Taxing Lessons From Court Decisions

Decisions — The rules of the game

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Image Source: Free Picture: Business GambleID: 53799 Dana Rothstein Dreamstime Stock Photos
Image Source: Free Picture: Business GambleID: 53799 Dana Rothstein Dreamstime Stock Photos

Here’s a sure bet: Gambling winnings are taxable income. That’s true even if you have gambling losses in excess of your winnings. According to the rules of the tax game, as a recreational or casual gambler, your winnings are included in your gross income while your losses are reported as an itemized deduction. The itemized deduction is limited to the amount of your winnings (section 165(d)), though not subject to the 2% deduction floor (section 67(b)(3)). Any excess is lost; that is, you can’t carry extra losses forward to future years or back to past years.

But what are “winnings”? Say you purchased a winning lottery ticket. Do you think your gross income should include the cost of the ticket?

or

Source: Hochman (T.C. Memo. 1986-24)

 

What about winnings from a “no purchase necessary” marketing sweepstakes promoted by a corporation in connection with the marketing of a product? Are these winnings considered gains from a wagering transaction?

or

Source: Technical Advice Memorandum 200417004

 

What about multiple bets? What constitutes gain or loss from a wagering transaction when a recreational gambler makes various $2 bets on one match and places the bets on different possible winning combinations, only one of which can be the winning combination?

or

Source: Internal Revenue Service written determination number 8123015, National Office Technical Advice Memorandum, February 27, 1981

 

Gambling winnings of recreational gamblers are included in gross income while losses can only be claimed as an itemized deduction. Do you think this mismatch affects:

— the amount of alternative minimum tax you might owe? or

— the amount of social security benefits that are taxed? or

— the net investment income tax?  or

— the health insurance premium penalty? or

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Although the power of congress to tax income is very broad, and although section 61 is intended to reach and tax all income, from whatever source derived, and although deductions are a matter of legislative grace, to be bestowed or withheld by congress, gross income still does not include the return of capital. The latter is an exclusion from gross receipts, and its allowance is not a matter of legislative grace, but rather a matter of determining the true gross income which constitutionally may be taxed.

To the extent that the cost of a winning ticket is included in the payoff which the taxpayer receives at the cashier’s window on a winning race, therefore, the taxpayer has only recovered capital, and is entitled to exclude the amount of that winning ticket from gross receipts in order to arrive at gross income within the meaning of section 61. Such recovery of capital, however, would clearly not include the cost of tickets which did not win. The latter items were separate wagers, made without reference to the winning wager, and are allowable only as permitted by section 165(d).

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Neither the code nor the regulations specifically define the term “wagering transaction” as used in section 165(d). An entry in a sweepstakes, raffle, or lottery can be a “wagering transaction.”

Not all activities in which one can win a prize involve wagering, however. It is generally accepted that in order for a transaction to be a “wager,” three elements must be present: (1) prize, (2) chance, and (3) consideration. The elements of a prize and chance are present here; the question is whether the requirement of consideration – the “wager” itself – is met.

The taxpayer agrees that consideration is a necessary element of a wagering transaction for purposes of section 165(d). He points out, however, that even relatively small consideration paid for a chance to win a prize, such as the purchase of a single lottery or raffle ticket, creates a wager, and argues that the costs of the postage, envelopes, and the time and effort he expended, at least in the aggregate, represented sufficient consideration.

We disagree.

Although, in the aggregate, the taxpayer may have expended a greater than nominal amount on postage and envelopes, he did so with respect to many chances to win. With respect to each chance the costs incurred were relatively insignificant, and they were not paid directly for the chance to win the prize. Therefore, no wager was made and the sweepstakes winnings are not gains from a wagering transaction for section 165(d) purposes.

The taxpayer’s winnings are not gains from a wagering transaction for purposes of section 165(d) because the taxpayer did not furnish consideration for the chance to win the prize.

Right answer!

It is clear from an examination of the legislative history of section 3402(q) of the code that a wagering transaction for purposes of the withholding taxes is one in which all wagers are identical, that is, all wagers are placed on the same animal (or team) to win the event. If the wagers are not identical, then there is more than one wagering transaction.

By using an analogy to section 3402(q) of the code, each bet on a different possible winning combination can be deemed to be a separate wagering transaction for purposes of section 61, and the amount of the bet on the winning wagering transaction does not become an item of gross income, but rather a tax-free return of capital.

Therefore, because each of the taxpayer’s bets (wagers) in a match was placed on a different combination, each bet is a different wagering transaction, and the proceeds of each winning bet, that is, the amount received from the bet less the $2 bet, are includible in gross income under section 61 of the Code. The losing bets are deductible as itemized deductions under section 165(d).

CONCLUSIONS

In a situation in which the taxpayer, a full-time gambler who was not in the trade or business of gambling, made various $2 bets on one jai-alai match with the jai-alai fronton and, in accordance with the gambler’s betting system, placed the bets on different possible winning combinations, only one of which could be the winning combination:

(1) Wagering gain is the amount the taxpayer received from the winning combination less the $2 he wagered on that combination. Such gain is includible in the taxpayer’s gross income under section 61 of the code.

(2) All of the $2 bets on the losing combinations are losses from wagering transactions and must be treated as itemized deductions on the taxpayer’s return in accordance with the provisions of section 165(d) of the code.

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Gambling winnings increase your adjusted gross income which in turn can affect your exposure to the alternative minimum tax. Gambling losses are allowed in the calculation of the alternative minimum tax. The standard deduction is not. If you claim the standard deduction instead of itemizing, you may lose the benefit of the gambling losses.

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You must include gambling winnings in adjusted gross income, which means gambling winnings are included in provisional income for purposes of calculating the taxability of social security benefits. See Office of Chief Counsel release 2010-0229.

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Gambling winnings are not “investment income” for purposes of the 3.8% net investment income tax. Winnings do increase your adjusted gross income which in turn can affect your exposure to the net investment income tax.

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Gambling winnings increase your adjusted gross income which in turn can affect the amount of penalty you might owe if you don’t have health insurance.

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