Will the IRS Issue Prediction Market Guidance Before April 15th?
Written By: Grady McMichen, J.D.
Prediction markets have experienced rapid growth, with both new entrants and established platforms drawing millions of users who trade on the outcome of discrete future events. Contracts offered range from election results and macroeconomic impacts to sports contests and weather conditions. As trading activity increases, a threshold question becomes unavoidable for participants and platforms alike: how will the Internal Revenue Service (the “IRS”) characterize and tax these transactions for U.S. federal income tax purposes?
A prediction market permits users to buy and sell event-based contracts whose payoff depends on whether a specified condition is satisfied at a stated time. Many such products are binary, “yes/no” instruments (ex. a contract pays $1 if an event occurs and $0 if it does not). The trading price generally reflects the market’s implied probability of the relevant outcome, and participants may enter and exit positions prior to settlement.
Prediction market contracts are sometimes described as an extension of derivatives markets, particularly futures. Future contracts are regulated by the Commodity Futures Trading Commission (the “CFTC”), a futures contract is a standardized, legally binding agreement to buy or sell a specified commodity or financial instrument at a predetermined price on a set future date, typically traded on a regulated exchange. Historically, futures have been used to hedge risk by locking in input costs and to speculate on price movements.
In a conventional futures transaction, a buyer and seller agree that, at a set date (the expiration date of the contract), the buyer will purchase a commodity, and the seller will deliver the commodity at a fixed price set at contract inception. The buyer generally benefits if the underlying increases in value relative to the contract price, and the seller generally benefits if it decreases. Gains and losses therefore mirror changes in the value of the referenced asset.
While early futures markets frequently contemplated physical delivery (ex. agricultural commodities), modern markets often provide cash as a settlement. With cash settlements, the parties exchange cash reflecting the change in value of the underlying reference by expiration rather than delivering the underlying itself.
Prediction markets may be viewed as a further expansion of what can be the subject of a tradable contingent claim: the parties’ contractual obligations tied to the realization (or non-realization) of a defined event. For example, a market could list a contract for the earnings of a company at a specified time, and parties may take opposing positions on that proposition.
Commentators frequently compare prediction market activity to gambling. Prediction markets and gambling share an element of uncertainty as to outcome. However, the core distinction between traditional derivatives markets and traditional gambling is structural. With prediction markets, there is ordinarily no “house” that sets odds to produce an embedded edge; rather, counterparties transact with one another at prices established through market bidding. However, certain prediction market makers do operate separate “market houses” that allow users who cannot find counterparties to be able to purchaser
Whether the distinction will have merit for tax purposes, particularly for those referencing sporting events or other consumer-facing outcomes, remains an open issue.
At present, the IRS and the U.S. Department of the Treasury have not issued comprehensive guidance addressing prediction market contracts as a product category. Accordingly, market participants must evaluate potential tax characterizations by analogy to existing regimes, with the attendant risk of disagreement on audit.
Certain contracts described in Internal Revenue Code (“IRC”) Section 1256most notably “regulated futures contracts” and certain foreign currency contractsare subject to (i) mark-to-market treatment at year-end and (ii) the so-called “60/40” rule, under which 60% of gain or loss is treated as long-term capital gain or loss and 40% as short-term, regardless of holding period. To the extent a prediction market contract is properly classified as a Section 1256 contract, particularly if traded on a CFTC-regulated exchange, the IRS may have a more constrained basis to recharacterize the transaction.
The IRS could contend that certain contracts, especially those tied to sports outcomes, are wagers in substance. If treated as gambling, gross proceeds would generally be includable in income under IRC Section 61, while losses may be limited (including potential itemization requirements and caps based on winnings), producing materially less favorable netting than capital loss rules would otherwise permit.
Alternatively, the IRS could characterize contracts as capital assets subject to general capital gain and loss rules. Under that framework, holding period becomes relevant (long-term treatment generally requires a holding period exceeding one year), and frequent trading may yield predominantly short-term results.
Character of gain or loss: The principal dispute risk is the proper character and timing of income: Section 1256 treatment (including mark-to-market and 60/40), general capital gain treatment, or gambling characterization. For high-volume traders, unfavorable loss limitations can produce significant economic exposure, particularly where losses cannot fully offset winnings or gains.
Crypto-based markets: If contracts are settled in cryptocurrency, settlement (and any intermediate conversions) may constitute a taxable disposition of the cryptocurrency itself, generating gain or loss separate from the underlying contract economics.
Reporting Requirements: Platforms and intermediaries will likely be expected to furnish information returns to users and the IRS. Depending on the characterization, this may involve Form 1099-B and, for Section 1256 activity, Form 6781 (Gains and Losses From Section 1256 Contracts and Straddles). If the IRS asserts gambling characterization, it may contend that Form W-2G (Certain Gambling Winnings) is required instead, with potential penalties for incorrect reporting.
Self-employment tax and net investment income tax: For taxpayers who trade regularly and continuously, the IRS could argue the activity rises to a trade or business in certain contexts, potentially implicating self-employment tax or other regimes. Separately, higher-income taxpayers should consider whether the Section 1411 net investment income tax (“NIIT”) could apply depending on characterization and circumstances.
Withholdings: Certain characterizations may implicate backup withholding or other withholding regimes depending on customer status and documentation. Failure to withhold where required can shift liability to the platform, together with interest and penalties.
As with most innovative financial markets, the IRS and Treasury lag behind before issuing a final rule or formal guidance. Until regulations are issued on prediction markets, uncertainty will remain on how gains and losses will be taxed. Consult your Pease Bell Tax Advisor or Grady McMichen for more information surrounding prediction market activity.
Pease Bell is the brand name under which Pease Bell CPAs, LLC and Pease Bell Advisory, LLC and its respective subsidiary entities provide professional services. Pease Bell CPAs, LLC and Pease Bell Advisory, LLC (and its respective subsidiary entities) practice in an alternative practice structure in accordance with the AICPA Code of Professional Conduct and applicable law, regulations, and professional standards. Pease Bell CPAs, LLC is a licensed independent CPA firm that provides attest services to its clients, and Pease Bell Advisory, LLC (and its respective subsidiary entities) provide tax and business consulting services to their clients. Pease Bell Advisory, LLC and its subsidiary entities are not licensed CPA firms.