Third is a Charm

Tweet Since we're closing in on tax season (in my real world anyways), today's post was inspired by an email from one of my partners regarding a journal of taxation blast out to members firms titled "Better to Be a Third Place Winner." The IRS issues related to reporting withholdings on racing winnings is well chronicled (especially by Steven Crist) so I thought this article was semi-relevant, and it is quite entertaining (albeit lengthy).

Here is the main body of the article (courtesy WG&L):

"Most of us probably have day-dreamed about winning a large lottery prize or a mega-payoff in Las Vegas (or the local casino of your choice). Your editors are aware of two situations—30 years apart—where being the third place winner in a big stakes event would prove to be far better off—tax wise—than being the number one winner.
Flash back to the mid-1970s: A law school classmate of ours, who had taken up practice a few hundred miles away in a small town, called us out of the blue with a tax problem. He told us his client was a milkman who had a rural route and had last filed an income tax return in the 1940s. He somehow missed timely filing the following year, and rather than file late, he didn't file—and never filed again.

The milkman happened to purchase a ticket in the Irish Sweepstakes, which was a forerunner of the multistate lotteries common today. Lo and behold, the milkman won the Sweepstakes and along with it, a $125,000 prize (which, adjusted for inflation, would have looked like a gazillion bucks in today's dollars to the milkman). The check arrived, and the milkman cashed it.

Unfortunately, the milkman's identity was published in his local newspaper (without his advance knowledge or approval), presumably planted there by the Sweepstakes' promoters. (Note to all large lottery winners and those hoping to join their ranks: maintaining your anonymity is very difficult, as lottery officials love to publicize their lotteries' big payoffs and may blow your cover).

Our classmate told us an IRS agent had read the local newspaper and opened an investigation based on the Sweepstakes story. As a result, the milkman was facing tax liability on some 30-plus years that he failed to file tax returns, along with potential civil and criminal sanctions, all because he had the misfortune of winning the Irish Sweepstakes! My colleague wanted to know if there was anything we could do, and specifically, if the milkman gave up all of his prize, would the revenooers just go away? See Shop Talk, "IRS Scours Newspapers for Large Awards," 97 JTAX 63 (July 2001).

We never found out the milkman's name or whether he went to prison, but we saw first hand how the tax system can indeed take all the joy out of being the grand prize winner. One could surmise, however, that the third-place winner of the Sweepstakes—the recipient of a much smaller prize—garnered no IRS audit attention.

Flash forward to 2008 for "The Main Event of the World Series of Poker," which concluded in Las Vegas in November. The event drew more than 6,800 players, all dropping in a $10,000 entry fee and all seeking their pot of gold—which turned out to be slightly more than $9,150,000 for the first-place winner, a 22-year-old Danish national named Peter Eastgate. His prize swamped the amount won by the third-place winner, Dennis Phillips of Cottage Hills, Illinois, who won about $4.5 million. But thanks to the tax laws, once again we'd rather have been the third-place winner than the grand-prize winner.

How come? According to Enrolled Agent Russ Fox (of Clayton Financial and Tax of Irvine, California), who writes on the Taxable Talk website, Mr. Eastgate will get hammered by the tax laws applicable to gambling winnings. The U.S. and Denmark have a tax treaty that provides that foreign winners at casinos must pay taxes to their country of residence (Denmark), rather than where they win (here, the U.S.). So the IRS loses here, but Mr. Eastgate loses more. According to Fox's website, for casino gambling, the applicable tax rate is 45% on a Danish taxpayer's first 4 million Danish kroner, and 75% on his income above that amount. According to Fox's computations, Mr. Eastgate will have an effective tax rate of 72.77% of his winnings. In other words, he will only keep approximately $2,491,000 (27.23%) of his first-place prize, while owing approximately $6,660,000 to SKAG (Denmark's version of Uncle Sam).

But Illinois resident Phillips, who won about $4.5 million as the third-place finisher, will owe approximately $1,560,000 to the IRS, according to Mr. Fox, and approximately $136,000 to the Illinois Department of Revenue (based on Illinois' flat 3% state tax rate). More good tax news for the third-best poker player in the world: As he reportedly is an amateur (not in the trade or business of gambling), he would not appear to be subject to self-employment taxes on his winnings!

The net result for Mr. Phillips: his take-home amount, after taxes, should be approximately $2,804,000, whereas Mr. Eastgate, the first place winner, will net only about $2,491,000. As one commentator observed, a net of $2.5 million for a college-age kid for winning a poker tournament is still an insane amount of money, but the tax bite constitutes a lot of chips going into someone else's pockets. (See Roeper, "A Very Taxing Final Table," Chicago Sun-Times, 11/17/08, page 11.)

Once again, better to have been the third-place winner than the grand-prize winner, thanks to income taxes. Of course, Mr. Eastgate, facing Danish tax rates, undoubtedly would rather have been the first-place winner than the third-place winner, but given their respective marginal tax rates, we'd still rather be Mr. Phillips!"

And I thought the show bet was a dumb bet.....and doesn't SKAG seem to fit the IRS?

A TBA welcome to blog sites Amateurcapper, Gallop France, Keiblog, Michigan-Bred Claimer and The Chalk Eating Weasel, all bright new additions to our growing (49!) alliance of racing blogs. Check out the home page and vote for your favorite Do-Over photo of the year for 2008!