Sale of lottery payments produces ordinary income.

A and B won the state lottery, entitling them to 26 annual payments of $369,000. Eight years later, they sold their right to receive all remaining payments for $3.3 million. They reported the sales price as a capital gain; however, the IRS and the Tax Court ruled that the amount was ordinary income. A and B appealed to the Third Circuit.

Analysis

Whether a sale of the right to lottery payments results in capital gain or ordinary income is one of first impression in the Third Circuit. Both the Tax Court and the Ninth Circuit have previously held such sales deserve ordinary-income treatment; see Maginnis, 356 F3d 1179 (9th Cir. 2004). In Maginnis, the court relied on the substitute-for-ordinary-income doctrine. Under that doctrine, lump sums received as a substitute for future ordinary income are not capital gains. However, the court 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" For example, a stock's value is the present discounted value of the company's future profits. Thus, the Ninth Circuit opted for "case-by-case judgments as to 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"

In Exch. Nat'l Bank of Chi., 544 F2d 1126 (2d Cir. 1976), the Second Circuit created a "family resemblance" test for deciding whether a note was a security. The test (1) presumes that notes of more than nine months' maturity were securities, (2) lists various types of those notes that it did not consider securities and (3) declares that a note with maturity exceeding nine months that "does not bear a strong family resemblance to these examples" was a security. The Supreme Court adopted this test in 1990.

Here, the Third Circuit adopted a family resemblance test. Under that test, stock and "things" that look and act like stock receive capital-gain treatment. For the in-between transactions that do not bear a family resemblance to the items in either category, like contracts and payment rights, two factors assist in the analysis: (1) type of "carve-out" and (2) character of asset.

Horizontal vs. Vertical Carve-Out

A horizontal carve-out is one in which the owner disposes of part of his interest and also retains a portion of it. A vertical carve-out is a complete disposition of a person's interest in property. In lottery terms, this is what happened here and in Maginnis--the lottery winners sold the rights to all their remaining lottery payments.

Horizontal carve-outs typically lead to ordinary-income treatment. However, as Maginnis demonstrates, a vertical carve-out does not necessarily mean that the transaction receives capital-gain treatment. Thus, if there is a vertical carve-out, the second factor--character of the asset--determines whether the sale proceeds should be taxed as ordinary income or capital gain.

Character of Asset

Assets that constitute a right to earn income merit capital-gain treatment, while those that are a right to earned income merit ordinary-income treatment. For example, when an employee is paid a termination fee for a personal-services contract, that employee still possesses the asset (the right to provide certain personal services); the money (the termination fee) has already been earned and will simply be paid. The employee no longer has to perform any more services in exchange for the fee. Thus, the termination fees are rights to earned income and are treated as ordinary income; see, e.g., Elliott, 431 F2d 1149 (10th Cir. 1970).

Here, A and B sold their right to all remaining lottery payments; thus, under the Third Circuit's analysis, the sale is a vertical carve-out, which could indicate either capital-gain or ordinary-income treatment. Because a right to lottery payments is a right to earned income (i.e., the payments will keep arriving due simply to ownership of the asset), the Third Circuit ruled that the lump-sum payment received should be treated as ordinary income.

GEORGE LATTERA, 3d Cir. (2/14/06)

David O'Driscoll, J.D., LL.M.