The Characterization of income and deduction Assignment Assignment should be briefed, i.e., include facts, issue(s), rule(s), analysis, and conclusion (FIR
The Characterization of income and deduction Assignment Assignment should be briefed, i.e., include facts, issue(s), rule(s), analysis, and conclusion (FIRAC). Each assigned problem should be analyzed (not just solved). Provide a straightforward brief of a case (or perhaps just the facts and issues).(DO NOT use any source/reference/cite from any other article) 732
THE CHARACTERIZATION OF INCOME AND DEDUCTIONS
the usual characterization rules intact at the time it changed the measuring
device for gain or loss on sales of terminable interests.
Watkins v. Commissioner
United States Court of Appeals. Tenth Circuit, 2006
447 F.3d 1269
– Before O’BRIEN, SEYMOUR, and BALDOCK, CIRCUIT JUDGES.
SEYMOUR, CIRCUIT JUDGE.
Taxpayer Roger L. Watkins won over $12 million in the Colorado
State Lottery, which he was to receive in twenty-five annual payments
After receiving six installments, Mr. Watkins sold his interest in the
remaining payments to a third party for a lump sum and claimed the sale
resulted in a capital gain. The Internal Revenue Service (I.RS.)
as ordinary income. In subsequent litigation, the tax court agreed with
disagreed, asserting the proceeds from the sale should be characterized
the I.R.S.’s position. * * * Mr. Watkins appeals, and we affirm.
On May 1, 1993, Mr. Watkins won $12,358,688 from the Colorado
State Lottery with a ticket he purchased for one dollar. At the time, he
was married to Tammy Watkins. His prize winnings were to be
distributed to him in twenty-five annual installments through an
annuity purchased by the Colorado State Lottery. Mr. Watkins reported
the receipt of his first six prize payments as ordinary income on his
federal tax returns. In 1997, Mr. Watkins and his wife were divorced. As
part of the divorce settlement, the court awarded each party a one-half
interest in the future lottery payments.
In 1998, Mr. Watkins entered into a contract with Stone Street
Capital, Inc. (Stone Street), agreeing to assign it his one-half interest in
the remaining lottery payments. Upon receiving a judicial order
permitting the assignment, see Colo. Rev.Stat. $ 2435212(1)(b), Mr.
Watkins consummated the contract. In consideration for the assignment,
Mr. Watkins received $2,614,744, which represented the discounted
present value of his remaining share of the lottery winnings. Of this
amount, he gave $200,000 to a third party who provided consulting
services in connection with the sale to Stone Street. On his 1998 tax
return, Mr. Watkins reported that the lump sum from Stone Street was
the result of a sale of a capital asset worth $2,414,744 with a cost basis
The I.R.S. issued a notice of deficiency to Mr. Watkins, claiming the
$2,614,744 he received from Stone Street was ordinary income, not the
result of the sale of a capital asset warranting capital gains treatment.
The I.R.S. did agree, however, that the $200,000 consulting fee was
as a miscellaneous itemized deduction. Mr. Watkins timely
CAPITAL GAINS AND LOSSES
appealed to the tax court, which ruled in favor of the I.R.S.
We exercise jurisdiction pursuant to I.R.C. $ 7482(a)(1) and review
the tax court’s decision in the same manner and to the same extent as
decisions of the district courts… tried without a jury.” Id. We thus
review legal questions de novo and factual questions for clear error. IHC
Health Plans, Inc. v. C.I.R., 325 F.3d 1188, 1193 (10th Cir. 2003); Kurzet
v. C.I.R., 222 F.3d 830, 833 (10th Cir. 2000). In so doing, we find no error
circuit court, and tax court authority, we easily conclude that Mr.
in the tax court’s ruling. Having reviewed the relevant Supreme Court,
Watkins’ sale of his lottery payments should be characterized as
producing ordinary income rather than capital gain.
A capital gain occurs when a taxpayer sells a capital asset at a profit.
See I.R.C. $ 1222(1), (3). Generally, a capital asset is defined as property,
held by the taxpayer (whether or not connected with his trade or
business)… “I.R.C. $ 1221(a). This statutory definition of property is
broad, and a plain reading of its language could result in drawing within
its scope all manner of property not necessarily appropriate for capital
gains treatment. The Supreme Court expressed this concern in CIR.
Gillette Motor Transp., Inc., 364 U.S. 130, 80 S.Ct. 1497, 4 L.Ed.2d 1617
(1960), noting that [w]hile a capital asset is defined … as ‘property held
by the taxpayer,’ it is evident that not everything which can be called
property in the ordinary sense and which is outside the statutory
exclusions qualifies as a capital asset. Id. at 134, 80 S.Ct. 1497. In
limiting the breadth of what could conceivably receive capital gains
treatment, the Court reasoned that
the term “capital asset” is to be construed narrowly in
accordance with the purpose of Congress to afford capital-gains
treatment only in situations typically involving the realization of
appreciation in value accrued over a substantial period of time,
and thus to ameliorate the hardship of taxation of the entire
gain in one year.
Id. (emphasis added).
The Court has further narrowed the scope of those gains which may
be characterized as capital through its creation of the substitute-for-
ordinary-income doctrine. Under this doctrine, the Court has indicated
that where a lump sum payment is received in exchange “for what would
otherwise be received at a future time as ordinary income,” C.I.R. v. P.G.
Lake Inc., 356 U.S. 260, 265, 78 S.Ct. 691, 2 L.Ed.2d 743 (1958), capital
gains treatment of the lump sum is inappropriate. This is so because the
consideration was paid for the right to receive future income, not for an
increase in the value of income-producing property.” Id. at 266, 78 S.Ct.
691. See also United States v. Midland-Ross Corp., 381 U.S. 54, 5758,
85 S.Ct. 1308, 14 L.Ed.2d 214 (1965) (gain based on earned original issue
THE CHARACTERIZATION OF INCOME AND DEDUCTIONS
discount from sale of promissory notes before maturity was equivalent
interest and therefore constituted ordinary income); Hort v. CI… 30%
U.S. 28, 31, 61 S.Ct. 757, 85 L.Ed. 1168 (1941) (lump sum paid tre
cancellation of rental payments owed under fifteen-year lease treated
ordinary income): Freese v. United States, 455 F.2d 1146, 1100
Cir. 1972) (receipt of lump sum representing commission rights puts
to contract not capital gain); Holt v. C.I.R., 303 F.2d 687.690-91
movies deemed ordinary income); Dyer v. C.I.R., 294 F.2d 123, 1260
Cir. 1962) (lump sum received in exchange for future proceeds from
Cir. 1961) (lump sum received for mineral leasehold payments held to be
ordinary income). We glean from these cases the basic lesson that when
a party exchanges for a lump sum the right to receive in the future
as a substitute for the ordinary income the party had the right to receive
ordinary income already earned or obtained, the amount received serves
over time. The lump sum is accordingly treated as ordinary income fost
Two other circuit courts, as well as numerous rulings from the Tax
Court, have applied this doctrine in lottery sales cases and have
consistently held that a lump sum payment in exchange for future
installments of lottery winnings is properly characterized as ordinary
income. See Lattera v. C.I.R., 437 F.3d 399 (3d Cir.2006); United States
v. Maginnis, 356 F.3d 1179 (9th Cir.2004); Wolman v. C.I.R., 2004 RIA
TC Memo 2004-262; Clopton v. CI.R., 87 T.C.M. (CCH) 1217 (2004)
Simpson v. C.I.R., 85 T.C.M. (CCH) 1421 (2003); Johns v. C.I.R., 85
T.C.M. (CCH) 1318, 2003 WL 21146797 (2003); Boehme v. C.I.R., 85
T.C.M. (CCH) 1039 (2003); Davis v. C.I.R., 119 T.C. 1 (2002 WL 1446631).
The Third and Ninth Circuits, in invoking the substitute-for-
ordinary income doctrine, outlined different methods for applying the
doctrine generally while simultaneously seeking to appropriately limit
its use. See Lattera, 437 F.3d at 405-09 (outlining a three step “family
resemblance” test for application of the doctrine while noting no rule
could “account for every contemplated transactional variation”);
Maginnis, 356 F.3d at 118283 (applying doctrine where there has been
no underlying investment of capital and where sale of asset did not reflect
accretion in value over cost of underlying asset, but acknowledging the
two factors would not be dispositive in every case). The test laid out in
Maginnis has been subject to academic criticism, see Matthew S. Levine,
Case Comment, Lottery Winnings as Capital Gains, 114 Yale L.J. 195,
197202 (2004); Thomas G. Sinclair, Comment, Limiting the Substitute-
for-Ordinary-Income Doctrine: An Analysis Through Its Most Recent
Application Involving the Sale of Future Lottery Rights, 56 S.C.L. Rev.
387, 421-22 (2004); and was rejected by the court in Lattera, 437 F.3d at
40405. We decline to enter the fray. While we acknowledge the
importance of placing appropriate limits on when to apply the substitute-
for-ordinary-income doctrine, in the instant case there is no question that
CAPITAL GAINS AND LOSSES
what Mr. Watkins exchanged for a lump sum payment was his future
right to receive set amounts of income he had essentially already
obtained as a result of his lottery success. Application of the substitute
for-ordinary-income doctrine is therefore entirely proper in Mr. Watkins
the appropriate limits of the doctrine’s application.
case. As a consequence, we need not formulate any specific test regarding
At bottom, Mr. Watkins exchanged the future right to receive his
received initially and wholly in a lump sum or in annual payments, are
treated as ordinary income under the tax code. C.I.R. v. Groetzinger, 480
U.S. 23, 32 n. 11, 107 S.Ct. 980,94 L.Ed.2d 25 (1987) (equating a state
lottery with public gambling in case treating gambling earnings as
ordinary income); Maginnis, 356 F.3d at 1183 (Lottery prizes are treated
by the tax code as gambling winnings, which are taxed as ordinary
income.”); Davis, 119 T.C. at 4 (“The parties agree that an amount
received as a lottery prize constitutes ordinary income.”). All of the
payments Mr. Watkins initially received in a series of annual
installments represented ordinary income Mr. Watkins had already
earned by virtue of his success in the lottery. The lump sum Mr. Watkins
received from Stone Street served as a substitute for the ordinary income
he would have otherwise received over a period of time, and therefore
was appropriately taxed as ordinary income. As in P.G. Lake, Inc.,
[t]he substance of what was assigned was the right to receive
future income. The substance of what was received was the
present value of income which the recipient would otherwise
obtain in the future. In short, consideration was paid for the
right to receive future income, not for an increase in the value
of the income-producing property.
356 U.S. at 266, 78 S.Ct. 691. Under these circumstances, the sale of Mr.
Watkins’s future lottery payments did not represent a capital gain.
We AFFIRM the determination of the tax court.
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