Opinion ID: 77887
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Heading: The Substitute for Ordinary Income Doctrine

Text: 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 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 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 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 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] 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. 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.