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.

 

Paying Tax Without Setting Foot In California

 

I expect that many tax practitioners would consider state taxes to be a bane in their professional practice. I – unsolicited and without trying – have known more than a few.

Let’s limit our discussion to state income tax.

Mind you, we are not discussing the right of a state to tax. I practice within a Tristate area (Indiana, Kentucky and Ohio) and all three states impose business and personal income taxes. Yes, it can get messy. Take bonus depreciation, for example. This is a federal tax provision allowing the accelerated deduction of equipment and similar asset purchases. Some states will follow along with the federal treatment, others will ignore it completely, and yet others will have some odd hybrid. Take a relatively simple business return with activities across multiple states, and depreciation alone can raise the difficulty level of the return.

Mind you, some states are user-friendly with their tax laws (at least, as much as possible), but some states do not even pretend to be.

I am going to crimp from a notorious California tax case, changing the underlying taxpayer just a smidge to someone you will recognize.

Let’s take a partially retired Cincinnati tax CPA. He has several California clients, both business and personal. He consults, prepares returns and assists with tax agency correspondence and issues.  He of course invoices for his work, and some of those California clients issue him a Form 1099 to memorialize the payment. Critically, he never sets foot in California, and he has not for decades.

Does our Cincinnati tax CPA need to file a California income tax return?

Let’s walk through this.

The California Franchise Tax Board (FTB) annually matches 1099s to filed returns to identify individuals who may not have filed required California returns. The FTB saw those California-origin 1099s and contacted our valiant protagonist, who explained that he did not live in California, had not been in California in years, and – given its current deterioration – had no intention to ever visit California for any reason.

The FTB rejected his explanation, explaining that he had performed services for California businesses and thus had California-source income. The FTB sent a Proposed Assessment for tax, penalty and interest.

Our scrappy hero protested the assessment.

The Office of Tax Appeals (a/k/a Vought) decided as follows:

California imposes a tax on the taxable income of every nonresident, broadly defined as “gross income and deductions derived from sources within this state.”

There is no dispute that appellant, as owner of a sole proprietorship … conducted his … business as a sole proprietor.”

Regulation 17951-4 does not define the term ‘unitary business,’ but the definition can be inferred from Regulation 17951-4(b) … applying to a nonresident’s business, trade or profession … conducted partly within and partly without the state, where the part conducted within the state and the part conducted without the state are not so separate and distinct from and unconnected to each other to be separate businesses, trades or professions.”

Here, appellant … conducted a one-service business …. Therefore, we find that appellant was conducting a unitary business.”

What is the point of all this gum flapping?

California wants to apportion the California invoices to California. They do not even care if you were ever there.

Under the statutory grant of authority of R&TC section 25136(b), the FTB promulgated Regulation 25136-2, which provides detailed market-based sales factor sourcing provisions that implement and interpret R&TC section 25136.”

Pray tell, oh Oracle. How shall R&TC section 25136 be interpreted?

Regulation 25136-2(c) states that sales from services are assigned to [California] to the extent the customer of the taxpayer receives the benefit of the service in [California].”

Here is the wrap:

       

I do not mean to distract the lofty legal minds at the big-building-with-marble columns, but don’t you have to start with more-than-one if you are uniting down to one? Is there a trick-of-the-language thing happening here? Asking for a friend.

The case we are discussing (with some literary license) is Appeal of Bindley (CA OTA, May 30, 2019, No. 18032402).

What got me thinking about Bindley is the (very) recent case of Xavier Garcia-Rojas v FTB, A172054, CA Ct of Appeal, First Appellate District, Division Three, 5/1/26.

Garcia-Rojas was a radiologist from Texas. He read images from around the nation, some of which came from California. The FTB wanted its pound of flesh, relying on Appeal of Bindley above.

This is, BTW, how bad tax law metastasizes. The first court misses the pitch altogether, and the next court just piggybacks.

The Court fortunately recognized the issue:

Here is the decision:

Bindley held that a “self-employed screenplay writer” in Arizona was a unitary business, and thus could be taxed under regulation 17951-4(c). (Bindley, at pp. 1, 4–5.) But in doing so, it focused on the tests to determine whether two different businesses are unitary. (Bindley, at pp. 4–5.) It ignored that there must be separate business activities to unite. (Ibid.; Bunzl Distribution USA, Inc. v. Franchise Tax Bd., supra, 27 Cal.App.5th at p. 991.) The Board also relies on regulation 25120, subdivision (b), but that regulation states it applies only if there are “two or more businesses of a single taxpayer.” Thus, the Board failed to show that Garcia-Rojas is a unitary business as a matter of law.

It took it a while but they eventually got it right. This did not help Bindley, however, who was robbed on an issue a second-year accounting student could spot.

This seems to be an awful lot of work just to determine if our winsome-CPA-hero-of-the-story needs to file a nonresident California tax return. It is also why many CPAs consider state tax to be the bane of their practice.