There is apparently a wide diversity in practice regarding the manner in which a casino operator accounts for slot-machine and other jackpots. With the issuance of Accounting Standards Update No. 2010-16, Accounting for Casino Jackpot Liabilities, the Financial Accounting Standards Board has introduced a welcome degree of uniformity to this issue.
The ASU provides that an entity shall accrue a liability, and charge a jackpot, at the time the entity has the obligation to pay the jackpot. Some slot machines, the ASU notes, may contain “base” jackpots. An entity may be able to avoid the payment of a base jackpot, for example, by removing the machine from play. Accordingly, no liability associated with the base jackpot is recognized in such cases until the entity has the obligation to pay the base jackpot. This is the case even if the entity has no plan or intention of removing the machine from play and fully expects the base jackpot to be won.
Some slot machines include “progressive” jackpots. Those are machines in which the value of the jackpot increases with every game played. Entities in many gaming jurisdictions cannot avoid payment of the portion of the progressive jackpot that is incremental to the base jackpot. That’s because the gaming regulators consider such incremental portions of prizes to be funded by customers, and therefore are required to be paid out. In these cases, the incremental portion of the jackpot should be accrued as a liability at the time of funding (that is, play) by its customers.
These rules will be operative with respect to fiscal years (and interim periods within such fiscal years) beginning on or after December 15, 2010. Moreover, an entity shall apply this guidance with a “cumulative effect” adjustment recorded in retained earnings in the period of adoption of such guidance.
Tax Accounting for Jackpots
When does the jackpot liability accrue for tax purposes? This issue was addressed by the Supreme Court in United States v. Hughes Properties, Inc., 476 US 593 (1986). There, the taxpayer owned and operated slot machines at its casinos, including a number of progressive machines. A progressive machine pays a fixed amount when certain symbol combinations appear on its reels. But a progressive machine has an additional progressive jackpot which is won only when a different combination of symbols appears. The casino initially sets these jackpots at a minimal amount. The figure increases, progressively, as money is gambled on the machine. The amount of the jackpot at any given time is registered on a “payoff indicator” on the face of the machine.
At the conclusion of each fiscal year, the taxpayer entered the total of the progressive-jackpot amounts shown on the payoff indicators as an accrued liability. From that total, it subtracted the corresponding figure for the preceding year to produce the current year’s increase in accrued liability. On its tax return, the taxpayer asserted this net figure as a deduction. The Internal Revenue Service disallowed the deduction. In its view, the taxpayer’s obligation to pay a progressive jackpot “matures” only upon a winning patron’s “pull of the handle” in the future. From the perspective of the IRS, until that event occurs, the taxpayer’s liability is merely contingent. However, both the Claims Court and the Court of Appeals for the Federal Circuit ruled in favor of the taxpayer. The Supreme Court sided with the taxpayer as well.
“Casino operators are, in effect, placed on a cash method of accounting when it comes to jackpots, so a difference between financial accounting and tax accounting for these sums will inevitably arise.” — Robert Willens
The All-Events Test
The high court noted that an accrual-method taxpayer is entitled to deduct an expense in the year in which it is incurred. The standard for determining when an expense is incurred is the so-called all-events test: all the events must have occurred that establish the fact of the liability, and the amount must be capable of being determined with “reasonable accuracy.” So to satisfy the all-events test, a liability must be “final and definite” in amount, “fixed and absolute,” and “unconditional.”1
The IRS argued that the taxpayer’s liability for the progressive jackpots was not “fixed and certain” and was not “unconditional or absolute” by the end of the fiscal year, for there existed no person who could assert any claim over those funds. It took the position that the indispensable event is the winning of the jackpot by a gambler.2
The effect of the Nevada Gaming Commission’s regulations3 was to fix the taxpayer’s liability. The regulations forbade reducing the indicated payoff without paying the jackpot. The taxpayer’s liability — that is, its obligation to pay the indicated amount — was not contingent. That an extremely remote and speculative possibility existed that the jackpot might never be won does not change the fact that, as a matter of state law, the taxpayer had a fixed liability for the jackpot that it could not escape.
The IRS, the court concluded, misstates the need for identification of a winning player. That is a matter “of no relevance” for the casino operator. The obligation is there, and whether it turns out that the winner is one patron or another makes no conceivable difference as to basic liability. In fact, the court acknowledged that there is always the possibility that a casino may go out of business with the result that the amount shown on the jackpot indicators would never be won. However, this potential nonpayment of an incurred liability exists for every business that uses an accrual method, and it does not prevent accrual. “The existence of an absolute liability is necessary; absolute certainty that it will be discharged by payment is not….” 4
The Economic Performance Test
However, under the law that exists today, a liability is not incurred until the historical all-events test is satisfied and “economic performance” occurs with respect to the liability. As a result, the all-events test cannot be met with respect to an item any earlier than the time that economic performance occurs with respect to the item.5
The introduction of the economic-performance test has the effect of overturning the holding of the court in United States v. Hughes Properties, Inc. Therefore, the tax rules — specifically Regulation Section 1.461-4(g)(4) — notes that “…if the liability of a taxpayer is to provide an award, prize, jackpot, or other similar payment to another person, economic performance occurs as payment is made to the person to which the liability is owed....” That means that the law now employs as its touchstone the litigating position the government embraced in United States v. Hughes Properties, Inc. Therefore, casino operators are, in effect, placed on a cash method of accounting when it comes to jackpots, so a difference between financial accounting and tax accounting for these sums will inevitably arise. The liability will accrue for financial-accounting purposes in advance of the time such liability is incurred for tax purposes. Therefore, a casino operator will be constrained to record a deferred tax asset to reflect the tax effect of this “deductible” temporary difference.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Thor Power Tool Co. v. Commissioner, 439 US 522 (1979).
2 See Nightingale v. United States, 684 F.2d 611 (9th Cir. 1982). The court, however, disagreed.
3 The regulations provided that “…no payoff indicator shall be turned back to a lesser amount, unless the amount by which the indicator has been turned back is actually paid to a winning player….” The court noted that this regulation is “strictly enforced.” By statute, Nevada authorizes the gaming commission to impose severe administrative sanctions, including license revocation, upon any casino operator that wrongfully refuses to pay a winning customer a guaranteed jackpot.
4 See Helvering v. Russian Finance & Construction Corporation, 77 F.2d 324 (2nd Cir. 1935).