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Saturday, November 12, 2005

Lottery Luck Runs Out in Recent Case

After the lottery winner checks to see how much he won, his or her next thoughts turn to what will be left after taxes. Since lottery payouts are taxed as ordinary income, a good piece of each payment goes to the IRS.

Some lottery winners sell their right to payments over many years to a third party buyer. The issue arises whether such sale can be taxed as a sale of a long term capital asset (if the original payout stream was held for long enough) so as qualify for the 15% maximum tax on individual capital gains. These rates can be less than 1/2 of the ordinary income rates.

In conformance to other recent rulings, the U.S. Tax Court has confirmed its reading of the law that long term capital gain treatment is not available. The Tax Court applied the "substitute for ordinary income doctrine" to disallow capital gain treatment. Under this doctrine, a court will narrowly construe the term "capital asset" when a taxpayer makes an attempt to transform ordinary income into capital gain. Prebola v. Commissioner, TC Memo 2005-261 , 2005 RIA TC Memo ¶2005-261
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