Back in the Middle Ages, alchemists attempted to transform base metals into gold and silver. If only one could change lead into gold. Unfortunately, lead is lead and gold is gold.
Why do I bring up alchemy? Because I received the following email:
I saw your post on [redacted’s] [social media] regarding gambling income. You said, “Gambling income stays gambling income no matter if you run it through 10 LLC’s….”
But [redacted]’s response basically said you didn’t know what you were talking about, and that it can be done, and that forming a business entity to transform gambling income is done all the time for casinos, hedge funds, venture capital firms and related entities.
I believe you are wrong, and that gambling income can be changed into normal [ordinary] income by running it through an LLC or corporation.
I’ve been asked this question many times. The devil that everyone wants to avoid is Section 165(d) of the Tax Code:
(d) Wagering losses
Losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.
So we first must look to the question, what is a wagering transaction? The Tax Code itself and the regulations promulgated under the code do not answer this question. The IRS, in Technical Advice Memorandum 200417004, does answer this (though the TAM cannot be used as a precedent). A transaction needs three things to be a wagering transaction: It must have a prize, the element of chance must be present, and the individual (who is doing the wagering) must be offering consideration.
There’s one other element: The transaction cannot be defined in the Tax Code as something else. For example, a securities trade has (at least to some) the exact same elements as a wagering transaction. However, the Tax Code says that securities are securities and aren’t wagers.
Section 165(d) holds for everyone under the Tax Code. Let’s say that you formed Acme Wagering as a C-Corporation, and you had the corporation place bets in Las Vegas. Let’s further assume you lost money on your bets. Section 165(d) prohibits Acme Wagering from taking the losses in excess of wins.
Well, what about an LLC? I’ll just note the gambling wins and losses as ordinary income on the Form 1065 I file and no one will know the better. There are two major issues with this:
1. You have gambling wins and losses. If you have a net loss, §165(d) applies to whomever is paying the tax.
2. Gambling wins and losses are not included as ordinary income.
A single-member LLC is a disregarded entity–it files a Schedule C (unless it elects corporate taxation–and that won’t transform gambling income into ordinary income). An LLC with multiple members files a partnership return (Form 1065). The instructions to Schedule K-1 for a partnership return note that gambling gains (wins) and losses are included on line 11 of Schedule K-1 using code F. (Ordinary income is included on line 1.) From the IRS instructions:
Code F. Other income (loss). Amounts with code F are other items of income, gain, or loss not included in boxes 1 through 10 or reported in box 11 using codes A through E. The partnership should give you a description and the amount of your share for each of these items…
Code F items may include the following…Gambling gains and losses.
So the IRS has told you not to report gambling income as ordinary income. And if you’re thinking you can get away with this in an S-Corporation, you can’t; the same instruction exists for the Schedule K-1 on a Form 1120S return; the only differences are the line number (10) and the code (E).
Alchemy has been tried in the past. Many have tried to change gambling income into capital gains income. This has been as successful as a lead balloon. For example, in Davis v. Commissioner (119 T.C. No. 1), the petitioner won a jackpot in the California lottery. He then sold the rights to future payouts and wanted to take the money he did receive as a capital gain (which is preferentially taxed) rather than as ordinary income. It didn’t work.
Well, why can hedge funds, casinos, venture capital firms and the like have ordinary income? Because they are not in the business of wagering. Hedge funds and venture capital firms invest; investments are not considered wagering transactions under the Tax Code. A casino does not wager; rather, it takes wagers. A wagering transaction for a gambler is ordinary income for the casino.
There is no Tax Fairy[1]. The Tax Code, no matter how unfair, is law. Until Congress rescinds §165(d), it holds for everyone. If the individual who sent me this email knows someone who is using a business entity to transform gambling income into ordinary income (so he or she can take gambling losses), this works well…until they’re audited. Bluntly, those individuals are playing audit roulette. Most partnership returns aren’t audited, so they’re hoping they sneak through. But if they’re audited they stand a 0% chance of prevailing. Additionally, they would be liable for potentially significant penalties (plus tax and interest, of course).
Finally, I strongly advise anyone to use some common sense when reading the Internet. If it sounds too good to be true, it probably is. Alchemy didn’t work in the Middle Ages; it doesn’t work today with the Tax Code.
[1] My thanks to Joe Kristan for the concept of the Tax Fairy.