Despite inexact substantiation of his losses, the Tax Court held that a taxpayer had lost more than he had won gambling during 2014, and he could take a gambling loss deduction equal to the amount of winnings reported to the IRS on Forms W-2G, Certain Gambling Winnings, from casinos for the year.
John Coleman is a self-acknowledged compulsive gambler. His preferred form of action is the slot machine, which, unfortunately, generally offers among the worst odds of any type of game in a casino. Coleman testified in Tax Court that over the years his love of playing the slot machines had adversely affected his financial circumstances and his family life. In 2014, it also brought him into conflict with the IRS.
During 2014, Coleman had nongambling income of $76,784 and a personal injury settlement of $150,000. He also won $350,241 gambling at four casinos in Maryland and Delaware, which was reported to him (and the IRS) on Forms W-2G from the casinos. The Forms W-2G from all of the casinos included only his wins of over $1,200 or more.
Besides recording prizes of $1,200 or more on Forms W-2G, two of the casinos tracked his wins and losses when he signed into slot machines using casino-issued rewards cards (sometimes called players cards). He frequently signed into slot machines with the rewards cards when he was gambling at these casinos, but not every time. Combining his prizes of $1,200 or more and his wins and losses when he used his rewards card, Coleman had net gambling winnings of $52,804 during 2014 at one of the casinos. At the other, he had net gambling winnings of $1,501. The other two of the four casinos he gambled at did not keep win/loss records based on rewards card data.
When going out for a gambling session, if Coleman did not have any money left from his last session, which he usually did not, he would stop to withdraw cash on the way to the casino. If he ran out of money while gambling, he would withdraw money from one of two credit union accounts or secure an advance on a debit or credit card from an ATM at the casino where he was playing, or get a cash advance from the casino itself (which he was required to pay back several days later). Sometimes he would replenish his funds more than once a day. During 2014 he made 210 withdrawals from his credit cards and credit union accounts while gambling at casinos, totaling $240,113.
Coleman did not file a federal income tax return. Because the casinos and other payers reported to the IRS that Coleman had received a significant amount of income, the IRS opened an examination and prepared a substitute for return (SFR) for him. In the SFR, the IRS included as income the $350,241 in gambling winnings reported to it on the Forms W-2G from the various casinos where Coleman had gambled in 2014 and approximately $40,000 of additional unreported income from other sources. It did not do Coleman the favor of including any of his substantial gambling losses for 2014 in the return. Based on the return, the IRS issued a notice of deficiency to Coleman for $128,866 in tax and $46,025 in failure-to-file and failure-to-pay penalties.
Coleman, after filing a petition challenging the IRS's determination in Tax Court, filed a return that included, along with his gambling winnings and other income, a $350,241 deduction for gambling losses. The IRS refused to accept the return, but before trial the IRS stipulated that all the items on the return were correct, except for the claimed gambling loss deduction and a minor business expense deduction.
The Tax Court's decision
The Tax Court held that Coleman had substantiated that his gambling losses for 2014 were in excess of his gambling winnings, so he was entitled to the $350,241 gambling loss deduction. In making its decision, the court relied in part on the testimony of a gaming industry expert who testified on behalf of Coleman.
Under Sec. 165(d), for a taxpayer who does not engage in gambling as a trade or business, losses from wagering transactions are allowable as an itemized deduction, but only to the extent of the gains from such transactions. Unlike currently, in 2014 taxpayers were allowed to take miscellaneous itemized deductions.
The court explained that while taxpayers must substantiate that they are entitled to take an expense and the amount of the expense, in some cases, under the Cohan rule, a court can estimate the amount of an expense if the taxpayer establishes that he or she paid or incurred an expense but not its precise amount (see Cohan, 39 F.2d 540 (2d Cir. 1930)). The court, noting that not all gamblers keep complete records of their wins and losses, found that the Cohan rule applied in Coleman's case. Thus, the question was whether Coleman could "substantiate his losses to a degree sufficient for [the court] to estimate, using [the court's] best judgment, that his gambling losses exceeded his gambling winnings."
The court found that Coleman had provided sufficient evidence to substantiate a deduction for gambling losses of at least the amount of his gambling winnings of $350,241. This evidence included Coleman's records showing he had withdrawn $240,113 from his credit union and credit card accounts, which he and the IRS stipulated he used for gambling; the small amount of money in his various bank accounts at the end of the year, despite his having deposited the $150,000 personal injury settlement into the account; and his continuation of a very modest lifestyle (apart from his gambling) throughout 2014. This evidence collectively convinced the court that Coleman could not have had any net gambling winnings in 2014.
The court found that this conclusion was confirmed by the report of Coleman's expert, Mark Nicely, whom the court recognized as an expert in mathematics, the casino gaming industry, and casino gaming equipment, particularly slot machines. Using established statistical techniques, 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, concluding, with a 99% level of certainty, that Coleman had overall net gambling losses of at least $151,690 during 2014.
In his report Nicely explained if a player gambles long enough and does not win any prizes that are exceptionally large relative to the size of the wager, it is virtually impossible for that player to have annual net gambling winnings. Based on his analysis, Nicely determined that the odds against Coleman's having earned even $1 of net gambling profit during 2014 were 140 million to 1.
The IRS criticized the methodology Nicely used in his report, claiming it was based on uncertain or flawed assumptions. The Tax Court disagreed, noting that it had approved of a report by the same expert using the same type of casino data and statistical techniques and that the expert claimed that in Coleman's case the information was more detailed and complete than in the previous case.
The IRS also asserted that the expert's conclusions were implausible because Coleman could not have sustained annual net gambling losses of $151,690 indefinitely into the future. The Tax Court found this argument to be faulty because the expert's conclusions were based on Coleman's frequency of gambling and the amount of money he gambled in 2014. The court found that Coleman had credibly testified that his gambling varied from year to year, based on how much money was available to him. Because he had received a one-time large windfall of $150,000 from his personal injury settlement (over 200% of his regular income) in 2014, it followed that he had unusually large gambling losses for 2014.
While it is clear from this case and Gagliardi, T.C. Memo. 2008-10, that the Tax Court will sometimes give bona fide compulsive gamblers great leeway in determining the amount of wagering losses they can deduct, less-prolific gamblers cannot assume the court will apply the Cohan rule to determine their gambling losses. Thus, if gambling losses of taxpayers not in a trade or business of gambling become deductible again in the future, these gamblers should track their losses through rewards card programs or some other method to ensure they are able to deduct their losses.
Coleman, T.C. Memo. 2020-146