Tuesday, May 23, 2006

DID HIS LUCK RUN OUT?

Roger L. Watkins won over $12 million in the Colorado State Lottery, which he was to receive in twenty-five annual payments. After receiving six installments, Mr. Watkins divorced his wife and received half of the lottery rights. He then sold his half interest in the remaining payments to a third party for a lump sum.

Lottery payments are subject to federal income tax at ordinary income tax rates. These rates can be over twice as high as current maximum capital gains rates. Mr. Watkins claimed, rightly so, that his right to the annual payments was an asset, and that he sold it. If the lottery rights are a capital asset, the sale of those rights should generate capital gain, and since Mr. Watkins held those rights for over a year, he would qualify for long term capital gain treatment at the lower rates.

Section 1221 of the Internal Revenue Code defines a capital asset - it is "property held by the taxpayer (whether or not connected with his trade or business)" that does not fit within certain exceptions listed in the statute (such as inventory property). Based on this definition, Mr. Wakins can report the gain from the sale of the lottery rights as long term capital gain, and that is what he did. The IRS challenged this treatment, and it ended up before the 10th Circuit Court of Appeals.

Lucky in the lottery, unlucky in love (the divorce)...unlucky in appellate court. The appeals court applied the substitute-for-ordinary-income doctrine to hold that lottery payment rights are NOT a capital asset (or at least do not generate capital gain upon sale), even though there is no such exception from capital asset treatment in the statute. Under this doctrine, courts have indicated that when a lump sum payment is received in exchange for what would otherwise be received at a future time as ordinary income, capital gains treatment of the lump sum is inappropriate. This is so because the consideration is paid for the right to receive future income, not for an increase in the value of income-producing property.

WATKINS v. COMM., 97 AFTR 2d 2006-XXXX, (CA10), 05/10/2006
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