Chapter 5: The Taxman Cometh by Steve Crist
Sometimes having partners is a good idea when you’re playing the races. Four friends who want to spend $32 on a pick four or especially a pick six would do better by pooling their $128 than going it alone with short money. Some bigger players have been known to sell a percentage of their action (usually at a markup) to passive investors who want some action without doing any handicapping, as a way of lessening their risk or gaining additional capital.
Suppose you had a partner though, who didn’t put up any money, didn’t pay for any losses, but demanded 25 percent of your very best payoffs? In addition to being unfair, it could bankrupt you before the end of the year. One of the downsides of exotic betting is that when you finally hit something big, you will discover that you have precisely such a partner. His name is Uncle Sam.
In the hedging story at the end of the previous chapter, I wrote that my $200 win saver on Casper Peterson, good for a $7,350 return, was decent consolation for missing a couple of pick four returns in the $10,000 range. From a cash-flow perspective, it was actually a virtually identical result: Under the absurd gambling regulations of the Internal Revenue Service, a $10,000 pick-four score is subject to a 25 percent Federal income-tax withholding, meaning you will receive only $7,500. A $7,350 triumph in the win pool, however, goes unreported and untaxed.
The current tax code is unfair to all gamblers but singles out racing’s exotic bettors for particularly brutal treatment. That these regulations have not been changed even as the exotics have come to dominate modern racetrack betting is an ongoing disgrace for the American racing industry, which has shown little interest or initiative in working to change them even though tracks would benefit as much as their customers. While most seasoned exotics players have reluctantly and bitterly accepted them as a cost of doing business, they can create financial complications for the most law-abiding citizen and are serious enough that you should understand them, and talk to a tax professional (which I am not) about them, should you have the mixed blessing of hitting a four-digit exotic payoff.
The United States is one of the few countries that even taxes gambling winnings at all. While selfishly we might prefer this were not so, the idea that your net gambling winnings in the course of a full year should be tax-free is hard to defend. If that were as far as it went, most horseplayers probably would have no real objection to the idea of paying an income tax on their true year-end winnings. Unfortunately, the tax code goes far beyond that.
The I.R.S. rules, formulated in the infancy of exotic betting, require that winnings at odds of 300-1 or higher be reported to the Government if they exceed $600 and that the payoffs are subject to withholding if they total $5,000 or more. (That latter threshold was raised from $1,000 to $5,000 in the early 1990’s, the last time the rules were changed.) Perhaps this was more palatable in the days when a daily double or exacta would pay off at 300-1 so rarely that such triumphs were true windfalls. Once trifectas and even more complex bets at those odds and payoffs became daily occurrences, however, the tax system became a nightmare for horseplayers.
There are several huge problems with this method of reporting and withholding:
1. The I.R.S.discriminates against horse-racing and people who make exotic bets.
It makes no sense that a $7,350 collection on a win bet is not subject to reporting or withholding but even an $1,100 trifecta is. In addition, even bigger winners at casino games get off virtually scot-free. The casinos have successfully argued that when someone walks away from a dice table with $10,000 in chips, the house has no way of knowing whether he started out with $500 or $15,000. All that such a gambler has to do is cash out for less than $10,000 at a time, to avoid another regulation regarding large cash transactions, to escape the same requirements imposed on a small bettor who hits an occasional four-digit trifecta.
2. The I.R.S. reports and withholds based on gross winnings, not net profits.
No other business or activity is treated this way. Suppose that a store sells $1 million worth of merchandise in the course of a year, and its true profit after cost of goods, expenses and payroll is $50,000. The business pays taxes on that $50,000 profit. If the I.R.S. treated the store the way it treats horseplayers, it would confiscate $250,000 right off the top as 25 percent of the gross receipts. The storeowner could apply for a refund, but would probably be out of business before receiving it up to a year later.
This is exactly what happens to an exotic bettor. If you lose $1,000 a day Monday, Tuesday, Wednesday and Thursday, then invest another $1,000 Friday and hit a pick four for $5,100, you have bet $5,000 for the week and gotten a return of $5,100. Your profit is $100, and you probably wouldn’t have a problem paying the government around $25 as income tax. Instead, the government seizes 25 percent of that $5,100 hit, which is $1275, leaving you with $1175 less cash than you started with at the beginning of the week.
3. The I.R.S. explicitly says that every exotic payoff is the result of a single, independent $1 or $2 bet.
Let’s say you put $1,458 into a 3x3x3x3x3x3 pick six partwheel (not a recommended play, as we shall discuss later), a bunch of favorites win, and you hit it but the payoff is only $1,500. You won $42, hardly the 300-1 return that is supposed to trigger I.R.S. involvement. The I.R.S., however, treats this “windfall” as if you bought a single $2 ticket on the winning combination and received a return of 749-1 on your money.
“For multiple wagers sold on one ticket,” the I.R.S. says in the 2006 version of its Instructions for Forms W-2G and 5754, “such as the $12 box bet on a Big Triple or Trifecta, the wager is considered as six $2 bets and not one $12 bet for purposes of computing the amount to be reported or withheld. Winnings on a $12 box bet must be reported if they are $600 or more, and federal income tax must be withheld if the proceeds total more than $5,000.”
This verbiage reflects how completely out of touch the tax code is with modern betting, since the “$12 box bet” went the way of the dodo when tracks dropped their minimum trifecta prices from $2 to $1 more than a decade ago, and “Big Triple” is a relic from the 1970’s.
The I.R.S.’s illogical insistence on treating multiple bets this way is the source of the majority of withholding and reporting. If it only taxed the proceeds of a $48 trifecta partwheel when the return on total investment were truly 300-1 or higher, it would require a $14,400 return on a $48 bet for you to start filling out forms.
4. The I.R.S. allows you to deduct losses against your winnings but only as an itemized deduction, not as an adjustment to income.
You would think that if you bet $50,000 in the course of a year and got back $52,000, the I.R.S. should be told that you made $2,000 and tax you accordingly, but you would be wrong. Instead, you are supposed to report $52,000 in income and then, and only if you itemize deductions, claim $50,000 in losses on a separate part of your tax return as a deduction against the $52,000 in “winnings.”
The problem here is that there can be adverse consequences to increasing your gross income, such as becoming subject to the Alternative Minimum Tax or reaching a threshold where other deductions are limited or phased out. Additionally, not everyone’s circumstances make it possible or prudent to itemize deductions at all.
In fact, the letter of the I.R.S. regulations compel you to do this even if you make nothing more than $2 win bets and even if you come out a loser for the year. Let’s say you made 10 $2 win bets in the course of a day, catching two winners at $11.60 and $8.40 to break exactly even. Technically, you are supposed to increase your gross income by $20 and itemize $20 in losses against it.
There is probably not a single person in the United States who does this and as a practical matter this requirement is not observed or enforced by anyone. Yet exotic bettors are treated precisely this way simply because exotic betting is a game of peaks and valleys where infrequent triumphs make up for long stretches of losing bets.
For most players, the whole I.R.S. issue amounts to an outrageous but manageable nuisance. The casual player who has a few signers and perhaps one instance of withholding for the year will, after receiving professional advice, probably deduct losses up to the amount of his reported so-called winnings, and should get back some or all of what was withheld – albeit after giving the government an interest-free loan for up to 18 months.
It becomes more burdensome the more you bet and win, because the constant confiscation of 25 percent of your gross receipts on your best days will begin denting and perhaps consuming your bankroll. One of the nation’s most successful exotics players says that his withholdings take away so much of his working capital by the final quarter of each year that he almost annually has to tap into a home equity credit line just to have enough working capital until his massive annual tax refund arrives. He would be happy to pay quarterly estimated taxes on his actual winnings four times a year even at the 25 percent rate, but the I.R.S. refuses to treat even fulltime professional gamblers this way.
What is almost as absurd as these regulations is the failure of the racing industry to get them revised. In 2003, the National Thoroughbred Racing Association took a step in the right direction, convening a Players’ Panel of serious handicappers and bettors to make recommendations, and this issue was at the top of their list. However, industry officials have claimed they have been unable to make any progress on the issue, though they seem to be able to influence legislation with a more direct impact on powerful horse owners.
The supposed lack of headway on changing gambling withholdings seemed particularly disingenuous when, in 2004, racing lobbyists were successful in overturning a similar I.R.S. regulation that previously had demanded a 30 percent withholding on all racetrack winnings by non-residents betting into United States pools. This was an equally idiotic provision and based on a similar issue, but industry lobbyists were able to get it dropped as part of a “Jobs Creation Bill” passed by Congress. The change allowed U.S. tracks to increase their profits by accepting wagers from countries such as Canada, which previously had been forced to create their own smaller betting pools on U.S. racing. The industry’s success with this bill, while failing to do anything about the W2-G situation for American bettors, made at appear that the industry either didn’t understand or didn’t care about the similar situation facing its own regular customers.
The shocking response of some track operators is that the withholding issue is not a big deal because bettors are so tickled to cash a big ticket that they barely even notice a tax deduction. If nothing else, this attitude is remarkably shortsighted in terms of the tracks’ self-interest. Constant withholding removes money from the bettors’ total available funds that would otherwise be repeatedly churned through the windows, increasing the industry’s handle and profits.
Consider what happens in an exotic pool when the payoff is over $5,000. The Magna 5 is a five-race multirace wager linking selected races at Gulfstream, Santa Anita, Laurel and Golden Gate on winter and spring Saturdays. On January 28, 2006, the bet attracted a robust pool of over $600,000. There were 70 winners of the bet, producing an after-takeout return of $6,792.20 for each winning ticket. None of those ticketholders, however, received $6,792.20. Because the $2 payout exceeded $5,000 at odds of over 300-1, each was subject to 25 percent withholding, which worked out to $1,698 per ticket, reducing the $6,792.20 payout to $5,094.
Of the $470,000 or so due to be paid out to winning ticketholders, more than $115,000 was instead shipped straight to the Internal Revenue Service and taken out of circulation - where, according to some economic models, it would have been churned at least five more times for an additional $500,000 in handle. Something similar happens every day with big payoffs at tracks all across the country. Only recently have a few enlightened track operators begun to see that this adds up to tens if not hundreds of millions of dollars annually.
What is particularly unfortunate about the Magna 5 – a bet that has frequently paid off in the $5,000 to $10,000 range – is that the entire withholding secenario could have been avoided if Magna offered the bet as a $1 rather than $2 minimum wager. At a payoff of $3396.10 for $1 instead of $6,792.20 for $2, winners would still have had to report their winnings but there would have been no withholding. Also, the bet would have been far more affordable for many players.
This brings us back, in a roundabout fashion, to the appeal of dime superfectas and the case for reducing minimum bets whenever possible. A superfecta that pays $48,000 for $1 will be reduced by $12,000 in Federal withholding to a $36,000 payout. A dime superfecta that returns $4,800 for 10 cents will not be subject to withholding because it falls below the $5,000 threshhold.
For that reason alone, superfecta players should strongly consider making their bets in dime increments wherever possible.
What the I.R.S. regulations have achieved above all is to create a thriving industry of illegal ticket-cashing. Many bettors, confused and frightened by the entire prospect of having any gambling activity reported to the government, seek out “ten percenters,” shady individuals with fake identification who loiter around every track in the country and will be glad to cash your ticket for an additional 10 percent of your ever-diminishing net.
In addition to being illegal, patronizing ten-percenters is criminally stupid, depriving yourself of the opportunity to recover some or all of your withholdings at year’s end, to which you will almost always be entitled. Remember, when the I.R.S. withholds from a payout of $5,000 or more, they are making the assumption that you made a single winning $1 or $2 bet and are not giving you credit for all the other bets you made in order to get that payout, much less for your losing days. If you have legitimately come out on the negative end of the ledger at year’s end, you should be able to get all of your withholdings back by taking a schedule A itemized deduction of your losses against the full amount of your reported gross winnings.
Fortunately, the I.R.S. seems to understand that horseplayers don’t win every time they bet, or at least the agents I dealt with when I was twice audited for gambling deductions did. I arrived at the I.R.S. offices with my detailed records of every bet I had made during the year, prepared to defend my deductions down to the penny, but the agents weren’t interested in more than a cursory look at all my paperwork. In both cases, the six-figure deductions I had claimed against six-figure reported winnings had set off an automatic red flag and they really just wanted to confirm that I actually gambled regularly and wasn’t somehow laundering money for criminals.
I didn’t lose any sleep over those audits because I had complied with and probably exceeded the I.R.S.’s recommendations for record-keeping, as enumerated in I.R.S. Publication 529, the 2006 version of which is excerpted below:
You must report the full amount of your gambling winnings for the year on Form 1040, line 21. You deduct your gambling losses for the year on Schedule A (Form 1040), line 27. You cannot deduct gambling losses that are more than your winnings. You cannot reduce your gambling winnings by your gambling losses and report the difference. You must report the full amount of your winnings as income and claim your losses (up to the amount of winnings) as an itemized deduction. Therefore, your records should show your winnings separately from your losses.
Diary of winnings and losses. You must keep an accurate diary or similar record of your losses and winnings.
Your diary should contain at least the following information.
1. The date and type of your specific wager or wagering activity.
2. The name and address or location of the gambling establishment.
3. The names of other persons present with you at the gambling establishment.
4. The amount(s) you won or lost.
Proof of winnings and losses. In addition to your diary, you should also have other documentation. You can generally prove your winnings and losses through Form W-2G, Certain Gambling Winnings, Form 5754, Statement by Person(s) Receiving Gambling Winnings, wagering tickets, canceled checks, substitute checks, credit records, bank withdrawals, and statements of actual winnings or payment slips provided to you by the gambling establishment.
For specific wagering transactions, you can use the following items to support your winnings and losses.
These recordkeeping suggestions are intended as general guidelines to help you establish your winnings and losses. They are not all-inclusive. Your tax liability depends on your particular facts and circumstances ...
Racing (horse, harness, dog, etc.). A record of the races, amounts of wagers, amounts collected on winning tickets, and amounts lost on losing tickets. Supplemental records include unredeemed tickets and payment records from the racetrack.
This is not quite as burdensome as it may first appear, and it gets you in the habit of keeping records of all your wagering, which has numerous side benefits. Having a log of all your wagers not only keeps you honest with yourself about how you’re doing but also allows you to analyze your betting and see what you might actually be better or worse at than you might think.
When the pick four first came to New York, I jumped in and played it with enthusiasm for a few months and felt I was holding my own while getting accustomed to the wager. After a few months I broke down my recent betting by wager-type and discovered to my horror that I had frittered away over $10,000 on the bet and hadn’t really noticed because of some offsetting successes in other pools. I belatedly realized I had been playing the bet what I now consider the “wrong” way, at least for me – playing it like a pick three and trying to crush a limited number of combinations instead of using a multiple-ticket strategy with mains and backups at lower levels.
You can enter you results by hand into a notebook or, as I do, into a simple spreadsheet, which will then allow you to sort and analyze the data. I keep three separate logs: A master wager-by-wager record, a daily summary showing total wagering and net results for each track played each day, and a Tax Log listing all W-2G reporting and withholding transactions. This is five minutes’ work at the end of each day and would be well worth the effort even if the I.R.S. requirements did not exist.
One I.R.S. form worth knowing about is Form 5754, which can be used to carve up a tax ticket among more than one partner. When a group pools its money to play the pick six and hits it, there is often a panicky discussion of who should sign for the ticket and how to deal with tax liability and withholding. Instead, such a winning group can ask to cash the ticket together using Form 5754 and each partner will be given a separate W-2G reflecting only his percentage of the ticket.
Track and OTB mutual departments will generally be helpful with navigating I.R.S. problems. One unnecessary concern among some players who hit their first signer is that they may not be carrying a Social Security card and thus think they must resort to doing business with a ten-percenter. A polite phone call to the track mutuel department is a better idea, and alternate forms of identification are sometimes accepted. Still, if you’re a regular exotic bettor who wagers in cash, it probably makes sense to carry a Social Security card.
Those betting outlets that offer account wagering can generate copies of your wagering history to prove offsetting losses for lazy players who do not keep their own betting logs. Dealing with tax tickets is itself a good reason for opening a wagering account. Once your account is established and your social-security number has been verified once, signable and taxable tickets you buy through an account will be processed automatically and your W-2G’s will be mailed to you.
Account wagering may ultimately offer the most realistic solution to the entire taxation mess. Most regular players who deal with multiple signers and withholdings in the course of a year would happily volunteer to have their account activity reported to the government at year’s end in exchange for not having 25 percent of their best scores confiscated. If nothing else, the industry could work with the I.R.S. to have the withholding rate for account-holders lowered from 25 to something like 10 percent to reflect the obvious fact that no one wins every day and that withholdings can often exceed a player’s total profits for an entire year.
What would be even simpler and fairer would simply be to multiply the current reporting and withholding thresholds by a factor of 10, from $1,000 and $5,000 to $10,000 and $50,000. That way the Government would still get its piece of true windfalls, ten-percenters would be driven out of business, and over 95 percent of current W-2G paperwork could be eliminated overnight.
Until that happens, players should be prepared but not scared of the tax consequences of winning big exotic bets. In most cases, they will be able to deduct their legitimate losses against their winnings, eventually get back their withheld money, and perhaps in the process get into the good habit of keeping wagering records. It’s just a shame that what should be your happiest moments in racetrack gambling are diminished by a situation the racing industry has failed to address.
Copyright 2006 By Steven Crist
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