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.
AM 2008-013.
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 .
Williams, TC Memo 1980-494 , PH TCM ¶80494 , 41 CCH TCM 312 ; Olk, 38 AFTR 2d 76-5219 , 536 F2d 876 , 76-2 USTC ¶9484 (CA-9, 1976); and Allen, 70 AFTR 2d 92-6124 , 976 F2d 975 , 92-2 USTC ¶50585 (CA-5, 1992).
See, for example, Crawford, supra, note 5 and Tschetschot, supra, note 6.
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