With the World Series of Poker main event in progress here in Las Vegas, the Tax Court coincidentally released a decision of a former “Bracelet” winner. (If you win any event at the WSOP, you not only win cash, but a specially inscribed gold bracelet to commemorate your victory.) The petitioner today may be an excellent poker player, but his strategy at Tax Court was that of a loser.
John Hom won the 2002 $3,000 limit hold’em event at the WSOP; he won $174,840 back then. He has numerous tournament poker wins and cashes dating back to 1994. He is also a licensed civil engineer.
The Tax Court case dealt with 2005 – 2008. The IRS sent the petitioner a Notice of Deficiency. Mr. Hom alleged:
1. The Notice of Deficiency is invalid because the address and telephone number of the local office of the National Taxpayer Advocate wasn’t present;
2. He should be allowed to deduct additional gambling losses for 2006-2008;
3. He did not receive unreported wages from his C-Corporation;
4. He should be allowed to deduct additional gambling expenses;
5. He should be allowed to deduct other expenses for a laundromat he owns; and
6. He should not be subject to the accuracy-related penalties for 2005 and 2006.
There are a number of red flags in the background information. First, “…petitioner ignored information document requests from the…IRS….” This was during the examination of Mr. Hom’s returns. It is important to fully cooperate during an examination (audit). Not only will this aid you with the examiner (good will is important during an audit), but if you fully cooperate you can shift the burden of proof to the IRS if the matter goes to Tax Court. His lack of cooperation continued, too:
Petitioner did not cooperate with respondent’s examination or with the Appeals Office. Petitioner refused to turn over requested records; he ignored information document requests, and the IRS had to resort to a court order to gain access to petitioner’s Pokerstars.com records.
Second, the corporate tax returns for 2004 – 2008 were not filed until April 2010. Late filing returns is always a red flag. Mr. Hom also late-filed all of his personal tax returns for the years in question.
Mr. Hom was considered a professional poker player. He filed a Schedule C for his poker playing business. It’s never a good sign when you look at gambling losses and see the word “Unknown” noted for losses in some years. A gambler must keep a gambling log. This is especially the case when you’re a professional gambler; if you’re in a business both the IRS and the Tax Court expect you to conduct yourself in a business-like manner.
Now, to the actual issues:
1. The Court held that the petitioner wasn’t prejudiced by the minor technical issue of not including the actual address and phone number of the Taxpayer Advocate. Interestingly, another entity controlled by Mr. Hom, John C. Hom & Associates, filed its own Tax Court case. Earlier this year, the Tax Court ruled (in a full decision) that not including the actual phone number and address didn’t make the Notice of Deficiency invalid. There was a second issue in that case: Whether the corporation could file a Tax Court case as the corporation was suspended. It couldn’t, as “The capacity of a corporation to engage in such litigation [in this Court] shall be determined by the law under which it was organized.” But I digress….
2. Could Mr. Hom take additional gambling losses? The Court was succinct in its ruling:
Citing Cohen v. Commissioner, 266 F.2d 5, 11 (9th Cir. 1959), remanding T.C. Memo. 1957-172, petitioner contends that respondent’s disallowance of petitioner’s claimed gambling losses in their entirety rendered the deficiency determination “arbitrary or erroneous”, thereby shifting the burden of proof to respondent. However, respondent disallowed petitioner’s claimed gambling losses because petitioner’s gambling records did not clearly show petitioner’s gambling losses and petitioner was uncooperative. Respondent accurately determined petitioner’s gambling income but disallowed petitioner’s claimed losses because petitioner failed to substantiate them.
There’s a second related issue which was discussed later in the ruling.
3. Did he receive unreported wages? The petitioner contended that the money were loans. Loans require interest, a note, and a repayment schedule. “Moreover, petitioner admitted at trial that (1) he did not execute a note to memorialize the purported loan, (2) JCHA did not pay interest on the purported loan, and (3) there was no repayment schedule on the purported loan.” Additionally,
Petitioner failed to introduce credible evidence showing that respondent’s characterization of the amounts that he withdrew from JCHA’s account as wages was erroneous. The evidence of petitioner’s services to JCHA, discussed further below, suggests strongly that the amounts withdrawn were compensation for his services as an engineer and as an officer of the corporation.
We sustain respondent’s determination on this issue.
2A. Did the petitioner have additional gambling losses that he can deduct under the Cohan rule? “Where a taxpayer establishes that he or she incurred a deductible expense but is unable to substantiate the precise amount, we may, bearing heavily against the taxpayer who has failed to maintain records, approximate the amount of the expense…However, we must have sufficient evidence upon which to make a reasonable estimate to apply the Cohan rule.” Let’s look at the Court’s ruling in regards to 2007 and 2008:
Petitioner had gross receipts from casino poker of $149,687 and $2,769 in 2007 and 2008, respectively. Petitioner introduced no evidence showing how often he played casino poker in 2007 and 2008. However, petitioner’s 2007 gross receipts from casino poker were won on four dates in 2007, including $136,695 at Grand Sierra Casino on February 27, 2007. This suggests that petitioner’s casino poker earnings were won in relatively few events. Petitioner was a skillful and seemingly successful poker player. Unlike cases involving slot machine players with continuous play but occasional jackpots, petitioner did not necessarily suffer any losses from playing casino poker in 2007 or 2008…We therefore have no basis upon which to estimate petitioner’s gambling losses for those years. Accordingly, petitioner is not entitled to deduct any additional gambling losses for 2007 and 2008.
It’s clear from reading between the lines of the decision that Mr. Hom did not keep a gambling log. He did not keep receipts of his tournament buy-ins. Had he done so, he would likely have had the documentation necessary to prevail. The Tax Court won’t help you unless you help yourself. If you’re a gambler and you’re not keeping a gambling log, expect to lose at audit, appeals, and at the Tax Court.
4. The petitioner argued he should be able to deduct additional gambling losses. This was a two-part argument. First, that he had additional transportation and lodging expenses. Unfortunately, he didn’t keep records and Section 274(d) of the Tax Code requires substantiation. Mr. Hom lost this argument.
Second, Mr. Hom argued that he should be able to deduct “rake” and tournament entry fees as gambling expenses.
Petitioner testified that he incurred rake fees of $2 to $4 per hand to play poker at Pokerstars.com. However, petitioner failed to introduce credible evidence corroborating his testimony. Petitioner’s testimony standing alone is not reliable, and we have no basis upon which to estimate petitioner’s rake fee expenses for the years in issue…Accordingly, petitioner is not entitled to deduct any rake fees.
The reality is that the Court got this right, but for the wrong reason. Mr. Hom’s winnings at Pokerstars.com already reflect the rake. Let’s say you play a hand of poker, and you win a pot of $100 after a rake of $3. Your account is credited with a win of $100; the $3 of rake has already been taken. Put another way, if you want to deduct rake, you must gross-up your poker winnings by the amount of the rake!
Mr. Hom did succeed in getting some tournament entry fees deducted. He could prove he entered a few tournaments, so the Court estimated and did allow an additional deduction of just over $200.
5. The petitioner wanted to deduct more expenses for a laundromat. Unfortunately, he didn’t provide proof of those expenses. That’s a good way to lose at Tax Court, and the petitioner did just that on this issue–he lost.
6. Finally, the petitioner argued that he shouldn’t be subject to the accuracy-related penalty. “The evidence of failure to maintain records, unreported income, and unsubstantiated loss and expense deductions claimed by petitioner is sufficient to prove negligence and satisfies respondent’s burden of production.” Mr. Hom lost this argument.
For a professional gambler (and anyone else running a business), there are several important takeaways from this decision.
1. Keep good records! If you have a gambling log (if you’re a gambler), a mileage log (if you’re deducting mileage), invoices, etc., you will do far, far better in audit, appeals, and at the Tax Court. The petitioner in this case apparently did none of these; that’s a good way to make Tax Court a bad gamble.
2. File timely returns. If you don’t timely file, the IRS will start investigating. Undoubtedly, Mr. Hom received 1099s and/or W-2Gs. When there was no tax return, the IRS came calling. Had Mr. Hom timely filed all returns, it’s possible he would never have been audited.
3. Keep your business entities in good standing. If a business entity is not in good standing, it loses its rights. If you have a corporation, make sure the filing fees paid to the Corporations Commissioner or Secretary of State are timely paid. Most states allow this to be done online.
4. Cooperate with the IRS in an examination (or appeals). It will make your case go far, far smoother. I recently had an examination where the IRS wanted bank records (from a past year). We asked the bank to supply us with the requested records; the bank kept sending us the wrong records. We let the IRS know exactly what was going on. The IRS eventually did not believe us (how could a bank be that messed up)…so they issued a summons. The IRS changed their mind on our cooperation when the bank sent the same wrong records to the IRS! (Yes, that bank is that messed up.) That audit went relatively well because we cooperated.
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