Thursday, June 30, 2011


GAMBLING EXPENSES
PROFESSIONAL GAMBLERS ALLOWED FULL DEDUCTIBILITY OF BUSINESS EXPENSES
The Tax Court has used the ordinary meaning of the words used in Section 165(d) to resolve the issue of the deductibility of professional gamblers' business expenses.
Author: WEI-CHIH CHIANG AND KAREN PIERCE
WEI-CHIH CHIANG, D.B.A., is an assistant professor in the School of Business Administration at the University of Houston-Victoria in Victoria, Texas. KAREN PIERCE, D.B.A., is an assistant professor at the School of Business Administration at Morehead State University in Morehead, Kentucky.
The deductibility of professional gamblers' business expenses has been a controversial issue for decades. The debate involves the interpretations of Sections 162(a) and 165(d) . Section 162(a) generally allows a deduction for “all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.” However, Section 165(d) allows “losses from wagering transactions” only to the extent of the gains from such transactions. Since the Tax Court in Offutt 1 held that a taxpayer's gambling losses cannot offset non-gambling income, the Section 165(d) limitation on the deductibility of professional gamblers' business expenses was generally followed by the judicial system for the past 60 years. Nonetheless, the Tax Court overruled Offutt in a recent case.
Mayo
In Mayo, 2 the taxpayer was engaged in gambling on horse races, and the IRS conceded that the taxpayer was a professional gambler. During the year, the taxpayer wagered $131,760 on the outcome of horse races and won $120,463. These wagering costs and gains were reported as gross receipts and expenses from a gambling business in the taxpayer's tax return. Further, the taxpayer incurred $10,968 of expenses on activities facilitating his gambling, such as transportation, meals and entertainment, admission fees, subscriptions, data, and so forth. He also claimed these expenses as gambling business expenses in his tax return. The IRS contended that the taxpayer's gambling expenses were deductible only to the extent of the wagering gains, $120,463. That is, the wagering cost in excess of the wagering gains ($11,297) and the gambling business expenses ($10,968) were not deductible.
Citing Groetzinger, 3 the taxpayer argued that Section 165(d) does not apply to an individual engaged in the gambling trade or business since it does not apply to other trades or businesses. However, the Tax Court found that the Supreme Court in Groetzinger acknowledged the congressional decision to treat gambling losses differently from other losses for federal income tax purposes. Also, the legislative history shows that Congress intended to apply the Section 165(d) limitation on the gambling conducted as a trade or business. Consequently, the Tax Court noted that although professional gamblers' losses fall under both Sections 162(a) and165(d) , Section 165(d) , as the more specific statute, should trump the more general provision of Section 162(a) . Therefore, the taxpayer's wagering losses, $131,760, were allowed only to the extent of his wagering gains, $120,463.
As for the deductibility of taxpayer's business expenses of $10,968, the Tax Court decided no longer to follow the Offutt rule and granted the taxpayer a gambling business expense deduction of $10,968 under Section 162(a) . The Tax Court's reasons were as follows.
First, neither the statute nor the regulations define the term “losses from wagering transactions” found in Section 165(d) . The legislative history did not address this specific issue, either. The Offutt court provided no reasoning to support its conclusion that “losses from wagering transactions” should include both the cost of losing wagers and business expenses incurred in the conduct of gambling activities.

Second, the Tax Court and the Courts of Appeals have generally held that gains from wagering transactions within the meaning of Section 165(d) must be the direct outcome of wagers entered by the taxpayer. Mere connection with the conduct of wagering activities is not sufficient. However, losses from wagering transactions were extended to expenses that were not the direct result of a wagering transaction such as a bookmaker's mailing, printing, and stenographic expenses. The Tax Court in Mayo found that there is no support in the statute to apply Section 165(d) differently in wagering losses and gains. In addition, the narrower interpretation ofSection 165(d) regarding gains more closely reflects the ordinary meaning of the words used in the statute.
Third, the Ninth Circuit in Boyd 4 strongly implied that the Section 165(d) limitation is confined to only direct wagering expenses. Specifically, the Ninth Circuit distinguished wagering losses from expenses incidental to gambling, signifying that the latter would not be necessarily subject to the Section 165(d) limitation.
Finally, even though the IRS generally applied the Offutt rule to limit professional gamblers' nonwagering business expenses, the IRS has conceded the deductibility notwithstanding Section 165(d) in several cases (e.g.,Crawford 5 and Tschetschot 6). Recently, an IRS Chief Counsel Attorney Memorandum 7 said that the Offutt rule would no longer be followed.
Professional gamblers frequently cite Groetzinger, arguing that the Section 165(d) limitation on the deduction of wagering losses does not apply to professional gamblers. However, the Tax Court has repeatedly rejected this claim. Specifically, the Tax Court in Mayo pointed out that the Supreme Court in Groetzinger acknowledged the Congressional decision to treat gambling losses differently from other losses for federal income tax purposes, even when incurred as a “means of making a living.” Further, the Supreme Court did not consider the relationship between Sections 162(a) and 165(d) because the Section 165(d) limitation was not at issue in that case. As a result, taxpayers have to realize that Groetzinger does not provide any assistance in disputing the Section 165(d) limitation on professional gamblers.

Constitutional challenges

Professional gamblers might want to challenge the Section 165(d) limitation on the basis of constitutional rights to equal protection under the law. The equal protection clause in the Fourteenth Amendment and the due process clause of the Fifth Amendment may serve this purpose. However, the Tax Court in Valenti 8 provided that even though the equal protection clause in the Fourteenth Amendment may limit the powers of the States, there is no comparable clause explicitly applicable to legislation enacted by Congress. Actually, the Supreme Court in Carmichael v. Southern Coal Co. 9 noted that, while exercising the power to tax, a state can freely select the subjects of taxation and grant exemptions. That is, the equal protection clause in the Fourteenth Amendment does not impose any rigid equality rule of taxation on a state. Consequently, the equal protection clause in the Fourteenth Amendment does not require that governments tax the gambling business and other businesses equally.
The due process clause in the Fifth Amendment requires that the different treatments based on classifications be justifiable. 10 Therefore, assuming it is justified, the government may tax the operations of a particular kind of business and exempt some other kind of business. 11 The Tax Court in Valenti noted that justifiable reasons (such as history of gambling, moral opposition by churches, anti-gambling legislation, public opposition to professional gambling, and public perception of the association between organized crimes and gambling) support the different treatments between gambling and other trades or businesses. As a result, neither the equal protection clause in the Fourteenth Amendment nor the due process clause in the Fifth Amendment would overcome the Section 165(d) limitation on professional gamblers.

Losses and gains


Section 165(d) 
allows “losses from wagering transactions” only to the extent of the gains from such transactions. In practice, this provision has a two-way mechanism to limit the deduction of professional gamblers' business expenses. First, the meaning of “losses” from wagering transactions could be extended to include related gambling expenses such as transportation, meals, and entertainment. The Tax Court in Offutt adopted this interpretation to treat professional gamblers' business expenses as wagering losses and the Offutt rule was generally followed by the judicial system. 12 The Offutt rule prevents professional gamblers from using gambling business expenses against non-wagering incomes or carrying back or forward the gambling business expenses.
On the other hand, the meaning of “gains” from wagering transactions could be strictly interpreted to exclude any gains other than the direct winnings from wagering. For example, tokes, the bets placed by the patron for the casino dealer's benefit, are viewed as service compensations to the dealer rather than gratuities or gains from wagering transactions. 13 Further, take-offs, table fees paid by patrons to the casino for a seat to play the games, are the casino's rental charges rather than gains from wagering transactions. 14 Likewise, the Ninth Circuit in Boyd held that a professional gambler's contractual share of the take-off was not gain from wagering transactions because it was not gain from wagers entered into by the professional gambler. The Tax Court in Bevers 15 also ruled that a dealer's tips were gains from his labor as a dealer, not gains from wagering transactions. Overall, one should be aware that the new Mayo rule narrows the interpretation of “losses” from wagering transactions but does not extend the content of “gains” from wagering transactions.
Since Offutt, the IRS has maintained its position in litigation that the nonwagering business expenses of a professional gambler are limited by Section 165(d) . However, the IRS seems to have loosened its stance recently. 16 Specifically, the IRS in AM 2008-013 expressed that the Offutt rule would no longer be followed. The Tax Court in Mayo realized this emerging trend and decided to address the issue of the deductibility of professional gamblers' business expenses to eliminate any future administrative inconsistency. After Mayo, professional gamblers' non-wagering business expenses are not limited by Section 165(d) . Nevertheless, the IRS may challenge the classification between wagering costs and non-wagering business expenses, an issue that will be discussed in detail later.

Comps.

Although the Tax Court in Mayo indicated that an applicable standard to interpret the “losses” or “gains” from wagering transactions should reflect the ordinary meaning of the words used in the statute, several scenarios may require the judicial system to clarify the application of this standard. First, an exception to this ordinary meaning standard is the treatment of “comps” in Libutti. 17 Comps are complementary goods and services that a casino gives a gambler to induce gambling. The Tax Court in Libutti held that the comps were taxpayer's gains from wagering transactions because “winnings” is not the only meaning for the word “gains.” Moreover, the Tax Court in Mayo provided further justifications, emphasizing that the nexus of the comps to the taxpayer's wagering was “close, direct, evident, and strong.”
The concurring opinions in Mayo, however, question whether the Libutti result can survive as an exception to the general rule, under which the gain must be the direct result of a wager entered by the taxpayer. The Tax Court in Libutti stated, “Although petitioner's receipt of the comps did not directly hinge on the success or failure of his wagers, he received the comps incident to his direct participation in wagering transactions.” On the other hand, the Tax Court in Mayo noted, “Generally, it is not sufficient that the gain arise merely in connection with the conduct of wagering activities; the gain must be the direct result of a wager entered by the taxpayer.” The concurring opinions cast doubt on whether there is any material difference between “incident to” and “in connection with” in these two cases. Whether the Tax Court will apply the “close, direct, evident, and strong” nexus criterion to substantiate the ordinary meaning standard in the future or whether the Tax Court will change its stand on Libutti remains to be seen.

Take-offs.

Whether the take-off fee paid by a professional gambler is part of the wager or a separate business expense is not addressed in Mayo. The Tax Court in Nitzberg held that take-offs are the casino's rental charges rather than gains from wagering transactions. Further, the Ninth Circuit in Boyd noted that take-off fees may raise the issue of whether they should be construed as a component of a gambler's cost or a business expense. Theoretically, if take-offs are treated as a casino's gains from wagering transactions, take-off fees paid by a professional gambler should be treated as part of wagering costs. However, because the Tax Court in Nitzbergdetermined take-offs to be the casino's rental charges, whether take-offs are to be classified as a professional gambler's business expenses is inconclusive. Although the inclusion of wagering costs should follow the ordinary meaning standard, the “close, direct, evident, and strong” nexus criterion in Libutti and Mayo can be applied here. Consequently, to decide whether take-offs are a professional gambler's business expenses may depend on whether the nexus of take-offs to the gambler's wagering is “close, direct, evident, and strong.” Since the “close, direct, evident, and strong” nexus criterion is ambiguous, it would not be surprising if professional gamblers and the IRS reach different conclusions regarding a particular gain or cost item.
Finally, assuming that take-offs paid by a professional gambler are business expenses, the professional gambler's contractual share of the take-offs would not be gambler's gains from wagering transactions because it is not gain from wagers entered into by the gambler. This conclusion is consistent with the Ninth Circuit in Boyd. However, if take-offs paid by a professional gambler are treated as wagering costs rather than business expenses, further analysis is required to classify the professional gambler's contractual share of the take-offs. A professional gambler's contractual share of the take-offs consists of two portions: one contributed by the professional gambler himself or herself and the other contributed by gamblers other than the professional gambler. The portion contributed by other gamblers is not gain from wagering transactions because it is not gain from wagers entered into by the professional gambler.
However, the portion contributed by the professional gambler may be gambler's gains from wagering transactions. The professional gambler's contractual share of take-offs is preset by the agreement between the casino and the professional gambler rather than by wagering odds, raising a doubt whether the contractual share is a “direct” result of wagers entered by the professional gambler. Nevertheless, the contractual share could be the professional gambler's gains from wagering transactions under the “close, direct, evident, and strong” nexus standard in Libutti and Mayo, since paying the take-off fees is necessary for the professional gambler to enter the games and the fees are treated as a gambler's costs of wagering transactions. Compared to comps in Libutti, which are not even part of a gambler's wagering, the professional gambler's contractual share of take-offs should have a closer and stronger nexus to a gambler's wagering. This conclusion is consistent with Libutti, but contradicts the Ninth Circuit in Boyd.
A possible solution to this contradiction is to abandon the ambiguous “close, direct, evident, and strong” nexus criterion and not view professional gambler's contractual share of take-offs as a gambler's gains from wagering transactions. However, even so, there is still an inconsistency between treating professional gambler's take-off fees as part of wagering costs, but not treating a professional gambler's contractual share of take-offs as a gambler's gains from wagering transactions. An alternative is to treat take-offs paid by a professional gambler as business expenses such that the professional gambler's contractual share of the take-offs is not gambler's gains from wagering transactions. This result would be consistent with the Ninth Circuit in Boyd but inconsistent with the Tax Court in Libutti. Overall, the preceding analysis indicates that the application of the “close, direct, evident, and strong” nexus criterion cannot reconcile the contradiction between Boyd and Libutti.
Conclusion
The Tax Court in Mayo tried to resolve the controversial issue of the deductibility of professional gamblers' business expenses based on the ordinary meaning of the words used in Section 165(d) . However, as an exception to the general rule, the “close, direct, evident, and strong” nexus criterion may complicate this effort. The inconsistency between Boyd and Libutti remains unresolved at this juncture.

1
   16 TC 1214 (1951).

2
   136 TC No 4 , Tax Ct Rep (CCH) 58524, 2011 WL 238822 .

3
   59 AFTR 2d 87-532 , 480 US 23 , 94 L Ed 2d 25 , 87-1 USTC ¶9191 , 1987-1 CB 77 (1987).

4

5
   TC Memo 2010-51 , RIA TC Memo ¶2010-051 , 99 CCH TCM 1213 .

6
   TC Memo 2007-38 , RIA TC Memo ¶2007-038 , 93 CCH TCM 914 .

7
  AM 2008-013.

8
   TC Memo 1994-483 , RIA TC Memo ¶94483 , 68 CCH TCM 838 .

9
   301 US 495 , 81 L Ed 1245 (1937).

  Bolling v. Sharpe, 347 US 497 , 98 L Ed 884 (1954).

  Charles C. Steward Machine Co. v. Davis, 19 AFTR 510 , 301 US 548 , 81 L Ed 1279 , 1937-1 CB 444 (1937).

  See, for example, Estate of Todisco, TC Memo 1983-247 , PH TCM ¶83247 , 46 CCH TCM 35 ; Kozma, TC Memo 1986-177 , PH TCM ¶86177 , 51 CCH TCM 956 ; Kochevar, TC Memo 1995-607 , RIA TC Memo ¶95607 , 70 CCH TCM 1627 ; and Praytor, TC Memo 2000-282 , RIA TC Memo ¶2000-282 , 80 CCH TCM 332 .



   26 TC 1218 .

  See, for example, Crawford, supra, note 5 and Tschetschot, supra, note 6.

   TC Memo 1996-108 , RIA TC Memo ¶96108 , 71 CCH TCM 2343 .





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