Establishing basis for gambling losses: most taxpayers are unaware of the reporting requirements for gambling wins and losses. This article explains how to calculate and prove taxable income, net winnings and basis or losses claimed.

• Author: Morris, Donald

EXECUTIVE SUMMARY

* Most taxpayers believe gambling proceeds are immune from tax, unless they receive a Form W-2G

* Each pull of a lever or push of a button on a slot machine, hand of blackjack or spin of a roulette wheel is an individual wager that may result in gambling winnings.

* To prove gambling losses and taxable income, taxpayers are subject to rules of proof, recordkeeping, estimating and credibility.

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Taxpayer-gamblers are not generally aware of the ease with which the IRS successfully counters attempts to offset gambling winnings with gambling losses. Often, gamblers are not concerned about the exact amount of gambling winnings they report, because they believe they have sufficient gambling losses to offset their winnings. The central issue raised by the Service on audit is not always the right to a deduction for gambling losses--allowed by Sec. 165 (d)--but taxpayers' inability to prove the amount of their gambling losses and, in particular, their basis in the losses claimed.

The Problem of Gambling Losses

A common scenario involves a taxpayer, as in Norgaard, (1) who reports gambling winnings because a Form W-2G, Certain Gambling Winnings, was issued. The fatal step is that the taxpayer dutifully reports the W-2G winnings, but fails to report any other winnings, however small. The IRS, on examination, questions the gambler about the possibility of any other winnings during the period. When the taxpayer admits to other winnings, the Service asserts that whatever the amount of the taxpayer's losses, they were already used to offset the unreported winnings and, thus, are not available to offset the W-2G winnings. The Tax Court has accepted this position when the taxpayer failed to report gambling income in excess of W-2G winnings. The taxpayer must establish that claimed gambling losses exceed unreported gambling income, to be entitled to a deduction. (2)

When the IRS determines that a taxpayer's income is incorrectly computed, he or she bears the burden of proving that the Service's position is erroneous. (3) In Mack, (4) the Service successfully denied gambling losses, arguing that the taxpayer's losses were already offset by winnings other than those reported on his return. In Lutz, (5) the IRS conceded unproven gambling losses of $43,818.75 to the taxpayers, then asserted they were not entitled to a deduction, because those losses were less than the unreported gross gambling winnings omitted from the notice of deficiency. The court responded that, to establish their entitlement to deduct gambling losses from gross gambling income, the taxpayers had to show that their gambling losses exceeded the $50,995 of unreported gross gambling income not reflected in the notice of deficiency. This approach may save the Service from having to reconstruct a taxpayer's unreported winnings, which can be daunting. (6)

The Taxpayer's Defense

A taxpayer's logical response to the IRS should be to produce his or her books and records regarding the year's gambling activities, as required by Rev. Proc. 77-29. (7) This procedure requires taxpayer-gamblers to maintain an accurate diary or similar record, supplemented by verifiable documentation of wagering winnings and losses. The diary must contain the following information:

1. Date and type of specific wager or wagering activity;

2. Name and address or location of gambling establishment;

3. Name(s) of other person(s) (if any) present with the taxpayer at the gambling establishment; and

4. Amounts won or lost.

For slot machines, the Service further requires that a taxpayer record all winnings by date, time and slot machine number (see Exhibit 1 on p. 332). But because few taxpayers (especially recreational gamblers) maintain convincing records of their gambling activities, they can be left paying tax on their gross W2G winnings, without any offset for gambling losses. Unreported W-2G winnings can also result in the imposition of penalties and interest.

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In Kalisch, (8) the taxpayer reported $41,979 in gambling income and claimed offsetting gambling losses in the same amount on his 1981 return. In its notice of deficiency, the IRS accepted the taxpayer's income figure, but disallowed the deduction for gambling losses, because the taxpayer failed to substantiate them and because he had additional unreported winnings that exceeded his losses for the year. The court rejected the additional-income argument and allowed the loss deduction. Fortunately for taxpayers, the courts do not always agree with the Service's reasoning.

A Growing Problem

What is the potential magnitude of this problem? Should practitioners and their clients be concerned? Part of the answer lies in the growing number of people participating in gambling. In 2000, the U.S. General Accounting Office reported that legalized gambling had spread to every state, except Utah and Hawaii. (9) Legalized gambling in the U.S. has seen a steady increase since the advent of Indian tribal casinos and the subsequent legalization of casino gambling by states other than Nevada. Gaming revenue for 2002 totaled $68 billion (up from $30 billion in 1992, or 127%), while in 2003, it totaled $73 billion, rising 7.4% from the previous year. (10) Of this total, $40 billion stems from casino revenue. (11) In addition, for 2004 (the most recent data available), 1.7 million taxpayers reported gambling winnings in the IRS totaling $23.3 billion. This is up from the 1.5 million taxpayers in 2003 who reported winnings of $19 billion. (12) An estimated 86% of Americans have participated in gambling in some form, and 63% reported gambling at least once in the past year. (13) The number of individuals visiting casinos in 2003 was 53 million--more than one quarter of the U.S. adult population. (14) Tax advisers should assume the same percentages apply to their clients, as gambling cuts across demographic and regional boundaries. As one tax observer recently noted, "Gambling is increasingly looked upon as a legitimate entertainment option akin to sporting events, the theater, and amusement parks." (15) What are the practical consequences of the spread of gambling?

As with other areas requiring recordkeeping (such as automobile mileage and entertainment), clients must be informed of the legal requirements for reporting gambling winnings, even if they erroneously believe they have no reportable winnings or they have sufficient gambling losses to offset them. It is crucial to determine gross gambling winnings and to separately establish the amount and basis for deducting gambling losses. As noted, the IRS wields a powerful argument in its arsenal; taxpayers and their advisers need to be educated.

Educating Clients

Education covers two fronts. First, which types or amounts of gambling winnings must be reported? The requirement to report gambling winnings (legal or illegal) at gross, even if the year's net result is a loss, is not frequently recognized by taxpayers, including recreational gamblers. Gross gambling income is reported on page one of Form 1040, while gambling losses are a miscellaneous itemized deduction (not subject to the 2%-ofadjusted-gross-income (AGI) limit).

Taxpayers often believe their winnings are immune from reporting unless they receive a Form W-2G. In Hamilton, (16) taxpayers failed to include $134,041 in lottery winnings in income on the grounds that they were neither professional nor part-time gamblers. The court disagreed, asserting that "an accession to wealth on account of gambling winnings is includable in an individual taxpayer's gross income whether he or she is a professional gambler, a part-time gambler, or simply a onetime gambler."

Taxpayers must also segregate winnings from losses to allow proper reporting. In Clemons, (17) the taxpayer argued that his $44,833 in gambling winnings need not be included in gross income, because he had sufficient gambling losses to offset them. According to the court, the taxpayer "steadfastly rejects or ignores certain basic principles of the Federal income tax laws." The taxpayer insisted on netting his winnings and losses and reporting only net winnings on his return. (18)

Once the need to report gambling, like any other form of income, is established and the corresponding requirement to segregate (as opposed to netting) winnings and losses is acknowledged, the next step is establishing a basis for gambling losses.

Tax Adviser's Responsibility

Tax advisers need to recognize the pitfalls involved in determining the amount of gambling losses available to offset winnings. As most taxpayers do not keep sophisticated books and records of their gambling activity, the tax preparer is in a potentially perilous position when advising a client on documentation requirements for establishing gambling losses. If the taxpayer is reporting Form W-2G winnings (and no other gambling income), a preparer should not take a taxpayer's word for the tact that he or she suffered sufficient offsetting losses without at least discussing the issue of documentation and the Service's expectations in Rev. Proc. 77-29. The IRS and the courts, for example, view the documentation required for gambling no differently from that for employee business expenses, charitable donations, casualty losses and medical expenses. In Schooler, (19) the court stated that there is no reason to treat taxpayers who claim deductions for wagering losses more favorably than other taxpayers by allowing a deduction for wagering...