[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FILED
FOR THE ELEVENTH CIRCUIT U.S. COURT OF APPEALS
________________________ ELEVENTH CIRCUIT
DEC 19, 2007
No. 07-11568 THOMAS K. KAHN
________________________ CLERK
Agency No. 13434-03
ROLAND WOMACK,
MARIE WOMACK,
Petitioners-Appellants,
versus
COMMISSIONER OF IRS,
Respondent-Appellee.
______________________
No. 07-11569
_______________________
Agency No. 19829-03
ANASTASIOS SPIRIDAKOS,
MARIA SPIRIDAKOS,
Petitioners-Appellants,
versus
COMMISSIONER OF IRS,
Respondent-Appellee.
________________________
Appeals from Decisions of the
United States Tax Court
_________________________
(December 19, 2007)
Before EDMONDSON, Chief Judge, DUBINA, Circuit Judge, and MARTIN,*
District Judge.
MARTIN, District Judge:
This is an appeal by Florida State Lottery winners from the United States
Tax Court’s decision that proceeds from the sale of the rights to future installment
payments from lottery winnings (“Lottery Rights”) are taxable as ordinary income,
rather than at the lower tax rate applied to the sale of a long term capital asset. The
Tax Court specifically held that Lottery Rights are not capital assets as defined in
26 U.S.C. § 1221 (“Section 1221"), under the judicially established substitute for
ordinary income doctrine. We affirm.
I. Background
Roland Womack won a portion of an $8,000,000 Florida State Lottery
(“Florida Lotto”) prize on January 20, 1996. At the time, the prize was payable
only in twenty annual installments of $150,000. Mr. Womack received four such
*
Honorable Beverly B. Martin, United States District Judge for the Northern District of
Georgia, sitting by designation.
2
annual installments from 1996 to 1999, and he reported those payments as ordinary
income on the federal tax returns he filed jointly with his wife, Marie Womack.
In 1999, Florida amended its law to permit lottery winners to assign Lottery
Rights. Fla. Stat. § 24.1153. Mr. Womack subsequently sold the right to receive
the remaining sixteen payments to Singer Asset Finance Company (“Singer”) in
exchange for a sum of $1,328,000. The total face value of the remaining payments
was $2,400,000. The Womacks reported the amount received from Singer on their
2000 joint federal income tax return as proceeds from the sale of a long term
capital asset.
Maria Spiridakos is also a Florida Lotto winner. She won a $6,240,000
prize on January 6, 1990, payable in 20 annual installments of $312,000. She
received ten annual payments and, from 1990 to 1999, she and her husband,
Anastasios Spiridakos, reported those payments as ordinary income on their jointly
filed federal income tax returns. Ms. Spiridakos sold the right to receive her
remaining payments to Singer for $2,125,000, which the Spiridakoses reported on
their 2000 joint federal income tax return as proceeds from the sale of a long term
capital asset.1
1
As required by Florida state law, Fla. Stat. § 24.1153(1), Mr. Womack and Ms. Spiridakos
each obtained Circuit Court approval to assign their respective rights to receive future lottery
winnings.
3
The IRS issued notices of deficiency to the Womacks and the Spiridakoses
(collectively, “Taxpayers”) for failure to pay tax on the lump sum payment as
ordinary income. Taxpayers each filed a petition with the Tax Court seeking a
redetermination. The Tax Court consolidated the petitions and denied both on
November 7, 2006. Taxpayers now appeal.2
II. Standard of Review
We have jurisdiction in this case pursuant to 26 U.S.C. § 7482, which
specifies that we review Tax Court decisions “in the same manner and to the same
extent as decisions of the district courts in civil actions tried without a jury.” 26
U.S.C. § 7482(a)(1). We review the Tax Court’s interpretations of the Internal
Revenue Code de novo. L.V. Castle Inv. Group, Inc. v. Comm’r, 465 F.3d 1243,
1245 (11th Cir. 2006).
III. Discussion
The question before us is whether Lottery Rights are “capital assets” as
defined by Section 1221 of the Internal Revenue Code, 26 U.S.C. § 1221. Income
representing proceeds from the sale or exchange of a capital asset that a taxpayer
holds for over a year is considered a “capital gain,” 26 U.S.C. § 1222(3), and is
2
Including the Womacks and the Spiridakoses, 59 Florida Lotto winners have agreed to be
bound by the decision in this case. Womack v. Comm’r, T.C.M. 2006-240, 2006 WL 3208890, at
*1 & n.1 (Nov. 7, 2006).
4
taxed at a favorable rate.3 Other income, or “ordinary income,” is taxed at a higher
rate. Section 1221 defines a capital asset as any property the taxpayer holds, but
excludes certain items from the definition.4 Taxpayers held their Lottery Rights for
3
As the Tax Court noted, for the year 2000, the maximum tax rate for the payment Taxpayers
received was 39.6% if ordinary income, and 20% if a capital gain. Womack v. Comm’r, T.C.M.
2006-240, 2006 WL 3208890, at *4 n.4 (Nov. 7, 2006).
4
The definition, in full, states:
For purposes of this subtitle, the term ‘capital asset’ means property held by the taxpayer (whether
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 whose personal efforts created such property,
(B) in the case of a letter, memorandum, or 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);
(6) any commodities derivative financial instrument held by a commodities derivatives
dealer, unless--
(A) it is established to the satisfaction of the Secretary that such instrument has no
connection to the activities of such dealer as a dealer, and
(B) such instrument is clearly identified in such dealer's records as being described
in subparagraph (A) before the close of the day on which it was acquired, originated, or entered into
(or such other time as the Secretary may by regulations prescribe);
(7) any hedging transaction which is clearly identified as such before the close of the day on
5
more than one year before selling them, so Taxpayers may report the lump sum
payment they received in consideration as a capital gain if Lottery Rights are
considered a capital asset.
The Tax Court and the four U.S. Circuit Courts to consider the question have
concluded that Lottery Rights are not a capital asset within the definition set forth
in Section 1221. E.g., Prebola v. Comm’r, 482 F.3d 610 (2d Cir. 2007); Watkins
v. Comm’r, 447 F.3d 1269 (10th Cir. 2006); Lattera v. Comm’r, 437 F.3d 399 (3d
Cir. 2006), cert. denied, 127 S. Ct. 1328 (2007); United States v. Maginnis, 356
F.3d 1179 (9th Cir. 2004); Davis v. Comm’r, 119 T.C. 1 (2002). These decisions
are based on the so-called substitute for ordinary income doctrine, which provides
that when a party receives a lump sum payment as “essentially a substitute for what
would otherwise be received at a future time as ordinary income” that lump sum
payment is taxable as ordinary income as well. Comm’r v. P.G. Lake, Inc., 356
U.S. 260, 265, 78 S. Ct. 691, 694, 2 L. Ed. 2d 743 (1958). We agree that the
substitute for ordinary income doctrine applies to Lottery Rights, and therefore that
proceeds from the sale of Lottery Rights are taxable as ordinary income.
which it was acquired, originated, or entered into (or such other time as the Secretary may by
regulations prescribe); or
(8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of
a trade or business of the taxpayer.
26 U.S.C. § 1221(a).
6
A. The Substitute for Ordinary Income Doctrine
The statutory definition of capital asset “has . . . never been read as broadly
as the statutory language might seem to permit, because such a reading would
encompass some things Congress did not intend to be taxed as capital gains.”
Maginnis, 356 F.3d at 1181. Congress intended ordinary income to be the default
tax rate, with capital gains treatment an exception applicable only in appropriate
cases. In fact, “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 period of time.” Comm’r v. Gillette Motor Transp., Inc., 364 U.S. 130,
134, 80 S. Ct. 1497, 1500, 4 L. Ed. 2d 1617 (1960). This interpretation prevents
taxpayers from circumventing ordinary income tax rates by selling rights to future
ordinary income payments in exchange for a lump sum. See Lake, 356 U.S. at
265, 78 S. Ct. at 694.
The doctrine is attributed to four seminal Supreme Court cases: Hort v.
Commissioner, Commissioner v. P.G. Lake, Inc., Commissioner v. Gillette Motor
Transport, Inc., and United States v. Midland-Ross Corp. The taxpayer in Hort,
313 U.S. 28, 29, 61 S. Ct. 757, 757, 85 L. Ed. 1168 (1941), a building owner,
received a lump sum in exchange for cancelling a lease on the property. The sum
was taxable as ordinary income because it was “essentially a substitute” for the
7
rental payments, themselves obviously ordinary income. Id. at 31, 61 S. Ct. at 758.
In Lake, 356 U.S. at 261-62, 78 S. Ct. at 692-93, the taxpayer, a corporation,
assigned a portion of oil and sulphur payment rights to its president in
consideration for the cancellation of a debt the corporation owed to the president.
The Supreme Court considered the profit to be in essence a substitution for the oil
and sulphur payments that the corporation would have otherwise received in the
future, and held it taxable as ordinary income for that reason. Id. at 265, 78 S. Ct.
at 694.
The Gillette taxpayer owned a motor vehicle facility during World War II,
which the government assumed control of and for which it paid just compensation.
Gillette, 364 U.S. at 131-32, 80 S. Ct. at 1499. Though the taking involved
“property” for purposes of the Fifth Amendment Takings Clause, that fact “[did]
not answer the entirely different question whether [the compensation] comes
within the capital-gains provisions of the Internal Revenue Code.” Id. at 133, 80
S. Ct. at 1500. Indeed, the Supreme Court held the compensation paid to taxpayer
taxable as ordinary income. Id. at 136, 80 S. Ct. at 1501. Finally, in Midland-
Ross, 381 U.S. 54, 55-56, 85 S. Ct. 1308, 1309, 14 L. Ed. 2d 214 (1965), the
taxpayer bought noninterest-bearing promissory notes subject to an original issue
discount, and then sold them for more than the issue price but still less than face
value. The Supreme Court held that the gains attributable to the original issue
8
discount were taxable as ordinary income, noting the similarity to stated interest.
Id. at 57-58, 85 S. Ct. at 1310. The overall effect of these cases has been to narrow
what a mechanical application of Section 1221 would otherwise cause to be treated
as a capital asset.
With that background, four Circuits have reviewed the precise legal question
we face here under materially identical circumstances.5 Each Circuit has
concluded that Lottery Rights are substitutes for ordinary income, but came to this
conclusion in different ways. The Ninth Circuit used a case-by-case analysis, but
focused on two factors in particular: that the taxpayer “(1) did not make any
underlying investment of capital in return for the receipt of his lottery right, and
(2) the sale of his right did not reflect an accretion in value over cost to any
underlying asset [he] held.” Maginnis, 356 F.3d at 1183. Though the Maginnis
court noted that these factors would not be dispositive in all cases, the Third
Circuit in Lattera, 437 F.3d at 404-09, found the factors problematic, and instead
formulated its own approach, which it termed the “family resemblance” test.
Within the confines of this test, the Third Circuit analyzed the nature of the sale
and the character of the asset, specifically, whether the payment was for the future
5
We note that Taxpayers’ initial brief is strikingly similar to that of the appellants in
Maginnis. Opening Br. of Maginnis et al., Defs.-Appellants, United States v. Maginnis, No. 02-
35664, Feb. 1. 2003. Thus, the Maginnis court confronted, and rejected, largely the same arguments
that Taxpayers raise here.
9
right to earn income or for the future right to earned income. Id. at 409. The
Second and Tenth Circuits did not explicitly adopt the Maginnis reasoning or the
Lattera test, but held that “whatever the [substitute for ordinary income] doctrine’s
outer limits, this case falls squarely within them.” Prebola, 482 F.3d at 612; see
Watkins, 447 F.3d at 1273 (“[W]e need not formulate any specific test regarding
the appropriate limits of the doctrine's application.”); Wolman v. Comm’r, 180
Fed. Appx. 830, 831 (10th Cir. 2006) (“For the same reasons stated in Watkins, we
reject the Wolmans’ argument and hold that the lump sum payments were taxable
as ordinary income.”).
We agree with our sister circuits that Lottery Rights are a clear case of a
substitute for ordinary income. A lottery winner who has not sold the right to his
winnings to a third party must report the winnings as ordinary income whether the
state pays him in a lump sum or in installments. See 26 U.S.C. § 165(d)
(describing tax treatment for losses from wagering transactions); Comm’r v.
Groetzinger, 480 U.S. 23, 32 & n.11, 107 S. Ct. 980, 986 & n.11, 94 L. Ed. 2d 25
(1987) (describing the lottery as a form of public gambling subject to 26 U.S.C.
§ 165(d)’s provision regarding wagering losses). Thus, when a lottery winner sells
the right to his winnings, he replaces future ordinary income. In defining “capital
asset,” Congress did not intend for taxpayers to circumvent ordinary income tax
treatment by packaging ordinary income payments and selling them to a third
10
party. See Lake, 356 U.S. at 265, 78 S. Ct. at 694 (illustrating courts’ need to
protect against “artful devices”).
There are important differences between Lottery Rights and the typical
capital asset. The sale of a capital asset captures the increased value of the
underlying asset. Perhaps the most common example occurs when a taxpayer
purchases shares of stock, owns the shares for longer than a year, and then sells
them at a higher price. The taxpayer makes an underlying investment in a capital
asset when he purchases the stock. When he sells the shares at a higher price, the
gain represents an increase in the value of the original investment. As the Ninth
Circuit noted in Maginnis, 356 F.3d at 1183, Lottery Rights lack these
characteristics emblematic of capital assets -- Lottery Rights involve no underlying
investment of capital. Furthermore, any “gain” from their sale reflects no change
in the value of the asset. It is simply the amount Taxpayers would have received
eventually, discounted to present value.6
6
As they are stated in Maginnis, these factors are obviously imperfect. For example, relying
on the taxpayer’s underlying investment ignores legitimate capital assets obtained through gifts or
inheritances, and consideration of accretion in value excludes capital assets that typically depreciate,
such as cars. See Lattera, 437 F.3d at 405. The Maginnis court properly observed that the factors
would not be dispositive in every case. Maginnis, 356 F.3d at 1183. A court would have no
occasion to evaluate these factors where the asset sold is something other than a claim to ordinary
income, such as a car. The factors do, however, serve to emphasize the essence of a capital
transaction: “that the sale or exchange of an asset results in a return of a capital investment coupled
with realized gain or loss.” Holt v. Comm’r, 303 F.2d 687, 691 (9th Cir. 1962); see also Gillette,
364 U.S. at 134, 80 S. Ct. at 1500 (“This Court has long held 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
11
Furthermore, when a lottery winner sells Lottery Rights, he transfers a right
to income that is already earned, not a right to earn income in the future. See
Lattera, 437 F.3d at 407-09. The Fifth Circuit long ago drew this distinction in
United States v. Dresser Industries, Inc., 324 F.2d 56 (5th Cir. 1963), when it held
that proceeds from the grant of an exclusive license to use an oil well surveying
patent warranted capital gains treatment. Recognizing the “vast difference between
the present sale of the future right to earn income and the present sale of the future
right to earned income,” id. at 59, the Dresser court noted that an exclusive patent
license is property that can produce unknown income in the future, as opposed to
property that represents income payments already certain in amount, but to be paid
in the future.
A capital asset has the potential to earn income in the future based on the
owner’s actions in using it. Lottery winners, by contrast, are “entitled to the
income merely by virtue of owning the property.” Note, Thomas G. Sinclair,
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, 406 (2004); see Lattera, 437 F.3d at 409-10; Dresser, 324 F.2d at 59.
Income need not be accrued for tax purposes to be “earned” in this sense. Cf.
substantial period of time . . . .”). We also note that the tax treatment of gifts, inheritances, and sales
of automobiles is well established and neither relevant to nor affected by the issues in this case.
12
Thomas v. United States, 45 F. Supp. 2d 618 (S.D. Ohio 1999), aff’d, 213 F.3d 927
(6th Cir. 2000) (holding that a lottery winner must report income from winnings
during the period the payment was received). Thus, income from a lottery
payment is earned income despite the fact that it does not accrue until the
scheduled annual payment date. Proceeds from the sale of Lottery Rights are a
clear substitute for ordinary income and are taxable as ordinary income.
1. Effect of Arkansas Best
We briefly address Taxpayers’ argument that the Supreme Court’s decision
in Arkansas Best Corp. v. Comm’r, 485 U.S. 212, 108 S. Ct. 971, 99 L. Ed. 2d 183
(1988), significantly limited the substitute for ordinary income doctrine. Like
other courts that have confronted it, we reject this contention. Maginnis, 356 F.3d
at 1185; Lattera, 437 F.3d at 403-04; Davis, 119 T.C. at 6; Gladden v. Comm’r,
112 T.C. 209, 221 (1999), rev’d on other grounds, 262 F.3d 851 (9th Cir. 2001);
FNMA v. Comm’r, 100 T.C. 541, 573 & n.30 (1993).
The Arkansas Best Court discussed the substitute for ordinary income
doctrine in a footnote.7 The footnote reads, in full:
Petitioner mistakenly relies on cases in which this Court, in narrowly
applying the general definition of “capital asset,” has “construed
7
Ark. Best, 485 U.S. at 216-18, 108 S. Ct. at 974-75, addressed the question of whether the
taxpayer’s motive in acquiring an asset, either a business motive or an investment motive,
determines whether it is a capital asset or an ordinary asset. The substitute for ordinary income
doctrine was not relevant to the decision.
13
‘capital asset’ to exclude property representing income items or
accretions to the value of a capital asset themselves properly
attributable to income,” even though these items are property in the
broad sense of the word. United States v. Midland-Ross Corp., 381
U.S. 54, 57, 85 S. Ct. 1308, 1310, 14 L. Ed. 2d 214 (1965). See, e.g.,
Comm’r v. Gillette Motor Co., 364 U.S. 130, 80 S. Ct. 1497, 4 L. Ed.
2d 1617 (1960) (“capital asset” does not include compensation
awarded taxpayer that represented fair rental value of its facilities);
Comm’r v. P.G. Lake, Inc., 356 U.S. 260, 78 S. Ct. 691, 2 L. Ed. 2d
243 [sic] (1958) (“capital asset” does not include proceeds from sale
of oil payment rights); Hort v. Comm’r, 313 U.S. 28, 61 S. Ct. 757, 85
L. Ed. 1168 (1941) (“capital asset” does not include payment to lessor
for cancellation of unexpired portion of a lease). This line of cases,
based on the premise that § 1221 “property” does not include claims
or rights to ordinary income, has no application in the present context.
Petitioner sold capital stock, not a claim to ordinary income.
Ark. Best, 485 U.S. at 217 n.5, 108 S. Ct. at 975 n.5 (emphasis added and citation
formatting modified). This footnote affirmed that the substitute for ordinary
income doctrine applies to “property” that represents a claim to ordinary income.
Taxpayers urge a different interpretation. They focus on the Court’s use of
the word “narrowly” and insist that the factual scenarios corresponding to the four
Supreme Court cases cited in the footnote, Hort, Lake, Gillette, and Midland-Ross,
are the only surviving remnants of the substitute for ordinary income doctrine.
They argue that because the footnote “directly clashes with the body of the opinion
. . . the only logical reading of the use of the term ‘narrowly’ in footnote 5 is that
only in those particular ‘narrow’ factual situations that existed in the cited cases is
the [d]octrine applicable.” (Br. for the Appellants 42.)
14
Taxpayers’ reading is not the natural one. In the footnote, the word
“narrowly” modifies the phrase that immediately follows, “applying the general
definition of ‘capital asset.’” The footnote unambiguously explains that in the
cited cases, the Court applied the statutory definition of capital asset narrowly. It
in no way implies that the Court applied the substitute for ordinary income
doctrine narrowly, nor hints that the Court would confine the doctrine to the facts
of the cases it cites. To the contrary, the Court cites general language that indicates
that it would apply the doctrine in any situation involving “‘income items or
accretions to the value of a capital asset themselves properly attributable to
income.’” Ark. Best, 485 U.S. at 217 n.5, 108 S. Ct. at 975 n.5 (quoting Midland-
Ross, 381 U.S. at 57, 85 S. Ct. at 1310). We have no trouble reconciling this
footnote with the body of the Arkansas Best opinion for the reasons stated in the
footnote itself: the taxpayer in that case “sold capital stock, not a claim to ordinary
income.” Id. We reject Taxpayers’ attempt to limit the substitute for ordinary
income doctrine in an unreasonable manner not suggested by the relevant case law.
This is not to say that the substitute for ordinary income doctrine applies
upon the sale of every asset that produces ordinary income. Taken to its logical
extreme, the substitute for ordinary income doctrine would obliterate capital gains
treatment altogether because a capital asset’s present value is often based on its
future ability to produce revenue in the form of ordinary income. Maginnis, 356
15
F.3d at 1182. We acknowledge that the doctrine has its outer limits, but we do not
define them here. We merely recognize that Arkansas Best did not circumscribe
the substitute for the ordinary income doctrine. See, e.g., Maginnis, 356 F.3d at
1185; Lattera, 437 F.3d at 403-04.
B. “Property” Under Section 1221
As Taxpayers note, Arkansas Best makes clear that if a given asset is not
listed within Section 1221’s exclusions, it is a capital asset unless it is not
considered “property.” Ark. Best, 485 U.S. at 217-18, 108 S. Ct. at 975. The
pertinent Treasury Department regulation also provides that “[t]he term capital
assets includes all classes of property not specifically excluded by section 1221.”
26 C.F.R. § 1.1221-1(a). The parties do not dispute that Lottery Rights are not
within the statutory exclusions. Therefore, in deciding that the substitute for
ordinary income doctrine applies, we necessarily find that Lottery Rights do not
constitute “property” as that term is used in Section 1221. 4 Mertens Law of
Federal Income Taxation § 22:4 (Sept. 2007) [hereinafter Mertens] (“In situations
where the court determines that the intangible right is a substitute for ordinary
income, the court concludes (either implicitly or explicitly) that the asset sold does
not constitute property for purposes of Section 1221.”).
Taxpayers also note that Lottery Rights are property in the ordinary sense of
the term and for purposes of other state and federal laws. We recognize that
16
Lottery Rights are property for most other purposes, but “property” under Section
1221 is a narrower concept. Gillette, 364 U.S. at 134-35, 80 S. Ct. at 1500-01;
Mertens, supra, § 22:4 (“The mere fact, however, that the asset in question
constitutes ‘property’ in the broad sense of the word does not mean that such asset
constitutes property for purposes of Section 1221 or that the property constitutes a
capital asset.”); Note, Distinguishing Ordinary Income from Capital Gain Where
Rights to Future Income are Sold, 69 Harv. L. Rev. 737, 737-38 (1956)
(“‘Property,’ as it is broadly used in other areas of the law, includes such items as
unpaid claims for personal services or for accrued rents. Unless Congress intended
that holders of such claims to ordinary income would be able by selling them to
transform ordinary income into capital gain, ‘property’ for the purposes of section
1221 is a more limited concept.”). As the Supreme Court has stated, “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.” Gillette, 364 U.S. at
134, 80 S. Ct. at 1500.8 The Court again recognized in Arkansas Best that a literal
reading of the term “property” is not appropriate where such a reading would
include ordinary income and substitutes for ordinary income. See Ark. Best, 485
8
Taxpayers argue that Gillette’s statement about “property” should be confined to the narrow
context of that case. Courts applying the substitute for ordinary income doctrine have relied on this
statement as a general proposition. E.g., Midland-Ross, 381 U.S. at 56-57, 85 S. Ct. at 1310;
Watkins, 447 F.3d at 1271-72.
17
U.S. at 217 n.5, 108 S. Ct. at 975 n.5 (describing the assets falling within the
substitute for ordinary income doctrine as “property in the broad sense of the
word”); see also Donna D. Adler, A Conversational Approach to Statutory
Analysis: Say What You Mean & Mean What You Say, 66 Miss. L.J. 37, 106
(1996) (“If the literal language of [Section 1221] were followed, taxpayers could
convert much of their ordinary income to capital gain merely by selling the right to
the income before the payment was actually made.”).
This interpretation, which courts repeatedly adopt, gives effect to
congressional intent. In defining “capital asset,” Congress used the term
“property” to mean “not income” -- that is, “property” serves to distinguish assets
suitable for capital gains treatment from mere income. “Property” in the most
general sense means anything owned, which would also include income and any
rights or claims to it. Even if other statutes use “property” in this broad sense, to
exclude substitutes for income in determining what constitutes a capital asset is
consistent with the word “property.” No other interpretation of “property” would
harmonize with the statute’s purpose, as the very nature of the term “capital asset”
excludes what is in essence ordinary income. See Stanley S. Surrey, Definitional
Problems in Capital Gains Taxation, 69 Harv. L. Rev. 985, 987-88 (1956) (“Since
in one sense everything that the taxpayer holds is ‘property’ and hence will be a
capital asset, at this point it would seem to follow that all income could well be
18
‘capital gain’ . . . .”). Indeed, in applying the substitute for ordinary income
doctrine, the Gillette court declined to use the all-inclusive definition of property
the Supreme Court espoused in one of its earlier decisions, Crane v. Comm’r, 331
U.S. 1, 6, 67 S. Ct. 1047, 1051, 91 L. Ed. 1301 (1947) (interpreting “property” as
anything subject to ownership). Rather, the Gillette court confirmed that some
things that would normally be “property” are not capital assets, even if no statutory
exclusion covers them. Gillette, 364 U.S. at 134, 80 S. Ct. at 1500. Lottery
Rights, as we explained above, are substitutes for ordinary income. We now
address two of Taxpayers’ arguments related to specific types of property.
1. Accounts Receivable
Taxpayers argue that Lottery Rights are property because they are “accounts
receivable.” Section 1221 excludes from the definition of capital asset certain
types of accounts receivable, specifically “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).” 26 U.S.C. § 1221(a)(4). The exclusion of
business-related accounts receivable, according to Taxpayers, implies that all other
types of accounts receivable are property, because otherwise that exclusion would
be surplusage.
Taxpayers’ primary support for their argument that Lottery Rights are
accounts receivable comes from the Uniform Commercial Code, which defines
19
“account” to include rights to payment “as winnings in a lottery or other game of
chance operated or sponsored by a State.” U.C.C. § 9-102(a)(2). But the Internal
Revenue Code does not define “accounts receivable.” As the Fifth Circuit stated in
a case involving contractual rights in a mortgage servicing agency, “[t]he fact that
[those rights] constitute a species of ‘property’ under state law affords no
assistance in determining whether such rights are capital assets.” Bisbee-Baldwin
Corp. v. Tomlinson, 320 F.2d 929, 932 (5th Cir. 1963); see also Miller v. Comm’r,
299 F.2d 706, 708 (2d Cir. 1962) (noting that although ordinary property concepts
are relevant, non-tax definitions are “certainly not binding” on a court interpreting
Section 1221).
In any event, the status of Lottery Rights as accounts receivable is a separate
question from whether Lottery Rights fall under the substitute for ordinary income
doctrine. As the Maginnis court stated: “Although some accounts receivable not
covered by 1221(a)(4)'s exception will be capital assets, under the substitute for
ordinary income doctrine, some will not be capital assets. Assuming without
deciding that Maginnis’ lottery right was an account receivable, that fact does not
affect our analysis.” Maginnis, 356 F.3d at 1187 n.9. In other words, even if a
certain asset is classified as a non-business-related account receivable, the
application of the substitute for ordinary income doctrine is not necessarily
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precluded, if the asset is otherwise a substitute for ordinary income under the
principles of the doctrine.
We acknowledge the merits of Taxpayers’ statutory interpretation argument.
But in order to effect congressional intent, courts applying the substitute for
ordinary income doctrine sometimes reach a different result than they would
applying bare interpretive canons without context. See In re Griffith, 206 F.3d
1389, 1393 (11th Cir. 2000) (explaining that canons of construction “‘are no more
than rules of thumb that help courts determine the meaning of legislation.’”)
(quoting Conn. Nat’l Bank v. Germain, 503 U.S. 249, 253, 112 S. Ct. 1146, 1149,
117 L. Ed. 2d 391 (1992)). The substitute for ordinary income doctrine prioritizes
substance over form to eliminate capital gains treatment in situations involving
claims for ordinary income. See Lake, 356 U.S. at 266, 78 S. Ct. at 695 (“The
substance of what was assigned was the right to receive future income.”).
Congress did not intend to tax lottery winnings as capital gains. Thus, whether or
not Lottery Rights are “accounts receivable,” they are not capital assets under
Section 1221.9
9
This is consistent with Arkansas Best. There, the Court rejected a taxpayer’s reading of
Section 1221 that would have made surplusage of the statutory exceptions. Ark. Best, 485 U.S. at
218, 108 S. Ct. at 975. The Arkansas Best taxpayer argued that the exceptions in the statute were
“illustrative, rather than exhaustive,” and suggested that the Court was free to create additional
exceptions. Id. at 217, 108 S. Ct. at 975. The court rejected that argument, but distinguished cases
in which courts apply the substitute for ordinary income doctrine. Id. at 217 n.5, 108 S. Ct. at 975
n.5. The doctrine’s purpose is to narrow the statutory language in order to effect congressional
intent. By contrast, where no substitute for ordinary income is involved, Arkansas Best requires a
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2. Debt Instruments
Finally, we are unpersuaded by Taxpayers' argument that Lottery Rights are
“debt instruments” under 26 U.S.C. § 1275. That section defines “debt instrument”
as “a bond, debenture, note, or certificate or other evidence of indebtedness.” 26
U.S.C. § 1275(a)(1)(A). Taxpayers argue that Lottery Rights are property, and
therefore capital assets, because they are “evidence of indebtedness.” 10 In
confronting the same argument, the Maginnis court cited Deputy v. du Pont, 308
U.S. 488, 498, 60 S. Ct. 363, 368, 84 L. Ed. 416 (1940), in which the Supreme
Court stated that “‘interest on indebtedness’ means compensation for the use or
forbearance of money.” Maginnis, 356 F.3d at 1187. For example, an individual
borrowing money from a bank pays interest to the bank in exchange for having
access to the bank’s money up front. The Maginnis court stated that a lottery
winner “receive[s] his right to payments from the state . . . as a prize, not as any
compensation for the use or forbearance of money, and therefore the lottery right
broad reading of Section 1221 that would result in capital gains treatment unless one of the listed
exceptions applies. Arkansas Best supports an approach in which courts analyze the substitute for
ordinary income doctrine somewhat independently of the bare statutory text. See id. at 217 & n.5,
108 S. Ct. at 975 & n.5.
10
Taxpayers note that assets classified as debt instruments under § 1275 are traditionally
capital assets under § 1221, but do not cite any authority for this proposition. We did not locate any
cases in which an asset was held to be a capital asset under § 1221 because it was a debt instrument
under § 1275, and we agree with the Tax Court below that § 1275 is not determinative of capital
asset status under § 1221. Womack v. Comm’r, T.C.M. 2006-240, 2006 WL 3208890, at *8
(Nov. 7, 2006). In any event, we accept the Ninth Circuit’s interpretation of § 1275 in Maginnis,
356 F.3d at 1187, which excludes Lottery Rights.
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d[oes] not constitute evidence of an indebtedness from [the state] to [the lottery
winner].” Id. We agree. That Lottery Rights are traded in the financial
marketplace is irrelevant to an asset’s characterization under Section 1275. In
determining whether Lottery Rights are evidence of indebtedness, we look to the
party allegedly indebted, here the state of Florida. Florida incurred no debt when it
undertook the obligation to make prize payments to lottery winners. The lottery
winners won a game of chance, for which they were awarded a certain amount of
money to be paid annually. They lent no money to Florida, and made no promise
to Florida to use money, or to refrain from using money. Lottery Rights are thus
not evidence of Florida’s indebtedness to Taxpayers, nor debt instruments under
Section 1275.
IV. Conclusion
For the foregoing reasons, we hold that proceeds from the sale of Lottery
Rights should be taxed as ordinary income under the substitute for ordinary income
doctrine. The Tax Court’s decision is AFFIRMED.
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