Refining the definition of a capital asset.

Section 1221 of the tax code broadly defines a capital asset. Over time the courts have attempted to narrow that definition and eliminate confusion. Recently a Third Circuit Court of Appeals ruling brought further clarification.

In June 1991 George and Angeline Lattera purchased a Pennsylvania lottery ticket for $1 and won $9,595,326. In September 1999 they received court approval to sell the rights to the remaining 17 annual payments of $369,051 for $3,372,342. They reported this transaction as a long-term capital gain. The IRS reclassified it as ordinary income and assessed a $660,784 deficiency. The taxpayers petitioned the Tax Court to eliminate the deficiency; the court sided with the IRS. The couple then appealed to the Third Circuit.

Result. For the IRS. Both the Tax Court and the Ninth Circuit Court of Appeals have ruled that the sale of lottery winnings generates ordinary income. Because of the harsh criticism of these decisions, the Third Circuit reexamined the issue to clarify what property qualifies as a capital asset.

In Hort and Lake, the Supreme Court narrowed the definition of capital asset by establishing the "substitute for ordinary income" exception. Under this exception, the sale of property that generates a receipt which is a substitute for future ordinary income is not a sale of a capital asset. It has been suggested that the Supreme Court's 1988 decision in Arkansas Best rejected this exception. Although most courts do not fully discuss the exemption's limits or reconcile differences in prior decisions, they find that the exception survived the Arkansas Best holding.

In the current case, the Third Circuit provided an analytical framework for addressing this issue. According to the appeals court, certain assets (stocks, bonds and options) are clearly capital and others (interest and rent) are unmistakably ordinary income. When disputes arise, a court should consider the nature of the property. If the property more closely resembles a capital asset, it is capital; if it more closely resembles ordinary income property, it is ordinary income.

If the property does not closely resemble either extreme, then the court should determine whether the transaction created a horizontal or a vertical carve-out. A horizontal carve-out, which disposes of only part of the taxpayer's interest in the property, generates ordinary income. In a vertical carve-out, which disposes of all of the taxpayer's remaining rights in the property, the court must determine whether the taxpayer disposed of a right to future income that had previously been earned--which generates ordinary income--or a right to earn future income--which creates capital gains.

A winning lottery ticket does not closely resemble either capital or ordinary income. Therefore, the court examined the type of carve-out the transaction created. The taxpayers sold all the remaining installments of their winnings; thus, they created a vertical carve-out. Since the purchaser receives the installments automatically, the taxpayers sold a right to future income. When they sold the remaining installments, the taxpayers received ordinary income.

The Third Circuit's approach, which is new, attempts to reconcile all of the major cases. If other courts adopt this approach, taxpayers will need to change their analysis of disputed property and present different arguments to support their capital asset treatment.

* George Lattera v. Commissioner, 437 F3d 399 (CA-3).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

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Source: IRS, www.irs.gov

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Source: IRS, www.irs.gov.