Lottery Players and Winners:
Estate Planning for the Optimistic and the Lucky

by

Gerry W. Beyer

Governor Preston E. Smith Regents Professor of Law
Texas Tech University School of Law
Lubbock, Texas

 

and

Jessica Petrini, J.D.

Boston College Law School


Winning a big jackpot in the Texas lottery is a fantasy for many clients. Many muse about what they would do with the money. Despite phenomenal odds, the dream does come true for dozens of Texans each year. The thrill of victory, however, can quickly become an estate planning nightmare, especially if the winner dies before collecting the entire prize.

Here is an example of what may happen without proper planning, both when purchasing the ticket and upon discovering it is a winner. In May 1995, Johnny Ray Brewster won $12.8 million in the Texas lottery. Johnny died of a heart attack ten months later after receiving only one annual payment of $463,320. Johnny’s sister, Penny, was the sole beneficiary of his estate which included as its primary asset the right to the remaining lottery payments. The estimated federal estate tax totaled approximately $3.5 million. Because the estate did not yet have these funds, the IRS agreed to a ten year payment plan with annual payments of approximately $482,000, that is, $18,680 more than the annual lottery payments. Under this arrangement, Penny would need to put $18,680 of her own money toward the taxes for ten years. Only in the eleventh year, would Penny finally be able to benefit from her brother’s lucky ticket. See Lotto Texas Heirs Cry For Help With Federal Tax Bills, San Antonio Express-News, July 12, 1996, at 6B. (Luckily for Penny, the Lottery Commission allowed the estate to cash in the remainder of the prize at its present value. Commission Moves to Aid Estate Handle Large Inheritance Tax Bill, San Antonio Express-News, Aug. 29, 1996, at 20A. Note that the 1999 Texas Legislature authorized court-approved assignments of the right to receive prize payments. If this situation were to arise today, perhaps Penny could sell her right to future payments, raise enough money to pay off the taxes, and have funds left over for herself.)

The majority of your clients need advice regarding the Texas lottery because according to the 1999 Demographic Study of Texas Lottery Players, approximately 62% of adult Texans play Lotto Texas each year, spending an average of $192 per year on tickets. This month’s article examines how the Texas lottery works and the steps lottery players and winners should consider taking to minimize the undesirable consequences of "striking it rich."

I. Texas Lottery Rules


A basic understanding of Texas lottery rules is essential before looking at tax ramifications and planning strategies.

A. Buying the Ticket


Proper tax planning begins when the player purchases a lottery ticket. Even before winning, lottery players are forced to make an important decision, that is, whether to mark a box at the bottom of the play slip declaring whether they wish to (a) receive their winnings in 25 annual payments or (b) be given the present cash value of those winnings in one lump sum which is approximately one-half the estimated jackpot. Players who fail to select a payment option when they purchase the ticket are deemed to have selected 25 annual payments. A player may not make or change the type of payment after winning. As explained in § IV(C)(1) below, the better choice in most circumstances is to elect the lump sum option.


B. Options After Winning

 

1. General Rules

A person holding a winning ticket must claim the prize within 180 days after the date on which the winning numbers were drawn. Tex. Gov’t Code Ann. § 466.408(a). A ticket holder forfeits any claim or entitlement to a prize after the expiration of the 180 day claim period. Id. § 466.408(d). If several persons present winning tickets, each winner is entitled to an equal share of the prize. Id. § 466.404(a). If the prizewinner dies, the prize payments are made to that deceased individual’s estate. Id. § 466.406(b).

2. Deductions from Winnings


If a prizewinner is delinquent in one or more of the following ways, the executive director of the Lottery Commission will deduct these amounts from that person’s winnings: (a) paying taxes or other moneys to the Texas Workforce Commission, (b) making child support payments, (c) reimbursing the Texas Department of Human Services for a benefit granted in error under the food stamp program or the Financial Assistance and Service Program, or (d) paying certain student loans. Tex. Gov’t Code Ann. §§ 466.407(a) & § 466.4075(b).

3. Assignment of Winnings


The winner’s right to a prize is generally not assignable. Tex. Gov’t Code Ann. § 466.406(a). However, an assignment is permitted provided the parties obtain an appropriate judicial order. Id. § 466.410. A person may assign, in whole or in part, the right to receive installment prize payments if the assignment is made to a person designated by an order of a district court of Travis County, except that installments due within the final two years of the 25 year payment schedule may not be assigned. The district court will approve a voluntary assignment and instruct the Texas Lottery Commission to direct payments to the assignee only if all the following requirements have been met.

 

A copy of the petition for the order approving voluntary assignment and copies of all notices of any hearing in the matter must have been served on the executive director not later than 20 days prior to any hearing or entry of any order.

The assignment must be in writing, executed by the assignor and assignee.

The assignment, by its terms, must be subject to the laws of the state of Texas.

The assignor must provide a sworn and notarized affidavit stating that the assignor:

   Is of sound mind, over 18 years of age, is in full command of the person’s faculties, and is not acting under duress;

   Has been advised regarding the assignment by independent legal counsel and has had the opportunity to receive
   independent financial and tax advice concerning the effects of the assignment;

   Understands that the assignor will not receive the prize payments, or portions of the prize payments, for the assigned
   years;

   Understands and agrees that with regard to the assigned payments, there is a waiver of any further liability or
   responsibility on the part of the commission and the Texas government to make the assigned payments to the
   assignor;

   Has been provided a one-page written disclosure statement stating, in boldfaced type which is 14 points or larger:

        The payments being assigned, by amounts and payment dates;

        The purchase price being paid, if any;

        If a purchase price is paid, the rate of discount to the present value of the prize; and

        The amount, if any, of any origination or closing fees that will be charged to the assignor.

   Was advised in writing, at the time the assignment was signed, that the assignor had the right to cancel without any
   further obligation not later than the third business day after the date the assignment was signed.

   If the assignor is married, the spouse must consent to the assignment unless the court finds that the consent is not
   necessary.

   The assignor may designate no more than three persons as assignees.

 

II. The Consequences of Winning – The Important Preliminary Decisions


An eager and excited lottery winner may quickly claim the Lotto winnings. However, a prudent winner has important decisions to make before accepting the prize. The holder of a winning ticket should use the 180 day claim period to evaluate and select the best options.

A. Who Owns the Ticket?


The threshold question is "who owns the winning ticket?" Lotto tickets are often purchased with (1) pooled funds of friends or colleagues or (2) the community property of a husband and wife. Therefore, it is possible that more than one person "owns" the winning ticket. In such situations, the potential owners of the winning ticket must determine whether they were in a partnership-type relationship at the time of the purchase of the winning ticket. If a partnership existed, then the potential owners must determine whether the winning ticket was purchased on behalf of the partnership.

For example, assume that A and B are unmarried, significant others who live together. Although they each have their own bank accounts, they share in the household expenses. A and B have a custom and practice of buying Lotto Texas tickets every Monday. They always elect the Lotto Texas lump sum payment. Sometimes A and B are together when the tickets are purchased. Sometimes it is agreed beforehand that either A or B will pick up the tickets on a Monday after work. Regardless of who buys the ticket, it is understood by both A and B that the ticket "belongs" to them both and that any prize money awarded will be split equally between them. On one particular Monday, A and B agree that B will purchase their weekly ticket on his way home from work. He pays with a dollar bill from his own wallet. Much to A and B’s delight, the ticket is a winner. So, who owns the ticket? A individually, B individually, or A and B together equally?

Courts typically focus on the facts and circumstances surrounding the purchase of a lottery ticket, including the intent and understanding of the parties at the time of purchase, to determine ownership of the proceeds of a winning ticket for tax purposes. See Estate of Winkler v. Commissioner, 73 T.C.M. (CCH) 1657 (1997). If a taxpayer purchased a lottery ticket with the intent and understanding that the proceeds would be shared with others, the courts have treated the proceeds of the ticket as income to all the recipients rather than as income to just the purchaser. See Solomon v. Commissioner, 25 T.C. 936 (1956).

B. Who Accepts the Prize?

 

1. Trust Arrangement for Individual Winners


The best entity to form for an individual winner is a revocable trust. See Kimberly Adams Colgate, Win, Lose or Draw: The Tax Ramifications of Winning a Major Lottery, 10 Cooley L. Rev. 275, 293 (1993) (providing extensive discussion of this technique which forms the basis of the discussion in this section). The lottery winner should create a revocable trust and apply for an employer identification number. The winner should then transfer the ticket into the trust and the trustee should redeem it for the benefit of the trust.

The winner receives a variety of benefits by creating a revocable trust. (1) Probate of the lottery proceeds will be avoided. Instead, the remaining payments are distributed to the beneficiaries according to the terms of the trust instrument. (2) No transfer occurs for gift tax purposes when the winner places the ticket in the revocable trust. (3) The transfer of the ticket prior to redemption is unlikely to trigger compliance with the special procedures needed to assign lottery winnings. (4) The settlor-winner may amend the trust without the approval of the lottery commission. With this freedom to amend, the settlor may later decide to relinquish his or her power to revoke a certain percent interest of the trust, thereby reducing the settlor’s taxable estate by that percentage. For example, the settlor could relinquish his/her power to revoke a two percent interest in both the trust income and principal, making someone else the irrevocable beneficiary of that two percent interest. The two percent interest would then be distributed and taxable to that irrevocable beneficiary. By making the complete transfer of a two percent interest in trust property, a taxable gift is triggered, however, as long as the settlor lives three years after relinquishing the right to revoke the two percent interest, his/her estate would include only ninety-eight percent of the value of the future lottery payments.

2. The Family or Group Partnership


Spouses and family members who make it a regular practice to pool their money to purchase lotto tickets should seriously consider forming a partnership entity before claiming their winnings. See Linda Suzzanne Griffin, The Lottery: A Practical Discussion on Advising the Lottery Winner, Fla. Bar J., Apr. 1998, at 84. If one person were to accept the prize individually on behalf of a group or multiple winners, only that individual, or that individual’s estate will receive checks. Therefore, when multiple "winners" are involved, it is important to establish an entity to serve as the recipient of the lottery proceeds on behalf of all winners.

Placing the lottery winnings in joint name with someone other than a spouse is not a wise idea. The full fair market value of jointly owned property is included in the taxable estate of the first joint tenant to die, except to the extent that the surviving joint tenant(s) can prove they contributed to the acquisition of the property or that there is a joint tenancy between the spouses. I.R.C. § 2040(a). By establishing an entity to serve as the recipient of the lottery proceeds, an outright, clear division of ownership is achieved preventing any joint tenancy issues that may arise when the first joint tenant dies. If the joint tenancy is with a spouse, however, there is an automatic division of the property, causing only 50% of the fair market value of the property to be included in the estate of the first joint tenant to die, regardless of who provided contributions. Nonetheless, even spouses would be prudent to use an entity.

III. Consequences of Winning – Income, Gift and Estate Tax Liabilities

 

A. Income Tax Liability


Lottery winnings are taxable income. I.R.C. §§ 61 & 74(a). A lottery winner has income only upon the receipt of a winnings check because most lottery winners are cash basis calendar year taxpayers. See Lavery v. Commissioner, 158 F.2d 859, 860 (7th Cir. 1946). If a Lotto winner elects to receive a lump sum payment of the present value of the winnings, the winner must report the entire amount of the lump sum payment as income. On the other hand, a winner who elects the option to receive 25 annual payments is taxed only on the amount received with each annual installment rather than the total present value of all future lottery distributions. A lottery winner is not in "actual receipt" of future winnings because the winner has not yet received the checks. Moreover, a lottery winner is not in "constructive receipt" of his or the future winnings because future winnings cannot be reduced to the taxpayer’s current possession or enjoyment.

B. Gift Tax Liability


A gift by a lottery ticket purchaser of a ticket or lottery proceeds to someone other than the purchaser may be a taxable transfer. I.R.C. § 2501. When lottery players purchase tickets jointly, it is important for them to execute a separate ownership agreement or partnership agreement before accepting the prize and to accept the prize as a group or partnership, not individually. If the players wish to distribute winnings unequally, they should execute a written partnership agreement detailing the proportions prior to purchasing the winning ticket. By taking these steps, the players may reduce the likelihood of the I.R.S. successfully contending that one person purchased the ticket and then made a taxable gift of the proceeds to another individual. In Priv. Ltr. Rul. 92-17-004 (April 24, 1992), the issue was whether a separate ownership agreement signed after winning created a gift tax liability because the sole official lottery winner gave a one-half interest in the winnings to a co-player. The I.R.S. determined that the underlying separate ownership agreement merely reflected the true intentions of the parties and that each party possessed equal ownership interests in the ticket from the inception. Accordingly, the ownership agreement acted to shift one-half of the winning proceeds without incurring any gift tax. See also Estate of Winkler v. Commissioner, 73 T.C.M. (CCH) 1657 (1997).

C. Estate Tax Liability


Quite possibly the most ominous potential tax liability facing a lottery winner is the federal estate tax upon the winner’s death. The value at the time of death of all the winner’s property, real or personal, tangible or intangible, wherever situated is included in the winner’s gross estate. I.R.C. § 2031(a). Consequently, the gross estate includes any lottery proceeds the winner has already received but has not yet spent as well as the present value of future lottery payments.

For the winner who elects the lump sum option, gross estate valuation is straight forward. Generally, only funds the winner has not spent or given away are in the winner’s gross estate. The winner has no future lottery payments to worry about because the winner has already received all lottery distributions.

If the winner elected to receive annual payments, the value of the estate includes the present value of the winner’s right to future payments. See Tech. Adv. Memo. 96-16-004 (Apr. 19, 1996) ("For estate tax purposes, the present value of lottery winnings payable in the form of an annuity for a specified period is determined based on the actuarial tables contained in § 20.2031-7(d)(6) using the § 7520 interest rate for the month of the decedent’s death, even though the annuity payment may not be assigned without judicial approval."); Tech. Adv. Memo. 1999-09-001 (Mar. 5, 1999). The actual computation of the present value is somewhat complex and is beyond the scope of this article. See Linda S. Griffin & Richard V. Harrison, Florida State Lottery Tax and Estate Planning Issues, Fla. B.J., Jan. 1996, at 74 (1996); Ja Lee Kao, Valuing Future Lottery Winnings for Estate Tax Purposes: Estate of Shackleford v. United States, 52 Tax Law. 609 (1999).

The valuation process results in the imposition of estate tax for the net present value of lottery payments outstanding at the time of a decedent’s death. The problem, however, for a deceased winner’s heirs and beneficiaries, is that this money is not actually in the estate. The estate cannot accelerate the payments even though the estate tax is currently due. How can an estate pay such a tax? Perhaps the heir or beneficiaries could seek court approval under Government Code § 466.410 to assign the proceeds to a company who purchases lottery annuities, pay the tax, and hopefully have funds remaining for themselves. The fewer payments the winner receives before dying, the greater the tax liability and consequentially the greater the hardship imposed on the winner’s successors in interest.

IV. Tax Planning For Lottery Winners

 

A. Income Tax


A winner should not accept a prize as a single individual if more than one person has rights to a winning ticket. The winner may thus avoid being assessed a tax on more than the winner’s own portion of the proceeds.

B. Gift Tax

 

1. Make Annual Exclusion Gifts


Every lottery winner may give up to $10,000 per year to an unlimited number of donees without incurring gift tax liability. I.R.C. § 2503(b)(1). Annual exclusion gifts will not augment the winner’s gross estate and the winner has no liability for tax on any appreciation or income which accrues after making the gift.

Annual exclusion gifts are a very effective way of depleting a winner’s estate and should be used aggressively as a tax saving strategy, unless, of course, the winner needs or wants the winnings for other purposes. To qualify for the annual exclusion, the donor must give a "present interest." Gifts of future interests in property, such as gifts in trust, are not covered by the annual exclusion unless special steps are taken (e.g., a § 2503(c) minor’s trust or a Crummey trust).

If a lottery winner is married, the winner can join with his or her spouse and the two can combine their annual exclusion amounts and make gift tax free gifts of $20,000 instead of $10,000.

2. Contribute to Education and Medical Care


All payments that a lottery winner makes for another person’s educational or medical expenses are not subject to the federal gift tax. I.R.C. § 2503(e). There is no limit on the amount of these gifts or on the number of donees. The lottery winner and the donee do not need to be related for this exclusion from gift tax to apply.

3. Consider Intraspousal Gift


A gift of lottery proceeds from one spouse to another is generally deductible and thus is not subject to federal gift tax. I.R.C. § 2523(a). By making inter vivos and testamentary gifts to a spouse, a lottery winner can essentially eliminate all of his or her gift and estate tax liability (to the extent of the winner’s share of the lottery proceeds) by use of the unlimited marital deduction. Remember, however, that this technique increases the size and potential tax liability of the surviving spouse’s estate. (Note that lottery winnings are community property, regardless of whether the ticket was purchased with community funds or a spouse’s separate property. See Dixon v. Sanderson, 10 S.W. 535 (Tex. 1888).)

4. Make Charitable Gifts


All gifts to qualified charities are totally deductible when computing the gift tax. I.R.C. § 2522. The lottery winner must make certain the recipient’s use of the property for religious, charitable, scientific, literary, or educational purposes is sufficiently charitable to qualify the gift for charitable deduction treatment.

5. Beware of the Generation Skipping Transfer Tax


Lottery winners should be aware that the generation-skipping transfer (GST) tax is imposed on certain inter vivos and at-death transfers to non-spouse donees who are more than one generation younger than the lottery winner. I.R.C. §§ 2601-2663. The GST tax is an additional 55% flat-rate tax on top of any federal gift or estate tax that the lottery winner or lottery winner’s estate might otherwise owe on the transfer. Generally, the second generation begins with individuals who are more than 37½ younger than the lottery winner, unless lineal descendants are involved. When lineal descendants are involved, the actual ages of the lottery winner and the donee do not matter. Instead, the number of generations between the winner and the donee are counted. However, if a member of the intermediate generation predeceased the transfer, then that generation is ignored. Annual exclusion gifts are usually not subject to GST tax, nor are gifts that qualify for the educational and medical expense exclusion. In addition, the lottery winner has a $1,010,000 exemption (indexed for inflation) from the GST tax.

C. Estate Tax

 

1. Elect Lump Sum Payment


The most tax-sound strategy for the lottery winner will often be to elect to take the lump sum present value lottery payment. A lump sum payment may seem a significant sacrifice of lottery winnings, however, the annual payments essentially equal what the winner would receive in the lump sum with the added appreciation from 25 years worth of Lottery Commission investments. Lottery winners may take the lump sum payment and invest the money wisely. Moreover, with a lump sum distribution, the lottery winner may control the method of investment. It is indeed possible that the investments a winner makes on his or her own could lead to a much better appreciation over 25 years than the Commission’s investments.

For estate tax purposes, the lump sum arrangement will prevent the lottery winner’s successors in interest from assuming a terribly burdensome death tax obligation. The winner’s estate will have the money with which to pay the estate tax. Liquidity problems are avoided.

The winner must also consider the non-tax benefits of a lump sum payment. A lottery winner never knows when he or she may need to access the winnings for emergency or other purposes. With the lump sum arrangement, the funds are always within the winner’s grasp. With annual payments, a winner is unable to accelerate payments, regardless of the emergency, unless a court mercifully grants a voluntary assignment request. (Caveat: An imprudent lottery winner could furiously spend a lump sum payment; measured distributions enforce a budget on a spendthrift lottery winner.)

2. Execute a Will


A lottery winner may maximize at-death deductions such as the marital and charitable deductions by executing an appropriate will. By planning ahead, a lottery winner may control the distribution of property to beneficiaries and may be able to structure marital trusts and bypass arrangements to greatly lessen the estate tax burden.

3. Purchase Life Insurance


Life insurance is a very effective technique to provide the funds necessary to pay the estate tax on either the remaining proceeds of a lump sum distribution or the present value of future lottery proceeds. See M. Eldridge Blanton, III, Who Gets a Dead Man’s Gold? The Dilemma of Lottery Winnings Payable to a Decedent’s Estate, 28 U. Rich. L. Rev. 443 (1994). Generally, the proceeds of a life insurance policy made payable to the lottery winner’s beneficiaries are not treated as the beneficiaries’ taxable income. I.R.C. § 101(a)(1). Moreover, by placing the policy in an irrevocable life insurance trust, or by otherwise divesting him- or herself of the incidents of ownership of the policy, the lottery winner can ensure that the proceeds of the policy will not be subject to estate tax in the winner’s estate. I.R.C. § 2042.

4. Consider the Marital Deduction Along With Bypass Planning


Any winnings that pass to the lottery winner’s spouse via will or intestacy are generally deductible and thus not subject to federal estate tax. I.R.C. § 2056(a). Like all marital deduction gifts, a gift of lump sum or future lottery winnings to a spouse increases the size and potential estate tax liability of the surviving spouse’s estate. Accordingly, the lottery winner should consider making outright gifts of any unused applicable credit amount to others, creating a bypass trust, or otherwise taking the steps necessary so that the winner does not waste his or her applicable credit amount.

5. Make Charitable Gifts


All at-death transfers to qualified charities are totally deductible when computing the federal estate tax. I.R.C. § 2055. The lottery winner must make certain the recipient’s use of the property for religious, charitable, scientific, literary, or educational purposes is sufficiently charitable to qualify the transfer for charitable deduction treatment.

6. Beware of the Generation Skipping Transfer Tax


As discussed in Section (IV)(B)(5), the lottery winner must also be alert to transfers which may trigger the GST tax and take steps necessary to reduce GST liability.

V. Conclusion


Winning the lottery has the potential of being both a blessing and a curse. Every lottery player needs to consider the ramifications of winning before playing the lottery because the option of electing a lump sum distribution is foreclosed once the ticket is purchased. Immediately after winning, but before claiming the prize, the lottery winner must decide the most effective way of claiming the prize. After collecting a lump sum payout or beginning to receive yearly distributions, the winner must continue to be alert to possible tax savings strategies. By following the steps outlined in this article, Texas lottery players and winners may increase the likelihood that their fortuity will not trigger unnecessary complications for surviving family members and friends.

(The authors would also like to thank Scott Zimmerer and Christopher Canevaro for their contributions to this article.)

In publishing this article, the authors are not engaged in rendering legal, accounting or other professional service. If legal advice is required, the service of a competent professional should be sought.

© 2000 Gerry W. Beyer