Taxable Talk

Somehow it’s fitting on the day that the World Series of Poker champion is crowned that we find out that Neteller, the beleaguered Internet payment processor, has settled with the U.S. Department of Justice. According to the press release that Neteller issued:

• Neteller will forfeit $136 million to the US (inclusive of $60 million that the US seized from Neteller transactions earlier);
• US customers will be able to request withdrawals of their funds no later than July 30th;
• Neteller agrees to cooperate fully with the USAO [U.S. Attorney’s Office/DOJ] in all matters relating to the ongoing investigation;
• Neteller agrees to fully implement procedures and controls to prevent illegal transactions between internet gambling merchants and persons located in the US; and
• The DOJ will dismiss a criminal information against Neteller in two years as long as Neteller fully implements this agreement and fully cooperates with the DOJ.

So what does this mean? US gamblers will get their money back, likely in August. Neteller’s founders will get off with a slap on their wrist (a monetary fine). Neteller won’t be operating in the United States any more. And the DOJ gets a big boost in its investigation of online gambling firms because Neteller will cooperate with the DOJ (including testifying in court against online gambling firms).

What’s not in the agreement—but is almost certain to be happening—is any mention of taxes. However, anyone who thinks that the DOJ (and the IRS, by extension) will not be getting records of Neteller transactions should think again. Almost certainly that information will be finding its way to the IRS by year-end.

It’s interesting to compare what happened with what I predicted back in January.

“Indeed, it’s clear what’s likely to happen. Neteller and the DOJ will likely come to an agreement. Neteller will announce that they will no longer do business with Americans, and they may have to pay a fine; the DOJ won’t indict the company, or any of its current stockholders. The DOJ might even accept some sort of plea bargain for the two founders who were arrested. It’s also certain that as part of such a deal Neteller will agree to release details of all transactions between American customers and Neteller.”

And that’s basically exactly what occurred.

One of the two Neteller founders pleaded guilty on Friday to one count of conspiracy. Stephen Lawrence told the Associated Press, “I came to understand that providing payment services to online gambling Web sites serving customers in the United States was wrong.” Lawrence faces up to five years in prison when sentenced on October 29th.

What does this mean for Neteller’s future and its ex-customers in the United States? Almost nothing. Neteller is scheduled to announce its plan for returning millions of dollars in held funds on July 13th. As to Neteller’s future, I said months ago,

“Indeed, it’s clear what’s likely to happen. Neteller and the DOJ will likely come to an agreement. Neteller will announce that they will no longer do business with Americans, and they may have to pay a fine; the DOJ won’t indict the company, or any of its current stockholders. The DOJ might even accept some sort of plea bargain for the two founders who were arrested. It’s also certain that as part of such a deal Neteller will agree to release details of all transactions between American customers and Neteller.”

Nothing that has happened to date in this saga has caused me to change my opinion.

As a reminder, July 2nd is the deadline for filing Form TD F 90-22.1. Remember, mail the form to the Department of the Treasury, not the IRS. If you had more than $10,000 at Neteller (or any combination of foreign bank accounts), you are required to report it. Willful non-reporting is punishable by a fine of $100,000, or 50% of the funds in the foreign accounts, whichever is greater, and can also result in criminal penalties.

As the saga of Neteller, the Isle of Man based financial intermediary, drags on, I’ve gotten many questions regarding the money that’s tied up. For those who are unaware, some of the Neteller money was seized by the US government as it was moving over the wires between Neteller’s banks and customers’ banks, and some is sitting in customer accounts at Neteller. All of it, though, remains out-of-reach of American customers of Neteller. So the question is, do customers of Neteller have to pay tax on gambling proceeds won in 2006 that are stuck at Neteller?

Yes.

When an American must pay tax on income is governed by the doctrine of “constructive receipt.” Suppose you gamble on an online poker site, and you win $1000. However, right when you win that money the poker site goes out of business, and you never collect a penny of the $1000. You’ve never had access to the money—you never were able to use it. You didn’t have constructive receipt of the money.

Now suppose you win $1000 on December 31, 2006, and the money is immediately put in your account. On January 16, 2007, you withdrew the money into Neteller. You immediately requested Neteller to transfer the money into your American bank account. On January 17th that money was either seized or is stuck at Neteller.

That individual has $1000 of gambling income in 2006. The gambler could have withdrew the money on January 1, 2007 or he could have gambled with it on January 1. He had constructive receipt of the money. That he was unlucky in that the money was seized or stuck at Neteller is unfortunate. He or she must pay tax on the $1000.

So what should an individual do who has significant funds stuck at Neteller—so significant that he may not be able to pay what he owes in taxes? Talk to a professional tax advisor now; don’t wait until April 10th. Most tax preparers are very busy between now and April 17th. We’re not (in general) going to be able to give you specific advice if you wait until the very last minute.

Realize that you owe the money. Find out what your total tax is (including your state income tax, if applicable). Determine what you can afford to pay. Options include going on extension and installment plans. But not filing a tax return (or at least an extension) by April 17th will subject you to the failure to file penalty!

The phrase caveat emptor (let the buyer beware) applies to many offshore entities. The IRS considers online gambling to be just another tax avoidance scheme. They’re not going to be very sympathetic to taxpayers using a financial intermediary that serviced offshore online gambling firms.

Neteller, the beleaguered Isle of Man financial intermediary firm whose two founders were arrested on money laundering charges in the United States, announced that they have come to an agreement with the US Attorney’s Office for the Southern District of New York (where the potential prosecution will take place). While it’s very unlikely the agreement with the DOJ will be made public, Neteller’s press release notes that:

• Within the next 75 days (by June 4th) they will announce a plan for the return of funds of their American customers;
• A consulting firm, Navigant Consulting, Inc., will, according to the press release, “…provide a report to the USAO on the Group’s current financial condition.”
• Neteller “is continuing to cooperate with the USAO’s investigation, under the advice of its legal advisers and in accordance with court orders in the Isle of Man”

So what does this mean for a Neteller customer?

1. Neteller is cooperating with the US Attorney’s Office (the Department of Justice). What is the DOJ interested in? Money laundering, of course. Large accounts with activity. Individuals (and entities) that haven’t reported their foreign bank accounts. Individuals and entities that haven’t filed tax returns on income earned overseas.

2. If you have a Neteller account, and you had $10,000 in it at any time during 2006, you should make sure that you mark the box on Schedule B of your tax return that indicates you have a foreign bank account. The IRS will likely, by year-end, have balance information on every Neteller account. You also need to file Form TD F 90-22.1 with the Department of the Treasury (not the IRS) by June 30, 2007.

3. If prior to 2006 you had $10,000 at Neteller and you didn’t file the TD F 90-22.1, you should consider filing it today, attaching a note that says you weren’t aware of the law requiring notification of a foreign bank account. The penalty for not filing the form is $10,000 (minimum), and it’s a felony—you can go to prison for this. Do realize you are likely going to have your tax return audited, but if you’re choosing between an audit and jail time, I know which one I’d choose.

4. A client asked me over the weekend when I thought he’d see his Neteller funds. I told him late Summer or Fall. I think a July to September time frame is a reasonable estimate.

So the Neteller saga continues, but the ending is clear. American customers will almost certainly see their funds this year, and the DOJ (and later, the Treasury Department and the IRS) will see Neteller’s records this Spring or Summer.

One of my practice areas is professional gambling. Many gamblers maintained an account with the e-wallet firm Neteller. Neteller served as a financial intermediary between US customers and online gambling firms. In January, the Department of Justice arrested the two founders of Neteller and charged them with multiple offenses, including money laundering. Neteller then pulled out of the US market. Neteller announced today that they are cooperating with the DOJ, and that $55 million in funds had been seized by US law enforcement.

Neteller, in one swell swoop, lost over half of its business. Ignoring whether or not such business was legal, assume you were running Neteller. The Department of Justice has arrested your two founders, has decided to fight you, and you no longer have any means to make financial transactions to the United States. What would you do? Fight the US DOJ, or make the best deal you can? It’s clear from the Neteller press release that they are in negotiations with the DOJ, and that transaction records are being sent from Neteller to the DOJ.

Indeed, it’s clear what’s likely to happen. Neteller and the DOJ will likely come to an agreement. Neteller will announce that they will no longer do business with Americans, and they may have to pay a fine; the DOJ won’t indict the company, or any of its current stockholders. The DOJ might even accept some sort of plea bargain for the two founders who were arrested. It’s also certain that as part of such a deal Neteller will agree to release details of all transactions between American customers and Neteller.

What does the DOJ want with thousands of pieces of data? Well, Neteller required the customer’s name, address, and for many accounts, their social security number. The details of those transactions will undoubtedly be sent to a government agency that’s in the revenue collection business: the IRS.

So what does that mean for the customer who used Neteller?

If you complied with the law—you reported all of your gambling income and your foreign bank accounts—you have nothing to worry about. But probably fewer than 5% of taxpayers report their gambling transactions as income.

First, Neteller is considered to be a foreign financial institution. If you have a foreign bank account, and have $10,000 or more in a foreign bank account(s) at any one time, you are required to file Form TD F 90-22.1 by June 30th of the following year with the Department of the Treasury and check the box at the bottom of Schedule B. If you have a foreign bank account and don’t declare it, you can face civil and/or criminal penalties. Anyone who received $10,000 or more in one transaction from Neteller had a foreign bank account. I expect the Treasury Department to check their records and come after those who didn’t declare their Neteller account. A few individuals may even face criminal prosecution over this, if they had extremely large transactions from Neteller.

Second, the IRS will check their records and see if individuals receiving funds from Neteller declared gambling winnings. The IRS will almost certainly target those receiving large amounts. If an individual received large amounts from Neteller, and didn’t declare any gambling winnings, now is the time to amend your return, and pay the tax, interest, and penalties. It’s almost always better to come forward to the IRS than to have the IRS knock on your door.

The IRS’s first targets will be those with large (in dollars) transactions. But given the ability of the IRS to conduct computer matching, if you received funds from Neteller and didn’t declare any gambling winnings, you might receive a “letter audit” from the IRS. (“Dear taxpayer, we’ve added $xxx [the amount of money you received from Neteller] to your income. If you agree, pay the tax, interest, and penalties….’)

I believe that a few individuals will likely face criminal prosecution over this. If the IRS can find an online gambler who earned over $100,000 and didn’t declare his gambling income (and I think the IRS will have several to choose from, and might even find someone who earned over $1 million) that individual could find himself facing jail time for tax evasion.

But what if you used Neteller for non-gambling activities? Interestingly enough, I know of one firm that paid individuals through Neteller. If you declared the income on your tax return (and can show that), there’s nothing to worry about. You may have to spend some time responding to an IRS notice, but if you’ve paid your taxes, you’re fine.

However, I believe that many (if not most) online gamblers have thought that since Neteller was based on the Isle of Man (a known tax haven), the IRS would never be able to see their records. You’ve just lost that gamble. It will take some time, probably several months at a minimum, for the IRS to conduct their matching of records. If you’re one of those who just lost the first gamble, do you want to double-down and bet that the IRS won’t find you or do you want to amend your return(s) and pay the tax that you knew you owed…and the interest and penalties?

As I’ve said many times, gambling income is taxable. The Tax Code isn’t fair to gamblers, but the alternatives if you don’t pay your taxes are worse than paying the tax that you owe.