Tax Code Favors the Wall Street Gamblers, Not the Race Track Kind

With the Kentucky Derby coming up and with the overpaid and largely unrepentant thieves from Goldman Sachs in the Congressional hot seat, it seems an appropriate time to renew a question that I initially raised some 15 years ago, in an article in that well-known handicapping publication, The Tax Lawyer. Namely, why does the Internal Revenue Code treat the ordinary schlub’s horse racing and casino gambling winnings and losses so much less favorably than it does the much more dubious gains and losses that those Wall Street’s masters of the universe receive from trading in billion dollar derivative bets?

[For those who want to explore the legal arguments, the full text is at 49 Tax Lawyer 1 (1995), available on Lexis and Westlaw or in your favorite law library.]

That tax treatment is hugely different. Just for a start:

● Gambling losses cannot be deducted against any other income, only against gambling winnings. In contrast, net losses from Wall Street trading are deductible against the trader’s other income.

● Any excess gambling losses that are not deductible in one year cannot be carried forward to the next tax year, even to offset gambling winnings in that later year. Non-deductible derivatives trading losses in one year, in contrast, can be carried forward or backward and used to offset income in other years.

● Racing and poker tournament payoffs in excess of $5,000 are subject to withholding, at 28%, when the bet reflected odds of 300-1 or greater. And the Internal Revenue Service considers each combination a separate bet. So a Pick Six ticket that contains, say, 1,500 separate combinations and that returns $5,000 is treated as paying off at 2,500-1 (on a $2 bet), even though the bettor actually put up $3,000 and so got net odds of only 2-3. With 28% withholding, the bettor actually gets back only $3,600 for his $3,000. No such rules apply to bettors in that big casino on Wall Street.

● Even if they hold the contracts for only a day, Wall Street speculators are allowed to treat 60% of their gains from many kinds of derivative contracts as long term capital gains, which qualify for lower tax rates. Racing and casino winnings, in contrast, are all just ordinary income, taxable at higher marginal rates.

● There’s a 2% federal excise tax on gambling transactions, but none at all on financial market transactions. The mere mention of one – even a proposal for a tax as tiny as 0.1% or less -- causes the Wall Street propaganda machine to spew out dire predictions of the end of the world as we know it (not that that would necessarily be a bad thing).

“Gambling” and “wagering” are not defined, for income tax purposes, anywhere in the Internal Revenue Code or the Treasury Regulations. I guess it’s like Justice Stewart’s definition of pornography: we know it when we see it. Merriam-Webster, though, says that gambling is to stake something on a contingency or to bet on an uncertain outcome. Isn’t that just what the hedge funds guys and Wall Street traders were doing when they bought and sold credit default swaps and other opaque instruments of mass destruction?

To my surprise, there’s very little in the tax law literature or in the case law that addresses these definitional problems, except for a couple of recent articles arguing that bets on “prediction exchanges” (“I’ll give you 10-1 that Sarah Palin won’t be the next President of the US”) are more like tax-favored futures contracts than they are like sports bets (“I’ll give you 10-1 that Todd Pletcher’s Derby jinx continues”). A serious search of the law and literature (one has to do something when there are four dark days between Aqueduct and Belmont) shows not a single article or judicial decision in the past 15 years – since my piece way back in 1995 – arguing for better treatment for sports and casino bettors.

Perhaps we could get Mitch McConnell, in his role as the Senator from horse racing, to introduce a few amendments to the pending “financial reform” bill. Oh, I forgot, McConnell, majority leader of the party whose motto is “just say no,” is also the Senator from Wall Street. Guess that little conflict of interest isn’t going to get us very far.

But, seriously, wouldn’t it be some sort of victory for Main Street over Wall Street to amend the tax code so that bets placed on Wall Street get the same (unfavorable) tax treatment that I get for betting the Pick Four at Belmont? Who knows, if they had to think about the tax consequences of their misbegotten bets, perhaps those masters of the universe wouldn’t be risking quite so much of our money.

And on another topic: for the Triple Crown season, I’m also blogging on the New York Times site, The Rail. Here’s a link to my first piece, which was on Zayat Stables and Eskendereya.