When the calendar turns to mid-March and tax season makes the leap from annoying to soul-crushing, I spend more time than I should daydreaming about goin’ all Walter White and breaking bad, only instead of cooking meth, I’d use my well-honed number-crunching skills to become an underground bookie.
Oh, what a life it would be. Instead of spending March Madness in a tiny office cranking out tax returns, I’d spend it in a giant war room complete with wall-to-wall flat screens, building my riches on the failed dreams of student athletes. I’d work the phone better than Gordon Gecko, avoiding detection by using subversive colloquialisms like “unit” and “juice.” I’d threaten to break thumbs with impunity. And I’d make money. Lots and lots of money. Because the house never loses.
The house doesn’t lose because it is (generally) indifferent to who the bettors favor. Not to get into Gambling 101, but if you bet $100 on the Seahawks + 2 ½ in the Super Bowl, you won $100, But if you bet $100 on the Broncos to cover the 2 ½ points (sucker), you lost $110. The $10 the loser pays over and above the wagered amount is the “vig.”
Thanks to the vig, bookies generally don’t care who people are betting on, as long as the bets are fairly even on both sides. And of course, bookies have the advantage of being able to move the line to make sure this happens.
When it comes to horse racing — which in my bookie fantasy world, I will occasionally dabble in but not invest heavily – the house has an added level of protection in the form of “parimutuel wagering.” It works like so:
The entire amount wagered on a particular race is referred to as the betting pool or “handle.” The pool can then be managed to ensure that the track receives a share of the betting pool regardless of the winning horse. This share of the betting pool that the track keeps for itself is often referred to as the “takeout,” and the percentage is driven by state law, but generally ranges from 15% to 25%.
The takeout is then used to defray the track’s expenses, including purse money for the winning horses, taxes, licenses, and fees. The takeout can also be used, if needed, to cover any shortfall in the amount necessary to pay off winning bettors. To the extent any excess takeout remains after covering these two classes of obligations, the track has profit.
Once the betting pool has been reduced by the takeout, the balance is generally used to pay off any winning wagers, with the excess, once again, representing profits. Great business model, isn’t it?
Yesterday, an enterprising CPA with a raging gambling habit threatened to strike a blow for bettors everywhere when he took on the IRS in the Tax Court and argued that the portion of his wagers attributable to the “takeout” were deductible without limitation. But before we can understand the significance of the case, we need to understand some basics about the taxation of gambling.
Treatment of Gambling Expenses, In General
Section 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Generally, any winnings are reported on page 1 of the Form 1040, while the losses (but only to the extent of winnings) must be claimed as itemized deductions. Thus, if a bettor is one of the 66% of Americans who don’t itemize their deductions, they would effectively be whipsawed – they would be forced to recognize the gambling income, but would receive no benefit from the losses.
Section 162, however, 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.”
Putting these two provisions together, many bettors have taken the position that if their gambling activities are so frequent, continuous and substantial as to rise to the level of an unhealthy addiction a Section 162 trade or business, then gambling losses are deductible as Section 162 business expenses, and are not subject to the loss limitations imposed by Section 165(d). In their view, if the gambling activity constitutes a business, because the losses (along with the gains) should be reported on Schedule C, rather than itemized deductions, the losses should be permitted in full.
The courts have repeatedly shot this theory down, holding that even a professional gambler who properly reports his activity on Schedule C may only deduct losses to the extent of gains.
In a very important 2011 decision out of the Tax Court, however, the court held that while gambling losses are limited to the extent of gambling winnings, any non-loss expenses of a professional gambler engaged in a trade or business – items like automobile expenses, travel, subscriptions and handicapping data – are not subject to the Section 165(d) limitation. Thus, a professional gambler could reduce his winnings to zero by his losses, and then further deduct any non-loss business expenses, generating a net loss from the activity. (See Mayo v. Commissioner, 136 T.C. 81 (2011).)
And that brings us back to our gambling CPA. In Lakhani v. Commissioner, 142 T.C. 8 (2014), settled yesterday, an accountant/prolific track bettor made the compelling argument that his portion of the track’s “takeout expenses” represented non-loss business expenses rather than gambling losses, and were thus deductible without limitation. The taxpayer posited that by extracting takeout from the taxpayer’s wagers and using those funds to pay the track’s operating expenses, the track was acting in the capacity of a fiduciary. The taxpayer further likened the process to that of an employer who collects payroll taxes from his employees and remits them to the IRS and state agencies. Stated in another manner, the taxpayer argued that he was paying the operating expenses of the track, with the track acting as a conduit by collecting the takeout and using the funds.
Based on this position, the taxpayer argued that he was entitled to non-loss gambling business deductions in excess of $250,000 between 2005 and 2009.
The IRS disagreed with the taxpayer’s argument, countering that because the takeout is paid from the pool remaining from losing bets, “it is inseparable from the wagering transactions,” and thus constitutes wagering losses that are subject to the limits of Section 165(d). Furthermore, the Service argued that the taxpayer could not deduct business expenses for amounts paid from the takeout by the track for taxes, fees, and licenses, etc… because these were expenses owed by the track, not the individual bettor.
The Tax Court sided with the IRS, holding that the taxpayer’s share of the takeout expenses represented wagering losses that could only be deducted to the extent of winnings under Section 165(d). In reaching this conclusion, the court differentiated between an employer remitting payroll taxes on the behalf of an employee and a track using takeout funds to pay its operating expenses.
The employee, the court stated, is ultimately responsible for his share of the payroll taxes on his wages, and it is the remittance of these taxes by the employer that discharges the employee of this obligation. To the contrary, at no point are the expenses of the track imposed on the individual bettor; they are always obligations of the track. The tracks use of the takeout to pay its expenses, the court stated, does not discharge any obligation of the bettor.
As a result, the court concluded that because the track’s expenses were never an obligation or expense of the bettor, the takeout could not qualify as the bettor’s business expense. Instead, the takeout represented an additional gambling loss by the taxpayer, and could only be deducted – when added to his other losses – to the extent of his winnings.
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