LIMITATION ON WAGERING LOSSES NOT APPLICABLE TO RELATED BUSINESS EXPENSES, TAX COURT SAYS.

Michael S. Hensley, for respondent.

GALE, Judge: Respondent determined a deficiency of $9,732 in Federal income tax and an accuracy-related penalty under section 6662(a) and (b)(2)¹ of $1,387 with respect to petitioners' 2001 taxable year.² Respondent subsequently conceded that petitioner Ronald Andrew Mayo (petitioner)³ was in the trade or business of gambling during 2001 and allowed petitioner's gambling expenses (which totaled $142,728) to be deducted as trade or business expenses to the extent of his gross receipts from gambling ($120,463). The foregoing concessions resulted in a reduced deficiency and accuracy-related penalty of $6,993 and $1,387, respectively. The issues for decision are:

(1) Whether petitioner's engagement in the trade or business of gambling entitles him to deduct the losses from his gambling business from gross income without regard to section 165(d), which allows wagering losses only to the extent of wagering gains;

(2) whether petitioner is entitled to deduct the expenses, other than the costs of wagers, incurred in carrying on his gambling business pursuant to section 162(a) without regard to section 165(d); and

(3) whether petitioners are liable for an accuracy-related penalty under section 6662(a) and (b)(2) for substantial understatement of income tax.

Petitioners resided in California when the petition was filed.

The parties have stipulated that petitioner was engaged in the trade or business of gambling on horse races during 2001. During that year he wagered $131,760 on the outcome of horse races and won $120,463 as a result of the wagers he placed. Petitioners attached a Schedule C, Profit or Loss From Business, to the 2001 Federal income tax return on which they reported the results of petitioner's gambling business. On the Schedule C petitioners reported as gross receipts the $120,463 of proceeds from petitioner's winning wagers and deducted as an expense the $131,760 in wagers petitioner placed (wagering expenses). Petitioners also claimed the following as expenses on the Schedule C (collectively, business expenses):

      Expense                                      Amount

On June 9, 2003, respondent sent petitioners a notice of deficiency for 2001 in which he determined that petitioner was not engaged in the trade or business of gambling and was therefore required to claim any gambling losses (but only to the extent of gambling gains) as itemized deductions (pursuant to section 63) and subject to the limitation of section 68, rather than as trade or business expenses under section 62(a)(1). On August 11, 2003, respondent sent petitioners a Notice CP2000 in which he conceded that petitioner was in the trade or business of gambling and that petitioners were therefore entitled to deduct petitioner's wagering expenses and business expenses on Schedule C, but only to the extent of his gross receipts from gambling. Consequently, respondent allowed Schedule C expenses of only $120,463, the amount of gross receipts reported from gambling, thereby eliminating the $22,265 net loss from gambling that petitioners had claimed as a deduction from gross income. Respondent's limitation of petitioners' allowable deductions from gambling to $120,463 effectively disallowed both the excess of the $131,760 in wagering expenses over the $120,463 in gross receipts from gambling ($11,297) and business expenses claimed in connection with the conduct of the gambling business ($10,968).

Petitioner contends that under Commissioner v. Groetzinger, 480 U.S. 23 (1987), the limitation of section 165(d) on the deduction of gambling losses does not apply to professional gamblers. Citing the Supreme Court's observation that "basic concepts of fairness * * * demand that * * * [gambling] activity be regarded as a trade or business just as any other readily accepted activity", id. at 33, petitioner contends that section 165(d) does not apply to an individual engaged in the trade or business of gambling since it does not apply to other trades or businesses.

In 1951 this Court considered whether an individual engaged in the trade or business of gambling is subject to the section 165(d) limitation on wagering losses, holding that the limitation applied in these circumstances. Offutt v. Commissioner, supra at 1215-1216;⁶ accord Skeeles v. United States, 118 Ct. Cl. 362, 372, 95 F. Supp. 242, 246-247 (1951). In recent years we have repeatedly rejected the claim that Groetzinger modified this settled law and should be read as confining the application of section 165(d) to casual or recreational gamblers and eliminating the section's limitation on the deduction of the gambling losses of professional gamblers. See Crawford v. Commissioner, supra; Lyle v. Commissioner, T.C. Memo. 1999-184, affd. without published opinion 218 F.3d 744 (5th Cir. 2000); Valenti v. Commissioner, supra.

In Valenti we considered this claim regarding Groetzinger at length. We observed that, even though the gambling losses of a professional gambler fall under both the section 162(a) allowance of deductions for trade or business expenses and the section 165(d) limitation on the deduction of losses from wagering, it is a well-settled principle that section 165(d), as the more specific statute, trumps the more general provisions of section 162(a). The former provision operates as a limitation on deductions otherwise allowable under the latter. See Nitzberg v. Commissioner, supra at 358; see also Boyd v. United States, supra at 1372-1373; Skeeles v. United States, supra at 247.

Moreover, we reasoned, the Supreme Court in Groetzinger did not consider the interplay between sections 162(a) and 165(d) because the restriction in section 165(d) was not at issue in that case. Instead, the issue decided in Groetzinger was whether the taxpayer's gambling activities constituted engagement in a trade or business under section 162 "for purposes of treating his gambling losses as a tax preference item under the minimum tax scheme governed by sections 55 and 56." Valenti v. Commissioner, supra. In Groetzinger the Supreme Court held that an individual engaged in gambling for his own account -- that is, not providing goods or services to others as would a casino operator or bookmaker -- is engaged in a trade or business within the meaning of sections 62(a)(1) and 162(a), with the result that his gambling losses were not items of tax preference for purposes of the then-applicable alternative minimum tax. As for the suggestion that Groetzinger's holding regarding the trade or business status of certain individual gamblers eliminated the section 165(d) limitation in the case of professional gamblers, we noted in Valenti the consistent line of cases holding the section 165(d) limitation applicable even where wagering activities were conducted as a trade or business, citing Boyd v. United States, supra, Estate of Todisco v. Commissioner, 757 F.2d 1, 6-7 (1st Cir. 1985), affg. in part and vacating in part T.C. Memo. 1983-247, Nitzberg v. Commissioner, supra,⁷Skeeles v. United States, supra, Offutt v. Commissioner, supra, Ward v. Commissioner, T.C. Memo. 1986-237, and Kozma v. Commissioner, T.C. Memo. 1986-177.⁸ See also Lyle v. Commissioner, supra. The section 165(d) limitation has been applied whether the professional gambler was an individual wagering for his own account, see Boyd v. United States, 762 F.2d 1369 (9th Cir. 1985); Crawford v. Commissioner, supra; Tschetschot v. Commissioner, T.C. Memo. 2007-38; Praytor v. Commissioner, T.C. Memo. 2000-282; Lyle v. Commissioner, supra; Kochevar v. Commissioner, T.C. Memo. 1995-607; Kozma v. United States, supra, an individual or partnership engaged in providing gambling services to others, see Estate of Todisco v. Commissioner, supra; Nitzberg v. Commissioner, supra; Ward v. Commissioner, supra, or an individual engaged in both, see Skeeles v. United States, supra; Offutt v. Commissioner, supra.

In Commissioner v. Groetzinger, supra at 32, the Supreme Court made the following observations regarding section 165(d):

The legislative history of the enactment of the Revenue Act of 1934 (1934 Act), ch. 277, sec. 23(g), 48 Stat. 689, the predecessor of section 165(d), also supports the conclusion that the limitation on losses from wagering transactions was intended to apply to all such losses, even if incurred in the conduct of a trade or business. Before enactment of 1934 Act sec. 23(g), there was no statutory provision specifically directed at wagering losses. The courts had determined the deductibility of losses from gambling on the basis of the predecessors of section 165(c)(2) that allowed deductions for losses incurred in any transaction entered into for profit, though not connected with a trade or business.⁹ Caselaw and administrative rulings before enactment of 1934 Act sec. 23(g) held that the deductibility of gambling losses depended upon whether the gambling was illegal or legal and whether it was undertaken for profit rather than merely for recreation. Losses from illegal gambling were deductible only to the extent of gains therefrom. Frey v. Commissioner, 1 B.T.A. 338 (1925).¹⁰ Losses from legal gambling were fully deductible against other types of income if the gambling had been entered into for profit, see G.C.M. 10873, 1932-2 C.B. 85; see also Cronan v. Commissioner, 33 B.T.A. 668 (1935) (construing law before enactment of 1934 Act sec. 23(g) as allowing deduction of losses from legal gambling against nongambling income), and not deductible at all if the gambling had not been entered into for profit, Beaumont v. Commissioner, 25 B.T.A. 474 (1932), affd. 73 F.2d 110 (D.C. Cir. 1934).

Against this backdrop, Congress decided in the 1934 Act that the unlimited deduction for legal, profit-motivated gambling was inappropriate. Instead, Congress determined that the judicially developed rule for illegal gambling, which limited losses to gains, should be extended to legal gambling. The report of the Committee on Ways and Means explained:

On the basis of the reasoning of Valenti v. Commissioner, T.C. Memo. 1994-483, and the additional reasons discussed above, we reject petitioner's contention that Commissioner v. Groetzinger, supra, requires a holding that the section 165(d) limitation on losses from wagering transactions does not apply to persons engaged in the trade or business of gambling. Instead, following Offutt v. Commissioner, 16 T.C. 1214 (1951), we hold that petitioner's wagering expenses of $131,760 constitute losses from wagering transactions that are limited by section 165(d) to the gains he reported from wagering ($120,463), notwithstanding petitioner's engagement in the trade or business of gambling. Accordingly, respondent disallowance of $11,297 of petitioner's claimed loss is sustained.

Neither the statute nor the regulations provide any definition of "Losses from wagering transactions" as used in section 165(d). The legislative history also provides no insight, as it does not address this specific point. Offutt offered no reasoning to support the conclusion that "Losses from wagering transactions" should be interpreted to cover both the cost of losing wagers as well as the more general expenses incurred in the conduct of a gambling business. Although Offutt's interpretation of "Losses from wagering transactions" has generally been followed by this Court in the 60 years since the case was decided, see Praytor v. Commissioner, T.C. Memo. 2000-282; Kochevar v. Commissioner, T.C. Memo. 1995-607; Kozma v. Commissioner, T.C. Memo. 1986-177;¹³ but see Meredith v. Commissioner, T.C. Memo. 1984-651 (allowing deduction of professional gambler's transportation expense where wagering losses exceeded gains), no Court of Appeals other than that for the First Circuit in Estate of Todisco has had occasion to directly address it. For the reasons discussed below, we conclude that reconsideration of Offutt's interpretation of "Losses from wagering transactions" is warranted and that it should no longer be followed.

While no Court of Appeals other than that for the First Circuit has directly addressed whether "Losses from wagering transactions" as used in section 165(d) encompass the business expenses of a professional gambler, various Courts of Appeals and this Court have considered the other side of the section 165(d) equation -- "gains from such transactions" -- and construed that phrase quite narrowly. The Courts of Appeals for the Fifth and Ninth Circuits and this Court have rejected arguments for an expansive reading of gains from wagering transactions and confined the phrase to the proceeds from a wager by the taxpayer where the taxpayer stands to gain or lose on the basis of chance. See Boyd v. United States, 762 F.2d 1369 (9th Cir. 1985); Allen v. U.S. Govt. Dept. of Treasury, 976 F.2d 975 (5th Cir. 1992); Bevers v. Commissioner, 26 T.C. 1218 (1956); see also Williams v. Commissioner, T.C. Memo. 1980-494. But see Libutti v. Commissioner, T.C. Memo. 1996-108.

In Boyd v. United States, supra, the Court of Appeals for the Ninth Circuit, in addition to finding that professional gambler Boyd's losses from poker played as a casino employee to attract customers were losses from wagering transactions limited by section 165(d), was also faced with Boyd's claim that his share of the casino's "take-off" from poker games conducted on the premises constituted gains from wagering transactions for purposes of section 165(d). Take-off was the fee the house charged card players for playing poker in the casino, computed either hourly or as a share of each pot, and Boyd was paid pursuant to his employment contract a portion of the take-off from the poker games in which he participated.

Finding no statutory or regulatory definition of "gains from wagering transactions", the Court of Appeals reasoned that the words should be given their "ordinary meaning." Boyd v. United States, supra at 1373. The court summarized the parties' arguments and its conclusion as follows:

In Allen v. U.S. Govt. Dept. of Treasury, supra, the Court of Appeals for the Fifth Circuit reached the same result, on similar reasoning, as we reached in Williams regarding a blackjack dealer's toke income. The Court of Appeals reasoned that since the dealer "has no part in deciding to make the wager, and stands to lose nothing by it", he does not have gain from a wagering transaction as contemplated in section 165(d) when he receives the winning proceeds from a toke bet made on his behalf. Id. at 976-977; see also Collins v. Commissioner, 3 F.3d 625, 631 (2d Cir. 1993) (taxpayer who stole racing tickets that generated net gambling losses had theft income, not gain from wagering transactions under section 165(d)), affg. T.C. Memo. 1992-478.

In sum, to the extent this Court and the Courts of Appeals have considered the question, they have generally held that "gains" from "wagering transactions" within the meaning of section 165(d) must be the actual product of wagers entered by the taxpayer. Generally, it is not sufficient that the gain arise merely in connection with the conduct of wagering activities; the gain must be the direct result of a wager entered by the taxpayer.¹⁵ By contrast, the holding in Offutt v. Commissioner, 16 T.C. 1214 (1951), is that "Losses from wagering transactions" extends to expenses incurred in connection with the conduct of a wagering activity, such as a bookmaker's mailing, printing, and stenographic expenses, even though such expenses are not the direct result of a wager by the taxpayer. Take-off and toke gains from card games have an equally close, if not closer, nexus to wagering transactions as do the mailing, printing, and stenographic expenses of a bookmaker. Yet the latter are treated as "from" wagering transactions in Offutt and its progeny when the issue is what constitutes a loss, while the former are not treated as "from" wagering transactions by this and other courts when determining what constitutes a gain. Section 165(d) by its terms applies to losses and to gains "from" wagering transactions. The use of different principles for determining what constitutes a gain versus a loss "from" a wagering transaction finds no support in the statute.

The narrower interpretation that has been applied to gains from wagering transactions, requiring that they be the result of a wager entered by the taxpayer, more closely reflects the ordinary meaning of the words used in the statute, which is the applicable standard. See Crane v. Commissioner, 331 U.S. 1, 6 (1947); Old Colony R.R. Co. v. Commissioner, 284 U.S. 552, 560 (1932). Offutt's more expansive interpretation of "Losses from wagering transactions" as covering expenses that are not the result of the taxpayer's wager goes beyond the ordinary meaning of the statutory phrase.

In addition, the Supreme Court's opinion in Commissioner v. Sullivan, 356 U.S. 27 (1958), decided 7 years after Offutt, casts some doubt on the treatment of a professional gambler's nonwagering business expenses as creating a loss from a wagering transaction limited by section 165(d). Sullivan concerned the deductibility of the wage and rental expenses of the partners in an illegal bookmaking operation. The Tax Court had held that deductions for these expenditures were not allowable because the expenditures were illegal. The Court of Appeals reversed our decision, and the Supreme Court affirmed the decision of the Court of Appeals, holding that the bookmaking operation's expenditures for wages and rent were ordinary and necessary business expenses deductible under section 162(a).

Moreover, the Court of Appeals for the Ninth Circuit, while not expressly holding that the section 165(d) limitation is confined to direct wagering expenses, has nonetheless employed reasoning which strongly implies as much. In Boyd v. United States, 762 F.2d 1369 (9th Cir. 1985), Boyd had also sought to deduct as business expenses under section 162(a) his tipping expenses and the take-off fees he paid in order to play poker at the casino. Boyd was a refund proceeding, and the Court of Appeals held that Boyd was not entitled to raise his claim for deductions for the tipping and take-off fees because he had not sufficiently identified these grounds in his refund claim filed with the Secretary, as required by the regulations under section 7422(a). The Court of Appeals distinguished between wagering losses and "expenses incidental to gambling", observing that the latter "would not be subject to the section 165(d) deduction limit." Id. at 1372. The Court of Appeals reasoned as follows:

Finally, the Commissioner has applied the holding in Offutt v. Commissioner, 16 T.C. 1214 (1951), regarding the treatment of nonwagering expenses inconsistently. Since Offutt, the Commissioner has successfully maintained in many cases that the nonwagering business expenses of a professional gambler are limited by section 165(d), see Estate of Todisco v. Commissioner, 757 F.2d at 6-7; Praytor v. Commissioner, T.C. Memo. 2000-282; Kochevar v. Commissioner, T.C. Memo. 1995-607; Kozma v. Commissioner, T.C. Memo. 1986-177, while in other cases he has conceded their deductibility notwithstanding section 165(d), see Crawford v. Commissioner, T.C. Memo. 2010-54; Tschetschot v. Commissioner, T.C. Memo. 2007-38,¹⁸ or failed to assert the section 165(d) limitation on expenses of this type, see Meredith v. Commissioner, T.C. Memo. 1984-651. After respondent had taken the position in this case that petitioner's business expenses were limited by section 165(d), the Internal Revenue Service announced that it would no longer follow Offutt or Estate of Todisco. See IRS Chief Counsel Attorney Memorandum, AM2008-013 (Dec. 19, 2008). However, our failure to address Offutt may invite further administrative inconsistency concerning a professional gambler's entitlement to deductions under section 162(a) for the nonwagering trade or business expenses of engaging in gambling.¹⁹

For the foregoing reasons, we conclude that the holding in Offutt v. Commissioner, supra, that "Losses from wagering transactions" include the trade or business expenses of a professional gambler other than the costs of wagers, should no longer be followed. We accordingly hold that petitioner is entitled to deduct under section 162(a) the $10,968 in business expenses claimed in connection with carrying on his gambling business.²⁰

To reflect the foregoing,

Decision will be entered under Rule 155.

Reviewed by the Court.

COLVIN, COHEN, THORNTON, MARVEL, GOEKE, WHERRY, KROUPA, HOLMES, GUSTAFSON, PARIS, and MORRISON, JJ., agree with this opinion.

² The foregoing reflected, among other adjustments, respondent's determination that petitioner Ronald Andrew Mayo was not engaged in the trade or business of gambling and was therefore required to claim any gambling losses (but only to the extent of gambling gains) as itemized deductions.

³ Petitioner Leslie Archer Mayo signed a joint return for the taxable year at issue but had no active involvement in the gambling activity.

⁴ Petitioner reserved relevancy objections to almost all of the stipulations and stipulated exhibits, including portions of the 2001 Federal income tax return, the notice of deficiency issued with respect to 2001, and the Notice CP2000 in which respondent conceded petitioner's status as a professional gambler. We hereby overrule petitioner's relevancy objections. Certain stipulations concerning petitioner's professional education and employment appear germane only to the accuracy-related penalty for substantial understatement of income tax. Since we conclude that there is no substantial understatement of income tax on the 2001 return, these stipulations are not material in any event.

⁵ Petitioner's gross income consisted of wages, interest, refunds of State and local income taxes, capital gain, pensions and annuities, royalties, Social Security benefits, and trust fees.

⁶Offutt v. Commissioner, 16 T.C. 1214 (1951), construed sec. 23(h) of the 1939 Code, a predecessor of current sec. 165(d) with identical language. The language first appeared in the Revenue Act of 1934, ch. 277, sec. 23(g), 48 Stat. 689, and has remained unchanged since.

⁷ Although Nitzberg v. Commissioner, 580 F.2d 357 (9th Cir. 1978), revg. T.C. Memo. 1978-154 and T.C. Memo. 1978-228, reversed two Memorandum Opinions of this Court, the reversal turned upon different views concerning whether the wagering transactions at issue were those of the taxpayers or third parties and not upon a different view of the applicability of sec. 165(d) to wagering activities conducted as a trade or business.

⁸ We acknowledge that the Court of Appeals for the Ninth Circuit, to which an appeal would lie, has voiced some doubts regarding this line of authority. In Kent v. United States, 185 F.3d 867 (9th Cir. 1999), an unpublished opinion, the Court of Appeals stated that its decisions in Nitzberg v. Commissioner, supra, and Boyd v. United States, 762 F.2d 1369 (9th Cir. 1985), "clearly hold that § 165(d) limits the deduction of gambling losses even of those who gamble professionally." However, the Court of Appeals went on to note:

¹⁰ The Board of Tax Appeals reasoned in Frey v. Commissioner, 1 B.T.A. 338, 340-341 (1925), that a loss from illegal gambling had not been "incurred" in any transaction entered into for profit (within the meaning of sec. 214(a)(5) of the Revenue Act of 1918) because the liability underlying the loss was not legally enforceable.

¹¹ Only later was the language of sec. 165(d) -- to the effect that losses from wagering transactions "shall be allowed" -- interpreted as a liberalizing measure in the case of recreational gamblers, entitling them to deduct gambling losses to the extent of gambling gains without regard to profit motive. See Humphrey v. Commissioner, 162 F.2d 853, 855 (5th Cir. 1947), affg. in part and revg. in part a Memorandum Opinion of this Court; see also Winkler v. United States, 230 F.2d 766, 774 (1st Cir. 1956).

¹² Respondent has not contended that the business expenses claimed are not "ordinary and necessary" expenses of petitioner's trade or business within the meaning of sec. 162(a) or that they have not been substantiated.

¹³ We have expressed some subsequent doubts, however, whether the Offutt holding concerning the nonwagering business expenses of gambling is correct. See Kozma v. Commissioner, T.C. Memo. 1986-177 n.4 (quoting, with reference to the Offutt precedent, Justice Brandeis in Di Santo v. Pennsylvania, 273 U.S. 34, 42 (1927) ("It is usually more important that a rule of law be settled, than that it be settled right.")).

¹⁴ We noted that, for example, the dealer was not free to take the "toke" chip before the cards were played, and a player was free to take back a winning bet he had placed for a dealer.

¹⁵ An exception is this Court's Memorandum Opinion in Libutti v. Commissioner, T.C. Memo. 1996-108, which held that complimentary goods and services provided to the taxpayer by a casino to induce gambling are gains from wagering for purposes of sec. 165(d). We nonetheless emphasized that the nexus of the "comps" to the placement of wagers was "close, direct, evident, and strong."

¹⁶ The taxpayer in Offutt v. Commissioner, 16 T.C. 1214 (1951), was engaged in both bookmaking and gambling for his own account.

¹⁷ The Court of Appeals noted, for example, that lavish tipping might raise the issue of whether it was an "ordinary and necessary" business expense within the meaning of sec. 162(a), and that take-off fees raised the issue of whether they should be construed as a component of a wager's cost rather than a business expense.

¹⁸ See also Orr v. Commissioner, T.C. Summary Opinion 2010-55. We do not cite Orr as precedent, see sec. 7463(b), but merely to document the Commissioner's concession in that case that gambling-related travel expenses of a professional gambler were deductible notwithstanding sec. 165(d).

¹⁹ Moreover, respondent's reliance on Offutt in this case to deny petitioner's business expenses incurred in gambling would result in an addition to tax for substantial understatement of income tax if respondent's position were upheld.

²⁰ Respondent has not argued that any of petitioner's claimed business expenses were so integral to his wagers that they should be treated as part of the wagers' cost. We leave any such issue for another day.

GOEKE and HOLMES, JJ., agree with this concurring opinion.