GPSOLO April/May 2010
Advising a Client Who Has Won the Lottery
For estate planning lawyers, representing lottery winners is not like representing your usual clients. It is a challenge that will require you to use your counseling skills as much as your knowledge of relevant tax and property laws. Most lottery winners are fairly unsophisticated when it comes to legal, tax, and financial matters. They will be relying on you to advise them and refer them to other necessary professionals.
Almost nothing is as rewarding as helping a client who has “won it big,” especially when such winnings can facilitate other dreams previously unattainable (e.g., sending a child to college, buying a home, or starting a business). At the same time, nothing is quite as frustrating as representing people who are starting “below ground zero” when it comes to their knowledge of the gift tax laws. Lottery winners want to buy new cars (or, in Texas, pickup trucks) for themselves and every family member. Even the cheapest vehicle is likely to have a value that exceeds the annual gift tax exclusion.
I have represented many lottery winners during my career. A few have declared bankruptcy, several have gotten divorced, and one committed suicide, all after winning the lottery. It seems inconceivable, but, as one ex-wife explained, “Before we won the lottery, my husband used to go out drinking all night with his buddies and I would lock him out of the house and he’d have to sleep in his truck in the driveway. After we won the lottery, he just got a big suite at the Four Seasons and partied all night—and never came home.” So, although winning the lottery may solve some problems, it may cause new problems your client never had before.
Someone once said, “A lottery is a tax on people who are bad at math.” Billions of dollars are “invested” in lotteries each year. Currently, 43 states and the District of Columbia sponsor a lottery. On the positive side, most lottery profits are used for the public welfare, such as educational expenses. On the negative side, many people spend too much of their disposable income on the chance to win it big. In Texas, for example, the likelihood of winning the Lotto jackpot is approximately 26 million to 1.
A psychological aspect of winning the lottery is “sudden wealth syndrome.” Sudden wealth can come from a variety of sources: settlement of a lawsuit, an inheritance, sale of a business, a signing bonus (think professional athletes), a lump-sum distribution from a retirement plan, division of assets on divorce, sale of a book or invention. Sudden wealth from winning the lottery is quite different from other types of sudden wealth. For example, with some types of “sudden” wealth, the recipient may already have worked with professional advisors for many years and planned ahead for the receipt of the wealth (as occurs with the sale of a business or public offering of company stock). In a divorce situation, both spouses are usually represented by counsel and have professional financial advisors. Thus, some people who receive a large sum at one time already have in place a trusted team of professional advisors. With other types of sudden wealth, a great deal of time, talent, and effort is required to achieve it (e.g., writing a best-selling novel or inventing a popular device), making it less likely that friends and relatives of the recipient will feel entitled to share in the wealth. Most lottery winners have little or no prior experience with professional advisors and no mind-set regarding the need for on-going guidance. Further, friends, relatives, mere acquaintances, and even strangers will appear from every corner with a sob story designed to induce guilt in the winner sufficient to result in a handout. Because winning the lottery is pure luck, lottery winners are expected to share their good fortune with others. This pressure can severely strain relationships.
Another difference between lottery winners and your usual clients is that most lottery winners are not able to pay a retainer. Further, lottery clients will pressure you to do the necessary legal work as quickly as possible—they want to collect that prize now! Thankfully, I have never had trouble getting paid for my work representing lottery winners. Based on my experience, though, you should have your bill ready to present the moment your client collects the prize.
Claiming the Prize
The first decision your client will need to make is whether to claim the lottery prize as an individual or on behalf of an entity. This decision is often impacted by a decision your client made when he purchased the lottery ticket: whether there is a cash option. A cash option is an alternative to receiving lottery winnings in the form of annual payments over many years; instead, the lottery winner receives cash, in a lump sum, equal to the discounted present value of the future stream of payments. Usually, this will amount to about half the advertised jackpot. Other factors that impact this decision are whether your client purchased the ticket on his or her own or for a group, whether your client is married, and whether your client should do any estate planning before claiming the prize.
People have created general partnerships, limited partnerships, corporations, limited liability companies, revocable trusts, and irrevocable trusts as the winner of a lottery prize. Whatever entity is created, it should be something that is justified under the facts and makes sense for the particular client. Keep in mind how unused to complexity most lottery winners are. Don’t over-plan a lottery winner’s situation (and contribute to post-winning stress).
If several people were involved in the purchase of the winning ticket (such as an office pool), an entity should be created because the rule of many state lotteries is that there can be only one payee per winning ticket. Thus, in a multiple- beneficiary situation, it is advisable to create an entity because if only one person in the pool claims the prize, when that person distributes shares of the prize to the other members of the group, it could be a taxable gift. In addition, only that individual will receive the W-2G, reporting the lottery winnings as 100 percent taxable to him or her for income tax purposes. Further, the other members of the pool may not be comfortable with just one member claiming the prize as the winner, individually. People have filed lawsuits based on an alleged breach of agreement to share a lottery prize. In these instances a group arrangement should be used for all purposes and should be documented appropriately.
I once represented a group of house framers who purchased lottery tickets jointly every payday. When they won their prize—which amounted to about $120,000 per person—we created a general partnership and appointed their boss (also a pool member) as the managing partner. Upon receipt of the net lottery proceeds (cash option was elected), the managing partner distributed each partner’s share of the winnings, along with a warning that, although the Texas Lottery Commission had already withheld federal income taxes (25 percent at the time), depending on a partner’s personal income tax bracket, additional income taxes could be due by April 15 of the following year. We also had another tricky issue: It appeared that two of the 16 house framers might not have been in the United States legally. So, those two each substituted a (resident alien) relative to represent them in the partnership.
If the claimant is married, you will also need to consider the marital property laws of the claimant’s domicile. In community property states, it will most likely be presumed that a winning lottery ticket purchased by either spouse is community property. Depending on the legal requirements of the particular state, it may be difficult to prove with sufficient evidence that a lottery ticket purchased by a married person is his or her separate property.
Married couples who win a large amount should consider estate planning issues prior to claiming their prize. For example, a married couple might create a joint revocable trust to which they contribute the winning lottery ticket. In their trust, they can create the usual estate planning trusts used by wealthier couples, such as a bypass trust and marital trust for the surviving spouse and lifetime, creditor-protected trusts for their children, effective on the death of the surviving spouse.
When the lottery first began in Texas, ticket purchasers did not have a cash option, and winners were prohibited from assigning any portion of their future lottery installment payments. This was unfortunate for winners of large prizes. At that time, estate planners often helped these winners create an irrevocable life insurance trust (ILIT) to provide liquidity to pay estate taxes in the event the winner died with many future lottery payments still outstanding.
From a financial planning standpoint, there are pros and cons of the cash option. Everyone who purchases a lottery ticket, however, should at least allow for the cash option at the time of purchase because having two choices for receiving the prize is better than having only one. For some people, taking the prize in a lump sum can be disastrous because they are not able to control their spending and they exhaust their winnings too quickly. For people with financial discipline, the cash option may be better because it enables them to use the money as they desire (buy a house, start a business). It also makes it easier to do estate planning.
Financial and Tax Planning
Every lottery winner who doesn’t already have a knowledgeable and trustworthy financial advisor will need one. You, as the lottery winner’s lawyer, should carefully scrutinize any financial “experts” who appear on the scene because some may not be professional or, worse, may not be legitimate. Early on, I had this happen to one of my lottery clients (who committed suicide). That client’s financial advisor absconded with most of the $2.2 million my client was to receive pursuant to an assignment of ten years’ worth of lottery payments.
In general, lottery winnings are taxable to the recipient as ordinary income when received. Each state sponsoring a lottery withholds federal income taxes pursuant to federal law requirements (state income taxes may be withheld also). The amount withheld, however, is often not sufficient to discharge the lottery winner’s total income tax liability for that year. Thus, you must advise the lottery winner to set aside some of the winnings to pay income taxes due the following year (and to make estimated tax payments, if appropriate). Make sure your lottery client has a good certified public accountant. In addition, it is often hard for those receiving sudden wealth to resist the temptation to spend the entire amount received. A good financial advisor can help your client set up a separate tax account that is “off-limits” from spending or investing.
If the cash option was elected during purchase of the ticket (i.e., prior to the ticket being selected as the winning ticket) and the winner chooses installment payments instead of a lump sum, the constructive receipt doctrine (a federal tax rule that makes the taxpayer subject to income tax on income as soon as the taxpayer has an unrestricted right to obtain it, whether he or she actually receives all of the income at that time or not) does not apply; each lottery payment is subject to income tax only as received. On the other hand, unless the qualified prize option (another federal tax exception to the constructive receipt doctrine) is available, if a winner can elect either the cash option or annuity payments after the ticket is selected as the winning ticket, then the constructive receipt doctrine makes the entire amount taxable as ordinary income in the year the winner becomes entitled to the prize, even if the winner elects annual payments instead of the cash option. If the qualified prize option is available (it must be adopted by the particular state sponsoring the lottery whose prize the winner has won) , a prize winner will have 60 days after winning to decide whether to take a lump sum or an annuity; as long as the decision is made within that time, an election to take the winnings in annual installments will not result in immediate income taxes on the full amount won under the constructive receipt doctrine.
The regular gift tax rules apply to lottery winners. Lottery winners may make tax-free gifts to any number of individuals as long as the total amount given to each beneficiary in a year does not exceed the annual exclusion from the gift tax ($13,000 per recipient in 2010). A married lottery winner whose winnings are separate property may give unlimited amounts to his or her U.S. citizen spouse without incurring any gift tax; however, gifts to a non-citizen spouse are only tax-free up to the annual limit ($134,000 for 2010). A married lottery winner and spouse can also elect to “split gifts” for federal gift tax purposes. As noted, many lottery winners are not aware that there is a federal gift tax (and there may be a state gift tax in their jurisdiction, too). Their desire is to make significant gifts to family members immediately after winning, so helping them understand the gift tax rules is an essential part of your job.
The trickier gift tax issue involves transfers made prior to claiming the lottery prize. Obviously, the best time to make a gift of all or a portion of a lottery ticket is before the winning numbers are drawn because, clearly, the value of such a gift when made is negligible. Most people will not want (or be able) to spend any money to document such a gift prior to holding a winning ticket, however, so the idea of creating a lottery trust to benefit family members in advance of having a winning ticket is mostly theoretical. The gift tax rules are more blurry in the time frame between purchasing a ticket (before the winning numbers are drawn) and presenting the ticket for certification as the prize winner (after the winning numbers are drawn). Usually, the best evidence to negate a gift during that time period is a written sharing agreement. Not every lottery player thinks this far in advance, however.
There have been cases where oral agreements to share a lottery prize have been sufficient to avoid adverse gift tax consequences. A family in one reported case was able to prove that the entire family (two parents and five adult children no longer living with the parents) contributed money jointly toward the purchase of lottery tickets each week by dropping dollar bills into a goldfish bowl. Thus, when a ticket purchased with the pooled funds proved to be a winner, the parents were not deemed to be making a gift to their children of the shares allocated to the children. Because there was no written partnership agreement documenting the sharing arrangement, however, the Internal Revenue Service ruled that state law regarding oral partnerships applied, meaning that all seven family members were deemed to own equal shares of the partnership (and not the unequal shares they wanted to use).
The federal estate tax issues are fairly straightforward. A lottery winner’s estate includes as an asset his or her interest in the lottery winnings as of his or her date of death, valued at fair market value. While many people believe that annual lottery payments cease on the death of the lottery winner and the value is zero, that is usually not the case. Instead, the discounted present value of the future lottery payments is included in the lottery winner’s estate for federal estate and state inheritance tax purposes. Thus, if the lottery winner who was receiving annual payments was not especially successful at retaining amounts distributed to him prior to his death and died with many future lottery payments outstanding, his estate will often lack sufficient funds to pay the federal estate and state inheritance taxes due. Absent an estate plan leaving everything to charity or a spouse, the estate and inheritance taxes are often so large compared to the lottery winner’s actual assets on hand that it can take up to ten years to pay all of the death taxes, plus interest. Thus, again, lottery winners may need to do some serious estate planning, such as creating an ILIT or designing a plan that uses the marital or charitable deduction. There are a number of reported cases involving discounting the value of the future stream of lottery payments for federal estate tax purposes. In general, if there are restrictions on the transfer of those future payments (e.g., state law prohibits assignments), the estate tax value of future lottery payments can be valued at a discount from the standard annuity tables used by the IRS.
Lottery winners are not your usual clients, and representing them can be challenging. If you are willing not only to learn the applicable rules but provide wise counsel and guidance, these cases can be among your most rewarding.