The Tax Cuts and Jobs Act of 2017 (TCJA) will have broad-ranging effects on all kinds of individuals. Taxpayers with a personal connection to gambling (i.e., recreational gamblers) or one in the form of a trade or business (i.e., professional gamblers) will find that the revisions to Internal Revenue Code (IRC) section 165(d) may have far-reaching consequences in the years before the provisions sunset at the end of 2025. This aspect of the TCJA has received little attention compared to other changes in the act, but given its complex legislative, judicial, and procedural history, it is worth understanding how, if at all, it may affect certain individuals.
Mayo v. Comm’r
Prior to the updates made by the TCJA, professional gamblers were permitted to deduct “ordinary and necessary” business expenses in excess of net gambling winnings, which are gambling winnings that exceed gambling losses from wagering, not business, transactions [IRC sections 162(a) and 165(d)]. This was in large part due to the ruling in Mayo v. Comm’r [136 T.C. 81 (2011)]. The court held that the limitation on deducting gambling losses under IRC section 165(d) does not apply to ordinary and necessary business expenses paid or incurred in connection with the trade or business of gambling as seen within IRC section 162 (and its accompanying regulations) as long as the individual qualifies as a professional gambler [Comm’r v. Groetzinger, 480 U.S. 23 (1987)]. As a result of Mayo, a professional gambler could report a business loss that could be applied against other ordinary income for the tax year, as well as be carried forward to future taxable years under IRC section 172, if applicable (Charles J. Reichert, “Wagering Losses Not Deductible, Gambling Expenses Deductible,” Journal of Accountancy, May 2011, https://tinyurl.com/ycupymeb).
Mayo set the precedent that a professional gambler may be able to deduct ordinary and necessary business expenses under IRC section 162(a), even if the expenses exceeded gross winnings or receipts from gambling activities, as long as the activity constituted a trade or business. The Mayo ruling, however, contradicted the Tax Court’s decision in Offutt v. Comm’r, 16 T.C. 1214 (1951). In Offutt, which was the precedent for gambling losses prior to Mayo, the court said wagering losses could only be deducted to the extent of gambling winnings and included professional gamblers’ nonwagering business expenses in the definition of losses. Therefore, since the court’s decision in Mayo, taxpayers could rely on the precedent set therein when deducting the business expenses and losses of a professional gambler.
Ultimately, this treatment negates the ability of a taxpayer to generate a loss in excess of gambling gains, especially if the taxpayer is a professional gambler.
While Mayo was upheld in subsequent rulings, until the passage of the TCJA the legislative intent of IRC section 165(d), as seen above, remained unclear as to what constituted “losses from wagering transactions.” Even the IRS’s Office of Chief Counsel, in AM 2008-13, explained that there was a difference between losses from “wagering transactions” and items that constituted “wagering activities” from the business of gambling. Their view was that from a “tax and accounting sense, a (wagering) loss is not considered an (business) expense.”
IRC Section 165(d) Redefined
Section 11050 (Limitation on Wagering Losses) of the TCJA redefined, and somewhat clarified, the contrary points mentioned above, rewriting IRC section 165(d) to define “losses from wagering transactions” to include “any deduction otherwise allowable under this chapter incurred in carrying on any wagering transaction.” The TCJA brought all expenses, including wagering losses, into one pool for recreational and professional gamblers. Effectively, all losses incurred in carrying on any wagering transactions became subject to the upper bound of wagering gains.
This viewpoint is also espoused in footnote 176 to the conference agreement to the TCJA, which noted that “the provision thus reverses the result reached by the Tax Court in Ronald A. Mayo v. Commissioner.” Ultimately, this treatment under the revised version of IRC section 165(d) negates the ability of a taxpayer to generate a loss in excess of gambling gains, especially if the taxpayer is a professional gambler.
The House version of the TCJA also mentioned that the limitation of netting gambling winnings applies not only to gambling losses, but also to other expenses related to all of the taxpayer’s “gambling activities.” This is contrary to AM 2008-13, as well as Mayo, which drew a fine distinction between “transaction” and “activity.” It seems that the intent of Congress in drafting the new law was to use the terms “transaction” and “activity” interchangeably when it came to recreational and professional gamblers. As a result, nonwagering (i.e., business) expenses may only be deducted by professional gamblers, and not recreational gamblers, who historically have not been allowed to deduct personal expenditures under IRC section 262. It seems the intent of Congress was to limit wagering gains against all “wagering transactions and/or activities.”
Even if any doubt still exists about whether an item is a “loss” or “trade or business expense,” the language within each code section still controls. Because the language in the new IRC section 165(d) talks about “any deduction otherwise allowable under this chapter,” it has been held in prior cases that the more specific code section [IRC section 165(d)] controls over the more general code section [IRC Section 162(a)] (Boyd v. U.S., 762 F.2d 1369, 1372-1373 (9th Cir. 1985); also Pham v. Comm’r, T.C. Summary Opinion 2016-73 (2016), and Christine Manolakas, “Taxation of Gamblers: The House Always Wins,” Oklahoma Law Review, Spring 2018, https://tinyurl.com/ydg9q3a6).
As mentioned in the conference agreement, all losses on wagering transactions shall not exceed gambling winnings whether the taxpayer is a recreational or professional gambler. The conference agreement also mentions that the new provision contained within IRC section 165(d) effectively reverses the decision in Mayo. No distinction, however, is made about whether a professional or recreational gambler is allowed to deduct any “losses from wagering transactions” as a “deduction for” or a “deduction from” (i.e., itemized deduction) adjusted gross income (AGI). This creates some further confusion, as a “deduction for” has traditionally applied to professional gamblers, while the “deduction from” has applied to recreational ones.
In Groetzinger, the court held that a professional gambler is in the business of gambling based on the continuity and extensiveness of the activities and the good faith intent of the taxpayer. Because the conference agreement makes no reference to Groetzinger, it can be implied that any losses or deductions paid or incurred, up to the amount of gambling winnings, by a taxpayer classified as a professional gambler may be allowed as a “deduction for AGI,” whether or not the taxpayer itemizes deductions. If the taxpayer is instead considered a recreational gambler, he may still be able to deduct any “losses on wagering transactions,” excluding any nonwagering or business transactions, as an itemized deduction, assuming itemizing is feasible.
Under Treasury Regulations section 1.165-10, the IRS has left alone, for now, the rules for married couples who both partake in gambling transactions/activities. According to the regulations, if a married couple files a joint return, then the combined losses of both spouses will be aggregated against their combined gains. The IRS does not, however, explain how wagering transactions are aggregated, if at all, if one spouse is a recreational gambler and the other is a professional gambler.
To see the TCJA’s impact on IRC section 165(d), one can look back to the holding in Mayo, where Ronald Mayo was originally permitted to subtract his wagering losses up to the amount of his wagering gains ($120,463) and his nonwagering ordinary expenses ($10,968) related to his gambling business, despite the fact that they generated a loss.
If the facts in Mayo were to be reexamined under current law, assuming that the nonwagering ordinary expenses paid or incurred were deemed to be associated with a wagering transaction/activity, Mayo would no longer be permitted to deduct any amounts in excess of his wagering gains of $120,463. He could only deduct his wagering losses and nonwagering ordinary expenses up to his gains. Therefore, given that Mayo’s wagering losses exceeded his wagering gains, he would be capped at deducting $120,493 in total as (possibly) a “deduction for AGI”—assuming he still meets the Groetzinger definition of a professional gambler—while his excess nonwagering ordinary expenses would not be permitted as a current- or future-year tax deduction. This would increase the amount of expenses disallowed by $10,968 and increase his tax liability accordingly.
Leave Nothing to Chance
It is important to note that this change may not affect taxpayers beyond certain professional gamblers. With the increased standard deduction, fewer taxpayers—including recreational gamblers—will opt to itemize deductions. Therefore, it is likely that many taxpayers will not receive a tax benefit for any wagering transactions/activities. The interpretation of the deductibility of various expenses is complex, however, and there is great uncertainty in terms of how future cases may decide the applicability of IRC section 165(d).