Sale of future lottery payments is ordinary income.

Lottery winnings generally are taxed as ordinary income in the year a taxpayer receives them. But what happens if the winner sells the right to receive future lottery payments in exchange for a lump sum amount? Is the transaction eligible for capital gains treatment?

In 1991 Mr. and Mrs. Macginnis and their sons were multi-million-dollar winners in the Oregon state lottery. Mr. Macginnis' share was $9 million, payable in 20 equal annual installments of $450,000. After receiving 5 payments, Macginnis sold his right to receive the remaining 15 payments to a third party for a $3,950,000 lump sum.

Macginnis reported the first 5 payments as ordinary income. Initially he also reported the lump sum in the same way. However, he later filed an amended return treating the lump sum as a capital gain. Based on his amended return, the IRS issued Macginnis a $352,517 refund. It then filed suit to recover the refund plus the costs of bringing the action.

Result. For the IRS. The taxpayer argued the right to the lottery payments was a capital asset under IRC section 1221. However, the district court held that the assignment of the right to receive the remaining payments did not convert the character of the income from ordinary to a gain from the sale of a capital asset. The court said capital gains treatment was not appropriate since no asset had appreciated. Instead, the transaction involved an assignment of an established, noncontingent right to receive future payments of ordinary income. Based on these findings, the court ordered the taxpayer to repay the refund to the IRS.

This ruling would apply to any transfer of a stream of future payments for a lump sum, such as annual lottery payments or a personal injury award settlement made through annual payments. See also Davis, 119 TC No. 1 (2002).

* Macginnis, 89 AFTR 2d 2002-3028.

Prepared by James Ozello, Esq., Ozello Tax and Legal Consulting, Ringwood, New Jersey.