The IRS is always waiting for taxpayers to have windfalls as the tax on these one-time events is significant. Lottery winnings are no exception, as they are treated as income from gambling and subject to ordinary income tax rates, which can be as high as 38% or more depending on the amount won.
But what happens when the right to receive annual lottery payouts is sold? Can a taxpayer avoid paying taxes by selling their right to receive lottery payments? The U.S. Tax Court addressed this issue in Prebola v. Commissioner, T.C. Memo 2006-240. In this case, the taxpayer won $17.5 million and later, she sold her interest in the annual payments for $7.1 million
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 a long-term capital gain.
Income Taxes on Lottery Winnings
Lottery winnings are treated as income from gambling. This is important as it dictates what tax rate applies.
Lottery winnings are not treated as capital gains, which are taxed at a lower rate than ordinary income. Instead, lottery winnings are subject to ordinary income tax rates, which can be as high as 38% or more depending on the amount won.
There are also timing issues when it comes to lotto winnings. The tax on lottery winnings is triggered at the time that the taxpayer receives the winnings. So, for example, if you win a $1 million lottery prize, you would owe federal income tax on that amount in the year you receive it.
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 a capital asset. Section 1221 defines the term in the negative, by providing a list of property that is not capital assets. The list in Section 1221 does not seem to address the right to lotto winnings. As such, the court turned to the judicial substitute-for-ordinary-income doctrine.
The substitute-for-ordinary-income is 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 local governments may also impose taxes on lottery winnings when the taxpayer receives them. These taxes can approach 10% or more, especially in high-tax states like California or New York.
Unfortunately, that’s not the end of it. Both federal and local governments may also tax any income or profits earned from invested lottery winnings, which could exceed 20% annually.
Furthermore, taxes may be imposed on items purchased with lottery winnings, such as sales and excise taxes, which can be over 10% of the item’s cost.
To make matters worse, gifting lottery winnings to others can also trigger taxes, which may exceed 50% of the unspent winnings.
All of these taxes combined can exceed 100% of the lottery winnings, underscoring the importance of advanced tax planning. It’s clear that when it comes to the lottery, the real winners are those who plan ahead for taxes.
Lottery winnings can be life-changing, but they also come with significant tax implications. While lottery winnings are typically subject to ordinary income tax rates, what happens when the right to receive annual lottery payouts is sold? The court in this case confirmed that the sale of lottery payments for a lump sum is also taxed as ordinary income at higher rates. While lottery winnings can already trigger significant taxes, the sale of the right to annual payments can further complicate matters which helps explain why it is important to consult with an experienced tax attorney to minimize tax liability.