FEDERAL TAXATION

February 2003

Tax Implications of Providing Cash Buyout Options

By Anthony J. Tucci

A taxpayer is generally required to include an item of income no later than the time of its actual or constructive receipt, unless the item is properly accounted for in a different period. If a taxpayer has an unrestricted right to demand the payment of an amount, he is in constructive receipt of that amount whether or not he makes the demand and actually receives the payment, as stated in Treasury Regulations section 1.451-2.

Under the doctrine of constructive receipt, the winner of a prize who is given the option at the time the prize is won of receiving either a single cash payment or an annuity, is required to include the value of the entire single cash payment in gross income, even if the annuity option is exercised. The Technical Correction to the Tax and Trade Release Extension Act of 1998 (P.L. 105-277) created IRC section 451(h). When a prizewinner is offered a “qualified prize option” that is exercisable within a limited time period after the individual becomes entitled to the qualified prize, the application of the constructive receipt doctrine can be removed.

IRC section 451(h)(2)(A) provides that the term qualified prize option means an option that—

IRC section 451(h)(2)(B) provides that the term qualified prize means any prize or award that—

Under the transition rule for qualified prizes won on or before October 21, 1998, an 18-month window beginning July 1, 1999, and ending December 31, 2000, is established during which eligible persons may be given an option to accept a lump-sum buyout of the balance of their qualified prize.

IRC section 451(h) and the transitional rule concludes that Congress intended to remove the application of the constructive receipt doctrine when an existing qualified prize winner is offered an option to accept a lump-sum buyout of the balance of the qualified prize. Nevertheless, there are at least three classes of existing qualified prizewinners that may be ineligible to receive a qualified prize option to accept a lump-sum buyout of the balance. The following are three fact patterns suggesting that the doctrine should not apply in all cases.

Example 1. Qualified prize winners that won on or before October 22, 1998, and were not provided with an option to accept a lump-sum buyout of the balance of their qualified prizes which could be exercisable before December 31, 2000 (pre-effective date winners). Assume that the payer of a qualified prize later decides to provide a pre-effective date winner with an option to accept a lump-sum buyout of the balance. In this case, the option received by the pre-effective date winner would not be considered a qualified prize option under the transitional rule, because that option would not have been exercisable before December 31, 2000. The pre-effective date winner would be required to include the amount of the single-sum cash payment offered in gross income, even while receiving the annual annuity payout.

Example 2. Qualified prizewinners that won after October 21, 1998, and opted to receive a qualified prize are later granted an option to receive a lump-sum buyout of the remaining balance of their qualified prize (opted annuity winner). Assume that the payer of a qualified prize later decides to provide an opted annuity winner with an option to accept a lump-sum buyout of the balance of the qualified prize. The option would not qualify under IRC section 451(h)(2)(A)(ii), because it would not have been exercisable within 60 days after the person became entitled to the qualified prize. Assuming the constructive receipt doctrine applies, the opted annuity winner would be required to include the amount of the single-sum cash payment offered in gross income, even while receiving the annual annuity payout.

Example 3. Qualified prizewinners that won after October 21, 1998, and were not offered an initial qualified prize option, but are later granted an option to receive a lump-sum buyout of the remaining balance of their qualified prize (gap winners). Assume that the payer of a qualified prize later decides to provide a gap winner with an option to accept a lump-sum buyout of the balance. The option received by the gap winner would not be considered a qualified prize option under IRC section 451(h)(2)(A)(ii), because it would not have been exercisable within 60 days after the winner became entitled to the qualified prize. Assuming the constructive receipt doctrine applies, the gap winner would be required to include the amount of the single-sum cash payment offered in gross income, even while receiving the annual annuity payout.

The author has seen a case where a casino gave a gap winner a 30-day option to accept a lump-sum buyout of the balance of her qualified prize. The casino suggested that, under the constructive receipt doctrine, the gap winner might be required to include in gross income the amount of the single-sum cash payment offered, even if the gap winner decided to keep her qualified prize. The casino lawyers concluded that a single- sum payout option offered to a gap winner was not a qualified prize option, because it was exercisable more than 60 days from the date that the qualified prize was won. It was suggested that the gap winner might not qualify for the exception to the constructive receipt doctrine.

Statutory Construction Argument

All gap winners and opted annuity winners that are subsequently offered an option to accept a lump-sum buyout of the balance of their qualified prizes should be treated as receiving qualified prize options under IRC section 451(h). This argument is supported by the fact that Congress must have intended gap winners and opted annuity winners to receive qualified prize options, because the definition of the term in IRC section 451(h)(2)(A)(i) includes prizewinners that are allowed to convert the remaining portions of their annuity to a lump-sum payment.

Instead, by providing that the option must be made exercisable within 60 days from the date that the person becomes entitled to the qualified prize, the IRS may have inadvertently argued that gap winners and opted annuity winners are not entitled to receive a qualified prize option. It would almost seem logical that Congress intended to say that the qualified prize option must be exercisable not later than 60 days from the date that the person first became entitled to the qualified prize option.

Excluding gap winners and opted annuity winners from the ability to receive qualified prize options is inconsistent with a literal reading of portions of IRC section 451(h). If the doctrine of constructive receipt is deemed inapplicable to pre-effective date winners, opted annuity winners, and gap winners that may be offered a lump-sum buyout of the balance of their qualified prizes, it would be inconsequential that a statutory exception to the applicability of that doctrine may be unavailable under the IRC.

Doctrine of Constructive Receipt

In Oliver v. United States [193 F. Supp. 930, 933 (E.D. Ark. 1961)], the U.S. District Court, addressing the constructive-receipt doctrine, stated the following:
It must be recognized that a taxpayer has a perfect legal right to stipulate that he is not to be paid until some subsequent year, or that the payments are to be spread out over a number of years. Where such a stipulation is entered into between buyer and seller prior to the time when the seller has acquired an absolute and unconditional right to receive payment, and where the stipulation amounts to a binding contract between the parties so that the buyer has a legal right to refuse payment except in accordance with the terms of the agreement, then the doctrine of constructive receipt does not apply, and the taxpayer is not required to report income until same actually is received by him.

In Basila v. Commissioner [36 T.C. 1961 (1961)], the IRS conceded that a taxpayer does not constructively receive income under a contract until the obligor becomes liable to pay it. In W.W. Millsaps v. Commissioner (TCM 1973-146), the Tax Court ruled that where there is a “bona fide contract providing for deferred payments [it will] be given effect notwithstanding that the obligor might have been willing to contract to make such payments at an earlier time” [Ray S. Robinson, 44 T.C. 20, 36 (1965)]. It would appear that these line cases, excepting application of the constructive receipt doctrine, would also apply when a pre-effective date winner, opted annuity winner, and gap winner are given the option to accept a lump-sum buyout.

In Private Letter Ruling 200031031, the IRS explained the treatment for cash-method lottery winners that were collecting annuities and given the right to assign them to a third party. The state payer proposed to amend its law to permit voluntary assignment of the right to receive future annual prize payments. The IRS stated that a winner’s ongoing power to assign his right to a lottery prize does not accelerate the time in which the lottery payer is required to make prize payments. The only person taxable on a lump-sum would be one who assigned his annuity.

A prizewinner’s option to accept a lump-sum buyout of the balance of a qualified prize does not accelerate the time in which the payer is required to make these payments. The only way that the payer would be required to accelerate the payments is when a prize winner voluntarily agrees to exchange the contractual right to future payments for the discounted present value of those payments. The only prize winner taxable on the lump-sum would be the one who elected to exercise the option to accept a lump-sum buyout in exchange for the annuity.

If the constructive doctrine does not apply in the first instance, then pre-effective date winners, opted annuity winners, and gap winners should have the unfettered privilege of entertaining buyout offers without fear of adverse tax implications. IRC section 451(h) must be carefully considered to ensure that all qualified prizewinners are treated equally.


Anthony J. Tucci, JD, LLM, CPA, is an adjunct assistant professor of law at the Tobin College of Business at Saint John’s University. He also maintains a private practice in New York and New Jersey, concentrating in the areas of taxation and estate planning.

Editor:
Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner


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