Casino Enterprise Management

Casinos spend large dollars on “comp” programs. As the gaming industry has evolved into a vast entertainment industry, casino properties are offering more and greater leisure amenities. Properties have become destination resorts. The modern casino property often incorporates multiple fine dining options, high-end retail shopping centers, spas, theaters, and golfing and other sporting venues. Casino operators reward their patrons, often generously, through comp programs. Casinos are no longer simply comping (or severely discounting) hotel rooms, meals and show tickets, but they also provide patrons access to exclusive golf courses, spas, entertainment adventures and shopping malls. Casinos often issue patrons credit card-like “reward cards” to earn and redeem comp credits.

At the same time that casinos have expanded comp programs, the use of gift cards has become increasingly prevalent in the retail sector. It seems that virtually every retail store, from the local coffee shop to the mega-department stores, offers gift cards. Moreover, financial institutions now issue gift cards through major credit card brands that can be used seamlessly at any location that accepts credit cards. Casinos have joined the gift card trend by allowing patrons to purchase gift cards to be used at spas, restaurants and other venues on casino properties.

Comp programs and gift cards differ in several respects. While gift cards and company programs share similar physical appearances and can often be used to redeem goods and services in comparable fashions, the means by which the cards are funded differ greatly. This difference in the methods that gift cards and comp reward cards are funded by means that these cards have vastly different tax considerations.

To explain and understand the differing tax considerations for gift cards and comp programs for casinos, it is helpful to view these cards through the prism of a commercial transaction. Gift cards and comp programs, in some respects, are representative of two sides of a transaction. Gift cards are funded by consumers tendering money to a casino operator to be held for use in the future to purchase goods and services. For tax purposes, a casino earns income in the form of an advance payment for goods and services when a person purchases a gift card. Thus, the tax law question is, when must the advance payment be recognized for income tax purposes?

On the other hand, comp programs are the opposite of a gift card when viewed through the lens of a commercial transaction. That is, the casino is expending resources to generate loyalty and, hopefully, future spending in the form of wagering by patrons. Thus, the casino has a capital outlay when it provides comps or when comps are redeemed. In other words, the casino has incurred expenses by providing comps. As a result, the tax law question is whether these expenses are deductible.

An understanding of the basic underlying transactions for gift cards and comp programs allows the tax treatment to be explained. With an understanding of the tax treatment, casino properties can structure their gift card and comp programs to gain tax efficiencies. The starting point is with an overview of the tax treatment of comps and gift card programs.

Tax Treatment of Comps

The Internal Revenue Code of 1986, as amended, generally allows a business to deduct ordinary and necessary expenses in carrying out its trade or business. But what the IRC giveth, it also taketh with its other hand. The IRC imposes an additional layer for determining whether certain types of trade or business expenses are deductible. IRC Section 274 is one such layer of limitation. Section 274 limits the deductibility of certain entertainment expenses.

IRC Section 274 operates by generally denying a deduction for entertainment expenses that otherwise would qualify as deductible trade or business expense. As even the casual observer of federal tax law is aware, the tax law is a complex web of rules that is replete with “exceptions to the exception.” IRC Section 274 follows this typical course by both calling off the general denial of a deduction for entertainment expenses in certain circumstances and expressly authorizing a deduction for certain types of entertainment expenses. Entertainment expenses can be deducted if the expenses are (1) directly related to the taxpayer’s trade or business, or (2) associated with the active conduct of the taxpayer’s trade or business (where the expense of the item is incurred directly preceding or following a substantial bona fide business discussion). Among other enumerated exceptions, relevant to the casino industry, IRC Section 274(e)(7) excepts from the general rule of denial expenses incurred for goods and services that are made available to the general public.

The Internal Revenue Service in two separate written authorities has provided guidance with respect to the application of IRC Section 274 to casino comp programs. In a Technical Advice Memorandum, TAM 9641005 (Oct. 11, 1996), the IRS provided a detailed analysis of the application of IRC Section 274 to casino comp programs. The IRS divided the comp program of the casino at issue in TAM 9641005 into two categories: inside comps and outside comps. The IRS defined inside comps as comps for meals, hotel rooms and other amenities at the casino property. Outside comps were defined in TAM 9641005 as comps provided for goods and services for its customers at locations other than the casino’s own business premises. The TAM identified examples of outside comps to include complimentary meals at restaurants, tickets to sporting events or concerts located on the premises of other casino properties.

Citing the legislative history of IRC Section 274, in TAM 9641005, the IRS concluded that inside comps were not subject to the limitation of IRC Section 274. Specifically, the IRS concluded that inside comps fell within the exception of IRC Section 274(e)(7) as expenses incurred for goods and services made available to the public. In other words, the IRS construed inside comps as promotional expenses of the casino. The IRS arrived at this conclusion even though inside comps still require a casino patron to engage in some level of gambling activity. The IRS found the legislative history had an analogous example. The example involved a hardware store that offered tickets to a baseball game to the first 50 people who purchased merchandise from the store. Hence, the condition casinos may place on patrons to engage in some level gambling activity did not negate the applicability of the exception to the general denial of a deduction for entertainment expenses for goods and services made available to the general public.

TAM 9641005, on the other hand, concluded that outside comps were subject to the limitation on the deduction of entertainment expenses of IRC Section 274. Specifically, the IRS distinguished outside comps on the basis that a casino was not distributing samples of its products. Rather, according to the TAM, it was the competing properties that made their products available to the patrons receiving outside comps and, importantly, not the casino awarding the comp. Thus, the IRS concluded that the exception to IRC 274 for goods and services made available to the general public did not apply.

Arguably, the distinction the IRS offers in TAM 9641005 between inside and outside comps is illogical. The example in the legislative history the IRS cited to support its conclusion with respect to inside comps arguably apply equally to outside comps. Specifically, regardless if the comps are inside or outside, effectively the comps are goods or services provided by the casino, similar to baseball tickets provided by the hardware store in the legislative history example. That is, in both circumstances, the business (whether it be the casino or a hardware store) provides something of value to induce a patron to purchase goods or services (wagers in the case of a casino and merchandise in case of the hardware store). Thus, the IRS’ focus on comps as providing a sample of the casino’s services misses the point. Rather, the proper point of factual similarly to draw the analogy to the legislative history is that both businesses are providing complimentary entertainment—regardless where the actual entertainment takes place—in exchange for a purchase by the patron. The example in the legislative history absolutely did not contemplate that the baseball tickets were a sample of the hardware store’s products.

In a more recent Private Letter Ruling, PLR 200315003 (April 11, 2003), the IRS addressed the treatment of goods and services purchased by a casino from tenants at the casino property that would be used as comps. The facts in PLR 200315003 disclosed that the casino property, in addition to a gaming floor, included several restaurants, a spa, theaters and a shopping center. The restaurants, spa and stores in the shopping mall were all operated by third-party tenants. In PLR 200315003, the IRS concluded that comps were promotional expenses and, therefore, fell within the exception to IRC Section 274 as expenses incurred for goods and services that are made available to the general public.

TAM 9641005 and PLR 200315003 are generally favorable to the casino industry and provide guidance that the costs associated with many comps should not be caught up in the limitation of IRC Section 274. Particularly, to the extent that the comps are redeemed for goods or services on the premises of the casino property, regardless whether the casino directly owns the business where comps are redeemed, the expenses incurred by the casino should not be caught up in the denial rule of IRC Section 274. While TAM 9641005 concluded that outside comps are subject to IRC Section 274, there are chinks in the IRS’ arguments and, coupled with the more recent PLR 200315003, casinos may be able to develop reporting positions that in some circumstances outside comps are not subject to the limits or IRC Section 274.

Tax Treatment of Gift Cards

A business receives an advance payment for supplying future goods and services when its sells gift cards. The significant tax issue with the sale of gift cards is whether the payment is currently included in gross income. In other words, if a casino receives $100 from the sale of a gift card for use at the casino’s spa, the question for tax purposes is whether the casino must include the $100 in income upon receipt or if it can defer recognizing the income to a later year, when the cardholder redeems the gift card for goods or services.

For an accrual method business—most businesses are accrual method taxpayers—income must be recognized when the “all events” test is met. Essentially, among other factors, all events are fixed, requiring income to be accrued when a business actually receives money. Thus, in general, regardless of the year in which the value of the gift card is redeemed, the income must be accrued in the year the money is received for the gift card. The federal tax law does, however, offer some exceptions when accrual method taxpayers do not have to recognize advance payments as income in the year the payment is received.

The IRS has flip-flopped positions with respect to when an accrual method business does not have to recognize income in the year money is received. Most recently, the IRS issued written guidance in the form of Rev. Proc. 2011-18 (Jan. 5, 2011) that identifies circumstances under which a business can defer recognizing income received for gift cards. Rev. Proc. 2011-18 allows the deferral of income for “an eligible gift card sale.” The Revenue Procedure defines an eligible gift card sale as essentially when a business remains primarily liable to the customer for the value of the card until its redemption or expiration and the gift card is redeemable as payment for certain permissible items.

Rev. Proc. 2011-18 is important guidance for casinos to further refine gift card programs. The ultimate goal from a tax planning perspective is to defer recognizing income for the longest legally permissible period. The protections of Rev. Proc. 2011-18 are only available to those businesses that have elected an appropriate accounting method. The IRC imposes limitations on a business’ ability to elect to change its accounting method. Thus, from a planning perspective, the initial step for a casino is to ensure that it either has, or is eligible to use, a permissible method of accounting to defer recognizing income for advance payments. Next, a casino must ensure that it has adopted procedures for recognizing the value of gift cards as revenues for financial reporting purposes.

Concluding Comments

Comp program reward cards and gift cards can be nearly indistinguishable in terms of how value is redeemed. In a seamless transaction, a casino patron might use a comp reward card to purchase merchandise at a high-end fashion boutique on the casino property. The very next customer in line may use a casino gift card to make a purchase at the same fashion boutique. The tax treatment to the casino of each transaction can greatly differ. Understanding the application of the tax rules can allow a casino to structure its comp and gift card programs in a tax-efficient manner.

Author’s Note: In response to IRS Circular 230 requirements, any discussions of federal tax issues in this article are not intended to be used and may not be used by any person for the avoidance of any penalties under the Internal Revenue Code, or to promote, market or recommend any transaction or subject addressed herein.

Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville,  Washington, D.C., Toronto and Phoenix. He received his LL.M in tax law from New York University. Kulick may be reached at pkulick[at]dickinsonwright.com.