Applying existing federal tax rules to novel digital asset products such as event contracts and perpetuals is an unsettled exercise, and a new wave of state-level transaction taxes is deepening the divergence, panelists said October 6 at a virtual American Bar Association Section of Taxation meeting.
How should event contracts be treated?
The characterization of event contracts, binary contracts tied to the outcome of a future event, is a “spicy topic,” said Vadim Novik, a partner at Fried, Frank, Harris, Shriver & Jacobson LLP. The central question is whether they are taxed as wagering or as a financial derivative. Wagering produces ordinary income, Novik said, and under the One Big Beautiful Bill Act only 90% of gambling losses are deductible against winnings, while derivative treatment can instead yield capital gains.
Some practitioners argue that a more specific characterization as a derivative under IRC § 1234A, or as a mark-to-market contract under IRC § 1256, should trump the general wagering rules. Complicating the analysis, the Commodity Futures Trading Commission (CFTC) regulates event contracts as swaps and has asserted that federal oversight preempts state gaming laws.
Qualifying for the favorable capital gains treatment under § 1256 is difficult, said Andie Kramer of ASKramer Law. For a contract to be a “non-equity option,” it must first be an option, and event contracts do not fit the typical structure. “The option typically gives the buyer the right, but not the obligation, to do something, and here it’s not really set up that way,” Kramer said.
Jason Schwartz, a partner at Cahill Gordon & Reindel LLP who moderated the panel, said the absence of underlying property for many contracts, such as those tied to sports, “stretches credulity in most cases to call these options.” The right answer, Kramer said, ultimately turns on the specific product and the taxpayer’s activity.
Tax uncertainty with perpetual contracts
Similar uncertainty surrounds perpetual contracts, or “perps,” derivatives that have no maturity date and track a reference asset’s price. Because the CFTC regulates perps on certain markets as futures contracts, Schwartz said there is a “very strong position that those are 1256 contracts.”
A central unresolved question is the treatment of the funding rate, the periodic payments that keep a contract’s price tethered to the underlying asset. Panelists debated whether those payments should be folded into the final § 1256 mark-to-market calculation or accounted for separately, potentially as ordinary income or expense under the rules for notional principal contracts.
Lucy Farr, a partner at Davis Polk & Wardwell LLP, said the notional principal contract definition is “a little bit circular” because it excludes regulated futures. A long-pending regulation that would align the § 1256 and notional principal contract rules could resolve the issue, but “it’s been proposed for many years,” she said.
Perps linked to U.S. equities also raise withholding risk under IRC § 871(m). Novik said that because perps deliver a linear, delta-one return mirroring the underlying asset, it would be a “treacherous path to try to reach the conclusion that perps linked to U.S. equities are not subject to 871M.”
States pursue divergent transaction tax models
While federal treatment remains unsettled, states are building their own regimes, producing a divergent landscape, said Jamison Sites, a principal at KPMG, and James Creech, a principal at Baker Tilly.
Creech described two approaches emerging for prediction markets. Kentucky and North Carolina tax the operator on the fees or revenue it earns, which he called a more “reasonable” approach that resembles a sales tax on a service and reflects a “sin tax” view of behavior some states consider unproductive.
Illinois takes a different route. Its Digital Asset Tax Act imposes a 0.2% privilege tax on the gross U.S. dollar value of a customer’s transaction, with strict liability on the broker to remit it. Creech warned the model could prove “catastrophic” for brokers, who remain liable even when they cannot collect the tax from the customer.
The Illinois tax was scheduled to take effect in January 2027 but has been delayed until July 2027 under a pause on enforcement while litigation proceeds, Sites said, and the state recently issued proposed rules open for public comment. He said the window gives brokers time to determine whether they are covered and to build systems to comply.
The law also drew concern for other provisions, Sites said, including a requirement that brokers maintain customers’ private key data as part of their tax records. He called that “a huge security risk.”
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