Womack v. Commissioner of IRS
100 A.F.T.R.2d (RIA) 7103, 2007 U.S. App. LEXIS 29294, 510 F.3d 1295 (2007)
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Rule of Law:
A lump sum payment received in exchange for the right to future income payments, which would have been taxed as ordinary income, is also taxable as ordinary income under the 'substitute for ordinary income' doctrine. Such a right to future income is not considered a 'capital asset' under 26 U.S.C. § 1221.
Facts:
- Roland Womack won a Florida Lotto prize in 1996, payable in twenty annual installments of $150,000.
- Maria Spiridakos won a Florida Lotto prize in 1990, payable in twenty annual installments of $312,000.
- Both Womack and Spiridakos received several annual payments and reported them as ordinary income on their joint tax returns.
- In 1999, Florida state law was amended to permit lottery winners to assign their rights to future payments.
- Womack sold his right to the remaining sixteen payments to Singer Asset Finance Company for a lump sum of $1,328,000.
- Spiridakos sold her right to her remaining ten payments to Singer Asset Finance Company for a lump sum of $2,125,000.
- Both the Womacks and the Spiridakoses reported these lump-sum payments on their 2000 federal income tax returns as proceeds from the sale of a long-term capital asset, which is taxed at a lower rate than ordinary income.
Procedural Posture:
- The IRS issued notices of deficiency to the Womacks and the Spiridakoses for failing to report the lump-sum payments as ordinary income.
- The taxpayers each filed a petition with the United States Tax Court seeking a redetermination of the tax deficiency.
- The Tax Court consolidated the petitions for consideration.
- On November 7, 2006, the Tax Court denied both petitions, ruling in favor of the IRS.
- The taxpayers (appellants) appealed the Tax Court's decision to the United States Court of Appeals for the Eleventh Circuit.
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Issue:
Are the rights to future lottery installment payments considered 'capital assets' under 26 U.S.C. § 1221, such that their sale results in a capital gain?
Opinions:
Majority - Martin, District Judge
No, the rights to future lottery installment payments are not considered capital assets. The court holds that the proceeds from the sale of these rights are taxable as ordinary income based on the substitute for ordinary income doctrine. This doctrine provides that when a taxpayer receives a lump sum payment that is essentially a substitute for what would otherwise be received in the future as ordinary income, that lump sum is also taxed as ordinary income. The court reasoned that lottery winnings are indisputably ordinary income. Therefore, selling the right to receive those future payments is merely an acceleration of that income, not the sale of a capital asset that has appreciated in value. The court distinguished lottery rights from typical capital assets, noting they involve no underlying investment of capital and their 'gain' upon sale is simply the discounted present value of a pre-existing right to ordinary income, not an appreciation of an asset's value. The court also held that the Supreme Court's decision in Arkansas Best Corp. v. Comm'r did not limit this doctrine, but rather affirmed its application to claims or rights to ordinary income.
Analysis:
This decision solidifies the prevailing view among federal circuit courts that the 'substitute for ordinary income' doctrine prevents taxpayers from converting future ordinary income streams into lower-taxed capital gains through a sale. By holding that lottery rights are not 'property' for the purposes of § 1221's capital asset definition, the court reinforces the principle that courts will prioritize the substance of a transaction over its form in tax law. This precedent effectively closes a potential tax loophole for lottery winners and others who might sell rights to future fixed payments, ensuring such transactions do not escape ordinary income tax rates. It confirms that the definition of a capital asset is to be construed narrowly to fulfill congressional intent.
