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Eighteen months ago, Barry Bartolo won a $2 million Massachusetts state lottery and chose to receive it as a $120,000 annual annuity for the rest of his life. This year his sisters persuaded him to sell the annuity to a financial institution for $1.79 million and invest the proceeds in a new family business. How much gain did Barry recognize on the sale of his annuity, and is it an ordinary income or a long-term capital gain?

Lottery winners can receive their prize in the form of annuities or as a lump-sum. The former option provides annual payments over time. Barry chose to collect the winnings of $120,000 for the entire life of the annuity. A lump-sum payment is received all at once after federal taxes, withholding tax by lottery companies and other state-specific taxes (if any), have all been deducted from the jackpot amount. A lump-sum payout is usually less than the advertised jackpot prize. In most cases, the prize from a jackpot is invested accounts that bear interests from which the winner receives annuity payments over a specified period (Matheson and Grote 559). While most winners will opt for a lump-sum payout, lottery-annuities are considered a better option. Since Barry chose such option, his winnings were not taxed immediately, as in the case of lump-sum payout. Instead, the tax is deducted every other year upon receiving his payment.

For Barry, had he gone for the lump-sum option, he would receive the $2 million minus taxes. However, with annuity payments, he will get the entire $2 million together with interests accumulated from investments over the life of the annuity. Barrys capital gain is to sell his rights to future annual annuity payments to the financial institution. The Internal Revenue Code argues that the sale of lottery winnings, in this case, as an annuity, results in capital gain under the following conditions:

To acquire the capital asset, the taxpayer must sell or exchange the property which constitutes a capital asset. However, the proceeds from the sale of lottery winnings may not qualify as property, as stated in Section 1221 of the Internal Revenue Code of 1986 (Coven).
If the right stated in (I) above is property, it may not be a capital asset.
The proceeds from the annuity sale are ordinary income if a lump-sum payment is an alternative for the right to obtain ordinary income in the future. Since Barry chose annuity payments instead of lump-sum payments, the proceeds, therefore, are ordinary income (Pistone 77).

Calculations

As of 2020, for all winnings above $5,000, the winner owed IRS not less than 37 percent in taxes consisting of federal taxation, withholding tax at the rate of 25 percent, and state tax. State taxes vary from one state to another whereas New Hampshire and Florida for example do not tax lottery winnings. The current state tax on lottery prize in Massachusetts is 5 percent (Williams). Considering his annuity option of $120,000 per year, after deducting taxes, he would end up with $84 000 as follows:

Federal tax (inclusive of withholding tax) = 0.37 x $120,000 = $44,000

State tax = 0.05 x $120,000 = $6,000

Net pay = $120,000 ($44,000 + $6,000) = $70,000

Initially, the annuity was to run for 16

2/3 years, that is ($2,000,000 ÷ $120,000) from which he would earn $1,400,000, as follows:

Annual annuity net payment = $70,000

Annuity period = 16

2/3 years

Total net payment = 16

2/3 x $70,000 = $1,166,666.70

Having received the first payment, he would expect $1,096,666.70 that is ($1,166,666.70 $70,000)

By selling his annuity at $1,790,000, Barry gained in the following way:

Proceeds from annuity sales =$1,790,000

Remaining net annuity payment = $1,096,666.70

Barrys gain = ($1,790,000 $1,096,666.70) = $693,333.30

Therefore, Barrys capital gain from the sale of his annuity to the financial organization was about $693,333.30.

According to Pistone

These points support the treatment of a sale of lottery winnings as a sale of a capital asset: (1) the language of Section 1221 of the Code and (2) the argument by analogy that the sale of lottery winnings should receive treatment as a debt instrument (80).

As Pistone (78) states, when a financial institution buys the legal rights to receive annual payments on behalf of the lottery winner for a lump sum cash, this transfer of ownership of the right to collect annual disbursement is a sale for the purposes of existing state laws. Regardless of whether the winner sells part of his remaining annuity amount or all of it, they would get a capital gain on this sale.

An Analogy of a Debt Instrument

This analogy serves to explain how ordinary income and interest arise. When a taxpayer purchases an item, which is the debt instrument, at a discount and keeps it until when they have fully paid for it, the income they realize in the long run due to the discount they initially received is referred to as ordinary income (Pistone 81). All the interests accumulated from keeping the debt instrument fully paid for are ordinary interest income. From the above analogy, this paper can confidently say that since the financial institution bought this annuity from Barry at a discount, the proceeds they would get from this annuity until maturity is ordinary revenue, and the interest accrued in the process is the ordinary interest income.

References

Coven, Glenn E. Congress as Indian-Giver: Phasing-out Tax Allowances under the Internal Revenue Code of 1986. Virginia Tax Review, vol. 6, 1986, pp. 505.

Matheson, Victor A and Grote Kent R. Jacking Up the Jackpot: Are Lotto Consumers Fooled by Annuity Payments? Public Finance Review, vol. 31, no. 5, 2006, pp. 550-567. web.

Pistone, Renee A. Dreaming an Impossible Dream: A Case for Treating Lottery/Gambling Winnings as Capital Gain. American Journal of Business and Society, vol. 1, no. 3, 2016, pp. 77-82.

Williams, M. How Much Tax Would a Massachusetts Resident Owe on a $1.5 Billion Powerball Jackpot? Advance Local, 2019, Web.

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