The Massachusetts District Court held in Estate of Donovan v. United States that, for estate tax purposes, the value of a stream of lottery payments due to a decedent must be based on the annuity valuation tables in IRC section 7520 without a discount for lack of marketability.
The decedent, John R. Donovan, won the Massachusetts lottery in January 1999. He received the first of 20 annual payments of $100,000 on the day he won, but died in July. Under Massachusetts law the decedent was prohibited from assigning the lottery payments. Based on this restriction, an appraiser determined the value of the 19 remaining payments was $367,482. The estate used that amount on its return; however, the IRS determined, based on the annuity valuation tables, that the value of the remaining payments was $1,091,553.
The decedent’s estate paid the resulting deficiency and subsequently sought a refund in the Massachusetts District Court. The IRS and the estate executor agreed the lottery payments should be included in the decedent’s gross estate but disagreed as to their valuation. The first issue was whether the lottery payments constituted an annuity. The second was whether the section 7520 annuity valuation tables should be applied or a discount for lack of marketability allowed.
Result. For the IRS. The district court held the payments were an annuity and should be valued in accordance with the section 7520 tables. The provisions of that section define an annuity as “the right to receive a fixed dollar amount at the end of each year during one or more measuring lives or for some other defined period.”
The estate argued that, due to the restrictions on assignment of the
lottery winnings, the “restricted beneficial interest” exception
applied. The exception provides that valuation according to annuity
tables is not required where an interest is restricted by a
contingency, power or other limitations. However, the court noted the
exception applies to restrictions that limit the decedent’s
receipt of payments, not to restrictions that affect his
ability to dispose of payments. Accordingly, the exception
did not apply and the lottery winnings were held to be an annuity.
The court next turned to valuation of the lottery annuity. Generally, the section 7520 tables must be used to value annuities unless their use would have an unreasonable result. The district court noted a split among the few circuit courts that have ruled in such cases. The Second Circuit Court of Appeals and the Ninth Circuit have held that the right to transfer property is a fundamental right of ownership and that any restriction on that right affects the value of the property. Therefore, those circuit courts have upheld a marketability discount for lottery payments. The Fifth Circuit, however, has held that such discounts are improper because there is an underlying assumption of nonmarketability in the annuity tables.
The decedent’s estate had sought valuation of the lottery annuity based on the willing buyer/willing seller standard, whereby what a willing buyer would pay for property is attributed to the willing seller. Since the estate tax values assets in the hands of the decedent, not a third party, it is inappropriate to use this method of valuation.
What was at issue in this case was essentially an income interest unaffected by market forces. The fact that the interest could not be assigned did not affect its value for estate tax purposes. Accordingly, for the time being CPAs should use the section 7520 annuity tables to value a client’s right to an annual stream of lottery winnings. However, Donovan has been appealed to the First Circuit, which has not yet ruled on the case. Given the split that already exists, it is possible this issue ultimately may be heard by the U.S. Supreme Court.
Estate of John R. Donovan, Jr. v. United States, 2005 US Dist., Lexis 7232; 95 AFTR2d 2005-2131 (April 26, 2005).
Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John’s University, New York.