California State Senator Ron Calderon Indicted on Bribery & Tax Charges

Posted on February 23, 2014 by Russ

This hasn’t been a good year for Democratic state senators in California. Back in January State Senator Roderick White of Inglewood was convicted of five counts of voter fraud, two counts of perjury, and one count of filing a false declaration of candidacy. His sentencing is scheduled for March. This past week State Senator Ron Calderon of Montebello was indicted in a bribery scandal.

Senator Calderon is accused of 24 counts, including mail fraud, wire fraud, honest services fraud, bribery, money laundering and conspiracy to commit money laundering, and aiding in the filing of a false tax return. From the Department of Justice press release:

The indictment describes a scheme in which Ron Calderon allegedly solicited and accepted approximately $100,000 in cash bribes – as well as plane trips, gourmet dinners and trips to golf resorts – in exchange for official acts, such as supporting legislation that would be favorable to those who paid the bribes and opposing legislation that would be harmful to them. The indictment further alleges that Ron Calderon attempted to convince other public officials to support and oppose legislation.

Another part of the press release states that Senator Calderon took bribes from Michael Drobot. Mr. Drobot used to own Pacific Hospital in Long Beach. The press release goes on to note,

Drobot allegedly bribed Ron Calderon so that he would use his public office to preserve this law that helped Drobot maintain a long-running and lucrative health care fraud scheme…

In another case filed this morning in United States District Court, Drobot has agreed to plead guilty to charges of conspiracy and paying illegal kickbacks. In his plea agreement, Drobot admits paying bribes to Ron Calderon.

We also have the wonder of film credits coming into the picture. Film credits have been a magnet for corruption; such was allegedly the case here:

In another part of the bribery scheme, Ron Calderon allegedly solicited and accepted bribes from people he thought were associated with an independent film studio, but who were in fact undercover FBI agents. Ron Calderon solicited and accepted bribes in exchange for supporting an expansion of a state law that gave tax credits to studios that produced independent films in California.

Mr. Calderon is facing a maximum of 396 years at ClubFed if found guilty on all charges.

Posted in California, Tax Fraud | Tagged | 1 Comment

Taxes and Daily Fantasy Sports: The Duck Test

Posted on February 23, 2014 by Russ

If it looks like a duck, walks like a duck and quacks like a duck, then it just may be a duck.

So said someone (this quote has been attributed to Walter Reuther among others), and it’s one of those cliches that have an impact in taxes. When something has the elements that make it look like something, generally the Tax Code will make it into that something.

Why am I bringing this up? Because of the popularity of daily fantasy sports sites. These sites allow contests based on the outcome of a day’s games in a sports league. For example, you can take various players in today’s NBA games and play against others who select their own players. Should your ‘team’ do better than your opponents’ teams, you win the contest.

The sites consider themselves to be skill games and contests and not gambling. They issue Form 1099-MISC’s to the winners, and put the income on line 3 (“Other Income”). They do not issue Form W-2G’s (“Gambling Winnings”) to their winners. For individuals who partake in these contests, how should they treat the income?

First, it’s income and must be included on the tax return. All income is taxable unless Congress exempts it; Congress hasn’t exempted daily fantasy sports income. So it must be included on your tax return no matter if you receive a Form 1099 or not.

Let’s say you play three contests, win $2,000 and never lose. You receive a 1099 noting $2,000 of “Other Income.” In this simple case, just include the income as “Other Income” on your tax return (line 21, Form 1040). No mater what the flavor of Other Income is you’ve included it.

Let’s say you make a living playing daily fantasy sports sites. You win $250,000 from various sites, and have $50,000 of losses. With that kind of income you are probably a professional fantasy sports player and should include the income and associated business expenses on a Schedule C. It sure looks like you’re in the profession of daily fantasy sports player–the first instance of the Duck Test.

Now let’s consider Jane. She plays daily fantasy sports occasionally. She receives a 1099-MISC noting her $30,000 of wins. She also has $20,000 of daily fantasy sports losses. For the sake of discussion, we’ll assume she has records proving those losses. Can she take those losses?

If you were to ask the daily fantasy sports sites, they would say no. They operate under the sweepstakes/skill game laws; there is no such thing as losses with skill games.

However, we’re concerned with Jane’s taxes, not a daily fantasy sports site’s taxes. A fundamental principal of US taxation is to look at the activity itself to determine what it is no matter what it calls itself. Ah yes, another instance of the Duck Test.

The tax laws on wagering (aka gambling) are different. You are allowed to take wagering (gambling) losses up to the amount of your winnings (§165(d) of the Tax Code). So we need to determine if daily fantasy sports are a wagering activity.

This is more difficult than you might think; wagering isn’t defined in the Tax Code. However, there are plenty of IRS and Tax Court rulings on this, and all say basically the same thing. For something to be gambling, three elements must be present:
1. A prize;
2. Chance; and
3. Consideration.

Clearly daily fantasy sports have elements 1 and 3. There’s a prize and there’s a cost to enter each event. Is there chance?

Gambling does not have to be 100% chance to be considered gambling. For example, poker is considered gambling under US tax law yet there’s plenty of skill involved with it. (Indeed, I’d argue that skill predominates over luck; however, there’s absolutely an element of luck in poker.) Let’s look at what’s involved with a daily fantasy sports contest. You generally select a team to play in a day’s events. Let’s say you selected Carlos Boozer and Shane Battier for today’s NBA daily fantasy sports contest. Those players scored 8 and 3 points, respectively. On the other hand, had you selected Taj Gibson and Chris Bosh you would have done far better; they scored 20 and 28 points. Yet before a single game who know what each player will score? If you had selected NBA star Lebron James you would normally do quite well; however, he didn’t play today.

There sure looks to me to be at least some elements of chance involved with who you select. While Carlos Boozer averages 14.8 points a game, he had only 8 today. On the other hand, Taj Gibson had 20 while he averages 12.9. Is that skill (that is, against the opponent they faced those players would play differently than their average) or is it luck? It’s probably some of each.

So daily fantasy sports have at least some element of luck. Then from a tax standpoint they sure look to be a form of wagering activity. There’s a prize, chance, and consideration. The Duck Test again: If it looks like a duck, walks like a duck and quacks like a duck, it might just be a duck.

So can players on daily fantasy sports sites treat their play like gambling? That’s something worth discussing with your tax professional if you partake in daily fantasy sports.

There’s a corollary to this: Do daily fantasy sports sites violate various gambling laws? (I am not an attorney and the following is just my speculation and not legal advice.) While the Unlawful Internet Gambling Enforcement Act (UIGEA) provides a carve-out for fantasy sports, there are numerous other gambling laws. Additionally, most states have laws on gambling. The daily fantasy sports sites all state they’re legal but I suspect that they probably violate various laws, mostly on the state level.

I looked at two sites. The first stated that the US government and most states consider fantasy sports to be a game of skill (this site doesn’t allow residents of AZ, IA, LA, MT, and WA to play). The second site used basically the same language and prohibits players from the same five states.

Unfortunately, many states look at just an element of chance to determine if something is gambling. And there’s no doubt that daily fantasy sports have such an element. The problem is that these sites are starting to bring in large dollars. That attracts attention, and some state attorney general is going to wonder the same thing that I am. He or she will conclude that the Duck Test applies and that these are gambling sites in violation of his or her state’s laws.

Posted in Gambling | Tagged | 4 Comments

What Are the Tax Impacts of the FullTiltPoker Remission Payments?

Posted on February 21, 2014 by Russ

In less than one week, many poker players will finally receive their balances that they had at FullTiltPoker when that online poker site was shut down as a result of “Black Friday.” According to the Garden City Group (the claims administrator hired by the US Department of Justice to handle the remission claims), the first payments will be made by the end of February. So how much of the money you receive will be income? Will 1099s be issued?

The answer to the first question–how much of the remission payment you receive is taxable–is “it depends.” This will depend on each individual’s facts and circumstances. I did an interview with CardPlayer last year and talked about some hypothetical cases. Some of this will be a repeat of that article while some of this will be new.

For most individuals, the amount of money you will pay tax on from the remission payments is the amount you receive less the amount you deposited less any money you receive that you’ve already paid taxes on. Let’s take three individuals, all of whom receive their full balances next week.

1. Joe receives $1,700. He earned it all in 2011, starting with a freeroll. He’ll have $1,700 of income that will need to be reported on his 2014 tax return.

2. Russ receives $1,700. He earned it all prior to 2011, and has already paid tax on all the money he’s receiving. He will not owe any tax on the remission.

3. John receives $1,700. He had a balance on January 1, 2011 of $500 (he paid taxes on this in previous years). He withdrew $500 during 2011 (and paid taxes on that). He’ll owe 2014 tax on the $1,200 he receives that he hasn’t paid tax on.

Those are all relatively simple scenarios. I can imagine far more complex ones; indeed, I spoke with someone today who has such a scenario. There are people with disputed balances, “Red Pros,” affiliates and others who still don’t know what they’ll receive. Anyone who doesn’t have a simple, straightforward scenario should consider speaking with a competent tax professional regarding their remission payments.

The other major question is whether or not GCG will issue Form 1099-MISCs to recipients. We don’t know the answer to this, and we likely won’t know until early February 2015. GCG hasn’t said they would (nor have they said they wouldn’t); they’ve been silent on this issue. It may be they simply don’t know. If 1099s will be issued, the deadline for mailing them out will be January 31, 2015.

The problem with issuing 1099s is that for most individuals the amount of money being received will not all be income. Almost everyone deposited something on FullTiltPoker; the return of those deposits is clearly not taxable. I could speculate on whether 1099s will be issued, but it would be just that: speculation. Until GCG makes a pronouncement or we’re one year from today (when 1099s would have been received), we just don’t know. My hope is that 1099s will not be issued because almost every one of them would be wrong. If there is official guidance on this from GCG I’ll update this post with that information.

So we are definitely nearing the end of the FTP remission process. That is definitely good news.

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The Fun With the Two-Month Automatic Extension Continues

Posted on February 20, 2014 by Russ

I’ve been having issues with clients who take the automatic two-month extension. As I learned years ago, a taxpayer outside of the United States on April 15th gets two extra months to file his return. This is noted in Treasury Regulation 26 CFR § 1.6073-4 (b):

Citizens outside the United States. In the case of a United States citizen outside the United States and Puerto Rico on the 15th day of the 4th month of his taxable year, an extension of time for filing the declaration of estimated tax otherwise due on or before the 15th day of the 4th month of the taxable year is granted to and including the 15th day of the 6th month of the taxable year. For purposes of applying this paragraph to taxable years beginning prior to January 1, 1964, Alaska shall be considered outside the United States.

That seems pretty specific to me. Given the reference to Alaska it’s pretty clear this regulation has been on the books for a long, long time.

It’s also noted in the Internal Revenue Manual. IRM 3.11.3.5.7.3 states:

Edit CCC “N” when the taxpayer is qualified for an automatic two-month extension. A taxpayer qualifies for this special extension if-on the date his/her return is due-the taxpayer meets any of the following criteria:
• Indication the taxpayer lives outside the U.S. and Puerto Rico and main place of work is outside the U.S. and Puerto Rico
• Indication the taxpayer is on military or naval duty outside of the U.S. and Puerto Rico
• Indication of taxpayer “abroad” or “overseas”.
• APO/FPO/DPO address. [emphases added]

I reported this as a systemic issue, and the IRS, after investigating, agreed. However, this got referred up the line and a supervisor told my contact in the systemic issues group that the two month extension apparently doesn’t exist; that it was eliminated when IRC §6073 was repealed in 1984. I pointed out to my contact both the regulation and the IRM. My contact didn’t know what the impact was on a regulation when the overlying code section is repealed. I said that since the regulation is still on the books, and regulations do carry the force of law, it’s valid. She said she’s referring this back to the supervisor along with the regulation and the IRM section.

In any case, it’s another step backwards after what I thought was a step forward. Meanwhile, to date all my clients who have been hit with erroneous penalties have had them removed…eventually.

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Tax on the Run Owners Run to ClubFed

Posted on February 16, 2014 by Russ

Here’s a scheme for you: The government has set up this new tax credit worth thousands of dollars. What if we find some impoverished individuals, have them fill out tax returns claiming this credit, and we pocket all that cash? We’ll just phony up some other parts of the return to make it look real. They’ll never catch us!

As an aside, this sort of thing happens with all refundable tax credits. It’s one of the reasons why they attract fraudsters like moths are drawn to bright lights.

Yes, this really happened…except for the part about never being caught. Jason Altman, his brother Jarrod, and Emanuel Harrison owned Tax on the Run, a tax preparation business in Dallas, Texas. They got the bright idea about the First Time Homebuyer’s Credit and did recruit individuals to file tax returns for the credit. They invented Schedule C’s (sole proprietorships) for those individuals so it looked like they made money (enough to afford a house) and then added in the homebuyer’s credit. Amazingly enough, all of those returns had refunds. They also had these clients obtain refund anticipation loans. Once the loan was approved, they drove the taxpayer to a check cashing business where their refund check was cashed. The members of the conspiracy took most of the money. None of the clients qualified for the homebuyer’s credit.

Jason Altman and Emanuel Harrison had already received 7 years at ClubFed. Jarrod Altman was luckier: He received eight months of home confinement as part of three years of probation on Friday. The trio used intermediaries to recruit impoverished taxpayers; the intermediaries are also heading to ClubFed. Everyone involved must also make restitution to the IRS.

Hopefully, our Congresscritters won’t invent new refundable credits. Wait, isn’t there something new this year with medical care?

Posted in Tax Fraud | 1 Comment

Utopia Is Dead

Posted on February 16, 2014 by Russ

A perfect place. That’s what comes to my mind when I hear the word “utopia.”

Vincent and Mary Giamo had a different idea; Utopia was their nightclub in Orchard Park, New York (near Buffalo). It was quite successful as they followed a formula that is illegal but helps with taxes: They kept two sets of books. One set was accurate, and showed they would owe $1.2 million in taxes to the IRS. The other set shockingly showed they didn’t owe that money. This scheme works quite well…until you’re caught.

And the Giamos were caught, tried, and convicted of tax evasion charges. Vincent received 12 months at ClubFed; his wife, Mary, received probation. They must also make restitution of another $671,840 to the IRS (they’ve already paid $550,000). They are also facing civil charges.

As usual, it’s a whole lot easier to just pay your taxes in the first place…but that though rarely occurs to the Bozo mind.

Posted in Tax Evasion | Comments Off on Utopia Is Dead

Texas’s Gain Is California’s Loss

Posted on February 16, 2014 by Russ

Today a client asked me about where to relocate her company headquarters. Her computer engineers aren’t thrilled with the current location, and would like to move to either California or Texas. I explained the decision has a cost difference of $165,000.

Currently, there’s a small office in California with one employee. The business, which is an S-Corporation, is taxed on the personal level (as almost all S-Corporations are). The business is profitable.

California uses a one-factor sales test to determine the percentage of income attributable to the state. Most of the sales of the company are not to California; she only owes a small amount of tax to California based on the income. Her California tax bill today is more of an annoyance than anything else.

However, if the company’s headquarters moved to California, then all sales not attributable to a state the company does business in would be attributable to California. In running an estimate for 2014, that amounts to an additional $170,000 she would owe in California tax.

On the other hand, Texas doesn’t have a state income tax. If the company’s headquarters moves to Dallas, her tax bill won’t change. Her engineers may like the Bronze Golden State slightly more than the Lone Star State; however, my client is a businesswoman who understands math.

This is a true story, and there’s no doubt in my mind that what I told my client has been duplicated by hundreds of accountants throughout the country. Taxes matter, as always.

Posted in California, Texas | Comments Off on Texas’s Gain Is California’s Loss

DC Court of Appeals Rules Against IRS: Loving Decision Upheld

Posted on February 11, 2014 by Russ

This morning the US Court of Appeals for the District of Columbia unanimously upheld the district court’s decision in Loving v. IRS. This means that the IRS’s goal of mandating licensing for all tax professionals is dead. At some future date Congress might enact such laws, but until that happens the RTRP designation is likely dead.

The IRS had interpreted an 1884 statute “signed by President Chester A. Arthur” (how often can I put President Chester Arthur into a blog post!) that regulated the practice of representatives of persons before the Department of the Treasury (31 U.S.C. § 330(a)(1)) to mean they could regulate all tax professionals.

In our view, at least six considerations foreclose the IRS’s interpretation of the statute.

That’s what the Court found, and let’s go over each in turn.

First is the meaning of the key statutory term “representatives.” In its opening brief, the IRS simply asserts that there “can be no serious dispute that paid tax-return preparers are ‘representatives of persons.’” IRS Br. 31 n.11. Beyond that ipse dixit, however, the IRS never explains how a tax-return preparer “represents” a taxpayer. And for good reason: The term “representative” is traditionally and commonly defined as an agent with authority to bind others, a description that does not fit tax-return preparers…

Put simply, tax-return preparers are not agents. They do not possess legal authority to act on the taxpayer’s behalf. They cannot legally bind the taxpayer by acting on the taxpayer’s behalf. The IRS cites no law suggesting that tax-return preparers have legal authority to act on behalf of taxpayers.

The second problem is that “practice…before the Department of the Treasury” doesn’t mean tax preparation. And for my friend Scott, some of the argument in this section turns on grammar: Congress used an “and” rather than an “or” in Section 330(a)(2), and the IRS’s view that practice before Treasury meant preparing tax returns was wrong.

The third issue is that Section 330 was enacted for people making claims against the Treasury. Here’s the Court’s excerpt:

[T]he Secretary of the Treasury may prescribe rules and regulations governing the recognition of agents, attorneys, or other persons representing claimants before his Department, and may require of such persons, agents and attorneys, before being recognized as representatives of claimants, that they shall show that they are of good character and in good repute, possessed of the necessary qualifications to enable them to render such claimants valuable service, and otherwise competent to advise and assist such claimants in the presentation of their cases. [Emphases in original]

The Court didn’t believe that this meant tax preparers.

The fourth issue is that the broader statutory framework already includes regulations on tax preparers.

Under the IRS’s view here, however, all of Congress’s statutory amendments would have been unnecessary. The IRS, by virtue of its heretofore undiscovered carte blanche grant of authority from Section 330, would already have had free rein to impose an array of penalties on any tax-return preparer who “is incompetent,” “is disreputable,” “violates regulations prescribed under” Section 330, or “with intent to defraud, willfully and knowingly misleads or threatens the person being represented or a prospective person to be represented.”

The fifth issue is that the scope of authority that the IRS claimed was beyond the scope anticipated by Congress in passing Section 330. I think this is the weakest of the six reasons as noted by the Court: There was no tax preparation industry in 1884. Still, it’s another point where the IRS lost.

The final issue is that the IRS never interpreted the law during the 127 years preceding 2011 as giving it the authority to regulate tax professionals.

Until 2011, the IRS never interpreted the statute to give it authority to regulate tax-return preparers. Nor did the IRS ever suggest that it possessed this authority but simply chose, in its discretion, not to exercise it. In 2005, moreover, the head of the IRS’s Criminal Investigation Division testified to Congress that “[t]ax return preparers are not deemed as individuals who represent individuals before the IRS.” Fraud in Income Tax Return Preparation: Hearing Before the Subcommittee on Oversight of the House Committee on Ways and Means, 109th Congress (2005) (testimony of Nancy J. Jardini). At the same hearing, the National Taxpayer Advocate – the government official who acts as a kind of IRS ombudsperson – stated to Congress that “the IRS currently has no authority to license preparers or require basic knowledge about how to prepare returns.”

All-in-all, the IRS’s proposed regulations on tax professionals are as dead as the dodo bird.

I’ve had quite a few individuals ask me why I’m against regulating tax professionals. I’m regulated as an Enrolled Agent; why shouldn’t others? After all, I report on bozo tax professionals all the time.

If Congress lawfully decides that regulating tax professionals should be done, that’s fine. However, I am very much opposed to the huge expansion of government during the past thirty years. The real problem is the huge complexity of the Tax Code, and the biggest villain here is Congress. Rather than regulating tax professionals, we need to regulate (gut) the Tax Code itself.

Finally, I want to congratulate Posted in IRS | Tagged | 1 Comment

Really Big Tax Evasion Leads to Really Long Sentence at ClubFed

Posted on February 9, 2014 by Russ

There’s tax evasion, big tax evasion, and then we have this story of really, really big tax evasion. And we also must highlight once again that tax protester arguments have as much chance of flying as the dodo bird.

I’ve actually written about this case before. Back in 2010 Bill Melot, a farmer in New Mexico, was convicted of tax evasion, agriculture program fraud, and several related offenses. His tax liability to the IRS was estimated at $18 million. When he was sentenced in 2011 he received five years at ClubFed followed by three years of supervised release. Mr. Melot appealed his conviction; the government appealed the sentence. The DOJ thought he should receive a far longer stay at ClubFed.

Last October the 10th Circuit Court of Appeals ruled on the appeals. Suffice to say it didn’t go well for Mr. Melot. Here’s a pertinent excerpt:

The Government’s evidence demonstrated overwhelmingly that Melot engaged in behavior consistent with an individual who had actual knowledge of his obligation to file returns and pay tax. Melot paid employees in cash, advising them they could avoid reporting the cash payments as income. He attempted to pay cash for inventory for his gas stations, in an effort to avoid creating a paper trail in his bank account. He used Social Security numbers he knew were false for numerous purposes. He transferred substantial assets into a foreign bank account but failed to file the necessary disclosure forms with the IRS. He frequently made domestic bank deposits in amounts slightly below $10,000, the amount at which he knew a bank must file a currency transaction report with the Internal Revenue Service. He transferred assets to corporations and trusts and used nominees to open bank accounts, but admitted he maintained control over the assets associated with these accounts and entities. He sent letters to the Internal Revenue Service denying he was a United States citizen or claiming to be either a non-resident alien or a citizen of the “republic of New Mexico.” Nonetheless, when he applied for a passport from the State Department and agricultural farm subsidies from the Department of Agriculture, Melot declared he was a United States citizen.

Both Mr. Melot and the DOJ didn’t like the sentence. Mr. Melot thought it was too long; the DOJ though it was too short. The sentencing judge had given Mr. Melot a two-level decrease (in the federal sentencing guidelines) for acceptance of responsibility. There was a problem with this according to the Court of Appeals:

…nor did [Melot] engage in any other conduct demonstrating an acceptance of responsibility for his offenses…To the contrary, the record clearly shows Melot continued to deny that he willfully engaged in criminal conduct and unambiguously shows Melot did not voluntarily pay restitution.

The Court of Appeals ordered a new sentencing hearing, with no downward adjustment in federal sentencing guidelines. It was not Mr. Melot’s day at the Court of Appeals.

The sentencing hearing occurred last week, and Mr. Melot’s five years at ClubFed lengthened to 14 years at ClubFed. The restitution hasn’t changed: $18,469,998 to the IRS and $226,526 to the Department of Agriculture.

Mr. Melot apparently believed that tax protester arguments (see the Tax Protester FAQ for a complete dismissal of each and every one of them) work. They don’t. Mr. Melot will have plenty of time to think that through.

Posted in Tax Evasion | 1 Comment

Mailbag: Can Gambling Income Transform to Ordinary Income by Moving It Through a Business Entity?

Posted on February 9, 2014 by Russ

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.

Posted in Gambling, IRS | Comments Off on Mailbag: Can Gambling Income Transform to Ordinary Income by Moving It Through a Business Entity?