Baxter v. United States—Landmark or Mirage?

Earlier this month, I posted about the recent Pennsylvania appellate court decision finding that poker was a game of chance, and could be regulated as gambling. The upshot of my post was that the “poker is a game of skill” argument isn’t getting any traction in court, and poker players and the Poker Players Alliance need to abandon the court-driven approach to legalizing poker in favor of lobbying Congress (for online poker) and state legislatures (for recreational home games) for statutory changes. I also cross-posted over on the All Vegas Poker forums to see what their reactions might be.

One of the AVPers—fellow Iowan “zzjitterzz”—posted a comment referring to a federal court case, Baxter v. United States, which suggested the Baxter court had found poker to be a game of skill.  I wasn’t familiar with the case, but with a little research, I discovered that many in the poker community regarded the case as definitively holding that poker was a game of skill (see here, here, here, here, here, and here for a sampling of the pro-Baxter discussion).  I decided I needed to read the actual court decision for myself, but could not find the decision on any of the usual free law sources. So, I logged onto Westlaw (the uber-site for legal research) and pulled up the case (you can read for yourself the text of the decision here).  I also did a little research about the legal aftermath of the decision, and found the case to be rather interesting.  So, considering the Baxter decision is held in such esteem by the poker community, let’s take a closer look and see what, if any, benefit the case may have for the current battle over legalizing poker.

Q: Who is Billy Baxter?

A: According to a biographical article in CardPlayer Magazine, William “Billy” Baxter, Jr. is a lifelong gambler, beginning as a pool hustler before moving into poker and sports betting. Baxter has won seven WSOP bracelets, and is widely regarded as one of the all-time greatest lowball poker players.

Q: Why was Baxter in federal court?

A: Baxter and the Internal Revenue Service (IRS) had a dispute over whether Baxter’s gambling winnings of over $1.2 million for a four year period (1978-81) should be taxed as “earned income” or “unearned income”. At that time, earned income had a substantially lower income tax rate, and certain expenses could be deducted from earned income that could not be deducted from unearned income. To protest the IRS decision to tax his poker profits at the higher tax rate, Baxter could either pay the amount the IRS demanded and sue in federal district court for a refund, or he could refuse to pay and file a lawsuit in federal tax court. Baxter chose to pay the assessed tax and sue for a refund in district court (the same courts that get first bite at hearing a wide range of cases involving federal criminal cases, federal statutory claims, constitutional law challenges, cases involving federal agencies, and high-dollar civil litigation).

Q: Why did Baxter win?

A: First and foremost, it’s vitally important to understand that tax law, like almost all statutory law, is based on definitions. At the beginning of most statutes are a few introductory sections that define all sorts of terms. These sections look boring, but they in fact drive most of the resulting analysis. Let’s assume Congress wants to encourage widget production and discourage gadget production through the tax code. Congress will enact laws giving preferential tax treatment to widgets, while penalizing gadgets. But, there are also wadgets and gidgets on the market that look quite a bit like widgets and gadgets. The definitions in the statute (or in the IRS regulations interpreting the statute) will determine whether wadgets and gidgets end up being treated like widgets, gadgets, or neither.

Turning to the Baxter decision, the court engaged in a three-step analysis to determine how to treat Baxter’s poker income. The first step (Section I of the decision) addressed whether Baxter’s “gambling” constituted a “trade or business”. The court essentially analogized Baxter’s poker playing to stock traders who played the market for their own profit (as opposed to trading other people’s stocks for a fee). Finding that gambling and playing the stock market were similar activities, the court decided:

[T]he frequency, extent, and regularity of Baxter's gaming activities as well as his intent to derive a profit were sufficient to constitute a trade or business under the relevant sections of the Cod

Note that the court did not find that skill was a factor relevant to establishing poker as a “trade or business".

The second step of the court’s analysis (Section II of the decision) addressed whether Baxter’s gambling income was “personal service income”, which turned on the question of whether his profits were “earned” or “unearned”. The purpose of the earned/unearned test is that the government treats income differently if it is earned through the labor or business efforts of the taxpayer, or whether it is obtained as a return on a passive investment. The court found that, in Baxter’s case, he in fact had “earned” his poker winnings:

Clearly, Baxter's $1.2 million gaming income for the years at issue was not derived from his passive investment of capital in a series of risky ventures. Baxter expended substantial time and energy playing poker. Baxter consistently won at poker because he possesses extraordinary poker skills. Any argument that Baxter's gaming income is not based upon his personal expenditure of time, energy, and skill is meritless. Thus, because Baxter's gaming income constitutes earned income under § 911(b), it also constitutes personal service income under § 1348.

The court also found that a regulation treating all gambling income generically as “unearned income” was void to the extent it was applied to poker; the court specifically found the IRS regulation should distinguish between games with a skill element (like poker), and games with no skill element (like keno or slots). A-ha! “Skill” is finally recognized by the court as an important part of poker distinguishing it from other casino games! Well, let’s hold off on celebrating just yet. The court’s analysis isn’t complete.

The final step in the court’s analysis (Section III of the decision) was to determine the extent to which Baxter’s poker winnings were the result of return on capital, which might potentially limit his ability to utilize the lower tax rate for “personal services income”. The court found that:

… Baxter's income was derived entirely from his personal services and that the capital he used to finance his poker playing was merely a “tool of the trade.” The money, once bet, would have produced no income without the application of Baxter's skills. As discussed previously, it was Baxter's extraordinary poker skills which generated his substantial gaming income, not the intrinsic value of the money he bet.

See! The court found that poker is a game of skill a second time! Well, it’s true that the court relied on Baxter’s skill in finding that his poker income should be treated as earned income, no differently than the income from a stock market speculator. Unfortunately, although the court recognized that poker was a game of skill, the Baxter decision doesn’t necessarily help poker players seeking to legalize poker by arguing that poker, as a game of skill, is not subject to state laws banning “games of chance” or “gambling”.

Q:  Why wouldn’t the Baxter decision be the final word on the “poker is a game of skill” debate for all courts?

A:  Three major reasons come to mind:

1. Baxter involves federal tax laws, not state gambling laws;
2. The federal tax law which formed the basis for Baxter has changed; and, 
3. Baxter was a federal district court case, which is not binding on any other court.

Q: Wait a minute! Wasn’t Baxter affirmed by a federal court of appeals? Doesn’t that make it binding on other courts?

A: A decision of a federal district court is binding only on the parties to the case in the particular dispute being litigated. Other courts (state or federal) may rely on the district court’s decision to the extent they agree with the court’s reasoning, but they are free to adopt, modify, or ignore the decision as they see fit. In fact, disagreements between district court judges as to the proper interpretation of a point of law often lead to a higher appeal court issuing a definitive ruling establishing an interpretation of law that is binding on all lower courts.

Several reports by people who know Baxter have repeated substantially the the same history:

The government appealed the ruling, and the case then went to a U.S. Circuit Court of Appeals. Again, the court ruled in Baxter's favor. And again, the government appealed and said it was going to take the case to the U.S. Supreme Court.

After due consideration, the government apparently thought it might not win there, and wanted to make a deal with Baxter. He held his ground and emphatically said, "No!" The government later dropped the case and Baxter got all of his money back with interest. (The interest barely covered his attorney's fees, but it was a sweet victory, which was all Baxter wanted.) He had stepped up to the plate and hit a home run off the government.

In poker terms, the government was bluffing when it said it wanted to go to the Supreme Court—and Baxter called the bluff.

—Mike Sexton, "Billy Baxter—The Man Who Made a Difference", in CardPlayer.com

In this case, the appeal would have been filed with the federal Ninth Circuit Court of Appeals, which is the federal appellate court for most of the western states. If the Baxter decision had been affirmed by the court of appeals, it would have been binding precedent for federal courts in those states, and would have been given more deference in other circuits than a mere district court decision.

The problem is, the court of appeals never issued a decision in the Baxter case. According to Westlaw, there is no decision of record from the court of appeals, not even a memorandum opinion affirming the district court without comment. Without a court of appeals decision, the IRS certainly never appealed to the U.S. Supreme Court.

I suspect that the government may have filed a notice of appeal to the court of appeals, but decided to drop the appeal before an appellate decision was entered. The IRS attorneys may also have engaged in typical rhetoric about appealing all the way to the U.S. Supreme Court as part of their attempts to negotiate a settlement. People who were unfamiliar with the case or the legal process might have misunderstood what occurred, leading to an inaccurate procedural history becoming part of the common lore surrounding the case.  But Baxter was never ruled on by any appellate court.

Q: Why would the IRS drop the appeal?

A: Probably for three reasons: 1) the tax laws at issue in the case had been amended in 1982, so the case was not particularly important from the government’s perspective, 2) the IRS realized they would likely lose the appeal in light of a subsequent U.S. Supreme Court decision, and 3) during the mid-1980s, the government’s position on gambling income was evolving along with changes in the tax laws.

This brings us to the second reason why Baxter is of limited benefit to current poker legalization litigation—the tax laws at issue in Baxter were amended in 1982 (and have been amended several times since). Further, less than a year after Baxter was decided, the U.S. Supreme Court addressed a similar legal question, this time arising from a full-time dog-race handicapper who wanted to claim his gambling wins as “earned income” from a “trade or business”. The U.S. Supreme Court held:

[I]f one's gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the meaning of the statutes with which we are here concerned. Respondent Groetzinger satisfied that test in 1978. Constant and large-scale effort on his part was made. Skill was required and was applied. He did what he did for a livelihood, though with a less-than-successful result. This was not a hobby or a passing fancy or an occasional bet for amusement.

—Commissioner v. Groetzinger, 480 U.S. 23, 35-36, 107 S.Ct. 980, 987 (1986).

 Hmmm, well there’s more “skill” talk, that's a big deal, right? There are two problems with relying on Groetzinger in the current poker legalization litigation, however. First, as the decision itself noted, the relevant tax laws had already been amended by the time the decision was entered, meaning it had little application going forward. Second, and more importantly, the IRS began to focus on the distinction between gambling for a livelihood and gambling for a hobby, without regard for skill. In the past twenty-odd years since Groetzinger, there are numerous tax court decisions finding not only dog and horse handicappers, but also sports bettors, keno players, and slots players to be “professional gamblers”. Professional poker players are now lumped into that same “professional gambler” category for tax law purposes, which is hardly an association poker players want to highlight in the current legal challenges to state gambling laws.

Q: But isn’t it important that Baxter found poker to be a game of skill?

A:  Frankly, no. It’s certainly nice that a federal judge made those findings, but his views are not particularly relevant to the state courts considering the current poker legalization cases. The primary reason Baxter is irrelevant to the poker legalization movement is the issue of statutory definitions discussed earlier. “Gambling” simply has different definitions under various federal and state statutes. It is entirely possible for a poker player to be considered a “professional gambler” for purposes of federal tax law, while his actual poker playing is "illegal gambling" pursuant to state gaming laws:

The issue before us is not whether the United States may tax activities which a State or Congress has declared unlawful. The Court has repeatedly indicated that the unlawfulness of an activity does not prevent its taxation, and nothing that follows is intended to limit or diminish the vitality of those cases.

—Marchetti v. U.S., 390 U.S. 39, 44, 88 S.Ct. 697, 701 (1968).

Q:  So are you saying that Baxter wasn’t an important case?

 A: The case was certainly important to Baxter himself. It was probably helpful to the small community of similarly situated poker players in the early 1980s. But the U.S. Supreme Court decision in Groetzinger—coupled with changes in tax laws and regulations and the public’s growing acceptance of legalized gambling—was the primary driving factor leading to recognition of “professional gamblers” for federal tax law purposes. Even the Baxter decision itself referred to Baxter as being a “professional gambler” rather than a “professional poker player”, which is a much more recent label. 

Baxter’s relative unimportance can be seen by the fact it has been cited exactly twice in nearly a quarter of a century. One citation was in a footnote in the Groetzinger decision, cited for the proposition that the tax court regards gamblers the same as active market stock traders. The other citation was in a 1989 tax court decision involving income from betting on horse races. No other courts have found Baxter important enough to either rely upon or to criticize. In other words, Baxter has had essentially no impact on the development of the law.

Although prominent poker players and bloggers want to credit Baxter as the basis for professional poker players being treated like any other occupation for purposes of tax laws, that credit more properly belongs with Groetzinger. As for the current challenges to state gambling laws, Baxter’s language regarding the skill required to play poker has no precedential value, and little relevance.

Q: So what is the legacy of the Baxter decision?

A: Although the importance of the Baxter decision has been greatly overstated in the poker community, Baxter himself does deserve credit for pursuing the case (even though he had a significant financial motivation to do so). I think Justin West, in reflecting on Baxter’s induction into the Poker Hall of Fame, probably gets it right:  

While this case may have been brought up later, it was Baxter who took one of the first steps in making poker not only a legitimate profession, but a mainstream, above-the-table endeavor.

—Justin West, "Baxter, Cloutier Admitted to Poker Hall of Fame" at PokerPages.com

But when tax season rolls around, professional poker players should give a tip of the cap to Robert Groetzinger, professional dog-handicapper.