11th Circuit Ruling Costs Lotto Winners Millions

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Written by John Pacenti

Sunday, 06 January 2008 16:00

Anthony Bertucci was a Florida Lotto winner about 10 years ago. Today, he is selling his home and moving out of state to pay the Internal Revenue Service after a federal appellate court decision last month that will cost 63 lottery winners nationwide millions in taxes.

“I got to start over again. It just doesn’t seem fair,” said Bertucci, of Boca Raton, Fla., as his 1-year-old child cooed in the background.

The 11^th U.S. Circuit Court of Appeals in Atlanta ruled Dec. 19 that Bertucci and the others around the country who sold their winnings to investment companies must pay income taxes on the lump sum they received instead of lower capital gains taxes. The group was represented by Miami Beach tax attorney Steven M. Kwartin.

The court did not ground its decision in the words of the internal revenue code; instead it relied on the uncodified “substitute-for-ordinary income doctrine.” The difference for the petitioners: pay a tax rate of 39.6 percent as opposed to 20 percent.

U.S. District Judge Beverly Martin, a visiting judge on the panel from the Northern District of Georgia, wrote in the 23-page opinion that Congress did not intend for taxpayers to circumvent ordinary income tax treatment by packaging ordinary income payments and selling them to a third party.

“A lottery winner who has not sold the right to his winnings to a third party must report the winnings as ordinary income whether state pays him in a lump sum or in installments,” Martin wrote. “Thus, when a lottery winner sells the right to his winnings, he replaces future ordinary income.”

Judges Joel F. Dubina and J.L. Edmondson concurred.

For Kwartin, who has fought this battle for his clients for five years, the tax code simply does not support the opinions of five appellate courts. He said the issue comes down to whether the string of payments lottery winners receive constitute property, and, therefore, are a capital asset like a mortgage or shares of stock.

Kwartin said the tax code carves out no exception.

“The court had to strain or completely avoid analyzing the (substitute-for-ordinary income) doctrine in order to reach the desired result, because they don’t like the concept that what the court sees as a gambling transaction can be converted to capital income,” Kwartin said.

“They can’t just say, ‘We want to apply the doctrine because we don’t like the results here.”

Tax attorney Alan S. Lederman of Akerman Senterfitt in Miami said the decision, along with four others in federal appellate courts around the country, solidifies the substitute-for-ordinary income doctrine as a powerful tool for the IRS, allowing it to re-classify income in order to make it more representative of its true nature.

“I think it’s a vindication of the IRS on the use of the substitute-for-ordinary income doctrine,” Lederman said. He was not involved in the cases before the 11th Circuit.

Bertucci, whose tax liability is $318,003, said he lost all of his winnings after consulting with a tax attorney. He declined to identify the amount he won. But he said he received an opinion letter about selling his lottery annual payments from the attorney. He also relied on investment advice from a stockbroker he claims was unscrupulous. “It’s really sad because you listen to people who you think are trustworthy,” Bertucci said.

Numerous calls to companies in Florida that buy lottery winnings went unanswered, but they have a clear presence on the Web. They often make their money by pooling several purchases from winners into one and selling it at a slightly larger fee to a large financial institution.

Martin S. Granoff, who owns Davie-based Granoff Enterprises, said on his Internet site that he has been buying lottery winnings since 1992 and claimed to “offer the highest possible amounts to prize winners.”

LotteryCashOut.Com claims a number of positives from selling lottery winnings for lump sums, including being able to use the winnings as collateral for loans that can be considered “tax-free income.”

Kwartin said the sad part about his clients is that many like Bertucci took their lump sum money and invested in the stock market just as the technology bubble burst. Now they only have tax debt to show for it.

The 11th Circuit took a look at two test cases in which the U.S. Tax Court ruled in favor of the IRS. In January 1996, Roland and Marie Womack won a portion of an $8 million Lotto prize and were to receive 20 annual payments of $150,000. Anastasios and Maria Spiridakos of Clearwater, Fla., in January 1990 won $6.4 million and were entitled to receive 20 annual $312,000 payments.

In November 1999, the Womacks entered into an agreement with Singer Asset Finance Co. to sell the 16 remaining payments in exchange for $1.328 million. With 10 payments left, the Spiridakos decided in 2000 to sell their annual proceeds to Singer for $2.125 million. Singer, of Boca Raton, Fla., no longer buys lottery proceeds. Both agreements were approved by state circuit courts.

The difference between paying income tax on the lump sum money as opposed to capital gains taxes for the Womacks was $235,852. The difference for Spiridakos was $425,678. They petitioned the tax court for relief when the IRS rejected their return listing the lump sum payments as capital gains.

By the time, the tax court heard their petition, three other appellate courts—the 9^th Circuit in San Francisco, the 3rd Circuit in Philadelphia, and the 10^th Circuit in Denver—had fashioned opinions favoring the IRS in regards to lump-sum payments sold to investment companies. “Petitioners recognize that they are swimming against a rising tide,” the tax court said in its opinion.

Lederman, who has represented lottery winners, said: “They [the appellate courts] all came up with different theories, but they all came up with the same answer. I don’t see the opinions were especially about gambling. I think it’s about the IRS simply doesn’t want you to convert ordinary income into capital gains.”

The 11th Circuit did not reverse the trend last month, finding that the money received from a third party for lottery payments fall under the substitute-for-ordinary income doctrine, which is not part of the tax code.

Martin, in her opinion, said Congress intended capital gains to be those that result from investments. “Lottery rights involve no underlying investment of capital,” Martin wrote, paraphrasing the 9^th Circuit’s decision.

Kwartin said he doesn’t expect to appeal the decision to the U.S. Supreme Court but said it is clear the tax code would allow his clients to take the lower tax rate.

“If this is somehow a loophole, an error, something that Congress hasn’t thought about, then perhaps they need to add another sub-section regarding lottery rights and capital assets, but they haven’t,” Kwartin said.

A lot of the deals that generated the tax petitions went down before state lotteries allowed lump sum payouts, or as in Bertucci’s case, the winners were told they could be taxed at a lower level or be given a larger lump sum if they sold privately.

“These people had no option at the time,” Kwartin said.

Bertucci said the slate of appellate rulings have devastated a number of lottery winners who have fallen on hard times—a familiar scenario. He said some have formed support groups. Bertucci said he knows of a 76-year-old man who was in a nursing home and the appellate decision cost him his last $12,000 in savings.

“I really regret the whole thing,” Bertucci said. “On paper it looked like a beautiful deal.”

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