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Gambling CPA Can't Deduct Share of Racetrack's "Take Out" Expenses.
(Parker Tax Publishing March 28, 2014)

It's difficult, but not impossible, for a gambler to deduct gambling expenses as a business expense. However, gambling losses are not treated as a business expense but instead are deductible up to gambling winnings, and only as an itemized deduction. While the gambling winnings are reported as gross income on page 1 of the Form 1040, the losses are deductible only if the taxpayer itemizes his or her deductions and then, only to the extent of gambling winnings.

In Lakhani v. Comm'r, 142 T.C. No. 8 (3/11/14), a CPA who lost more money gambling at the race track than he made in his accounting practice argued that he was entitled to deduct his pro rata shares of the track's "takeout" from the parimutuel betting pools, which would wholly or partially offset the disallowed net gambling losses for the years at issue. Unfortunately, the Tax Court rejected the CPA's argument, holding that because the takeout expenses represented obligations of the race track and not the bettors, the CPA was not entitled to deduct any portion of such expenses.

Facts

For 2005-2009, Shiraz Lakhani was a CPA who operated an accounting practice in California that included the preparation of tax returns. He reported the income and expenses from his accounting practice on a Form 1040, U.S. Individual Income Tax Return, Schedule C, Profit or Loss From Business. During those years, Shiraz was also a professional gambler whose gambling activities were limited to parimutuel wagering on horse races. Shiraz placed bets on races occurring both at California racetracks and at racetracks in other states.

Shiraz reported his gambling winnings and losses on a separate Schedule C (i.e., his gambling Schedule C) for each of the years at issue. On each of the gambling Schedules C, he reported the gross amount he received on winning bets as "Gross receipts or sales," and he reported the amounts he bet as "Cost of goods sold," subtracting the latter from the former, to determine his gross income or loss from gambling. He also reported and deducted miscellaneous other expenses associated with his gambling activities and reported the sum of his gambling winnings, losses, and miscellaneous other expenses as his income or loss (net gambling income or loss, respectively) from gambling for the year. He then combined his net gambling income or loss with his accounting practice income for the year and reported the sum of the two on page 1, Line 12 of his Form 1040 as his total net "Business income or (loss)" for the year.

For each of 2005, 2006, 2008, and 2009 (gambling loss years), Shiraz's net gambling loss exceeded his accounting practice income, so that Line 12 of each Form 1040 reported a business loss. For 2007, in which he reported a net gambling gain, and for 2009, Shiraz claimed net operating loss carryover deductions, which arose out of unused net gambling losses incurred in prior years.

Upon auditing Shiraz's tax returns, the IRS adjusted each of the gambling loss years by disallowing Shiraz's deduction for his net gambling losses on the basis of Code Sec. 165(d), which provides that gambling losses are allowed only to the extent of the gains from such transactions. The IRS also disallowed the net operating loss carryovers to 2007 and 2009.

General Rules for Deducting Gambling Losses

Taxpayers must report the full amount of their gambling winnings for a year (with no reduction for gambling losses) as income on page 1 of Form 1040. Under Code Sec. 67(b)(3), taxpayers can deduct their gambling losses for the year separately on Schedule A (Form 1040) as a miscellaneous itemized deduction not subject to the 2 percent floor. Under Code Sec. 165(d), taxpayers cannot deduct gambling losses in excess of winnings.

However, the limitation in Code Sec. 165(d) does not limit deductions for expenses incurred to engage in the trade or business of gambling. In Mayo v. Comm'r, 136 T.C. 81 (2011), the Tax Court held that a gambler's business expenses were not "losses from wagering transactions" subject to the Code Sec. 165 deduction limitation. Such business expenses, the Tax Court concluded, are deductible under Code Sec. 162. In AOD-2011-06, the IRS acquiesced to that decision.

Example: Ronald is in the trade or business of gambling on horse races. During the year, Ronald incurred $10,000 of business expenses relating to gambling. He also had an $11,000 loss from gambling (gambling gains of $120,000 less gambling losses of $131,000). Ronald cannot deduct the $11,000 of excess gambling losses over gambling gains. However, he can deduct the $10,000 of gambling business expenses on his Schedule C.

Parimutuel Wagering and the "Takeout"

In parimutuel wagering, the entire amount wagered on horse races is referred to as the betting pool or "handle." The pool can be managed to ensure that the event manager (i.e., the track) receives a share (or a percentage) of the betting pool regardless of who wins a particular event or race. That share is referred to as the "takeout," and the percentage, set by state law, varies from state to state, generally ranging from 15 percent to 25 percent and often depending upon the type of bet, e.g., "straight" or "conventional" win, place, or show wagers or "exotic" (multiple horse or multiple race) wagers, the latter usually resulting in higher takeout percentages.

The takeout is used to defray the track's expenses, including purse money for the horse owners, taxes, license fees, and other state-mandated amounts. What remains from the takeout after those expenses are paid is the track's profits. The takeout may also be used to cover any shortfall in the amount available in the parimutuel pool, after reduction for takeout, to pay off the winning bettors. That circumstance, generally referred to as the creation of a "minus pool," arises by virtue of the requirement, in many states, that the track provide a minimum profit to winning ticket holders.

Taxpayer's Argument

Shiraz argued that, in extracting takeout from the betting pools, the tracks are acting in the capacity of a fiduciary because they are collecting taxes and fees that they are then sending to the different state and local tax authorities. He likened the process to that of an employer collecting payroll taxes from employees and sending the payroll taxes to the IRS and state agencies.

According to Shiraz, his pro rata share of the takeout is a business expense and, as such, is not a loss from gambling subject to disallowance under Code Sec. 165(d). In making this argument, Shiraz cited the Tax Court's opinion in Mayo.

Shiraz also argued that the Code Sec. 165(d) limitation does not apply to the expenses, including the net gambling losses, of a professional gambler because professional gamblers are entitled to the same protection as any other profession when the activity is legal and conducted as a profession. According to Shiraz, Congress enacted Code Sec. 165(d) many decades ago, only because, at that time gambling was taboo. Now that gambling is legal in most states, Shiraz said, Code Sec. 165(d) is a discriminatory, unconstitutional deprivation of professional gamblers' right to equal protection under the law. Thus, he argued, Code Sec. 165(d) should be considered unconstitutional and struck down since gambling is part of American life and professional gamblers are "recognized in society and on television."

IRS's Arguments

The IRS's main arguments against allowing Shiraz's deductions were the following:

(1) because the race track takeout is paid from the pool remaining from losing bets, it is inseparable from the gambling transaction and constitutes gambling losses subject to the Code Sec. 165(d) limitation; and

(2) the taxes, license fees, and other expenses discharged from the takeout are expenses owed and paid by the track, not by the individual bettor.

The IRS also argued that, even if a deduction for takeout were available to Shiraz, his failure to furnish the factual information necessary to make a reasonable determination of the takeout percentage applicable to his losing bets (e.g., the extent to which those bets were attributable to the various parimutuel pools with varying takeout percentages at tracks in various states) was sufficient to bar Shiraz's right to a passthrough deduction for takeout expenses.

With respect to Shiraz's equal protection argument, the IRS pointed out that, in Valenti v. Comm'r, T.C. Memo. 1994-483, the Tax Court rejected that argument after noting the historical distinction between gambling and other forms of business activity. In Valenti, the court held that where a classification that differentiates the business of gambling from other businesses has a rational basis, that rational basis must be supported. The Tax Court concluded that the argument in Valenti that Code Sec. 165(d) violates equal protection as applied to those engaged in the trade or business of gambling bordered on the frivolous. Thus, the IRS said, Shiraz's equal protection argument was contrary to settled law and, therefore, should be rejected.

Tax Court's Analysis

The Tax Court began its analysis by agreeing with the IRS that, because the taxes, license fees, and other expenses discharged from the takeout are expenses imposed upon the track and not the bettors, Shiraz was not entitled to a deduction for any of those expenses.

The court said that Shiraz's attempt to analogize the track's retention and disbursement of takeout to an employer's payroll tax obligations with respect to its employees was misguided. First and foremost, the court observed, none of the payments the track makes from the "handle" (i.e., betting pool) discharge any obligation of any bettor. And while reduction of the parimutuel pool by the amount of the takeout reduces the amount in the pool available to pay winning wagers, none of the takeout can be said to come from a winning bettor's wager, which in all events must be returned to him in full with at least a small profit.

Because the takeout is not an obligation or expense of the bettor, the court said, it cannot qualify as the bettor's deductible nongambling business expense under Mayo. Thus, the court held that Shiraz was not entitled to a passthrough deduction of such expenses under Code Sec. 162, Code Sec. 165, or Code Sec. 212.

With respect to Shiraz's argument regarding the constitutionality of Code Sec. 165(d), the court agreed with the IRS that its decision in Valenti was dispositive of Shiraz's equal protection claim. The lessening in recent time of the historical moral opposition to gambling, the court stated, does not undercut the rational basis for treating professional gambling losses differently from other business-related losses. The basis for enacting the former version of Code Sec. 165(d) was to force taxpayers to report their gambling gains if they wanted to deduct their gambling losses. According to the Tax Court, this constitutes a rational basis for the continued application of Code Sec. 165(d) to gambling losses. (Staff Editor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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