When are lottery winnings taxed?
A treatise on
Constructive Receipt of
Why lottery proceeds are not taxed until the lottery commission presents a check to the lottery winner,
regardless of the purchase date, date of the drawing, or date that the winning ticket is presented for payment.
When are lottery winnings taxable? Just suppose you win $42,000 in a lottery drawing on September 21st, 2017. Suppose you are due to retire in November. Wouldn’t it be better to have those winnings taxed in 2018 when you’re in a lower tax bracket. Well, you can, and it’s very simple. Just wait until January to redeem the winning ticket and then the winnings are taxed in 2018.
There are a lot of ill-informed tax professionals who claim that you can’t do that. These so-called “experts” claim that lottery proceeds are taxable in the year of the lottery drawing. These experts claim that the date of the drawing determines when you pay taxes. They cite the doctrine of “constructive receipt” as the reason that the lottery winnings would be taxed in 2017. They fail to consider that constructive receipt does not happen until the lottery winner receives a check from the lottery commission or cash. So far, I have found the following tax professionals who share this opinion:
These self-proclaimed tax experts are wrong. The experts are not looking at the fine print. They fail to realize that taxpayers, (like this author) can get nit-picky. The tax professionals’ problem is that they can’t see the forest for the trees. A winning lottery ticket is not a negotiable instrument. It is just an unsecured promise-to-pay. It is nothing more than an invoice payable to the bearer. Yes, the timing of taxes is based upon “constructive receipt”. It’s just that constructive receipt does not happen before you receive your prize. I realize that I am in the minority here, because I have found few tax professionals who agree with me:
So let me explain this in detail.
FIRST: Here are four different definitions of “constructive receipt” taken from the IRS web site or court records. All four of them say the same thing, but in different words.
From 26 CFR 1.451-2(a) –
General rule. 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. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.
From private letter ruling 200031031, at http://www.irs.gov/pub/irs-wd/0031031.pdf (Page 4, 3rd paragraph) on the IRS’s website. Take note of items (2), (5), and the final sentence.
The courts have determined that the following conditions are necessary to tax an amount under the doctrine of constructive receipt: (1) the amount must be due; (2) the amount must be appropriated on the books of the obligor; (3) the obligor must be willing to pay; (4) the obligor must be solvent and able to pay; and (5) the obligee must have knowledge of the foregoing facts. In essence, the obligee's demand for payment must be the only thing that would be necessary for payment.
Take specific note of item (5). Not only must items (1) through (4) be true, but the taxpayer must know that items (1) through (4) are true.
From Aldrich H Ames v. Commissioner - 112 T.C. 304 (1999)
Following the regulatory definition, courts have held that income is recognized when a taxpayer has an unqualified, vested right to receive immediate payment. [Citations omitted]. Normally, the constructive receipt doctrine precludes the taxpayer from deliberately turning his back on income otherwise available. [Citations omitted].
The First Circuit explained the purpose of the doctrine - Ross v. Commissioner, 169 F.2d 483, 491 (1st Cir. 1948).
The doctrine of constructive receipt was, no doubt conceived by the Treasury in order to prevent a taxpayer from choosing the year in which to return income merely by choosing the year in which to reduce it to possession. Thereby the Treasury may subject income to taxation when the only thing preventing its reduction to possession is the volition of the taxpayer.
For your reading pleasure, I invite you to read the following court cases: Augustin B. Jombo, Roy V. Thomas, and Thomas J. Paul were lottery winners. These three lottery winners WANTED constructive receipt in the year of the drawing, but the IRS and tax court said that constructive receipt happened when the prize was received. Also consider Paul Hornung and Beatrice Davis.
Onward and upward …
Here are five reasons that why constructive receipt does not exist at the time of the lottery drawing:
1. The taxpayer may not realize that they have won the lottery.
2. The doctrine of constructive receipt requires that there be no substantial limitations.
3. A lottery winner does NOT have an unqualified, vested right to receive immediate payment.
4. The funds are not credited to the account of the winner until a check is presented to the winner.
5. Numbers: There are zero court cases to support the tax professionals’ opinion.
I explain each of these five points, in detail, below. Any single one of these points is enough to void constructive receipt.
So let’s take my five bullet points, one at a time …
#1. - The taxpayer may not realize that they have won the lottery.
I didn’t know I had a winning ticket until January 3rd.
Many so-called tax experts cite, “Normally, the constructive receipt doctrine precludes the taxpayer from deliberately turning his back on income otherwise available.” (Ames v. Commissioner). Absolutely true. For example, the courts have ruled that possessing a valid, but un-deposited check on December 31st, does not avoid constructive receipt. One cannot avoid constructive receipt by postponing a check deposit. Tax professionals think the same rules apply to winning lottery tickets. Winning lottery tickets do not follow the same rules. A check’s value is written on it. How does the holder of a lottery ticket know how much his lottery ticket is worth? Perhaps he was on vacation when the drawing was held. After all, 2% of all lottery winnings are never claimed.
If a taxpayer has no knowledge of income, then she is not turning her back on that income. In other words, “If ya don’t know about it, it ain’t income”. In order for constructive receipt to exist, the taxpayer must know it exists. Item #5 from the private letter ruling, “the obligee must have knowledge of the foregoing facts” also exemplifies this point. G.I. Joe’s motto was, “knowing is half the battle”. With constructive receipt, knowing is a prerequisite.
The case of Beatrice Davis affirms this point. Davis was not home on December 31st to receive a paycheck that she was not expecting for another two weeks. Appearing without an attorney, Davis took the IRS to court and won. Davis did not know that the money would be available, so it wasn’t constructively received until she did pick up the check at the Post Office on January 2nd.
So, if the lottery drawing is in September, but Mabel submits the winning ticket in March of the following year, who knows when Mabel realized when the ticket was a winner. Certainly, the act of claiming a lottery prize is an admission that Mabel is aware that she holds a winning lottery ticket. The IRS has no basis for determining whether Mabel knew any sooner.
As an example, my cousin, Harold, gives scratch lottery tickets for Christmas. One May afternoon, I discovered that my mother had an unscratched Christmas ticket in the kitchen drawer. Like Harold, the lottery ticket was a loser, but that’s not the point here. If it had been a winner, my mother would have had constructive receipt in May because she had no idea whether the ticket was a winner until she scratched it.
#2. - The doctrine of constructive receipt requires that there be no substantial limitations.
I had to jump through hoops to get my money.
“Substantial limitations” appears in the IRS regulations as a prohibitor of constructive receipt.
I know a lot of so-called tax experts will disagree with me on part of what I say here. What is a substantial limitation? In Massachusetts, prizes between $600 and $50,000 must be claimed in person at a Lottery Office which could be as much as 80 miles away. Prizes over $50,000 must be claimed, in person, at lottery headquarters, which may be as much as 155 miles away. If mailing the ticket is not a viable option, the requirement to bring the winning ticket to the lottery office is, in and of itself, a substantial restriction to claiming the prize. I feel this is true, even if the Lottery’s office is across the street. How far does it need be in order for it to be a substantial limitation? Two miles? Sixty-eight miles? (as in the case of Thomas Paul). Well, until a statute or court has set guidelines, I say fifty-seven feet. I’d love to argue that in court if it were necessary. However, it isn’t necessary because the IRS doesn’t claim that constructive receipt happens when the winning lottery number is drawn. If I would be willing to go to court (Note #6) over this issue, surely someone else would have tried. (See section #5: Numbers)
Massachusetts and New York, among others, require that winners attend a press conference for marketing purposes. I’m a very private person. I don’t want beggars hounding me for a handout. The Ashkar brothers of Syracuse, New York, were willing to accept a reduction of their three million dollar prize if the press conference requirement could be waived (Note #7). To me, this is another substantial limitation. (See section #5: Numbers) Why hasn’t anyone tested this in court? Answer: because the IRS considers constructive receipt to occur when the winner is handed a check.
When the ticket is redeemed (assuming it is within 60 days of the drawing), the winner must select lump-sum or annuity. Decisions, decisions. In my mind, this is just another substantial limitation. (See section #5: Numbers) If ticket redemption and payout selection happen in a different year than the drawing itself, which way would it be taxed? As a cash-basis taxpayer, the events of one year do not affect the taxes of another year. Again, this is a moot point because IRS doesn’t claim that constructive receipt happens when the winning lottery number is drawn.
Winning tickets must be verified by the lottery commission. Again, another substantial limitation that I’d argue in court just for the hell of it, unless someone else has tried it before. But I don’t have to argue this in court because I don’t have to declare winnings in the year of the drawing. And if verification isn’t a “substantial limitation”, it certainly is a time constraint which prohibits immediate payment of the funds (See section #3, below).
The Massachusetts lottery requires that winners execute a waiver upon claiming large prizes. My bank doesn’t’ require this when I cash a check. It is just one more “substantial limitation”.
#3. - A lottery winner does NOT have an unqualified,
vested right to receive immediate payment.
Here’s my winning ticket. Please give me a check, immediately. I have to catch a bus in five minutes and I am unwilling to wait any longer.
Constructive receipt requires "an unqualified, vested right to receive immediate payment“, as defined by the court in Ames v. Commissioner. I stress, “immediate payment”. The private letter ruling says the same thing with, “In essence, the obligee's demand for payment must be the only thing that would be necessary for payment”. As the First Circuit also stated, “Thereby the Treasury may subject income to taxation when the only thing preventing its reduction to possession is the volition of the taxpayer.” Lottery winners don’t have this right when the lottery drawing occurs. They don’t even have this right when they walk into a lottery office to claim their winnings.
Consider the following: You buy a scratch ticket on August 1st. You scratch the ticket on December 4th. It’s a $20,000 winner. On December 30th, you walk into lottery headquarters to collect your winnings. They tell you that they will have to verify that it is a winning ticket, and prizes over $2000 take 3 business days. Even on December 30th, you don’t have constructive receipt because something other than the taxpayer’s volition prevents the taxpayer from receiving the funds.
From 961 CMR: 2.43 [Massachusetts] STATE LOTTERY COMMISSION
All prizes shall be paid within a reasonable time after they are awarded and after the claims are verified by the Director. [text omitted] The Director may, at any time, delay any payment [text omitted]
Payments are made within a reasonable time. That is not “immediate” as required for constructive receipt. Not only that, but claims must be verified by the Director. That’s another delay which nullifies “immediate payment”. Also, The Director may, at any time, delay any payment. Need I say more?
Take the case of Roy V. Thomas. After a drawing on 12-DEC-1992, he requested payment on 14-DEC-1992 by submitting his winning lottery ticket to the Ohio Lottery Commission. They took six weeks to pay him. Mr. Thomas did not receive immediate payment when he presented his ticket for payment. It would not have made any difference if the lottery drawing had been in June. If Mr. Thomas submitted his winning ticket on December 14th, Mr. Thomas would still have had to wait for his winnings. Without the ability to receive immediate payment, there is no constructive receipt.
Steve Williams of Shenandoah, VA, won $200 million in a drawing on 16-OCT-2009. Steve kept quiet for five months until March, 2010. I highly doubt that Steve walked into the lottery office and walked out with a check five minutes later. Even though Steve had been holding his winning ticket for five months, there is no doubt in my mind that Steve’s constructive receipt was in 2010 when they issued a check. Now, we could all call Steve and ask him when he declared the money on his tax return but he probably has an unlisted phone number by now.
In Massachusetts, lottery prizes less than $600 may be claimed by any lottery sales agent. In January, 2014, I went into a Tedeschi’s convenience store and asked the clerk, “What happens if a customer submits a $500 winning lottery ticket early in the morning before you have any daily receipts?” The clerk’s response was short and sweet, “We tell ‘em we can’t do it.” So, even small lottery winners may not receive immediate payment for their win. Without the vested right to receive immediate payment, constructive receipt has not yet occurred.
#4. - The funds are not credited to the account of the winner
until a check is presented to the winner.
Which bank account holds the funds for winning ticket #1677-7216-5440-2133?
From the regulations, the funds must be “credited to his account”. Alternately, from the private letter ruling, “(2) the amount must be appropriated on the books of the obligor”. These both say the same thing and are easy to refute.
Does anyone really believe that there is a separate account for each and every outstanding winning lottery ticket? That would be an accounting make-work exercise, especially for tickets that are never redeemed. Did any of these people take accounting courses in college? I only took two.
Here is Ohio’s procedure for paying lottery winners: http://codes.ohio.gov/oac/3770:1-8-04. For payments under $600 in Massachusetts and Ohio, the lottery sales agent pays the winner from the agent’s own lottery receipts before remitting the balance to the lottery commission. There is no reference to the account from which the funds are to be debited. In other words, the funds had not been set aside in a specific account as required by 26 CFR 1.451-2(a). The funds were finally set aside into the lottery agent’s account when the agent handed the winner the cash. Then, and only then were the funds in a specific place.
Three weeks AFTER Roy V. Thomas presented his $8 million winning ticket to the Ohio lottery commission, the Ohio lottery commission had to confirm with the Office of Budget Management that there were sufficient funds in the state lottery fund to pay Mr. Thomas. Ergo, Mr. Thomas did not have is winnings credited to any specific account for at least three weeks after he came forward with the winning ticket. If Mr. Thomas’ winnings were not credited to his account, how does anyone know whether their winnings are specifically set aside for him/her. Remember, item (5) of the private letter ruling: “the obligee must have knowledge of the foregoing facts.”
A winning ticket is a contractual obligation, not a legal obligation. It’s an unsecured debt. If a bank loses a $4 million lawsuit, depositor’s funds are not at risk, by law. If the lottery commission loses a lawsuit, those assets waiting for a winner to step forward are subject to forfeiture. When a lottery winner (read: debtor) presents his ticket (read: invoice) for payment, the lottery commission sends it to their accounts-payable department. It probably is not the same accounts-payable clerk that pays the electric bill, but it is just an accounts-payable department.
Massachusetts pays about $3.6 billion to winners every year. Statistically, 2% of all lottery winnings are never claimed. Massachusetts has a 12-month time limit for claiming a lottery prize. Therefore, at any given moment, there are about $70 million in unclaimed funds that will never be claimed. Also (and I’m guessing here), there is about $50 million that will be claimed, but it may take a several days/weeks for the winners to come forward. In order to meet the appropriation part of constructive receipt, these funds must be sitting in a demand account just waiting for the winner to step forward. Apparently, the so-called tax experts never learned about cash management. Big businesses don’t let funds sit around idle. They hire actuaries, like me, to maximize cash flow. Why should Massachusetts pay interest on bonds when $120 million is available interest-free. In other words, those funds are not credited to a specific account or person as required by the definition of constructive receipt.
Should you need further convincing … In the summer of 2015, the Illinois lottery suspended payments of $25,000 or more pending a budget impasse. As I write this, some lottery winners have been waiting two-and-one-half months. I trust this will finally convince you holdouts that that possession of a winning lottery ticket does not constitute constructive receipt.
Lastly on this subject, the regulations say, “set apart for him”. In other words, the funds must be set apart for a person. The so-called tax experts claim that the money is set aside for a specific lottery ticket, so that’s good enough. I would contest this as well, but I don’t have to. The above paragraphs already refute the “credited to his account” clause of constructive receipt. If the IRS took the position that the so-called expert have taken, surely someone would have taken them to court by now.
#5. – Numbers: There are zero court cases to support the tax professionals’ opinion.
If you truly believe that constructive receipt happens before a check is given to the winner, show me one case in which the IRS so claimed. I only need to see one case.
I am able to cite four court decisions in which the IRS argued (and the courts agreed) that constructive receipt happened in the year the prize was received. In each of these cases, it was the taxpayer that wanted constructive receipt in the year of the drawing. This is just the opposite of the experts’ opinions, but the experts always have an excuse.
Here are four people who wanted constructive receipt in the year of the prize award. In all four cases, the I.R.S. argued that the taxes were owed when the prize was delivered. The I.R.S. won all four cases. I can’t find any cases where the IRS argued for constructive receipt in the year of the lottery drawing.
Here’s where the numbers come in: The Massachusetts Lottery sells $4.7 billion worth of lottery tickets every year. Let’s assume an average ticket costs $2.00, so that’s 2.35 billion tickets per year, or 6.4 million tickets per day. About one ticket out of 40,000 is a significant winner of $2,000 or more. That means that there are about 160 significant winners every day just in Massachusetts. By my estimate, there would then be at about 4000 significant winners every day nationwide. While most winners claim their prize immediately, I’m guessing that the average delay between the drawing and the submission of a winning ticket is five days. So every year, twenty thousand big-time lottery winners redeem their ticket in a year other than the one in which they won the prize. I’m also estimating that there are probably another twenty thousand who intentionally delay their claim for several months because they think (correctly) that they will be in a lower tax bracket the following year.
With the plethora of winners who delay, either willfully or otherwise, some of them would claim, “I didn’t know” as I pointed out in section #1. Some of them would try and claim “substantial limitation” as I pointed out in the section #2. Some of them would complain that they did not have immediate access to their money, as I pointed out in section #3. Why haven’t any of these taxpayers taken the IRS to court? Why hasn’t the IRS taken any of these taxpayers to court? If Thomas Paul was willing to go to tax court over a paltry $274 tax bill, surely there would be at least one case where the IRS tried to get constructive receipt in the year of the drawing. I can’t find any. I’ll bet that you can’t find any either. I conclude that the IRS doesn’t even attempt to attach constructive receipt at the time of the lottery drawing. When I asked two “tax experts” (Stuart Bronstein, Mark Bole) to defend their (incorrect) position, they said they would do so only if I paid them.
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Notes and other interesting tidbits:
A.>No, this is different. When one receives a $100 poker chip, it has a value of $100. Consider it a “barter” transaction. It’s no different than if you had received $100 worth of fried chicken. It has a “book” value of $100 when received. The book value doesn’t change when you cash-in. On the other hand, a one dollar lottery ticket has a book value of one dollar when purchased. The lottery ticket’s book value changes when you exchange it for something of higher value, so that’s when you declare the income.
Although the self-proclaimed tax experts claim that constructive receipt attaches in the year of the lottery drawing, somehow they are not able to define the exact moment of attachment. Given the four cases mentioned in section #5, it is obvious that constructive receipt does not occur at the instant of the lottery drawing. All that the tax experts can claim is that it happens shortly thereafter, in the year of the lottery drawing. They are blinded by their own beliefs much like the Flat Earth Society or the moon landing conspiracy theorists.
It boggles my mind that the tax experts
Lottery winners do not have “an unqualified, vested right to receive immediate payment”, at the time of the drawing. In the end, a lottery winner is not “vested” until they submit the ticket. Their rights are not “unqualified” until the lottery commission proclaims them to be the winner. They don’t receive “immediate payment” until they take possession of (or have the right to possess) a check. Then, and only then, has constructive receipt attached to the transaction.
Now I know this is getting really nit-picky, but if the lottery commission calls you and says, “Your check is ready, but you must pick it up in person”, I would argue that constructive receipt would not occur until you hold the check in your hands.
This topic has been discussed ad-nauseam at asktax.org, accountantforums.com, and misc.taxes.moderated but the so-called tax experts simply choose to ignore the obvious. In their hearts, they believe that an unclaimed, winning lottery ticket is a negotiable instrument.
Stewart Howe, senior actuary
Dewey, Cheatham, and Howe
BS, Mathematics, Whatsamatta U, 1967
617 413 3940 (cell)
“The lottery is a tax on the mathematically inept or financially desperate”