“We have long had death and taxes as the two standards of inevitability. But there are those who believe that death is the preferable of the two. ‘At least,’ as one man said, ‘there’s one advantage about death; it doesn’t get worse every time Congress meets.’”
—Erwin N. Griswold
JEAN: Okay, you’ve kept your gambling diary faithfully all year long. You’ve added up all your wins for the year to get one total and added up all losses for another total. Now, how do you put this information on your tax return?
This depends on whether you’re a recreational gambler—as most gamblers are—or can file as a professional gambler (the latter having been firmly established as a recognized option by the courts only within the last generation).
JEAN: Casual or recreational gamblers can usually handle fairly easily the job of recording their gross gambling wins on their tax returns. You must use the long Form 1040, not 1040A or 1040EZ. You put your total win for the year (from all types of gambling, including live and online, added together) on the line “Other Income” and label it “Gross Gambling Income.”
Married couples filing jointly combine their winning-session totals for the figure to put on the “Other Income” line. This again means adding all types of gambling together, even if the husband and wife play entirely different games.
But here comes the tricky part. You can claim a loss figure (for all types of gambling, live and online, added together) only if you itemize on Schedule A. Again, married couples that file jointly add their individual loss figures together for one total loss figure. You put the total allowed loss figure on Schedule A on a line in the section for “Other Miscellaneous Deductions” and label it “Gambling Losses to Extent of Gambling Income.”
Did you notice I said total allowed loss figure? There’s a restriction on listing your losses on Schedule A: You cannot reduce your tax on non-gambling income if you have more gambling losses than wins. The tax instructions put it quite clearly: If you itemize your deductions on Schedule A, you can deduct gambling losses you had during the year, BUT ONLY UP TO THE AMOUNT OF YOUR WINNINGS (emphasis added).
MARISSA: Here’s an example. If your year-end winning total is $10,000 and your total loss is $20,000 (a net loss of $10,000), you may claim only a $10,000 deduction on Schedule A under “Other Deductions.” You cannot use the excess $10,000 to reduce non-gambling income.
Also, there’s no carry-over to another year. This condition is stipulated in IRC section 165(d): Losses from wagering transactions shall be allowed only to the extent of the gains from such transactions. The courts have ruled time and time again that 165(d) does take precedence when applying tax law.
JEAN: The recreational gambler can feel real pain in the pocketbook because of IRS tax rules and procedures. Having to put your loss figure on Schedule A as a deduction isn’t a problem for taxpayers who itemize anyway. However, a taxpayer forced to itemize only because of a large loss figure (to offset the large win figure in “Other Income”) is losing the dollar amount of what would have been his standard deduction. Many find they need to figure it both ways, itemizing versus taking the standard deduction, to see which has the overall lowest tax obligation. (See the comparison of these two alternatives in the sample tax forms in Appendix B1 and B2.) If you do itemize, the one bright spot is that your loss figure isn’t further limited as some other itemized deductions are.
However, there can be a far more severe punishment awaiting the recreational player because of the rule against netting out wins at the end of the year (subtracting gross losses from gross wins to report a net win only). Having to use a gross win figure on page 1 of your federal income tax form can put you in a higher AGI (adjusted gross income) category, where you’ll be ineligible for certain benefits, such as IRA eligibility or education credits, and for some deductions that phase out as your AGI goes up. Seniors may find that they have to pay taxes on more of their Social Security income. You may even lose your exemption deductions. And to pour salt in the wound, many may live in an area where state and/or local taxes will be based on this higher AGI figure, a problem we discuss in Chapter 8.
Here’s a comprehensive list of what can be affected negatively by having to include your gross gambling win figure in your adjusted gross income (AGI):
Social Security
Medicare premiums
IRA contributions
Mortgage interest deductions
Real estate taxes
Charitable contributions
Employee business expenses
Medical expense deductions
Rental real-estate deductions
Casualty loss deductions
Child tax credit
Earned income credit
DMV taxes (when the tax is based upon the value of the car)
Points on a home loan
Investment interest
Miscellaneous itemized deductions subject to the 2% limit
Lifetime learning credit
Hope credit
Retirement savings contribution credit
Adoption credit
Alternative Minimum Tax (AMT)
JEAN: For some, the answer to the problems we just discussed is filing as a professional gambler, using Schedule C, Profit or Loss from Business (Sole Proprietorship). In this case, the gross-win figure for the year is put in Part I, Income. The gross loss figure for the year is put, with other business expenses, under Part II, Expenses, and subtracted from the gross win. This allows the much smaller net win to be carried over to page 1 of Form 1040, resulting in a lower AGI and avoiding some of the penalties we mentioned earlier. (See example in Appendix B3.)
However, filing as a professional gambler using Schedule C has its own set of problems. First, the IRS imposes rigid requirements on anyone wanting to claim gambling as his “business,” although these are not all set in stone; individual situations are considered. However, court cases have established that your intent must be to make money as a primary source of income; it must not be just a hobby. The Supreme Court has defined a professional gambler as one who gambles “with regularity, continuity, and with an expectation of profit.”
MARISSA: The landmark Supreme Court case that allowed gamblers to file as professionals was the case of Commissioner v. Groetzinger (see Appendix D). In that case, the Court concluded, “If one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the meaning of the statutes with which we are here concerned.” Essentially, the court ruled that each taxpayer’s situation must be evaluated according to the facts and circumstances of the case.
JEAN: Some people might think that if you make money at least three out of five years, you can automatically file as a business. However, many people make money in an avocation as well as in their vocation. You’re probably still a recreational gambler unless you can meet the higher standard of being a professional. Being a professional is not just about winning; it’s about showing that this activity is a major source of your income.
| Nuclear physics is much easier than tax law. It’s rational and always works the same way. |
| —Jerold Rochwald |
MARISSA: Some people misunderstand the “three-of-five” rule for Schedule C, making a profit three years out of five. One tax expert explained it this way: “A gambler who makes a profit in three (or more) of five tax years is entitled to a presumption, which the IRS can overcome, that he is in business; a gambler who doesn’t has to overcome the contrary presumption.”
One video poker player who understands the strict requirements to be a professional gambler put it this way: “Especially if your records show a loss, you’d better have a documented plan of what you’re doing to correct the problem: switching to better games, changing to casinos with more cashback, playing more on double-point days, spending more time practicing on your computer, consulting with experts in your field, creating a better business plan. Don’t laugh; courts and the IRS expect this! You’ll be held to the same standard as any other self-employed person, plus you’ll have to overcome the standard of ‘personal pleasure that is derived from the activity.’ (It’s OK to enjoy what you do for a living, but a hobby is not a business.) Lack of records and a sound business plan are the biggest reasons for the denial of deductions.
“For example, one taxpayer deducted his expenses for his gold-mining trips to the Mojave Desert for 10 years. He’d kept perfect records, had a business plan, and consulted experts. Some years he made a buck, but mostly he didn’t. A tax court ruled that since he was sincere in his attempt to make a go of it, his deductions were allowed. The court stated that ‘a person can believe he can strike oil in Times Square, and while that may be far-fetched if not impossible, if he gets the best people and the best equipment and has a plan to accomplish his goal, this court will not and cannot judge how reasonable is his goal, only on his sincerity to accomplish it.’”
JEAN: You must spend “substantial” time conducting your gambling business; however, how many hours are “enough” would be evaluated on a case-by-case basis. Gambling income does not have to be your sole source of support, but a couple of trips a year to Las Vegas most likely won’t be convincing.
Being business-like in your record-keeping is a must. For example, having a separate bank account for your playing bankroll and expenses will strengthen your case for being a pro.
MARISSA: Filing as a business is not necessarily an automatic good choice, even for a “big” gambler. It requires paying self-employment (SE) tax, in addition to your regular income taxes, if your net win is over $400. (A recreational gambler doesn’t have to pay this SE tax, because his gambling win isn’t categorized as “earned” income.) Self-employment tax is a hefty amount (about 15%) that can minimize or even wipe out the advantage you gain from filing Schedule C. (When you work for someone else, your employer picks up 50% of your Social Security contribution. When you’re self-employed, you must pay it all.)
Another caveat here: You will not be entitled to all of the Schedule C advantages of taxpayers involved in businesses other than gambling. Schedule C filers normally may carry forward their losses. They can also offset losses against other income. Because IRC 165(d), which we quoted on page 44, takes precedence in determining gambling losses, the professional gambler is at a disadvantage when compared to other businesses. If you sell Amway and fail, you can use the net loss to offset other income. This is not permitted for any gambler, including professionals. As it has in many previous cases, the court ruled again, in Praytor v. Commissioner (2000), that claimed losses, even as a professional, may not exceed gains. That pesky Section 165(d) of the tax code takes precedence.
JEAN: Why am I reminded here of the old expression, “You can’t be just a little pregnant?”
MARISSA: There’s a glimmer of hope that the IRS might be moving toward a more reasonable stance in how they look at gambling as a legitimate business. A 2008 IRS memo, which can be found at www.irs.gov/pub/irs-utl/am2008013.pdf, addresses the issue of whether expenses (as an issue separate from actual gambling losses) incurred by a professional gambler to engage in the business of gambling are subject to the limitation on deducting “losses from wagering transactions” in § 165(d) of the Internal Revenue Code.
The memorandum points out that there have been two divergent tracks of court cases pertaining to whether a professional gambler can deduct expenses in excess of gambling wins. I think eventually we’ll see a court case, maybe even at the Supreme Court level, which will try to resolve the differences between these two highly differing opinions. For right now, deducting expenses in excess of wins is a use-at-your-own-peril strategy, since this memo is merely the opinion of one researcher at the IRS and plainly states: This advice may not be used or cited as precedent.
JEAN: There’s a common belief among many tax professionals that filing as a professional gambler will increase the possibility of an audit, although no firm statistics support it. It is known that owning your own business and dealing in large amounts of cash are two things that can increase your chances of being audited. And the IRS’ new emphasis on compliance and its plan to set up a new unit to deal exclusively with small businesses and the self-employed should certainly inspire professional gamblers to make sure they have very good records.
It’s easier to meet the standards we have been talking about if one is a full-time professional gambler with no other jobs or other sources of income. But how about the retiree who is collecting Social Security or a pension and plays live poker full-time? Or how about the person who plays video poker 40 hours a week and works another full-time job, too? These issues are not as clear.
MARISSA: There have been court cases where the taxpayer who works a full-time job and also gambles full time has been allowed to file as a professional gambler. Barrish v. Commissioner (1984) is one example.
Another interesting case is Castagnetta v. Commissioner (2006). Castagnetta was a part-time truck driver and claimed on his taxes to be a professional gambler. He kept detailed records and also did extensive research in his area of gambling (horse racing). The court used a variety of factors to determine if he was in the “business of gambling.” What won it for him was his methodical and business-like approach to the activity and the fact that he put in more than 40 hours a week on it. The drawback in this case is that this is only what’s called a “summary opinion,” so one cannot cite this case as precedent for other cases.
We have that same problem with the 2007 case of Linda M. Myers, also just a “summary opinion” (www.ustaxcourt.gov/InOpHistoric/myers.wpd.sum.WPD.pdf). Linda Myers convinced the Tax Court that she was in the business of gambling even though she ran a trucking business at the same time. They accepted that she conducted her gambling in a businesslike manner just as she did her trucking business, and that she had been gambling for 10 years and considered herself an expert. Although she had not shown a profit for the 3 years before and the year after the period in question, the court took into consideration that she had won many small jackpots and some large ones, as evidenced by her W2-Gs. This proved to them that there was the possibility she could have earned enough to cover her expenses. And they believed her when she testified that she actually did not enjoy gambling, that it was work and not for pleasure, thus discounting that the activity was just a “hobby.”
This was a surprising decision to me, because the case mentioned only “slots,” and it’s well known that slots are primarily a gambling activity that encompasses no skill factor. Perhaps Linda played video poker, where there is a huge skill factor. To a gambling expert, video poker is a separate category from reel or video slots, but the general public often lumps them all together as “slot machines.” If video poker had been involved, the decision would have made more sense, but there was no mention of skill in the summary opinion.
In contrast to the Linda Myers case, you might want to check out the case of Jose Calvao that same year (www.ustaxcourt.gov/InOpHistoric/calvao.TCM.WPD.pdf). Calvao used some of the same arguments as Myers. He “spent a substantial amount of time preparing for his trips to the casino and developed a strategy for his gambling.” He read many books on the subject and said he even bought a slot machine and studied how the cycles worked in his desire to win money in his “business.” However, although he said he kept daily records, he did not produce those records, merely submitting a summary record reconstructed at a later date. The court said this evidence was “unreliable,” because it was not “contemporaneously maintained.” This, and other factors, resulted in a final determination that Calvao was not engaged in the trade or business of gambling.
The bottom line: It may be possible for you to file as a professional gambler even if you don’t meet every standard. However, you’ll have to show that the profession of gambling is your primary one on as many levels as possible—time, earnings, expertise, etc. And then, if you are audited, you’re still at the mercy of a capricious tax department.
JEAN: On the flip side, despite the stringent requirements and some disadvantages, there are many advantages to filing as a self-employed professional gambler, advantages that are afforded to anyone who has a business.
1. Deduction of work-related expenses. This might include such items as travel, tips, office supplies and equipment, professional fees, study books, classes/seminars, mileage, and Internet and cell phone usage. IRS Publication 535, Business Expenses, is a good resource to learn what deductions are allowed and their limitations. (An important note here: Your losses plus your expenses may not exceed your winnings; see discussion on page 49.)
2. Earned income credit eligibility. You might qualify for additional money given to low wage earners in those years you have minimal net gaming winnings.
3. Self-employed health-insurance deductions. As a self-employed individual, you may deduct your own health-insurance premiums. If you’re married and hire your spouse as an employee, you can deduct your spouse’s premium and the premium for the whole family, if applicable.
4. Eligibility for Social Security and Medicare benefits. Self-employment taxes are an expense now, but could be considered a future plus for many as a way to finance part of their retirement.
5. Eligibility to set up a retirement plan to shelter income. You can choose a SEP or an IRA or a solo 401(k). In the latter, for 2012 you can shelter up to $50,000 a year ($55,500 if you’re over 50) and get a tax deduction that lowers AGI as well. (This figure is adjusted annually for inflation.)
MARISSA: One bright spot regarding filing as a professional gambler is that the IRS, in November 2002, issued a regulation stating that husband/wife partners in a business may be considered a “disregarded entity” in community-property states, such as California and Nevada. I believe this effectively allows husband/wife pros to offset their gambling wins/losses against each other. Therefore, spouses are no longer penalized if one is really lucky and the other one isn’t. The other community-property states are Arizona, Idaho, Louisiana, New Mexico, Texas, West Virginia, and Wisconsin.
JEAN: A warning. You may not always have a choice in how you file; you might be required to file as self-employed, utilizing forms 1040, Schedule C, and Schedule SE, if the IRS feels you fit into the category of professional gambler. This has caught up with a few gamblers who collected a large number of W-2Gs or who tried to switch back to filing as a recreational gambler after having filed as a business for one or more years.
MARISSA: And I have another warning. The IRS has a propensity to want to have it both ways. They’ve displayed this attitude when it comes to the issue of employee compensation within close corporations and they display this attitude when it comes to gamblers. If you have large losses and file as a professional, the IRS will try to classify you as a recreational gambler. Conversely, if you report a large net win, they’ll try to classify you as a professional gambler. That’s why it’s important to seek the advice and assistance of a tax professional, should you ever be contacted by the IRS about your filing status.