## Facts

- Roger L. Watkins won $12,358,688 in the Colorado State Lottery in 1993, payable in 25 annual installments funded by an annuity.
- Watkins reported the first six annual lottery payments as ordinary income on his federal returns.
- In a 1997 divorce, a court awarded Watkins and his former spouse each a one-half interest in the future lottery payments.
- In 1998, Watkins assigned his one-half interest in the remaining installments to Stone Street Capital, Inc., after obtaining a Colorado court order permitting the assignment.
- Watkins received $2,614,744, described as the discounted present value of his remaining share of lottery payments.
- Watkins paid $200,000 to a third party for consulting services related to the transaction.
- On his 1998 return, Watkins reported the lump sum as proceeds from selling a capital asset (zero basis), claiming capital gains treatment and deducting the $200,000 fee.
- The IRS issued a notice of deficiency, treating the $2,614,744 as ordinary income but allowing the $200,000 as a miscellaneous itemized deduction.
- The Tax Court sustained the IRS’s characterization, and Watkins appealed.

## Issues

1. Whether a taxpayer’s contractual right to future lottery installment payments is a “capital asset” under I.R.C. § 1221 such that selling the right for a discounted lump sum produces capital gain.
2. Whether the lump-sum proceeds from assigning rights to future lottery installments are ordinary income as a substitute for the future ordinary income stream.

## Decision

- The Tenth Circuit affirmed the Tax Court.
- The court held that the $2,614,744 lump sum Watkins received was ordinary income, not capital gain.
- The court accepted the treatment of the $200,000 consulting fee as a miscellaneous itemized deduction and did not disturb it.

## Legal Principles

- A lump-sum amount received in exchange for the right to receive future ordinary income is generally taxed as ordinary income when it functions as a substitute for that income.
- Lottery winnings are ordinary income; exchanging the right to future lottery installments for present cash does not change the income’s character.
- Characterization turns on the substance of the transaction: accelerating receipt of an ordinary income stream through a discounted assignment does not create a capital asset for capital-gain treatment.

## Conclusion

The court held that selling the right to future lottery installment payments for a discounted lump sum yields ordinary income because the payment substitutes for the ordinary income stream the taxpayer otherwise would have received.


Watkins v. Commissioner, 447 F.3d 1269 (10th Cir. 2006)