Two posts back, I discussed the Internal Revenue Code section that limits any deduction
for gambling losses to the amount of gambling winnings. In other words, if a
bettor has a bad year and ends up with a net loss, that loss cannot be applied
against other income, such as a salary or a consulting fee, to reduce total
taxable income. But, even with that limitation, it’s better if the IRS says
you’re in the “trade or business” of gambling, as opposed to gambling as a
hobby or recreation. Here’s why.
Someone who’s in a trade or business can deduct all
the “ordinary and necessary” expenses of that business. For a horse-race
bettor, that would include the cost of past performances (yes, you, Daily
Racing Form, with your $9 tabloids!), handicapping software and advice, travel
to the track, as long as it’s not a daily commute, track admission and parking,
internet service provider costs for those who bet online, some of the cost of
meals while at the track, and even, in a couple of cases, ATM fees at the track.
No, you can’t deduct net gambling losses, but these other expenses are still
valuable as deductions.
Even more important – and here I have to get a
little wonkish – being in a trade or business lets you take your deductions on
a Schedule C, for sole-proprietorships, instead of on a Schedule A, for
personal deductions. Here’s why that’s important.
First, when gambling income is listed on the Form
1040, and then gambling expenses and losses (the latter only up to the amount
of winnings) are taken as personal deductions, that has the effect of
increasing a taxpayer’s gross income. That, in turn, means that the Internal
Revenue Code’s limits on personal deductions are also increased. Some
deductions disappear entirely for taxpayers with high gross incomes, and some,
like those for “miscellaneous business expenses” (those Racing Forms again) and
medical expenses, must exceed a certain fraction of the taxpayer’s gross income
to qualify. So, the higher the gross income, the higher the threshold before
those expenses can be deducted.
Second, even apart from the increase in gross
income, having to report expenses as personal, on a Schedule A, has its own
drawbacks. Under current law, those miscellaneous deductions are allowable only
to the extent that they are more than 2% of gross income. So, for a taxpayer
with $100,000 in gross income, that means the first $2,000 of expenses are
non-deductible.
In contrast, if someone is in the trade or business
of gambling, then all this income and all these deductions go into the Schedule
C business form. Instead of having to take the wagering losses and the expenses
as personal deductions, they get subtracted from the wagering income right on
the Schedule C, and only the bottom line of the Schedule moves over as income
or loss onto the Form 1040. No
limitation on deductions, no artificial increase in gross income.
So, how do you get to be a professional, in the
“trade or business” of gambling? The answer is in Internal Revenue Code Section
183 and the Regulations and court cases that have interpreted it.
Section 183 distinguishes between activities
engaged in for profit, on the one hand, and all other activities. If an
activity is not engaged in for profit, then the only allowable deductions are
(1) deductions that would be allowable without regard to trade or business
status (e.g., certain state and local taxes or interest); and (2)
business-related deductions incurred in the activity, including a professional
gambler's wagering losses and incidental expenses, but only to the extent of
any taxable income that remains after subtracting the first category of
generally allowable deductions. So, if you’re not a professional gambler, you
can never have a net loss from gambling that reduces your tax bill from
non-gambling activity.
Section 183 also establishes a presumption that an
activity is engaged in for profit if gross income from the activity exceeds the
deductions attributable to it in at least three of the most recent five taxable
years. It’s only a presumption, though. The IRS can still argue that your
gambling is just a hobby, even if you show that three-out-of-five-year profit.
The Treasury Regulations spell out the factors that
matter in deciding if you’re in a trade or business. You don’t need a perfect
six out of six, but most people who win their cases have at least a majority of
the factors on their side.
First,
the manner in which the taxpayer carries on the activity, in particular whether
he or she carries it on in a businesslike way and maintains complete and
accurate books and records. On this criterion, the casual gambler,
going to the track or the casino every few weeks and not maintaining regular ledgers,
would appear to fall in the hobby/recreation category, while those (relatively
few) gamblers who maintain detailed and complete records would be seen as
reasonably seeking a profit.
Second,
the expertise of the taxpayer (or of the taxpayer's advisers). On this
criterion, the gambler who has read all of Andy Beyer or who
has served a faithful apprenticeship to an acknowledged expert in the field –
think Andy Serling sitting in Steve Crist’s box at Belmont all those years -- is
more likely to be seen as engaging in the activity for profit. Buying a tip
sheet on your way into the track might not qualify. Interestingly, the Tax
Court has treated a taxpayer’s development of a “system” for beating slot
machines as evidence of expertise. I guess the Tax Court judges themselves are
a bit lacking in such expertise.
Third,
the amount of time and effort the taxpayer spends on the activity. Unless,
according to the regulations, if the time and activity has substantial personal
or recreational aspects. In other words, the more fun one is having, the less
likely the IRS is to view the activity as engaged in for profit. The more you
hate going to the track, the more likely you are to be a professional.
Fourth, the
presumption that an activity is carried on for profit if it actually shows a
profit in three of five years. Aha! You think, I can show a
$100 profit in each of three years and a $10,000 loss in each of the other two.
Nope. The relative size of the profits and losses is also relevant. A
presumption is just that, a presumption.
Fifth,
the financial status of the taxpayer. Do you really look to gambling
to pay the rent and buy groceries? The wealthy industrialist or actor, for
example, who gambles heavily, might not be seen to be engaging in gambling for
profit, but the working-class retiree, whose only other source of income is a
Social Security check, might have a stronger case.
Sixth and
last, whether the activity contains elements of personal pleasure or
recreation. This raises some generally troubling issues; most
people, presumably, would prefer to work in occupations that gave them some
personal satisfaction. To say that achieving such a goal puts the tax
deductibility of legitimate expenses in jeopardy seems perverse.
No one of these factors is decisive. In each case
the IRS and the courts weigh them all and reach a decision.
There has been a flurry of court cases in the past
decade involving gamblers who seek to be classified as being in the trade or
business. There have been several cases where the IRS agreed that the taxpayer
was a professional gambler, others in which the Tax Court rejected the
gambler’s claims, and a few where the Tax Court overruled the initial IRS determination
and found the taxpayer actually was in a trade or business, most recently, in
February of this year, in the case of a poker player who succeeded in deducting
travel expenses for his trips to Las Vegas and Atlantic City casinos by showing
the court that he played tournaments most weeks in the year.
But the general trend of the cases is against us.
Relatively few gamblers approach their task with the single-mindedness of
purpose necessary to escape the limitations described above. Those that do win in
court typically spend at least 40 hours a week gambling. Thus, most losing
gamblers would still not be able to deduct losses and expenses in excess of
their winnings.
Next, the
importance of keeping good records.
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