PLR 200031031: Lottery assignment option does not accelerate nonassigning winners' income

Plain-English summary

A state lottery asked whether a law allowing jackpot winners to assign future annual prize payments would change the tax timing for winners who kept their annuities. Under the law, an assignment required a court order and specified disclosures. The IRS analyzed constructive receipt, economic benefit, and cash equivalence. It ruled that assignments by some winners would not cause cash basis winners who did not assign their payment rights to recognize income before receiving their own payments. The letter did not rule on the tax treatment of the winners who assigned their rights. It also excluded circumstances in which prizes were frequently transferred at discounts close to the prevailing cost of money.

Ruling snapshot

• Question: Does permitting some winners to assign future lottery payments accelerate income for winners who retain their annuity payments?
• Outcome: Approved. Nonassigning cash basis winners need not recognize payments before receipt under the described arrangement.
• Key authorities: IRC § 451(h); constructive receipt, economic benefit, and cash equivalence doctrines.

Full text (IRS public release)

Internal Revenue Service                           Department of the Treasury

Index Number:          451.14-00                   Washington, DC 20224



Number: 200031031                                  Person to Contact:
Release Date: 8/4/2000
                                                   Telephone Number:

                                                   Refer Reply To:
                                                   CC:DOM:IT&A:05-PLR-110663-99
                                                   Date:

                                                   May 5, 2000




State Lottery                 =

State                         =

Act                           =

X                             =

Date a                        =

Date b                        =


Dear     .      :

      This responds to your request for a private letter ruling, dated June 9, 1999,
submitted on behalf of the State Lottery. Specifically, you have asked for a ruling that:

                The assignment of all or part of future lottery payments by a
                “Lotto” jackpot prize winner pursuant to the procedures established by the
                State statute, as amended by the [Act], will not cause other cash basis
                lottery prize winners who are entitled to receive their prizes in the form of
                an annuity and who do not assign their rights to such payments to realize
                income for federal income tax purposes in advance of the receipt of such
                payments from the State Lottery.

FACTS:

        The State Constitution authorizes the establishment of a state lottery. Enabling
legislation created State Lottery as a separate agency of the State. State “Lotto” is one
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of several lottery games administered by State Lottery. Lotto contestants select six
numbers from a field of forty-nine numbers at the time they purchase lottery tickets.
Lottery drawings are held once a week, with six numbers selected, and prizes are
awarded to contestants who correctly match three, four, five, or six of the selected
numbers. The amount of the prizes depends upon the total amount wagered on the
particular drawing, amounts rolled over from previous drawings in the particular prize
category (i.e., because there were no matching combinations in the prior drawing), and
the number of winning tickets in each category. Under the State Lottery rules, the first
prize ("jackpot") in a Lotto drawing is awarded to any player who matches all six
numbers on one ticket.

        The State Lottery has implemented the provisions of § 451(h) of the Internal
Revenue Code. This provision allows states to offer prize winners the option of
receiving in a single cash payment any lottery prize that otherwise is payable over at
least ten years, provided the option is exercised within sixty days of the date of the
taxpayer’s entitlement to the prize. Section 451(h) also provides that the availability of
this option will not affect the taxation of those prize winners who do not choose the
single payment option. In accordance with § 451(h), the State Lottery rules provide that
“Lotto” jackpot winners have the option of receiving their share of the jackpot pool either
as a single cash payment or in thirty (30) annual payments.

       State law requires the X to invest moneys available for payment of prizes on a
deferred basis in accordance with a trust agreement between the State Lottery and the
X. The trust agreement requires investment in U.S. Treasury Bonds that will mature in
each of the years for which an annual payment must be made. The securities are
purchased in the name of the State and are not set aside for any specific winner.

      Prior to the effective date of the amendment contained in the Act (the
"Amendment"), the State statute provided that a prize winner's right to a prize was not
assignable other than to the estate of a deceased prize winner or to a person
designated pursuant to an appropriate judicial order.

         The Amendment, which was signed into law on Date a, expressly permits the
voluntary assignment of the right to receive future annual prize payments, in whole or in
part, if the assignment is made pursuant to an appropriate court order, and provides
specific procedures for obtaining that order. Specifically, under the Amendment, a
written notice (a petition) of the proposed assignment and any court hearing must be
provided in advance to the State Lottery. The State Lottery may intervene in the judicial
proceeding, and the court receiving the petition is authorized to issue an order
approving the assignment provided all of the following conditions are met: (1) the
assignment is in writing and is subject to by its terms to State law; (2) the discount rate
being used does not exceed State’s usury limit for loans; (3) the assignor provides a
sworn written declaration that he/she had an opportunity to consult with independent
legal counsel, has received independent tax and financial advice, is of sound mind and
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not acting under duress, understands that he/she will not receive payments or portions
thereof during the assignment period and that the State Lottery will have no liability to
make the assigned payments to him/her, has been provided a disclosure statement
setting forth the payments being assigned, the purchase price being paid, the discount
rate, and any origination or closing fees, and was advised in writing that he/she had the
right to cancel the contract within 3 business days; and (4) the State Lottery received
the required notice. The court order must provide that delinquent child support
obligations of, or debts owed to a state agency by the assigning prize winner as of the
date of the court order shall be offset first against remaining payments to the winner
and then against payments to the assignee. The Amendment also authorizes the State
Lottery to establish a reasonable fee to defray administrative expenses associated with
effecting assignments.

        The effective date of the Amendment is the earlier of date b, or the receipt of the
ruling requested from the Internal Revenue Service (Service). The Amendment
provides that if at any time the Service or a court of competent jurisdiction issues a
determination letter, revenue ruling, other public ruling of the Service, or published
decision to any state lottery or prize winner of any state lottery declaring that voluntary
assignment under the State statute will affect the federal income tax treatment of prize
winners who do not assign their prizes, a court may not issue an order authorizing a
voluntary assignment after the date any such ruling, letter, or published decision is filed.

        The State Lottery has represented that several private companies operate in
other states with voluntary assignment provisions similar to the Amendment. These
private companies contract to purchase a winner’s future installment payments in
exchange for a discounted, fixed sum. This has already occurred in State after the
Amendment became effective. Experiences in other states with similar statutes in
effect indicate that pricing is negotiated on a case-by-case basis and that, as a result,
discount rates vary widely.

LAW AND ANALYSIS:

       Lottery winners generally use the cash receipts and disbursements method of
accounting. Taxation of the value of an annuitized lottery prize in the year the prize is
won requires application of one of three tax doctrines: constructive receipt, economic
benefit, or cash equivalence.1

A. Constructive Receipt



       1
         Although there are distinct criteria for application of each of the doctrines, they
are often referred to collectively as constructive receipt. Nevertheless, each of these
three theories of income inclusion will be considered separately in this ruling.
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       Section 451 of the Internal Revenue Code provides that the amount of any item
of gross income shall be included in a taxpayer’s gross income for the taxable year in
which received by the taxpayer, unless, under the method of accounting used in
computing taxable income, such amount is to be properly accounted for as of a
different period. According to § 1.451-1(a) of the Income Tax Regulations, under the
cash receipts and disbursements method of accounting, such amounts are includible in
gross income when actually or constructively received.

        Section 1.451-2(a) of the regulations provides that income, which is not actually
reduced to a taxpayer's possession is constructively received by the taxpayer in the
taxable year during which it is credited to the taxpayer's account set apart for the
taxpayer, or otherwise made available so that the taxpayer may draw on it at any time,
or so that the taxpayer could have drawn on it during the taxable year if notice of
intention to withdraw had been given. However, income is not constructively received if
the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

       The courts have determined that the following conditions are necessary to tax an
amount under the doctrine of constructive receipt: (1) the amount must be due; (2) the
amount must be appropriated on the books of the obligor; (3) the obligor must be willing
to pay; (4) the obligor must be solvent and able to pay; and (5) the obligee must have
knowledge of the foregoing facts. In essence, the obligee's demand for payment must
be the only thing that would be necessary for payment.

       The value of an annuitized lottery prize under the State Lottery would not be
taxable by reason of the constructive receipt doctrine. Prior to the effective date of the
Amendment, the value of an annuitized lottery prize was not taxable by reason of
constructive receipt in the year the prize was won. The winner had no current right to
receive the prize. Constructive receipt requires that an amount credited to an
individual's account be subject to unqualified demand. Robinson v. Commissioner, 44
T.C. 20 (1965); Basila v. Commissioner, 36 T.C. 111 (1961) acq., 1962-1 C.B. 3; Oates
v. Commissioner, 18 T.C. 570 (1952), aff’d, 207 F.2d 711 (7th Cir. 1953); Veit v.
Commissioner, 8 T.C. 809 (1947), acq., 1947-2 C.B. 4. The Amendment does not alter
the time in which the Lottery makes prize payments. A lottery winner's power to assign
his or her rights to a lottery prize does not accelerate the time in which the Lottery is
required to make prize payments. Accordingly, a lottery winner is not taxable on the
value of an annuitized prize in the year it is won under the doctrine of constructive
receipt by virtue of the Amendment.
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B . Economic Benefit

       The doctrine of economic benefit requires a determination that the actual receipt
of property or the right to receive property in the future confers a current economic
benefit on the recipient. Economic benefit applies when assets are unconditionally and
irrevocably paid into a fund or trust to be used for a taxpayer’s sole benefit. Sproull v.
Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 195 F.2d 541 (6th Cir. 1952); Rev.
Rul. 60-31, 1960-1 C.B. 174 (Situation 4).

        In Sproull, the court applied the economic benefit doctrine to tax amounts an
employer paid to an interest bearing trust as compensation for an employee's past
services. No one other than the employee had any interest in or control over the
monies in the trust. The employee was required to take no further action to earn or
establish his rights to the amounts in trust. The trustee's duties were limited to holding,
investing, and paying the amounts in trust to the employee or his estate in the event of
his prior death in the two taxable years following the creation of the trust. The Tax
Court held that “there is no doubt that such an interest had a value equivalent to the
amount paid over for his benefit.” Sproull, 16 T.C. at 248.

       In Pulsifer v. Commissioner, 64 T.C. 245 (1975), a minor was held taxable on
winnings from the Irish Sweepstakes in the year the winnings were deposited in an
interest bearing bank account for the minor's benefit. The funds, including interest,
were to be held in the account until the minor reached age 21 or the minor's legal
representative applied for release of the funds on the minor's behalf.

        The absence of a right to assign an individual's interest in amounts held in a fund
or trust for the exclusive benefit of the individual does not preclude taxation under the
doctrine of economic benefit. However, it may affect the value of such interest. United
States v. Drescher, 179 F.2d 863 (2d Cir. 1950). In circumstances where an employer
provided additional compensation to an employee in the form of a paid-up single
premium non-assignable annuity contract that had no cash surrender value, the
employee was taxed on the value of the annuity contract in the year received. Brodie v.
Commissioner, 1 T.C. 275 (1942).

       If the State Lottery purchased an annuity and irrevocably named a lottery winner
as the beneficiary of the annuity, the lottery winner could be taxed in the current taxable
year on the value of the annuity under the economic benefit doctrine. Lotteries that
purchase annuity contracts to fund prize payments avoid application of the economic
benefit doctrine by naming the lottery rather than the winner as the owner and
beneficiary of the annuity. The lotteries use the payments received under the annuity
contracts to fund payments to the lottery winners. Similarly, lotteries that invest in
Treasury securities or strips of Treasury securities do not set aside securities beyond
the reach of creditors for the exclusive benefit of a lottery winner. Proceeds of maturing
securities are used to fund the annual payments to a prize winner.
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        The Amendment would not result in the application of the economic benefit
doctrine. Following the effective date of the Amendment, a winner would have very
limited rights to amounts he or she has not received. Unlike the taxpayers in the cases
described above, State law would not provide for an irrevocable set aside of funds for
the benefit of a particular lottery prize winner. The State statute and rules, both prior to
and subsequent to the effective date of the Amendment, do not provide for crediting to
a prize winner’s account any amount greater than the required annual payment due and
payable to the prize winner that year. The prize winner has no right under State law to
obtain a greater sum in any year from State. Accordingly, the present value of
annuitized prizes would not be taxable by reason of economic benefit subsequent to the
effective date of the Amendment.

C. Cash Equivalency

       Amounts that are not taxable under constructive receipt or economic benefit may
nonetheless be includible in gross income under the doctrine of cash equivalency.
Under this doctrine, a taxpayer is treated as having income when he or she receives
property that is the "equivalent of cash." Decisions in cases involving cash equivalency
have been based on the facts and circumstances of the particular cases; neither the
Code nor the regulations define cash equivalency. In situations where a contract
provided for deferred payments and no notes or other evidences of indebtedness were
given, the contract rights, which were not of a type commonly sold or given as part of
the purchase price, were held not to be property and, therefore, not a cash equivalent.
Estate of Ennis v. Commissioner, 23 T.C. 799 (1955); Ennis v. Commissioner, 17 T.C.
465 (1951); Johnson v. Commissioner, 14 T.C. 560 (1950).

       In Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961), rev’g and rem’g 32 T.C.
853 (1959), on remand T.C. Memo 1961- 229, the court considered the taxation of
contract rights to non- interest bearing deferred bonus royalty payments under an oil
and gas lease. The rights to the deferred bonus payments were discounted to a bank
for a nominal discount. The court stated that a promissory note, negotiable in form, is
not necessarily a cash equivalent. Considerations such as the doubtful solvency of the
maker might prevent the market's acceptance of a note. Current taxation of the
contract rights as a cash equivalent was based on the solvent obligor's assignable
unconditional promise to pay being of a kind not subject to set-offs and frequently
transferred to lenders or investors at a discount not substantially greater than the
generally prevailing premium for the use of money. On remand, the Tax Court held the
contract in Cowden to be a cash equivalent even though it did not make a finding that
the contract was not subject to set-offs.

        In Jones v. Commissioner, 524 F.2d 788 (9th Cir. 1975), the Ninth Circuit
considered circumstances involving a cash basis taxpayer's sale of an apartment
building. The taxpayer received a $20,000 down payment and the buyer's promise in a
standard form real estate contract to pay $133,000, plus interest, over the following
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fifteen years. The contract -- which was the only evidence of the purchaser’s
indebtedness -- was of a type typically bought and sold in the area. The Tax Court
determined the fair market value of the contract to be $76,980. Based on the
substantial discount from the $133,000 face amount of the contract indicated by the
lower fair market value, the Tax Court held that the fair market value of the contract was
not includable in the amount realized because the contract was not a cash equivalent.

       The Ninth Circuit reversed the Tax Court’s decision in Jones. According to the
appeals court, if the fair market value of a deferred payment obligation received in a
sale or other exchange can be ascertained, that fair market value must be included as
an amount realized under § 1001(b) of the Code. However, the Ninth Circuit's decision
in Jones appears to stand only for the proposition that, for § 1001(b) purposes, the fair
market value of property (other than money received) is includable as an amount
realized from a sale or other disposition of property. If the fair market value of property
received can be ascertained, the fair market value constitutes an amount realized. The
Ninth Circuit did not hold that the fair market value of property received in an exchange
is a cash equivalent. Section 1001(b) is not applicable in determining the income tax
consequences of winning a lottery prize because the lottery prize is not received
incident to the sale or other disposition of property.

        It has not been established that the cash equivalency doctrine should be applied
in this case to require immediate recognition of gross income. As discussed above,
there are no prevailing market rate discounts applied to lottery prize payments paid in
the form of an annuity. Rather, discounts will be negotiated on a case-by-case basis.
Thus, it has not been established that prizes are frequently transferred to lenders or
investors at a discount not substantially greater than the prevailing premium for the use
of money.

CONCLUSION:

        The assignment of all or part of future State Lottery payments by a “Lotto”
jackpot prize winner pursuant to the procedures established by the State statute, as
amended by the Amendment, will not cause other cash basis “Lotto” prize winners who
are entitled to receive their prizes in the form of an annuity and who do not assign their
rights to such payments to realize income for federal income tax purposes in advance
of the receipt of such payments from the State Lottery.

       Except as specifically ruled above, no opinion is expressed as to the federal tax
treatment of the above transactions under other provisions of the Code and regulations
that may be applicable. No opinion is expressed as to the tax treatment of any
conditions existing at the time of or effects resulting from the transaction that are not
specifically covered by the above ruling. A copy of this letter ruling should be attached
to the appropriate federal income tax returns for the taxable years in which the
transactions described herein are consummated.
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       This letter ruling does not express an opinion of the above transactions where
prizes are frequently transferred at a discount that is not substantially greater than the
prevailing premium for the use of money.

      This letter ruling is directed only to the taxpayer who requested it. Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.

                                                 Sincerely,


                                                 Assistant Chief Counsel
                                                 (Income Tax & Accounting)

                                                 By____________________
                                                 Douglas A. Fahey
                                                 Acting Branch Chief, Branch 5