Lottery Winners Lose Tax Appeal Before 3rd Circuit

Shannon P. Duffy

The Legal Intelligencer

Lottery winners cannot claim a "capital gain" when they sell off the rights to future annual payments, but instead must treat that lump sum as "ordinary income," a federal appeals court has ruled.

In Lattera v. Commissioner of Internal Revenue, the 3rd U.S. Circuit Court of Appeals became the second federal appellate court to agree with the IRS' application of the "substitute-for-ordinary-income doctrine" in such cases.

But in doing so, the 3rd Circuit's unanimous three-judge panel said it recognized that the 2004 decision by the 9th Circuit in United States v. Maginnis "has drawn significant criticism" from commentators.

"While we agree with Maginnis' result, we do not simply adopt its reasoning," Judge Thomas L. Ambro wrote.

Instead, the 3rd Circuit fashioned its own test for deciding 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.

But in the end, the 3rd Circuit reached the same result -- that a lottery winner's acceptance of a lump sum in return for the rights to future payments cannot be deemed a capital gain.

For George and Angeline Lattera, the ruling is a costly one because it upholds the IRS' assessment of a tax deficiency of more than $660,000.

According to court papers, the Latteras paid $1 for a Pennsylvania Lottery ticket in June 1991 that yielded more than $9.5 million in winnings.

Under lottery rules, the Latteras did not have the option to take the prize in a single, lump-sum payment, but instead were promised 26 annual installments of $369,051.

In 1999, the Latteras sold their rights to the 17 remaining lottery payments to Singer Asset Finance Co. for more than $3.3 million.

On their joint tax return, the Latteras reported the sale as the sale of a capital asset held for more than one year. But the IRS disagreed and notified the couple that they owed an additional $660,784 in taxes because the sale price was ordinary income.

Since then, the IRS has won a string of similar cases against lottery winners before the U.S. Tax Court.

But until 2004, none of the federal appeals courts had addressed the issue.

The 9th Circuit's decision in Maginnis involves a set of facts strikingly similar to the Latteras' case, in which an Oregon family won $9 million in a lottery that promised 20 annual installments of $450,000.

After receiving five payments, the Maginnises assigned their right to receive the remaining 15 payments to a third party for a lump sum of more than $3.9 million. Although they originally reported the payment as ordinary income, they later amended a tax return to reclassify the amount as a long-term capital gain and requested a refund of more than $300,000.

The IRS at first issued the refund check, but it later filed suit to recover it, arguing that the sale of future lottery winning payments cannot be treated as a capital gain.

The 9th Circuit sided with the IRS and applied the substitute-for-ordinary-income doctrine.

But the court said it 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."

As a result, the Maginnis court opted instead for a case-by-case approach and announced two factors, which it characterized as "crucial" to its conclusion, but not "dispositive in all cases."

First, the court noted that the Maginnises "did not make any underlying investment of capital" in return for the receipt of the lottery right. Second, it found that the sale "did not reflect an accretion in value over cost to any underlying asset."

Now the 3rd Circuit has found that the 9th Circuit's approach has been the subject of some valid criticism in a pair of student law review articles -- Matthew S. Levine's case comment "Lottery Winnings as Capital Gains" in the 2004 Yale Law Journal and Thomas G. Sinclair's comment titled "Limiting the Substitute-for-Ordinary Income Doctrine: An Analysis Through Its Most Recent Application Involving the Sale of Future Lottery Rights" in the 2004 South Carolina Law Review.

Ambro, in an opinion joined by Judge Maryanne Trump Barry and visiting U.S. District Judge Dickinson R. Debevoise of the District of New Jersey, found that both of the 9th Circuit's factors were potentially faulty.

"The first factor -- underlying investment of capital -- would theoretically subject all inherited and gifted property (which involves no investment at all) to ordinary-income treatment," Ambro wrote.

The second factor also posed "analytical problems," Ambro found, because "not all capital assets experience an accretion in value over cost. For example, cars typically depreciate, but they are often capital assets."

As a result, Ambro set out to "craft a rubric" that would offer guidance in future cases, saying "it is both unsatisfying and unhelpful to future litigants to declare that we know this to be ordinary income when we see it."

In doing so, Ambro took some cues from Sinclair's law review comment and a 1976 decision from the 2nd Circuit in a securities case.

In Exchange National Bank of Chicago v. Touche Ross & Co., the 2nd Circuit was forced to decide whether a note was a security for purposes of §10(b) of the 1934 Securities and Exchange Act.

To do so, the court created a "family resemblance" test, presuming that notes of more than nine-months' maturity were securities; listing types of notes that it did not consider securities; and declaring that a note with maturity exceeding nine months that "does not bear a strong family resemblance to these examples" was a security.

Ambro found that the U.S. Supreme Court has since adopted the test and added four factors to guide the "resemblance" analysis -- the motivations of the buyers and sellers; the plan of distribution; the public's reasonable expectations; and applicable risk-reducing regulatory schemes.

Using analogous reasoning, Ambro found that "several types of assets we know to be capital: stocks, bonds, options and currency contracts."

Likewise, Ambro said, "there are several types of rights that we know to be ordinary income," including rental income and interest income.

For the "in-between" transactions that bear no "family resemblance" to the items in either category, such as contracts and payment rights, Ambro said that courts should consider two factors - the type of "carve-out" and the character of asset.

In a footnote, Ambro said "we borrow these factors from Thomas Sinclair's comment ... but we differ from him slightly in the way we apply the character factor."

Carve-outs, Ambro said, come in two forms -- horizontal and vertical. In the horizontal form, the owners disposes of only a portion of the interest, whereas the vertical form results in a complete disposition of the person's interest in the property.

Horizontal carve-outs "typically lead to ordinary-income treatment," Ambro said, but a vertical carve-out is more complicated.

"Because a vertical carve-out could signal either capital gains or ordinary-income treatment ... we proceed to the second factor -- character of the asset -- to determine whether the sale proceeds should be taxed as ordinary income or capital gain," Ambro wrote.

The key distinction, Ambro found, is whether the asset represents "earned income" or "a right to earn income."

Examples of earned income include rental income and stock dividends, Ambro said, while ownership of a patent would represent a right to earn income.

Applying that reasoning to the Latteras' case, Ambro found that "the right to receive annual lottery payments does not bear a strong family resemblance to either the 'capital assets' or the 'income items' listed at the polar ends of the analytical spectrum."

Since the Latteras sold their right to all their remaining lottery payments, Ambro found that the transaction was a vertical carve-out that "could indicate either capital gains or ordinary-income treatment."

But because a right to lottery payments is a right to earned income -- since the payments will keep arriving due simply to ownership of the asset -- Ambro concluded that the lump-sum payment received by the Latteras "should receive ordinary-income treatment."

Ambro found that the result was a fair one because it "ensures that the Latteras do not receive a tax advantage as compared to those taxpayers who would simply choose originally to accept their lottery winning in the form of a lump-sum payment."

The Latteras were represented in the appeal by attorney Mark E. Cedrone of Cedrone & Janove.

Justice Department attorney Regina S. Moriarty argued the case for the IRS.