Re: How are STRIPS for lottery jackpots taxed?
- From: "Shyster1040" <Shyster1040@xxxxxxxxxxxxxxxxx>
- Date: Mon, 02 Apr 2007 15:47:21 -0400
""Re: How are STRIPS for lottery jackpots taxed?
by "nomail1983@xxxxxxxxxxx" <nomail1983@xxxxxxxxxxx> Apr 1, 2007 at 12:27
AM
On Mar 31, 7:25 pm, "Shyster1040" <Shyster1...@xxxxxxxxxxxxxxxxx>
wrote:
The means by which the lottery commission chooses to fund your annualassets,
payments is irrelevant to the tax treatment of the payments you receive
because you do not have any beneficial ownership in the underlying
merely a claim against the lottery commission that is secured usingthose
assets as collateral.
Thanks. That is a very real possibility, one that I also thought of. I
will ask the lottery commission for confirmation (or not) on Monday.
Not to sound provocative, but I wonder: what are you basing your
assertion on?
The assertion makes a lot of sense. But I thought it is equally possible
that the state is the "nominee" (holder of record) and the jackpot winner
is the beneficial owner. If that were the case, as noted in Pub1212,
although the nominee would initially receive the 1099-OID, the nominee is
required to send a 1099-OID to the "true owner".
Moreover, I thought I had read quite some time ago that the tax due on the
accrued, but unreceived OID is a hidden cost that catches jackpot winners
by surprise. But my recollection could be wrong; or the source of that
information (long-since forgotten) could be wrong.
Finally, I wondered why the Calif Lottery Commission goes to such lengths
to explain the investment mechanics in the Winner's Handbook.
If all the commission wanted to do was assure the winner that his future
payments are guaranteed, I think it would be sufficient for the handbook
to explain simply that the state invests in bonds that are backed by the
US Treasury. Instead, the handbook explains the state invests in US
Treasury zero-coupon bonds and the annual payments are a combination of
the "principal" (presumably meaning issue price) and accrued interest.
Of course, that could merely be a case of saying more than is necessary.
And it could be a case of answering a FAQ.
In any case, those are the reasons while I labored under the ass-u-me-tion
that it was a significant fact that the underlying investment is zero
coupons. And I presumed that the significance was the fact (assertion)
that the jackpot winner is responsible for the tax on the accrued, but
unreceived OID.
If you can point to a source for your assertion to the contrary, that
would go a long in dispelling my speculations.
To the extent that the commission chooses to fund your payment stream
using STRIPS, the issue of OID and etc is one that matters only to the
commission, not to you.
I highly doubt that the state would pay tax on the OID. If the jackpot
winner is not required to pay tax on OID in the year that it accrues, he
will certainly pay tax on the entire annual payment, which includes the
OID for the bond that matured.
Thanks again for your thoughts. I guess I will pursue my questions with
the lottery official.""
*****************************************
Basically, my statements rest on the foundation of the fundamental
principles of income taxation, primarily the doctrine of constructive
receipt.
Without having a specific set of documents or transactions in front of me,
I cannot give specifics; however, there are two basic ways of analysing
the matter, all of which generally lead to the same conclusion - a lottery
winner receiving annual payments does not include any OID over and beyond
the amount actually received for any payment.
First, under the general rules of constructive receipt, a winner has no
entitlement to a payment until it is paid, and then only in that amount -
this being because, until the payment is made, the winner's right to draw
on the amount is subject to substantial limitations (i.e., he can't get it
until the payment date). See, e.g., Hamilton National Bank of Chattanooga
v. Commissioner, 29 B.T.A. 63 (1933).
The doctrine of constructive receipt is typically used to force a taxpayer
to include an item in income even though the taxpayer has not yet received
cash; however, it can also be used by a taxpayer to defer the recognition
of income - constructive receipt is the keystone to every deferred
compensation arrangement.
Added to this is the more general provision that income belongs to the
person who earned it or, in this case, the person who owns the assets that
generated the income. In the case of a lottery winner receiving annual
payments, the lottery winner does not own the assets generating the OID,
and thus is not the proper taxpayer to report that income. This is the
case whether or not the winner will ultimately receive an amount equal to
the value of the assets, or even the assets themselves. This provision
generally falls under the doctrine of anticipatory assignment of income
(which states that an owner of income cannot shift the tax incidence
related to that income by giving away or otherwise transferring the right
to receive the income before it is paid). That doctrine derives from
Lucas v. Earl, 281 U.S. 111 (1930).
Thus, in the absence of any indication who owns the assets used to fund
the annual lottery payments, and assuming in that case that the state
lottery commission retains ownership of the assets, the income is taxable
to the lottery commission, not the lottery winner because (a) the
commission presumably owns the assets generating the income (including
OID), see Lucas v. Earl, and (b) the winner is not entitled to anything
until the payment date is reached, see, Hamilton National Bank of
Chattanooga v. Commissioner.
Second, if the state lottery commission sets aside an amount equal to the
money needed to fund the annual payment streams, that segregated account
may be treated as a trust. To the extent that the trust is revocable, or
the lottery commission retains control over the fund or the trustee, the
fund would constitute a grantor trust under subpart E of subchapter J, the
commission would be treated as the owner, and the analysis would go as
above.
On the other hand, if the fund were an irrevocable non-grantor trust, it
would then constitute a complex trust under subchapter J because the fund
is not limited to distributing all of its fiduciary accounting income to
the beneficiary (the winner) in full every year - since the winner is
entitled to a fixed dollar amount, and since the fund is intended to be
exhausted at the end of 20 years, the annual payment will almost always
exceed the amount of fiduciary accounting income.
Under the rules of subchapter J, as a complex trust, the distribution
would pull out the trust's taxable income for the year, in an amount equal
to the lesser of the amount distributed or the amount of the trust's
taxable income for the year. The trust itself would get an offsetting
deduction to the extent that its taxable income was pulled out.
The beneficiary receiving the distribution would instead be required to
include in his own income that part of the trust's taxable income that was
distributed to him (i.e., the amount his distribution pulled out).
As a result, under this analysis, the beneficiary/winner would include all
accrued OID for a given year, up to the amount of his annual payment.
Further, to the extent that the annual payment exceeded accrued OID for
the year, the distribution would be treated as a distribution of
principal. Such a distribution is ordinarily not taxed to a beneficiary
who received his interest as a gift; however, in this case, the amount of
the principal received itself represents income that the
beneficiary/winner was not required to recognize earlier on account of the
constructive receipt doctrine, and thus would be recognized as income for
the year in which distributed.
If you run a spreadsheet using publicly available STRIPS data (e.g.,
price, maturity, and YTM), you will see that the amount of OID that
accrues for a particuar year from all of the STRIPS held in a lottery
funding account is less than the total amount of the annual payment to be
made for that year; as a result, if the funding account were treated as a
trust, the beneficiary/winner would generally be required to treat a
certain percentage of his annual payment as interest income, and the
remainder as a distribution of principal that must be included in income
as deferred income.
Correspondingly, the trust itself would get a deduction for the full
amount of the OID, and would not owe any income tax as a result.
Thus, the taxable income attributable to the OID is effectively shifted to
the beneficiary/winner without the state lottery commission also having to
pay tax on that amount.
However, it should be noted that, under this analysis, if the OID for a
year exceeded the amount of the annual payment, the entire payment, but no
more, would be treated as interest income, and the trust would be taxable
on the remaining excess OID.
However, the trust construct is really not needed here, and is probably
inapposite since, as far as I can tell (never having been a lottery winner
myself) lottery payments are not broken down into an interest component
and a principal component.
Instead, it is more likely that the state lottery commission is treated as
the owner of the assets used to fund the annual payments, and thus is
taxable on the accrued OID from those assets. However, since the state
lottery commission would be engaged in the trade or business of holding
lotteries, payments it makes to lottery winners would constitute
deductible business expenses.
As noted above, the amount of accrued OID for any year will almost always
be less than the amount of the related annual payment and, as a result,
the deduction for the annual payment would more than offset any income
recognized as a result of the OID rules.
As a result, the state lottery commission would not have any federal
income tax liability as a result of the OID rules. Which is more or less
irrelevant in the first place, since state lottery commissions are,
typically, treated as instrumentalities of their states are are thus most
likely exempt from federal income tax under Sec. 115. See, e.g., Wodjick
v. Massachusetts State Lottery Commission (1st Cir. August 20, 2002, No.
01-2032 (concluding that lottery commission was instrumentality of state
for non-tax purposes).
So, bottom line is, under the doctrines of constructive receipt and
assignment of income, any OID accruing on assets used to fund annual
lottery payments is not included in the income of the lottery winner
because (a) such income belongs to the state lottery commission, not the
lottery winner, and (b) in any event, even if the asset account were
treated as a taxable trust under subchapter J, the lottery winner would
not be required to include any OID in income in excess of the amount of
the annual payment.
----------------
Below are some of my earlier thoughts, which I leave for forensic analysis
by those so inclined.
Under the doctrine of constructive receipt, which is generally applicable
to lottery winnings, subject to a statutory modification under Code Sec.
451(h), a cash method taxpayer does not include an amount in income until
the taxpayer has actually received payment of that amount, or the amount
has been set aside for the taxpayer or credited to his account, is not
subject to any substantial risk of forfeiture, and is available for the
taxpayer to draw on at any time without any substantial limitations.
Put another way, if a taxpayer's ability to enjoy the economic benefit of
an amount is either subject to a substantial risk of forfeiture, or to
substantial limitations, then the taxpayer has not yet received that
amount for purposes of the income tax.
That doctrine, subject to the provisions of Sec. 451(h), is the reason why
a lottery winner who chooses to take the 20 (or however many) annual
payments is not required to include the net present value of the entire
amount won in income for the year in which the prize was won - the winner
in that situation has no ability to enjoy the economic benefits of each
payment until the year in which it is actually made.
Sec. 451(h) extends the doctrine of constructive receipt to certain
lottery winners who are given the option, after they've won, to take
either a lump sum or annual payments - provided the choice is made within
60 days of winning. Absent this provision, the unaltered doctrine of
constructive receipt would require a winner to include the full amount won
in income for the year in which won, regardless of whether the winner
chose lump sum or annual payments.
Generally, if a cash basis taxpayer receives a "mere unfunded promise to
pay," the taxpayer does not have income until actual payment. A funded
promise to pay also frequently does not give rise to income for the
obligee until actual payment if the assets funding the promise are subject
to the claims of the obligor's general creditors.
That is the situation most lottery winners who elect to take the annual
payments are in - they have received from the state lottery commission a
promise to pay amounts in the future, which promise is funded with the
assets held in the funding account, but which assets are not limited, as
against the rest of the world, to being used to fund those payments.
If the assets held in any account were dedicated solely to making the
annual payments to one particular winner, then that winner would most
likely have to include the face value of those assets in income for the
year in which the prize was won (or the account is funded, if later).
Conversely, if a taxpayer subsequently sells the right to receive the
future annual payments, the taxpayer must treat the entire amount of the
proceeds as ordinary income. See, e.g., Womack v. CIR, T.C. Memo
2006-240(http://www.ustaxcourt.gov/InOpHistoric/WOMACK2.TCM.WPD.pdf).
The states are generally sensitive to the federal tax consequences of
persons like lottery winners, and will generally structure their lotteries
so that winners who take the annual payments option do not have to include
the full amount of their winnings in income for the first year.
As a result, I am quite confident that, because California offers the
annual payment option, it has structured its lottery to avoid constructive
receipt for federal income tax purposes.
Thus, as a necessary corollary, it must be the case that, until an amount
is actually paid to a winner, that winner has no economic entitlement to
the amount, including any OID, and thus is not required to include that
amount in income until the time of receipt.
If you actually do a spreadsheet, you will find that, typically, the sum
of the amount of OID accruing between one payment date and the next, plus
the amount of the STRIP that matures for that same period and is paid over
to the winner, generally equals the amount of the payment the winner is
entitled to receive, so there really is not a big wedge between the
ordinary income the winner must report and the amount of OID accrued.
Lastly, the character of the OID (and any actual stated interest, for
lotteries that are funded other than with STRIPS) does not pass through to
the winner because, again, they do not bear any of the benefits or burdens
of ownership of the STRIPS, and instead are entitled to a fixed annual
payment. This is similar to the situation in partnership taxation where a
partner receives a guaranteed payment (i.e., a payment that is not
dependent on the amount of the partnership's income) - under subchapter K,
a guaranteed payment does not carry with it the character of the
underlying income that funded the payment, and is instead characterized
under ordinary tax principles with respect to the reason for why the
partner received the payment.
E.g., if it was for services, it would be ordinary compensation income, if
it was for sale of property, it would be long/short term capital gain,
unless the property was inventory or Sec. 1231 property in the hands of
the selling partner.
.
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- From: nomail1983@xxxxxxxxxxx
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