Davis v. Comm'r of Internal Revenue

• Decision Date: 03 July 2002
• Docket Number: No. 6389–01.,6389–01.
• Citation: 119 T.C. No. 1,119 T.C. 1
• Parties: James F. DAVIS and Dorothy A. Davis, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

119 T.C. 1

119 T.C. No. 1

James F. DAVIS and Dorothy A. Davis, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 6389–01.

United States Tax Court.

July 3, 2002.

Taxpayer petitioned for redetermination of deficiencies arising from unreported income from sale of rights to receive lottery winnings. The Tax Court, Chiechi, J., held that amount received from sale of rights was ordinary income to taxpayer.

Decision for IRS. Ps assigned to S their right to receive a portion of each of certain future annual lottery payments in exchange for a lump-sum payment to them by S of $1,040,000.Held: S paid Ps a lump-sum amount for the right to receive certain future ordinary income. Held, further, Ps' right to receive certain future annual lottery payments does not constitute a capital asset within the meaning of sec. 1221, I.R.C. Held, further, the $1,040,000 that Ps received from S is ordinary income.Donald J. Gary, Jr., for petitioners.

Thomas J. Fernandez, for respondent.

OPINION

CHIECHI, J.

Respondent determined a deficiency in petitioners' Federal income tax (tax) for 1997 in the amount of $210,166.

We must determine whether the amount that petitioners received in exchange for the assignment of their right to receive a portion of certain future annual lottery payments is ordinary income or capital gain.¹ We hold that that amount is ordinary income.

Background

This case was submitted fully stipulated. The facts that have been stipulated are so found except as stated herein.

Petitioners resided in Lake Arrowhead, California, at the time they filed the petition.

On July 10, 1991, petitioner James F. Davis (Mr. Davis) won $13,580,000 in the California State Lottery's On–Line LOTTO game (lottery). Pursuant to certain rules and regulations governing the California State Lottery (CSL) in effect during 1991, Mr. Davis became entitled upon winning the lottery to receive the $13,580,000 in 20 equal annual payments of $679,000 (annual lottery payments), less certain tax withholding. At the time that Mr. Davis won the lottery, CSL did not offer to any lottery winner the option to elect to receive a single lump-sum payment of the lottery prize.²

On December 13, 1991, CSL sent Mr. Davis a letter which stated, inter alia:

This letter certifies that on July 10, 1991 you won $13,580,000 [sic] the California State Lottery's On–Line LOTTO game. You have already received your first payment of $679,000, less 20% for Federal tax withholding. In addition, you will receive nineteen (19) subsequent annual payments of $679,000 each, as near as possible to the anniversary of the day on which you won your prize, $13,580,000. Please maintain this letter for your permanent record.

In accordance with Internal Revenue Service regulations, all payments are subject to appropriate Federal tax withholdings. Deductions authorized by California statutes, if such are appropriate, will also be made.

Your rights under this agreement cannot be assigned, but all remaining rights do become a part of your estate. This document is not negotiable.

On June 16, 1997, at a time when petitioners ³ were entitled to receive 14 future annual lottery payments of $679,000 (less certain tax withholding) during the years 1997 through 2010, petitioners and Singer Asset Finance Company, LLC (Singer), entered into an agreement pursuant to which, in exchange for a lump-sum payment to petitioners by Singer of $1,040,000, petitioners assigned to Singer their right to receive a portion (i.e., $165,000 less certain tax withholding) of each of 11 of the future annual lottery payments that they were entitled to receive during the years 1997 through 2007. (We shall refer to the foregoing assignment as petitioners' assignment.) Petitioners thus assigned to Singer the portions of those future annual lottery payments at a discount of $775,000 (i.e., $1,815,000 (total of 11 future annual payments of $165,000) less $1,040,000 (total of the amount that Singer paid to petitioners)). After petitioners' assignment, petitioners were entitled to receive from CSL for each of the years 1997 through 2007 only $514,000 (less certain tax withholding) of each of the $679,000 future annual lottery payments (less certain tax withholding) to which they had been entitled prior to that assignment. After that assignment, CSL was to pay the balance of each of those future annual lottery payments (i.e., $165,000 (less certain tax withholding)) to Singer.

At all relevant times, the laws of the State of California precluded a lottery winner from assigning such person's right to receive future annual lottery payments without obtaining California Superior Court approval. On or about July 22, 1997, petitioners and Singer filed with the California Superior Court for the County of Sacramento (Sacramento County Superior Court) a joint petition “FOR AN ORDER APPROVING VOLUNTARY ASSIGNMENT OF LOTTERY WINNINGS”. On August 1, 1997, Sacramento County Superior Court issued an order approving petitioners' assignment.

Singer issued to petitioners Form 1099–B, Proceeds From Broker and Barter Exchange Transactions (Form 1099–B), for 1997. That Form 1099–B showed gross proceeds from the sale of “Stocks, bonds, etc.” in the amount of $1,040,000.

CSL issued to petitioners Form W–2G, Certain Gambling Winnings (Form W–2G), for 1997. That Form W–2G showed “Gross winnings” from “STATE LOTTERY” of $514,000 and tax withheld of $143,920.

On March 13, 1998, petitioners signed Form 1040, U.S. Individual Income Tax Return, for their taxable year 1997 (petitioners' 1997 joint return). In petitioners' 1997 joint return, they reported petitioners' assignment as a sale of a capital asset held for more than 1 year, a sale price of $1,040,000, a cost basis of $7,009, and long-term capital gain of $1,032,991. In that return, petitioners also reported as ordinary income the $514,000 payment that they received in 1997 from CSL.

In the notice that respondent issued to petitioners with respect to their taxable year 1997, respondent determined, inter alia, the following:

b) It is determined that you [petitioners] received the amount of $1,040,000.00 from Singer Asset Finance Company, for the tax year ended December 31, 1997, in payment of assignment of rights to future lottery payments from the State of California. This amount is determined to be ordinary income because rights to future annual lottery payments do not meet the definition of a capital asset according to the provisions of the Internal Revenue Code. Therefore, income is increased $1,040,000.00 for the year 1997.

Discussion

The parties agree that an amount received as a lottery prize constitutes ordinary income. The parties' dispute is over whether the $1,040,000 that petitioners received in exchange for petitioners' assignment is ordinary income or capital gain.⁴ Resolution of that dispute depends on whether petitioners' right to receive future annual lottery payments constitutes a capital asset within the meaning of section 1221.⁵

Section 1221 defines the term “capital asset” as follows:

SEC. 1221. CAPITAL ASSET DEFINED.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;

(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by—

(A) a taxpayer whose personal efforts created such property,

(B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or

(C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B);

(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1);

(5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by—

(A) a taxpayer who so received such publication, or

(B) a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A).

Petitioners ⁶ contend that their right to receive future annual lottery payments constitutes property held by them and that such property meets the definition of the term “capital asset” in section 1221. Respondent acknowledges that petitioners' right to receive future annual lottery payments is property in the ordinary sense of the word. However, respondent contends that such right does not qualify as a capital asset within the meaning of section 1221. According to respondent, the $1,040,000 that petitioners received from Singer constitutes ordinary income because petitioners received that amount in exchange for their future right to receive ordinary income.

In support of petitioners' position that the $1,040,000 that they received from Singer constitutes capital gain, petitioners rely on Ark. Best Corp. v. Commissioner, 485 U.S. 212, 108 S.Ct. 971, 99 L.Ed.2d 183 (1988). In support of respondent's position that that amount constitutes...