Taxable Talk

In this article, part 3 of probably 5 parts, I examine recordkeeping and professional status for online gamblers. Unfortunately, a lot of this material is, frankly, boring. But it’s necessary. Some of the material in this article is based on an article I wrote for Chuck Humphrey’s excellent website, http://www.gambling-law-us.com/. The original article can be found here.

First, let’s examine the situation for the casual (or non-professional) gambler. The Tax Code requires gamblers to record their wins and losses by session. You take all of your winning sessions for the year, add them together, and you come up with a result. Let’s assume that’s $12,000.00. Then you take all your losing sessions, add those up, and come up with a second number. Let’s further assume that’s $10,000.00. However, you cannot net those two numbers! The wins go as part of Other Income (line 21) while the losses are an itemizable deduction (Schedule A) not subject to the 2% AGI limitation on itemized deductions.

Well, you’re probably thinking that there’s no particular difference between netting and this result. That’s wrong, for three reasons. First, if you don’t itemize your deductions (because you don’t have enough deductions to itemize) you lose out on your gambling losses. In such a situation your gambling losses are presumed to be part of your standard deduction. Second, many items on the tax return are tied to Adjusted Gross Income (AGI). The prescribed method for handling gambling income and losses increases AGI (even if the taxable income remains unchanged). This can limit some taxpayers’ other deductions, including medical and miscellaneous itemized deductions. Finally, gambling losses can, in certain circumstances, trigger the dreaded Alternative Minimum Tax (AMT).

So you ask, why not declare myself a “professional” gambler. A few years ago that would not have been possible. Luckily a gambler named Robert P. Groetzinger fought the IRS on this issue. In a case that made it to the Supreme Court, the court held that you can legally be a professional gambler. The most relevant portion of the opinion reads:

…[W]e conclude that if one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the meaning of the statutes with which we are here concerned. Respondent [480 U.S. 23, 36] Groetzinger satisfied that test in 1978. Constant and largescale effort on his part was made. Skill was required and was applied. He did what he did for a livelihood, though with a less-than-successful result. This was not a hobby or a passing fancy or an occasional bet for amusement. [Commissioner v. Groetzinger, 480 U.S. 23 (1987)]

There are some caveats to this. Note the usage of full time, with regularity, and production of income for a livelihood. If you gamble in this manner, you can classify yourself as a professional. And, yes, you can be a professional gambler and lose.

Professional gamblers have a business. They file their gambling results on Schedule C. Their wins and losses are netted, they may deduct necessary and reasonable expenses (i.e. mileage and travel, computer ISP, books and other training materials, etc.). However, they are subject to self-employment tax (Schedule SE). That tax (equivalent to Social Security and Medicare) is 15.3% of the first $90,000 of income (2005 limits) and 2.9% thereafter. You do get to deduct half of your self-employment tax as an adjustment to income on line 30 of Form 1040. For some gamblers, it’s cheaper (for taxes) to be an amateur than a professional. Talk to a professional tax advisor before making the decision to become a professional gambler. There are several other caveats and limitations.

Finally, the IRS has fought some taxpayers who have declared themselves professionals. The IRS has been relying on the literal wording of the Groetzinger decision; that a professional must be a “full time” gambler. They have rejected that status for some gamblers who maintain other businesses. None of these cases have been decided in Tax Court (yet). I think this is a losing position for the IRS. Consider a hypothetical professional gambler, John Smith. Mr. Smith plays in only the biggest poker tournaments of the year. The remainder of the year he and his wife operate a successful jewelry store. He files two Schedule C’s on his return. Is he a professional gambler?

Of course he is, assuming that his goal is to earn income from gambling—”…[the] production of income for a livelihood….” There are many individuals who file multiple Schedule C’s. I believe that the IRS’s position is wrong. However, be forewarned. If you’re in this situation the IRS may fight you.

In conclusion, becoming a professional gambler should be decided on the basis of your skill (in gambling), not your tax situation. However, you must keep your tax situation in mind.

In part 4 (coming next week), I’ll take a look at some tax filing requirements for gamblers. The joy of estimated taxes, state taxes, and how some states treat (or mistreat) gamblers. I’ll also look at some legal realities of online gambling.

I recently read a blog where a very successful online poker player wrote,

There really aren’t IRS regulations on online gambling. It exists in a grey area. As fun160 pointed out “In the financial markets money earned off-shore is not taxable until it is repatriated. A strong case can be made that the same is true for off-shore gambling.”

I have talked to CPAs about whether the taxes should be paid upon earning the money or upon cashing out and the answer I was given is that a strong argument could be made for either. In the end it would be up to a court.

Well, some of the statements this player made are true: there aren’t any IRS regulations on online gambling and I’m sure he spoke with a CPA. As to the rest…

1. The recognition of income is a long-decided principle in the United States based on the concept of Constructive Receipt of Income. As the IRS’s Publication 525 states, “You are generally taxed on income that is available to you, regardless of whether or not it is in your posession.” Let’s say you win $500 at the poker club, but you decide to leave it in the form of chips and put it in your safety deposit box. It’s still income.

2. “But I won the money online, and it’s in [Gibraltar, the Isle of Man, Costa Rica, etc.], and not in my hands….” So what! When there are no specific rules governing the online world, the rules of the real world govern. The rules for gambling income are quite clear. You must keep a log of your sessions, you must report wins and losses by session, with your wins going on Line 21 (Other Income) and losses as an itemizable deduction not subject to the 2% limitation on AGI. Repatriation of income as far as gambling is totally irrelevant. Offshore casinos are considered by the IRS as just another taxpayer avoidance scheme (see here).

3. Repatriation of investment income isn’t relevant, either. Let’s say you have an investment in a hypothetical British company, BritCo Ltd. They declare a dividend of £2 per share today and you own 10 shares. You will owe the dollar equivalent of tax based on £20 on this year’s tax return. You will get a tax credit for any British taxes imposed on your investment, and you may be able to deduct investment expenses on your investment.

4. “In the end it would be up to a court.” Well, anyone can bring a case in Tax Court. Since there has yet to be a case in Tax Court on online gambling, it’s unlikely you’ll end up paying a frivolous penalty. But you’re going to lose. There have been many Tax Court cases dealing with the issue of constructive receipt. The opinion in a recent case, Millard v. Commissioner (TC Memo 2005-192) notes, “Consequently, a cash method taxpayer constructively receives income as of the date that a check is received absent a substantial limitation. Furstenberg v. Commissioner, 83 T.C. 755, 791 n.28 (1984); Kahler v. Commissioner, 18 T.C. 31, 34-35 (1952); Roberts v. Commissioner, T.C. Memo. 2002-281.” Now, I find it hard to believe that the Tax Court would rule that money put in a players’ online casino account wasn’t constructively received.

The tax rules for online gambling are quite clear—the rules are the exact same as in the brick and mortar world of casinos. This may not be what the typical online gambler wants to hear, but it’s the bitter truth.

In Part 3 (coming next week), I’ll examine how to keep records, what a session really is, and whether or not you are (or want to be) a professional gambler.