Some 22 years ago in a law review article, I addressed the irrationality of the current rules under Treas. Reg. 31-3402(q): "The Federal Income Tax Treatment Gambling: Fairness or Obsolete Moralism," 49 Tax Lawyer 1 (1995). A diligent search of Westlaw today indicates that this is still the only extant legal academic comment on the subject. In that article, I pointed out the issues that, thankfully, Treasury has apparently now recognized in its proposed revisions to the Regulations. My critique then, which is, if anything, even more valid today, as the menu of complex or "exotic" bets has expanded in the past two decades, was as follows:
"Under section 3402(q), certain gambling winnings are subject to withholding, generally at a rate of 28 percent. In general, those winning bets that attract withholding are those that pay more than $5000 where the amount of the winnings is at least 300 times the amount wagered. State conducted lottery proceeds of more than $5000 are subject to withholding regardless of the amount wagered, and proceeds from slot machines, bingo, and keno games are exempt from withholding. Since gambling is still largely a cash business, it is reasonable to impose withholding requirements on those who otherwise might forget to keep accurate records of their winnings. But the definitions incorporated in section 3402(q) were apparently drafted by someone who had not spent much time at the race track; they substantially overstate the amount of economic winnings, thereby leading to what a rational gambler would consider to be excessive withholding.
"If the gambler’s wager is a simple “straight” bet (e.g., $20 to win on horse number five), then the withholding definitions cause no problem. In the unlikely event that horse number five wins and pays 325 to 1, and our lucky gambler receives a total of $6,520, the statutory definitions result in $6,500 of “proceeds from a wager” and withholding of $1,820 (28 percent of $6,500).
"Suppose, however, that our gambler’s strategy is a little more complex. To take a relatively common example, suppose that, instead of making straight win, place, or show bets, our gambler wagers on the trifecta, in which one must pick the three horses finishing first, second, and third in order. In a race with ten entries, for example, there would be 7200 possible trifecta combinations. Suppose further, that through careful handicapping our gambler has identified three horses that should finish ahead of the rest, but worries that one of the three (the gambler does not know which one) might have an off day and not run well, and that, therefore, any of the rest of the entries might finish third. The gambler might well bet a trifecta ticket with these three top choices in the first position, with the same three in the second position, and with all ten entries in the third position. Such a ticket would cover 48 of the 7,200 possible combinations. If the gambler bets $2 on each of the 48 chosen combinations, the total amount bet on this single ticket would be $96. If the winning combination pays, for example, $6,000, then the gambler might sensibly conclude that the winnings should be exempt from withholding, because the $6,000 is nowhere near 300 times the $96 wagered. (It is, in fact, only 62.5 times the amount actually wagered.) This sensible interpretation would, however, be wrong. The Service takes the position that each bet on a specific combination of three horses is a separate wager, even if all the combinations are recorded on a single ticket. According to the Service, the bettor made 48 separate $2 bets, and the $6,000 payoff was therefore 3,000 times the amount bet.
"An even more unfair application of the single-wager rule from the gambler’s point of view would occur in a multiple-race wager, like the increasingly popular “Pick Six,” in which the gambler must choose the winners of six races in a row. The payoff for this type of bet is ordinarily several thousand dollars and may reach the hundreds of thousands. Assuming that each of 6 races has 8 entries, the number of possible winning combinations would be 262,144. Very few serious gamblers would bet only a single $2 combination; picking only one horse in each of the six races. It is common for bettors or syndicates to wager thousands of dollars, especially where no one has won the Pick Six for several days and there is a “carryover” of several hundred thousand dollars in the mutuel pool. In such circumstances, most bettors spread their bets over two, or even four to six horses in each race, sometimes putting all of them on one ticket, more often on a number of different betting tickets, with each $2 bet being on a different possible combination of winners. A bettor might be happy to win $10,000 for a $500 investment, representing odds of 19 to 1. But, from the Service’s perspective, such a result would be subject to withholding, even if the bettor had played all the combinations on a single ticket, because the total proceeds exceeded $5000 and the payoff on the one $2 combination that actually won would, in the Service’s view, be 4999 to 1, rather than 19 to 1. In contrast, if a bettor won the same $10,000 on a single win bet, wagering $500 on a single horse that went off at 19 to 1, no withholding would apply, because even the Service would recognize that the odds were less than 300 to 1.
"From the gambler’s point of view, it is difficult to appreciate the difference; in each case, the gambler has wagered the same amount, at what he or she presumably considers to be the same odds. Of course, differences in the odds are not necessarily meaningful. Even for win bets, the bettor does not know the odds that will actually be paid; these are determined by the ultimate size and distribution of bets in the parimutuel pool, and the bettor must rely on the information available at the time the bet is placed, which may not match the final distribution of the pool.
"Recently, knowledgeable handicappers have hit upon more profitable ways to play exotic wagers like the Pick Three and the Pick Six. Instead of playing all the possible winners of each race on the same ticket, they divide the wagers among many different tickets, thereby reducing the total cost of the bet. If a bettor plays, say, twenty different tickets, each of which has multiple Pick Six combinations, what is the amount wagered? From the bettor’s viewpoint, it is almost certainly the total amount bet on all the tickets on a given wagering opportunity (i.e., on that day’s Pick Six). From the Service’s point of view, at least with respect to the section 3402 withholding rules, it is not even the amount played on the winning ticket; it is still only the $2 bet on the single combination that happens to win.
"Given the nature of betting, the successful Pick Six player will be substantially over-withheld. Assume that our hypothetical gambler plays the Pick Six 100 times a year, wagering an average of $1,000 per day, for a total amount bet of $100,000. Assume further that he or she is spectacularly successful by race track standards and has winning tickets twenty times, paying $10,000 each, for total proceeds (including the amounts bet) of $200,000. Our gambler will have (ignoring everything else) taxable income of $100,000, which, applying 1994 rates under section 1(c), would result in federal income tax due of $26,522. Yet virtually the entire $200,000 in gross winnings (minus only the $40 representing the $2 winning combinations that were bet) would have been subject to twenty-eight percent federal withholding, resulting in a withholding of $56,000, or more than twice the tax that actually turned out to be due. Speculators in junk bonds and derivative securities are not required to make these sorts of loans to the government by way of excess withholding, and there seems to be no clear policy reason why gamblers should do so.
"The Service justifies its interpretation by reference to the legislative history of section 3402(q), citing the 1976 Senate Conference Committee report, which noted,
......The conference agreement also makes it clear that withholding applies to winnings net of the ticket price, taking into account all tickets for identical wagers. For example, if one $100 bet and two $50 bets are placed on a single horse to win a single racetrack event, any winnings from the three tickets should be added together and the ticket prices of all three tickets should be deducted to determine net winnings. However, if the bets are placed on different horses or on different events, the net winnings are to be determined separately for each ticket.
"In the Service’s view, “it is clear” from this statement that “a wagering transaction for purposes of the withholding taxes is one in which all wagers are identical, that is, all wagers are placed on the same animal (or team) to win the event.”
"In fact, the legislative history simply provides no guidance for the case in which multiple wagers are made on a single ticket or on multiple tickets, which in either case represents a gambler’s response to a single wagering opportunity. In Private Letter Ruling 8123015 the Service was apparently dealing with a case in which each separate combination was bet on a separate ticket, thus perhaps confusing the analysis. But there is no reason that the “ticket,” any more than the individual winning bet, should be the measure of the “wager” for withholding purposes. The proper measure, in economic terms, should be the gambler’s total bet on the wagering opportunity, taken as a whole, which might be all bets on a particular race, or, in the case of a multi-race wager, all bets on that combination wager.
"The original legislative history of the wagering withholding provisions, adopted in 1976, offers some rationale for using a more expansive definition of “amount of the wager” that would take into account the economic reality of the betting. One reason advanced in the congressional debates for exempting bingo, keno, and slot machines from the withholding provisions was that it is not possible to show a deduction for losses on returns or allow for offset of losses prior to withholding. Surely the same rationale applies to the hypothetical Pick Six bettor described above, at least to the extent that such a bettor could demonstrate, at the time the winning ticket is cashed, how much the bettor has spent on that entire ticket or on a series of consecutively numbered tickets.
"An alternative justification for the definition of “proceeds from a wager” in section 3402(q), although not reflected in the legislative history, is the administrative convenience of the payor of gambling proceeds. Under section 3402(q), the race track, for example, can rely on the post-time odds for a single bet to determine whether withholding will apply when the winning bettor presents a ticket for payment. If the economically more accurate approach just discussed were to apply, however, the track would have to calculate the applicable odds separately for each bettor, based on that bettor’s total wager on the event. The track would be responsible for verifying that the multiple tickets submitted by a winning bettor had in fact been purchased by him or her. While such reporting and withholding liabilities on the part of the track might be dealt with by regulations that established a safe harbor in respect of the track’s duty of inquiry, the increasing complexity and uncertainty of such an approach is more than a negligible cause for concern."
That critique is, if anything, even more valid today than it was in 1995, for at least two reasons. First, the gambling menu at race tracks has expanded in the past two decades to include Pick Four, Pick Five, and "superfecta" (picking the first four horses in a race, in order) bets, all of which typically employ the multiple-bet strategy that I described in my article with respect to trifectas and Pick Six wagers. Second, the vast majority of horse race wagering is now carried out by way of online accounts, which provide an easy-to-follow paper (or computer) trail for calculating a bettor's total investment in a given wagering opportunity, easing the race tracks' administrative burden described in my article.
The Proposed Regulations are a welcome, if overdue, corrective. They adopt the reasoning that I proposed back in 1995, considering a bettor's total wager rather than breaking that wager up into a series of hypothetical discrete bets, no one of which a rationale bettor would have made in isolation. The Proposed Regulations reflect the economic reality of parimutuel betting in its current form and ease the chilling economic effect of massive over-withholding, as occurs under the current rules.Their adoption would be a good start toward fairness.