Taxes in the Back

Living in the NYC metropolitan area, I feel extremely fortunate to have survived Hurricane Sandy without losing power or sustaining flood damage. Thoughts and prayers to those less fortunate.

Stuck indoors all day yesterday, I watched the 2012 World Series of Poker Main Event final table reduce from nine to three. Play resumes tonight at 9:00 PM ET on ESPN (on a fifteen minute taping delay) until a champion wins the coveted bracelet. The winner takes home (before taxes) $8,531,853.

The current chip leader, Greg Merson, is a twenty-four year old American from Laurel, MD. According to this article in the Washington Post, Merson’s most recent tax filing stated he is an “internet probability specialist.” The article goes on to describe Merson’s ups and downs as he emerged in the poker world.

I’ve discussed on several occasions that a poker player reports gambling winnings as a professional or amateur gambler. Does filing instead as an “internet probability specialist” raise any issues? Maybe.

Merson began playing poker online while in high school. At 19 years old, he dropped out of college to play poker online full time. After “Black Friday” effectively eliminated the online poker market in the U.S. in April 2011, he moved to Toronto to continue playing online.

Playing live at this year’s World Series of Poker has already paid off big time for Merson. He won $1.1 million and the gold bracelet in the Six Max No-Limit Hold’Em Event in July, and stands to win at least $3,799,073 in the Main Event.

From the little I’ve read, it seems that Merson played minimal to no live poker prior to 2012. Let’s assume he in fact played no live poker prior to 2012. In that case, “internet probability specialist” is merely a euphemism for professional gambler. All of his gambling winnings and losses as an “internet probability specialist” would be reportable on Schedule C and he could deduct ordinary and necessary business expenses associated with the online poker play.

More interestingly, what if Merson also had live poker winnings and losses during a tax year for which he filed as an “internet probability specialist”? Could an ”internet probability specialist” report online poker winnings as a professional and separately report live poker winnings as an amateur on the same return? Or must the live and online winnings be combined?

Because there is no case law or statutory authority to my knowledge that supports a bifurcation of gambling winnings between live and online play, I believe in that case filing as an “internet probability specialist” would be inappropriate.

The Internal Revenue Code does not distinguish between types of gambling for tax purposes. Whether a taxpayer’s winnings are from horse racing, live poker, online poker, etc., all of the gambling winnings are combined together and thus taxable either as a professional or amateur. There is no case law to support the position of a taxpayer claiming to be a “professional blackjack player” but also an amateur poker player at the same time. If the taxpayer is a professional of any type of gambling, then all the gambling should be considered part of the profession.

Of course, if Merson filed as an “internet probability specialist” and combined all his gambling winnings (live and online) on Schedule C anyway, then the tax law would seem to be applied correctly. Instead it’s just a labeling issue.

A final question to consider is whether one who files as an “internet probability specialist” is more likely to trigger an IRS examination. High income taxpayers are already at a high risk of audit, so I suppose not. Lower to moderate income taxpayers, however, may be asking for an examination by using an unfamiliar term for their profession. Then again, “professional gambler” is unfamiliar to many at the IRS anyway, so I’m not so sure the difference would be beyond marginal.

Good luck to the remaining three in tonight’s conclusion of the Main Event!

(Hat tip to @PokerScar for sharing the piece in the Washington Post.)

2011 was anything but a boring year in the poker world. With tax season approaching, it’s time to review some noteworthy events during the year that may impact items on a poker player’s 2011 U.S. income tax return.

Mayo Decision

In general, the tax code is very harsh towards gamblers. In January, however, the U.S. Tax Court issued a pro-gambler decision. In Mayo v. Commissioner, the court held that a professional gambler may deduct “ordinary and necessary” business expenses beyond the extent of a taxpayer’s “net” gambling winnings.

Here’s a simple example to illustrate. Suppose during 2011 I had $50,000 of gambling winnings, $70,000 of gambling losses, and $20,000 of ordinary and necessary business expenses incurred in connection with my gambling activity. Section 165(d) of the Internal Revenue Code limits the deductibility of my gambling losses to $50,000, producing “net” gambling winnings of $0. Because of Mayo, I may further deduct the $20,000 of business expenses, producing a $20,000 business loss, which may be applied against other income.

If there was any concern over the IRS appealing the decision, it’s now gone. In a recent Action on Decision, the IRS explicitly acquiesced to the tax court’s Mayo opinion. Victory for professional gamblers.

For more comprehensive commentary on the case, click here.

Black Friday

On April 15, the Department of Justice seized the internet domains of Absolute Poker, Full Tilt Poker, and PokerStars. At the time, players’ funds on each of these sites were also frozen and inaccessible. To date, only PokerStars has repaid its customers. Absolute Poker is in bankruptcy, and may or may not repay customers. Full Tilt has agreed to forfeit its assets to the U.S. Department of Justice, and French investment firm Groupe Bernard Tapie is currently in the process of purchasing the assets from the DOJ. It has been reported that the DOJ will repay Full Tilt’s U.S. customers, but nothing has been finalized.

With 2011 behind us and a lot of uncertainty remaining, it’s no surprise the number one tax question on poker players’ minds is how to treat the frozen funds on their tax returns. Of course, PokerStars customers have been fully repaid, so the tax treatment of its customers’ gambling winnings is no different this year. With respect to Absolute Poker and Full Tilt accounts, however, the current state of affairs warrants careful consideration of a couple of tax principles.

1. Constructive Receipt

As I discussed back in April, the doctrine of constructive receipt sometimes requires cash method taxpayers to include an item in income even if no cash, services, or property are actually received in hand during that year. When are some of those times? A taxpayer has constructive receipt of income in the taxable year during which it is:

• credited to the taxpayer’s account;
• set apart for the taxpayer; or
• otherwise made available such that the taxpayer may draw upon it during the taxable year if notice of intention to withdraw had been given.

Now, if an online casino maintains segregated accounts for each customer, as in the case of PokerStars, then it’s pretty clear that constructive receipt is triggered when a customer earns winnings on the site, and not when the funds are actually withdrawn. But what if an online casino pays its customers through a general operating account? Further, what if that casino’s operating account balance is far less than the total amount owed to players? According to the amended civil complaint filed against Full Tilt Poker, that was precisely the case: At the end of March 2011, Full Tilt owed $390 million to its players but had less than $60 million in its bank accounts. Does constructive receipt still apply?

I would argue that it doesn’t. Constructive receipt does not apply if the taxpayer’s control of its receipt is subject to substantial restrictions or limitations. Gambling winnings in Full Tilt accounts on April 15, 2011 were, in my view, subject to substantial limitations because Full Tilt didn’t have the money to pay the balances. With the Department of Justice alleging in a press release that Full Tilt was operating a “massive Ponzi scheme” against its own players, it would be rather inconsistent for the IRS to then assert that winnings in Full Tilt player accounts not actually received in 2011 are still taxable.

Although we have less evidence to make the same case for winnings in Absolute Poker player accounts, a pending bankruptcy without the return of player funds seems like a strong argument for no constructive receipt.

2. Claiming a Loss for Unpaid Funds

May a poker player write off unpaid Full Tilt and Absolute Poker funds? For 2011, the answer is no. I covered this issue in detail back in May. What has changed? Now there’s a pending sale of Full Tilt assets by the DOJ to Groupe Bernard Tapie. It seems more likely players will be repaid.

Ultimately, because it’s still possible Absolute Poker and Full Tilt will pay its players back, no loss may be realized. I suspect sometime in 2012 we’ll learn the final fate of unpaid accounts.

3. Possible IRS Examination of Online Poker Players

Back in April, I explored the possibility of the IRS examining U.S. customers of Absolute Poker, Full Tilt Poker, or PokerStars. To my knowledge, the IRS has not pursued these individuals.

With reports that the DOJ may handle the repayment process of Full Tilt funds to U.S. players, it’s not far-fetched to speculate that some tax examination process will take place. Players may have to apply to the DOJ to obtain unpaid funds. The DOJ or IRS may very well take a look at applications of taxpayers claiming significant balances, perhaps $10,000 or greater.

Another possible alternative is the DOJ offering an amnesty program to poker players who have unpaid balances and are not in compliance with U.S. tax laws. We’ve seen similar programs far greater in scope. In 2011, for example, U.S. taxpayers with certain unreported foreign financial accounts may have came forward under the 2011 Offshore Voluntary Disclosure Initiative.

World Series of Poker

In November, Pius Heinz took home $8,715,638 after capturing the 2011 World Series of Poker Main Event bracelet. And I say “took home” in the literal sense. Because Mr. Heinz was a resident of Germany, he was able to take advantage of the U.S.-Germany Tax Treaty, which exempts from U.S. income tax gambling winnings earned in the U.S. by German residents.

For a complete breakdown of how much tax each of the Main Event’s final nine players had to pay, be sure to check out Russ Fox’s article.

Legislative Developments

In December, the Department of Justice released a memorandum opinion taking the position that the Wire Act applies only to sports wagering. Not exactly a tax event, but an event worth mentioning nonetheless. Although the opinion itself addresses only online state lotteries, states now have been shown a green light for intrastate online gaming. Although player liquidity issues remain for online poker under an intrastate regime, state compacts combining player pools is a realistic possibility. Because of the opinion, legislative developments for U.S. online gaming in 2012 became far more interesting.

Postscript:

I must remind all readers that it is impossible to offer comprehensive tax advice on the internet. Information I write on this blog is not legal advice, and is not intended to address anyone’s particular tax situation. Should you seek such advice, consult with a tax professional to discuss your facts and circumstances.

IRS Circular 230 Notice:

To ensure compliance with requirements imposed by the IRS, I inform you that any U.S. federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this blog.

The 2011 World Series of Poker, to be held at the Rio All-Suite Hotel & Casino in Las Vegas, Nevada, and run by Caesar’s, commences later this month.  I suspect the aura to be different from previous years, with #BlackFriday to blame.  Considering only one of the three major poker companies recently shut down in the U.S. is currently returning player funds, the fields for larger entry fee tournaments are likely to take a hit.  To that end, since many players will be strapped for funds, my hunch is there will be an uptick in staking agreements (sponsorships).

Back in February, I wrote about the tax implications of staking arrangements for U.S. residents at the WSOP.  Simply put, Caesar’s does not recognize staking arrangements, despite being required to.  If you are a U.S. resident and win $100,000 at the World Series with a backer, for example, and submit to the casino a completed Form 5754, Statement by Person(s) Receiving Gambling Winnings so the Casino issues W-2Gs to both you and your backer, Caesar’s won’t acknowledge the form; instead, the casino will issue to you a W-2G for the full amount of the winnings.  Read that February post for suggestions on how to properly allocate the winnings in a staking agreement at the WSOP between two (or more) U.S. residents for tax purposes.

What are the tax implications when we introduce a U.S. nonresdient to a staking agreement?  Let me be clear: It’s a mess, and I present my longest blog post to date.  Note that if a U.S. resident is involved with a staking arrangement with a nonresident, these issues are still most certainly of significance.

Basic Facts and the Three Scenarios:

The Facts:  Suppose the staking agreement is between one “staker” (the person putting up the funds) and the “stakee” (the person playing in the tournament).  The staker agrees to contribute 100% of the tournament entry fee, and the staker and stakee are each entitled to 50% of total winnings, if any (beyond the entry fee, which the staker is fully entitled to, if the stakee places).  Further suppose the entry fee is $10,000 (which is the entry fee to enter the WSOP main event), the stakee ends up placing and wins $100,000, less the $10,000, for a total gambling winnings of $90,000.

See my prior post for the tax implications if both the staker and stakee are U.S. residents.  The implications are quite different, however, when a nonresident is involved.  Further, it depends on the hat the nonresident wears, hence the three possible scenarios:

A)  U.S. stakee, nonresident staker

B)  Nonresident stakee, U.S. staker

C)  Nonresident stakee, nonresident staker

Before delving into the particular tax consequences of each scenario, I must first discuss how the Internal Revenue Code treats U.S. gambling winnings earned by U.S. nonresidents in general.

Taxation of U.S. Gambling Winnings Earned by U.S. Nonresidents and Possible Treaty Relief

In general, gambling winnings paid to foreign individuals are subject to 30% withholding.  For example, if a Canadian resident wins $90,000 (net the entry fee) at the WSOP, Caesar’s will withhold $27,000 for U.S. taxes, and the winner walks away with only $63,000.  The winner also walks away with a Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, reflecting the $27,000 withheld.  This document must be kept in a safe place for tax time at year-end.

Note that the 30% withholding rule applies only if the income is not effectively connected with a U.S. trade or business and is not exempted by treaty.  (For purposes of this post, I assume no income is effectively connected.  I’ll address those consequences in a future post.)  Indeed, an applicable tax treaty between the United States and a treaty partner may reduce the amount withheld by Caesar’s.  U.S. gambling winnings earned by residents of the following countries are not taxable in the U.S.:

Austria, Belgium, Bulgaria, Czech Republic, Denmark, Finland, France, Germany, Hungary, Iceland, Ireland, Italy, Japan, Latvia, Lithuania, Luxembourg, Netherlands, Russia, Slovak Republic, Slovenia, South Africa, Spain, Sweden, Tunisia, Turkey, Ukraine, and the United Kingdom.

Some other tax treaties reduce the percentage of gambling winnings withheld by the U.S.  If you are a nonresident, be sure to find out whether the U.S. has a tax treaty with your resident country, and whether it addresses gambling winnings.

Withholding Agents

If withholding for tax on U.S. gambling winnings is required, how does Uncle Sam actually receive his cut?  Through withholding agents.  A “withholding agent” is a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding.  Thus, payments of gambling winnings from the WSOP made by Caesar’s to U.S. nonresidents are subject to withholding, with Caesar’s acting as the withholding agent.

Because withholding agents are required to withhold tax from income paid to a foreign person, they are liable for such tax.  If at the end of any quarter-monthly period the total amount of undeposited taxes exceeds $2,000, the withholding agent must deposit the taxes within three business days after the end of the quarter-monthly period.  (A quarter-monthly period ends on the 7th, 15th, 22nd, and last day of the month).  Beginning January 1, 2011, all withheld taxes must be deposited by electronic funds transfer.  Penalties may be imposed for failure to timely deposit, up to 15% of the required amount.

Withholding agents are also required to report payments on Form 1042-S and file a tax return on Form 1042, Annual Withholding Tax Return for U.S. Source Income for Foreign Persons (note: 2011 Form 1042 not yet available).  For income paid in 2011 subject to 1042-S withholding, the withholding agent is required to file the Form 1042 and Form 1042-S with the IRS no later than March 15, 2012, and is required to furnish the 1042-S to the recipient of the income by the same date.  Penalties may be imposed if either requirement is not satisfied.

WSOP Gambling Winnings Earned by U.S. Nonresidents

With the taxation framework in place, we’re now prepared to address each of the scenarios, applying the basic facts above.  Assume that no tax treaty applies to the gambling winnings.

A)  U.S. stakee, nonresident staker

Caesar’s will issue to the stakee a check for $100,000, along with a Form W-2G reflecting $90,000 of gambling winnings.  Yet, the stakee only has $45,000 of taxable gambling winnings.  To account for this difference, the stakee may allocate the nontaxable portion to a Schedule C as gross receipts, and list on the Schedule C the amount of winnings paid to the staker, here $45,000, as a business expense.  The result: net income from the transaction between staker and stakee (i.e. the mere shifting of funds) as zero.

The staker receives the initial $10,000 entry fee, which of course is not taxable income, as well as $45,000 of the winnings.  Because the stakee is paying gambling winnings to the nonresident staker, the stakee is a withholding agent required to withhold $13,500 of the winnings from the staker (30% of $45,000).  The stakee must complete a Form 1042-S and issue a copy to the staker, file a Form 1042 by March 15, 2012, and deposit the $13,500 with the U.S. Treasury within three business days after the end of the applicable quarterly-monthly period.

B)  Nonresident stakee, U.S. staker

In this case, the roles are reversed, yet the outcome is far different.  Casear’s will withhold 30% of the nonresident stakee’s gambling winnings, and issue a check to the stakee for $73,000 ($90,000 winnings less $27,000 for withholding, plus $10,000 entry fee), along with a Form 1042-S reflecting amounts won and withheld.

The U.S. staker is entitled to $55,000 ($10,000 entry fee, plus $45,000 winnings), and will report and pay tax on his share of the winnings.  Note that after paying this amount, the stakee is left with only $18,000 cash in hand.

But wait, if the staker pays tax on his gambling winnings, isn’t Uncle Sam getting two bites at the apple?  Yes, and the party who paid too much in tax will be due a refund.  In this case, it’s the nonresident stakee.  After the close of the tax year, the stakee should file a Form 1040-NR (income tax return for nonresidents), and attach a Schedule C, reflecting the transaction between the staker and stakee (as described in greater detail in the first paragraph under Scenario A).  The stakee should also be sure to list the $27,000 withheld by Caesar’s on line 60d of the 1040-NR.

C)  Nonresident stakee, nonresident staker

For the stakee, the consequences are same as those under Scenario B, except the stakee is also a withholding agent, and pays the staker $10,000 entry fee, plus $31,500 in winnings (net 30% withholding).  The filing and depositing requirements of the stakee are the same as described in the second paragraph under Scenario A.

Final Thoughts

Staking arrangements at the WSOP create headaches when accounting for taxes.  If Caesar’s ever changes its policy of disregarding the Form 5754, most of this discussion becomes moot.  But for now, it stands.  Of course, the assistance of a tax professional who is knowledgeable with these issues could make the headaches turn painless.