F IL E D
United States Court of Appeals
Tenth Circuit
May 10, 2006
PUBLISH
Elisabeth A. Shumaker
Clerk of Court
UNITED STATES COURT OF APPEALS
TENTH CIRCUIT
RO GER L. W ATK INS,
Petitioner-A ppellant,
v.
No. 04-9016
C OM M ISSIO N ER OF IN TER NAL
REVENU E,
Respondent-Appellee.
A ppeal From a Decision of the
U nited States T ax C ourt
(N o. 19587-02)
Eric J. Zinn of Brow nstein Hyatt & Farber, PC, Denver, Colorado, for Petitioner-
Appellant.
Regina S. M oriarty, Attorney, Tax Division (Richard Farber, Attorney, Tax
Division; and Eileen J. O’Connor, Assistant Attorney General, with her on the
brief), Department of Justice, W ashington, D.C., for Respondent-Appellee.
Before O ’B R IE N , SE Y M O U R , and B A L D O C K , Circuit Judges.
SE Y M O U R , Circuit Judge.
Taxpayer Roger L. W atkins w on over $12 million in the Colorado State
Lottery, which he was to receive in twenty-five annual payments. After receiving
six installments, M r. W atkins 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.R.S.) disagreed, asserting the proceeds from the sale
should be characterized as ordinary income. In subsequent litigation, the tax
court agreed with the I.R.S.’s position. See Watkins v. C.I.R., T.C.M . (RIA)
2004-244 (T.C. 2004). M r. W atkins appeals, and we affirm.
I
On M ay 1, 1993, M r. W atkins w on $12,358,688 from the Colorado State
Lottery with a ticket he purchased for one dollar. A t the time, he was married to
Tamm y W atkins. His prize winnings were to be distributed to him in twenty-five
annual installments through an annuity purchased by the Colorado State Lottery.
M r. W atkins reported the receipt of his first six prize payments as ordinary
income on his federal tax returns. In 1997, M r. W atkins and his wife w ere
divorced. As part of the divorce settlement, the court awarded each party a one-
half interest in the future lottery payments.
In 1998, M r. W atkins entered into a contract with Stone Street Capital, Inc.
(Stone Street), agreeing to assign it his one-half interest in the remaining lottery
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payments. Upon receiving a judicial order permitting the assignment, see C OLO .
R EV . S TAT . § 24-35-212(1)(b), M r. W atkins consummated the contract. In
consideration for the assignment, M r. W atkins 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, M r. W atkins 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 of zero. 1
The I.R.S. issued a notice of deficiency to M r. W atkins, 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. 2 The I.R.S. did
agree, however, that the $200,000 consulting fee w as allow able as a
miscellaneous itemized deduction. M r. W atkins timely appealed to the tax court,
which ruled in favor of the I.R.S.
II
W e exercise jurisdiction pursuant to I.R.C. § 7482(a)(1) and review the tax
1
M r. W atkins treated the $200,000 paid for the consulting services as an
itemized deduction, thereby reducing the $2,616,744 amount to $2,414,744.
2
The Internal Revenue Code generally taxes capital gains at a more
favorable rate than ordinary income. See I.R.C. § 1(h).
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court’s decision “in the same manner and to the same extent as decisions of the
district courts . . . tried without a jury.” Id. W e 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 in the tax court’s ruling. Having reviewed
the relevant Supreme Court, circuit court, and tax court authority, we easily
conclude that M r. W atkins’ 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). 3 This statutory definition of property is broad, and a plain
3
The relevant portion of the statute directs the following:
(a) In general.--For purposes of this subtitle, the term “capital asset”
means property held by the taxpayer (w hether or not connected with
his trade or business), but does not include--
(1) stock in trade of the taxpayer or other property of a kind which
would properly be included in the inventory of the taxpayer if on
hand at the close of the taxable year, or property held by the taxpayer
primarily for sale to customers in the ordinary course of his trade or
business; (2) property, used in his trade or business, of a character
which is subject to the allowance for depreciation provided in section
167, or real property used in his trade or business; (3) a copyright, a
literary, musical, or artistic composition, a letter or memorandum, or
similar property, held by--(A ) a taxpayer w hose personal efforts
created such property, (B) in the case of a letter, memorandum, or
(continued...)
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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 C.I.R. v. Gillette M otor Transp., Inc., 364 U.S.
130 (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. 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
3
(...continued)
similar property, a taxpayer for whom such property was prepared or
produced, or (C) a taxpayer in whose hands the basis of such
property is determined, for purposes of determining gain from a sale
or exchange, in whole or part by reference to the basis of such
property in the hands of a taxpayer described in subparagraph (A) or
(B); (4) accounts or notes receivable acquired in the ordinary course
of trade or business for services rendered or from the sale of property
described in paragraph (1); (5) a publication of the United States
Government (including the Congressional Record) which is received
from the United States Government or any agency thereof, other than
by purchase at the price at which it is offered for sale to the public,
and which is held by--(A) a taxpayer who so received such
publication, or (B) a taxpayer in whose hands the basis of such
publication is determined, for purposes of determining gain from a
sale or exchange, in whole or in part by reference to the basis of such
publication in the hands of a taxpayer described in subparagraph (A).
I.R .C. § 1221(a) (1986).
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period of tim e, 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
(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. See also
United States v. M idland-Ross Corp., 381 U.S. 54, 57-58 (1965) (gain based on
earned original issue discount from sale of promissory notes before maturity was
equivalent of interest and therefore constituted ordinary income); Hort v. C.I.R.,
313 U.S. 28, 31 (1941) (lump sum paid for cancellation of rental payments owed
under fifteen-year lease treated as ordinary income); Freese v. United States, 455
F.2d 1146, 1150 (10th Cir. 1972) (receipt of lump sum representing comm ission
rights pursuant to contract not capital gain); Holt v. C.I.R., 303 F.2d 687, 690-91
(9th Cir. 1962) (lump sum received in exchange for future proceeds from movies
deemed ordinary income); Dyer v. C.I.R., 294 F.2d 123, 126 (10th Cir. 1961)
(lump sum received for mineral leasehold payments held to be ordinary income).
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W e glean from these cases the basic lesson that when a party exchanges for a
lump sum the right to receive in the future ordinary income already earned or
obtained, the amount received serves as a substitute for the ordinary income the
party had the right to receive over time. The lump sum is accordingly treated as
ordinary income for taxation purposes.
Two other circuit courts, as w ell 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. M aginnis, 356 F.3d 1179 (9th Cir. 2004); Wolman
v. C.I.R., 2004 RIA TC M emo 2004-262; Clopton v. C.I.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) 1818 (2003); Boehme v. C.I.R., 85 T.C.M . (CCH) 1039 (2003);
Davis v. C.I.R., 119 T.C. 1 (2002 W L 1446631). W e agree.
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”); M aginnis, 356 F.3d at 1182-83 (applying doctrine where there has
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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 M aginnis has
been subject to academic criticism, see M atthew S. Levine, Case Comment,
Lottery Winnings as Capital Gains, 114 Y ALE L.J. 195, 197-202 (2004); Thomas
G. Sinclair, Comment, Limiting the Substitute-for-Ordinary-Income Doctrine: An
Analysis Through Its M ost Recent Application Involving the Sale of Future
Lottery Rights, 56 S.C.L. R EV . 387, 421-22 (2004); and was rejected by the court
in Lattera, 437 F.3d at 404-05. We decline to enter the fray. W hile 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 what M r. W atkins 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 M r. W atkins’ case. As a consequence, we need not
formulate any specific test regarding the appropriate limits of the doctrine’s
application.
At bottom, M r. W atkins exchanged the future right to receive his parceled-
out lottery winnings for a lump sum. Lottery winnings, whether received initially
and wholly in a lump sum or in annual payments, are treated as ordinary income
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under the tax code. 4 C.I.R. v. Groetzinger, 480 U.S. 23, 32 n.11 (1987) (equating
a state lottery with public gambling in case treating gambling earnings as ordinary
income); M aginnis, 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 M r. W atkins initially received in a series
of annual installments represented ordinary income M r. W atkins had already
earned by virtue of his success in the lottery. The lump sum M r. W atkins
received from Stone Street served as a substitute for the ordinary income he
4
M r. W atkins contends the one dollar he paid for the lottery ticket was a
capital investment, relying on Rev. Rul. 83-130, 1982-2CB 148. In the ruling, an
individual had purchased a $100 winning raffle ticket for a home worth $100,000.
W hat was received in exchange for the $100 was the chance to win a valuable
prize and, by implication, the purchase of the ticket was therefore not
consideration for the prize itself. Id. at 149. The ruling stated that “[a] raffle is
the disposal by chance of a single prize among purchasers of separate chances,
and an individual buying a raffle ticket makes a wager through such purchase.”
Id. Purchasers of raffle tickets are permitted to deduct the loss of the price of the
ticket, “but only to the extent of the gains from wagering transactions.” Id. The
ruling held that the taxpayer who won the home would be required to include in
his gross income as gambling winnings the value of the house, but he could
deduct the cost of the ticket as a gambling loss. M r. W atkins argues that by virtue
of the ruling, the I.R.S. “acknowledges that the purchase of a raffle or lottery
ticket does represent an underlying investment in exchange for a right to future
payments and that a return of that investment is, like any other return of capital,
not subject to taxation.” A plt. Br. at 17. He is w rong. As the court said in
M cGinnis, 356 F.3d at 1184, “[t]he purchase of a lottery ticket is no more an
underlying investment of capital than is a dollar bet on the spin of a roulette
wheel.”
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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 w hat 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 otherw ise 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. Under these circumstances, the sale of M r. W atkins’s future
lottery payments did not represent a capital gain.
W e A FFIR M the determination of the tax court.
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