As a tax professional, sometimes you get those questions that are small enough that you don’t want to bother charging anything for the reply, but are time-consuming enough that you want a reward greater than good vibes from your client. The answer? Write a blog post and use it for marketing.
Client and 4 friends are participating in a gambling pool that has the potential to pay out approximately $50,000. The organization that is sponsoring the pool will be issuing the winners a W-2G. Client wants to know how to allocate the potential winnings among the 4 participants, given their various marginal tax rates.
Who receives the W-2G?
Should the participants set up a partnership?
How should proceeds be allocated?
How are costs reported?
Gambling activity is a common area of interest in U.S. tax law. The reason? Americans like gamble. State lottery, sports betting , Vega$, even the ponies and greyhounds, back in the day. In fact, taxation of gambling winnings is such a popular topic, the IRS has issued a brochure that gives an overview of applicable tax law and regulation. In addition, there is an entire page of the IRS web site that provides even more detail. Finally, there are many court cases that address the topic.
For an individual, the answer is fairly straight-forward. Report gambling winnings as other income on Schedule 1 of the 1040. Costs (losing bets – cost of tickets, etc.) can be deducted on Schedule A, IF: the taxpayer itemizes deductions, AND costs exceed 2% of adjusted gross income (AGI). The deduction is capped by the amount of winnings. For those who qualify as “professional gamblers” (it’s their main professional activity), winnings and costs are reported in Schedule C. Costs can include items that a casual gambler would not be able to deduct – travel, lodging, meals, etc. However, after the passage of the Tax Cuts and Jobs Act in December 2017, the amount of deductible costs is limited to the amount of winnings. In other words, a net loss from gambling activities can not be used to offset other income. See article on the topic HERE.
So, back to our gambling friends. Absent a tax entity to hold the gambling activity, one of the participants will receive a W-2G, with winnings, cost of wager, and withholding amount listed. In most cases, if the net winnings (winnings less cost of wager) exceed $5,000, the IRS requires that 24% be withheld from the payment.
The “simple” solution would be to split the net among the 4 participants. However this results in several problems. First, the 3 participants not receiving the W-2G would not be accurately reporting their income. If they report the net as misc income they are reporting an amount net of withholding, and would effectively be “double taxed” on the income. If they report the gambling income as a gross amount, before their share of withholding, and report their 25% of the withholding as taxes remitted, then there would be a mismatch between what has been reported by the sponsor of the gambling pool and the winning group. For the participant receiving the W-2G, he or she would properly report 100% of the net gambling winnings, and 100% of the withholding. But this participant would also be stuck with 100% of the taxes.
The solution? Create a partnership, obtain an EIN, and file a Form 1065 for the year in which the gambling activity occurs. In this case, every participant will receive a Schedule K-1, detailing their share of winnings, costs, and withholding. These amounts will then transfer to their individual 1040 and be reported correctly. Note that to create a partnership one does not need to create a legal entity, or even have a written agreement in place (not recommended). This partnership could still apply for an EIN, and the W-2G would be issued to the partnership, instead of one of the participants.
State tax implications will vary according to local law.