Recently, professional gamblers’ luck prevailed as the Tax Court changed directions on the deductibility of nonwagering business expenses. The Tax Court in Mayo (136 T.C. 81 (2011)) partially overruled its precedent, Offutt (16 T.C. 1214 (1951)).
Offutt allowed the deduction of wagering losses only to the extent of winnings and included professional gamblers’ nonwagering business expenses in the definition of losses. The Mayo court, contrary to Offutt and subsequent cases, allowed a professional gambler to deduct ordinary and necessary business expenses under Sec. 162(a), potentially in excess of gross receipts from gambling as a trade or business. In doing so, the court noted it was following recent IRS policy on the issue outlined in a 2009 IRS legal memorandum. Furthermore, in December 2011, the IRS acquiesced to the court’s holding and analysis (Action on Decision 2011-06).
PROFESSIONAL VS. CASUAL GAMBLERS
Historically, gamblers have had difficulty establishing themselves as members of a profession engaged in a trade or business of gambling. Most people gamble for pleasure. Some do so for profit, but those taxpayers historically have had problems defining their occupation. The Supreme Court in Groetzinger (480 U.S. 23 (1987)) said a gambling activity could be considered a trade or business if it is pursued full time, in good faith and with regularity, to make income for a living, and not merely as a hobby. Along the same lines, Sec. 183 denies deductions beyond income derived from any activity that is not a trade or business engaged in for profit—in other words, without a profit motive.
Naturally, the deductibility of a gambler’s costs depends on the tax status of the gambler as either a casual or professional gambler. A casual gambler can deduct gambling losses on Form 1040, Schedule A, Itemized Deductions, but only to the extent of winnings and cannot deduct associated expenses, which are nondeductible under Sec. 262 (AM 2008-013).
A professional gambler, on the other hand, who is engaged in the trade or business of gambling, is allowed to offset losses and expenses of gambling against income from it on Schedule C, Profit or Loss From Business (Sole Proprietorship). Among the requirements for being considered a professional gambler engaged in gambling as a trade or business, the profit motive requirement may easily cause a dispute with the IRS. To determine whether a profit motive exists, all facts and circumstances with respect to an activity should be taken into account. Regs. Sec. 1.183-2(b) provides nine factors:
1. The manner in which the taxpayer carries on the activity. If the taxpayer conducts gambling activities in a businesslike manner, such as maintaining complete books and records, this factor favors finding a profit motive.
2. The expertise of the taxpayer or his or her advisers. Preparing for gambling activities by extensive study and consulting with experts may indicate that the taxpayer has a profit objective.
3. The time and effort expended by the taxpayer in carrying on the activity. A taxpayer who devotes much time and effort to conducting gambling activities may thereby show an intention to make a profit.
4. The expectation that assets used in the activity may appreciate in value. This factor might not be applicable to gambling activities, since the assets involved usually are cash.
5. The success of the taxpayer in carrying on other activities. A taxpayer’s success in converting other nongambling business activities from unprofitable to profitable may indicate a profit motive for the gambling.
6. The taxpayer’s history of income or losses with respect to the activity. A history of substantial gambling losses may indicate that the taxpayer did not conduct the gambling activities for profit.
7. The amount of any occasional profits. A few large wins, however, can indicate a profit motive despite more routine losses of lesser amounts.
8. The taxpayer’s financial status. If a taxpayer does not have substantial income from nongambling activities, it may indicate that the taxpayer engages in gambling for profit.
9. The presence of elements of personal pleasure or recreation. Since gambling at a casino is commonly understood to be an amusement, a taxpayer has to show there is no pleasure in gambling (for example, no friends or family members accompanied the taxpayer).
This is a nonexclusive list, and none of these factors is determinative. The Tax Court in Chow (T.C. Memo. 2010-48) and Myers (T.C. Summ. 2007-194, discussed in “Tax Matters: A Hard Night at the Casino,” JofA, March 2008, page 69) applied these factors in deciding whether taxpayers were professional or casual gamblers.
WAGERING GAINS AND LOSSES
Although Sec. 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business, Sec. 165(d) specifies that deductible losses from wagering transactions are limited to the gains from such transactions. In the past six decades, the Tax Court has generally followed the Offutt rule, under which courts have applied Sec. 165(d) to limit the deductibility of professional gamblers’ trade or business expenses.
In Offutt, the petitioner’s principal occupation and source of income was bookmaking and betting on horse races. He sought to claim and carry back a net loss from these activities against other income, arguing that, because gambling was his regular business, he should be treated differently from a taxpayer who undertook such activities for profit but only sporadically. The Tax Court noted that the predecessor statute to Sec. 165(d) (which contained identical language) made no such distinction and ruled against the taxpayer.
In practice, courts tended to interpret “wagering gains” as limited to “wagering winnings” but “wagering losses” as including nonwagering business expenses and limited to wagering gains. Nonwagering gains (for example, “take-offs,” or table fees paid by gamblers to a casino and sometimes passed along from the casino to an employee, who may also gamble) could not be used to offset wagering losses. Besides takeoffs, professional gamblers’ income sources not directly from their own wagering activities may include “tokes” (tips to casino dealers, sometimes in the form of bets placed by gamblers for their benefit) and “comps” (complimentary goods and services a casino provides gamblers). Courts have also addressed treatment of these income sources.
Take-offs. The taxpayer in Boyd (762 F.2d 1369 (9th Cir. 1985)) was a professional gambler managing a poker room in a casino. Under the contract with the casino, he participated in poker games with his own money to stimulate play. The casino gave him a portion of the take-offs as compensation. The IRS and the courts rejected Boyd’s attempt to offset his wagering losses against his take-off income. The Ninth Circuit noted that, because a takeoff is a fee, it is not gain from wagers entered into by the casino or the taxpayer. Therefore, Boyd was not allowed to offset wagering losses against his contractual share of the take-offs. The take-offs received by the taxpayer should be treated as ordinary income, the court said.
Tokes. The Tax Court in Bevers (26 T.C. 1218 (1956)) held that wagering tokes received by a dealer were gains from his labor as a dealer, not from wagering transactions. The court said that, if the taxpayer had been merely an observer and taken no active part in the games, he would not have received the tokes. Therefore, tokes are compensation for the recipient’s services and should be treated as ordinary income. Likewise, the Fifth Circuit in Allen (976 F.2d 975 (5th Cir. 1992)) concluded that a dealer receiving a wagering toke has not entered into a wagering transaction, since the dealer has no part in deciding to make the wager and stands to lose nothing from it.
Interestingly, a federal district court reached a different conclusion, although it was reversed on appeal (Olk, 388 F. Supp. 1108 (D. Nev. 1975), rev’d, 536 F.2d 876 (9th Cir. 1976)). The taxpayer in Olk was employed as a casino craps dealer. Dealers were forbidden to engage in unnecessary conversation with casino patrons and were required to treat all patrons equally. At the end of each shift, dealers divided their tokes evenly among them. Occasionally, players could give money to the dealers or place bets for them. The district court in Olk found that wagering tokes given to dealers were not incidents of their services, since the dealers functioned in an almost machinelike manner, making such tokes different from traditional tips for personal services. As a result, the court held that such tokes were nontaxable gifts. In reversing, the Ninth Circuit reasoned that the regularity, equal division and daily receipts of the tokes indicated that a reasonable dealer would view such receipts as a form of compensation for his or her services.
Comps. An exception to the narrow interpretation of wagering gains is comps. The taxpayer in Libutti (T.C. Memo. 1996-108) was allowed to include comps as a part of his wagering gains against which he could deduct his gambling losses. The Tax Court held that the comps were the taxpayer’s gains from wagering transactions because “winnings” is not the only meaning for the word “gains” in Sec. 165(d). Further, the court found that, although the taxpayer’s receipt of the comps was not directly related to the success or failure of his wagers, he received the comps incident to his direct participation in wagering transactions. Therefore, the relationship between the taxpayer’s comps and his wagering was “close, direct, evident, and strong,” such that the comps were sufficiently related to his gambling losses for the purposes of Sec. 165(d).
THE MAYO HOLDING AND ILLUSTRATIONS
Although the Tax Court in Mayo followed Offutt to limit allowable losses from wagering transactions to the extent of gains from such transactions, it held that it will no longer follow Offutt with respect to nonwagering expenses, for the following reasons: First, the Offutt court provided no reason to support its conclusion that “losses from wagering transactions” under Sec. 165(d) should include both the cost of losing wagers and business expenses incurred in gambling activities. Second, there is no support in Sec. 165(d) for applying it differently with respect to wagering losses versus gains. Third, the Ninth Circuit in Boyd distinguished wagering losses from expenses incidental to gambling, indicating that the nonwagering expenses would not necessarily be subject to Sec. 165(d). Last, the IRS in recent years has conceded the deductibility of professional gamblers’ business expenses in several cases (see, e.g., Crawford, T.C. Memo. 2010-54, and Tschetschot, T.C. Memo. 2007-38) and said in a chief counsel memorandum (AM 2008-013) that the Offutt rule would no longer be followed on this point.
The Tax Court’s holding in Mayo and the IRS’ acquiescence to it do not change the precedential perspectives on wagering gains. Rather, they merely confine the broad interpretations of “wagering losses” and make professional gamblers’ business expenses beyond wagering gains deductible. Based on examples in the chief counsel memorandum, different nonwagering gain items illustrate the Mayo rule in the following scenarios. Assume all of the gamblers in the scenarios qualify as professional gamblers and that they have no income other than that specified in the scenario.
Scenario 1. Andes worked in a casino as a card room manager and participated in poker games with his own money. In a tax year, Andes had total wagering gains of $100,000 and total wagering losses of $75,000 and incurred $15,000 in gambling-related business expenses for transportation, the deductible portion of meals, and table fees. Also, Andes received from the casino his contractual share of take-offs, $2,000. Andes had wagering net income of $25,000 (wagering gains of $100,000, minus wagering losses of $75,000). Andes may deduct business expenses of $15,000, resulting in net business income of $10,000. In addition, Andes should report the $2,000 in take-offs as ordinary income. Andes’ taxable income is $12,000.
Scenario 2. Cher worked in a casino as a dealer and also gambled there during her spare time. Cher had total wagering gains of $75,000 and total wagering losses of $100,000 and incurred $15,000 in gambling-related business expenses for transportation, the deductible portion of meals, and data fees. Also, Cher received tokes of $2,000 while working as a dealer. Cher could use her wagering losses to offset wagering gains up to $75,000. Her business expenses of $15,000 result in a business net loss of $15,000. Additionally, Cher should report ordinary income of $2,000 from tokes.
Scenario 3. Dennis traveled to various casinos and participated in poker tournaments. Dennis had total wagering winnings of $75,000 and total wagering losses of $100,000. He incurred $15,000 in gambling-related business expenses for transportation, the deductible portion of meals, and lodging. The casinos also provided Dennis comps worth $2,000. Dennis could use his wagering losses to offset his wagering winnings of $75,000 and comps of $2,000. His business expenses of $15,000 result in a business loss of $15,000. Consequently, Dennis has a loss of $15,000 from gambling activities.
Under the holding in Mayo and the IRS’ acquiescence to it, professional gamblers are allowed to fully deduct their nonwagering business expenses beyond wagering gains. Nonwagering business expenses may include transportation, meals and entertainment, admission, subscriptions and other fees. In addition, if nonwagering expenses exceed wagering gains and other income, they may give rise to a net operating loss that may be carried back to previous-year returns or carried forward to future-year returns. Professional gamblers still must substantiate the amount and the business purpose of the expenses to secure their deductibility (Presley, T.C. Memo. 1979-339).
The IRS acquiesced to the Tax Court’s recent holding that a professional gambler in the trade or business of gambling could deduct nonwagering expenses in excess of gambling winnings under Sec. 162(a).
Historically, such costs in excess of gambling winnings have been disallowed under Sec. 165(d) and previous Tax Court precedent. Now, however, such deductions may offset other income and even result in a net operating loss that may be carried back or forward to other tax years.
To be considered a professional gambler, taxpayers generally must demonstrate to the satisfaction of the IRS that they are engaged in gambling as a trade or business rather than casually. The IRS and courts apply nine factors in regulations under Sec. 183, as well as all relevant facts and circumstances, in making the determination.
Nonwagering business expenses may include transportation, meals and entertainment, admission, subscriptions and other fees. Wagering gains include wagering winnings and “comps” (the fair market value of complimentary goods and services) but not additional income to casino personnel in the form of “take-offs” and “tokes,” which are likely to be considered compensation or other, nonwagering income.
Wei-Chih Chiang (firstname.lastname@example.org) and Randy Reed (email@example.com) are assistant professors of accounting at the University of Houston–Victoria in Victoria, Texas.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
“Tax Matters: A Hard Night at the Casino,” March 2008, page 69
2011 Tax Practice Guides & Checklists (#PTX1203D, on-demand)
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.
AICPA’s 1040 Tax Return Workshop by Sid Kess (#IITW)
AICPA’s 2011 Individual Tax Review Series: Beyond the Basics (#TRBB)
AICPA’s Annual Federal Tax Update (#PTU)
AICPA’s Hottest Tax Topics for 2011 (#HOT)
To access courses, go to aicpalearning.org/on-site, then search for courses by “Alphabetical Index” or “Acronym Index.” For assistance, contact a training representative at 800-634-6780 (option 1).
The Tax Adviser and Tax Section
The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.
More from the JofA:
Find us on Facebook | Follow us on Twitter | View JofA videos