Ismat M. Abeid purchased a lottery ticket in 1992 for $1 while living in California. He was luckier than most and won twenty annual payments of $722,000 each. He was not given a choice of payment plans but was required to accept the prize as 20 payments. He subsequently moved to Israel, where he is a citizen.
During the tax years 1997, 1998 and 1999, Abeid filed U.S. income tax returns in which he took the position that the $722,000 payments each year were not taxable in the United States. The IRS disagreed and determined a deficiency of $216,600 for each of the three years.
Result. For the IRS. Abeid argued the lottery payments were an annuity under Article 20(2) of the treaty, which says “alimony and annuities paid to an individual who is a resident of one of the contracting states shall be taxable only in the contracting state.” If this clause applied, the lottery payments would have been taxable to Abeid only in Israel, where he resided during the years at issue. Abeid made several different arguments to support the position the lottery payments were an annuity under the treaty, but the court disagreed with each one.
Abeid’s first argument relied on a definition of the term annuity from outside the treaty in Estate of Gribauskas v. Commissioner . However, the language of the treaty implies that any term used and defined in the treaty should employ that definition. The term annuities is defined in the treaty as “a stated sum paid periodically at stated times during life, or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered).”
The key question was whether the payments were “in return for adequate and full consideration.” Since this term was not defined in the treaty, the court used the meaning of the term in U.S. tax law. It determined that adequate and full consideration would require a bona fide and arm’s-length price and must be reasonably related to the value of the property acquired.
Abeid said the California lottery had received “adequate and full consideration.” First, he argued the treaty did not require the payor to receive such consideration from the recipient of the lottery payments and, in fact, that the lottery did receive it from the contributions of all lottery players.
Abeid then argued that if the consideration had to come from the recipient of the lottery payment, his $1 ticket purchase was “adequate and full consideration” because it was the full, undiscounted price for the ticket. He supported this claim by citing Estate of Shackleford. In this case, the estate tried to exclude the value of uncollected lottery payments (an annuity) because the decedent had paid only the $1 purchase price of the lottery ticket in exchange for the payments. Under IRC section 2039(b), the gross estate includes a proportionate share of an annuity if the purchase price was paid by more than one party. The court in Abeid’s case pointed out that the issue in Shackleford was whether anyone else had paid a portion of the cost of the annuity, not whether the amount paid for the annuity constituted “adequate and full consideration.”
The Tax Court disagreed with both of Abeid’s arguments without addressing who was required to provide the consideration. The court reasoned the purchase price of the ticket was not in exchange for the lottery winnings but in exchange for a chance—that is, a wager. Each ticket purchaser provided “adequate and full consideration” for his or her own chance or wager. Similarly, Abeid received a chance in exchange for his $1. He won the wager, which is a separate taxable event under U.S. law. This separate event produces gambling income, which is not excluded under the U.S./Israel treaty. In addition, the $1 purchase price was deemed to have had no “reasonable relationship” to the value of the lottery payments he won.
Nonresident aliens who choose to wager on U.S. lotteries should be aware the language in the U.S./Israel treaty, the U.S. Model Income Tax Treaty and most other treaties in force at this time does not exclude this income from taxation in the United States. Lottery authorities also may need to consider federal withholding obligations when making payments to nonresident alien recipients as a consequence of this ruling.
Ismat M. Abeid v. Commissioner, 122 TC 404.
Prepared by Cheryl Metrejean, CPA, PhD, assistant professor of accountancy, Texas State University, San Marcos.