Kentucky To Tax Prediction Markets

 

Something landed in my inbox about Kentucky HB 757.

So I am reading about prediction markets.

You have probably heard of these things: they are being used as an oracle of a sort. What are the odds that so-and-so will be elected to the political office of such-and-such in whatever state this fall? It is more than a poll, as people are wagering hard cash. I may tell a pollster just about anything to wrap-up the call, but I am certainly not parting with money.

I read that Kentucky will impose a 14.25% transaction tax on “event contracts” beginning January 1, 2027.

I get the concept of an “event contract.” It is a binary arrangement between two parties, with the contract resolving as either a “yes” or a “no.” To me the perfect example is a sports game: either the Reds will win or they will lose when they play the Mets on May 27. Bet your heart out accordingly.

I would have thought that these transactions were already being taxed.

Here is the point: they are not.

It is due to technology.

The sports betting you and I grew up with involved a house, a handle and the house establishing the odds. The key here is that the house (or DraftKings, FanDuel or whatever) received the bets, determined the handle and odds, paid-out the winners, and kept the difference (the “juice”).

The above is called “betting,” folks. It was taboo in major professional sports until the 2018 Supreme Court decision in Murphy v NCAA. Those of us who have been around for a moment remember the NFL barring Tony Romo from attending a fantasy football convention in Las Vegas, which act seems quaint today as gambling commercials blare at us on football Sundays. Fantasy was considered too close to betting, and sports betting would diminish the integrity of the game. Fast forward and the NFL started partnering with DraftKings and FanDuel in 2021.  Heck, they have probably had a baby by now.

The “new” sports betting is cribbing on territory belonging to futures contracts: both are considered derivatives and both are regulated by the Commodity Futures Trading Commission (CFTC).

Let’s say you and I bet on the May 27 Reds game.

Here is Robinhood:

This is easy: I will pay you 49 cents on the dollar that the Reds will win. If the Reds win. I win a dollar. If the Reds lose, I lose 49 cents. There will also be commissions and such, because … of course.

The fiction here is that you and I are not betting. We are instead “investing” in “financial instruments” subject to the CFTC. Granted, one of us will win and the other lose as the “event contracts” settle, but we are not “betting.” We are competing against each other on future events. We are not betting against a house, as that would describe a sportsbook. Nothing to see here, officer. Have a good day.

Hit somebody’s wallet and they will deny the very law of gravity.  

Almost 90% of these “financial instruments” are tied to sports betting.

This my shocked face: 

           

The effect of this is to remove the prediction markets from the routine and customary state gambling regulatory apparatus.

Which means that state taxes are taking a hit as money leaves their sportsbooks.

Enter Kentucky.

Since 2023 Kentucky has levied a 9.75% tax for on-track wagers and 14.25% for online and mobile wagers.  The last time I checked, the horse racing industry was contributing upwards of $200 million annually to state tax revenue. You can bet your bippy Kentucky is going to protect it.

The new 14.25% tax on prediction markets is the same as for other online betting.

And the tax will apply whether one bets via DraftKings or DraftKings Predictions. Or FanDuel or FanDuel Predicts.

Yep, same companies but two platforms.

This is new frontier in state taxation, and you can be certain there will be litigation before the matter is settled.  I suspect this will go to the Supreme Court eventually.

The issue affects all states, of course. We limited our discussion today to Kentucky for one nontechnical reason: I live here.

 

Caleb William’s NFL Contract

 It may be that the NFL saved him from bad tax advice.

We are talking about Caleb Williams, the 2024 NFL number one overall draft pick by the Chicago Bears. He signed a four-year fully guaranteed contract for $39.5 million.

I can only wish.

But it was two additional negotiating positions that caught my eye.

(1)  He wanted to be paid via an LLC.

(2)  He wanted some/all of his contract to be structured as a forgivable loan.

I read that he was represented by his father, who has experience in commercial real estate but is not a registered agent.

But it helps to explain the LLC. The use of LLCs for real estate is extremely common, so his father would have seen their use repetitively. Still, what is the point of an LLC with an NFL contract?

It might be the expenses that an NFL player might incur: agent fees, union dues, specialized training and related travel, certain therapies and so forth. As those receiving a W-2 know, employee business expenses are presently nondeductible. If Caleb could run his NFL earnings through an LLC, perhaps he could avoid employee business expense classification and deduct them instead as regular business expenses.

There is a hitch, though. None of the four major team sports will pay compensation to an entity rather than directly to the athlete. In contrast, non-team athletes – like golfers – can route their earnings through a business entity. A key difference is that the PGA considers its golfers to be independent contractors, whereas the NFL (or MLB, NBA, or NHL) considers its players to be employees.

There is speculation that Caleb may have preferred an LLC because LLCs – ahem – “do not file tax returns.”   

Not quite. The tax treatment of LLCs is quite straightforward:

(1)  If the LLC has partners, then it will file a partnership return.

(2)  If the LLC elects to be taxed as a corporation, then it will file a corporate return. If an S election in place, it will file an S corporation return.

(3)  If the LLC has a single member, then the LLC is disregarded and does not file a tax return.

Do not misunderstand that last one: it does not say that income belonging to the LLC does not land on a tax return.

Let’s say that Caleb created a single member LLC (SMLLC). SMLLCs are also referred to as disregarded entities. The tax  Code instead considers Caleb and his SMLLC to be the same taxpayer. That is why there is no separate LLC return: all the income would be reportable on Caleb’s personal return.

Could someone have read the above and thought that income routed through an SMLLC is not taxed at all?

If so, Caleb really needs to hire a tax professional yesterday.

What about the loan forgiveness proposal?

I get it: loans are normally not considered income, as any increase in wealth is immediately offset by an obligation to repay the loan.

OK, Caleb receives contract monies, but he is liable for their repayment to the NFL. This potential liability means no immediate income to him. He would have income when the loan is forgiven, and (hopefully) he has some control when that happens.

But the NFL can call his loan, meaning he then must repay.

Oh puhleeeze.

Not to worry, says whoever. The NFL has no intention of calling the loan.

I am a huge NFL fan, but I am not an NFL team owner fan. There is no way I am trusting my money to owners who are monetizing their sport to such a degree that many fans cannot even see the games. Seriously, how many streaming services do they think an average person can afford?

What if Caleb includes conditions and guarantees and collateral and puts and ….?

Listen to yourself. You are leaving loan-land and whatever tax idea you started with. The IRS will come to the same conclusion. You have accomplished nothing, and you may even be exposing yourself to fraud charges.

I suppose Caleb could structure it as deferred compensation, the way Shohei Ohtani did with the Los Angeles Dodgers. Deferred compensation can get into crazy tax tripwires, but at least we are no longer talking about loans. If this is what he wants, then drop the loan talk and negotiate deferred compensation.

That is BTW what I would do. There is enough money here to make Caleb rich both now and later.

The NFL did Caleb Williams a favor by shooting down both proposals. 

Ohtani’s New Baseball Contract

I was reading about Shohei Ohtani’s new contract with the Las Angeles Dodgers. If the name rings a bell, that is because he both bats and pitches. He is today’s Babe Ruth. He played with the Los Angeles Angels in 2023, led the American League with 44 home runs and pitched over 130 innings with a 3.14 ERA.

I am more an NFL than an MLB fan these days, but it is hard to ignore this guy’s athletic chops. It is also hard to ignore his new contract.

•  Contract totals at $700 million
•  He will draw “only” $2 million for the first 10 years.
•  He will draw the deferral (that is, $68 million annually) beginning in 2034 and through 2043.

At $700 million, Ohtani’s is the largest MLB contract ever, but what caught my eye was deferring 98% of the contract for over a decade. Do not be concerned about his cash flow, however. $2 million a year is sweet (that is way over CPA bank), and I understand that his endorsements alone may exceed $50 million annually. Cash flow is not a problem.

Why would Ohtani do this?

For one, remember that athletes at his level are hyper-competitive. There is something about saying that you received the largest contract in MLB history.

Why would the Dodgers do this?

A big reason is the time value of money. $100 ten years from now is worth less than $100 today. Why? Because you can invest that $100 today. With minimal Google effort, I see a 10-year CD rate of 3.8%. Invest that $100 at 3.8% and you will have a smidgeon more than $145 in ten years. Invest in something with a higher yield and it will be worth even more.

Flip that around.

What is $100 ten years from now worth today?

Let’s make it easy and assume the same 3.8%. What would you have to invest today to have $100 in ten years, assuming a 3.8% return?

Around $70.

Let’s revisit the contract considering the above discussion.

Assuming 10 years, 3.8% and yada yada, Ohtani’s contract is worth about 70 cents on today’s dollar. So, $700 million times 70% = $490 million today.

My understanding is the experts considered Ohtani’s market value to be approximately $45 million annually, so our back-of-the-envelope math is in the ballpark.

Looks like the Dodgers did a good job.

And deferring all that money frees cash for the Dodgers to spend during the years Ohtani is on the team and playing. He may be today’s Ruth, but he cannot win games by himself.

There is one more thing …

This is a tax blog, so my mind immediately went to the tax angle – federal or state – of structuring Ohtani’s contract this way.

Take a look at this bad boy from California Publication 1005 Pension and Annuity Guidelines:

          Nonresidents of California Receiving a California Pension

In General

California does not impose tax on retirement income received by a nonresident after December 31, 1995. For this purpose, retirement income means any income from any of the following:

• A private deferred compensation plan program or arrangement described in IRC Section 3121(v)(2)(C) only if the income is either of the following:

1.    Part of a series of substantially equal periodic payments (not less frequently than annually) made over the life or life expectancy of the participant or those of the participant and the designated beneficiary or a period of not less than 10 years.

Hmmm. “Substantially equal periodic payments” … and “a period of not less than 10 years.”

Correlation is not causation, as we know. Still. Highly. Coincidental. Just. Saying.

Ohtani is 29 years old. 98% of his contract will commence payment when he is 40 years old. I doubt he will still be playing baseball then. I doubt, in fact, he will still be in California then. He might return to Japan, for example, upon retirement.

That is what nonresident means.

Let me check something. California’s top individual tax rate for 2024 is 14.4%.

COMMENT: Seriously??

Quick math: $680 million times 98% times 14.4% equals $95.96 million.

Yep, I’d be long gone from California.

 

Can You Have Income From Life Insurance?

 

I was looking at a recent case wondering: why did this even get to court?

Let’s talk about life insurance.

The tax consequences of life insurance are mostly straightforward:

(1) Receiving life insurance proceeds (that is, someone dies) is generally not an income-taxable event.

(2) Permanent insurance accumulates reserves (that is, cash value) inside the policy. The accumulation is generally not an income-taxable event.

(3) Borrowing against the cash value of a (permanent) insurance policy is generally not an income-taxable event.

Did you notice the word “generally?” This is tax, and almost everything has an exception, if not also an exception to the exception.

Let’s talk about an exception having to do with permanent life insurance.

Let’s time travel back to 1980. Believe it or not, the prime interest rate reached 21.5% late that year. It was one of the issues that brought Ronald Reagan into the White House.

Some clever people at life insurance companies thought they found a way to leverage those rates to help them market insurance:

(1)  Peg the accumulation of cash value to that interest rate somehow.

(2)  Hyperdrive the buildup of cash value by overfunding the policy, meaning that one pays in more than needed to cover the actual life insurance risk. The excess would spill over into cash value, which of course would earn that crazy interest rate.

(3)  Remind customers that they could borrow against the cash value. Money makes money, and they could borrow that money tax-free. Sweet.

(4)  Educate customers that – if one were to die with loans against the policy – there generally would be no income tax consequence. There may be a smaller insurance check (because the insurance is diverted to pay off the loan), but the customer had the use of the cash while alive. All in all, not a bad result – except for the dying thing, of course.

You know who also reads these ads?

The IRS.

And Congress.

Neither were amused by this. The insurance whiz kids were using insurance to mimic a tax shelter.

Congress introduced “modified endowment contracts” into the tax Code. The acronym is pronounced “meck.”

The definition of a MEC can be confusing, so let’s try an example:

(1)  You are age 48 and in good health.

(2)  You buy $4,000,000 of permanent life insurance.  

(3)  You anticipate working seven more years.

(4)  You ask the insurance company what your annual premiums would be to pay off the policy over your seven-year window.

(5)  The company gives you that number.

(6)  You put more than that into the policy over the first seven years.

I used seven years intentionally, as a MEC has something called a “7 pay test.” Congress did not want insurance to morph into an investment, which one could do by stuffing extra dollars into the policy. To combat that, Congress introduced a mathematical hurdle, and the number seven is baked into that hurdle.     

If you have a MEC, then the following bad things happen:

(1) Any distributions or loans on the policy will be immediately taxable to the extent of accumulated earnings in the policy.

(2) That taxable amount will also be subject to a 10% penalty if one is younger than age 59 ½.

Congress is not saying you cannot MEC. What it is saying is that you will have to pay income tax when you take monies (distribution, loan, whatever) out of that MEC.

Let’s get back to normal, vanilla life insurance.

Let’s talk about Robert Doggart.

Doggart had two life insurance contracts with Prudential Insurance. He took out loans against the two policies, using their cash value as collateral.

Yep. Happens every day.

In 2017 he stopped paying premiums.

This might work if the earnings on the cash value can cover the premiums, at least for a while. Most of the time that does not happen, and the policy soon burns out.

Doggart’s policies burned out.

But there was a tax problem. Doggart had borrowed against the policies. The insurance company now had loans with no collateral, and those loans were uncollectible.   

You know there is a 1099 form for this.

Doggart did not report these 1099s in his 2017 income. The IRS easily caught this via computer matching.

Doggart argued that he did not have income. He had not received any cash, for example.

The Court reminded him that he received cash when he took out the loans.

Doggart then argued that income – if income there be - should have been reported in the year he took out the loans.

The Court reminded him that loans are not considered income, as one is obligated to repay. Good thing, too, as any other answer would immediately shut down the mortgage industry.  

The Court found that Doggart had income.

The outcome was never in doubt.

But why did Doggart allow the policies to lapse in 2017?

Because Doggart was in prison.

Our case this time was Doggart v Commissioner, T.C. Summary Opinion 2023-25.

Downside Of Not Issuing 1099s

Let’s be honest: no one likes 1099s.

I get it. The government has conscripted us – business owners and their advisors – into unpaid volunteers for the IRS. Perhaps it started innocently enough, but with the passage of years and the accretion of reporting demands, information reporting has become a significant indirect tax on businesses.

It’s not going to get better. There is a proposal in the White House’s Green Book, for example, mandating banks to report gross deposit and disbursement account information to the Treasury.

Back to 1099s.

You see it all the time: one person pays another in cash with no intention – or ability – to issue a 1099 at year-end.

What can go wrong?

Plenty.

Let’s look at Adler v Commissioner as an example.

Peter Adler owned a consulting company. He had a significant client. He would travel for that client and be reimbursed for his expenses.

The accounting is simple: offset the travel expenses with the reimbursements. Common sense, as the travel expenses were passed-on to the client.

However, in one of the years Peter incurred expenses of approximately $44 thousand for construction work.

The Court wondered how a consultant could incur construction expenses.

Frankly, so do I.

For one reason or another Peter could not provide 1099s to the IRS.

One possible reason is that Peter made his checks out to a corporation. One is not required to issue 1099s to an incorporated business. Peter could present copies of the cancelled checks. He could then verify the corporate status of the payee on the secretary of state’s website.

Nah, I doubt that was the reason.

Another possibility is that Peter got caught deducting personal expenses. Let’s assume this was not the reason and continue our discussion.

A third possibility is that Peter went to the bank, got cash and paid whoever in cash. Paying someone in cash does not necessarily mean that you will not or cannot issue a 1099 at year-end, but the odds of this happening drop radically.

Peter had nothing he could give the Court. I suppose he could track down the person he paid cash and get a written statement to present the Court.

Rigghhhtttt ….

The Court did the short and sweet: they disallowed the deduction.

Could it get worse?

Fortunately for Peter, it ended there, but – yes – it can get worse.

What if the IRS said that you had an employee instead of a contractor? You are now responsible for withholdings, employer matching, W-2s and so on.

COMMENT: You can substitute “gig worker” for contractor, if you wish. The tax issues are the same.

Folks, depending upon the number of people and dollars involved, this could be a bankrupting experience.

Hold on CTG, say you. Isn’t there a relief provision when the IRS flips a contractor on you?

There are two.

I suspect you are referring to Section 530 relief.

It provides protection from an IRS flip (that is, contractor to employee) if three requirements are met:

1.    You filed the appropriate paperwork for the relationship you are claiming exists with the service provider.

2.    You must be consistent. If Joe and Harry do the same work, then you have to report Joe and Harry the same way.

3.    You have to have a reasonable basis for taking not treating the service provider as an employee. The construction industry is populated with contractors, for example.

You might be thinking that (3) above could have saved Peter.

Maybe.

But (1) above doomed him.

Why?

Because Peter should have issued a 1099. He had a business. A business is supposed to issue a 1099 to a service provider once payments exceed $600.

There was no Section 530 relief for Peter.

I will give you a second relief provision if the IRS flips a contractor on you. 

Think about the consequences of this for a second.

(1)  You were supposed to withhold federal income tax.

(2)  You were supposed to withhold social security.

(3)  You were supposed to match the social security.

(4)  You were supposed to remit those withholdings and your match to the IRS on a timely basis.

(5)  You were supposed to file quarterly employment reports accounting for the above.

(6)  You were supposed to issue W-2s to the employee at year-end.

(7)  You were supposed to send a copy of the W-2 to the Social Security Administration at year-end.

(8)  Payroll has some of the nastiest penalties in the tax Code.

This could be a business-shuttering event. I had a client several years ago who was faced with this scenario. The situation was complicated by fact that the IRS considered one of the owners to be a tax protestor. I personally did not think the owner merited protestor status, as he was not filing nonsense appeals with the IRS or filing delaying motions with the Tax Court. He was more …  not filing tax returns.  Nonetheless, I can vouch that the IRS was not humored.

Back to relief 2. Take a look at this bad boy:

§ 3509 Determination of employer's liability for certain employment taxes.

(a)  In general.

If any employer fails to deduct and withhold any tax under chapter 24 or subchapter A of chapter 21 with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for-

(1)  Withholding taxes.

Tax under chapter 24 for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages (as defined in section 3401 ) paid to such employee.

(2)  Employee social security tax.

Taxes under subchapter A of chapter 21 with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph .

Yes, you still owe federal income and social security, but it is a fraction of what it might have been. For example, you should have withheld 7.65% from the employee for social security. Section 3509(a)(2) gives you a break: the IRS will accept 20% of 7.65%, or 1.53%.

Is it great?

Well, no.

Might it be the difference between staying in business and closing your doors?

Well, yes.