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