Lottery Winnings and Gift Taxes

If records were kept about such things, Tonda Lynn, a waitress at a pancake house, may have received the largest tip in history when a customer gave her a lottery ticket that turned out to be worth $10 million. As the U.S. Tax Court put it a heading in its opinion resolving gift tax issues arising from subsequent events, suddenly “she’s got a ticket to ride.”

From the start, Tonda Lynn knew she wanted to share her good fortune with her family. With no shortage of advice and guidance, especially from her father, she settled on setting up a corporation that would claim the lottery proceeds. She and her spouse owned 49% of the stock, with family members owning the remaining 51%.

Similar arrangements, some set up before the lottery win and some after, are commonly maid to share lottery winnings while trying to avoid gift taxes.

However, the IRS will scrutinize shared lottery arrangements and assert gift taxes when such arrangements do not pass muster. Tonda Lynn and her relatives found this out when the IRS, backed up by the Tax Court ruled that there had been no binding contract to share the lottery proceeds and that there was a taxable gift as to the 51% of the winnings that went to family members.

In principle, there was nothing wrong with what Tonda Lynn was trying to do after her big win. The problem was that the purported contract among family members was too vague and indefinite to enforce under state law, and thus her contribution of the winning ticket to the newly formed corporation constituted a taxable, indirect gift to the family members.

The court focused on these factors: There was no requirement for each family member to by lottery tickets, no established pattern of buying lottery tickets, no pooling of money, no predetermined sharing of percentages, and no definition as to the meaning of “substantial” winnings to which the agreement would apply. In addition, who was party to the agreement was unclear, and the agreement was essentially imposed by the taxpayer’s father rather than arrived at by family discussion. All in all, the arrangement was not a joint effort.

In Tonda Lynn’s loss may be found some lessons for other regular players in lotteries who want to achieve what she set out to do. These elements may help avoid the fate of Tonda Lynn’s effort to share the wealth without gift taxes taking a big chunk of it:

• Regular and consistent purchases of lottery tickets

• A clear agreement to share winnings

• Common knowledge of the ticket purchases on the part of all participants, and

• Joint decision making about what to do with winnings.

In fact, the Tax Court that ruled against Tonda Lynn cited a successful sharing arrangement from another case in which the evidence established the existence of an agreement between two men to share equally in the proceeds of any winning lottery ticket, in view of a long-standing course of conduct in which the men would jointly purchase tickets and jointly “scratch” them to reveal any winnings. The mutual promise exchanged by the two men to share in the proceeds of a winning lottery ticket amounted to adequate consideration for a valid contract.

This is not legal advice. You should consult your attorney before applying any of this information to a specific situation.