Tax Court: Gambling Losses Were Substantiated Using Statistical Analysis

(Parker Tax Publishing November 2020)

The Tax Court held that a taxpayer who was a compulsive gambler substantiated his gambling losses for the year at issue based in part on an expert witness report which concluded that the odds against the taxpayer having earned even $1 of net gambling profit were 140 million to 1. The court rejected the IRS's argument that the expert witness's methodology was based on uncertain or flawed assumptions, finding that a similar report prepared by the same expert was found to be persuasive in Gagliardi v. Comm'r, T.C. Memo. 2008-10. Coleman v. Comm'r, T.C. Memo. 2020-146.

Background

John Coleman retired from the District of Columbia Department of Insurance, Securities, and Banking (DISB) in 2004 after working there for 28 years. Upon retiring he started an insurance consulting business that generated a modest amount of income during 2014, the year at issue. His wife, to whom he has been married for 47 years, also earned wage income in 2014.

Coleman is a compulsive gambler. He started gambling in high school. During the 1980s, he began playing commercial slot machines in Atlantic City, New Jersey. As more casinos opened closer to his home in Maryland, he gambled at those locations and did so more frequently. The frequency of his gambling increased further after he retired from DISB in 2004. Coleman's gambling adversely affected his financial circumstances and his family life. Despite receiving substantial income over the years, Coleman was delinquent in paying property taxes on the family home, which was exposed to the risk of tax sales in 2014 and other years. His cell phone service was disconnected for failure to pay. He received numerous final notices threatening to cut off household utility services.

During 2014, Coleman received taxable nongambling income of $76,784 and a nontaxable personal injury insurance settlement of $150,000. He also received $350,241 of gambling winnings, reported to him on 160 separate Forms W-2G, Certain Gambling Winnings, by the casinos at which he gambled. During 2014, Coleman gambled at four casinos: Maryland Live! (ML), Rod 'N' Reel Resort (RNR), Dover Downs (DD), and Horseshoe Casino Baltimore (Horseshoe). None of the four casinos kept complete records of his gambling transactions. Casinos are required to issue Forms W-2G reporting slot machine jackpots of $1,200 or more but are not required to keep track of gambling losses or smaller winnings. All four casinos kept records of every instance in which Coleman won a prize of $1,200 or more. Besides recording prizes of $1,200 or more, DD and Horseshoe tracked Coleman's wins and losses when he signed into slot machines using casino-issued rewards cards (sometimes called players cards). Coleman used these cards fairly often, but he did not always use them, either because he forgot or because he believed that temporarily not using the cards might help change his luck.

Coleman gambled on at least 193 days during 2014, most likely more. Drawing on the $150,000 insurance settlement, Coleman gambled more that year than he had been able to in other years because he had more money available to him. He was regularly away from home gambling for 8- to10-hour periods, at all times of day and night. Coleman gambled almost exclusively on slot machines. If Coleman did not have prize winnings left over from his last gambling excursion--and he usually did not--he would stop to withdraw cash on the way to the casino. He typically made such withdrawals, in amounts often ranging between $2,000 and $3,000, from his account at Industrial Bank. He rarely started any day of gambling with less than $1,000. Coleman had two credit cards and two credit union accounts. If he ran out of money while gambling, he would withdraw money from an onsite ATM, secure an advance on a debit or credit card, or get a cash advance from the casino. During 2014, he made 210 withdrawals from his credit card and credit union accounts while gambling at casinos.

Coleman's financial accounts did not reveal any increase in net worth that could be traced to net gambling winnings. He drew down the balance of his $150,000 insurance settlement chiefly by withdrawing funds to use at casinos. When he retired from DISB in 2004, Coleman had $75,000 in a retirement plan account. He took numerous distributions from that account during the ensuing 10 years, chiefly to fund his gambling habit, and by the end of 2014 only $2,725 remained. Coleman had no other retirement accounts, brokerage accounts, certificates of deposit, checking accounts, or investment assets. He made no significant changes to his lifestyle during 2014, took no vacations, made no large gifts, and did not purchase any real estate, jewelry, or other expensive personal property.

Neither Coleman nor his wife filed a tax return for 2014 or made any estimated tax payments. The IRS prepared a substitute for return (SFR) and issued a notice of deficiency based on the SFR. The notice determined a deficiency of $128,886 plus penalties for failure to timely file, failure to timely pay, and failure to pay estimated tax. The deficiency was largely attributable to $350,241 in unreported gambling winnings, the total reported to the IRS by the casinos on Forms W-2G. Coleman challenged the notice in the Tax Court, arguing that he had gambling losses in excess of the winnings reported on Forms W-2G.

Under Code Sec. 165(d), a taxpayer who does not engage in gambling as a trade or business can deduct losses from wagering transactions as an itemized deduction, but only to the extent of the gains from such transactions. Gambling losses can be substantiated with evidence such as ATM receipts, canceled checks made payable to casinos, and credit card statements showing cash advances at casinos. A taxpayer's bank statements, lifestyle (modest or luxurious), and overall financial position can also be considered. In Gagliardi v. Comm'r, T.C. Memo. 2008-10, the Tax Court considered expert testimony from Mark Nicely, an expert in mathematics, the casino gaming industry, and casino gaming equipment (particularly slot machines), regarding the taxpayer's likelihood of having net gambling winnings given the frequency of his gambling.

Mark Nicely prepared an expert report for Coleman and testified at his trial. Nicely estimated the likely outcome of Coleman's gaming transactions during 2014 on the basis of the frequency with which he gambled and the expected win percentages at the casinos where he gambled. Nicely concluded, with a 99 percent level of certainty, that Coleman had overall net gambling losses of at least $151,690 during 2014. Nicely explained that, if a player gambles long enough and does not win any prizes that are exceptionally large relative to the size of the wager, it would be virtually impossible for that player to have annual net gambling winnings. Nicely opined that the odds against Coleman's having enjoyed even $1 of net gambling profit, for the entirety of 2014, were at least 140 million to 1.

The IRS argued that records maintained by DD and Horseshoe, the two casinos at which Coleman gambled the least, show that he had net gambling winnings for 2014. The IRS also criticized Nicely's methodology, asserting that it was based on "uncertain or flawed assumptions." The IRS portrayed Nicely's conclusions as implausible by extrapolating his results to future years, urging that Coleman could not have sustained annual net gambling losses of $151,690 indefinitely.

Analysis

The Tax Court ruled in Coleman's favor after finding, based on his financial records, testimony, and expert witness report, that Coleman substantiated gambling losses in excess of his gambling winnings for 2014.

The court found that Coleman's financial accounts revealed no increase in his net worth that could be evidence of net gaming winnings during 2014. In addition, the court noted that Coleman maintained a modest lifestyle and made no significant changes to his lifestyle during 2014. The court further found that Nicely's report confirmed that Coleman could not have had any net gambling winnings during 2014. The court said it had no trouble finding that Coleman provided sufficient evidence to show that his gambling losses were at least $350,241, the amount of his winnings.

The court rejected the IRS's arguments. It found that the casino records on which the IRS relied were incomplete because the casinos kept track only of jackpots of $1,200 or more and other transactions where Coleman was using his rewards card, which Coleman did not always use.

The court also disagreed with the IRS's view of Nicely's methodology. The court noted that it had found Nicely's approach persuasive in Gagliardi, a case in which Nicely used the same types of casino data and similar statistical techniques to generate his results. The court further found that Nicely's conclusions were based on the frequency of Coleman's gambling during 2014 and the amounts of money he gambled. According to the court, the broader point of Nicely's report 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. And in the court's view, there was no doubt that Coleman played long enough.

For a discussion of the rules for deducting gambling losses, see Parker Tax ¶85,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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