Valuation of Lottery Prize Payments for Estate Tax Purposes: An Analysis

CPA Journal, The, Jun 2007 by Englebrecht, Ted D, Anderson, Mary M

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]. This stance, 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.

What follows 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.

Lottery Prizes

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 activities.

While the 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).

When someone 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?," www .dafusa.com/Pages/gamblinglotteryready.ht ml, 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.

Statutory Background

Lottery winnings 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 20.2031-(1)(b)].