Tax Research Memorandum To: Bruce Wilson From: Tax Accountant, CPA Date: December 31, 2015 Re: Tax Treatment of Lottery Winnings Facts You won $2,000,000 in the state lottery. The lottery pays out the prize money in 20 annual installments of $100,000 each. After receiving three $100,000 installments ($300,000), you sold the remaining $1,700,000 for $1,000,000. You want to report the $1,000,000 as long- term capital gain, on which the tax rate is 15%, rather than reporting it as ordinary income, on which you would be required to pay your 35% marginal tax rate. Issue The issues are (1) whether lottery winnings can be taxed at the long-term capital gains tax rate, and (2) whether selling the right to the cash flow from the winnings for a lump sum after owning the right to such cash flow for more than one year qualifies for long-term capital gains tax treatment. Rule Lottery rights are not a capital asset, and selling those rights, even after holding them for over one year, falls under the “substitute for ordinary income doctrine, which provides that when a party receives a lump sum payment as essentially a substitute for what would otherwise be received at a future time as ordinary income, that lump sum payment is taxable as ordinary income as well.” R.W. Womack v. Comm’r, 510 F. 3d 1295 (11th Cir. 2007). Analysis It is well established that Lottery rights are not a capital asset. Watkins v. Comm’r, 447 F. 3d 1269 (10th Cir. 2006); Lattera v. Comm’r, 437 F. 3d 399 (3d Cir. 2006), cert. denied, 127 S. Ct. 1328 (2007); United States v. Maginnis, 356 F. 3d 1179 (9th Cir. 2004); Davis v. Comm’r, 119 T.C. 1 (2002). Although 26 U.S.C. §1221 defines Capital Asset quite broadly, and does not specifically except lottery winnings from the definition, the 11th Circuit has found that “the statutory definition of capital asset has never been read as broadly as the statutory language might seem to permit, because such a reading would encompass some things Congress did not intend to be taxed as capital gains.” Womack, 510 F.3d 1295; Maginnis, 356 F.3d at 1181;. All of these decisions are based on the so-called substitute for ordinary income doctrine, which provides that when a party receives a lump sum payment as “essentially a substitute for what would otherwise be received at a future time as ordinary income, that lump sum payment is taxable as ordinary income as well.” Comm’r v. P.G. Lake, Inc., 356 U.S. 260, 265, 78 S. Ct. 691, 694 (1958). Womack, 510 F.3d 1295. The courts have focused on two significant factors in determining that lottery rights are not a capital asset and, therefore, the sale of such asset would not constitute a long term capital gain: 1. The taxpayer did not make any underlying investment of capital in return for the receipt of the lottery right, and 2. The sale of the right did not reflect an accretion in value over cost to any underlying asset held by t ...

1. Tax Research Memorandum
To: Bruce Wilson
From: Tax Accountant, CPA
Date: December 31, 2015
Re: Tax Treatment of Lottery Winnings
Facts
You won $2,000,000 in the state lottery. The lottery pays out
the prize money in 20 annual
installments of $100,000 each. After receiving three $100,000
installments ($300,000), you
sold the remaining $1,700,000 for $1,000,000. You want to
report the $1,000,000 as long-
term capital gain, on which the tax rate is 15%, rather than
reporting it as ordinary income, on
which you would be required to pay your 35% marginal tax rate.
Issue
The issues are (1) whether lottery winnings can be taxed at the
long-term capital gains tax
rate, and (2) whether selling the right to the cash flow from the
winnings for a lump sum after
owning the right to such cash flow for more than one year
qualifies for long-term capital
gains tax treatment.

2. Rule
Lottery rights are not a capital asset, and selling those rights,
even after holding them for over
one year, falls under the “substitute for ordinary income
doctrine, which provides that when a
party receives a lump sum payment as essentially a substitute
for what would otherwise be
received at a future time as ordinary income, that lump sum
payment is taxable as ordinary
income as well.” R.W. Womack v. Comm’r, 510 F. 3d 1295
(11th Cir. 2007).
Analysis
It is well established that Lottery rights are not a capital asset.
Watkins v. Comm’r, 447 F. 3d
1269 (10th Cir. 2006); Lattera v. Comm’r, 437 F. 3d 399 (3d
Cir. 2006), cert. denied, 127 S.
Ct. 1328 (2007); United States v. Maginnis, 356 F. 3d 1179 (9th
Cir. 2004); Davis v. Comm’r,
119 T.C. 1 (2002). Although 26 U.S.C. §1221 defines Capital
Asset quite broadly, and does
not specifically except lottery winnings from the definition, the
11th Circuit has found that
“the statutory definition of capital asset has never been read as
broadly as the statutory
language might seem to permit, because such a reading would
encompass some things
Congress did not intend to be taxed as capital gains.” Womack,
510 F.3d 1295; Maginnis, 356
F.3d at 1181;. All of these decisions are based on the so-called
substitute for ordinary income
doctrine, which provides that when a party receives a lump sum
payment as “essentially a
substitute for what would otherwise be received at a future time

3. as ordinary income, that
lump sum payment is taxable as ordinary income as well.”
Comm’r v. P.G. Lake, Inc., 356
U.S. 260, 265, 78 S. Ct. 691, 694 (1958). Womack, 510 F.3d
1295. The courts have focused
on two significant factors in determining that lottery rights are
not a capital asset and,
therefore, the sale of such asset would not constitute a long
term capital gain:
1. The taxpayer did not make any underlying investment of
capital in return for the receipt of
the lottery right, and
2. The sale of the right did not reflect an accretion in value over
cost to any underlying asset
held by the taxpayer.
The first factor goes to the treatment of the initial distribution
of the winnings and, to quote
the 11th Circuit, “Lottery Rights are a clear case of a substitute
for ordinary income. A lottery
winner who has not sold the right to his winnings to a third
party must report the winnings as
ordinary income whether the state pays him in a lump sum or in
installments.” 26 U.S.C.
§165(d). As to the second factor, the court focused on the
difference between lottery rights
and “the typical capital asset,…shares of stock. [In the case of
stock], the taxpayer makes an
underlying investment in the stock, owns the shares for longer
than a year, and then sells
them at a higher price. The gain represents an increase in the

4. value of the original investment.
Lottery rights involve no underlying investment of
capital…[and] gain from their sale reflects
no change in the value of the asset. It is simply the amount [the]
taxpayers would have
received eventually, discounted to present value. Furthermore,
when a lottery winner sells
lottery rights, he transfers a right to income that is already
earned, not a right to earn income
in the future. A capital asset has the potential to earn income in
the future based on the
owner’s actions in using it. Lottery winners, by contrast, are
entitled to the income merely by
virtue of owning the property.” Womack, 510 F.3d 1295.
Conclusion
Based on the analysis above, it is clear that, notwithstanding the
sale of the remaining
payments for a lump sum after owning them for more than one
year, you will have to pay
income taxes on the $1,000,000 at your 33% marginal rate. Any
other action will ultimately
result in your owing interest and penalties to the IRS.
Doctor Bones prescribed physical therapy in a pool to treat Jack
Borden’s broken
back. In response to this advice (and for no other reason), Jack
built a swimming
pool in his backyard and strictly limited use of the pool to

5. physical therapy. Jack
paid $25,000 to build the pool. Jack consults you for advice
concerning whether
this amount or any portion of the amount would qualify as a
deductible medical
expense on his federal income tax return.
Research the tax law and write Jack a brief memo of no more
than two pages, in
which you communicate the results of your research. Use the
format for
communicating research findings modeled in the Sample Tax
Research
Assignment with the Sample Tax Research Memo, which can be
found under Tax
Research in the Course Table of Contents. Identify relevant
statutory, regulatory,
and judicial authorities and discuss how these authorities affect
your conclusion
concerning the deductibility of the pool construction costs as a
medical expense on
Jack’s federal income tax return.

6. ACCT 323 7980 INCOME TAX I (Spring 2016)
WEEK 4 HOMEWORK
1) In the current tax year, Gunther earned $125,000 from his
job as a civil engineer. In addition,
he received $30,000 of income from Activity A, and lost
$40,000, and 20,000 from Activities B
and C respectively. Activities A, B, and C are passive activities
that Gunther acquired in the
current year. What amount of loss may Gunther deduct on his
current year taxes with respect to
each activity? What amount of loss, if any, must be carried
over to the subsequent year for each
activity?
2) During the current year, Beth and Bill, who file a joint
return, incurred the following items of
income and loss:
Salary $ 130,000
Activity A (passive) 10,000
Activity B (rental real estate/nontrade or business) (30,000)
Activity C (rental real estate/nontrade or business) (20,000)
Beth and Bill actively participate in activities B and C, and they

7. own 100% of each rental
property.
a) What is their AGI for the year?
b) What is the amount of suspended losses, if any, that may be
carried over with
respect to each activity?
3) In the current tax year, Neil’s personal automobile was
totaled in a traffic accident. Neil had
purchased the automobile two years earlier for $28,000. The
FMV of the automobile just prior
to the accident was $18,000. The automobile is now worthless.
Neil received a $14,000
insurance check in settlement of his accident claim. Later that
same year, a thief broke into
Neil’s home and took several antiques purchased several years
ago for $8,000. Their current
FMV at the date of the theft was $12,000. The antiques were
not insured. Neil’s AGI for the
current year is $60,000. What is the amount of Neil’s
deductible casualty loss in the current
year?
4) In 2013, Sarah loans Seymour $5,000 for his use in
establishing his business. As Seymour

8. has no other assets and needs cash to establish the business, the
loan agreement provides that
Seymour will repay the $5,000 debt to Sarah with interest at the
prevailing rate over a five-year
period. Seymour’s business is unsuccessful, and he files for
bankruptcy in 2014. By the end of
2014, it is estimated that Seymour’s creditors will receive only
20% of the amount they are
owed. In 2015, the bankruptcy proceedings are closed, and the
creditors receive 10% of the
amount due on Seymour’s debt obligations. What is Sarah’s
bad debt deduction for 2014? 2015?
How is Sarah’s bad debt deduction, if any, characterized?
5) During 2015, Kiran, a single taxpayer, reported the
following income and expense items
relating to her interior design business:
Revenues $52,000
Cost of Goods Sold 41,000
Advertising 3,300
Office supplies 1,700

9. Rent 13,800
Contract labor 28,000
Kiran also worked part-time during the year, earning $13,500.
She reports a long-term capital
gain of $4,200, and a short-term capital loss of $3,800. Her
itemized deductions total $5,200.
a) What is Kiran’s taxable income or loss for the year?
b) What is Kiran’s NOL for the year?
6) Brandy is a self-employed consultant who solicits business
from numerous clients and
receives consulting fees as income. During the current year,
Brandy incurred the following
expenditures:
Airfare & lodging while away overnight $ 4,000
Business meals while traveling at which business was discussed
1,000
Local business transportation costs for automobile, parking &
tolls 2,000
Commuting expenses 1,000
Local entertainment of clients 2,000
Total $ 10,000

10. a) Which of the expenditures listed above, if any, are
deductible by Brandy?
b) Which of the above items are classified as For AGI and
From AGI deductions?
c) How would your answers to parts (a) and (b) change if
Brandy were an employee
rather than self-employed and none of the above expenditures
were reimbursed by her
employer?
7) On February 20, 2015, Charles, who is single and age 32,
establishes a traditional
deductible IRA and contributes $5,500 to the account. Charles’
AGI is $66,000 in 2014 and
$57,000 in 2015. Charles is an active participant in his
employer’s retirement plan.
a) What amount of the contribution is deductible? In what
year is it deductible?
b) Is the deduction For AGI or From AGI?
c) How would your answer to part (a) change, if at all, if
Charles were not an active
participant in his employer’s retirement plan?

11. d) How would your answer to part (a) change if Charles were
married and filed a joint
return with his spouse, who has no earned income, assuming
their combined AGI is
$85,000? What would be their maximum IRA contribution
deduction?
8) Joe and Jean have five grandchildren, ages 19, 16, 15, 12,
and 10. The have established
Coverdell Education Savings Accounts (CESA) for each of the
grandchildren and would like to
contribute the maximum amount allowable to each CESA for the
2015 taxable year. Joe and
Jean’s AGI for 2015 is $196,000.
(a) How much can Joe and Jean contribute to each grandchild’s
CESA in 2015?
(b) Assume that the 19-year-old granddaughter is a freshman
in college and makes a
withdrawal of $7,000 from her CESA during the year 2015.
Her college expenses for
2015 were as follows:
Tuition $1,500
Room & board 2,500
Books & supplies 500

12. The extra amount withdrawn was used as a down payment on
an automobile that the
granddaughter purchased during the year. She needed the
automobile to drive to school
rather than to ride the bus. What are the tax consequences of
the $7,000 distribution to
the granddaughter?
9) Roger is a cash basis self-employed air-conditioning
repairman with current year gross
business receipts of $20,000. Roger's cash disbursements were
as follows:
Air conditioning parts $ 2,500
Yellow Pages listing 2,000
Estimated federal income taxes on self-employment income
1,000
Business long-distance telephone calls 400
Charitable contributions 200
What amount should Roger report as net profit or loss on
Schedule C of his 2014 Form 1040?

13. a. $15,100
b. $14,900
c. $14,100
d. $13,900
10) Robert Corp. granted an incentive stock option for 200
shares to Beverly, an employee, on
March 14, Year 12. The option price and FMV on the date of
grant was $150. Beverly exercised
the option on August 2, Year 14, when the FMV was $180 per
share. She sold the stock on
September 20, Year 15, for $250 per share. How much gross
income did Beverly recognize in
Year 12?
a. $30,000
b. $150
c. $0
d. $20,000