Tax Research Memorandum

Date: To: From: Subject: September 28, 2011 Tax Files Johnny Appleseed Taxability of Gambling Gains/Losses and Business Expenses

Summary of Facts Stephen Colbert is a part-time talk show host earning wages of $100,000 annually. Mr. Colbert is also a professional slot machine gambler, whose gambling activities rise to the level of a trade or business. In over 50 days of gambling in 2010, Mr. Colbert generated $102,000 in slot machine winnings and concurrently lost $116,000 at the slots. Mr. Colbert kept meticulous records of his gains, losses and expenses. Besides the $102,000 in gambling winnings and $116,000 in wagering losses, Mr. Colbert also incurred $3,000 in gambling business expenses that included supplies, travel and telephone costs. These expenses were ordinary and necessary expenses that directly related to his gambling business. Issue What is the tax treatment of Mr. Colberts gambling business gains, losses and expenses? Law and Analysis IRC 162(a) generally allows a deduction for all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. However, IRC 165(d) applies to gambling losses more narrowly by specifically providing that losses from wagering transactions are only deductible to the extent of wagering gains. This serves to limit the applicability of 162(a) to the deductibility of gambling losses. In Offutt v. Commissioner, 16 TC 1214, the Tax Court held that a taxpayers gambling losses cannot offset active wages or income from other non-gambling sources. Thus, under the limitations of 165 and Offutt, Stephens gambling losses of $116,000 are deductibility only to the extent of his gambling gains of $102,000. In Mayo v. Commissioner, 136 TC No 4, the Tax Court concluded that although the gamblers losses may not offset other income, his business expenses incurred in the course of his trade were deductible under IRC 162(a). The court reasoned that while 165(d) limited gambling losses it did not define losses from wagering

transactions. The court in Mayo held that non-wagering expenses were not within the loss limitations established by 165 and reversed Offutt on this matter. In further support, the Tax Court in Mayo cited Boyd v. Commissioner, 56 AFTR 2d 85-5266, which found that the 165(d) restriction applied only to direct wagering expenses. In Boyd, the Ninth Circuit made a distinction between direct wagering losses and expenses accompanying the gambling business, making clear that peripheral expenses would not be held to the 165(d) limitation. Thus, while the losses incurred from direct wagering would still be subject the limitation of gambling winnings, the expenses incurred in association with those bets would be subject to 162(a), making them deductible. Some professional gamblers have cited Groetzinger v. Commissioner, 59 AFTR 2d 87532, claiming that the limitation of 165(d) does not apply to professionals who gamble for a living, this assertion was rejected in Mayo. The Tax Court alluded to the Supreme Courts ruling in Groetzinger that the intent of 165(d) was to differentiate gambling losses from other business losses, even when those gambling losses were incurred as a means of making a living. Conclusion Based on 165(d) of the IRC, gambling losses are limited in deductibility to gambling winnings. Furthermore, the ruling in Mayo holds that the business expenses incurred in carrying on a gambling business are deductible separately and fully under 162(a). Thus, Mr. Colbert may deduct in full his $3,000 in gambling business expenses that were incurred in the ordinary and necessary course of business. However, the $116,000 in wagering losses that Mr. Colbert suffered is subject to limited deductibility. Mr. Colbert may only deduct $102,000 of his $116,000 of gambling losses.