After a week when dreams of $640 million in instant riches took over the national consciousness — with desperate yet misinformed Americans even checking out every available copy of the Shirley Jackson tale from local libraries in search of winning tips – we can all finally get back to accepting that we’ll live out our days as corporate drones. The triumphant numbers have been announced, and they ain’t ours.
There were three winners, to be exact; one in Maryland, Illinois, and Kansas. Each ticket was expected to be worth $213 million, before taxes.
But where the story ends for those with Mega Millions fever, it begins for CPAs and the like. What are the tax consequences of hitting the jackpot?
The first step towards an answer is understanding the payout options. From the lottery website:
If you are a Mega Millions jackpot winner, you will have the choice of a Cash Option or an Annual Payout.
Annuity option: Provides annual payments over a 26-year period. For every $1,000,000 in the jackpot, you will receive approximately $38,500 per year before taxes.
Cash option: A one-time, lump-sum payment that is equal to all the cash in the Mega Millions jackpot prize pool.
In general, the taxation of lottery winnings is extremely straight forward:
A one-time cash payment is taxed as ordinary income under I.R.C. § 61 and I.R.C. § 74. Lottery winnings are not tax-free gifts under I.R.C. § 102, as the lottery commission did not make them with a “detached and disinterested generosity.”
Given the current tax rate structure, the winners will be sending 45% of their hard-earned money to the IRS.
Individuals are overwhelmingly cash-basis taxpayers. As such, they recognize income when it is “actively or constructively received.” Typically, if a taxpayer is granted an option between taking cash now or receiving it in installments, they have “constructively received” the income and must recognize it all immediately, even if the annuity option is selected.
Section 451(h) offers a reprieve to this harsh treatment. Provided the annuity payment is received over a period longer than 10 years, a taxpayer will not be treated as having constructively received the value of the winnings. Instead, each annuity payment will be taxed as ordinary income when received.
In general, the winner has 60 days from the date his numbers are announced to make the election to receive the annuity and qualify for tax deferral.
Sale of a lottery ticket:
This is where things get interesting. Say you win the lottery, and decide you want to do the conservative, fiscally responsible thing and collect your winnings annually as an annuity. Your restraint is limited, however, and after you collect one annuity payment, you decide that your newfound wealth and status isn’t complete without a jumpsuit made from solid gold.
To finance your purchase, you decide to sell the remaining stream of annuity payments for a one-time lump sum payment. Someone offers you a purchase price equal to the present value of the payments, and you happily accept.
This begs the question: does the sale of your annuity stream for a lump sum payment generate capital gain? Is your winning lottery ticket a “capital asset” in which you have a basis equal to its purchase price?
The answers, unfortunately, are no and no. As numerous courts[i] have decided — with perhaps the most commonly cited decision being Davis v. Commissioner, 119 T.C. 1 (July 3, 2002) — lottery tickets are not capital assets, and the sale of future annuity payments generates ordinary income under the “assignment of ordinary income doctrine.”
In short, this doctrine provides that a taxpayer cannot convert future income that would be ordinary income when received into capital gain by selling the right to receive the future income for one-time payment.
Under an alternate argument, the courts have also held that the sale generates ordinary income because unlike the sale of a typical capital asset, the amounts received from the seller upon the sale of future annuity payments are not received due to the appreciation in value of the underlying asset.
To soften the tax burden, the IRS does allow a tax deduction for any gambling “losses” you had. These are taken as miscellaneous itemized deductions that cannot exceed your winnings under I.R.C. § 165(d). If your lottery winnings are payable in annual installments, the installments you receive in future years are still gambling winnings, making losses in those future years deductible to the extent of the installments, even if you have no other gambling winnings in those years. Gambling losses aren’t subject to the 2%-of-adjusted-gross-income floor on miscellaneous itemized deductions.
[i] Including appeals courts in the Second, Third, Ninth, Tenth and Eleventh Circuits