Sale of lottery payments produces ordinary income.

• Author: O'Driscoll, David

A and B won the state lottery, entitling them to 26 annual payments of $369,000. Eight years later, they sold their right to receive all remaining payments for $3.3 million. They reported the sales price as a capital gain; however, the IRS and the Tax Court ruled that the amount was ordinary income. A and B appealed to the Third Circuit.

Analysis

Whether a sale of the right to lottery payments results in capital gain or ordinary income is one of first impression in the Third Circuit. Both the Tax Court and the Ninth Circuit have previously held such sales deserve ordinary-income treatment; see Maginnis, 356 F3d 1179 (9th Cir. 2004). In Maginnis, the court relied on the substitute-for-ordinary-income doctrine. Under that doctrine, lump sums received as a substitute for future ordinary income are not capital gains. However, the court was concerned about taking an "approach that could potentially convert all capital gains into ordinary income [or] one that could convert all ordinary income into capital gains" For example, a stock's value is the present discounted value of the company's future profits. Thus, the Ninth Circuit opted for "case-by-case judgments as to whether the conversion of income rights into lump-sum payments reflects the sale of a capital asset that produces a capital gain, or whether it produces ordinary income"

In Exch. Nat'l Bank of Chi., 544 F2d 1126 (2d Cir. 1976), the Second Circuit created a "family resemblance" test for deciding whether a note was a security. The test (1) presumes that notes of more than nine months' maturity were securities, (2) lists various types of those notes that it did not consider securities and (3) declares that a note with maturity exceeding nine months that "does not bear a strong family resemblance to these examples" was a security. The Supreme Court adopted this test in 1990.

Here, the Third Circuit adopted a family resemblance test. Under that test, stock and "things" that look and act like stock receive capital-gain treatment. For the in-between transactions that do not bear a family resemblance to the items in either category, like contracts and payment rights, two factors assist in the analysis: (1) type of "carve-out" and (2) character of asset.

Horizontal vs. Vertical Carve-Out

A horizontal carve-out is one in which the owner disposes of part of his interest...