Sale of Lottery Payments Produces Ordinary Income

W won $12 million in a state lottery, to be distributed in 25 annual installments. He reported the first six prize payments as ordinary income. As part of a divorce settlement, a court awarded his former spouse a half-interest in the future lottery payments. W assigned his remaining one-half interest in the lottery payments to a third party for approximately $2.6 million (the discounted present value of his remaining share). He reported this lump sum as a sale of a capital asset with a cost basis of zero.

Law

A capital gain occurs when a taxpayer sells a capital asset at a profit; see Sec. 1222(1) and (3). Generally, under Sec. 1221(a), a capital asset is defined as “property, held by the taxpayer (whether or not connected with his trade or business).”  This statutory definition of property is broad, and a plain reading of its language could result in drawing within its scope all manner of property not necessarily appropriate for capital gain treatment.

Substitute-for-Ordinary-Income Doctrine

The Supreme Court has narrowed the scope of those gains that may be characterized as capital through the creation of the substitute-for-ordinary-income doctrine. Under this doctrine, when a lump-sum payment is received in exchange for payments that would otherwise be received at a future time as ordinary income, capital gain treatment of the lump sum is inappropriate, because the consideration was paid for the right to receive future income, not for an increase in the value of income-producing property.

Two other circuits, as well as numerous Tax Court rulings, have applied this doctrine in lottery sales cases and have consistently held that a lump-sum payment in exchange for future installments of lottery winnings is properly characterized as ordinary income; see Lattera, 437 F3d 399 (3d Cir. 2006); Maginnis, 356 F3d 1179 (9th Cir. 2004); Wolman, TC Memo 2004-262; Clopton, TC Memo 2004-95; Simpson, TC Memo 2003-155; Johns, TC Memo 2003-140; Boehme, TC Memo 2003-81; and Davis, 119 TC 1 (2002).

The Third and Ninth Circuits, in invoking the substitute-for-ordinary-income doctrine, outlined different methods for applying it generally while simultaneously seeking to appropriately limit its use; see Lattera, 437 F3d at 405–09 (a three-step “family resemblance” test for application of the doctrine, while noting no rule could “account for every contemplated transactional variation”); Maginnis, 356 F3d at 1182–83 (applying doctrine when there is underlying capital investment and sale did not reflect accretion in value over cost of underlying asset, but acknowledging the two factors would not be dispositive in every case).

Conclusion

In the instant case, there is no question that W exchanged his future right to receive set amounts of income he had essentially already obtained for a lump-sum payment. Application of the substitute-for-ordinary-income doctrine is thus entirely proper. As a consequence, there is no specific test as to the appropriate limits of the doctrine’s application. The lump sum W received served as a substitute for the ordinary income he would have otherwise received over a period of time. Thus, the sale of W’s future lottery payments did not represent a capital gain.

Roger L. Watkins, 447 F3d 1269 (10th Cir. 2006)