Sale of lottery payments produces ordinary income.

• Author: Watkins, Roger L.

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)...