I believe the fastest way to get a "love letter" from the IRS is to ignore your gambling "winnings" when you file your tax return. I know what you're thinking. It's either "they already withheld taxes at the casino, so that took care of it" or "I lost more than I won, so that means I don't have to report it". Wrong and wrong.
The saddest example of this that I've seen was a fellow who came in my office one day to see if he needed to file a tax return. He was single, 72 years old, and living on a $800 monthly pension and his social security. I asked him all the usual questions, and all I could get out of him was a statement from his bank showing he had earned $0.37 in interest on his savings account for the year. He specifically said he had no gambling winnings. So I told him his pension was below the limit for needing to file a tax return, and at his income level his social security wasn't taxable.
Several months passed before I saw him again, this time red faced, beyond angry, and clutching an IRS letter saying he owed them over $3,100 because he didn't file his tax return. Of course, I was guilty until proven innocent.
I sat him down in my conference room. If you've been there, you know I have a couple of large, nicely framed Carl Frederic Aagaard prints of the Amalfi coast ... the whole point of which is to be calming. If there is something that stresses people more than taxes in general, I can't think of it, unless of course you just got a collection letter from the IRS. I thank my son Jacob, who has far more design skills than I ever will, for picking those prints out for me, and also my wife Willyne for arranging just the right frames for them.
But I digress. I sat there with him and read his letter, then asked in the softest, calmest voice I could muster, "I thought you said you didn't have any gambling winnings. Did I misunderstand what you said?" He stuck by his story with an emphatic "NO! I didn't have any gambling winnings!"
Then I explained that there can be errors in the IRS letters, and since he didn't have gambling winnings I would be happy to go to bat for him to respond to this letter. I continued with "Let me show you what the IRS claims you received so we can get started on the response." I then showed him the page that listed the names of four casinos with dates and amounts won at each. They totalled a little over $17,000. I asked him if those were mistakes. He was more subdued in his no this time. "But I lost more than those winnings at each casino. I thought they were only considered winnings if they were larger than my losses."
I miss Paul Harvey's cheerful, quirky take on life. As he would say, here's the rest of the story: The casinos had each issued 1099 forms, which my friend undoubtedly had received but didn't understand. The IRS received them too, but didn't know anything about gambling losses because no tax return was filed. So they added $17,000 to his income, which in turn made $3,800 of his social security taxable. The result was the IRS claim of $30,400 of adjusted gross income, $2,533 in tax, $50 in penalty for not paying that tax during the year, and over $500 in penalty and interest for not filing the return reporting all this. They wanted a little over $3,100 by a week from Tuesday, or more drastic measures were threatened.
I asked him if he was a member of the "frequent gambler's club" at any of those casinos. He was, at each of them. I suggested that he contact each casino and ask them to send him a letter showing his losses for the year. In the meantime, I contacted the IRS on his behalf, told them what we were doing, and arranged for a delay in collection activity for 45 days while we prepared a response.
About three weeks later, he returned with the letters from the casinos. They showed losses totalling about $21,000. I then prepared a tax return for him. I couldn't do anything about the $30,400 in adjusted gross income, not even the fact that the gambling winnings made $3,800 of his social security payments taxable. Gambling losses don't offset those. This is a nasty little fact that isn't talked about much.
I was able to claim itemized deductions for him that totalled about $20,400. In addition to the $17,000 deductible portion of gambling losses he had $589 of sales tax, $832 of property tax on his house, some medical expenses and receipts for $200 in household items donated to charity.
Those itemized deductions reduced his tax to $628, a whole lot better than what the letter wanted, but still a lot of money to this gentleman. His state wanted $44 in addition to that. Even though he had no net gambling winnings and wouldn't have even been required to file a federal or a state income tax return if he didn't have those gambling winnings.
You may have thought the casinos would have withheld tax on the winnings and that would have taken care of it. It's true that they usually do. Sometimes that withholding is enough, but often it isn't because the gambling income triggers other income such as social security to be taxable. Also, you have to claim itemized deductions to deduct gambling losses, so if you don't have enough deductions to itemize you will pay taxes on the gambling winnings without being able to deduct any of the gambling losses.
I'm sad to say that I try to ask all my clients whether they had any gambling winnings when I'm reviewing what needs to be included in their tax returns. I now follow it up with a question asking if they received any 1099s from gambling activity. I wish I had a crystal ball that could tell me who does and who doesn't gamble (even "just once") so I wouldn't have to ask. I also wish the story of my 72 year old retired friend was the only time I encountered this problem.
Truth is, I see this multiple times every year. I think that's more than sad.
Photo credit: Angry Man - Free Clip Art at FunDraw.com