This is the second in a series of blog posts about the
tax treatment of gambling. The first post applauded the decision by the
Treasury Department to propose revised withholding regulations that adversely
affected bettors who made big scores on exotic wagers. This one looks at the
deductibility of gambling losses and of gambling-related expenses, like buying
the Daily Racing Form. Future posts will examine the constitutionality of
treating gambling differently from other kinds of economic activity, the application
of the “hobby loss” rules to gambling, and the difficulties involved in fairly
determining gambling gains and losses. Eventually, it may all end up in a law
review article, the first such critical survey of gambling taxation since I
originally tackled the subject back in 1995.
Deductions are
something every taxpayer wants to have. Every allowable $100 deduction reduces
the taxpayer’s tax bill by a substantial fraction of that $100, depending on
the taxpayer’s marginal tax rate (that is, the rate she pays, under our
somewhat graduated tax system, on her last dollar of income). Because the tax rate
table is graduated, a deduction is worth more – lots more – to a rich person
than to a poor one. Those with incomes under $9,325 in 2017 will get only a $10
benefit from that $100 deduction, since their marginal rate is 10%, while those
with incomes over $418,400 will get a benefit of $39.60.
Deductions are allowable for gambling losses, but not to the
extent that one would think, given the broad language in Internal Revenue Code
Sec. 165(a). That section allows a deduction for any losses incurred in a
transaction entered into for profit, even if that transaction is not part of a
trade or business. Thus, in the absence of a specific statutory limitation, one
could reasonably presume that all gambling losses, or at least those that were
the result of profit-oriented transactions, and not mere self-indulgent
consumption, would be
deductible against income from other sources, like a salary for the gambler’s
day job or, to match horse racing’s demographic, a taxable pension. But that
reasonable presumption is denied by Code section 165(d), which provides, in its
entirety, that “losses from wagering transactions shall be allowed
only to the extent of the gains from such transactions.”
This limitation, as it has been elaborated by the courts in the
nearly a century since its initial enactment, imposes a burden on gamblers that
is not borne by other similarly situated taxpayers. Traders in commodity
futures, or even in stock options, for example, don’t face the same limitation
on losses; if they lose money in a year on their “trading” activities, which
are economically nothing more than placing bets, they can fully deduct those
losses against other kinds of income, like a bonus from their employer. But a
full-time horseplayer who has a losing year at the track can’t do the same.
A more equitable approach would be for Congress to repeal section
165(d) and to rely on other generally applicable Tax Code
provisions to protect the Treasury against over-reaching by gamblers, in the
same way that the “at risk” and “hobby loss” provisions of the Code (to be
discussed in future posts) generally act to limit the deductibility of expenses
and losses.
Before the enactment in 1934 of what is now section 165(d), the
principal distinctions regarding deductibility of gambling losses (whether
against gambling winnings or against other income) were whether the losses had
been incurred in legal or illegal gambling and whether gambling transactions
had been entered into for profit. For example, an early Bureau of Internal
Revenue (the predecessor of the IRS) ruling took the position that
losses incurred in betting on horse races in Arkansas, where such wagers were
then illegal, were nondeductible, while wagers across the state line in
Louisiana, where they were legal, could give rise to deductible losses.
Under that early case
law, even those losses incurred in legal gambling were deductible only if the
taxpayer could show that the gambling transactions were entered into for
profit. Thus, an
independently wealthy taxpayer, with a steady record of losses at fashionable
resort casinos in Europe, was found to lack the requisite profit motive,
although his gambling was legal, because his real motive,
at least the way the court saw it, was “the thrill and exhilaration . . . inherent in taking a chance.” In
contrast, a poorly paid journalist, who lost money at the racetrack while covering
the races, was permitted a deduction, based on his testimony that he did not
much enjoy watching the races and bet only in order to make money. Even then, apparently, the
ink-stained wretches in the press box couldn’t resist a trip to the window.
Congress originally enacted what is now section 165(d) in 1934. That original version of
the statute left open the question of whether the limits on deducting losses
applied to all gamblers or only to casual gamblers (i.e., those for whom
gambling is an occasional recreation and who are not in the trade or business
of gambling). As we’ll see shortly, the courts have applied the rule to all
gamblers, though only professionals can deduct expenses.
That left it up to
the courts to decide, based on how they interpreted the statute. They did so
very restrictively, refusing to allow anyone, including a fulltime gambler, to
deduct gambling losses against anything other than gambling winnings. This
restrictive interpretation appears to have been based on the courts’ view that
gamblers were inherently immoral. For example, the Court of Claims
described gamblers in the following terms:
In practically all countries, a distinction
has been made in the public mind and in legislative enactment between the
occasional wagerer and the professional who undertakes, without work, to wring
a living from the wages of others. The professional or common gambler has never
occupied a high position in society. . . . The churches have generally opposed
gambling as immoral. The Talmud classes gambling winnings with thievery.
That Talmudic reference
might be news to some of the most renowned figures in horse race betting, from
Arnold Rothstein to Steve Davidowitz, Len Ragozin, Len Friedman and many other successful
Jewish bettors.
On the basis of this
moral disapproval of gambling, any interpretation of the new statute that would
apply the gambling-loss limitation only to the occasional recreational wagerer
and not to the parasitic, thieving, professional gambler bookmaker was
foreordained to fail.
In 1947, in Humphrey v.
Commissioner, the first significant appellate court interpretation of the
new limitation, the Court of Appeals for the Fifth Circuit held that the 1934
legislation had eliminated the distinction between legal and illegal gambling
to the extent that a gambler did not have to show a profit motive to be eligible to deduct gambling losses up to the
amount of gambling winnings.
But by holding that what is now section 165(d) was the exclusive provision for
treating gambling losses, the court also treated professional gamblers, whether
in the bookmaking business or gambling full-time for their own accounts,
differently from most other taxpayers, who are generally able to
use losses incurred in one activity to offset income from another activity.
In addition, the courts on occasion confused the gambler’s
ordinary business expenses with wagering losses, refusing to permit gamblers to
deduct not just their losing bets, but also the reasonable expenses incurred in
order to place those bets, like purchasing the Daily Racing Form or paying admission to the track, from anything
other than their winnings. Fortunately, for the full-time bettor at least, that
interpretation was just recently rejected by the Tax Court, in the 2011 case of
Mayo v. Commissioner. There, the
taxpayer made $131,000 in bets, cashed tickets for $120,000, and tried to
deduct both the $11,000 wagering loss and his additional $11,000 in expenses,
including $4,000 for vehicle and transportation costs, $1,960 for handicapping
data (this data should be free if we want to grow racing!), $1,251 for track
admission fees, $1,056 for subscriptions, $670 for telephone and internet
charges and, perhaps in a bit of chutzpah, $148 in ATM fees at the track. The
court said that Section 165(d) prohibited the deduction from other income of the
actual betting losses, but allowed the expenses, which had the effect of wiping
out any tax attributable to the wagering. Some small consolation, if not a
total victory.
One might, in analyzing gamblers, distinguish among three types:
(1) those for whom gambling is clearly central to their trade or business – for
example, “shills” hired by poker rooms to create the illusion of activity and to
attract real, paying customers; (2) those who gamble with a sincere and genuine
profit motive (whether, in fact, they win or lose in a particular time period);
and (3) those for whom gambling is primarily recreational, although most people
would probably prefer to win rather than lose. The application of section 165(d),
however, recognizes no difference among these three categories. As a result, in
many cases, the section 165(d) limitation operates unfairly. While some courts
have expressed uneasiness at the strict application of the wagering-loss
limitation, they have
generally followed the advice of Justice Brandeis that “ it is usually more
important that a rule of law be settled, than that it be settled right.” The broad reach of the
gambling loss deduction, as the courts have interpreted it, may be a settled
rule, but it is almost certainly wrong.
A possible justification for such a broad reach for section 165(d)
might be that the statute, at least when read together with section 162(a), is
ambiguous and that, in the light of such ambiguity, courts are justified in
interpreting the statute in a manner consistent with an underlying legislative
policy that gambling, as a supposedly unproductive activity, should not be
accorded the slightest degree of favorable tax treatment. There are, however,
two problems with such an approach. First, the legislative history is somewhat
lacking in evidence that Congress has ever made such an explicit judgment.
Second, the presumed dichotomy between the economic and social utility of the
financial markets on the one hand and the unproductive nature of gambling remains
to be proven. In fact, if you’re looking for economic impact, horse racing, supported
by gambling, employs many more people per dollar than does Wall Street. And, as
US Attorney Preet Bharara’s investigations have proved, there are probably more
thieves per capita on Wall Street than on the backstretch.
In a
parallel universe, tax reform might well include the repeal of Section 165(d),
putting professional bettors on a par with professional pork-belly traders. In
the actual universe we live in right now, I’m happy to lay you 100-1 that
Section 165(d) and its discrimination against full-time handicappers is still
in place when we’re all dead.
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