Taxable Talk

Yesterday, the Tax Court ruled in Au v. Commissioner. The Aus, husband and wife from California, gambled during 2006 but lost money. Indeed, they lost over $40,000. They took those gambling losses as a miscellaneous itemized deduction.

Unfortunately, the Tax Code doesn’t allow that. Section 165(d) of the Tax Code states that gambling losses are deductible as a miscellaneous itemized deduction (not subject to the 2% AGI limitation on miscellaneous itemized deduction) up to the amount of gambling winnings. Since the Aus had no gambling winnings, they couldn’t take any gambling losses.

The Aus, as Joe Kristan notes, contested the accuracy-related penalty they were charged. They relied on the “Turbo Tax” defense: Tax Cut (the software they used to prepare their return) allowed us to do this.

Petitioners contend that they followed the instructions on the tax preparation software that they used in preparing their 2006 tax return, asserting that the software was “approved by the IRS”. They indicate that they were unaware of the provisions of the Code and that they did not consult any Internal Revenue Service (IRS) publications or professional tax advisers before claiming deductions equaling almost half of their reported income in 2006. The software instructions are not in the record, so we cannot determine how the error occurred. We doubt that the instructions, if correctly followed, permitted a result contrary to the express language of the Code. Petitioners may have acted in good faith but made a mistake. In the absence of evidence of a mistake in the instructions or a more thorough effort by petitioners to determine their correct tax liability, we cannot conclude that they have shown reasonable cause for the underpayment of tax on their 2006 return.

The Turbo Tax defense doesn’t work in Tax Court.

The Court also noted that they gave plenty of opportunities for the Aus to negotiate a settlement with the IRS, and/or to consult attorneys regarding their case. They didn’t until the Court was about to render its decision. Had they asked a tax professional or an attorney familiar with tax law about their case, they likely would have been advised to settle and they would be paying less than they’ll have to.

Case: Au v. Commissioner, T.C. Memo. 2010-247

Nine individuals came to Las Vegas this past weekend to compete for the championship at the World Series of Poker. Who would be the lucky winner? And who really got to keep the money?

This year’s World Series of Poker concluded late last night at the Rio Hotel and Casino in Las Vegas. The winner of the main event won $8,944,310 but would he actually end up with all that money?

This year we have the first winner ever from Canada. Congratulation to Jonathan Duhamel of Boucherville, Quebec.

Let’s see how much of the prize Mr. Duhamel will actually keep. First, as a Canadian he loses 30% of his win to the IRS. Under the US-Canada Tax Treaty, that’s the percentage of gambling winnings that’s withheld by the IRS. So the IRS gets $2,683,293. Mr. Duhamel can file a Form 1040NR in 2011 and get back some of what was withheld if he can show gambling losses while in the US. However, that probably won’t change his tax situation.

I say probably because there is some debate as to how Canada treats professional gamblers. (Amateur gamblers in Canada do not pay income tax on their gambling winnings.) Canadian tax law is similar to US tax law in that individuals who have a business are supposed to pay income tax on the income from their business. However, unlike in the US where it is very clear that a professional gambler owes income tax on his winnings (there are numerous court decisions stating this), there are fewer decisions in Canada. Additionally, the decisions that exist are older and not necessarily ‘on point’ as they are in the US.

That said, given the amount that Mr. Duhamel won, and the tax rate in Quebec (see below), I strongly suspect that Revenue Canada and Revenue Quebec will be sending Mr. Duhamel a “Dear Valued Taxpayer” letter (perhaps I should say “Cher Contribuable” lettre) if he decides not to include his $8,944,310 on his 2010 tax return. I think it quite likely that Mr. Duhamel is subject to income tax on his winnings.

In any case, Quebec is decidedly not a low tax province with a top marginal tax rate of 48.22% in 2010 (that starts at income over $127,020 CAD and includes both federal and provincial income tax). All told, Mr. Duhamel’s Canadian and provincial tax will total $4,293.560 (expressed in US Dollars). Luckily, he should be able to take a tax credit for the tax withheld and taken by the IRS, so his Canadian tax bite will only be $1,610,267. Overall, Mr. Duhamel lost 48% of his win to taxes.

John Racener, a professional poker player from Port Richey, Florida, finished in second place. Mr. Richey entered heads-up play trailing by a six-to-one margin and couldn’t overcome the deficit. The $5,545,855 will likely assuage his feelings of finishing second. Florida is a popular locale for professional gamblers: There’s a nice climate and no state income tax. I estimate that Mr. Racener will owe $2,105,160 to the IRS (38% of his winnings will go to taxes).

Finishing third was Joseph Cheong of San Diego. Mr. Cheong, another professional poker player, delighted California’s Franchise Tax Board with his high finish. Actually, it looked like Mr. Cheong would make it to heads-up play but he lost a huge pot that propelled Mr. Duhamel to his victory. Mr. Cheong will likely owe $1,578,346 to the IRS and $432,147 to the FTB. That’s a total tax bite of $2,010,493. Mr. Cheong may not have won the tournament but he did win the prize of facing the highest tax rate on his winnings: 49%.

Filippo Candio of Caligari, Sardinia, Italy was the only non-North American player to make the final nine. Italy has a tax treaty with the United States that exempts gambling, so none of Mr. Candio’s winnings will be taxed by the IRS. However, Mr. Candio is a professional gambler and his winnings will be subject to income tax in Italy. Italy’s marginal tax rate goes up to 43% on earnings above €75,000. For finishing fourth, he earned $3,092,545 (€2,201,892). I estimate he’ll owe €924,664 in tax to the Agenzia delle Entrate. That equates to $1,298,685. In Dollars or Euros, Mr. Candio faces a 42% tax on his winnings.

Michael “The Grinder” Mizrachi was the most well known of the players who made the final table. You may remember that Mr. Mizrachi faced tax troubles earlier this year. Mr. Mizrachi later stated that he has paid those taxes.

Mr. Mizrachi almost won Player of the Year at the WSOP. Earlier, he won the Players’ Championship, a $50,000 buy-in event, and collected $1,559,046 for that win. For finishing fifth in the main event he collected $2,332,992. Mr. Mizrachi resides in Miami so he doesn’t have to worry about state income tax. However, he will owe about $868,970 to the IRS for this result (37% tax rate).

Another Floridian, John Dolan, finished sixth. Mr. Dolan is a professional gambler so like all American professionals the tax he owes to the IRS includes the self-employment tax. I estimate that Mr. Dolan will owe $651,430 out of the $1,772,959 he collected for finishing sixth (37% lost to taxes).

Jason Senti of St. Louis Park, Minnesota finished seventh. Mr. Senti is a professional gambler, and he also recently was married. He’ll be able to afford a nice honeymoon with the $1,356,720 he collected for seventh place. He will have to pay an estimated $103,826 to the Minnesota Department of Revenue and $486,381 to the IRS. Overall, he lost 43.5% to tax.

The only two amateur gamblers in the final nine finished in eighth and ninth places. Matthew Jarvis of Surrey, British Columbia finished in eighth place. Mr. Jarvis had 30% of his $1,045,743 in winnings withheld for the IRS ($313,723). As an amateur gambler he won’t have to pay tax to Canada on his winnings.

Cuong “Soi” Nguyen of nearby Santa Ana finished in ninth place. Mr. Nguyen collected $811,823 for his efforts. As a resident of California he will have to pay tax to the FTB ($77,624) as well as to the IRS ($270,119). Mr. Nguyen figures to lose nearly 42% of his winnings to taxes.

Here’s a table summarizing the tax bite:

That’s a total tax bite of 42.99%.

Here’s a second table with the winners sorted by their estimated take-home winnings:

As you can see, taxes make a big difference in the true amount of winnings. The real winner at the World Series of Poker was the Internal Revenue Service with Mr. Duhamel finishing over $4,306,000 behind.

So congratulations to the winners. Just remember that a winner—perhaps the biggest winner of all—is the taxman. As we all know the house always wins.