Appeal from the Decision of the United States Tax Court Docket No. 03-4269. Tax Court Judge: Honorable Juan F. Vasquez.
The opinion of the court was delivered by: Ambro, Circuit Judge
Before: BARRY and AMBRO, Circuit Judges, and DEBEVOISE,*fn1 District Judge.
Lottery winners, after receiving several annual installments of their lottery prize, sold for a lump sum the right to their remaining payments. They reported their sale proceeds as capital gains on their tax return, but the Internal Revenue Service (IRS) classified those proceeds as ordinary income. The substitute-for-ordinary-income doctrine holds that lump-sum consideration substituting for something that would otherwise be received at a future time as ordinary income should be taxed the same way. We agree with the Commissioner of the IRS that the lump-sum consideration paid for the right to lottery payments is ordinary income.
I. Factual Background and Procedural History
In June 1991 George and Angeline Lattera turned a one-dollar lottery ticket into $9,595,326 in the Pennsylvania Lottery. They did not then have the option to take the prize in a single lump-sum payment, so they were entitled to 26 annual installments of $369,051.
In September 1999 the Latteras sold their rights to the 17 remaining lottery payments to Singer Asset Finance Co., LLC for $3,372,342. Under Pennsylvania law, the Latteras had to obtain court approval before they could transfer their rights to future lottery payments, and they did so in August 1999.
On their joint tax return, the Latteras reported this sale as the sale of a capital asset held for more than one year. They reported a sale price of $3,372,342, a cost or other basis of zero, and a long-term capital gain of the full sale price. The Commissioner determined that this sale price was ordinary income. In December 2002 the Latteras were sent a notice of deficiency of $660,784.*fn2
In March 2003 the Latteras petitioned the Tax Court for a redetermination of the deficiency. The Court held in favor of the Commissioner. The Latteras now appeal to our Court.
II. Jurisdiction and Standard of Review
The Tax Court had subject matter jurisdiction under I.R.C. § 7442. Because its decision was final, we have appellate jurisdiction under I.R.C. § 7482(a)(1). The Latteras reside in our Circuit, so venue is proper under I.R.C. § 7482(b)(1)(A).
We review the Tax Court's legal determinations de novo, but we do not disturb its factual findings unless they are clearly erroneous. Estate of Meriano v. Comm'r, 142 F.3d 651, 657 (3d Cir. 1998).
The lottery payments the Latteras had a right to receive were gambling winnings, and the parties agree that the annual payments were ordinary income. Cf. Comm'r v. Groetzinger, 480 U.S. 23, 32 n.11 (1987) (calling a state lottery "public gambling" in a case treating gambling winnings as ordinary income). But the Latteras argue that, when they sold the right to their remaining lottery payments, the sale gave rise to a long-term capital gain.
Whether the sale of a right to lottery payments by a lottery winner can be treated as a capital gain under the Internal Revenue Code is one of first impression in our Circuit. But it is not a new question. Both the Tax Court and the Ninth Circuit Court of Appeals have held that such sales deserve ordinary-income treatment. United States v. Maginnis, 356 F.3d 1179, 1181 (9th Cir. 2004) ("Fundamental principles of tax law lead us to conclude that [the] assignment of [a] lottery right produced ordinary income."); Davis v. Comm'r, 119 T.C. 1, 1 (2002); see also Watkins v. Comm'r, 88 T.C.M. (CCH) 390, 393 (2004); Clopton v. Comm'r, 87 T.C.M. (CCH) 1217, 1217 (2004); Boehme v. Comm'r, 85 T.C.M. (CCH) 1039, 1041 (2003).
The Ninth Circuit's reasoning has drawn significant criticism, however. See Matthew S. Levine, Case Comment, Lottery Winnings as Capital Gains, 114 Yale L.J. 195, 197--202 (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). In this context, ...