Big Brother (the IRS) is Watching

by I. Nelson Rose | Published: Apr 27, 2001

The Internal Revenue Code is unkind to winners – and it doesn't much like losers, either. The federal government taxes gambling winnings at the highest rates allowed, and so do the many states and even cities that impose income taxes on their residents. If you make enough money in a high-tax state like California or New York, the top tax bracket is about 50 percent. Out of every additional dollar you take in through work or play, governments take 50 cents.

Of course, the tax collector first has to find out that you have won. Congress and the Internal Revenue Service know that gambling is an all-cash business and that few winners indeed would voluntarily report their good luck. So, statutes and regulations turn the gambling businesses – casinos, state lotteries, racetracks, and even bingo halls – into agents for the IRS.

Big winners are reported to the IRS on a special Form W-2G. If winnings are to be split, as in a lottery pool, winners are reported on a Form 5754.

Pooling money to buy lottery tickets is common among employees and friends. But whether there are two or 200 in the pool, there is going to be only one winning ticket, and somebody has to turn it in. If you are that someone, make sure that you fill out a Form 5754. If your share of a $5 million prize is $1 million, you do not want to be stuck with paying income tax on the entire $5 million.

Gambling has become such big business that the IRS receives nearly four million W-2G and 5754 forms each year. This tells the tax collectors that nearly four million big winners are out there waiting to be taxed.

But the IRS does not always wait. The government wants to make sure that it gets paid. What good does a W-2G do if the winner is a foreigner who is going to be in his own foreign country when April 15th rolls around?

So, the IRS not only wants reports filed, but often requires that a part of the winnings be withheld. As anyone who earns a salary knows, withholding also allows the government to use taxpayers' money for many months without having to pay interest.

The withholding rate for nonresident aliens is 30 percent. Not coincidentally, the tax rate for nonresident aliens is also 30 percent. So, if a citizen of a foreign country wins $1 million cash on a slot machine in Las Vegas, he will find that he is paid only $700,000. The remaining $300,000 is sent to the IRS. The foreign citizen is unlikely to ever file an income tax return, but the IRS gets paid in full, anyway.

Citizens of foreign countries are also, of course, usually taxed by their own governments. So, some countries have treaties with the United States that protect those foreigners from having to pay the 30 percent withholding to the IRS.

U.S. citizens and resident aliens have it both better and worse than nonresident aliens. The withholding rate for gamblers living in America is only 28 percent (it was 20 percent, up to 1992). Having the IRS take $28,000 out of a jackpot of $100,000 is painful, but it can hurt even more when tax forms are filled out. There is no 30 percent maximum tax for people living in the United States, and really big winners often end up paying a lot more than 28 percent or 30 percent.

The one piece of good news is that Nevada casinos were also able to convince the IRS that they could not keep track of players at table games. They said that when a player cashes out for $7,000, they do not know whether he started with $25 or $25,000. So, it is actually written into the law that there is no withholding or even reporting of big winnings to the IRS for blackjack, baccarat, craps, roulette, or the big-six wheel.

There is another general IRS rule that states that anyone paying anyone else $600 in one year is supposed to file a report. The IRS has been going after casinos and cardrooms that run tournaments, forcing them to file tax reporting forms on grand prize winners. Here, the IRS has the very good argument that the operator knows exactly how much a player has paid to enter a tournament, and how much the finalists are paid.

Is there anything a winning player can do to lower the bite of the income tax? And what about those who gamble and lose? This includes everybody, occasionally. The law does allow players to take gambling losses off their taxes, but only up to the amount of their winnings.

Of course, if you win, say, $135,000, you can take off all gambling losses up to that amount. If you gambled away, say, $65,000, you would only have to pay taxes on the remaining, let's see: $135,000 minus $65,000 equals $70,000. The tax on $70,000 is a lot less than the tax on $135,000.

Of course, you have the small problem of proving that you actually lost $65,000. Large winnings may be required to be reported to the IRS, but large losses are not.

One former IRS revenue officer, who quit government work to open his own small tax preparation firm, thought he had found the answer. One of his clients won a share in a state lottery: $2.7 million, paid out over 20 years in installments of about $135,000 before taxes. The winnings were reported, but the tax return claimed gambling losses of $65,000. The IRS decided that $65,000 was a lot to lose, and it sent an agent to conduct an audit.

The tax preparer found a man with an extremely large collection of losing lottery tickets and made a deal: He would borrow 200,000 losing tickets for a month for $500. The losing tickets were bound in stacks of 100 and shown to the IRS auditor: 45,000 instant scratch tickets, 5,000 other Massachusetts lottery tickets, and 16,000 losing tickets from racetracks throughout New England. There were so many losing tickets that it would have been physically impossible for one man to have made these bets. The New York Times called it "one of the more visibly inept efforts at tax fraud." They pleaded guilty eight days after being indicted.

By the way, the man who rented his tickets was not charged. It's not a crime to collect losing lottery tickets, but it is to use them to try to cheat the IRS.