How to Substantiate Gambling Tax Losses

There are several types of tax disputes that are frequently litigated. Gambling losses are an example.

Taxpayers who gamble often incur significant losses. If the taxpayer is found to be a professional gambler, these losses can be counted for income tax purposes and used to offset the taxpayer’s other income. These tax losses can reduce or even eliminate the taxpayer’s income tax liability. One can understand why the IRS would be interested in auditing and, absent records to show the amount of the loss, challenging these losses.

But the IRS goes further than this. It will often challenge the amount of losses claimed by those who are not professional gamblers. These losses are limited to the gambling income received. Thus in these cases, the IRS asserts that the taxpayer cannot count some or all of the gambling losses to offset the gambling winnings received. This position by the IRS results in the taxpayer having gambling income.

The IRS may even take this approach when the taxpayer is a compulsive gambler who gambles frequently. Stepping back from it, the IRS is taking the position that the compulsive and frequent gambler comes out ahead over time. Common sense suggests that this does not happen absent the gambler having one or a small handful of very large wins and then quitting while they are ahead.

The casinos report large wins to the IRS. This is where the IRS’s approach fails. After accounting for the large wins that are reported to the IRS, gamblers who only make small bets and they do so frequently generally cannot have gambling winnings. The math just doesn’t support the IRS’s position. Yet taxpayers often have to argue with the IRS about this.

This brings us to the Coleman v. Commissioner, T.C. Memo. 2020-146. The case shows how frequency low-dollar gamblers can substantiate their gambling losses if questioned by the IRS.

Facts & Procedural History

The taxpayer is a compulsive gambler. He had retirement income in 2014 and $150,000 nontaxable personal injury settlement.

The casinos where the taxpayer gambled issued Forms W-2G reporting $350,241 of gambling winnings.

The IRS audited the taxpayer’s tax return for 2014. It asserted that the taxpayer incurred no gambling losses to offset the $350,241 of gambling winnings reported on the Forms W-2G. The taxpayer’s IRS appeal must have been unsuccessful, as tax litigation ensued.

The question was whether the taxpayer could substantiate his gambling losses.

About Gambling Losses

Gambling winnings are taxed as other types of income. Taxpayers have to report gambling winnings as income. They are reported as “other income” on the Form 1040. As in this case, gambling income and any tax withholding are often reported to the IRS by casinos on the Form W-2G. This form alerts the IRS of the income and it often results in IRS audits.

The IRS audits gambling income as many taxpayers cannot substantiate the amount of their gambling losses. Gambling losses can be used to offset gambling income when computing the amount of income tax due.

That is what appears to have happened here. This case is a substantiation case. Substantiation cases come down to what records are available and the testimony and credibility of the taxpayer.

Traditional Evidence of Gambling Losses

The taxpayer claimed that he had more than $350,241 of gambling losses.

In support of his position that he incurred gambling losses, the taxpayer testified as to the number of days he visited casinos to gamble, the high frequency of his gambling transactions, and his gambling activities. This can be summarized as he visited casinos most days throughout the year, he withdrew money from his bank and credit card accounts to gamble, and he played primarily small dollar slot machines.

The evidence also included the taxpayer’s testimony as to his finances. He testified that he did not take expensive vacations, buy expensive assets, etc.

The evidence also included the taxpayer’s bank and credit card records. These records showed $240K of withdraws at the casinos. The IRS agreed that this amount was spent on gambling.

The IRS cited to the casino records. These records consisted of rewards cards the taxpayer used at two casinos. The records track jackpots of $1,200 or more and other transactions where petitioner was using his rewards cards. The taxpayer did not always use the rewards cards and they were not even available at some of the casinos.

Expert Testimony for Gambling Losses

The evidence also included expert testimony as to the statistical likelihood that the taxpayer earned even a $1 of profit from his gambling.

The taxpayer’s expert testified that the state-mandated payouts would have resulted in significant losses. This included expert testimony that “the average ‘return to player’ percentages ranged from 87% to 95%.” The expert’s position was that “in a game with odds that disfavor the gambler, the law of large numbers means that a gambler who plays long enough is virtually guaranteed to have net losses.” The taxpayer’s expert concluded “with a 99% level of certainty, that petitioner had overall net gambling losses of at least $151,690 during 2014.”

The IRS asserted that the method the taxpayer’s expert used was flawed. It challenged the “uncertain or flawed assumptions.” It described the conclusions as implausible as it was based on extrapolating results to future years.

The Tax Court’s View of the Evidence

The court found the evidence to be more than sufficient to show that the taxpayer did not have gambling income in excess of gambling losses.

The traditional evidence of gambling losses included testimony that the court found credible. Based on the court’s opinion, it appears that the court reached this conclusion as the tax attorneys did a good job of putting on evidence showing that gambling losses were probable. This evidence bolstered and corroborated the taxpayer’s testimony.

The court also accepted the expert testimony. This testimony showed that losses were inevitable. This testimony was based on accepted statistical techniques. It also comported with generally known outcomes. The casinos report all but small dollar transactions to the IRS. A high volume of small dollar transactions, like high frequency slot machine transactions in this case, would require more small wins than losses. Common experience suggests that one generally does not have more small wins than losses.

Based on this evidence, the court seems to suggest that it applied the Cohan doctrine to estimate the amount of the gambling losses. The Cohan doctrine allows the court to estimate the amount of a deduction if it is clear that the expense was incurred and there is evidence in the record of a method for estimating the amount of the deduction.

In applying the Cohan doctrine, the court found that there was a loss and, given the expert testimony and statistical analysis, there was a method for estimating the amount of the loss.

Unlike other cases where the tax court has applied the Cohan doctrine, the court did not clearly articulate how it applied the Cohan doctrine.

For example, the court did not require precision in the taxpayer’s method for computing the amount of the loss. The court did not even cite the “bear heavily … upon the taxpayer whose inexactitude is of his own making” that it almost always cites in substantiation cases.

This may be due to the personal nature of gambling activities. The Cohan doctrine is usually applied to deductions for business expenses or business tax credits, such as the research tax credit or mileage expenses for truck drivers. It may be that businesses are expected to keep records, whereas individuals are not held to such a high standard in applying the Cohan doctrine.

This is good news for gamblers. The case provides a great road map for defending gambling losses. Those whose tax returns report gambling losses and are audited by the IRS should take note of this case.