Casino properties have developed comprehensive marketing programs designed to lure and keep the best patrons. Across North America, gross gaming revenue has experienced a decline over the past three years. As gaming revenue has declined, new markets continue to come online and the number of properties has increased. A struggling economy and rising market participants work in tandem to increase the already stiff competition for gambling dollars.
To attract patrons, casinos use a variety of marketing tools and incentives. Casino comp programs have expanded significantly in recent years. Comp programs allow patrons to redeem reward points for a variety of goods and services. While economic studies often reveal that high-roller gamblers, affectionately known in the industry as “whales,” are often not a casino property’s greatest profit center as a group, properties will nonetheless still seek to attract the whales by offering financial incentives. In addition, casino properties may extend financial incentives beyond just multimillion dollar whales. One mechanism that casinos have long used to attract patrons, and maintain patron loyalty, is the extension of credit.
The concept of casinos extending credit is straightforward and involves advancing a “marker.” The credit process is similar to common lending practices: A casino will perform a credit check, establish a credit line and extend a marker that a patron can exchange for casino chips. In exchange for the marker, the patron will sign a promissory note agreeing to repay the face amount of the marker.
In the financial sector, financial institutions use a host of incentives to attract new customers and maintain the business of valuable existing customers. These incentives range from teaser interest rates to cash rebates. Similar to financial institutions, casinos also use economic incentives to enhance the value of a marker and maintain loyalty to the property. One incentive used by casinos is offering a prearranged discount on the face amount of a marker. A second incentive that casinos may offer is discounting the face amount of the marker after the patron completes his or her gambling play. These incentives are designed to generate customer loyalty via economic inducement. When an incentive is economically based, tax consequences are likely to follow. Recent guidance issued by the Internal Revenue Service (IRS) provides insight with respect to the tax consequences arising from marker discount programs and offers casinos a planning road map to structure such programs in a tax-efficient manner.
Pre-Arranged Marker Discounts
The IRS explained the treatment of prearranged marker discounts in two Chief Counsel Advice letters,1 CCA 20110701 and CCA 20110710, both issued earlier this year. A prearranged marker discount program involves the use of a predetermined discount. The discount is typically established as an amount equal to a percentage of the patron’s losses. For example, the prearranged discount program may offer to discount the face value of a patron’s marker in an amount equal to 5 percent of the patron’s losses. If a patron wins, the patron is expected to repay the full face amount of the marker. As described in the Chief Counsel Advice, the prearranged marker discount is memorialized in writing between the casino and the patron. The amount of the discount and writing are negotiated before the marker is advanced and play begins. While the marker discount is set forth in writing, the patron must still execute a promissory note for the full amount of the marker. The prearranged discount, by its terms, is contingent upon the patron’s payment of the full amount of the discounted marker. Thus, if the patron refuses to pay the marker, or pays less than the discounted marker amount, the casino would retain a legally enforceable right to collect the entire, undiscounted marker amount.
Similar to most businesses, casino operators report income for federal tax purposes using the accrual method of accounting. Under the federal tax law, the accrual method of accounting provides that a taxpayer must accrue income when (1) all events have become fixed with respect to the right to receive the income, and (2) the amount is determined with reasonable accuracy. The underlying goal with all tax accounting methods, including the accrual method, is to ensure that income is accurately reflected for federal tax purposes. Hence, there are exceptions that have developed under the federal tax law that can deviate from the general timing requirements with respect to when income is accrued under the accrual method of accounting.
The fundamental tax question for the casino property offering a preapproval marker discount is whether the full face amount of the marker must be included in gross income. In the abstract, simply focusing on the baseline federal tax law test governing when income must be accrued, an argument could readily be made that the full face amount of a marker must be accrued at the time it is issued. That is, to the extent that the marker is represented by a demand note, the casino has the right to collect the income and, because the face amount of the maker is stated, the amount that is owed is readily ascertainable.
The Chief Counsel Advice letters, however, reach a conclusion that is far more favorable to casino operators. Specifically, the IRS determined that the casinos at issue only had to include the amount of the pre-negotiated discounted marker in income. The IRS analogized the marker discount as being similar to allowances in sales transactions that resulted in a reduced net sales price. The Chief Counsel Advice letters relied on a line of court decisions, which recognized that only the amount of the net sales price needs to be taken into income for federal tax purposes. The adjustment is construed as a reduction in the purchase price—or in the case of casino markers, a reduction in the amount due—which reduced the amount realized.
The fact that the casino had the right to, and may attempt to, collect the marker in the future did not modify the IRS’ conclusion. Rather, the IRS found that the discounted price was not changed by the casino’s reservation of the right to collect the full face amount of the marker based on certain conditions. Significantly, the IRS concluded that the parties—the casino and the patron—had negotiated a predetermined, discounted price.
Post-Play Marker Discounts
A second form of incentive related to markers that casinos may offer is a post-play discount. In contrast to the prearranged discount, a post-play discount is extended after the patron has completed play. In other words, at the time the marker is extended, the casino has not made a determination whether, if at all, it will extend a discount and, if it will, the amount of the discount. Post-play discounts apparently are determined on a case-by-case basis and thus are not negotiated at the time the marker is extended by the casino to the patron.
The IRS distinguished post-play discounts from pre-arranged discounts in the Chief Counsel Advice letters. Significantly, the IRS determined that the parties did not have an intent to reach an agreed “net sales price,” i.e., the amount or percentage of the marker discount. Therefore, under the accrual method of accounting, a casino cannot reduce its gross income by the amount of the post-play discount, at the time the marker was extended.
The Chief Counsel Advice letters do, however, offer a casino a life line by concluding that post-play discount may offer the casino the basis to deduct the amount of the post-play discount as a loss under Section 165 of the Internal Revenue Code of 1986, as amended (IRC). IRC Section 165 authorizes a deduction, among other items, for any “loss.” While the amount of the discount is initially included in income, under the Chief Counsel Advice letters, the casino is effectively placed in the relatively same tax position as a result of the loss deduction, albeit with one important difference: timing. To the extent that the post-play discount is extended in a subsequent tax year, there is an economic loss based on time value of money. In other words, the value of a future deduction compared to a current exclusion from income is less based on time-value of money.
Opportunities and Questions
The pair of Chief Counsel Advice letters offer helpful guidance in structuring marker discount programs. At the outset, the IRS guidance reveals that casinos can implement customer loyalty programs that potentially can generate tax savings. Specifically, by offering prearranged marker discounts, the Chief Counsel Advice letters recognize that a casino using the accrual method of accounting has a basis to currently exclude the value of the prearranged discount from income. Similarly, while potentially producing a timing disadvantage, post-play discounts may be eligible as a loss deduction under IRC Section 165.
The Chief Counsel Advice letters do leave an open question. The letters explicitly state that the rulings do not address a circumstance whereby a casino discounts a marker either due to concerns of worthlessness or collectability, or due to disputed liability. To that end, there are factual circumstances under which the IRS could take a position that precludes the availability of an IRC Section 165 loss deduction. The bottom line from the IRS guidance ultimately offers a road map to structure patron loyalty programs through the use of markers that may produce tax advantages.
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.
1 Chief Counsel Advice letters are similar to other written authorities issued by the IRS, such as private letter rulings and technical advice memoranda, which offer legal conclusions with respect to the application of the tax law to the particular facts and circumstances of a transaction entered into by a specific taxpayer. Chief Counsel Advice letters are interpretations offered by the IRS Chief Counsel’s office to other IRS personnel, such as a revenue agent undertaking an audit examination of a taxpayer.