Should You Disclose a Prediction Market Tax Position on Form 8275?

Consider Form 8275 when your position has at least a reasonable basis, you doubt it reaches substantial authority, and the tax at stake could trigger the substantial understatement penalty. With substantial authority, you don't need the form for that penalty. Without a reasonable basis, the form won't help. It protects against certain penalties only. If the IRS wins, you still owe the tax and the interest.

OddsFile is software, not tax advice. The IRS has not issued guidance on how prediction-market contracts are taxed. This article explains the options and the sources behind them; a tax professional can tell you which position fits your situation.

What the penalty is

Section 6662 adds 20% to the part of an underpayment caused by, among other things, negligence, disregard of rules, or a substantial understatement. For an individual, an understatement is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000.

The understatement is reduced for any item with substantial authority, and for any item with a reasonable basis whose facts are adequately disclosed. Separately, §6664(c) bars the penalty where you show reasonable cause and good faith.

The three standards

Only the last has a percentage in the regulations. Treat any number you see attached to the other two as a rule of thumb, not law. The more-likely-than-not test is mainly for tax shelters and reportable transactions, so reasonable basis and substantial authority are the two that matter for most traders.

How this applies when the IRS has said nothing

No guidance doesn't automatically mean no authority. Under the regulations, there may be substantial authority "despite the absence of certain types of authority", and a position can rest on a well-reasoned reading of the statute alone. What counts is listed in §1.6662-4(d)(3)(iii): the Code, regulations, revenue rulings, court cases, committee reports and similar sources. Treatises, articles and professional opinions aren't authority in themselves, so a blog post, including this one, adds nothing to the count.

Nobody can grade these positions in advance, but the question is sharper for some than others:

• Section 1256. The strongest candidate for disclosure. The statute's definitions don't fit fully collateralized contracts comfortably, it excludes swaps and similar agreements, and no authority applies it to event contracts.
• Capital or other income. Disclosure matters if you report much less tax than a gambling or ordinary recast would produce. See gambling vs capital gains for the competing arguments.
• Gambling. Usually the most expensive treatment, so an understatement is less likely. Disclosure rarely comes up.

Worked example

Dana is single in 2026 with $90,000 of wages and $150,000 of net Kalshi gains, reported under Section 1256. That is $60,000 short-term and $90,000 long-term. Taxable income is $223,900 after the $16,100 standard deduction. The figures use 2026 rates and ignore the net investment income tax and state tax.

The understatement is $9,870. The threshold is the greater of $5,000 or 10% of $48,104, so $5,000. The understatement is substantial, and the penalty would be 20% of $9,870, or $1,974.

If Dana had a reasonable basis and filed an adequate Form 8275, the item comes out of the understatement, so the substantial understatement penalty falls away. She would still owe the $9,870 and interest.

What disclosure can't fix

The Form 8275 instructions say disclosure can't avoid the part of the penalty due to negligence, or a substantial understatement on a tax shelter item. They also say that if you failed to keep proper books and records or failed to substantiate the items, you can't avoid the penalty by disclosure. Negligence includes failing to keep adequate books. For a trader, a clean position with a messy ledger is still exposed.

How to fill it in

• Part I. Identify the item, describe it, and give the form or schedule, line and amount. A group of similar items with the same treatment can be described as a group.
• Part II. Describe the facts in enough detail to tell the IRS the item, the amount, and the nature of the controversy. Say what the contracts are, which venue, and why you treated them as you did.
• Attach it to your original return. The instructions say you may be able to file it with an amended return, and §1.6662-4(f) refers to a qualified amended return.
• Repeat for recurring items. The instructions require a form each year for recurring items. Carryovers are disclosed in the year they originate.

Some items count as disclosed on the return itself under an annual revenue procedure, Rev. Proc. 2026-12 for 2025 forms. If an item isn't listed, Form 8275 is the route, and we found nothing in that list for event contracts. A position contrary to a regulation goes on Form 8275-R instead.

Your preparer has a separate problem

Under §6694, a preparer faces a penalty of the greater of $1,000 or 50% of the income derived from the return for an unreasonable position they knew or should have known about. A position is generally unreasonable unless it has substantial authority, or it has a reasonable basis and is disclosed. So a preparer who doubts substantial authority may require the form, or decline the position.

The trade-off

Disclosure points the IRS straight at the issue. That is the price of the protection, and it can't be weighed without knowing the dollars involved. Start with the number. Run the free OddsFile check: paste a Polymarket or Hyperliquid address and see your 2026 P&L under each treatment, no signup. The gap between treatments is what you would be protecting. If you've already filed, fixing an earlier return explains qualified amended returns.

FAQ

Is filing Form 8275 an admission that I'm wrong?

No. It describes a position and the uncertainty around it, and you can believe the position is correct.

Does Form 8275 stop an audit?

No. It affects penalties, and nothing in the instructions suggests it changes whether a return is examined.

Does it protect against state penalties?

Form 8275 is a federal form. Check your state's rules separately.

Does reasonable cause work without the form?

Possibly. §6664(c) is a separate defense that depends on your facts, such as what you did to get the answer right. It isn't automatic.