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HOYT M. AND HELEN J. ORR, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentOrr v. Comm'rNo. 11017-07S
United States Tax Court T.C. Summary Opinion 2010-55; 2010 Tax Ct. Summary LEXIS 70;April 26, 2010, FiledPURSUANT TO
INTERNAL REVENUE CODE SECTION 7463(b) , THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.*70Hoyt M. and Helen J. Orr, Pro sese.Horace Crump , for respondent.Morrison, Richard T.RICHARD T. MORRISONMORRISON,
Judge : This case was heard pursuant to the provisions ofsection 7463 of the Internal Revenue Code in effect when the petition was filed.section 7463(b) , the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.Respondent Commissioner of Internal Revenue (i.e., the IRS) determined a deficiency in the Orrs' 2004 federal income tax of $ 16,653 and a section 6662(a) accuracy-related penalty of $ 3,331. Petitioners Helen J. Orr (Orr) and Hoyt J. Orr (Orr's husband) disagree with the IRS's determination. The issues for decision are (1) whether the Orrs are entitled to a deduction for Orr's net gambling loss because she was a professional gambler rather than a casual gambler, (2) whether they are liable for an accuracy-related penalty for a substantial understatement of income tax for erroneously *71 claiming the gambling-loss deduction and omitting certain retirement benefits, and (3) the extent to which the Orrs omitted certain retirement benefits from their return. We conclude that section 165(d) prohibits the Orrs from deducting the net gambling loss even though Orr was a professional gambler. We further conclude that the Orrs are not liable for the penalty because they acted in good faith and because (a) Orr's husband's disabling illness, (b) Orr's diminished mental capacity associated with severe depression, and (c) Orr's efforts to prepare the return together constitute reasonable cause for the errors. We will direct that the parties address the issue of whether the retirement benefits the Orrs did report on their return are a portion of the amount the IRS says they omitted (which may mean that their taxable income and deficiency are lower than the IRS claims) or are a separate amount through a Rule 155 computational proceeding.
Background Orr suffered from depression in and about 2004, the year in issue. (The record before the Court does not describe Orr's mental condition precisely. We follow her in calling it simply "depression".) Her condition is associated with diminished *72 mental capacity to address even moderately complex responsibilities. Her boss at the railroad for which she worked "saw [she] was more than a little disturbed", and sent her to a psychologist, who sent her to a psychiatrist. The psychiatrist put her on medication and directed that she take a leave of absence. Later, in 1999, the railroad granted her early retirement on account of permanent disability. *73
Orr's depression appears to have arisen, at least in part, from a series of unfortunate circumstances that would have been a severe emotional drain for almost anyone. In 1994, Orr's husband was diagnosed with an illness believed to be terminal. Some time later, Orr's elderly, ill mother came to live with the Orrs. In 2000, Orr's mother died. In further explaining why she was depressed, Orr also noted that she lost two brothers in one year (about the time her mother died, we infer, although she did not say which year).
Orr's husband was present at trial but did not participate except to identify himself. He appears not to have had any significant economic activity during 2004. (Some of the retirement benefits at issue appear to have been his, and some of the interest and dividends the Orrs received and some of the shares they sold during 2004 may have belonged to him or the Orrs jointly.) We infer that he relied on Orr to prepare the Orrs' joint return, which both he *74 and she signed. We find that his illness was reasonable cause for him to rely on Orr to prepare the return correctly. *75 It appears that all of her gambling for the year was part of her gambling business.
Orr had previously been a casual gambler. *76 to take up gambling as a business. She explained that her professional gambling activity differed from her earlier casual gambling activity in that she made a greater effort to learn to gamble profitably.
Although Orr became a professional gambler "to try to win some money", she now realizes that "it was not a smart decision." Orr found that she could not make money at blackjack or poker, games in which a skilled player may in some circumstances reasonably expect to profit over time. Nor could she make money at craps, a game in which it is generally accepted that one playing under typical casino rules cannot reasonably expect to profit over time. She then focused on slot machines.
Slot machines are devices that allow the player to engage in simple games of chance. It is generally accepted that a slot-machine player cannot reasonably expect to profit over time. Orr tried various misguided "strategies" in her attempt to make money playing slot machines. Not surprisingly, they failed. As discussed in more detail later, *77 Orr had an overall loss of about $ 200,000 from gambling in 2004.
Orr had two other ventures during 2004.
Another, for which Orr received $ 1,920 in 2004 (which she reported as gross income) but "never even got my original money back" (suggesting that she had over time "invested" a greater amount), was an arrangement that would supposedly "multiply" her investment every 90 days. She now thinks that it "was just fed by *78 people coming in and paying * * * to begin with", meaning that it was a Ponzi scheme. We infer that she was correct. *79
The Orrs reported the tax consequences of the three businesses on three respective Schedules C, Profit or Loss from Business (Sole Proprietorship), attached to the return. These Schedules C are simple, and apparently required little accounting work to prepare. (Orr kept track of her winnings and losses for the gambling business by using a "player's club card" issued by a casino. Apparently, she gambled only at one casino, or perhaps one group of related casinos, during 2004. *80 expenses", described specifically as "gambling losses", of $ 1,113,766. It stated on the designated line that the net loss for the business was $ 215,488. Of this amount, the IRS challenges the deductibility of $ 204,708, which is the excess of the amounts Orr bet over her proceeds from the bets. We refer to this excess as the "net gambling loss".
The Schedule C for her Web site business (described as "computer web site and affordable homes for rent") listed five items of expenses, each apparently a sum of monthly fees that she paid to the promoter of the business, for Web site maintenance, or for banking or similar services, which totaled to the $ 1,360 loss she reported for *81 the business. The Schedule C for her business which now seems to have been a Ponzi scheme described the business as "reading advertisements" and listed the $ 1,920 in payments she received as both gross receipts and gross income.
The Orrs reported $ 16,470 on the return's line entitled "Pensions and annuities", and, of this, $ 9,529 on the return's next line, entitled "Taxable amount" (of the "Pensions and annuities"). As we explain later, it is not clear whether these entries reflect some portion of the Railroad Retirement Board and Social Security benefits the couple received, which would mean that the remainder of those amounts may contribute to a deficiency; or whether the entries reflect other income, which would mean that the entirety of the Railroad Retirement Board and Social Security benefits may contribute to a deficiency.
The Orrs reported several thousand dollars in interest and dividend income and about $ 100,000 in capital gains (from a sale of shares of Norfolk Southern stock; as one line in the short-term capital gain and loss schedule and another in the long-term schedule indicate, sales of "various amsouth funds", which we infer probably means mutual-fund shares; and *82 capital-gain distributions, probably from the mutual funds) on the return. *83 so. She believed that the guidance in the IRS publication did not apply for 2004 because she had become a professional gambler.
Orr did not inquire as systematically or thoroughly as a sophisticated tax practitioner might. She did not examine the Code, tax regulations, or a treatise on tax law. But she satisfied herself that (1) she was a professional gambler (which is correct) and (2) therefore her gambling losses could offset her other income in the same manner as most other business losses would (which, as discussed later, is incorrect).
Orr made limited attempts to seek advice from tax professionals and from other professional gamblers. *84 be new, expressed doubt that she could claim the deduction; while another in the next cubicle said, as Orr recalls: "I've seen it done; I don't know how they do it, but I know that it's been done."
Orr did legal research. She went to the main library at a courthouse in Trenton, Georgia. The librarian there was unable to help Orr except to suggest that she go to the courthouse's tax library. There was no librarian or anyone else at the tax library to help her. On her own, Orr found the case of
Commissioner v. Groetzinger , 480 U.S. 23">480 U.S. 23Orr went to a lawyer whom someone had recommended to her. The lawyer explained that he was not a tax practitioner, but recommended an accountant, Ben Hill.
Orr asked Hill whether she could claim the deduction. She recalls that Hill responded: "I'm not saying it can't be done, but I don't know."
Orr also approached another *85 accountant. This second accountant had in the past filed returns for another gambler. But she would not tell Orr about the tax treatment of gambling losses because she wanted a fee and Orr did not want to pay her. The other professional gamblers that Orr knew would not discuss their tax affairs with her.
Orr relied in part on her past experience as a tax preparer. She had "done business taxes" *86 further tax experience she may have had. Her legal research and analysis leading to this case, and the form and content of her arguments in it, indicate that her understanding of tax law is limited. See
Kees v. Commissioner , T.C. Memo 1999-41">T.C. Memo. 1999-41After filing the return, in preparing for this case (or the administrative proceedings which led to it) Orr obtained a copy of
Commissioner v. Groetzinger ,supra The Web site "Professional Gambler *87 Status" repeatedly and consistently states that net gambling losses are not deductible, for professional as well as casual gamblers, and explains what section 165(d) is and what it means. But since the Web site is fairly large and complex, we infer that one suffering from diminished mental capacity might well fail to recognize the significance of the Web site's material about net gambling losses' being nondeductible for professional as well as casual gamblers. The Court asked Orr whether she had seen parts of the Web site that referred to section 165(d), which by that point in the trial had been repeatedly described to her as the section of the Code that, in the IRS' view, would generally disallow net gambling losses. She said she had, but that she had understood other parts of the site to be more important. We accept this explanation.
The IRS issued a notice of deficiency to the Orrs for 2004. The explanatory material accompanying the notice showed that the deficiency and penalty on the notice resulted from the following determinations. One determination appears to be that the Orrs received the $ 30,391 in now-stipulated retirement benefits discussed earlier, that the now-stipulated *88 taxable portion of those benefits was $ 25,832, and that this entire taxable portion was to be added to their income because none of it had been shown on the return.*89 before the Court does not indicate that Orr had notice before she filed the 2004 return that she was incapable of complying with her tax obligations on her own. For example, it does not indicate that any tax-return errors for previous years had been revealed by an audit.
The Orrs timely filed a petition for redetermination of their deficiency in which they "request[ed] that professional gambler status be granted." The IRS agrees that Orr's gambling activity was a business in 2004. Thus, the contention in the petition is moot. Even so, the main issues actually relevant to the Orrs' tax liability for 2004 -- the omission of certain retirement benefits, the deductibility of net gambling losses, and the existence of reasonable cause to except the Orrs from an accuracy-related penalty for errors on their return -- are properly before the Court because the IRS presented them in its pretrial memorandum *90
Discussion I. Deductibility of Net Gambling Loss The Orrs present several theories why they are entitled to deduct their net gambling loss (i.e., the $ 204,708 excess of the amounts Orr bet over her proceeds from bets). *91 The IRS argues that section 165(d), which provides that "[l]osses from wagering transactions shall be allowed only to the extent of the gains from such transactions", makes the loss nondeductible, noting that we held in
Valenti v. Commissioner , T.C. Memo. 1994-483The Orrs argue that the status of Orr's gambling as a business made the net gambling loss deductible. In support of this argument, they present
Commissioner v. Groetzinger , 480 U.S. at 35Clemons v. Commissioner , T.C. Summary Opinion 2005-109, andPanages v. Commissioner , T.C. Summary Opinion 2005-3. *93 constitute a business for tax purposes. Clemons and Panages both concluded that a casual gambler must include gambling winnings in gross income and may deduct gambling losses that do not exceed winnings as an itemized deduction. *94 As discussed later, treatment of a deduction as "above-the-line" or "itemized" affects various other tax items.In their posttrial brief, the Orrs noted that there is no mention of section 165(d) in section 162 (subsection (a) of which provides that "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business"). Their argument, we infer, is that section 165(d) does not limit the scope of section 162. *95 easier to understand, we reject this argument. *96 The word "wagering" is synonymous with "gambling".
Tschetschot v. Commissioner , T.C. Memo. 2007-38Section 165(d) denies a deduction for a net gambling loss even if the loss is also described as a kind of generally deductible item, such as a section 162(a) business expense, a section 165(a) loss from a transaction entered into for profit, or a section 212 expense for the production of income. This broad interpretation of section 165(d) is supported by its history, the plain language of the Code, and, as discussed earlier, judicial precedent.
Congress first enacted the language now reflected in Section 165(d) as section 23(g) of the Revenue Act of 1934 (1934 Act), ch. 277, 48 Stat. 689. According to committee reports, Congress wished to reverse caselaw that allowed legal gamblers to deduct their gambling losses against nongambling income: *97 for in the bill. Under the present law many taxpayers take deductions for gambling losses but fail to report gambling gains. This limitation will force taxpayers to report their gambling gains if they desire to deduct their gambling losses.
Section 23 of the 1934 Act is entitled "Deductions from Gross Income". Its flush language is simply "In computing net income there shall be allowed as deductions:". It set forth most of the deductions allowable against gross income in computing net (i.e., taxable) income. 48 Stat. 688) and losses on transactions entered into for profit (sections 23(e)(1) and (2) *98 of the 1934 Act, ch. 277, 48 Stat. 689).
The location of section 23(g) of the 1934 Act alongside the other subsections of section 23, which in turn set forth most of the deductions allowed by the Code (including the deduction for business expenses), confirms what we believe to be the most logical reading of section 23(g): section 23(g) limited all net gambling losses, even those that could also be described as another kind of generally deductible item, such as business expenses. *99 The 1934 Act did not contain a provision similar to current section 7806(b), which provides that "No inference, implication, or presumption of legislative construction shall be drawn or made by reason of the location or grouping of any particular section or provision or portion of this title".
Section 23(g) of the 1934 Act came into the Internal Revenue Code of 1939 as subsection (h) of section 23. Ch. 2, 53 Stat. 13. Section 23 of the 1939 Code was still entitled "Deductions from Gross Income" and still contained most of the deductions allowed under the income-tax law.
The Internal Revenue Code of 1954, ch. 736, 68A Stat. 49, brought what is now section 165(d) to its present location within section 165, a section that addresses "Losses". The 1954 Code, like the currently effective Internal *100 Revenue Code of 1986, placed section 165 in part VI of subchapter B of chapter 1, a part entitled "Itemized Deductions for Individuals and Corporations". The 1954 Code placed some other kinds of deductions that might address gambling losses, such as section 162 business expenses, in other sections of part VI. But other kinds of deductions that might also address gambling losses, such as the section 212 deduction for expenses for the production of income, were placed in part VII of subchapter B of chapter 1, a part that was entitled "Additional Itemized Deductions for Individuals". *101 in the relationship of those provisions to each other. The designation of section 165(d) as a subsection of section 165 (which, unlike section 23 of the 1934 Act and 1939 Code, contains only a few of the kinds of deductions the income-tax law allows) might suggest that section 165(d) does not limit deductions allowable under other sections of the Code (such as section 162). Similarly, the location of section 165(d) within part VI of subchapter B of chapter I might suggest that it does not limit deductions allowable under other "parts" of the Code (such as part VII, which contains section 212).
However, the House and Senate reports on the 1954 Code stated that "Rules for the treatment of losses contained in various subsections of section 23 of the 1939 Code have been brought together in [section 165]. * * * No substantive change is made by this rearrangement." H. Rept. 1337, 83d Cong., 2d Sess. A46 (1954); S. Rept. 1622, 83d Cong. 2d Sess. 198 (1954). In addition, the 1954 Code introduced section 7806(b) (inference of legislative construction not to be drawn from location or grouping of provisions of Code) in its present form, carrying forward similar language from section 6 of the introductory *102 "enacting clause" of the statute containing the 1939 Code (ch. 2, 53 Stat. 1). Section 7806(b) confirms that the designation of section 165(d) as a subsection of a section addressing only a particular kind of deduction (the deduction for certain "losses") does not in itself prevent section 165(d) from applying to other kinds of deductions. *103
II. Applicability of Section 165(d) to Orr's Gambling The Orrs make a comment in their posttrial brief that we construe as an argument that section 165(d) should not be applied to Orr's gambling activity because no meaningful distinction can be drawn between her gambling activity and other activities whose net losses are undisputedly deductible. The brief says:
When Mr. Eric Evans, of the IRS office in Birmingham, interviewed us for our preliminary court case,
Conway Twitty (Harold Jenkins) started a restaurant (Twitty Burgers) with 75 of his friends investing in the business. The business went under in 1971 and Mr. Twitty reimbursed his friends for their losses and claimed and was allowed the reimbursements as *104 business expenses. *106 Furthermore, *105 such a holding would be tantamount to saying that there is no activity that qualifies as gambling, which would render section 165(d) surplus language. See
Calafati v. Commissioner , 127 T.C. 219">127 T.C. 219Weinberger v. Hynson, Westcott & Dunning , Inc., 412 U.S. 609">412 U.S. 609Schoneberger v. Commissioner , 74 T.C. 1016">74 T.C. 1016III.
Does Section 165(d) Unconstitutionally Discriminate Against Gambling Businesses? The Orrs ask in their brief:
How can a business (professional gambler) be subject to self employment tax and yet be unable to claim business deductions as any other business. It is the only business the IRS places the restriction that can't show a loss. What part of the law makes that distinction and is that constitutional? We understand our laws are created by Congress, but shouldn't the rules made by the IRS be governed by someone?
As we have discussed, section 165(d) contains the gambling-loss limitation relevant to this case. Section 165(d) is a part of the Internal Revenue Code, a statute enacted and amended from time to time by Congress. Through section 7805 and other more specific delegations of authority, Congress has authorized the Department of the Treasury, of which the IRS is a part, to issue official interpretations of the Code. But we do not base our decision that a professional gambler is not entitled to deduct gambling losses in excess of gambling gains upon an IRS interpretation. We base it on the language and history of the Code and a *107 longstanding principle of statutory construction.
We acknowledge that the Internal Revenue Code treats gambling less favorably than most other businesses. But we have previously rejected the argument that the Constitution does not permit Congress to single out the business of gambling for unfavorable tax treatment. See
Valenti v. Commissioner ,supra Gordon v. Commissioner , 63 T.C. 51">63 T.C. 51572 F.2d 193">572 F.2d 193 (9th Cir. 1977). InValenti , we noted that "thedue process clause of the Fifth Amendment has been construed as imposing an equal protection requirement in respect of classification" by the federal government, but that the Supreme Court has recognized legislatures to have wide powers to distinguish between even closely related businesses in the exercise of their taxing powers. We cited the extensive history of gambling set forth inSkeeles v. United States , 118 Ct. Cl. 362">118 Ct. Cl. 362Valenti v. Commissioner ,supra Carmichael v. S. Coal & Coke Co. , 301 U.S. 495">301 U.S. 495IV.
Deductibility of the Net Gambling Loss "Above the Line" A. The Classification of the Orrs' Net Gambling Loss as an "Above-the-Line Deduction" Does Not Affect the Section 165(d) Limitation The Orrs claimed their gambling losses on Schedule C, a standard preprinted attachment to an individual income tax return (IRS Form 1040). The instructions for Form 1040 and Schedule C provide for deductions listed on Schedule C to be claimed "above the line", which means that the deductions are subtracted in computing adjusted gross income. As we explain later, the Code does provide for a professional gambler to deduct allowable gambling losses "above the line".
The Orrs stated in their pretrial memorandum that they believed the issue in this case is whether "To allow or disallow gambling losses above the line." It is not. The IRS did not dispute that the Orrs could deduct the allowable losses "above the line". *109 The Orrs did not explain at trial or in their posttrial briefs why they thought the IRS disagreed with an above-the-line deduction for their gambling losses.
We infer that the Orrs believed that deducting the losses "above the line" would except the losses from the limitation of section 165(d). Such a belief would not be correct. It is well established that section 165(d) applies both to professional gamblers, who, as discussed later, deduct their allowable gambling losses above the line, and to casual gamblers, who deduct their allowable gambling losses below the line. See, e.g.,
Tschetschot v. Commissioner , T.C. Memo. 2007-38 n.7Boyd v. United States , 762 F.2d 1369">762 F.2d 1369Offutt v. Commissioner , 16 T.C. 1214">16 T.C. 1214Heidelberg v. Commissioner , T.C. Memo. 1977-133B. Consequences of Deducting Business-Related Gambling Losses Above the Line A deduction which is subtracted from gross income to determine adjusted gross income (AGI) is known as an "above-the-line" deduction because it is taken into account above a conspicuous line at the end of the section of Form 1040 relating to AGI. Section 62(a) lists the kinds of deductions that are claimed "above the line." *110 One set of above-the-line deductions is "The deductions allowed by this chapter (other than by part VII of this chapter) *111
Deductions other than (1) above-the-line deductions or (2) the section 151 deduction for personal exemptions are known as "itemized deductions". Sec. 63(d). (An individual may claim "itemized deductions" only if he or she does not claim the "standard deduction". Sec. 63(e).) Therefore, a casual gambler's gambling losses and expenses are normally itemized (i.e., "below-the-line") deductions. See sec. 62(a);
Hochman v. Commissioner , T.C. Memo 1986-24">T.C. Memo. 1986-24Above-the-line deductions and itemized deductions both generally reduce taxable income dollar-for-dollar. But an above-the-line deduction for a gambling loss is sometimes more valuable than an itemized deduction because (a) a taxpayer is entitled to claim an above-the-line deduction even if the standard deduction *112 is also claimed and (b) an above-the-line deduction reduces AGI, and AGI is used to limit certain tax benefits.
Calvao v. Commissioner , T.C. Memo. 2007-57 n.6We noted earlier that Orr may have reported the Orrs' gross receipts from gambling as gross income and their gross expenditures on bets as losses, and that even if technically incorrect this practice probably does not in itself affect their tax liability. This follows in part from *113 the fact that Orr, as a professional gambler, deducts allowable gambling losses above the line. We and other courts have from time to time held that a gambler's gross income is properly determined by reducing gross receipts from a particular bet, and, in the case of a professional gambler, a series of related bets, by the amount wagered on those bets. (Any net loss would still be subject to section 165(d).) See
Winkler v. United States , 230 F.2d 766">230 F.2d 766McKenna v. Commissioner , 1 B.T.A. 326">1 B.T.A. 326Hochman v. Commissioner ,supra V. Substantial Understatement Penalty Section 6662(a) generally imposes a 20-percent penalty, described in the section's title as the "accuracy-related penalty", on underpayments of tax attributable *115 to certain circumstances, including, under section 6662(b)(2), a "substantial understatement of income tax." Section 6664(a) defines an "underpayment" for relevant purposes not simply as a lack of payment but, in relevant part, as an excess of the correct tax over the sum of (A) the amount shown as tax on the return and (B) amounts not shown as tax on the return but previously assessed or collected. Since the Orrs paid only a small amount of tax before filing the return and reported on the return that no tax was due, the majority of their correct tax liability for the year was an "underpayment" under section 6664(a). (This is true regardless of the precise amount of their omitted retirement benefits, which, as we discuss later, remains to be determined.) Section 6662(d) provides that a substantial understatement of income tax is, with exceptions not relevant here, the excess of the correct tax required to be shown on the return over the tax shown on the return, but only if that excess is greater than the greater of (1) $ 5,000 and (2) 10 percent of the correct tax. *116 5,000 (regardless of the precise amount of the omitted retirement benefits), and the tax shown on the return was zero, they have a substantial understatement of income tax for the year. It is undisputed that the entire underpayment is attributable to the substantial understatement.
Section 6664(c) provides that no penalty shall be imposed under section 6662 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such *117 portion.
The Orrs argue that they had reasonable cause for omitting the retirement benefits because Orr had diminished mental capacity on account of her depression. They further argue that if their deduction of net gambling losses was in error (and it was, as we have explained), Orr's diminished mental capacity and unsuccessful attempts to understand the law constitute reasonable cause. As discussed earlier, Orr's husband was too ill to be expected to ensure that the Orrs' joint return was filed correctly. The record does not indicate that anyone else had a duty to ensure the return was correct: there was no agent or guardian, for example. Thus, we consider the reasonableness of the actions taken to ensure the return was correct only in the light of Orr's own diminished mental capacity.
The IRS argues that Orr's attempts to understand the law were not sufficient, and her mental capacity was not sufficiently diminished to constitute reasonable cause. *118 state was sufficient that she "could adequately carry on her personal affairs", "take care of her ailing mother and husband", and "keep accurate business records of her gambling enterprise as well as two other business enterprises"; and that Orr's implicit contention that she was a novice in tax law research was undermined by her work for H&R Block and her "familiarity with" TurboTax.
The IRS did not contend that Orr acted in bad faith separate from the argument that she did not have reasonable cause. *120 The kinds of activities Orr conducted in connection with filing the return -- doing legal research and discussing her situation with the IRS, tax advisers, and colleagues -- tend to indicate that she was honestly attempting to file it correctly. Her transactions are consistent with a good-faith mistake: she simply claimed a deduction for an actual business loss, which, were it not for a special *119 rule, normally would be deductible. She described the transactions on her return clearly, as a business of "gambling" in which she incurred "gambling losses", making no attempt to hide the tax issue, and enabling the IRS to easily determine whether an examination would be appropriate. Moreover, Orr's omission of some or all of the Orrs' retirement benefits appears to be essentially an "isolated computational or transcriptional error" that "generally is not inconsistent with reasonable cause and good faith."
Sec. 1.6664-4(b)(1), Income Tax Regs. Consequently, we infer that if Orr's mental capacity was sufficiently diminished that she would have honestly understood her objectively flawed efforts to file a correct return to be adequate (a point we address later), she acted in good faith.Section 1.6664-4(b)(1), Income Tax Regs. , interprets "reasonable cause" for purposes of section 6664 in relevant part as follows:The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. * * * Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge and education of the taxpayer. * * *
We have found tax compliance failures resulting from mental illness, including severe emotional disturbance, to be due to reasonable cause and not inconsistent with good faith. In
Ruckman v. Commissioner , T.C. Memo 1998-83">T.C. Memo. 1998-83Gray v. Commissioner , T.C. Memo. 1982-392Kees v. Commissioner , T.C. Memo 1999-41">T.C. Memo. 1999-41We are satisfied that Orr suffered from diminished mental capacity that impaired her ability to file a correct tax return, and that she was not sufficiently aware *122 of this diminution for us to find bad faith from her failure to do something more than she did (such as her failure to hire a tax adviser). Orr gave undisputed testimony that her employer had granted her early retirement for permanent disability on account of her depression. She also stated, and we accept, that the fact of her disability was certified by a doctor. Her mother, for whom she had been caring, had recently died; two of her brothers also had recently died; and her husband had an illness, believed to be terminal, which continued to require her care. Her conduct of her "businesses", discussed later, corroborates that she did not understand how far her mental capacity had diminished. We have in the past accepted evidence less extensive than what Orr presented to establish diminished mental ability as reasonable cause for penalty purposes. See
Ruckman v. Commissioner ,supra Gray v. Commissioner ,supra .We noted earlier that in her pretrial memorandum Orr asserted that the issue in this case *123 was whether "To allow or disallow gambling losses above the line" and that Orr believed that an IRS publication's statement that a net gambling loss was not deductible did not apply to a professional gambler. Informal IRS guidance is not itself law, but a reasonable misunderstanding of its discussions of law can be relevant to whether a taxpayer should be excused from a penalty.
Gray v. Commissioner ,supra .The IRS' argument that Orr's handling of her businesses indicates that her mental ability was not so diminished as to prevent her *124 from filing a correct tax return is misplaced. None of Orr's businesses had a reasonable potential for profit. The fact that she thought they did tends to show that her mental capacity was diminished, and the fact that she persisted in them tends to show that she did not know how far her mental capacity had diminished.
We reject the IRS' argument that Orr's ability to keep financial records for her businesses indicates a high degree of sophistication. As discussed earlier, all of these records were very simple. The records indicate Orr's ability to accurately report the amounts of what she understands to be her income and deductions -- which, generally, she did. But they do not indicate an ability to adequately address the legal issue of whether a professional gambler may deduct net gambling losses.
We reject the IRS' argument that Orr's care for her ailing mother and husband, or her ability to "carry on her personal affairs" meant that she did not have reasonable cause for the errors on the return. Nothing suggests that Orr's care for her mother and husband reflected a degree of sophistication relevant to tax return preparation rather than simply hard work. Her ability to care for them *125 suggests at most that she may have had the ability to perform periodic tasks, such as filing a tax return every year, which she did. As discussed earlier, Orr's handling of her affairs did not reflect any degree of sophistication. Her employer had found her unable to do her job. Her "businesses" were illogical. (The parties did not elaborate on the Orrs' sales of shares, but, as discussed earlier, these appear not to reflect any particular skill or judgment.)
Tamberella v. Commissioner , 139 Fed. Appx. 319">139 Fed. Appx. 319T.C. Memo. 2004-47 , which the IRS cites for the proposition that carrying on one's personal affairs indicates a lack of reasonable cause, is distinguishable. InTamberella , we held and the Court of Appeals for the Second Circuit affirmed that a taxpayer did not have reasonable cause for an omission of income from his return on the ground of mental incapacity. We found that he had been hospitalized for mental illness on two occasions -- 10 days near the beginning of the year before the year at issue and 5 weeks a few years after the year at issue -- but that there was no evidence that he suffered from any mental incapacity in the interim. We also found that *126 during the tax year at issue he had represented himself in an arbitration proceeding and settlement negotiations through which he obtained a large employment-related award. Mental incapacity did not actually prevent that taxpayer from complying with his tax obligations. He was just trying to use mental incapacity from an irrelevant period as an excuse for not complying.The fact that Orr once prepared tax returns at H&R Block does suggest that she had more relevant knowledge and experience than the average taxpayer. But we infer that her skills deteriorated with time and with her overall mental capacity. By the time she prepared her 2004 return, she was neither able to determine the correct treatment herself nor recognize that she was unable to do so. We note, moreover, that Orr's way of addressing an issue she found difficult would have been very roughly correct even for a tax expert: she consulted others in her industry, IRS employees, accountants, a lawyer, and a law librarian, and considered these people's advice in the light of her own experience, research, and analysis. Orr should have made a greater effort to find someone able to help her with her particular tax issue, but we *127 find her diminished mental capacity to be reasonable cause for this omission.
We reject the IRS' argument that Orr's "familiarity with TurboTax" "undermines her contention that she is a novice in tax law research." Nothing about Orr's use of TurboTax suggests special knowledge of tax law or tax law research.
We have found before that taxpayers with substantial tax and financial experience can become unable to prepare their returns correctly. In
Gray v. Commissioner , T.C. Memo 1982-392">T.C. Memo. 1982-392Ruckman v. Commissioner , T.C. Memo. 1998-83VI. Computation of Retirement Benefits The stipulation of facts that the parties submitted jointly at trial stipulated that the Orrs received and reported Railroad Retirement Board and Social Security benefits totaling $ 30,391 (the stipulated retirement benefits):
4. During the 2004 taxable year, the petitioners received retirement benefits of $ 17,784.00 from the U.S. Railroad Retirement Board and $ 12,607.00 from the Social Security Administration.
5. The petitioners failed to report any of the retirement benefits on their 2004 federal income tax return.
I know retirement funds are taxable and I don't know why I did not include them; I thought I had everything listed. I have enclosed a copy *129 of Form 1040 showing I DID report $ 16,470 of which $ 9,529 was considered taxable." *130 on the line for "Pensions and annuities": these benefits are a kind of pension, in the generic sense, and, like certain other pensions, they are only partially taxable. See, e.g., secs. 72 (annuities, including certain pensions), 86 (Social Security and Railroad Retirement Board benefits). Since the record before the Court does not specify the source of the amounts they listed on the relevant lines,
If the Orrs reported some of the stipulated retirement benefits on the return, only a part of the stipulated retirement benefits (and only a part of their taxable portion) would properly be added to the figures they had listed for "pensions and annuities" in determining the Orrs' taxable income, and tax, for the year. Alternately, the Orrs may simply have reported on the return "pensions and annuities" other than the amounts to which the stipulation refers.
We decline *131 to adopt paragraph 5 of the stipulation as a finding of fact. We may permit a party to contradict a stipulation "where justice requires", and "We are not bound by stipulations of fact that appear contrary to the facts disclosed by the record." Rule 91(e);
Estate of Eddy v. Commissioner , 115 T.C. 135">115 T.C. 135Jasionowski v. Commissioner , 66 T.C. 312">66 T.C. 312To reflect the foregoing,
Decision will be entered under Rule 155 .Footnotes
1. All section references are to the Internal Revenue Code (Code) in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.↩
2. The record reflects that the Orrs received payments from the Railroad Retirement Board, but it does not reflect that they received any payments from a particular railroad. It seems possible, therefore, that Orr's employer did not itself grant her permanent disability benefits but instead helped her to apply for Railroad Retirement Board disability benefits. We infer that either organization would have required proof of disability.↩
3. On brief, the IRS suggested that we should not believe Orr's trial testimony thus describing her diagnosis of severe depression on the ground that the testimony lacks corroboration. But the IRS did not question the substance of or basis for the testimony at trial or argue that it did not then have sufficient notice of the issue of Orr's depression and diminished mental capacity. We observe that the testimony is congruous with Orr's undisputed overall explanation for becoming a professional gambler and otherwise apparently credible, and we reject the IRS' challenge on this point.
4. Each spouse is generally responsible for ensuring that a joint return the couple files is timely and correct. See
LaBelle v. Commissioner , T.C. Memo. 1984-69↩5. She also testified, and we accept, that to some extent her mental abilities were still diminished even at the time of trial.↩
6. For tax purposes, the term "professional gambler" refers to a gambler who gambles as a "trade or business" (or simply a "business", as there appears not to be any distinction between a "trade" and a "business" for tax purposes). See, e.g.,
Hochman v. Commissioner , T.C. Memo 1986-24">T.C. Memo. 1986-24Commissioner v. Groetzinger , 480 U.S. 23">480 U.S. 23Dreicer v. Commissioner , 78 T.C. 642">78 T.C. 642702 F.2d 1205">702 F.2d 1205 , 1983 U.S. App. LEXIS 30334">1983 U.S. App. LEXIS 30334↩ (D.C. Cir. 1983). Consequently, our use of the term "professional gambler" does not imply sophistication.7. A casual gambler is a gambler who is not a professional gambler.
Hochman v. Commissioner ,supra↩ .8. Orr explained that her mother enjoyed being taken to the casino regularly.↩
9. The IRS does not dispute that these activities were businesses for tax purposes.↩
10. Orr did not mention this business in her petition, nothing suggests that the IRS had even informal notice that it would be addressed at trial, and the parties address it only briefly in the course of a general explanation of the entries on the Orrs' return. Consequently, we conclude that it is not appropriate to redetermine the Orrs' gross income from that business, or to determine that they suffered any loss from it.↩
11. We understand that Orr did not receive a warning to review her entries for the gambling business either on the ground that the deductibility of gambling losses is limited or on a less specific ground such as that the amounts were unusually large.
12. We understand that a "player's club card" is a card resembling a credit card by means of which a gambler enables a casino to automatically track the gambler's winnings and losses. See, e.g.,
Merkin v. Commissioner , T.C. Memo. 2008-146↩13. It appears that the Orrs may have reported their gross receipts from gambling (including, for instance, all coins paid out of slot machines) as gross income, and their gross expenditures on bets (including, for instance, all coins inserted into slot machines) as losses. As discussed later, this practice may not have been technically correct, but the IRS does not challenge the practice's correctness, and the use of the practice probably does not in itself prevent the correct determination of their tax liability.↩
14. Nothing before the Court suggests that receiving these gains reflected special skill or judgment.↩
15. These people were not called as witnesses. Given Orr's overall situation, it seems possible that she may not have fully understood their advice. We find, however, that she testified honestly, and that an honest misunderstanding of their advice (which we would accept in the light of her situation) would similarly inform our consideration of whether there was reasonable cause for the errors on her return.↩
16. We do not know what kind of "business taxes" these were. She could have, for instance, merely prepared simple Schedules C to IRS Forms 1040, U.S. Individual Income Tax Return, to report individuals' business activities.↩
17. We do not know what Orr's job at the railroad was, but the record does not indicate that it was tax related.↩
18. The IRS Notice CP2000 accompanying the notice of deficiency asserts as follows that the Orrs failed to report any of the stipulated retirement benefits:
Amount Amount Reported Included Item Account to IRS by on Your No. Issue Received From Information Others Return Difference 1 Social US Railroad SSN [for Orr] $ 17,784 -- -- Security/ Retirement Board Form 1099-SSA Railroad Retirement 2 Social Social Security SSN [for Orr's $ 12,607 -- -- Security/ Administration husband] Railroad$ Form 1099-SSA Retirement *2*Social Security/Railroad $30,391 -- -- *2*Retirement Total *2*[Fn. ref. omitted.] In another table, it asserts that the taxable amount of these benefits is $ 25,832:
↩ Changes to Your Reported to IRS, Income and Deductions Shown on Return or as Corrected Difference Social $ 0 $ 25,832 $ 25,832 Security/Railroad Retirement 19. We appreciate the IRS' introduction of these issues, which are genuine issues that the Orrs appear not to have grasped on their own. It likely helped them to more fully present their case to the Court.↩
20. Since the Orrs have the burden of proof on these issues under Rule 142(a)(1), they benefit from our decision to consider the issues at all.
21. Since the Orrs are representing themselves, we have construed their arguments liberally. Cf., e.g.,
Erickson v. Pardus , 551 U.S. 89">551 U.S. 8922. The IRS does not dispute that Orr's gambling-related travel expenses are deductible. Courts have disagreed on whether the sec. 165(d) limitation applies only to net losses from bets themselves (for instance, an excess of money paid into a slot machine over money paid out from the slot machine) or also to other expenses (such as travel expenses) that constitute part of an overall loss from a gambling activity. A recent IRS internal memorandum, AM2008-013, summarizes precedent on each side of the issue and concludes that because the statute refers to wagering "transactions", which the memorandum asserts to be a narrower term than "activity" or others used in comparable provisions, sec. 165(d) addresses only net losses from bets themselves as described above, which we discuss as "net gambling losses". For this case, we accept the parties' agreement that the Orrs' gambling-related travel expenses are not limited by sec. 165(d) because this position has a reasonable basis in law. (An internal memorandum does not normally bind the IRS, but it may cite law and contain reasoning that can inform our consideration of a case.)
23. Although
sec. 7463(b) prohibits us from treatingClemons v. Commissioner , T.C. Summary Opinion 2005-109, andPanages v. Commissioner↩ , T.C. Summary Opinion 2005-3, as precedent, meaning that we cannot base our decision in this case on having made a similar decision on comparable facts in those cases, we consider the law they address and the reasoning they contain in deciding whether the Orrs' treatment of their net gambling loss was correct.24. We understand, however, how Orr, who suffers from diminished mental capacity, might infer from them that net gambling losses are deductible.
Commissioner v. Groetzinger , 480 U.S. 23">480 U.S. 23↩25.
Commissioner v. Groetzinger ,supra at 32the confinement of gambling-loss deductions to the amount of gambling gains, a provision brought into the income tax law as section 23(g) of the Revenue Act of 1934, 48 Stat. 689, and carried forward into section 165(d) of the 1954 Code, closed the door on suspected abuses * * * but served partially to differentiate genuine gambling losses from many other types of adverse financial consequences sustained during the tax year. * * *
Note 3 in
Panages v. Commissioner ,supra Praytor v. Commissioner , T.C. Memo 2000-282">T.C. Memo. 2000-282We infer that Orr did not understand the significance of the foregoing passages.↩
26. The brief states in relevant part: "In the case of a taxpayer not engaged in the trade or business of gambling, losses are allowable as a miscellaneous itemized deduction, but only to the extent of gains. Professional gamblers have qualified as being eligible to file as a business according to tax code 162(a). NO WHERE in irc code 162 does it mention 165(d)."↩
27. It appears that, at least until trial, Orr did not merely draw an incorrect conclusion from the absence of a cross-reference to sec. 165(d) but failed more generally to understand the significance of that section and its relation to other tax rules. Consequently, we need not focus on the absence of a cross-reference in deciding whether Orr's misunderstanding of law is consistent with the reasonable-cause exception to the accuracy-related penalty.↩
28.
Sec. 1.165-10, Income Tax Regs. , provides that this limitation of wagering losses to wagering gains applies on a year-by-year basis rather than over a shorter period.29. See
Beaumont v. Commissioner , 25 B.T.A. 474">25 B.T.A. 47473 F.2d 110">73 F.2d 110↩ (D.C. Cir. 1934), for a discussion of gambling taxation before the 1934 Act.30. The deductions not addressed in sec. 23 of the Revenue Act of 1934 (the "1934 Act") were generally limited to special classes of taxpayers, such as trusts and estates, and lack relevance to gambling transactions as such (addressing instead, for example, distributions by trusts and estates). See sec. 162(b) of the 1934 Act, ch. 277, 48 Stat. 728.↩
31. It is a longstanding maxim of statutory construction that if two statutes overlap, the later enacted statute prevails over the earlier to the extent of the inconsistency.
Posadas v. National City Bank , 296 U.S. 497">296 U.S. 49732.
Valenti v. Commissioner , T.C. Memo. 1994-483Moreover, the provisions in section 165(d) first appeared in our revenue law as section 23(g) of the Revenue Act of 1934, ch. 277, tit. I, 48 Stat. 689.4 * * *
4 The provisions were redesignated section 23(h) in the Revenue Act of 1938, ch. 298, 52 Stat. 447, 461, and continued as such in the 1939 Code until they became the current section 165(d) as enacted in the 1954 Code.↩
33. Sec. 165(d)'s use of sec. 165's term "losses", rather than the sec. 162 and 212 term "expenses", might also in isolation suggest that the sec. 165(d) limitation does not extend to deductions described in the latter sections. But we and other courts have consistently held that net gambling losses incurred in a business are nondeductible under sec. 165(d) and its predecessors. See, e.g.,
Nitzberg v. Commissioner , 580 F.2d 357">580 F.2d 357Valenti v. Commissioner ,supra Skeeles v. United States , 118 Ct. Cl. 362">118 Ct. Cl. 362sec. 1.162-1, Income Tax Regs. , describing sec. 162 business expenses), nothing suggests that they thereby cease to be "losses".34. At trial, Orr testified that "Eric in the Appeals court" gave her the copy of
Commissioner v. Groetzinger , 480 U.S. 23">480 U.S. 23↩35. Nothing else in the record addresses these losses. We infer they may have occurred in years other than the one in issue.↩
36. The Court characterized the reimbursements as expenses of preserving the famous country singer's reputation, which we found to be essential to his country music business.
Had Conway not repaid the investorsHis career would have been under cloud, Under the unique facts of this case
Held : The deductions are allowed.Jenkins v. Commissioner , T.C. Memo. 1983-667↩ n.1437. The Orrs appear to argue that defining gambling to include slot-machine playing would require the equally absurd result that every business is "gambling". It does not. Courts interpreting "gambling" for tax purposes have followed common understandings of the term which do not include most businesses. For instance, betting on horse races (
Schooler v. Commissioner , 68 T.C. 867">68 T.C. 867Winkler v. United States , 230 F.2d 766">230 F.2d 766Tschetschot v. Commissioner , T.C. Memo 2007-38">T.C. Memo. 2007-38Chow v. Commissioner , T.C. Memo. 2010-48LaPlante v. Commissioner , T.C. Memo 2009-226">T.C. Memo. 2009-226Jasinski v. Commissioner , T.C. Memo 1978-1">T.C. Memo. 1978-1Skeeles v. Commissioner ,supra at 365-367, 95 F. Supp. at 242-243">95 F. Supp. at 242-24338. The Code is divided into "subtitles", "chapters", "subchapters", "parts", "subparts", and "sections". (Sec. 7806(b), discussed earlier, explains that this classification does not in itself have any legal effect.) The subchapter to which the quoted passage refers is entitled "Computation of Taxable Income" (containing, as of the year at issue, secs. 61291), and the "part" whose deductions it excludes is entitled "Additional Itemized Deductions for Individuals" (secs. 211-224).↩
39. Since sec. 62(a)(1) requires merely that the deductions be attributable to a trade or business, not that they be deductible under sec. 162, "Trade or Business Expenses", this result does not depend on whether the professional gambler's deduction for gambling losses (1) arises under sec. 162(a) and is limited by sec. 165(d), see
Valenti v. Commissioner ,supra Humphrey v. Commissioner , 162 F.2d 853">162 F.2d 85340. Itemized deductions generally are disallowed to the extent of 3 percent of AGI over a threshold amount for a taxpayer whose income exceeds that amount, sec. 68(a), and certain itemized deductions, classified as "miscellaneous itemized deductions", are disallowed to the extent they do not exceed 2 percent of total AGI, sec. 67(a). But these disallowance rules do not apply to gambling losses. See secs. 67(b)(3), 68(c)(3); H.R. Conf. Rep. 99-841 (Vol. II), at II-34 (1986), 1986-3 C.B. (Vol. 4) 1, 34;
Whitten v. Commissioner , T.C. Memo. 1995-508↩41. Nothing suggests that the Orrs have any tax item whose treatment would be affected by the amount of their gross income as such. The extent to which the Orrs would be taxable on their Railroad Retirement Board and Social Security benefits may depend in part on their "modified adjusted gross income", which, like AGI, would not be affected by equal overstatements of gambling gross income and losses.↩
42. Sec. 6662(d)(2)(B) provides that a portion of an understatement attributable to a position which, although ultimately determined to be erroneous, is or was supported by "substantial authority", or has a "reasonable basis" and was adequately disclosed to the IRS, is not taken into account in determining the existence of a "substantial understatement". Neither party argues that this rule is relevant. We need not consider it because we decide that the Orrs are excepted from any substantial-understatement penalty on the ground that they had reasonable cause for and acted in good faith with respect to each of their errors. See
sec. 1.6662-3(b)(3), Income Tax Regs.↩ 43. The IRS has the burden of production with respect to the penalty, which has been met. See sec. 7491(c). Because we affirmatively find that Orr suffered from diminished mental capacity that constituted reasonable cause for the errors, we express no view on which party had the burden of proof.↩
44. The IRS concludes the section of its brief addressing the accuracy-related penalty by stating that "petitioners in bad faith and without reasonable cause tried to circumvent the limitations of section 165(d)" but does not specifically explain why it believes they acted in bad faith. If Orr's mental capacity was not sufficiently diminished for her to have believed that she had done enough to ensure her return was correct, it would follow that she did not act in good faith. But if that were the case, she would not have reasonable cause for her errors, either.
45. It is well established that an ambiguity or error in informal guidance, such as IRS form instructions and informal publications, "cannot affect the operation of the tax statutes or * * * [a taxpayer's] obligations thereunder." See
Weiss v. Commissioner , 129 T.C. 175">129 T.C. 175Green v. Commissioner , 59 T.C. 456">59 T.C. 45646. We consider the partial copy of the Orrs' return enclosed with their reply brief merely an informal reference to the copy of the return which the parties had earlier submitted as a joint exhibit and stipulated to be authentic.
Orr should not have waited until filing her reply brief to introduce the retirement-benefits issue. But we consider it because we conduct proceedings in
sec. 7463↩ "small tax cases" informally and because the IRS will have a full opportunity to address the issue in a Rule 155 computational proceeding.47. Any relevant information returns or payee statements that the Orrs may have filed with the return, such as IRS Forms 1099, are not before the Court.↩
Document Info
Docket Number： No. 11017-07S
Citation Numbers： 2010 T.C. Summary Opinion 55, 2010 Tax Ct. Summary LEXIS 70
Judges： "Morrison, Richard T."
Filed Date： 4/26/2010
Precedential Status： Non-Precedential
Modified Date： 4/18/2021