Tax Court Rules Lottery Winnings Are Not Capital Gains

November 14, 2006

The government profits in more than one way from state-run lotteries. In addition to the implicit tax revenue that state governments receive from lotteries, state and federal coffers benefit from taxes paid on lottery winnings.

Two Florida lottery winners recently tried to keep more of their winnings for themselves by paying capital gains taxes rather than individual income taxes on part of their winnings. In response, the U.S. Tax Court ruled earlier this month that lottery winners who sell their future payments for a lump sum may not declare the lump-sum payment as capital gain. From Lottery Post:

The Tax Court reaffirmed that proceeds from the sale of a right to future annual lottery payments constitutes ordinary income, not capital gain, after reviewing two test cases involving winners of the Florida State Lottery.

In both cases, petitioners in the cases won the lottery and reported the annual installment payments as ordinary income for a number of years. Eventually, however, the petitioners sold the right to their remaining installment payments and claimed that the resulting gain (a lump payment) was reportable as capital gain, rather than ordinary income.

Citing "extensive precedent" against the petitioners' claims that lottery rights should be considered property under state and federal law, the Tax Court rejected the taxpayers' arguments, saying that the sale of the remaining installments does not convert what would have been ordinary income payments into income taxable as capital gain.

The court said that, as in prior cases, the sale of a right to future lottery payments produces ordinary Income (taxable at a 35 percent rate), not capital gain (taxable at a 15 percent rate).

The Tax Court ruled correctly, but a more important—and often overlooked—aspect of lottery taxation is the question of whether state governments’ lottery “profits” are tax revenue. As we have argued before (here, here and here), state lottery revenue should be considered tax revenue rather than miscellaneous government revenue.

For more on state-run lotteries, click here.

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