gaming.
It is still an open question whether i-gaming will be authorized through federal or individual state law. Without the benefit of the proverbial “crystal ball,” it is nearly impossible to predict whether state or federal action will occur first. Recent developments, however, have focused greater attention on the prospect that individual states will move forward with plans to authorize intrastate i-gaming in the near future. In the event that the states are first to the table in authorizing intrastate i-gaming, interesting questions involving the federal tax obligations of i-gaming operators are presented.
Laying the Groundwork: The DoJ Memorandum
Efforts to authorize i-gaming in the U.S. gained renewed momentum on Dec. 20, 2011, when the U.S. Department of Justice publicly released a Sept. 20, 2011 internal memorandum opinion. The DoJ memorandum has reverberated across the Internet gaming community because it represents a significant shift in the DoJ’s interpretation of the Wire Act, 18 U.S.C. § 1084. The DoJ memorandum addresses the applicability of the Wire Act to in-state lottery transactions conducted via the Internet. The DoJ memorandum concluded that the criminal prohibitions of the Wire Act extend only to a “sporting event or contest.”
The Wire Act establishes a criminal violation for, among other things, the use of “a wire communication facility for the transmission in interstate or foreign commerce of bets or wagers or information assisting in the placing of bets or wagers on any sporting event or contest,” as well as the receipt of money as a result of or information assisting in placing bets or wagers. To support a conviction under the Wire Act, the wire transmission must simply cross state lines or enter foreign commerce. For example, the DoJ successfully upheld a Wire Act conviction when a bet was placed and received in West Virginia through telephone lines, where the telephone lines used in placing the bet crossed into neighboring Ohio. Prior to the release of the memorandum, the long-standing, consistent position advocated by the DoJ was that the Wire Act prohibits all forms of gambling—and was not just limited to wagers on “sporting events or contests”—involving interstate wire transmissions. Thus, an underlying concern with state-authorized intrastate i-gaming has been whether the DoJ would argue that intrastate i-gaming violates the Wire Act. The DoJ memorandum changes the playing field.
Federal Taxation of Intrastate I-Gaming
There are three topics under the U.S. federal tax law that have specific application to wagering activities: the federal wagering excise tax; withholding for payment of winnings; and suspicious activities. Absent the enactment of federal legislation addressing the tax obligations arising from i-gaming, the rules of current tax law would necessarily have to be adapted to intrastate i-gaming. Neither the withholding nor the suspicious activity reporting obligations necessarily present any substantial obstacles. The federal excise tax on wagering, however, presents several interesting questions relative to its application to intrastate i-gaming.
Withholding and Suspicious Activity Reporting
Presumably, guidance issued within the past five years applicable to income tax withholding for poker tournaments would equally apply to i-gaming. Rev. Proc. 2007-57 provides guidance with respect to the withholding and information reporting obligations of sponsors of poker tournaments. Generally, the poker tournament sponsor is compelled to withhold and report the payment of winnings to a player exceeding $5,000. Thus, i-gaming operators likely would need to collect certain information from players (such as the player’s name, address and Taxpayer Identification Number) to fulfill the operators’ information reporting obligations.
The existing suspicious activity reporting obligations applicable to casinos may apply to i-gaming operators as well. The federal Bank Secrecy Act, and its underlying regulations, require “financial institutions” to report and track certain types of transactions. A casino is considered to be a “financial institution” for purposes of the BSA if the casino (1) has gross annual gambling revenue exceeding $1 million and (2) is licensed as a casino under state or federal gaming laws. There are two types of reports casinos may file with FinCEN pursuant to the BSA: (1) a Currency Transaction Report Casino for currency transactions that exceed $10,000; and (2) Suspicious Activity Report by Casinos. Under the BSA, casinos are mandated to implement anti-money laundering programs that set forth written procedures for detecting and reporting suspicious activities.
Ambiguity in Applying Excise Tax on Wagering
The application of the federal wagering excise tax is where things begin to get interesting relative to the federal tax obligations of an intrastate i-gaming operator. The analysis of the application of the wagering tax turns on whether wagers placed through the Internet are “wagers” for purposes of the excise tax. If so, a second question arises whether any exemptions to the wagering tax are available. Thus, the applicability of the wagering tax turns on what is a “wager” and the availability of any exemption.
The federal tax law imposes an excise tax on any “wager.” There are two different tax rates, depending on whether the wager is authorized under state law. For wagers authorized under the law of the state where the wager is accepted, the excise tax is imposed at a rate equal to 0.25 percent of the amount of the wager. For all other wagers, the excise tax is equal to 2 percent of the amount of the wager. A person engaged in the business of accepting the wagers—the i-gaming operator—is liable for payment of the wagering excise tax.
For purposes of the wagering excise tax, the federal tax law defines “wager” to consist of (1) wagers on a sports event or contest, (2) wagers placed in a “wagering pool” on a sports event or a contest, or (3) any wager placed in a “lottery” conducted for profit. The federal tax law further defines the term “lottery.”
Wagers placed on poker—regardless if the poker game is conducted in-person or through the Internet—should fall outside of the first two prongs of the definition of a “wager.” That is, the wagers are not made with respect to a sports event or contest. Interestingly, the IRS issued a Field Service Advice in 1992, which concluded that poker tournaments were wagering pools and, as result, could be subjected to the wagering excise tax under the second prong of the definition of “wager.” A Field Service Advice is a form internal guidance the IRS Chief Counsel Office issues to revenue agent on legal issues. A Field Service Advice may be persuasive authority by indicating the IRS’ position; however, it is not binding on taxpayers. The 1992 Field Service Advice did readily “caution” the revenue agent “that there are litigating hazards in pursuing this position in light of the taxpayer’s potential arguments that poker is a game of skill and that Congress did not intend to subject this type of game to the excise tax.” The arguments outlined in the 1992 Field Service Advice appear to be dubious, particularly when viewed in conjunction with the conclusions reached in the DoJ memorandum. While the DoJ memorandum construed a different federal body of law, the Wire Act, and not the Internal Revenue Code of 1986, as amended, (IRC), the DoJ construed nearly identical language found in each state, “sporting events or contests.” Further, it does not appear that the IRS has uniformly adopted the legal position outlined in the 1992 Field Service Advice.
Whether the wagering tax applies, as presently in effect, to i-gaming turns on whether the particular game—for our purposes, Internet poker—is a “lottery” under the federal wagering tax. The IRC definition of “lottery” exempts certain types of games. Specifically, a lottery does not include games where 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.” This statutory carve-out is relevant to table and card games. Wagers placed in card games conducted at a casino are not subject to the federal wagering excise tax. The exception, however, may not be available to Internet-based wagers because the distribution of the prize is not made in the presence of all persons placing wagers in the Internet poker game. That is, the language of the statutory exception arguably requires players to be physically present at the location where the game is played and prizes are distributed for the exception to apply. In the context of different forms of keno, Rev. Rul. 79-147 determined that certain forms keno each were not a lottery where the players will usually not leave the casino premises during the game. Thus, Rev. Rul. 79-147 can be construed as standing for the proposition that wagers must placed, the game conducted, and winnings collected on the premises of the casino.
As a result, the treatment of Internet-based wagers on poker turns on whether poker qualifies as a “lottery” for purposes federal tax law. The IRS has applied the three-part common law definition of consideration, change and prize to determine whether a game is a “lottery” under the wagering excise tax. Rev. Rul. 57-521 examined the skill versus chance dichotomy with respect to a puzzle game. Rev. Rul. 57-521 determined that the puzzle was a game of mental skill “and chance was not a factor.” Rev. Rul. 57-521 are silent with respect to whether the IRS applied the predominant factor analysis to determine whether a particular game is a game of chance or game of skill. Assuming that an i-gaming operator can convince the IRS that poker is predominantly a game of skill, an argument may exist that Internet poker is not a “lottery” for purposes of the federal excise tax on wagering.
Even assuming Internet poker constitutes a lottery, an argument can also be made that Internet poker is exempt from the federal excise tax on the basis an exception for “coin-operated devices.” The IRC specifically exempts from the wagering tax “any wager placed in a coin-operated device (as defined in section 4462 as in effect for years beginning before July 1, 1980). Under prior law, a “coin-operated device” was defined to include a machine, which among other factors, “by application of the element of chance” allows a player to receive a prize. It is an open question whether a coin-operated device involves pure chance or predominantly operates by chance. Accordingly, an argument could be made that poker games played through the Internet are played through a “coin-operated device” and, thus, is exempt from the wagering excise tax.
Sweepstakes, a wagering pool or a lottery conducted by an agency of the state acting under authority of state law is also exempt from the federal wagering excise tax. Therefore, state-operated i-gaming would likely be exempted from the federal wagering tax.
Conclusion
While it is far from certain whether legislative approval will come first from Congress or state legislative chambers, some form of authorized i-gaming is coming to U.S. The authorization of i-gaming in the U.S. is simply a question of when and who acts first. The recent DoJ memorandum raises the prospects that the states will enter the intrastate i-gaming marketplace. The federal tax law is universally assailed from its complexity and areas of ambiguity. The introduction of intrastate i-gaming raises more questions with respect to the federal tax obligations to i-gaming operators.
Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville, Washington, D.C., Toronto and Phoenix. He received his LL.M in tax law from New York University. Kulick may be reached at pkulick[at]dickinsonwright.com.
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