While lottery winnings may be subject to tax at ordinary tax rates, what about the sale of the right to receive annual lottery payouts?  The court addressed this in Prebola v. Commissioner, T.C. Memo 2006-240.

Facts & Procedural History

The taxpayer won $17.5 million from the lottery.  She selected the annual installment option, which would pay out over 26 years.  

The taxpayer sold her interest in the annual payments for $7.1 million three years after the payments started.  

When filing her income tax return, she reported the $7.1 million as capital gain from the sale of a capital asset.  She reported the sale as long-term capital gain to be more precise. 

The IRS audited the taxpayer’s return and determined that the $7.1 million was taxable as ordinary gain at the higher ordinary gain rates.   Litigation ensued.

Income Taxes on Lottery Winnings

Lottery winnings are treated as income from gambling.  Lottery winnings are generally accorded ordinary tax treatment, rather than capital gains tax treatment. This means that the federal income tax can be as high as a 38%+ tax on significant lottery winnings.  This tax is triggered at the time that the taxpayer receives the winnings.

Sale of Lottery Payments a Capital Asset? 

While the winnings may be taxed at ordinary rates, what about the sale of the right to the annual payments?  Are the right to annual lotto payments a capital asset?  

Generally a capital asset is an investment property or right held for the production of income.  Real estate is an example.  Stocks, bonds, and mutual funds are also examples.  

The court in Prebola addressed this issue by starting with Section 1221 and the definition of capital asset.  Section 1221 defines the term in the negative, by providing a list of property that is not a capital asset.  

Given that the list does not seem to address the right to lotto winnings, the court turned to the judicial substitute-for-ordinary-income doctrine.  This is essentially a legal theory the courts use to prevent taxpayers from converting ordinary income to capital gains.  

According to the court, this judicial doctrine required the lotto payment stream sale to be treated as ordinary income. 

Impact of Taxes on Lottery Winnings

In addition to Federal income taxes, state and city governments where the taxpayer resides may also impose taxes on the lottery winnings at the time that the taxpayer receives the winnings. These taxes could approach 10%+, as is the case for taxpayers in high tax states such as California or New York.

If that is not bad enough, both the Federal and local governments generally impose a second round of tax on any profits derived from invested lottery winnings. These taxes could exceed 20%+ of the profits.

In addition, the federal and local governments may collect sales and excise and other taxes on items purchased with lottery winnings. These taxes could exceed 10%+ of the cost of the items purchased.

And still, the federal and state governments may impose a tax on gifted or unspent lottery winnings. These taxes could exceed 50%+ of the unspent lottery winnings.

For those keeping tabs, the total tax liability can exceed 100% of the lotto winnings — which shows who really wins the lottery absent advance tax planning.  Had Prebola contacted a tax attorney upon learning that she won the lottery, she may have been able to avoid or minimize most of these taxes.

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