Lattera v. Commissioner IRS ( 2006 )

Opinions of the United
2006 Decisions States Court of Appeals
for the Third Circuit
2-14-2006
Lattera v. Commissioner IRS
Precedential or Non-Precedential: Precedential
Docket No. 04-4721
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PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 04-4721
GEORGE LATTERA; ANGELINE LATTERA,
Appellants
v.
COMMISSIONER OF INTERNAL REVENUE
Appeal from the Decision of the
United States Tax Court
Docket No. 03-4269
Tax Court Judge: Honorable Juan F. Vasquez
Argued January 9, 2006
Before: BARRY and AMBRO, Circuit Judges,
and DEBEVOISE,* District Judge
*
Honorable Dickinson R. Debevoise, Senior District
Court Judge for the District of New Jersey, sitting by
(Opinion filed February 14, 2006)
Mark E. Cedrone, Esquire (Argued)
Cedrone & Janove
150 South Independence Mall West
Suite 940 Public Ledger
Building, 6 th & Chestnut Streets
Philadelphia, PA 19106
Counsel for Appellants
Eileen J. O’Connor
Assistant Attorney General
Regina S. Moriarty, Esquire (Argued)
Richard Farber, Esquire
United States Department of Justice
Tax Division
P.O. Box 502
Washington, DC 20044
Counsel for Appellee
OPINION OF THE COURT
designation.
2
AMBRO, Circuit Judge
Lottery winners, after receiving several annual
installments of their lottery prize, sold for a lump sum the right
to their remaining payments. They reported their sale proceeds
as capital gains on their tax return, but the Internal Revenue
Service (IRS) classified those proceeds as ordinary income. The
substitute-for-ordinary-income doctrine holds that lump-sum
consideration substituting for something that would otherwise
be received at a future time as ordinary income should be taxed
the same way. We agree with the Commissioner of the IRS that
the lump-sum consideration paid for the right to lottery
payments is ordinary income.
I. Factual Background and Procedural History
In June 1991 George and Angeline Lattera turned a one-
dollar lottery ticket into $9,595,326 in the Pennsylvania Lottery.
They did not then have the option to take the prize in a single
lump-sum payment, so they were entitled to 26 annual
installments of $369,051.
In September 1999 the Latteras sold their rights to the 17
remaining lottery payments to Singer Asset Finance Co., LLC
for $3,372,342. Under Pennsylvania law, the Latteras had to
obtain court approval before they could transfer their rights to
future lottery payments, and they did so in August 1999.
3
On their joint tax return, the Latteras reported this sale as
the sale of a capital asset held for more than one year. They
reported a sale price of $3,372,342, a cost or other basis of zero,
and a long-term capital gain of the full sale price. The
Commissioner determined that this sale price was ordinary
income. In December 2002 the Latteras were sent a notice of
deficiency of $660,784.1
In March 2003 the Latteras petitioned the Tax Court for
a redetermination of the deficiency. The Court held in favor of
the Commissioner. The Latteras now appeal to our Court.
II. Jurisdiction and Standard of Review
The Tax Court had subject matter jurisdiction under
I.R.C. § 7442. Because its decision was final, we have appellate
jurisdiction under I.R.C. § 7482(a)(1). The Latteras reside in
our Circuit, so venue is proper under I.R.C. § 7482(b)(1)(A).
We review the Tax Court’s legal determinations de novo,
but we do not disturb its factual findings unless they are clearly
erroneous. Estate of Meriano v. Comm’r, 142 F.3d 651, 657 (3d
Cir. 1998).
1
The parties’ stipulation of facts states this number as
$660,748, but the notice of deficiency reads $660,784.
4
III. Discussion
The lottery payments the Latteras had a right to receive
were gambling winnings, and the parties agree that the annual
payments were ordinary income. Cf. Comm’r v. Groetzinger,
480 U.S. 23, 32 n.11 (1987) (calling a state lottery “public
gambling” in a case treating gambling winnings as ordinary
income). But the Latteras argue that when they sold the right to
their remaining lottery payments, that sale gave rise to a long-
term capital gain.
Whether the sale of a right to lottery payments by a
lottery winner can be treated as a capital gain under the Internal
Revenue Code is one of first impression in our Circuit. But it is
not a new question. Both the Tax Court and the Ninth Circuit
Court of Appeals have held that such sales deserve ordinary-
income treatment. United States v. Maginnis, 356 F.3d 1179,
1181 (9th Cir. 2004) (“Fundamental principles of tax law lead
us to conclude that [the] assignment of [a] lottery right produced
ordinary income.”); Davis v. Comm’r, 119 T.C. 1, 1 (2002); see
also Watkins v. Comm’r, 88 T.C.M. 390, 393 (2004);
Clopton v. Comm’r, 87 T.C.M. 1217, 1217 (2004);
Boehme v. Comm’r, 85 T.C.M. 1039, 1041 (2003).
The Ninth Circuit’s reasoning has drawn significant
criticism, however. See Matthew S. Levine, Case Comment,
Lottery Winnings as Capital Gains, 114 Yale L.J. 195, 197–202
(2004); Thomas G. Sinclair, Comment, Limiting the Substitute-
5
for-Ordinary Income Doctrine: An Analysis Through Its Most
Recent Application Involving the Sale of Future Lottery Rights,
56 S.C. L. Rev. 387, 421–22 (2004). In this context, we propose
a different approach. We begin with a discussion of basic
concepts that underlie our reasoning.
A. Definition of a capital asset
A long-term capital gain (or loss) is created by the “sale
or exchange of a capital asset held for more than 1 year.” I.R.C.
§ 1222(3). Section 1221 of the Internal Revenue Code defines
a capital asset as “property held by the taxpayer (whether or not
connected with his trade or business).” This provision excludes
from the definition certain property categories, none of which is
applicable here.2
2
Section § 1221, as it read when the Latteras sold their
lottery rights, contained five exceptions (stock in trade of the
taxpayer, depreciable trade or business property, copyrights,
accounts receivable acquired in the ordinary course of trade or
business, and Government publications). The provision was
amended in December 1999 to exclude also commodities
derivative financial instruments held by dealers, hedging
transactions, and supplies used or consumed in trade or business.
Tax Relief Extension Act of 1999, Pub. L. No. 106-170, tit. V,
§ 532(a), 113 Stat. 1860, 1928–30. These exclusions are not
applicable to this case; the amendments did not apply to
transactions entered into before December 17, 1999, see id.
§ 532(d), 113 Stat. at 1931, and the Latteras sold their lottery
6
A 1960 Supreme Court decision suggested that this
definition can be construed too broadly, stating that “it is evident
that not everything which can be called property in the ordinary
sense and which is outside the statutory exclusions qualifies as
a capital asset.” Comm’r v. Gillette Motor Transp., Inc., 364
U.S. 130, 134 (1960). The Court noted that it had “long held
that the term ‘capital asset’ is to be construed narrowly in
accordance with the purpose of Congress to afford capital-gains
treatment only in situations typically involving the realization of
appreciation in value accrued over a substantial period of time,
and thus to ameliorate the hardship of taxation of the entire gain
in one year.” Id. But the Supreme Court’s decision in Arkansas
Best Corp. v. Commissioner, 485 U.S. 212 (1988), at least at
first blush, seems to have reversed that narrow reading.
Arkansas Best suggests instead that the capital-asset definition
is to be broadly construed. See id. at 218 (“The body of § 1221
establishes a general definition of the term ‘capital asset,’ and
the phrase ‘does not include’ takes out of that broad definition
only the classes of property that are specifically mentioned.”).
B. The substitute-for-ordinary-income doctrine
The problem with an overly broad definition for capital
assets is that it could “encompass some things Congress did not
intend to be taxed as capital gains.” Maginnis, 356 F.3d at
1181. An overly broad definition, linked with favorable capital-
rights in September 1999.
7
gains tax treatment, would encourage transactions designed to
convert ordinary income into capital gains. See id. at 1182. For
example, a salary is taxed as ordinary income, and the right to be
paid for work is a person’s property. But it is hard to conceive
that Congress intends for taxpayers to get capital-gains treatment
if they were to sell their rights (i.e., “property held by the
taxpayer”) to their future paychecks. See 2 Boris I. Bittker &
Lawrence Lokken, Federal Taxation of Income, Estates and
Gifts ¶ 47.1 (3d ed. 2000).
To get around this problem, courts have created the
substitute-for-ordinary-income doctrine. This doctrine says, in
effect, that “‘lump sum consideration [that] seems essentially a
substitute for what would otherwise be received at a future time
as ordinary income’ may not be taxed as a capital gain.”
Maginnis, 356 F.3d at 1182 (quoting Comm’r v. P.G. Lake, Inc.,
356 U.S. 260, 265 (1958)) (alteration in original).
The seminal substitute-for-ordinary-income case is the
1941 Supreme Court decision in Hort v. Commissioner, 313
U.S. 28 (1941). Hort had inherited a building from his father,
and one of the building’s tenants canceled its lease, paying Hort
a cancellation fee of $140,000. Id. at 29. Hort argued that the
cancellation fee was capital gain, but the Court disagreed,
holding that the cancellation fee was ordinary income because
the “cancellation of the lease involved nothing more than
relinquishment of the right to future rental payments in return
8
for a present substitute payment and possession of the leased
premises.” Id. at 32.
The Supreme Court bolstered the doctrine in Lake. P.G.
Lake, Inc. was an oil- and gas-producing company with a
working interest in two oil and gas leases. 356 U.S. at 261–62.
It assigned an oil payment right “payable out of 25 percent of
the oil attributable to [Lake’s] working interest in the two
leases.” Id. at 262. Lake reported this assignment as a sale of
property taxable as capital gain. Id. But the Court disagreed,
holding that the consideration received was taxable as ordinary
income. Id. at 264. The Court’s reasoning gave full voice to the
substitute-for-ordinary-income doctrine: “The lump sum
consideration seems essentially a substitute for what would
otherwise be received at a future time as ordinary income.” Id.
at 265.
Our Court has rarely dealt with this doctrine. We have
only cited Lake twice—once in 1958, Tunnell v. United States,
259 F.2d 916, 918 (3d Cir. 1958), and once in 1974, Hempt
Bros., Inc. v. United States, 490 F.2d 1172, 1176, 1178 (3d Cir.
1974) (citing Lake with approval, but deciding the case under a
§ 351—nonrecognition of transfers of property for corporate
stock—analysis).
The Latteras argue that the substitute-for-ordinary-
income doctrine, which takes “property held by the taxpayer”
outside the statutory capital-asset definition, did not survive
9
Arkansas Best. But although Arkansas Best ostensibly cabined
the exceptions to the statutory definition, it made clear that the
Hort–Lake “line of cases, based on the premise that § 1221
‘property’ does not include claims or rights to ordinary income,
ha[d] no application in the present context.” Arkansas Best, 485
U.S. at 217 n.5. The Tax Court has several times confirmed that
Arkansas Best “in no way affected the viability of the principle
established in the [Hort–Lake] line of cases.” Davis, 119 T.C.
at 6 (citing cases). And the Ninth Circuit agrees. Maginnis, 356
F.3d at 1185. We follow suit, holding that the substitute-for-
ordinary-income doctrine remains viable in the wake of
Arkansas Best.
But there is a tension in the doctrine: in theory, all capital
assets are substitutes for ordinary income. See, e.g., William A.
Klein et al., Federal Income Taxation 786 (12th ed. 2000) (“A
fundamental principle of economics is that the value of an asset
is equal to the present discounted value of all the expected net
receipts from that asset over its life.”); see also Lake, 356 U.S.
at 266 (noting that the lump-sum consideration—held to be
ordinary income—paid for an asset was “the present value of
income which the recipient would otherwise obtain in the
future”). For example, a stock’s value is the present discounted
value of the company’s future profits. See, e.g., Maginnis, 356
F.3d at 1182; cf. United States v. Dresser Indus., Inc., 324 F.2d
56, 59 (5th Cir. 1963) (applying this concept to the value of
land). “[R]ead literally, the [substitute-for-ordinary-income]
doctrine would completely swallow the concept of capital
10
gains.” Levine, supra, at 196; accord 2 Bittker & Lokken,
supra, ¶ 47.9.5, at 47-68 (“Unless restrained, the substitute-for-
ordinary-income theory thus threatens even the most familiar
capital gain transactions.”). Also, an “overbroad ‘substitute for
ordinary income’ doctrine, besides being analytically
unsatisfactory, would create the potential for the abuse of
treating capital losses as ordinary.” 3 Levine, supra, at 197. The
doctrine must therefore be limited so as not to err on either side.
C. The lottery cases
Even before the Ninth Circuit decided Maginnis, the Tax
Court had correctly answered the question of whether sales of
lottery winnings were capital gains. In Davis v. Commissioner,
lottery winners had sold their rights to 11 of their total 14 future
lottery payments for a lump sum. 119 T.C. 3. The Tax Court
found that the lump-sum payment to the lottery winners was the
“discounted value . . . of certain ordinary income which they
otherwise would have received during the years 1997 through
2007.” Id. at 7. The Court held, therefore, that (1) the purchaser
of the lottery payment rights paid money for “the right to
receive . . . future ordinary income, and not for an increase in the
value of income-producing property”; (2) the lottery winners’
right to their future lottery payments was not a capital asset; and
(3) the lump-sum payment was to be taxed as ordinary income.
3
Note that our holding in this case does not consider the
substitute-for-ordinary-income doctrine in loss transactions.
11
Id.; see also Watkins, 88 T.C.M. at 393 (following Davis,
in a post-Maginnis decision); Clopton, 87 T.C.M. at
1219 (citing Tax Court cases following Davis).
In 2004 the Ninth Circuit decided Maginnis, the first (and
so far only) appellate opinion to deal with this question.
Maginnis won $9 million in a lottery and, after receiving five of
his lottery payments, assigned all of his remaining future lottery
payments to a third party for a lump-sum payment of
$3,950,000. Maginnis, 356 F.3d at 1180. The Ninth Circuit
held that Maginnis’s right to future lottery payments was not a
capital asset and that the lump-sum payment was to be taxed as
ordinary income. Id. at 1182.
The Court relied on the substitute-for-ordinary-income
doctrine, but it was concerned about taking an “approach that
could potentially convert all capital gains into ordinary income
[or] one that could convert all ordinary income into capital
gains.” Id. The Court opted instead for “case-by-case
judgments as to whether the conversion of income rights into
lump-sum payments reflects the sale of a capital asset that
produces a capital gain, or whether it produces ordinary
income.” Id. It set out two factors, which it characterized as
“crucial to [its] conclusion,” but not “dispositive in all cases”:
“Maginnis (1) did not make any underlying investment of capital
in return for the receipt of his lottery right, and (2) the sale of his
right did not reflect an accretion in value over cost to any
underlying asset Maginnis held.” Id. at 1183.
12
But two commentators have criticized the analysis in
Maginnis, especially the two factors. See Levine, supra, at
197–202; Sinclair, supra, at 421–22. The first
factor—underlying investment of capital—would theoretically
subject all inherited and gifted property (which involves no
investment at all) to ordinary-income treatment. See Levine,
supra, at 198. It also does not explain the result in Lake, where
the company presumably made an investment in its working
interest in oil and gas leases, yet the Supreme Court applied
ordinary-income treatment. Id.
The second factor also presents analytical problems. Not
all capital assets experience an accretion in value over cost. For
example, cars typically depreciate, but they are often capital
assets. See Sinclair, supra, at 421. Levine criticizes the second
factor for “attempt[ing] to determine the character of a gain
from its amount.” Levine, supra, at 199. The Maginnis Court
held that there was no accretion of value over cost in lottery
winnings because there was no cost, as “Maginnis did not make
any capital investment in exchange for his lottery right.” 356
F.3d at 1184. But if Maginnis’s purchase of a lottery ticket had
been a capital investment, would the second factor automatically
have been satisfied? (That is, the “cost” in that scenario would
have been $1, and the increase would have been $3,949,999.)
Our first instinct is no. Moreover, the second factor does not
seem to predict correctly the result in both Hort (where a
building was inherited for no “cost”) and Lake (where the
13
working interest in the oil lease presumably had a “cost”), in
both of which the taxpayer got ordinary-income treatment.
Thus, while we agree with Maginnis’s result, we do not
simply adopt its reasoning. And it is both unsatisfying and
unhelpful to future litigants to declare that we know this to be
ordinary income when we see it. The problem is that, “[u]nless
and until Congress establishes an arbitrary line on the otherwise
seamless spectrum between Hort–Lake transactions and
conventional capital gain transactions, the courts must locate the
boundary case by case, a process that can yield few useful
generalizations because there are so many relevant but
imponderable criteria.” 2 Bittker & Lokken, supra, ¶ 47.9.5, at
47-69 (footnote omitted).
We therefore proceed to our case-by-case analysis, but in
doing so we set out a method for analysis that guides our result.
At the same time, however, we recognize that any rule we create
could not account for every contemplated transactional
variation.
D. Substitute-for-ordinary-income analysis
In our attempt to craft a rubric, we find helpful a Second
Circuit securities case and a recent student comment. The
Second Circuit dealt with a similarly “seamless spectrum” in
1976 when it needed to decide whether a note was a security for
purposes of section 10(b) of the 1934 Securities and Exchange
14
Act. See Exch. Nat’l Bank of Chi. v. Touche Ross & Co., 544
F.2d 1126, 1138 (2d Cir. 1976). The Court created a “family
resemblance” test, (1) presuming that notes of more than nine
months’ maturity were securities, (2) listing various types of
those notes that it did not consider securities, and (3) declaring
that a note with maturity exceeding nine months that “does not
bear a strong family resemblance to these examples” was a
security. Id. at 1138, 1137–38. The Supreme Court, adopting
this test in 1990, added four factors to guide the “resemblance”
analysis: the motivations of the buyers and sellers, the plan of
distribution, the public’s reasonable expectations, and applicable
risk-reducing regulatory schemes. Reves v. Ernst & Young, 494
U.S. 56, 65–67 (1990).
We adopt an analogous analysis. Several types of assets
we know to be capital: stocks, bonds, options, and currency
contracts, for example. See, e.g., Arkansas Best, 485 U.S. at
222–23 (holding—even though, as noted above, the value of a
stock is really the present discounted value of the company’s
future profits—that “stock is most naturally viewed as a capital
asset”); see also id. at 217 n.5 (distinguishing “capital stock”
from “a claim to ordinary income”); Simpson v. Comm’r, 85
T.C.M. 1421, 1423 n.7 (2003) (distinguishing “currency
contracts, stocks, bonds, and options” from a right to receive
lottery payments). We could also include in this category
physical assets like land and automobiles.
15
Similarly, there are several types of rights that we know
to be ordinary income, e.g., rental income and interest income.
In Gillette Motor, the Supreme Court held that ordinary-income
treatment was indicated for the right to use another’s
property—rent, in other words. See 364 U.S. at 135. Similarly,
in Midland-Ross, the Supreme Court held that earned original
issue discount should be taxed as ordinary income. See United
States v. Midland-Ross Corp., 381 U.S. 54, 58 (1965). There,
the taxpayer purchased non-interest-bearing notes at a discount
from the face amount and sold them for more than their issue
price (but still less than the face amount). Id. at 55. This gain
was conceded to be equivalent to interest, and the Court held it
taxable as ordinary income. Id. at 55–56, 58.
For the “family resemblance” test, we can set those two
categories at the opposite poles of our analysis. For example,
we presume that stock, and things that look and act like stock,
will receive capital-gains treatment. For the in-between
transactions that do not bear a family resemblance to the items
in either category, like contracts and payment rights, we use two
factors to assist in our analysis: (1) type of “carve-out” and (2)
character of asset.4
1. Type of carve-out
4
We borrow these factors from Thomas Sinclair’s
comment, see Sinclair, supra, at 401–03, but we differ from him
slightly in the way we apply the character factor.
16
The notion of the carve-out, or partial sale, has
significant explanatory power in the context of the Hort–Lake
line of cases. As Marvin Chirelstein writes, the “‘substitute’
language, in the view of most commentators, was merely a
short-hand way of asserting that carved-out interests do not
qualify as capital assets.” Marvin A. Chirelstein, Federal
Income Taxation ¶ 17.03, at 369–70 (9th ed. 2002).
There are two ways of carving out interests from
property: horizontally and vertically. A horizontal carve-out is
one in which “temporal divisions [are made] in a property
interest in which the person owning the interest disposes of part
of his interest but also retains a portion of it.” Sinclair, supra,
at 401. In lottery terms, this is what happened in Davis,
Boehme, and Clopton—the lottery winners sold some of their
future lottery payment rights (e.g., their 2006 and 2007
payments) but retained the rights to payments further in the
future (e.g., their 2008 and 2009 payments). See Clopton, 87
T.C.M. at 1217–18 (finding that the lottery winner sold
only some of his remaining lottery payments); Boehme, 85
T.C.M. at 1040 (same); Davis, 119 T.C. 3 (same).
This is also what happened in Hort and Lake; portions of the
total interest (a term of years carved out from a fee simple and
a three-year payment right from a working interest in a oil lease,
respectively) were carved out from the whole.
A vertical carve-out is one in which “a complete
disposition of a person’s interest in property” is made. Sinclair,
17
supra, at 401. In lottery terms, this is what happened in Watkins
and Maginnis—the lottery winners sold the rights to all their
remaining lottery payments. See Maginnis, 356 F.3d at 1181
(noting that the lottery winner assigned his right to receive all
his remaining lottery payments); Watkins, 88 T.C.M. at
391 (same).
Horizontal carve-outs typically lead to ordinary-income
treatment. See, e.g., Maginnis, 356 F.3d at 1185–86 (“Maginnis
is correct that transactions in which a tax-payer transfers an
income right without transferring his entire interest in an
underlying asset will often be occasions for applying the
substitute for ordinary income doctrine.”). This was also the
result reached in Hort and Lake. Lake, 356 U.S. at 264; Hort,
313 U.S. at 32.
Vertical carve-outs are different. In Dresser Industries,
for example, the Fifth Circuit distinguished Lake because the
taxpayer in Dresser had “cut[] off a ‘vertical slice’ of its rights,
rather than carv[ed] out an interest from the totality of its
rights.” Dresser Indus., 324 F.2d at 58. But as the results in
Maginnis and Watkins demonstrate, a vertical carve-out does not
necessarily mean that the transaction receives capital-gains
treatment. See, e.g., Maginnis, 356 F.3d at 1185 (holding “that
a transaction in which a taxpayer sells his entire interest in an
underlying asset without retaining any property right does not
automatically prevent application of the substitute for ordinary
income doctrine” (emphasis in original)); see also id. at 1186.
18
Because a vertical carve-out could signal either capital-
gains or ordinary-income treatment, we must make another
determination to conclude with certainty which treatment should
apply. Therefore, when we see a vertical carve-out, we proceed
to the second factor—character of the asset—to determine
whether the sale proceeds should be taxed as ordinary income or
capital gain.
2. Character of the asset
The Fifth Circuit in Dresser Industries noted that “[t]here
is, in law and fact, a vast difference between the present sale of
the future right to earn income and the present sale of the future
right to earned income.” Dresser Indus., 324 F.2d at 59
(emphasis in original). The taxpayer in Dresser Industries had
assigned its right to an exclusive patent license back to the
patent holder in exchange for a share of the licensing fees from
third-party licensees. Id. at 57. The Court used this “right to
earn income”/“right to earned income” distinction to hold that
capital-gains treatment was applicable. It noted that the asset
sold was not a “right to earned income, to be paid in the future,”
but was “a property which would produce income.” Id. at 59.
Further, it disregarded the ordinary nature of the income
generated by the asset; because “all income-producing property”
produces ordinary income, the sale of such property does not
result in ordinary-income treatment. Id. (This can be seen in the
sale of stocks or bonds, both of which produce ordinary income,
but the sale of which is treated as capital gain.)
19
Sinclair explains the concept in this way: “Earned income
conveys the concept that the income has already been earned
and the holder of the right to this income only has to collect it.
In other words, the owner of the right to earned income is
entitled to the income merely by virtue of owning the property.”
Sinclair, supra, at 406. He gives as examples of this concept
rental income, stock dividends, and rights to future lottery
payments. Id.; see also Rhodes’ Estate v. Comm’r, 131 F.2d 50,
50 (6th Cir. 1942) (per curiam) (holding that a sale of dividend
rights is taxable as ordinary income). For the right to earn
income, on the other hand, “the holder of such right must do
something further to earn the income. . . . [because] mere
ownership of the right to earn income does not entitle the owner
to income.” Sinclair, supra, at 406. Following Dresser
Industries, Sinclair gives a patent as an example of this concept.
Id.
Assets that constitute a right to earn income merit capital-
gains treatment, while those that are a right to earned income
merit ordinary-income treatment. Our Court implicitly made
this distinction in Tunnell v. United States, 259 F.2d 916 (3d Cir.
1958). Tunnell withdrew from a law partnership, and he
assigned his rights in the law firm in exchange for $27,500. Id.
at 917. When he withdrew, the partnership had over $21,000 in
uncollected accounts receivable from work that had already been
done. Id. We agreed with the District Court that “the sale of a
partnership is treated as the sale of a capital asset.” Id. The sale
of a partnership does not, in and of itself, confer income on the
20
buyer; the buyer must continue to provide legal services, so it is
a sale of the right to earn income. Consequently, as we held, the
sale of a partnership receives capital-gains treatment. The
accounts receivable, on the other hand, had already been earned;
the buyer of the partnership only had to remain a partner to
collect that income, so the sale of accounts receivable is the sale
of the right to earned income. Thus, we held that the portion of
the purchase price that reflected the sale of the accounts
receivable was taxable as ordinary income. Id. at 919.
Similarly, when an erstwhile employee is paid a
termination fee for a personal-services contract, that employee
still possesses the asset (the right to provide certain personal
services) and the money (the termination fee) has already been
“earned” and will simply be paid. The employee no longer has
to perform any more services in exchange for the fee, so this is
not like Dresser Industries’s “right to earn income.” These
termination fees are therefore rights to earned income and
should be treated as ordinary income. See, e.g., Elliott v. United
States, 431 F.2d 1149, 1154 (10th Cir. 1970); Holt v. Comm’r,
303 F.2d 687, 690 (9th Cir. 1962); see also Chirelstein, supra,
¶ 17.03, at 376–77 (noting that “courts have held consistently
that payments made to an employee for the surrender of his
employment contract are ordinary”).
The factor also explains, for example, the Second
Circuit’s complex decision in Commissioner v. Ferrer, 304 F.2d
125 (2d Cir. 1962). The actor José Ferrer had contracted for the
21
rights to mount a stage production based on the novel Moulin
Rouge. Id. at 126. In the contract, Ferrer obtained two rights
relevant here: (1) the exclusive right to “produce and present” a
stage production of the book and, if the play was produced, (2)
a share in the proceeds from any motion-picture rights that
stemmed from the book. Id. at 127. After a movie studio
planned to make Moulin Rouge into a movie—and agreed that
it would feature Ferrer—he sold these, along with other, rights.
Id. at 128–29. Right (1) would have required Ferrer to have
produced and presented the play to get income, so it was a right
to earn income—thus, capital-gains treatment was indicated.
Right (2), once it matured (i.e., once Ferrer had produced the
play), would have continued to pay income simply by virtue of
Ferrer’s holding the right, so it would have become a right to
earned income—thus, ordinary-income treatment was indicated.
The Second Circuit held as such, dictating capital-gains
treatment for right (1) and ordinary-income treatment for right
(2). Id. at 131, 134.5
5
One well-known result that these factors do not predict
is the Second Circuit’s 1946 opinion in McAllister v.
Commissioner, 157 F.2d 235 (2d Cir. 1946). In that case, a
widow was forced to sell her life estate in a trust to the
remainderman. Id. at 235. Thus, she received a lump-sum
payment in exchange for her right to all future payments from
the trust. Although this was a vertical carve-out, susceptible to
both types of treatment, she gave up her right to earned income,
because she would have continued receiving payments simply
22
E. Application of the “family resemblance” test
Applied to this case, the “family resemblance” test draws
out as follows. First, we try to determine whether an asset is
like either the “capital asset” category of assets (e.g., stocks,
bonds, or land) or like the “income items” category (e.g., rental
income or interest income). If the asset does not bear a family
resemblance to items in either of those categories, we move to
the following factors.
by holding the life estate. Thus, the sale proceeds should have
received ordinary-income treatment. The Court held instead that
capital-gains treatment was indicated. Id. at 236.
But the result in McAllister has been roundly criticized.
The Tax Court in that case had held that ordinary-income
treatment was proper, id. at 235, and Judge Frank entered a
strong dissent, id. at 237–41 (Frank, J., dissenting). The
McAllister Court relied on a case that did not even discuss the
capital-asset statute. Id. at 237 (majority opinion). Chirelstein
writes that the “decision in McAllister almost certainly was
wrong.” Chirelstein, supra, ¶ 17.03, at 373. And a 2004 Tax
Court opinion did not even bother to distinguish McAllister,
stating simply that it was “decided before relevant Supreme
Court decisions applying the substitute for ordinary income
doctrine” (referring, inter alia, to Lake). Clopton, 87 T.C.M.
(CCH) at 1219.
We consider McAllister to be an aberration, and we do
not find it persuasive in our decision in this case.
23
We look at the nature of the sale. If the sale or
assignment constitutes a horizontal carve-out, then ordinary-
income treatment presumably applies. If, on the other hand, it
constitutes a vertical carve-out, then we look to the character-of-
the-asset factor. There, if the sale is a lump-sum payment for a
future right to earned income, we apply ordinary-income
treatment, but if it is a lump-sum payment for a future right to
earn income, we apply capital-gains treatment.
Turning back to the Latteras, the right to receive annual
lottery payments does not bear a strong family resemblance to
either the “capital assets” or the “income items” listed at the
polar ends of the analytical spectrum. The Latteras sold their
right to all their remaining lottery payments, so this is a vertical
carve-out, which could indicate either capital-gains or ordinary-
income treatment. But because a right to lottery payments is a
right to earned income (i.e., the payments will keep arriving due
simply to ownership of the asset), the lump-sum payment
received by the Latteras should receive ordinary-income
treatment.
This result comports with Davis and Maginnis. It also
ensures that the Latteras do not “receive a tax advantage as
compared to those taxpayers who would simply choose
originally to accept their lottery winning in the form of a lump
24
sum payment,” something that was also important to the
Maginnis Court. Maginnis, 356 F.3d at 1184.6
IV. Conclusion
The lump-sum consideration paid to the Latteras in
exchange for the right to their future lottery payments is
ordinary income.7 We therefore affirm.
6
We do not decide whether Singer, who purchased the
right to lottery payments from the Latteras, would receive
ordinary income or capital gain if it later decided to sell that
right to another third party. See Maginnis, 356 F.3d at 1183 n.4.
Such a determination would need to be made on the specific
facts of the transaction. For example, if Singer bought and sold
such rights as part of its business, the lottery payment rights
could theoretically fall under the inventory exclusion to the
capital-asset definition. Cf. Arkansas Best, 485 U.S. at 222
(suggesting that if Arkansas Best had been a dealer in securities,
its bank stock might have fallen within § 1221’s inventory
exclusion).
7
The Latteras appear to argue that their lottery ticket was
itself a capital asset. We do not need to address this issue, as we
note that the Latteras did not sell their winning ticket to Singer.
Instead, they relinquished it in 1991 to the Pennsylvania State
Lottery so they could claim their prize. They sold Singer eight
years later not the physical lottery ticket but their right to the
annual lottery payments.
25