Taxable Talk

Today, the Tax Court looked at another unsuccesful gambler who thought he was a professional. This individual, though, gambled at video poker, not live poker (or poker tournaments).

Video poker differs substantially from live poker. Instead of playing against other players (and having the house (casino) take a small fee, or "rake," from each pot), video poker is played on a machine against the casino. Almost all video poker machines play five card draw, with your goal to make the highest scoring hand (based on the pay table on the front of the machine). Computers have been used to evaluate each game, and have computed the long-term payback rate with perfect play.

Our unlucky taxpayer played video poker in the Chicago area. He considered it a side job, as he earned $51,840 as an engineer. As the Court noted,

"Petitioner testified that he tried to only play on machines with an expected payout value of a 100-percent return, meaning he thought he would never lose money; he also testified that the only way to get a return of more than 100 percent is to play on a "progressive" machine. He further testified that despite his hours of practice on a computer and diligent study of the perfect way to play the game, “it didn’t work”. [citations omitted]"

Luck was not with the petitioner, but he filed as a professional gambler in 2003, claiming $1.3 million in income and $1.3 million in losses (or a $0 overall Schedule C). The IRS believed he should have filed as an amateur, and would take his winnings on line 21 (other income) and his losses as an itemized deduction. If that were the case, the petitioner would owe another $3,068 in tax.

The Court felt that the petitioner wasn't a professional gambler, and ruled for the IRS. In order for an activity to be a business, it must be conducted with continuity and regularity, and the purpose must be to make a profit.

"Occasionally, devoting all of one’s free time to a particular activity may be a sign of addiction.* Further, the amount of time spent engaged in the activity is not the most significant aspect of the trade or business analysis. More important is the taxpayer’s actual or honest objective of making a profit. (*At trial, petitioner testified that he had himself barred from his usual casinos for 5 years to prevent him from continuing to gamble there.)"

But the petitioner didn't treat video poker as a business. He failed to maintain books, which a professional should do. He never sought help when, after five losing years, he continued to lose in 2003. Then the Tax Court notes,

"We are additionally unconvinced that petitioner’s gambling activity meets the standard for being a trade or business because we are not persuaded that an individual who gambles against a machine that is programmed by a casino can have, as his or her primary purpose, income or profit. After all, such a machine is on the floor to make money for the casino and is not there to provide income or profit for the casino’s patrons. For most individuals, gambling against a machine that is programmed to make money for the casino constitutes what the Supreme Court in Commissioner v. Groetzinger, 480 U.S. 23 (1987), characterized as a sporadic activity, hobby, or amusement diversion. For other individuals, gambling against such a machine may become a habit or an addiction. In neither scenario is it a trade or business with the participant’s primary purpose being income or profit. [citation omitted]"

I strongly disagree with the Court about video poker. I know that it is quite possible to be a video poker professional. It takes practice, skill, and effort (and if you're a professional, you will maintain books, because it's the only way you will know how you're doing). This is a memorandum decision, and doesn't establish a precedent. However, it does tell you what the Tax Court is thinking, and it's clear that you would have to show substantial statistical records in order to be considered a professional video poker player.

That said, it is clear that the petitioner in this case didn't meet the standards of being a professional gambler. You do need to keep records and treat it like a business. And the petitioner didn't. And admitting that you're addicted to gambling in your own testimony probably didn't help matters at all.

Case: Ferguson v. Commissioner, T.C. Memo 2007-30

A very interesting case today from the Tax Court. A husband and wife play poker. The wife is a professional, playing in poker tournaments; the husband is not a professional. The wife wins some money playing in poker tournaments; however, her expenses exceed her income. Can she deduct the additional expenses and have her net income from playing poker professionally be a net loss?

In 2000, the wife earned $11,708, but she claimed a net loss of $29,933 on her Schedule C. Section 165(d) of the Internal Revenue Code limits deductions for gamblers to the amount of their wins. However, the petitioner claimed that tournament poker is not a form of gambling; instead, it should be looked at like a professional sporting event such as tennis or golf. Alternatively, they claim an equal protection argument.

The Court first examined tournament poker (and provided one of the best descriptions for the layman that I've ever read), and come to these conclusions about whether tournament poker is a form of gambling:

"Betting is so intrinsic to poker that it is nearly impossible to avoid using a word that implies gambling in any way when discussing the topic. Bets are placed on each hand, and each round of betting has consequences. Whether or not the chips being used to make these bets have immediate and tangible monetary value does not change the fact that the players are still placing bets, hoping to win. This is true even in a tournament setting.

Petitioners agree that the first poker tournaments held were, in fact, “wagering events”. For example, in those early games, “Each participant put up $10,000 and received $10,000 in chips.” The fact that the chips being used to place bets in tournament poker today only bear some fractional relationship to the dollar values of the prizes and/or entry fees does not change the basic nature of the game as a wagering activity."

It's hard for me to argue with this conclusion; while poker tournaments have become sporting events, poker is definitely a form of gambling.

The equal protection argument also fails.

"Petitioners argue that the benefits of being able to offset “exaggerated income” from very successful years by losses sustained in less successful years should be available to professional tournament poker players as much as they are to other professions.

Congress made a policy decision to treat businesses based on
wagering activities differently. In the absence of Congressional action, we are not free to correct any perceived unfairness stemming from a rationally based policy choice. In Valenti v. Commissioner, T.C. Memo. 1994-483, the Court noted that treating businesses based on wagering and gambling differently from other businesses is a rational differentiation and not one that rises to the level of being violative of due process or equal protection."

As I've written in the past, I believe the equal protection argument could succeed in the right venue. However, that venue is likely a District Court, a Court of Appeals, or the Supreme Court. That's an expensive road to take to fight the IRS and the precedents that exist on this issue.

The Tax Court's conclusion hints that they think the law should be changed:

"The moral climate surrounding gambling has changed since the tax provisions concerning wagering were enacted many year ago. Not only has tournament poker become a nationally televised event, but casinos or lotteries can be found in many States. Further, the ability for the Internal Revenue Service to accurately track money being lost and won has improved, and some of the substantiation concerns, particularly for professionals, no longer exist. That said, the Tax Court is not free to rewrite the Internal Revenue Code and regulations. We are bound by the law as it currently exists, and we are without the ability to speculate on what it should be. Accordingly, we hold that tournament poker is a wagering activity subject to the limitations of section 165(d)."

The petitioner in this case loses out on being able to deduct additional expenses; poker tournaments are just another form of gambling. For all gamblers it's just another reminder that the Tax Code isn't fair, but you have to live with it or get Congress to change it.

Case: Tschestschot v. Commissioner (T.C. Memo 2007-38)

Three Senators have introduced the "Stop Tax Haven Abuse Act." Senators Carl Levin (D-MI), Norm Coleman (R-MN), and Barack Obama (D-IL) are targeting the 30+ offshore tax havens. Senators Levin and Coleman have led an investigation into these tax havens, and believe they shelter $100 billion in annual tax losses to the U.S. Treasury.

“It is simply unacceptable that some individuals are using offshore tax havens and secrecy jurisdictions to shelter trillions of dollars in assets from taxation,” said Coleman. “These tax schemes cause a massive revenue shortfall and, sadly, it is the honest American taxpayer who must bear a disproportionate burden of investing in areas like education and healthcare. We are introducing this bill to close these loopholes, shut down offshore tax schemes, and ensure that every American pays their fair share of taxes.”

I expect this bill has a good chance of passage this year. It may end up being tied to this year's AMT relief act (whenever that's introduced). The press release (from Senator Levin) lists the goals of the bill (available below).




Though this legislation targets the securities industry and the offshore trust industry, at least one other industry will be impacted by this bill (should it pass Congress): the offshore gambling industry. The Isle of Man and Gibraltar are two of those offshore tax havens, and they happen to be two of the main domiciles of offshore gambling firms. Depending on the actual text of the legislation (the bill is not yet available on the Thomas system) and any regulations promulgated by its passage, Americans might have even more difficulties in getting funds from the U.S. to the offshore gambling firms.

Thanks to the TaxProf Blog for the heads-up.

One of my practice areas is professional gambling. Many gamblers maintained an account with the e-wallet firm Neteller. Neteller served as a financial intermediary between US customers and online gambling firms. In January, the Department of Justice arrested the two founders of Neteller and charged them with multiple offenses, including money laundering. Neteller then pulled out of the US market. Neteller announced today that they are cooperating with the DOJ, and that $55 million in funds had been seized by US law enforcement.

Neteller, in one swell swoop, lost over half of its business. Ignoring whether or not such business was legal, assume you were running Neteller. The Department of Justice has arrested your two founders, has decided to fight you, and you no longer have any means to make financial transactions to the United States. What would you do? Fight the US DOJ, or make the best deal you can? It's clear from the Neteller press release that they are in negotiations with the DOJ, and that transaction records are being sent from Neteller to the DOJ.

Indeed, it's clear what's likely to happen. Neteller and the DOJ will likely come to an agreement. Neteller will announce that they will no longer do business with Americans, and they may have to pay a fine; the DOJ won't indict the company, or any of its current stockholders. The DOJ might even accept some sort of plea bargain for the two founders who were arrested. It's also certain that as part of such a deal Neteller will agree to release details of all transactions between American customers and Neteller.

What does the DOJ want with thousands of pieces of data? Well, Neteller required the customer's name, address, and for many accounts, their social security number. The details of those transactions will undoubtedly be sent to a government agency that's in the revenue collection business: the IRS.

So what does that mean for the customer who used Neteller?

If you complied with the law—you reported all of your gambling income and your foreign bank accounts—you have nothing to worry about. But probably fewer than 5% of taxpayers report their gambling transactions as income.

First, Neteller is considered to be a foreign financial institution. If you have a foreign bank account, and have $10,000 or more in a foreign bank account(s) at any one time, you are required to file Form TD F 90-22.1 by June 30th of the following year with the Department of the Treasury and check the box at the bottom of Schedule B. If you have a foreign bank account and don't declare it, you can face civil and/or criminal penalties. Anyone who received $10,000 or more in one transaction from Neteller had a foreign bank account. I expect the Treasury Department to check their records and come after those who didn't declare their Neteller account. A few individuals may even face criminal prosecution over this, if they had extremely large transactions from Neteller.

Second, the IRS will check their records and see if individuals receiving funds from Neteller declared gambling winnings. The IRS will almost certainly target those receiving large amounts. If an individual received large amounts from Neteller, and didn't declare any gambling winnings, now is the time to amend your return, and pay the tax, interest, and penalties. It's almost always better to come forward to the IRS than to have the IRS knock on your door.

The IRS's first targets will be those with large (in dollars) transactions. But given the ability of the IRS to conduct computer matching, if you received funds from Neteller and didn't declare any gambling winnings, you might receive a "letter audit" from the IRS. ("Dear taxpayer, we've added $xxx [the amount of money you received from Neteller] to your income. If you agree, pay the tax, interest, and penalties....')

I believe that a few individuals will likely face criminal prosecution over this. If the IRS can find an online gambler who earned over $100,000 and didn't declare his gambling income (and I think the IRS will have several to choose from, and might even find someone who earned over $1 million) that individual could find himself facing jail time for tax evasion.

But what if you used Neteller for non-gambling activities? Interestingly enough, I know of one firm that paid individuals through Neteller. If you declared the income on your tax return (and can show that), there's nothing to worry about. You may have to spend some time responding to an IRS notice, but if you've paid your taxes, you're fine.

However, I believe that many (if not most) online gamblers have thought that since Neteller was based on the Isle of Man (a known tax haven), the IRS would never be able to see their records. You've just lost that gamble. It will take some time, probably several months at a minimum, for the IRS to conduct their matching of records. If you're one of those who just lost the first gamble, do you want to double-down and bet that the IRS won't find you or do you want to amend your return(s) and pay the tax that you knew you owed...and the interest and penalties?

As I've said many times, gambling income is taxable. The Tax Code isn't fair to gamblers, but the alternatives if you don't pay your taxes are worse than paying the tax that you owe.