Predicting the taxation of prediction markets.

TABLE OF CONTENTS I. INTRODUCTION 954 II. BACKGROUND OF PREDICTION MARKETS 956 III. CURRENT TAXATION OF PREDICTION MARKETS 962 IV. PREDICTIVE DERIVATIVES ARE FINANCIAL INSTRUMENTS UNDER 965

CURRENT TAX LAW

A. Taxation as a Financial Instrument: Options 965

B. Taxation as Forward Contracts 967

C. Taxation as a Financial Instrument: Notional

Principal 967

D. Taxation as a Financial Instrument: Section 1256 973

Contracts

E. The Illegality of Prediction Markets 976

F. Summary: Prediction Derivatives Are Financial 977 V. WHY PREDICTION MARKETS ARE NOT GAMBLING OR CONTRACTS 977

HELD AS PROPERTY

A. The Income Tax Concept of Gambling 978

B. Prediction Derivatives Have Social Usefulness 981

C. Summary: Why Trading Prediction Derivatives Is Not

Gambling 984

D. Taxation of Prediction Derivatives as Contractual

income 984

E. Summary: Why Predictive Derivatives Are Contracts

Held as Property 988 VI. CONCLUSION 989

I. INTRODUCTION

Taxation is to the study of law what derivatives are to the study of finance: a subject matter that is both very complicated and very important. Each field is heavily technical and of little concern to most laymen. Further, the set of rules governing the taxation of derivatives is still largely unsettled. At the intersection of these two complicated fields is a new kind of purported financial instrument, a product of the internet that has been actively marketed to the masses. Generally called "prediction markets," websites host a trading system where members of the public can stake real money on their predictions concerning the occurrence or nonoccurrence of future events. Participants are able to buy and sell contracts, the value of which is directly tied to the probability of the occurrence of an event. The contracts are priced between zero (representing the perceived impossibility of an event's occurrence) and one (indicating that the market considers the event to be an established certainty). In effect, the participants in these prediction markets are betting on the occurrence of a well-defined event, the nature of which is limited only by the human imagination. Some of the most popular contracts seem to be based on political outcomes.

The terminology of this product has become as diverse as the events in which they specialize. For example, the contracts have been called "event derivatives," "nonproperty derivatives," "informational futures," and "electronic futures contracts," to name just a few terms. (1) The label "derivative" is used because these contracts are assets, the value of which depends on (or is derived from) something else. The description "nonproperty" refers to the idea that the value is based on the occurrence of an event or the level of a financial index at a fixed point in the future, instead of the future price of a commodity. Sometimes the label depends on the subject matter. For example, "political futures contracts" are based on political outcomes, like an election result. Alternatively, they have been called "binary options," because upon expiration the contract is an all-or-nothing proposition.

In contrast to the diversity of the terms, there is a unified belief among not only their promoters but also among academics in the utility and legitimacy of prediction markets. (2) The exchanges have been praised as more accurate than political polls, (3) and some exchanges have even been used by some well-known companies as marketing tools. (4) Other prediction markets are used merely for recreational purposes (using fake money). (5) Yet, the legality of real-money prediction markets is in serious question. In the view of some, trading in such contracts constitutes gambling and violates both federal and state laws. (6)

The tax treatment of prediction markets is an equally contentious issue--or, at least, it should be. To date, federal tax law gives little guidance on how to treat gains and losses from these types of contracts. As a result, the actual taxation proceeds at the discretion of the taxpayer reporting the income. In fact, only one exchange, HedgeStreet, puts a tax label on its contracts. Other taxpayers might genuinely consider the activity to be gambling, investing, or some other occupation entirely. The lack of federal guidance on how to characterize proceeds from prediction contracts also enables taxpayers to elect inconsistent tax treatments for gains and losses from year to year in order to achieve the most beneficial tax result. In sum, there is a lack of consensus and awareness about the taxation of this type of income, a type that is growing exponentially.

In response, this note first aims to discuss what is known about the current taxation of prediction markets. This note then attempts to answer how they should be taxed under current tax law and concludes that prediction derivatives based on political and financial events should best be considered forward contracts under current tax law. Part II summarizes the development of prediction markets. Part III discusses the current lack of consensus on their tax treatment. Three specific prediction markets are examined: Intrade, HedgeStreet, and Iowa Electronic Markets. In Part IV, the case is made that prediction derivatives are best understood as forward contracts under current tax law. Part V elaborates on this point by discussing why prediction futures do not represent gambling or mere income producing contracts held by the taxpayer as property. Finally, the conclusion, Part VI, reaffirms the proposition that prediction contracts are forward contracts and thereby creatures of finance.

II. BACKGROUND OF PREDICTION MARKETS

Prediction markets are created for the purpose of making predictions. Contracts are created between two parties, the market value of which is continually dependent on the probability of the eventual occurrence or nonoccurrence of a certain event, such as the election of a candidate. Alternatively, a prediction contract's value could be dependent on the eventual value of an index upon a set date, for example, the median housing price in a given real estate market. The current market price for such a contract can then be interpreted as an expression of the event's probability. Because these contracts may be traded amongst many exchange members, there is said to be a prediction market. There are three prediction markets where the majority of Americans make their predictions with real money: Iowa Electronic Markets, Intrade, and HedgeStreet.

Iowa Electronic Markets (IEM), the oldest of the modern exchanges, dates back to just before the 1988 Presidential election. (7) Organized by the Tippie College of Business at the University of Iowa for classroom purposes, the website has since expanded tremendously. (8) It now allows the general public (including foreign individuals) to trade on a limited assortment of political and economic outcomes, such as presidential nominations and elections and stock price returns. The goals of the IEM are to serve as an educational tool and generate data for research purposes. In contrast, Intrade, incorporated since 2001, operates as a for-profit exchange based out of Dublin, Ireland. (9) Intrade offers markets in domestic and international politics and pieces of legislation, as well as contracts based on the weather, current events, and financial indicators. Intrade states that it has over 70,000 members and takes orders from over 100 countries. (10) In contrast, HedgeStreet allows only U.S. individuals or organizations to trade contracts on its website. (11) HedgeStreet offers only informational futures that have a financial aspect to them (that is, no political futures). Among the most popular contracts are those based on foreign exchange rates, housing prices, the consumer price index, weather indicators, or even the price of gold.

In some ways, prediction markets, especially those involving contracts based on political events, are not new. During the turn of the last century, newspapers, such as the New York Times would publish daily quotes in the weeks before a presidential election. (12) The 1916 election, for example, witnessed some $165 million (in 2002 dollars) wagered on the organized New York markets. (13) Comparatively, modern online prediction markets are smaller. Nonetheless, Intrade garnered $15 million in trade volume for the Bush reelection contract during a year-and-a-half of trading activity. (14) Modern and antiquated political prediction markets do share a great deal in common. Then, as now, they serve as a reliable substitute for polls. It is generally thought that these markets provide an aggregation of all available information about the probability of an event's occurrence, and they create incentives for people to both seek information and provide truthful information. (15) In contrast to traditional polls, the markets also purportedly capture the strength of people's beliefs. (16) Simply stated, the confident will trade more. Academics consider prediction market numbers superior to polling data for another reason: the information can respond in real time to campaign gaffes and breaking news stories. (17)