No Gain, Some Pain for Another Lottery Winner

The Second Circuit Court of Appeals joined other courts holding that a taxpayer’s sale of rights to future installments of lottery winnings is ordinary income and not capital gain.

Shirley Prebola won $17.5 million in the New York State Lottery. The winnings were to be paid in 26 annual installments. Prebola reported the first three payments as ordinary income. She then sold her rights to the remaining payments for a lump sum of $7.1 million and reported that amount as a long-term capital gain. The IRS disagreed and issued a notice of deficiency for $1.31 million. The Tax Court (TC Memo 2005-261) held for the IRS.

On appeal, Prebola pointed to the broad definition of “capital asset” in section 1221 and market forces outside her control, such as variable interest rates, that determined the value of the right to the future payments. The circuit court, however, agreed with the Tax Court and relied on the long-standing doctrine developed by the Supreme Court holding that, with few exceptions, a lump-sum payment received in exchange for what would otherwise be a stream of ordinary income payments is treated as ordinary income and not capital gain.

The Third, Ninth and Tenth circuits have also ruled for the IRS in similar recent cases.

Shirley Prebola v. Commissioner , 99 AFTR 2d 2007-1660.

Prepared by Ryan H. Pace , M.Tax, J.D., LL.M., assistant professor of accounting, Goddard School of Business and Economics, Weber State University, Ogden, Utah.