As technology and computers advance, there are more and more activities that put us, as humans, against computers. We, as humans, are in the position of having to game or strategize how to manipulate or beat computers to produce desired results.
While it is not pointed out generally, whole industries are focused on doing just this. Whether it is stock brokerage firms that have advanced computer algorithms or internet companies that bid on online advertising. The activities are carried on by businesses large and small.
But what happens if you view it on the individual level? What if an individual dedicate time to trying to profit from beating computers? Can that be a business for tax purposes and can any losses be deducted as business losses?
The court addresses this very question in Ferguson v. Commissioner, T.C. Summary Opinion 2007-30. The case involves video poker and a taxpayer who incurred losses playing video poker. The question in the case is whether playing video poker can be a business.
Facts & Procedural History
The taxpayer was employed full-time as a building operating engineer in Chicago and earned approximately $51,840 from his employment in 2003.
In addition to his employment, he spent a significant amount of time playing video poker, which was his only form of gambling. He bet an average of $25 on each hand and had been playing since 1997.
He tried to only play on machines with an expected payout value of 100 percent return, meaning he thought he would never lose money. He spent a lot of hours of practice on a computer and diligent study of the perfect way to play the game, but it didn’t work. He also spent time traveling to and from the casinos, scouting machines, and studying strategy. He also obtained a tutoring program to learn how to play and avoid mistakes.
The taxpayer filed a Schedule C, Profit or Loss From Business, for the taxable year 2003. Reporting as a professional gambler, he claimed $1,311,200 in gross income from gambling, and a corresponding $1,311,200 in gambling losses.
The IRS determined that the taxpayer was not a professional gambler in 2003, and his gambling winnings should have been reported as other income. The IRS also determined that the gambling losses should have been claimed as itemized deductions.
The taxpayer filed a petition with the U.S. Tax Court. The sole issue for the decision was whether the taxpayer’s gambling activity constituted a trade or business under Section 162 in 2003 so that his gambling losses could offset his wage income.
About Video Poker
The court cites Wikipedia for background information on video poker. According to the court (and Wikipedia), video poker is a type of casino game that is based on five-card draw poker. Unlike traditional poker games, players do not play against other players but rather against a computerized machine. The objective of the game is to obtain the best hand possible, and after the player’s draw, the machine evaluates the hand and offers a payout if the hand matches one of the winning hands in the posted pay schedule.
Some people believe that if one plays video poker in a mathematically and theoretically perfect manner, they may eventually realize a profit. The payout value or payback rate is the expected return a particular game will provide when played over a long enough period of time. However, it is important to note that most video poker games offer a payback rate of less than 100 percent, even when played with perfect strategy. While short-term results may vary, over the long term, most players will lose a few cents or fractions thereof for each dollar bet.
A “Trade or Business”
Whether an activity is a “trade or business” is one of the most common disputes taxpayers have with the IRS. The IRS audits this issue frequently. This issue can come up in a number of different contexts. As in this case with professional gambling status, the import is always whether a tax deduction in excess of income from the activity is deductible.
To understand this issue, we need to start with the basic concepts of income and ordinary and necessary expenses. Our tax laws start with a broad net–saying that all income is subject to income tax. This is set out in Section 61 of the tax code. This means every increase in a person’s net worth. It then applies various exclusions, for things like loans, gifts, etc.
Against this backdrop, the tax law allows taxpayers to deduct “ordinary and necessary” business expenses and expenses incurred to earn a profit. This is set out in Sections 162 and 212 of the tax code. The “ordinary and necessary” deduction requires there to be a “trade or business.”
The term “trade or business” is a term used in the tax code to refer to an activity that is engaged in with the primary purpose of generating income or profit. It is a key concept for determining whether expenses related to a particular activity can be deducted on an individual’s income tax return.
The courts have clarified what this term means. According to the courts, to be considered a “trade or business” under the code, an activity must be conducted with “continuity and regularity” and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. The determination of whether an activity constitutes a “trade or business” is a question of fact and is made on a case-by-case basis, taking into account all the relevant facts and circumstances of the activity.
The courts have also used the rules in Section 183 to clarify these rules. The Section 183 rules are referred to as the “hobby loss” rules. That code section and the court’s interpretation of them allow the IRS and courts to disallow deductions for activities that are more akin to a hobby rather than a business activity.
As a side note, the courts have also disallowed gambling losses taken under the guise of being casualty losses and considered whether gambling was a disability for tax purposes, which are also interesting topics in their own right. You might also be interested in the rules for non-resident aliens and whether they can exclude gambling winnings from tax.
Professional Gambler Status
For gambling to be a trade or business, one has to be a professional gambler.
To be considered a professional gambler for tax purposes and be eligible to deduct gambling losses, a taxpayer must meet the following requirements:
- Regular and continuous activity: The taxpayer must engage in gambling activity on a regular and continuous basis. This means that gambling must be a primary source of income for the taxpayer and not just a casual hobby.
- Intent to make a profit: The taxpayer must have a genuine intent to make a profit from their gambling activity. This means that they must be engaging in gambling with the expectation of winning money, rather than just for fun or entertainment.
- Keeping detailed records: The taxpayer must keep accurate and detailed records of all their gambling activity, including wins and losses. This documentation will be necessary to support any deductions claimed on the tax return.
- Expertise and knowledge: The taxpayer must have expertise and knowledge in the type of gambling activity they are engaged in. This can be demonstrated through past experience, training, or education.
The taxpayer also has to substantiate the gambling losses, which can also be problematic.
If a taxpayer meets these criteria, they may be considered a professional gambler for tax purposes and may be eligible to deduct gambling losses against their gambling income. However, it is important to note that the rules for deducting gambling losses can be complex, and taxpayers should consult with a tax professional to ensure compliance with all relevant tax laws and regulations.
The court found that the taxpayer did not have the requisite profit objective to qualify his gambling activity as a trade or business.
Video Poker Gambling
The court in this case determined that the taxpayer was not a professional gambler and that his gambling activity did not constitute a trade or business under Section 162.
The court found that while the taxpayer spent a significant amount of time and effort on video poker, he did not carry on his activity in a businesslike manner and did not maintain adequate books or records. Furthermore, the court found that the taxpayer’s primary purpose for engaging in the activity was not for income or profit, as he never had a winning year despite spending over 1,000 hours gambling in 2003.
The court did not stop there. The court also considered that gambling against a machine programmed by a casino is not a trade or business with the participant’s primary purpose being income or profit, and may constitute a sporadic activity, hobby, or amusement diversion. Therefore, the court concluded that the taxpayer’s gambling activity was not a trade or business, and he was not a professional gambler in the taxable year in issue.
This case seems to suggest that video poker cannot be considered professional gambling for tax purposes. The court considered that gambling against a computerized machine may constitute a sporadic activity, hobby, or amusement diversion rather than a trade or business. The court may have reached a different conclusion if the facts were different, such as if the testimony included other factors beyond what was provided by Wikipedia as to the strategy and skill required to win in this type of gambling. As this case shows, it is essential to plan for tax problems and understand the rules and requirements for professional gambling status and to maintain accurate records to support any deductions claimed on a tax return.