Lattera v. C.I.R.

• Decision Date: 14 February 2006
• Docket Number: No. 04-4721.,04-4721.
• Citation: 437 F.3d 399
• Parties: George LATTERA; Angeline Lattera, Appellants v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Third Circuit

437 F.3d 399

George LATTERA; Angeline Lattera, Appellants v. COMMISSIONER OF INTERNAL REVENUE.

No. 04-4721.

United States Court of Appeals, Third Circuit.

Argued January 9, 2006.

Filed February 14, 2006.

Mark E. Cedrone, (Argued), Cedrone & Janove, Philadelphia, PA, for Appellants.

Eileen J. O'Connor, Assistant Attorney General, Regina S. Moriarty, (Argued), Richard Farber, United States Department of Justice, Tax Division, Washington, DC, for Appellee.

Before BARRY and AMBRO, Circuit Judges, and DEBEVOISE,^* District Judge.

AMBRO, Circuit Judge.

Lottery winners, after receiving several annual installments of their lottery prize, sold for a lump sum the right to their remaining payments. They reported their sale proceeds as capital gains on their tax return, but the Internal Revenue Service (IRS) classified those proceeds as ordinary income. The substitute-for-ordinary-income doctrine holds that lump-sum consideration substituting for something that would otherwise be received at a future time as ordinary income should be taxed the same way. We agree with the Commissioner of the IRS that the lump-sum consideration paid for the right to lottery payments is ordinary income.

I. Factual Background and Procedural History

In June 1991 George and Angeline Lattera turned a one-dollar lottery ticket into $9,595,326 in the Pennsylvania Lottery. They did not then have the option to take the prize in a single lump-sum payment, so they were entitled to 26 annual installments of $369,051.

In September 1999 the Latteras sold their rights to the 17 remaining lottery payments to Singer Asset Finance Co., LLC for $3,372,342. Under Pennsylvania law, the Latteras had to obtain court approval before they could transfer their rights to future lottery payments, and they did so in August 1999.

On their joint tax return, the Latteras reported this sale as the sale of a capital asset held for more than one year. They reported a sale price of $3,372,342, a cost or other basis of zero, and a long-term capital gain of the full sale price. The Commissioner determined that this sale price was ordinary income. In December 2002 the Latteras were sent a notice of deficiency of $660,784.¹

In March 2003 the Latteras petitioned the Tax Court for a redetermination of the deficiency. The Court held in favor of the Commissioner. The Latteras now appeal to our Court.

II. Jurisdiction and Standard of Review

The Tax Court had subject matter jurisdiction under I.R.C. § 7442. Because its decision was final, we have appellate jurisdiction under I.R.C. § 7482(a)(1). The Latteras reside in our Circuit, so venue is proper under I.R.C. § 7482(b)(1)(A).

We review the Tax Court's legal determinations de novo, but we do not disturb its factual findings unless they are clearly erroneous. Estate of Meriano v. Comm'r, 142 F.3d 651, 657 (3d Cir.1998).

III. Discussion

The lottery payments the Latteras had a right to receive were gambling winnings, and the parties agree that the annual payments were ordinary income. Cf. Comm'r v. Groetzinger, 480 U.S. 23, 32 n. 11, 107 S.Ct. 980, 94 L.Ed.2d 25 (1987) (calling a state lottery "public gambling" in a case treating gambling winnings as ordinary income). But the Latteras argue that when they sold the right to their remaining lottery payments, that sale gave rise to a long-term capital gain.

Whether the sale of a right to lottery payments by a lottery winner can be treated as a capital gain under the Internal Revenue Code is one of first impression in our Circuit. But it is not a new question. Both the Tax Court and the Ninth Circuit Court of Appeals have held that such sales deserve ordinary-income treatment. United States v. Maginnis, 356 F.3d 1179, 1181 (9th Cir.2004) ("Fundamental principles of tax law lead us to conclude that [the] assignment of [a] lottery right produced ordinary income."); Davis v. Comm'r, 119 T.C. 1, 1, 2002 WL 1446631 (2002); see also Watkins v. Comm'r, 88 T.C.M. (CCH) 390, 393 (2004); Clopton v. Comm'r, 87 T.C.M. (CCH) 1217, 1217 (2004); Boehme v. Comm'r, 85 T.C.M. (CCH) 1039, 1041 (2003).

The Ninth Circuit's reasoning has drawn significant criticism, however. See Matthew S. Levine, Case Comment, Lottery Winnings as Capital Gains, 114 Yale L.J. 195, 197-202 (2004); Thomas G. Sinclair, Comment, Limiting the Substitute-for-Ordinary Income Doctrine: An Analysis Through Its Most Recent Application Involving the Sale of Future Lottery Rights, 56 S.C. L.Rev. 387, 421-22 (2004). In this context, we propose a different approach. We begin with a discussion of basic concepts that underlie our reasoning.

A. Definition of a capital asset

A long-term capital gain (or loss) is created by the "sale or exchange of a capital asset held for more than 1 year." I.R.C. § 1222(3). Section 1221 of the Internal Revenue Code defines a capital asset as "property held by the taxpayer (whether or not connected with his trade or business)." This provision excludes from the definition certain property categories, none of which is applicable here.²

A 1960 Supreme Court decision suggested that this definition can be construed too broadly, stating that "it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset." Comm'r v. Gillette Motor Transp., Inc., 364 U.S. 130, 134, 80 S.Ct. 1497, 4 L.Ed.2d 1617 (1960). The Court noted that it had "long held that the term `capital asset' is to be construed narrowly in accordance with the purpose of Congress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year." Id. But the Supreme Court's decision in Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 108 S.Ct. 971, 99 L.Ed.2d 183 (1988), at least at first blush, seems to have reversed that narrow reading. Arkansas Best suggests instead that the capital-asset definition is to be broadly construed. See id. at 218, 108 S.Ct. 971 ("The body of § 1221 establishes a general definition of the term `capital asset,' and the phrase `does not include' takes out of that broad definition only the classes of property that are specifically mentioned.").

B. The substitute-for-ordinary-income doctrine

The problem with an overly broad definition for capital assets is that it could "encompass some things Congress did not intend to be taxed as capital gains." Maginnis, 356 F.3d at 1181. An overly broad definition, linked with favorable capital-gains tax treatment, would encourage transactions designed to convert ordinary income into capital gains. See id. at 1182. For example, a salary is taxed as ordinary income, and the right to be paid for work is a person's property. But it is hard to conceive that Congress intends for taxpayers to get capital-gains treatment if they were to sell their rights (i.e., "property held by the taxpayer") to their future paychecks. See 2 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 47.1 (3d ed.2000).

To get around this problem, courts have created the substitute-for-ordinary-income doctrine. This doctrine says, in effect, that "`lump sum consideration [that] seems essentially a substitute for what would otherwise be received at a future time as ordinary income' may not be taxed as a capital gain." Maginnis, 356 F.3d at 1182 (quoting Comm'r v. P.G. Lake, Inc., 356 U.S. 260, 265, 78 S.Ct. 691, 2 L.Ed.2d 743 (1958)) (alteration in original).

The seminal substitute-for-ordinary-income case is the 1941 Supreme Court decision in Hort v. Commissioner, 313 U.S. 28, 61 S.Ct. 757, 85 L.Ed. 1168 (1941). Hort had inherited a building from his father, and one of the building's tenants canceled its lease, paying Hort a cancellation fee of $140,000. Id. at 29, 61 S.Ct. 757. Hort argued that the cancellation fee was capital gain, but the Court disagreed, holding that the cancellation fee was ordinary income because the "cancellation of the lease involved nothing more than relinquishment of the right to future rental payments in return for a present substitute payment and possession of the leased premises." Id. at 32, 61 S.Ct. 757.

The Supreme Court bolstered the doctrine in Lake. P.G. Lake, Inc. was an oil- and gas-producing company with a working interest in two oil and gas leases. 356 U.S. at 261-62, 78 S.Ct. 691. It assigned an oil payment right "payable out of 25 percent of the oil attributable to [Lake's] working interest in the two leases." Id. at 262, 78 S.Ct. 691. Lake reported this assignment as a sale of property taxable as capital gain. Id. But the Court disagreed, holding that the consideration received was taxable as ordinary income. Id. at 264, 78 S.Ct. 691. The Court's reasoning gave full voice to the substitute-for-ordinary-income doctrine: "The lump sum consideration seems essentially a substitute for what would otherwise be received at a future time as ordinary income." Id. at 265, 78 S.Ct. 691.

Our Court has rarely dealt with this doctrine. We have only cited Lake twice—once in 1958, Tunnell v. United States, 259 F.2d 916, 918 (3d Cir.1958), and once in 1974, Hempt Bros., Inc. v. United States, 490 F.2d 1172, 1176, 1178 (3d Cir. 1974) (citing Lake with approval, but deciding the case under a § 351—nonrecognition of transfers of property for corporate stock—analysis).

The Latteras argue that the substitute-for-ordinary-income doctrine, which takes "property held by the taxpayer" outside the statutory capital-asset definition, did not survive Arkansas Best. But although Arkansas Best ostensibly cabined the exceptions to the statutory definition, it made clear that the Hort-Lake "line of cases, based on the premise that § 1221 `property' does not include claims or rights to ordinary income, ha[d] no application in the present context." Arkansas Best, 485 U.S. at 217 n. 5, 108 S.Ct....