                        T.C. Memo. 2004-95



                      UNITED STATES TAX COURT



     ALDEN L. CLOPTON AND YOLANDA Y. CLOPTON, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4627-03.             Filed April 6, 2004.


     Frank Sommerville, for petitioners.

     W. Lance Stodghill, for respondent.



                        MEMORANDUM OPINION


     GOEKE, Judge:   Respondent determined a deficiency in

petitioners’ 1999 Federal income tax of $221,269.96.   The sole

issue for decision is whether a lump-sum amount received in

exchange for an interest in a trust holding the right to receive

future annual lottery payments is ordinary income or capital
                                   - 2 -

gain.       We hold under the substitute for ordinary income doctrine

that the lump-sum amount is ordinary income.

Background

        The parties submitted this case fully stipulated under Rule

122.1       The stipulation of facts and the attached exhibits are

incorporated herein by this reference.       Petitioners, Mr. Clopton

and Mrs. Clopton, resided in Pearland, Texas, at the time they

filed their petition.

        Mr. Clopton and two coworkers participated in a lottery pool

to purchase 60 tickets costing $1 each for the June 4, 1997,

Texas Lottery drawing.       One of the purchased tickets was the

winning ticket for the lottery drawing.       The prize for the

lottery drawing was valued at $9 million and was payable in 25

annual installments of $360,000.

        In June 1997, Mr. Clopton, R.L. Littleton, III, Freddie

Lofton, Joseph Hill, and Sally Hill, as trustors, established the

“June 4, 1997 Lottery Trust” (the trust).       Under the terms of an

amended trust agreement (trust agreement), Mr. Clopton and the

other trustors granted, assigned, and delivered all their rights,

title, and interests in the lottery ticket to the trust.       Mr.

Clopton held a one-third beneficial interest in the trust and



        1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 3 -

each of the other trustors held a one-sixth beneficial interest.

The trust agreement provides that the trust shall within 5

business days after the receipt of any cash amount from the Texas

Lottery Commission, distribute all cash amounts received by the

trust to the beneficiaries in proportion to their respective

beneficial interests in the trust.     A portion or all of each

beneficial interest could be assigned to any other person or to

any organization.   The first prize payment was made in June 1997,

with subsequent installments to be paid on or about June 15 of

every year continuing through June 15, 2021.     There is no

evidence that the trust has held any other property or has been

involved in any other activity.

     On July 28, 1999, Mr. Clopton and Singer Asset Finance Co.,

LLC (Singer) entered into a “Sale Agreement for Lottery Prize

Payments of Alden Clopton” and “Terms Rider to Sale Agreement for

Lottery Prize Payments of Alden Clopton” (the sale agreements),

which provided that Mr. Clopton’s interest in the rights, title,

and interest in the lottery prize were sold and assigned to

Singer.   Under the terms of the sale agreements, 20 annual

payments of $120,000, payable on or about June 15 of the years

2000 through 2019, were sold to Singer for $1,155,000.     The sale

agreements provided that the law of Texas required the parties to

consummate an agreement and to obtain a court order directing the

Texas Lottery Commission to make the payments to Singer.       The
                               - 4 -

record is unclear whether Singer ultimately received the payments

from the trust or directly from the Texas Lottery Commission.

The sale agreements also provided that Mr. Clopton was the sole

owner of the portion of the lottery prize being assigned to

Singer free and clear of any right, interest, or claim of any

other person or entity, and Mr. Clopton had not previously

assigned, pledged, or otherwise encumbered his rights in the

lottery prize.   Finally, the sale agreements stated:

     1)   The lottery law in Texas has been interpreted as
     not permitting voluntary assignments of lottery prize
     payments. However, the lottery law does not prohibit
     the voluntary assignment of a beneficial interest in a
     trust. The record owner of the Lottery Prize is the
     June 4th Lottery Trust. Lottery Winner [Mr. Clopton]
     is a beneficiary of the June 4th Lottery Trust and
     desires to assign his entire beneficial interest in
     said trust to Purchaser [Singer].

The right to receive the 2020 and 2021 payments was not sold or

assigned.

     On August 4, 1999, the parties to the sale agreements filed

with the Probate Court for Travis County, Texas (Travis County

Probate Court), a joint petition for a declaratory judgment

allowing Mr. Clopton to assign all or a portion of his beneficial

interest in the trust.   On October 5, 1999, the Travis County

Probate Court issued a final declaratory judgment (the

declaratory judgment) allowing the assignment of Mr. Clopton’s

beneficial interest in the trust for the years 2000 through 2019.
                               - 5 -

     Singer issued to Mr. Clopton a Form 1099-B, Proceeds From

Broker and Barter Exchange Transactions, for 1999.   The Form

1099-B showed proceeds from the sale of “Stocks, bonds, etc.” of

$1,155,000.10.

     Petitioners jointly filed a Form 1040, U.S. Individual

Income Tax Return, for 1999.   On Schedule D, Capital Gains and

Losses, petitioners reported the assignment of the 20 future

annual payments of $120,000 to Singer as a sale of a capital

asset held more than 1 year.   Petitioners reported a sales price

of $1,155,000, a cost or other basis of $10,334,2 and a long-term

capital gain of $1,144,666.

     On December 24, 2002, respondent issued a notice of

deficiency to petitioners for the year 1999.    In the notice,

respondent determined that the $1,155,000 received from Singer

was ordinary income.   Respondent determined that the cost or

other basis reported on petitioners’ return with respect to the

amount received from Singer was zero.

     Petitioners reported on their joint return for 1999 a short-

term capital loss of $9,088 on Schedule D, Capital Gains and

Losses, for unrelated transactions.    Due to a scrivener’s error,



     2
      The record does not reflect how petitioners computed the
cost or other basis amount of $10,334. Petitioners have not
argued or elaborated on brief with respect to this point, nor
have they argued that if we find for respondent then this basis
amount must be considered in calculating the amount of ordinary
income resulting from the sale to Singer.
                                 - 6 -

the notice of deficiency failed to state the proper adjustment,

thereby denying petitioners the benefit of this capital loss.

The parties agree that petitioners are entitled to a short-term

capital loss adjustment, subject to the limitations on the amount

of such adjustment, if respondent ultimately prevails in this

case.

Discussion

     The parties dispute whether the $1,155,000 received by Mr.

Clopton from Singer is ordinary income or capital gain.    Our

resolution of the issue presented does not depend on who has the

burden of proof in this case.     Resolution of this issue depends

on whether the sale to Singer involved a capital asset within the

meaning of section 1221.

     Section 1221 provides the following definition of the term

“capital asset”:

           SEC. 1221.    Capital Asset Defined.

     (a)   In general.

          For purposes of this subtitle, the term “capital
     asset” means property held by the taxpayer (whether or
     not connected with his trade or business), but does not
     include-–

                (1) stock in trade of the taxpayer or other
           property of a kind which would properly be
           included in the inventory of the taxpayer if on
           hand at the close of the taxable year, or property
           held by the taxpayer primarily for sale to
           customers in the ordinary course of his trade or
           business;
                    - 7 -

     (2) property, used in his trade or business,
of a character which is subject to the allowance
for depreciation provided in section 167, or real
property used in his trade or business;

     (3) a copyright, a literary, musical, or
artistic composition, a letter or memorandum, or
similar property, held by-–

          (A) a taxpayer whose personal efforts
     created such property,

          (B) in the case of a letter, memorandum,
     or similar property, a taxpayer for whom such
     property was prepared or produced, or

          (C) a taxpayer in whose hands the basis
     of such property is determined, for purposes
     of determining gain from a sale or exchange,
     in whole or part by reference to the basis of
     such property in the hands of a taxpayer
     described in subparagraph (A) or (B);

     (4) accounts or notes receivable
acquired in the ordinary course of trade or
business for services rendered or from the
sale of property described in paragraph (1);

     (5) a publication of the United States
Government (including the Congressional Record)
which is received from the United States
Government or any agency thereof, other than by
purchase at the price at which it is offered for
sale to the public, and which is held by-–

          (A) a taxpayer who so received such
     publication, or

          (B) a taxpayer in whose hands the basis
     of such publication is determined, for
     purposes of determining gain from a sale or
     exchange, in whole or in part by reference to
     the basis of such publication in the hands of
     a taxpayer described in subparagraph (A). ***
                                - 8 -

Petitioners contend that capital gains treatment is appropriate

because a beneficial interest in the trust was assigned and the

future annual lottery payments were payable to the trust and not

to Singer.    Petitioners claim that because an interest in a trust

not used in a taxpayer’s trade or business is not excluded from

capital asset status, the sale of an interest in a trust results

in capital gain.

     This Court and the Court of Appeals for the Ninth Circuit

have previously addressed the issue of whether a lump-sum amount

received in exchange for the assignment of the right to receive

future annual lottery payments is ordinary income or capital

gain.    Respondent contends that these cases are controlling for

purposes of deciding the present issue.3

     In Davis v. Commissioner, 119 T.C. 1 (2002), the taxpayer

won a California State lottery prize and assigned his right to

receive annual lottery payments to a trust.     Id. at 2 n.2.   He

and his wife took all subsequent actions with respect to the

lottery payments and took the position that all income of the

trust was includable in their income.    Id.   A portion of each of

11 of the future annual lottery payments was subsequently

assigned to Singer in exchange for a lump-sum payment.     Id. at 3.


     3
      On brief, respondent also raises the issue of whether the
lump-sum payment constitutes ordinary income because of the
grantor trust rules under secs. 671-679. This issue was not
raised in the notice of deficiency, and it is unnecessary for us
to address it.
                                - 9 -

We held that the right to receive such future annual payments

does not constitute a capital asset within the meaning of section

1221 and, therefore, the lump-sum payment was ordinary income.

Id. at 7.   We have subsequently relied on and followed our

analysis in Davis.    See Simpson v. Commissioner, T.C. Memo. 2003-

155; Johns v. Commissioner, T.C. Memo. 2003-140; Boehme v.

Commissioner, T.C. Memo. 2003-81.

       In Simpson v. Commissioner, supra, we addressed a situation

with facts almost identical to the instant case.   The lottery

winner in that case assigned his lottery prize to a trust of

which he was sole trustee.    Like the taxpayers in Davis v.

Commissioner, supra, the lottery winner took the position that

all income of the trust was includable in his income.     Id. at

n.2.    The lottery winner subsequently entered into assignment

agreements whereby the right to receive all future annual lottery

payments for the years 1999 through 2008, and a portion of the

payments for 1997 and 1998, was assigned to Singer.     The trust

retained the right to a portion of the payments for 1997 and

1998, and the right to receive future annual payments for the

years 2009, 2010, and 2011 was not assigned.   Relying on our

analysis in Davis, we held that the right to receive the future

annual lottery payments did not constitute a capital asset.

Additionally, we noted that the right to receive future annual

lottery payments is distinguishable from currency contracts,
                                 - 10 -

stocks, bonds, and options, because the taxpayers received the

lump-sum payment as a substitute for the right to receive

ordinary income.   Id. at n.7.

     The most recent case on this issue is United States v.

Maginnis, 356 F.3d 1179 (9th Cir. 2004), which involved a

taxpayer who assigned to a third party his right to future

lottery payments from the State of Oregon.   The Court of Appeals

for the Ninth Circuit thoroughly analyzed Supreme Court precedent

regarding the definition of a capital asset and concluded that

under the substitute for ordinary income doctrine the taxpayer’s

right to the future payments was not a capital asset.     Id. at

1182.   The Court of Appeals ultimately rejected the taxpayer’s

argument that the right to future lottery payments is a capital

asset within the meaning of sections 1221 and 1222.      Id. at 1185.

In analyzing whether the right to future lottery payments was a

capital asset, the Court of Appeals for the Ninth Circuit relied

on Supreme Court precedent and looked at whether there was an

underlying investment of capital and an accretion in value over

the cost of any underlying asset held.    Id. at 1183.   The Court

of Appeals concluded capital gains treatment was not appropriate

because the taxpayer made no underlying investment in exchange

for the right to future payments, and, because there was no

underlying investment, there was no cost to the taxpayer for the

right to receive the payments (i.e., the money he received for
                             - 11 -

the sale of his right did not reflect an increase of value above

the cost of any underlying capital asset).   Id. at 1184.

     The Court of Appeals also rejected the taxpayer’s argument

that the substitute for ordinary income doctrine was limited to

specific fact situations, none of which were present in the case.

The court noted that treating the sale of a lottery right as a

capital gain would reward lottery winners who elect to receive

periodic payments in lieu of a direct lump-sum payment from the

State and then sell that right to a third party.     Id. at 1184.

The court stated:

     Nothing in the Revenue Code compels the creation of
     such a dichotomous system for the taxation of lottery
     winnings. The purpose of narrowly construing the term
     capital asset under the substitute for ordinary income
     doctrine is to “protect the revenue against artful
     devices” that undermine the Revenue Code’s standard
     treatment of ordinary income and capital gains. * * *
     That is precisely what Maginnis has attempted here.
     [Id. at 1184-1185.]

Finally, the Court of Appeals rejected the taxpayer’s argument

that capital gains treatment was appropriate because his lottery

right is a debt instrument under section 1275.     Id. at 1187.

     Petitioners, relying on McAllister v. Commissioner, 157 F.2d

235 (2d Cir. 1946), revg. 5 T.C. 714 (1945), and Bell’s Estate v.

Commissioner, 137 F.2d 454 (8th Cir. 1943), revg. 46 B.T.A. 484

(1942), contend that property not within the statutory exclusions

for capital assets produces capital gain on its sale. We have

previously recognized that the cases cited by petitioners were
                              - 12 -

decided before relevant Supreme Court decisions applying the

substitute for ordinary income doctrine.    Hrobon v. Commissioner,

41 T.C. 476, 493, 497-498 (1964).   As explained in numerous

Supreme Court cases and the recent decisions discussed above, the

fact that certain property is not within the statutory exclusions

for capital assets does not automatically mean that the property

is a capital asset.   See, e.g., Ark. Best Corp. v. Commissioner,

485 U.S. 212, 217 n.5 (1988); Commissioner v. Gillette Motor

Transp., Inc., 364 U.S. 130, 134 (1960); Commissioner v. P.G.

Lake, Inc., 356 U.S. 260, 265 (1958); United States v. Maginnis,

supra at 1181-1182; Davis v. Commissioner, 119 T.C. at 7.      If

lump-sum consideration received for the property is essentially a

substitute for what would otherwise be received at a future time

as ordinary income, then the consideration may not be taxed as a

capital gain.   Commissioner v. P.G. Lake, Inc., supra at 265;

United States v. Maginnis, supra at 1182.   The appropriate

inquiry in this case is whether the $1,155,000 received for the

property transferred to Singer was essentially a substitute for

future payments of ordinary income.

     Petitioners claim that Mr. Clopton transferred a beneficial

interest in the trust, not the right to future lottery payments,

and that the interest is a capital asset.   Petitioners claim that

the future payments were required to be made directly to the

trust, not to Singer.   Petitioners imply that this means that
                                - 13 -

despite the fact that they did not make an underlying investment

in exchange for their right to future lottery payments or for the

beneficial interest in the trust, capital gains treatment is

appropriate.

     There is no question that the lottery payments in the first

instance were ordinary income.    See United States v. Maginnis,

supra at 1183.   The trust was simply a conduit to facilitate the

distribution of the lottery proceeds.    The character of the

lottery payments as ordinary income did not change as a result of

the payments being distributed through the trust.    Sec. 652(b);

see also Van Buren v. Commissioner, 89 T.C. 1101, 1106 (1987);

Picchione v. Commissioner, 54 T.C. 1490, 1492 n.1 (1970), affd.

440 F.2d 170 (lst Cir. 1971).    Thus, the sale of the future

lottery payments to Singer lacked the requisite realization of

appreciation in value accrued over a substantial period of time

that is typically necessary for capital gains treatment,

regardless of whether Singer bought rights to the trust

distributions or direct lottery payments.    United States v.

Maginnis, supra at 1184 (citing Commissioner v. Gillette Motor

Transp., Inc., supra at 134).

     At the time the agreement between Mr. Clopton and Singer was

made, Texas law prohibited the assignment of rights to a lottery

prize.   Tex. Govt. Code Ann. sec. 466.406 (Vernon 1998).

However, Texas law changed effective September 1, 1999, prior to
                               - 14 -

the issuance of the declaratory judgment assigning Mr. Clopton’s

beneficial interest in the trust to Singer.   Id. secs. 466.406,

466.410 (Vernon Supp. 2004).   The new law allows the assignment

of the right to receive lottery payments to a person designated

by court order, excepting only the lottery payments due within

the final 2 years of the prize payment schedule.   Id. sec.

466.410 (Vernon Supp. 2004).

     It is not clear in this case whether, subsequent to the

declaratory judgment, the lottery payments were made through the

trust or directly to Singer.   The payment of the lottery prize

installments to the trust, as the declaratory judgment provides,

is inconsistent with the sale agreements between Mr. Clopton and

Singer, which provide that a court order would be obtained to

direct that the lottery payments be paid directly to Singer.

However, we do not find it significant whether the lottery

payments were paid directly to the trust or to Singer because the

trust agreement specifically provides that within 5 days of

payment from the Texas Lottery Commission, the lottery proceeds

shall be distributed to the beneficiaries in proportion to their

respective interests.

     The substance of the transfer to Singer is the right to

receive future annual lottery payments of $120,000 for the years

2000 through 2019.   As recently noted by the Court of Appeals for

the Ninth Circuit:   “The Supreme Court has narrowly construed the
                              - 15 -

term capital asset when taxpayers have made transparent attempts

to transform ordinary income into capital gain in ways that

undermine Congress’ reasons for differentially taxing capital

gains.”   United States v. Maginnis, 356 F.3d at 1182 (citing

Commissioner v. Gillette Motor Transp., Inc., supra at 134).

     Additionally, the Court of Appeals for the Tenth Circuit has

stated:

     It is well settled that the incidence of taxation
     depends upon the substance of a transaction; that tax
     consequences which arise from gains from a sale of
     property are not finally to be determined solely by the
     means employed to transfer legal title; and that the
     Government may look at the realities of a transaction
     and determine its tax consequences despite the form or
     fiction with which it was clothed. [Hamlin’s Trust v.
     Commissioner, 209 F.2d 761, 764 (10th Cir. 1954)
     (citing Higgins v. Smith, 308 U.S. 473 (1940)), affg.
     19 T.C. 718 (1953); Commissioner v. Court Holding Co.,
     324 U.S. 331 (1945); Jones v. Grinnell, 179 F.2d 873
     (10th Cir. 1950)).]

We believe that these statements are applicable to the transfer

of the future annual lottery payments to Singer.    Under the facts

of the instant case, we find no meaningful distinction between

the transfer of the interest in the trust and the transfer of the

right to receive the lottery payments from the Texas Lottery

Commission because both involve the right to receive future

ordinary income and the sale to Singer did not result in an

accretion in value over any cost of the property.
                             - 16 -

     After reviewing pertinent caselaw, we are not persuaded that

the transfer to Singer involved the sale of a capital asset.

Accordingly, we hold that the lump-sum amount of $1,155,000

received by Mr. Clopton is ordinary income.4


                                        Decision will be entered

                                   under Rule 155.




     4
      We express no opinion whether a purchaser, such as Singer,
of a lottery right from a lottery winner who then sells that
right to a third party would receive ordinary income or capital
gain on that sale. See United States v. Maginnis, 356 F.3d 1179,
1183 n.4 (9th Cir. 2004).
