Can You Play the Lottery as a Business?

Originally Published on forbes.com on November 3rd,2011

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Gambling losses are only deductible to the extent of gambling winnings to most people.  Since the deduction is an itemized deduction a heavy break-even gambler might have some increase in federal tax from his activity.  Although the deduction is not an AMT preference, the increase in adjusted gross income might trigger limitations and phase-outs in other areas.  Still break-even gambling will often be  close to a wash on your federal return.  Not so in many states, which base their tax on some form of federal adjusted gross income rather than federal taxable income.  Those states, Massachusetts among them, only want to partner with you when you make winning bets.  It seems like a particularly unfair result when you are playing the state lottery, but – It is what it is.  Deal with it.  One way to deal with it is to establish that you are a professional gambler.  If you gamble as a trade or business, then your losses are deductible on Schedule C, which makes them deductible for state income tax purposes in Massachusetts.  That is the approach that Clarance Jonesdecided to take.  It is not easy.

The Massachusetts Department of Revenue was looking for a lot of money from Clarance Jones.  Over $300,000 for the years 2001 through 2006.  Then there was the $13,715,219 in tax due for 2007.  Prior to the trial, the Department of Revenue admitted that when they had sent Mr. Jones a notice that he had  over 250 million in  lottery winnings, someone had been careless with the decimal point.  Presumably the gross winning number that he had reported – more in the vicintiy of 2.9 million was more accurate. Of course he also had losses and expenses and ended up reporting a net profit of around $25,000.  Nonetheless, the decimal point problem was resolved and they moved on to the other issues.

Although there are people who have come out ahead on the lottery, it seems that someone playing systematically over time would have to lose money. Apparently Mr. Jones, who has been at it for many years, thinks he has found weakness in the system:

He testified that, in his opinion, Massachusetts has “the easiest lottery system” for a regular gambler to successfully play. He explained some of his methodologies, like buying Lottery tickets in the middle of a pack where, he believed, the winning tickets were grouped, and purchasing tickets at stores that have had recent large winnings, because, in his opinion, those stores have a higher chance of selling winning tickets. The appellant submitted into evidence a manual that he had written entitled “The Gambler,” which contained some of the observations and “trade secrets” for successful gambling that he has accumulated over his gambling career.or business.

For whatever it is worth a DOR representative testified that in all the years in question Mr. Jones was either the highest or second highest casher of winning tickets in the Commonwealth.  So maybe there is something to his system.  I think I’ll stick with my day job though.  Even putting aside the decimal point problem the Department of Revenue did not distinguish itself in the way that it handled the audit of Mr. Jones.  He had voluminous records documenting his wins and losses and the auditors did not want to deal with them.

The parties stipulated that the appellant maintained numerous boxes of losing dog and horse racing tickets from both live and simulcast races, along with programs, losing Foxwoods Keno tickets, and losing Massachusetts Lottery tickets, including scratch tickets and various numbers games including, among others, Keno, Daily Numbers Games, Mega Bucks, Mega Millions, Mass Millions, Cash Windfall, Big Game, Powerball and Daily Race Game. The appellant testified that he maintained at least 200 boxes at a storage facility in Lynn, Massachusetts. A sample, as agreed to by both parties, of about fifteen boxes of those records, was submitted to the Board. The boxes were filled with various losing Lottery tickets, losing Foxwoods Casino Keno tickets, losing racing tickets and racetrack programs. All items were bagged and/or bound together in groups and labeled by notations which either included dates, places, number of tickets and total cost of tickets, or a number corresponding to the appellant’s personal numbering system from his records where that same information would be listed.

Edward Sherman CPA, Mr. Jones accountant, gave testimony on the nature of his records and his interaction with the state auditors:

Mr. Sherman offered detailed testimony with respect to the sufficiency of the appellant’s records. He explained that the appellant maintained more than 200 boxes of records in a storage facility and that he had seen these records and had advised the appellant on his record keeping.

Mr. Sherman next testified to the disagreements between the appellant and the Commissioner’s auditors with respect to the examination of his records during the course of the audit for the tax years at issue. Mr. Sherman explained that the auditor originally assigned to the appellant’s case was replaced by another auditor, Judith D’Auteuil, midway through the audit. He also testified that he had repeatedly requested that the Commissioner’s auditors come to see the appellant’s records at the storage facility, but that the auditors refused all requests for examination. He explained that the auditors sent out form requests seeking certain types of records, such as logs of the appellant’s gambling activities, but that the appellant did not maintain his records in the specific format requested. Mr. Sherman explained, however, that he had advised the appellant to retain all of his racetrack tickets and programs and Lottery tickets because they collectively contained all of the information required for completing and verifying a tax return. Particularly with respect to a Lottery ticket, Mr. Sherman explained that “[a]ll of the information is on the ticket,” including the date and location of purchase and the amount of the wager.

Based on an agreed sample of the records the Appellate Tax Board concluded that Mr. Jones had substanitated his losses.  They dismissed as speculative a last minute contention by DOR that he was either collecting losing tickets from other gamblers and claiming them as his own or cashing winning tickets for other gamblers in exchange for a share of the winnings.

Given the volume of tickets, programs and other records maintained by the appellant, and the fact that they contained many shorthand notations that were not self-explanatory, the Board found that the auditors could not assume that the records were not adequate based on the extraordinarily small portion of records that they reviewed, particularly when no auditor ever conducted a desk audit with the appellant in order to give the appellant an opportunity to explain those records.

I think it is likely that this case would not have gone to trial without the decimal point error making it seem like it was a huge case.  As to the feasibility of making a living in the scratch ticket business, I remain skepitcal.

You can follow me on twitter @peterreillycpa.