of Lottery Prize Payments for Estate Tax Purposes: An Analysis
By Ted D. Englebrecht and Mary M. Anderson
JUNE 2007 -
The valuation of future lottery prize payments that flow through
an estate has resulted in diametrically opposed decisions at the
different appellate levels. The most recent opinion of Donovan
v. United States (95 AFTR 2d 2005-2131, April 26, 2005) supports
the IRS’s contention that these winnings should be valued
as an annuity in accordance with IRC sections 2039 and 7520. This
district court ruling in the First Circuit aligns with the decision
of the Fifth Circuit in Cook v. Comm’r [349 F.39
850 (92 AFTR 2d 2003-7027) 5th Cir. 2003].
however, is at odds with two separate appellate decisions, in
the Second Circuit case of Gribauskas v. Comm’r
[116 T.C. 142 (2001), 2001 WL 227025, reconsidered and rev’s,
342 F.3d 85 (92 AFT 2d 2003-5914)(2nd Cir. 2003)] and the Ninth
Circuit case of Shackleford v. United States [262 F.3d
1028 (88 AFTR 2d 2001-5658)(9th Cir. 2001)]. These rulings support
an estate tax valuation of lottery winnings per IRC section 2033.
Thus, on one hand, the IRS and the Tax Court consistently value
lottery winnings in an estate tax context as the present value
of an annuity, using the actuarial formula in the regulations.
On the other hand, several appellate jurisdictions support the
taxpayers’ contention that the proper valuation is the fair
market value method.
What is at
issue in this growing controversy are the marketability and assignability
restrictions of lottery payouts. Under the actuarial formula,
these characteristics are irrelevant. Using the fair market value
methodology, the restrictions are crucial and, as expected, the
resulting valuations can affect estates in very different ways.
is a review of the statutory, administrative, and judicial interpretations
involving valuation of lottery payments for estate tax purposes,
along with an analysis of the critical elements in this interpretive
controversy, and several recommendations on how to alleviate this
growing estate tax issue.
In the mid-1970s,
gambling was relatively rare in the United States. Nevada was
the destination for gamblers; a few states provided lotteries
and parimutuel gambling, such as horse racing, dog racing, and
jai-alai. Today, however, some form of gambling is allowed in
47 states and Washington, D.C. Revenues in 1997 were estimated
at over $50 billion and rapidly increasing. This amount represents
more than 10% of the monies available to Americans for leisure
goods, services, and activities. To judge the impact of this immense
industry, note that this amount does not include hotels, food,
transportation, or other expenditures associated with gambling
federal government is not heavily involved in the gaming industry,
state governments participate by regulating and taxing commercial
enterprises or sponsoring state lotteries [National Gambling Impact
Study Commission, National Gambling Impact Study Commission Final
Report (1999), govinfo.library.unt
.edu/ngisc (as of March 16, 2006)]. In 2003, $49.1 billion was
spent on state lotteries alone. As of March 2006, when North Carolina
introduced its lottery, 42 state governments and Washington, D.C.,
offered government-sponsored lotteries (www.naspl.org/). State-sponsored
lotteries operate as quasimonopolies within their jurisdictions.
With the state government’s backing, this most common form
of gambling provides little risk of default by the sponsoring
entity (K.C.E. Grogan, “Lucky for Life: A More Realistic
and Reasonable Estate Tax Valuation for Nontransferable Lottery
Winnings,” Washington Law Review, November 2004).
wins a large lottery prize, the state lottery commission generally
provides the winner the ability to receive the amount in a series
of payments over a stipulated number of years or in a single lump-sum
payment. Currently, only Arizona, Colorado, Ohio, and Oregon offer
lump-sum payouts to new winners (R. Sanford, “Are You Ready?,”
2005). These states indicate that the majority of elderly winners
choose a lump sum, while a majority of younger winners choose
installment payments. The factoring of structured settlement awards
from litigation is a thriving industry. But many states make lottery
prize payments inalienable without a court order. Thus, the untimely
death of a lottery winner during this stream of payments creates
several estate tax dilemmas. First, with a substantial estate
asset being illiquid because of the future receipt of the payout,
the ability to timely pay any resultant estate tax due may be
problematic. In addition, statutory guidance on the proper valuation
of the structured payments is ambiguous.
are not specifically mentioned in the statutes, but two Tax Code
sections bring these payments into the estate: IRC sections 2033
and 2039. A transfer tax (i.e., the estate tax) is imposed on
the taxable estate of every decedent who is either a citizen or
resident of the United States in accordance with IRC section 2001(a).
Computing this taxable estate begins by including all real, personal,
tangible, and intangible property of the decedent, wherever situated
[IRC section 2031(a)]. IRC section 2051 delineates the allowable
reductions of the gross estate. Where the value of the decedent’s
estate is substantial (in excess of $2 million for 2006–2008),
the estate is required to file Form 706 and to pay federal estate
taxes. Generally, the value of property to be included in the
gross estate is the fair market value of the item at the time
of the decedent’s death or (if elected) at the alternate
valuation date six months after the decedent’s death. The
fair market value is defined by regulations as “the price
at which the property would change hands between a willing buyer
and a willing seller under no compulsion to buy or sell and both
having knowledge of the relevant facts” [Treasury Regulations
section 2039, property includes any annuity or other payment receivable
by a beneficiary under any contract or agreement dated after March
3, 1931 [Treasury Regulations section 20.2038-1(b)(1)(i)]. Annuities
are financial products that periodically pay the obligee a specific
amount for a determined period of time (or until death). Typical
uses for structured payouts include individual retirement accounts,
pension plans, commercial annuities, and litigation awards. For
annuities payable after death to an estate, a surviving spouse,
or another beneficiary upon the annuitant’s death, the present
value of the future payments is includable property in the estate.
Because future lottery winnings represent rights to receive annual
fixed-dollar amounts for a defined period of time, similar to
annuities, IRC section 2039 could serve to bring these payments
into the estate.
computations entail subjective measurements and estimates. As
a result, IRC section 7520 seeks to minimize valuation discrepancies
that might occur when the interest rates prevailing in the economy
differ substantially from the fixed interest rate assumptions
in IRS tables (G. Hayes and E. Krzanowski, “When IRS Actuarial
Tables Don’t Apply in Valuing Interest,” Estate
Planning Journal, February 2005). IRC section 7520 mandates
the use of IRS-issued actuarial tables provided in Publication
1457. The tables are based on monthly floating interest rates
and mortality assumptions; they are used to value interests in
property, including annuities, life estates, remainder interests,
and reversions mandated for transfers after April 30, 1989.
2033 and 2039 provide indirect guidance to estates that include
future lottery payments. The gross estate includes any future
lottery payments as well as any lottery prize proceeds the winner
has already received but has not yet spent.
lottery payments as annuities under IRC section 2039, the IRS
considers the future lottery payouts includible in an estate using
the IRC section 7520 actuarial methodology. The IRS has promulgated
regulations for IRC section 7520 and issued several technical
advice memoranda to provide on-point guidance when valuing unpaid
lottery payments for estate tax purposes.
Treasury Regulations section 20.2031-7(d)(1) provides that the
fair market value of an annuity includible in the gross estate
is its present value determined by use of the section 7520 mandated
actuarial factors (assuming the valuation date for the estate
is after April 30, 1989).
Regulations section 20.7520-1, the present value of an annuity
is generally determined by use of the interest rate component
pursuant to IRC section 7520. The present value is computed using
the method described in Treasury Regulations section 20.2031-7.
Treasury Regulations section 20.7520-3(b), effective for estates
of decedents dying after December 13, 1995, provides exceptions
to the use of standard actuarial factors. It notes that a standard
IRC section 7520 annuity, income, or remainder factor may not
be used to value a “restricted beneficial interest.”
A restricted beneficial interest is an annuity, income, remainder,
or reversionary interest that is “subject to any contingency,
power, or other restriction, whether the restriction is provided
for by the terms of the trust, will, or other governing instrument
or is caused by other circumstances.” Of the appealed cases,
only Donovan (95 AFTR 2d 2005-2131, April 26, 2005) is relevant.
Advice Memorandum 9616004. This memorandum was issued
in response to a request by the estate of an individual who had
died testate and was survived by his mother. A few years before
his death, the decedent had won the lottery in a state where assignment
of the lottery payments was prohibited without appropriate judicial
order. At the time of death, the decedent was entitled to receive
additional annual lottery payments, which were transferred to
his mother pursuant to his will.
estate contended that the IRC section 7520 annuity factor and,
thereby, the interest rate applicable on the valuation date, should
not be used to determine the present value of the lottery payments
for estate tax purposes. The estate argued that, because the recipient
of lottery proceeds could not assign the payments without court
approval, the annuity constituted a restricted beneficial interest
under the regulations. Thus, the annuity could not be valued under
the tables. The estate argued that a valuation based on a discount
rate derived from the sale of long term bonds, adjusted to take
into account the state’s assignment approval requirement,
would better reflect the fair market value of the annuity.
The IRS disagreed
with the estate’s analysis that the restriction on transfer
constitutes the kind of restriction referenced in the regulations
that would justify departure from the use of the actuarial tables.
TAM 9616004 mandated that the decedent’s estate use the
IRC section 7520 annuity factor to determine the present value
of the lottery winnings payable to the decedent’s beneficiary,
despite the restriction on assigning the payments under state
law. The IRS thought that lottery payments are not a restricted
beneficial interest under Treasury Regulations section 20-7520-3(b)(1)(ii)
because the assignment restriction does not alter the recipient’s
right to receive all lottery payments, but only affects the right
to assign the right to receive the payments.
Advice Memoranda 199909001. This memorandum dealt
with two relatives who won a state lottery and had the winnings
paid to a partnership. After winning, one of the relatives executed
a revocable living trust, naming herself as beneficiary during
her life and her nieces and nephews as beneficiaries upon her
death. Before her death, she transferred her interests in the
partnership to the trust. She died after only one of the 20 annual
payments was paid to the partnership. Applicable state law provided
that lottery prizes were not assignable except pursuant to an
appropriate judicial order.
her interest in the partnership held in the revocable living trust,
her estate claimed several discounts to the lottery payments and
her interest in the partnership. First, the estate discounted
the payments to present value using a discount rate based on the
AAA-rated general-obligation bond yield rather than using the
section 7520 interest rate applicable on the valuation date. The
estate also discounted each payment by 39.6% for federal income
taxes, 25% for lack of marketability, and 20% for lack of control.
The executor then allocated the discounted value to the partnership
The IRS concluded
that none of the exceptions to using the standard actuarial factors
applied in this case. TAM 199909001 noted that the state law restricting
transfer did not affect the right of the partnership to receive
any and all of the lottery winnings. As a result, the present
value of the right to receive the remaining lottery payments had
to be computed using the standard IRC section 7520 annuity factor
as of the valuation date. Consequently, in valuing the lottery
winnings payable to the partnership, the executor was allowed
neither the discount for lack of marketability nor a reduction
for income taxes payable on receipt of the winnings.
1457 provides actuarial factors for an annuity payable for a term
of years (Table B) and adjustment factors for period payments
(Table K). Multiplying the annuity factor from Table B by the
aggregate amount payable annually and by the applicable adjustment
factor from Table K for payments made at the end of the specified
period will result in the actuarial valuation amount.
At the time of the decedent’s death, the survivor is entitled
to receive an annuity of $20,000 a year for 10 years, payable
in equal monthly installments at the end of each period. Assume
the IRC section 7520 rate for the month of death is 9.6%. Under
Table B in Publication 1457, the annuity factor at 9.6% for 10
years is 6.2516. Under Table K, the adjustment factor for payments
made at the end of each monthly period at the rate of 9.6% is
1.0433. The annual annuity amount, $20,000, is multiplied by each
factor to yield a present value of the annuity, at the date of
the decedent’s death, of $130,445.88 ($20,000 x 6.2516 x
The Tax Court
has consistently supported the IRS in using IRC section 7520 to
value lottery winnings includable in an estate. The U.S. District
Court, Eastern District of California, as the court of original
jurisdiction in Shackleford, found that the taxpayer overcame
the presumption of correctness by providing evidence that the
IRC section 7520 valuation was unrealistic and unreasonable under
the facts and circumstances of the case (262 F.3d 1028; 88 AFTR
2d 2001-5658; 9th Cir. 2001). In addition, several appellate courts
(Second and Ninth Circuits) have discounted the valuation of lottery
winnings because of their lack of marketability or assignability.
Because the IRS tables fail to consider lack of marketability,
the Second and Ninth Circuits have held that the valuation tables
produce an unrealistic valuation result. This is similar to the
adjustments made when valuing property at its fair market value.
Conversely, the Fifth Circuit and the U.S. District Court, District
of Massachusetts, have held that a marketability discount is not
appropriate for unalienable lottery winnings and that the valuation
tables are controlling.
States v. Estate of Shackleford
Thomas J. Shackleford, a retired U.S. Air Force officer, won a
California lottery jackpot of more than $10.16 million. According
to California law, Shackleford could not collect his prize in
a lump sum, and at the time, California prohibited any assignment
of lottery payments. He was to receive his winnings in 20 annual
payments of $508,000.
died in 1990 and had received only three payments. The compound
value of the 17 remaining payments was $8,636,000 at the time
of death. Originally, when Shackleford’s estate filed Form
706, the present value of these payments was reported at nearly
$4 million. After paying the estate tax, however, the estate claimed
the value of the payments was zero and filed for a refund. The
IRS disagreed and insisted that the $4 million valuation was correct.
The estate sued the IRS, and the case went to court.
District Court, Eastern District of California, ruled that a taxpayer’s
estate did not have to use IRS valuation tables to calculate the
value of lottery annuity payments. Specifically, it thought that
the use of IRC section 7520 tables would result in unrealistic
and unreasonable values because of restrictions on the assignment
of payments under state law. The lack of liquidity also was not
taken into account and no discount was taken. The court did not
allow a zero valuation in light of “gray market” transactions.
It noted that at least 10 California lottery winners had tried
to transfer all or part of their winnings in 1990, even though
assignments of prizes are constrained by state law. In each case,
the amount the winner received for the payments was substantially
discounted to take into account the validity of the transactions.
it allowed the Shackleford estate to apply an alternative valuation
method for its tax return. The court ruled that the payments had
a value of $2,012,500 based on expert testimony (84 AFTR 2d 99-5802).
The IRS appealed
to the Ninth Circuit Court of Appeals [(262 F.3d 1028; 88 AFTR
2d 2001-5658 (9th Cir. 2001)]. In his decision, the judge explained
that the right to transfer is an important property right, and
that the transfer restrictions on the remaining lottery payments,
accordingly, reduced their fair market value. The judge also noted
that, conversely, when the results would favor the IRS, the IRS
had argued that departure from the tables was warranted (Estate
of Lin v. Comm’r, 438 F.2d 56, and Frok V. Comm’r,
100 T.C. 1). In upholding the district court’s decision,
the Ninth Circuit enunciated a new standard: If the taxpayer proves
that a more realistic and reasonable valuation method exists that
more closely approximates fair market value, courts are free to
employ it. The key to the district court’s and the Ninth
Circuit’s decisions to depart from the tables was the ability
of the taxpayer’s expert to locate arm’s-length attempted
transactions of lottery prizes. Had a discount for lack of marketability
been taken without such data, the courts would probably not have
agreed that a more realistic and reasonable valuation method existed.
of Cook v. Comm’r
had a longstanding informal agreement with her sister-in-law,
Myrtle Newby, by which they jointly purchased Texas lottery tickets
and shared the winnings. On July 8, 1995, Cook won a $17 million
lottery prize, payable in 20 annual installments. The initial
payment of $848,648 was made on July 10, 1995, and the remaining
payments of $853,000 would be made over the next 19 years. The
assignment of the payments is prohibited without court order,
according to Texas law, under which the prize cannot be collected
in a lump sum [349 F.3d 850; 92 AFTR 2d 2003-7027 (5th Cir. 2003)].
their first annual prize disbursement, Cook and Newby converted
their informal partnership to a formal limited partnership. Both
of them assigned their interests in the lottery winnings to the
partnership and each received a 45% limited partnership interest
and a 2% general partnership interest. Cook died on November 6,
1995, when the valuation of the partnership’s assets for
estate tax purposes was cash in the amount of $391,717 and the
right to receive 19 annual lottery payments of $853,000 each.
executor hired a valuation expert, who valued the partnership’s
right to lottery payments at $4,575,000 using a discounted cash
flow method and including a discount for nonmarketability. Because
of the prohibition on transfer of the lottery prize, no market
for the right to lottery payments existed. The expert valued the
estate’s interest in the partnership at $1,529,749.
The IRS assessed
a deficiency based on the value of the partnership interest and
rejected the estate’s expert valuation. The IRS valued the
partnership’s right to the lottery payments, using IRC section
7520 and the accompanying tables, at $8,557,850. The IRS then
valued the estate’s partnership interest, discounted for
the lack of control restriction in the partnership agreement,
and lack of a ready market, at $3,222,919, yielding a tax deficiency
procured a second expert valuation and petitioned the Tax Court
for a redetermination of the deficiency. The estate contended
that the IRS erred in using the annuity tables to value the lottery
prize held by the partnership, and thereby assigned an unreasonable
value to the lottery prize. The Tax Court relied on its decision
in Estate of Gribauskas v. Comm’r [116 TC 142 (2001)]
to value the lottery payments using the annuity tables.
Circuit affirmed the Tax Court’s holding that the lottery
prize, an unsecured right to a series of fixed payments for a
certain term with virtually no risk of default, fell within the
definition of a private annuity and thus should be valued under
the IRC section 7520 tables. The appellate court further concluded
that nonmarketability did not render the valuation of the prize
unreasonable under the section 7520 tables because it is assumed
in the annuity tables.
of Gribauskas v. Comm’r
In late 1992,
Paul Gribauskas and his wife won a $15,807,307 Connecticut lottery
prize, payable in 20 annual installments of $790,365. Following
disbursement of the first installment, Gribauskas and his wife
divorced. Thereafter, each was entitled to receive $395,183 annually.
Gribauskas died intestate on June 4, 1994, with 18 installments
remaining to be paid. His estate filed an estate tax return on
September 11, 1995. The value of the remaining prize installments
was discounted on the return to account for prohibitions imposed
on lottery winnings by Connecticut, which severely restricted
the ability of winners to exchange their contractual rights to
future payments for a lump sum [116 T.C. 142 (2001), 2001 WL 227025,
reconsidered and rev’s, 342 F.3d 85, 92 AFT 2d 2003-5914
(2nd Cir. 2003)]. Nevertheless, both parties recognized that a
market for such unassignable winnings did exist at the time, but
at a significant discount.
estate, after factoring in this risk-based market discount, valued
the lottery prize at $2,603,661 on its tax return. The IRS disagreed
with the estate’s method of valuation and valued the remaining
payments, pursuant to the IRC section 7520 tables, at $3,528,058.
Correspondingly, the estate was assessed a $403,167 tax deficiency.
The estate contested this valuation in the Tax Court. In support
of its petition, the estate argued that the section 7520 tables
should not govern valuation because they yielded an “unrealistic
and unreasonable” result that did not accurately account
for marketability restrictions. The Tax Court held that the IRC
section 7520 tables provided the proper method for valuing the
winnings, which should not receive a marketability discount. The
Tax Court emphasized that the valuation tables serve the important
function of increasing consistency and efficiency, and that courts
have narrowly construed any exceptions to their use.
the Second Circuit reversed the Tax Court’s decision. The
Second Circuit held that the pre-Shackleford cases, in
which courts allowed departures from the tables, involved situations
where there was an inconsistency between the tables’ factual
assumptions and the facts of the case. The Second Circuit held
that the same reasoning that required departures from the tables
in those pre-Shackleford cases, however, also required
departures from the tables in cases involving a substantial error
in the tables’ ultimate valuation result. The court noted
that the party seeking to depart from the tables has the considerable
burden of proving that the tables’ value is unrealistic
and unreasonable, and it concluded that this burden was met in
the Ninth and Second Circuits departed from the strict use of
the valuation tables because the tables produced an unrealistic
and unreasonable result by failing to consider the lack of marketability
of nontransferable lottery winnings. In contrast, the Fifth Circuit
held in Cook that a marketability discount was inappropriate.
of Donovan, Jr., v. United States
Jr., won the Massachusetts lottery on January 4, 1999. The prize
was to be paid in 20 annual installments of $100,000, and could
not be assigned. Donovan died in July 1999 after having received
only the first annual payment. The remaining 19 payments were
valued at $367,482 on the decedent’s estate tax return.
On audit, the IRS calculated the value of the payments at $1.09
million using the IRC section 7520 annuity tables. This resulted
in an additional $173,611 of tax liability, which was paid by
the estate. The estate later filed suit for a refund, arguing
that the nonmarketability of the lottery payments had to be considered
for valuation purposes.
the issue of valuation, the U.S. District Court for the District
of Massachusetts thought that the threshold question was whether
the lottery prize constituted an annuity (Estate of Donovan
v. U.S., 2005-1 USTC par. 60,500). The court rejected the
estate’s position that the restriction on the marketability
of the prize made the lottery payments exempt from the annuity
tables. Specifically, it noted that the prohibition on assignment
was not a restriction that placed limitations on the estate’s
right to receive the remaining installments in full.
believed that factoring nonmarketability into the valuation of
a lottery prize was inappropriate because, as Cook noted, nonmarketability
was an assumption underlying the annuity tables. In addition,
the inability to assign winnings did not affect the value of the
property interest held at death, which represented an enforceable
right to receive annual payments in a specified amount from a
reliable party (Massachusetts). The limitations on transferring
the property interest did not, reasoned the court, reduce its
worth to the estate in a manner not already accounted for by the
annuity tables. In short, it was unreasonable to apply a nonmarketability
discount. The court believed that the approach taken in Gribauskas
and Shackleford, where nonmarketability was factored into
the valuation of lottery winnings, was flawed by failing to give
proper regard to the usefulness of the annuity tables.
won the Massachusetts lottery in 1989 and died in 1999 after receiving
10 of 20 annual payments of $209,220. Subsequent to an audit of
the tax return, the estate decided that the IRC section 7520 annuity
tables were not appropriate and filed an informal refund claim
based upon a fair market valuation methodology factoring in nonmarketability.
The IRS denied this claim on November 21, 2002, and the estate
filed suit in the U.S. District Court, District of New Hampshire.
this suit has yet to be heard, it is noteworthy that the IRS’s
motion for summary judgment has been denied (97 AFTR 2d 2006-332,12/19/2005).
The IRS asked for reconsideration, which was also denied (97 AFTR
2d 2006-824, 1/18/2006). In his opinion, the judge disagreed with
the Cook and Donovan (notably, also in the First
Circuit) courts’ perspectives that nonmarketability is an
underlying assumption of the annuity tables. He further stated
that it would be more correct to infer that the tables assume
marketabililty; however, as presented, the tables account for
only two factors: assumed interest rate and the time period of
the annuity. As such, the judge reasoned that the tables are less
accurate in gauging fair market value when an annuity is nonmarketable,
stressing: “The paramount goal of the Tax Code is, after
all, to determine the fair market value of the asset in question.”
For a summary
of the judicial positions on the valuation of lottery payments,
see the Exhibit.
Tax Consequences. In Comm’r v. Groetzinger
[480 U.S. 23, 32 n.11, 107 S. Ct 980, 94 L. Ed 2d 25 (1987)],
the Supreme Court eliminated any controversy concerning the income
tax treatment of lottery winnings. The Court characterized lottery
payments as gambling winnings, which is ordinary income. The income
tax treatment of lump-sum proceeds received in exchange for assigning
the rights to future lottery payments is, however, ambiguous.
Taxpayers contending this exchange qualifies as a sale of a capital
asset and capital gains treatment have been challenged by the
IRS. In a reported decision, Davis v. Comm’r [119
T.C. 1 (2002)], and several memorandum decisions, most recently
Watkins v. Comm’r (T.C. Memo 2004-244), the Tax
Court has found for the IRS. Although the reasons differ, the
Third Circuit, in Lattera v. Comm’r [437 F.3d 399
(3rd Cir. 2006)], the Ninth Circuit, in United States v. Maginnis
[356 F.3d 1179, 1181 (9th Cir. 2004)], and the Tenth Circuit,
in Wolman v. Comm’r (U.S. App. Lexis 12490, May
19, 2006), have affirmed the lower courts’ decisions that
the proceeds from the assignment of future lottery payments constitute
As previously discussed, a lottery winner’s untimely death
before the payout is complete may create a liquidity problem for
an estate. Federal estate tax is payable on the entire lottery
prize even though cash has not yet been received. Due no later
than nine months after the taxpayer’s death, the amount
of the estate tax can be far greater than the estate’s cash
on hand. Delinquent taxes are subject to a monthly penalty of
one-half of one percent per month, up to a maximum penalty of
25%. In addition, the IRS assesses interest on the delinquent
tax and assessed penalties at the federal short-term rate plus
three percentage points (Eldridge Blanton III, “Who Gets
a Dead Man’s Gold? The Dilemma of Lottery Winnings Payable
to a Decedent’s Estate,” University of Richmond
Law Review, April 1994).
To deal with
the problem of illiquidity where the annual lottery payments constitute
a major portion of an estate, a lottery winner may consider making
inter vivos gifts and testamentary bequests to a spouse. This
can essentially eliminate all of a winner’s gift and estate
tax liability (to the extent of the winner’s share of the
lottery proceeds) by use of the unlimited marital deduction. Survivorship
insurance may also be attractive if the taxing and liquidity dilemma
causes a problem in the estate of the surviving spouse. For unmarried
prize winners, purchasing an insurance policy to fund estate taxes,
while expensive, may be appropriate. Inter vivos assignment through
court order, in states that allow such transfers, is another option.
If the assignment is for a present interest, the annual gift tax
exclusion would be available. When several beneficiaries are involved,
the tax savings may be substantial.
may request a postponement of paying estate taxes due to reasonable
cause or undue hardship. Treasury Regulations section 20.6161-1(a)(1)
explicitly mentions annuities as an asset that may qualify an
estate for postponement due to reasonable cause. While the ability
to borrow against such assets may ameliorate the cash flow problem,
when such borrowing inflicts loss upon the estate, reasonable
cause may be established. Reasonable cause provides a 12-month
extension to pay these taxes. Undue hardship allows for payment
periods up to 10 years; depending upon the remaining payout period
for the lottery winnings, this may not be sufficient.
in respect of a decedent. Because a lottery prize
is received in exchange for the purchase of a lottery ticket and
not as a gift (i.e., it is not excludible from income), winnings
from lotteries are gambling winnings included in gross income
under IRC section 61. In accordance with IRC section 74(a), gross
income includes amounts received as prizes and awards. When a
lottery prize is payable in installments, amounts designated as
interest to be paid on the unpaid annual installments of the prize
are also included in gross income under IRC section 103(a).
If a lottery
winner dies, the rights to the future payments become part of
the winner’s estate, and will be distributed to the beneficiaries
The state lottery will make the payment to the estate and, after
distribution of the estate, directly to the heirs. Receipt of
each payment constitutes income in respect of a decedent (IRD)
per IRC section 691. As such, the payments, after reduction for
the associated estate tax, are subject to income taxes upon the
recipient. That is, the lottery income must be reported as gross
income while a separate itemized deduction is allowed under IRC
section 691(c) for the estate tax applicable to the amount of
IRD reported. This requirement serves to compound the liquidity
problem, as payment of income taxes further reduces the cash available
to meet the estate tax obligation.
decisions discussed above present a problem that is both conceptual
and pragmatic in nature. Conceptually, there appears to be significant
confusion and disagreement concerning the valuation of lottery
payments under IRC section 7520 as annuity payments when there
are significant restrictions making the payment not assignable.
Pragmatically, a taxable estate that includes future lottery payments
may leave the estate with a tax liability and no available means
demonstrated a lack of consistency because there is a lack of
authoritative guidance on the peculiarities of lottery payments.
Because lottery payouts are never addressed directly, the statutory
and administrative provisions on annuities are applied to lottery
payments, seemingly by default. A fundamental difference, however,
is that lottery winnings are generally not alienable or assignable,
while an annuity generally is. Classifying future payouts as annuities,
however, is not an issue the appellate courts have been presented.
Because the right to future payouts is not marketable and transferable,
the requirement that section 7520 tables be used to value lottery
payments is questionable. The
IRS stance on valuation is presumptive and can only be overcome
by the taxpayer establishing that the table valuation is unrealistic
variety of findings at the appellate level, the judicial split
over the proper valuation methodology for lottery payouts includible
in an estate will eventually have to be resolved by the U.S. Supreme
Court. To circumvent this eventuality, Congress should address
the lack of statutory guidance. Meanwhile, taxpayers facing this
valuation dilemma should file suit in the applicable district
court. Generally, payment of the assessed tax deficiency is required
before filing for a hearing. Additionally,
a defense presenting a supportable alternative valuation based
on fair market valuation grounded in marketability similarities
with other property may lead to a favorable finding. Merely attacking
the unreliability and unreasonableness of an IRC section 7520
valuation is not enough.
several potential ways to solve illiquidity when lottery prize
payments are estate property. Congress could enact a law recognizing
the inequity of imposing estate taxes on income rights that yield
cash over a period of many years. Allowing for the payment of
estate taxes related to nontransferable streams of income to be
paid upon receipt of the income would alleviate this predicament.
Failing this, the IRS could promulgate a new regulation that takes
the illiquidity of the lottery income rights into consideration.
If state lotteries permitted a discounted lump-sum payout or eased
the transferability of prizes, this would also address several
of the issues.
taxpayers must plan ahead. A professional tax planning advisor
is crucial to maximize the marital deduction and annual gift tax
exclusions. Life insurance, if cost effective, may solve the estate
tax liquidity problem completely.
D. Englebrecht, PhD, is the Smolinski professor of accounting
at the school of professional accountancy at Louisiana Tech University,
Mary M. Anderson, CPA, is an assistant professor
of accounting at the school of accounting and information systems
at the University of Southern Mississippi, Hattiesburg, Miss.