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This page contains a single entry from the blog posted on November 10, 2005 11:41 AM. The previous post in this blog was Saturday Market: Save it, move it, kill it?. The next post in this blog is I missed this one. Many more can be found on the main index page or by looking through the archives.

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Thursday, November 10, 2005

Little lotto tax problem

The folks who won the monster Powerball jackpot came out of the closet earlier this week. They held onto their winning ticket for 20 days before coming forward. According to press reports, that was so that they could talk to tax and financial advisers. And, according to the Oregonian story (lost in the black hole of Oregon Live at the moment), the prize claim was timed so that they wouldn't receive their winnings -- more than $100 million in cash after taxes -- until early 2006. That, it was suggested, would keep the winnings off their 2005 income tax returns, and allow them to wait until their 2006 returns to report it and try to shelter it.

Don't count on that last part.

In the tax world, individuals have income when they receive it, and not until then. But there are two kinds of receipt: actual receipt, and something called constructive receipt. When the law says "constructive," it's making believe. The event in question (here, getting paid) didn't actually happen yet, but we treat it as if it did. What this means is you can have income even though you have not actually received it, provided that you have "constructively" done so.

When does a taxpayer have "constructive receipt"? The IRS has regulations out on this that are as old as dirt. They state:

Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.
In other words, you can't turn your back on income. You can't postpone paying tax on income that's at your disposal by simply "letting it ride."

This may sound like some esoteric tax doctrine, but its application is extremely commonplace. Take that bank account of yours that earns interest every month. If you leave the interest in the account and never go get it, does that means you don't have to report it as income until later? No, you constructively receive it as soon as it's in your account. As soon as it's there for the taking. The same is true of uncashed paychecks, reinvested mutual fund dividends, and lots of other kinds of income.

In the case of the lottery winners, their lucky numbers came out on October 19. It takes 60 days to actually receive your winnings once you turn in your ticket. So they could have had their money on December 19 if they had claimed it promptly. The IRS may take the position that that constitutes constructive receipt in 2005.

Even if there was no constructive receipt of the $110 million cash in 2005, the IRS might also argue that the winners were in actual receipt of the "economic benefit" of winning as of Oct. 20. This doctrine is a bit murkier, but one of the cases typically used to illustrate it involves underage kids who won the Irish sweepstakes. Although they couldn't collect the prize until they were 21, they were taxed when they won, because of the "economic benefit" they actually received by winning. Application of this rule to lottery winnings is not a sure thing -- there's one case out of the Midwest that suggests it doesn't apply -- but you could expect the IRS to take a run at it, at least.

Now, maybe the IRS will look the other way with the Powerball folks. Maybe they'll be able to postpone until their 2006 tax returns reporting all that money as income (by my rough calculation, triggering federal income tax of around $59,000,000, much or all of which will have already been withheld). But if I were an enterprisng IRS agent or lawyer, I'd be pushing for them to show it on their 2005 return, triggering the tax at an earlier date.

Comments (20)

i had to pay several thousands of dollars to learn the above and all your readers get it for free? :)

that was pretty well spelled out... if i didn't know better, i'd say you show real potential as a tax law professor.

Ahhh...the little Pulsifer kids and their Irish Lottery winnings. See, I do remember cases from your Income Tax class!

Came out of the closet? Is that a pun? Probably not... The winners' son is a student at OSU and is actually well-known in the LGBTQIA community, but you were probably unaware. Caught my attention though.

So let me get this straight. These people are about to get $100 mil after taxes as a pure windfall and they are looking for tax dodges so they can keep even more of the money?

2:59 Stacy: gee, thanks for sharing. Really important we all know that bit of cultural trivia.

I did not mean that "closet."

As for tax dodges, there's a line between tax avoidance (legitimate) and tax evasion (criminal). If I was about to take a $110 million hit of income, I'd definitely be looking to do some tax avoidance (from my beach chair). You'd be crazy not to. One's patriotic duties do not include paying more than the law requires.

Jack

I agree, if I won the first thing I'd do would be find a good accountant, one used to dealing with large fortunes. (the second thing I would do is get out of the country for a while so every 3rd cousin twice removed can't track me down:-)) But at the same time when you have that much money worrying about every penny gets a little ridiculous. The tone of this news bit made it sound like they are going towards the extreme.

"Cutlural trivia" indeed. Is velledorchid just envious, or what?
The tax collector's share of this powerball payout must represent a nice piece of change for the state, and even the feds' portion should pay for a few minutes of fun and games in Iraq! Good advice would be a valuable thing -- and this winner doesn't seem to have stumbled onto it.

Comments aside, I find my trivia interesting, where I find the babble about taxes not so much. The Pride Center on campus is bound to have a donation soon! Can't wait!

Good advice would be a valuable thing -- and this winner doesn't seem to have stumbled onto it.

Actually, if I'm right about the constructive receipt, there's nothing they could have done to change the outcome. What they actually did may be worth a try, but if push comes to shove, it may very well not work.

Wouldn't it be better if 340 people each won $1m? And to stay on topic, would that mean more tax revenues?

Jim

Twenty days' time value of holding $110 million, even at short-term US treasury rates, is pretty impressive: over $241,000 (pre-tax, of course). That's a clear-cut opportunity cost for a deferred recognition attempt. I guess what I'm missing is the ideas for mitigating the tax in a more significant way than just postponing recognition into the next tax year, even assuming that would work out.

Another tax-savvy move they made was having nine people claim joint ownership of the prize. Did they really have nine people go in on the winning ticket, or was that something they thought up in the 20 days after they had won?

Nine winners means nine different lower income tax brackets to soak up some of those winnings. Each of those nine folks has a 10% federal income bracket, a 15% bracket, a 25% bracket, etc., which is way less than the 35% bracket that most of the winnings would have sat in if the ticket was owned by one person or married couple.

And the amount of wealth that will be in each person's estate for estate tax purposes when each one dies will be eligible for a $1.5 million exclusion (which saves more than $600,000 in federal tax each). Nine winners multiplies that exemption by nine, compared to what it would be for a single winner. I think that's $4.8 million of a smart tax move right there.

The best maneuver would have been if they somehow could have avoided Oregon state income tax (9% of the whole $110 milion). But for that, they'd have to show that the winner was not an Oregon resident and that this was not Oregon-source income. I don't think these folks could prove either one.

I've thought for a long time that there is a market out there for a particular type of service: Transition-Period Legal, Tax and Financial advice for the newly wealthy. Some enterprising lawyer should go out there and offer her services as "the lawyer who will help you do the transition services, including hiring permanent tax advisors, lawyers, etc." She would need to be able to relate the basics, such as this fine article and the '9 winner' comments do. She could build credibility by having agreements for 60-day 0% bridge loans from banks ready on the shelf.

Good point about the estate taxes, Jack (unless, of course, they all die in 2010), but presumably they've already used up part of those lower brackets. Still, pretty good income spreading!

Looking back at the article behind the "out of the closet" link, I note that the prize is actually $164 million, so the $110 million is after taxes. This makes the income tax deferral (if it works) even more significant than Allan L's calculation.

On the back of my envelope, I had the federal income tax at about $59 million -- 35 percent of around $169 million. By pushing the tax out to 2006, they would (roughly speaking) postpone paying quarterly estimated tax of that amount by roughly a calendar quarter. At 5 percent annual interest, you would save 1.25 percent as the time value of money. On $59 million of tax, that's like an additional $737,500 in your pocket today. Definitely worth a try.

Gee, I wish I had these problems myself, don't you?

Totally wish I had that problem.

The largest advantage I see to having the income includible in 2006 is that the winner is receiving an extra 12 months to carefully plan ways to shelter the income. Charitable giving comes immediately to mind.

Actually, I was wondering about avoiding the Oregon tax. Since they are Oregonians, it is a moot point. But suppose they were visiting from out of state when they bought the ticket:

Oregon is one of several states that work together on putting up the PowerBall. So could you argue that it isn't entirely income derived from Oregon? After all, they could have bought a winning ticket in Wisconisn or one of several other states.

Can Oregon thus claim all the income from a PowerBall win by a non-Oregonian?

(A) If someone buys a (winning) ticket for an October drawing, tucks it into their wallet, forgets about it, discovers the ticket in January, claims the prize at that time...when did they constructively receive the income? If they realize in Jnauary they have a winning ticket and then lose it, did they constructively receive income?

(B) If someone does all of the above but does not discover the ticket until the following November - beyond the redemption period - did they constructively receive any income at all?


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