Friday, February 15, 2013

An open letter: A simple, sensible change to fix almost all amateur poker income tax inequities

To the IRS, and to the legislators, regulators, and operators of future US online poker markets:

A longstanding quirk of the US tax code relating to how non-professionals must report their poker income has persisted despite the explosion in poker's popularity over the past decade. This tax rule creates effective surtaxes on amateur poker play that vary wildly with a player's personal circumstances and very frequently exceed 100% of a player's actual earnings. It is long overdue, and more pressing now than ever as we stand on the verge of domestically-regulated internet poker, that our tax code catch up with modern poker by taxing its earnings in a reasonably consistent way.

The problem

Amateur poker players currently cannot simply report their net poker winnings. Instead, they must report the sum of their winning poker sessions (gross poker winnings) as income, taking the sum of their losing poker sessions as itemized deductions.

An amateur poker player's bottom-line income is correctly calculated as his or her net income for most tax considerations. However, there are several intermediate steps within the process of determining a taxpayer's income tax obligation that can trigger off of or otherwise treat as proxy for true income the taxpayer's Adjusted Gross Income (AGI), a figure which includes gross amateur poker winnings before losses are deducted.

Consider an amateur poker player who, for simplicity, alternates between winning $100 and losing $100 in a weekly poker game for a year. Although he has made no money, his poker play contributes $2,600 to his AGI, as he reports $2,600 in Gambling Winnings and takes $2,600 in Gambling Losses. There is no meaningful theoretical or practical sense in which gross poker winnings represent actual income. Not only is our example a net loser at the end of the year, but he or she certainly has not had $2,600 of any sort of income. He or she never even possessed that much money at any point during the year!

Having any aspect of the tax code consider this player to have $2,600 of some sort of income is akin to taxing corporate revenue as if it were its income, or to considering the holder of this stock to have had $1,000 in investment earnings over this year ($1,000 being the sum of returns only over days in which the stock increased in value).


Of course, this is not how taxes work on these sources of income, but this is the problem that amateur poker players face. Depending on an amateur poker player's level of play, choice of game, and frequency of beginning and ending sessions, his or her AGI can very easily exceed his or her true income by tens or even hundreds of thousands of dollars, with no upper limit to the potential AGI inflation for higher-stakes amateur players.

What are the impacts of an artificially-inflated AGI?

The tax code appears to be designed so as to consider AGI to be a reasonable measure of a taxpayer's income, and it seems that amateur poker play is one of the few common ways that a taxpayer's AGI can significantly exceed his or her actual income. An artificially-inflated AGI can bring about the following inequities for a taxpayer:
  1. Taxpayers who reside or play in one of about a dozen "bad poker tax states" owe state income tax on their gross wins, with no state deduction permitted for gambling losses.
  2. A taxpayer who would otherwise take the standard deduction will either be unable to take gambling losses as an itemized deduction, or will lose out on the difference between his or her "real" deductions and the standard deduction.
  3. That taxpayer's spouse also loses his or her standard deduction, even if filing separately.
  4. The deductibility of medical expenses is limited by AGI, which includes winning poker sessions before losing poker sessions are deducted.
  5. Roth IRA contributions cannot be made by taxpayers whose AGI exceeds $127,000. Traditional IRAs have similar limits in cases where the taxpayer is covered by an employer pension plan.
  6. The Free Application for Federal Student Aid uses AGI instead of net income in determining the financial capability of a family to pay for a child's college education.
  7. Most non-poker itemized deductions are phased out at certain AGI thresholds.
  8. ... as are exemptions.
  9. A 3.8% surtax is applied on the investment income of "high-income" taxpayers, again determined by AGI.
The first two of these have a broad reach and can have a significant impact for many amateur poker players. About 30% of the US population resides in the "bad poker tax states", and the majority of poker players within any game environment are net losers who will be getting hit with an effective tax on their losing if they take the standard deduction or fit into any of these other circumstances. My conservative estimate is that at least a million Americans currently owe a tax on their poker activity which exceeds their actual winnings.

They're not currently paying these taxes, of course. That the status quo has gone untouched for so long is almost certainly due to the low tax compliance rate on poker income, whether it be due to conscious tax evasion of unreported income or to a lack of awareness that a losing year of poker would have any tax implications at all.

A solution that covers all nine inequities

All nine inequities would be instantly and completely alleviated if amateur poker players could simply report their net annual poker winnings instead of reporting gross winnings and deducting gross losses.

This can be achieved by defining the length of a poker session to be an entire year of play. The definition of a poker session is currently lacking modern guidelines from the IRS anyway and will already require explicit or implicit clarification when the first domestically-licensed sites start reporting player results, so let's do it right.

Why is this a sensible solution?

To define a session as an entire year of play is actually quite appropriate for poker. Even many amateur poker players are, by the very nature of the game, quite businesslike in planning their financial risk, managing a segregated poker bankroll and focusing on long-term expectations for their play.

Reporting net instead of gross income for amateur poker players would also have the benefit of being consistent with what almost every reasonable American would expect and perhaps how many amateur poker players incorrectly report their poker income currently. There'd be no need to file any poker activity during a losing year, and, while contemporaneous records should still be required, the players who inevitably fail to keep proper session-by-session accounting would nonetheless have a reasonable chance of estimating their total win or loss at the end of a year.

Why should you care about fixing this problem?

IRS & Legislators: Fair public policy should never tax an activity at more than 100% of the income it generates. Even if you believe that there should be some sort of extra "sin tax" to discourage activities that may be resemble or enable gambling, the more appropriate way to address that should be a stable, flat fee that players could easily plan and account for.

Regulators: Proper consumer protection involves being transparent about the costs of using a service. Regulated online poker should absolutely involve compulsory reporting of winnings to the IRS, but to have that in place before repairing this issue is to set a trap that millions of Americans would unknowingly fall into and is an abdication of regulatory responsibilities.

Operators: Communicating the current state of amateur poker tax reporting to your online players would turn many customers (rightly) away, yet failure to do so will likely lead to a dramatic drop-off in your player base. A delayed-impact, often-unanticipated and occasionally-large annual fee for losing is not good for customer retention. This will have to be fixed eventually for your customer base to subsist and grow, so out of respect for your customers, please expend resources towards fixing it now.

Conclusion

This simple and sensible change will eliminate an undue and capricious tax burden on millions of present and future American amateur poker players. To fail to correct this prior to the spread of domestically-regulated internet poker is to ensure an inefficient outcome for all parties involved.

Frankly, this rationale applies to traditional gambling activities as well. However, the need for change is most crucial for poker, a competitive strategy game which naturally lends itself towards narrow edges over regularly-occurring play, compels conscious maintenance and management of a bankroll, and attracts intelligent, price-sensitive competitors.

I don't know exactly how the poker community goes about changing this part of the tax code. I suspect that players cannot do it alone. We need our industry to stay aware of this problem and to represent our mutual interests. Keep the dialogue going.


Sincerely,

Mike Stein

4 comments:

  1. Well stated Mike. Fixing this inequity would likely result in greater returns for the IRS as well, as many an amateur player is simply not reporting at all under present guidelines. A more reasonable and streamlined method would likely find more players actually reporting.

    ReplyDelete
    Replies
    1. I agree, that's another excellent benefit of tax reform. I would not be shocked to learn that some amateurs once had intentions to file but balked upon learning about what can go wrong. Thanks for adding that, Curtis.

      Delete
  2. I'm not holding my breath for this to happen. Given that the current tax rules for gambling increase revenues (to the government) and the government is desperately seeking ca$h, nothing will change.

    That said, the idea that a Gambling Session is the entire year is ridiculous. A better change is to allow gamblers to net their wins and losses and report solely the net number on their returns.

    Finally, point 7 in your list of AMT items is not likely. One of the few deductions available in AMT is gambling losses, so if someone is impacted by AMT, generally the gambling activity will not have an impact on the amount of AMT.

    ReplyDelete
    Replies
    1. Point well-noted on the uphill battle given that internet poker is being pitched mainly on its tax revenue, and that the inertia of the status quo favors the rules which ostensibly give "higher revenue"... higher revenue, at least for the time until enough customers become price-sensitive. It's hard to be optimistic about.

      Allowing netting is a fine (equivalent, right?) way to pose the solution, and perhaps does have less of a potentially-ridiculous feel to it. I was thinking that clarifying session length might be simpler because it doesn't involve revising an existing rule, but merely adding a new clarification to it. You've got the better perspective than I on these matters for sure. Thanks for the correction on the AMT, I had been under the impression that phantom poker income couldn't trigger the AGI but could increase the tax liability if triggered otherwise. Really appreciate your feedback, thanks Russ.

      Delete

Note: Only a member of this blog may post a comment.

Related Posts Plugin for WordPress, Blogger...