The Tax Court looked at an individual (call him “Mr. A.”) who looked like a professional poker player, appeared to have an income from poker, but was described on his tax return as a “consultant.” His tax return showed less than half the income that his W-2Gs totaled. The IRS added in a negligence penalty, and the whole dispute ended up in Tax Court.
Before I get into the meat of the case, a comment about gambling and the IRS (and the Tax Court). The IRS does not have a good understanding of the mechanics of poker tournaments. The petitioner today lost some deductions because of this (and that they didn’t explain things point by point). For example, the Court stated (in footnote 4):
The parties also stipulated the authenticity of two receipts showing that Mr. A had paid buy-ins as an “alternate” to participate in “$540 No Limit Hold’em” contests at the Bellagio on July 11 and 17, 2009. As the record does not disclose whether Mr. A in fact played–and if he did not, whether his buy-in was refunded–we conclude that petitioners have not shown that Mr. A paid these buy-ins.
That’s not how alternates in a poker tournament work. Alternates are just the people who get seated when original entrants are eliminated from the tournament. I’ve never seen or heard of an alternate not being seated. But the petitioners didn’t mention this in their briefs or testimony, so the Court used what they thought the term meant, not what really happens in poker tournaments. But I digress….
The problems began with the preparing of their 2009 return.
The return was prepared by petitioners’ accountant…who has a master’s degree in accounting and had previously prepared tax returns for professional poker players. For purposes of preparing the return, Mr. A advised the preparer that his exclusive source of income in 2009 was his poker tournament winnings. He further advised the preparer that he did not have records of the expenses he incurred in order to play in poker tournaments. The preparer concluded that Mr. A was a professional poker player on the basis that poker was his exclusive source of income. Given the absence of expense records, the preparer advised petitioners to report the net income from the gambling activity on Schedule C as gross receipts but not to report any offsetting business expenses.
Let’s look at the problems here. First, the IRS computer system was almost certain to hiccup on this return. If the W-2Gs totaled $42,000 and you report $21,000, there’s a problem. I’m certain that the petitioner received an IRS automated underreporting unit notice on this issue. The second problem deals with the preparer. Tax returns have places for expenses; they aren’t supposed to be lumped with gross receipts. Additionally, there are basic standards in preparing a return. The idea of a preparer putting down, say, $10,000 for expenses when a client says he has no records of those expenses makes no sense.
The taxpayers return showed a Schedule C—the only source of income—with $20,045 of net and gross income. The Schedule C was listed Mr. A’s occupation as “Consultant.” The IRS assumed that was the case, and saw $40,395 of wagering income to be added to the return. That was the first issue. This they won:
On the basis of Mr. A’s and his accountant’s testimony and the entire record, we agree with petitioners. Other than the reference on the Schedule C to Mr. A’s business as a “consultant”, there is no evidence that Mr. A engaged in any consulting activities for compensation during 2009. He denied doing so. When called upon to explain why Mr. A’s business was described as that of a “consultant” on the Schedule C, both he and his accountant dissembled. In the circumstances, we conclude that the business was described this way in a misguided attempt to head off the closer scrutiny of the return that would likely be triggered by a description of Mr. A’s business as “poker” or “gambling”–scrutiny that would likely unearth the inadequacies in the substantiation of Mr. A’s expenses.
The Court included gambling winnings that weren’t on W-2Gs. Yes, all income is taxable no matter if you receive a piece of paper or not. The Court noted, “On this record we find that Mr. A had poker tournament winnings of $48,686 for 2009. Given our conclusion that petitioners reported $20,045 of Mr. A’s gambling income on their return, it follows that they had unreported gains from wagering transactions of $28,641 for 2009.”
The IRS contended that the petitioner wasn’t a professional gambler. Given that the only source of income for the petitioner and his wife was his gambling, the petitioner won this argument. He also was able to deduct his losing poker tournament entries (save the “alternate” entries that the court got wrong).
The taxpayer ran into trouble with his business expenses. “Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deduction claimed on a return.” Mr. A. was allowed to deduct those items that he had receipts for. There were almost certainly more expenses, but a line from Tom Clancy comes to mind: If you don’t write it down it never even happened. That’s definitely the case for business expenses: Keep receipts and good records!
The IRS also asserted an accuracy-related penalty for negligence or disregarding IRS rules and regulations.
“‘[N]egligence’ includes any failure to make a reasonable attempt to comply” with the internal revenue laws. Sec. 6662(c). It connotates “a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the
circumstances…This includes “any failure by the taxpayer to keep adequate books and records or to substantiate items properly.” Sec. 1.6662-3(b)(1), Income Tax Regs. Disregard of rules or regulations includes any careless, reckless, or intentional disregard of the Internal Revenue Code, the regulations, or certain Internal Revenue Service administrative guidance.”Respondent contends that petitioners are liable for an accuracy-related penalty on the basis of negligence. We agree. They failed to maintain records of Mr. A’s gambling activities, including the related expenses. Lacking adequate records, they filed a return that reported an estimate of their net income as if it were gross receipts. As a consequence, they significantly understated both gross receipts and net income. They also participated in a misrepresentation of Mr. A’s business as being that of a consultant rather than a professional poker player. The failure to keep records is prima facie evidence of negligence, and the misrepresentation of the nature of Mr. A’s business falls short of a reasonable effort to comply with the internal revenue laws…
Petitioners have not shown reasonable cause and good faith with regard to any portion of the underpayment. While they were advised in the preparation of their return by an accountant, the return as prepared stated a gross receipts figure that Mr. A certainly knew to be inaccurate and further identified the nature of his business in a way that both petitioners knew to be inaccurate. Petitioners have not shown that they acted with reasonable cause and in good faith with respect to any portion of the underpayment. They are liable for the negligence penalty under section 6662(a).
Some helpful hints if you want to fade into the crowd: Accurately report your gross receipts. The IRS matches things reasonably well, and if they have records that show you have $50,000 of income and your report $20,000, there’s going to be a notice sent to you. If you’re a consultant, would you note your occupation as “professional gambler?” I assume not. The converse is also true; if you’re a professional gambler, you’re not a consultant.
Second, you sign your return, and you’re expected to review it. If you’re gross income is $50,000 and you report $20,000, that you used a tax professional will not absolve you from the accuracy-related penalty.
Finally, keep good records! Every time I get a new client I emphasize with them the importance of keeping good records. An audit is an inconvenience if you have records that substantiate what’s on your tax return. If you don’t, it will be a very painful, very expensive inconvenience.