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.