The 2nd Circuit joined the 3rd, 9th, and 10th Circuit Courts of Appeal today and won’t allow a lottery winner to turn ordinary income into a long-term capital gain. We’ve written about this before (see here and here).
The question for the Court, in this case originally decided at the Tax Court, was whether the right to future lottery winnings can be converted into a capital asset (under Section 1221 of the Tax Code). The “Substitute for Ordinary Income Doctrine” governs this issue; lump sum payments for what would be ordinary income in the future can’t be magically changed into a capital gain.
The 10th Circuit came up with the crux of the matter. “[W]hen a party exchanges for a lump sum the right to receive in the future ordinary income already earned or obtained, the amount received serves as a substitute for the ordinary income the party had the right to receive over time. The lump sum is accordingly treated as ordinary income for taxation purposes.” Watkins vs. C.I.R., 447 F.3d at 1272.
So if you do get lucky and win the lottery, congratulations. Just save enough money to pay your taxes.