Gambling Taxation - Part 3 - But Isn't That Unconstitutional?

In my previous post, I discussed the limitation imposed by Internal Revenue Code Section 165(d), which prohibits gamblers from using losses that exceed their winnings to offset other income. Today’s post asks whether that limitation is a violation of the US Constitution’s equal protection guarantee. I’m not the first to raise that issue, and the courts have, so far, sided with the IRS and against the taxpayers who have raised it. But, in the interest perhaps of saving some folks unnecessary legal fees, here’s my analysis of the issues.

Federal tax law treats gamblers differently from other categories of taxpayers. On rare occasions, gamblers have used the fact of this different treatment to claim that their Constitutional rights have been violated. In the 1994 Tax Court case, Valenti v. Commissioner, and in the 2014 case of Lakhani v. Commissioner, the taxpayers, both “professional” horse race bettors, asserted that such differential treatment amounts to a denial of equal protection or due process. The starting point for their – ultimately unsuccessful – argument is the 14^th Amendment to the US Constitution, which provides that:

. . . . Nor shall any State . . . deprive any person within its jurisdiction of the equal protection of the laws.

While the Equal Protection Clause, in its own terms, does not apply directly to the federal government, the Supreme Court has held that the Due Process Clause of the Fifth Amendment imposes a similar equal protection obligation on the federal government. Thus it is at least theoretically possible that a federal tax statute may be so discriminatory as to violate the equal protection-due process requirement. To take an example that is no longer as far-fetched as we might have thought, a tax that applied only to Muslims would not only violate the 1^st Amendment’s guarantee of religious freedom but would also be a denial of equal protection.

In the case of Code Section 165(d), which disallows any deduction of net gambling losses, the taxpayers’ argument was that the law singles out gamblers and treats them unequally compared, say, to commodities futures traders or the issuers of credit default swaps, both of which are essentially bets.

Well-established equal protection doctrine, however, made it unlikely that a challenge to tax statutes singling out gambling would succeed. Unless a higher level of judicial scrutiny is mandated because the government action creates a suspect classification (like race, for example) or impinges on a fundamental right or interest (like free speech or religion), in which case a “strict scrutiny” standard is applied, all that is required to sustain a statute or administrative action against an equal protection attack is for the court to find a rational basis, that is, any possible logical relationship between the governmental action and any permissible governmental objective. As the Supreme Court said in a 1953 case:

The general rule is that legislation is presumed to be valid and will be sustained if the classification drawn by the statute is rationally related to a legitimate state interest. When social or economic legislation is at issue, the Equal Protection Clause allows the states wide latitude, and the Constitution presumes that even improvident decisions will be rectified by the democratic processes.

  

More specifically, in a 1992 case, the Supreme Court upheld a California initiative provision that reassessed residential property only upon sale, with the result that more recent buyers paid substantially higher taxes than long-term residents. The Court said:

In general, the Equal Protection Clause is satisfied so long as there is a plausible policy reason for the classification, the legislative facts on which the classification is apparently based rationally may have been considered true by the governmental decision maker, and the relationship of the classification to its goal is not so attenuated as to render the distinction arbitrary or irrational. This standard is especially deferential in the context of the classifications made by complex tax laws.

Even under this very deferential rational-basis standard, a few tax laws and administrative procedures have been held so irrational as to violate the Equal Protection Clause. For example, in 1985 the Supreme Court invalidated three state tax laws: (1) an Alabama statute imposing higher taxes on out-of-state insurance companies than on those based in the state; (2) a Vermont statute imposing automobile use taxes only on those cars registered in Vermont by persons who had been nonresidents at the time of the automobile purchase, but not on those bought by Vermonters; and (3) a New Mexico property tax exemption that applied only to certain veterans who moved into the state before a particular cut-off date.

The relatively few Supreme Court federal tax cases that have addressed equal protection issues have uniformly upheld the Code and its application by the Internal Revenue Service. For example, lower federal courts have denied equal-protection challenges to the differential rate structures for married and single taxpayers. The Supreme Court had always refused to hear appeals from these decisions until its landmark decision of LGBT rights in its 2013 decision in U.S. v. Windsor. In that case, the Court held that a validly married same-sex couple was entitled to the same benefits under the estate tax laws as a heterosexual couple. But that case involved gender – a suspect classification – and the right to marry – a fundamental right. The right to bet on horse races probably doesn’t rise to the same level of Constitutional protection.

Horse race bettors, as noted above, have raised the equal protection argument, twice, in 1994 and in 2014, each time with the same result, upholding Section 165(d)’s denial of net losses. In the 1994 case, Valenti, the Tax Court concluded, without much analysis, that Congress could have had a “rational basis” for treating gambling differently from other businesses. The 2014 Lakhani case added a specific rationale that might have been what Congress had in mind back in 1934 (if, indeed, Congress can ever be said to have anything in mind), namely, that the limitation on losses was really a device to ensure that gamblers reported their winnings.

So, if you think discriminating against gamblers in the tax laws is unconstitutional, my advice is: get over it. The courts have been there and done that, and there’s essentially zero likelihood that the established rule will change. Yes, it is true that horse race bettors and other gamblers are treated unequally with, say, commodities traders or other “investors” in zero-sum financial market bets. But, short of having someone in Congress like Joe Bruno, New York’s former State Senator (R-Horse Racing) to push our interests, there’s not much we can do about it.

So, what can we do, given that the loss-deduction rule isn’t going to change any time soon? For a start, those of us who are serious bettors can do whatever it takes to ensure that we’re in the “trade or business” of gambling, so at least we can deduct expenses, like our purchases of the obscenely overpriced Daily Racing Form. That’s the subject of the next couple of blog posts on taxation, which will appear after a brief intermission for the OBS two-year-old sale this week.