Taxing Lottery Winnings

To: Bruce Wilson

From: Matt Thurston, CPA

Date: February 27, 2011

Subject: Taxing lottery winnings

I understand that you, Mr. Bruce Wilson, won $2 million dollars in the state lottery. As a result, you selected the option to receive the prize money in annual installments of $100,000 over the next 20 years. The first three installments of $100,000 were reported as ordinary income on your tax return. After receiving the third installment, you sold the remaining $1.7 million of payments to a third party for a lump sum of $1 million.

The tax question at hand involves how to properly report the $1 million lump sum payment in your (Mr. Wilson's) annual income tax return. Specifically, it must be determined whether the $1 million should be reported as a long-term capital gain on your tax return at a rate of 15 percent, or as ordinary income at the marginal tax rate of 35 percent. In the following paragraphs, I will produce the findings of my research as it relates to this question and explain the legal requirement for reporting this money on your tax return.

The tax laws pertaining to the issue at hand are found in the Internal Revenue Code of the United States Code 26 U.S.C.S. §1221, §1222, and §64. The issue is further explored in several United States Court of Appeal cases, most notably Roland and Marie Womack vs. Commissioner of I.R.S. (R. Womack, CA-11, 2007 USTC ¶29,294, 510 F.3d 1295, 100 AFTR2d 2007-250) and the United States of America versus J. Michael Maginnis and Janet Y. Maginnis (J. Maginnis, CA-9, 2004 USTC ¶1,400, 356 F.3d 1179, 93 AFTR2d 2004-660).

Pursuant to 26 U.S.C.S. §1221, lottery winnings do not fall under the definition of a capital asset, and therefore cannot be claimed as a capital gain. In 26 U.S.C.S. §1221, the term "capital asset" is defined as property held by the taxpayer, whether or not connected with his trade or business, subject to several statutory exceptions that are not relevant to the issue at hand. This definition could be read broadly, however, the definition has never been read so broadly as to include lottery winnings because when a capital asset is sold it would capture the increase in value of the underlying asset, whereas lottery winnings have no underlying investment of capital, and therefore cannot be considered capital assets. To help put this into perspective, an example of a capital asset would be shares of stock, which have an underlying value. If 100 shares of Apple stock were purchased and held for more than a year, they could be sold and claimed as a capital gain, in which the capital gain would be the difference between the selling-price and the stock purchase price, along with any sales charges that were related to the transaction. The primary distinguishing factor between stock sales and lottery winnings, is that stocks have a tangible underlying value at the time of purchase, whereas lottery