Wouldn’t it be nice if you could turn some worthless material, like pyrite, into something quite valuable, like gold? Sure. But the laws of chemistry don’t allow it.
Wouldn’t it be nice to turn ordinary income into a capital gain, so that the tax you owed would be significantly less? Sure. But the laws of the United States (the Tax Code) don’t allow it.
Today the Tax Court took a look at two test cases (out of 59 filed cases) where petitioners were trying to turn ordinary income into a capital gain. The lucky petitioners won the lottery in Florida. That was the good news. They began receiving their annual payments, and decided they wanted to get a lump sum. They contracted with a firm that does this, got approval (Florida law required a Court to approve this), and got their lump sum payment. And then the trouble began.
The petitioners contended that when they received their lump sum, they converted their lottery rights (rights to future payments) into a capital asset. They sold the capital asset; thus, they have a capital gain, not ordinary income, and would be taxed at the much lower rate for capital gains.
The Tax Court felt otherwise. Previously, the Tax Court and three Appeals Courts have held that the “Substitute for Ordinary Income Doctrine” holds; you can’t change ordinary income (the lottery winnings) into capital gains through a simple transaction. The Court stated,
“The basic principle of the doctrine was expressed in Commissioner v. P.G. Lake, 356 U.S. 200, 266 (1958): The 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. Stated another way: if a taxpayer merely transfers for consideration the right to receive ordinary income in the future, the right transferred will not be treated as a capital asset.”
The petitioners contend that a Supreme Court decision (Ark. Best Corp. v. Commissioner, 485 U.S. 212 (1988)) made the precedents invalid. Interestingly enough, just last year the Tax Court looked at a similar case that I blogged about; the petitioner lost. So it’s not surprising that the Tax Court here noted, “Given that the doctrine has not been obviated or limited, we see no reason to depart from the established and uniform precedent. We, accordingly, proceed to decide whether the factual circumstances of the case we consider fall within the
doctrine’s embrace…Under the principle of the doctrine, the sale of the remaining right to the ordinary income payments did not cause their conversion to a capital asset.”
So if you win the lottery, congratulations! Just remember to save enough money to pay your taxes.
Cases: Womack v. Commissioner, Spiridakos v. Commissioner (T.C. Memo 2006-240)
