Lottery winnings as capital gains.

• Author: Levine, Matthew S.
• Position: Case Note

United States v. Maginnis, 356 F.3d 1179 (9th Cir. 2004).

Pity J. Michael Maginnis. In 1991, he had the misfortune to win $9 million in the lottery. (1) Five years later, he sold his remaining winnings--fifteen annual payments of $450,000 each--to Woodbridge Financial Corporation for a $3.95 million lump sum. He reported this payment on his tax return as ordinary income, but he changed his mind several years later and sought a refund of some $305,000, claiming that the lottery payment was a capital gain. (2) Strangely, the IRS agreed and refunded his money. Then the IRS had its own change of heart--again several years later--and, in 2001, sued Maginnis, claiming that the refund was erroneous. An Oregon district court agreed with the Service, (3) the Ninth Circuit affirmed, (4) and poor Maginnis had to return his refund.

There is little debate that this is the right result: Maginnis's attempt to convert gambling income into capital gain was a fairly transparent ploy. (5) Nonetheless, Judge Fisher's opinion for the Ninth Circuit, which sets out a two-factor test for whether a gain is ordinary income under the "substitute for ordinary income" doctrine, is problematic. This Comment argues that an alternative approach that analyzes the transaction by which Maginnis received his lottery right may better explain and confine the use of the notoriously murky "substitute for ordinary income" doctrine.

Part I of the Comment discusses the "substitute for ordinary income" doctrine. Part II describes Maginnis's two-pronged test for applying the doctrine and points out the economic and doctrinal difficulties with that test. Part III proposes an alternate analysis that better achieves the policies of the "substitute for ordinary income" doctrine.

I

The Ninth Circuit sided with the IRS on the basis of the "substitute for ordinary income" doctrine, which holds that "'lump sum consideration [that] seems essentially a substitute for what would otherwise be received at a future time as ordinary income' may not be taxed as a capital gain." (6) A classic example is that of an employee who sells his rights to collect future wages: He will receive ordinary income, not capital gain, because the payment is a mere substitute for his right to receive ordinary income. (7)

This doctrine is usually traced to two leading cases: Hort v. Commissioner, which held that a payment to cancel a lease was ordinary income, (8) and Commissioner v. P.G. Lake, Inc., which held that the assignment of a right to receive (some of) the proceeds of future sales of oil also created ordinary income. (9) In both cases, the taxpayer attempted to secure capital gains treatment by selling future rights to receive ordinary income. If this were allowed, virtually no one would have to pay tax on ordinary income; any such income could be packaged, assigned, and transformed into capital gain. (10) The "substitute for ordinary income" doctrine sprung up to prevent this abuse.

The problem with the doctrine is that every capital asset is a substitute for ordinary income; read literally, the doctrine would completely swallow the concept of capital gains. A commercial building is worth only as much as the present value of its future leases--but those lease payments are ordinary income, while the building is a capital asset. The Fifth Circuit long ago noted this absurdity, explaining that "[t]he only commercial value of any property is the present worth of future earnings or usefulness," and quoting Lord Coke as asking, "[W]hat is land but the profits thereof?." (11)

The doctrine thus has little explanatory power. Instead, it lends itself to ad hoc decision making: "[C]ourts must locate the boundary case by case, a process that can yield few generalizations because there are so many relevant but imponderable criteria." (12) An overbroad "substitute for ordinary income" doctrine, besides being analytically unsatisfactory, would create the potential for the abuse of treating capital losses as ordinary. (13) The difficulty, then, is finding a way to appropriately cabin the doctrine to prevent abuses without allowing it to consume the entire notion of capital assets.

II

To limit the doctrine and avoid these difficulties, the Ninth Circuit in Maginnis identified two factors that characterize an asset as capital: first, that the taxpayer made "any underlying investment of capital" in exchange for the asset and, second, that the sale "reflect[ed] an accretion in value over cost to any underlying asset." (14) While the court qualified these factors, noting that "we do not hold that they will be dispositive in all cases," it nonetheless found them "crucial" to its decision. (15) At first glance, this test might seem to bring some clarity to the extremely murky theory of substitutes for ordinary income. But on closer examination, each prong of the Ninth Circuit's test proves to be untenable.

The first prong of the Maginnis test requires that the taxpayer make an "underlying investment in exchange for a right to future payments." (16) This, presumably, aims to distinguish capital assets, like stock, from noncapital assets, like assignments of future wages. But such a test is both over- and underinclusive.

First, this prong of the test does not explain the result in many standard cases. The taxpayer in P.G...