A lottery winner recently tried to get lucky twice by beating the IRS on some of the taxes owed on the winnings. Unfortunately, she lost that round with lady luck, with the Tax Court ruling that she was liable for the gift tax on a maneuver with an S corporation designed to spread some of the good fortune around to various family members.
It all started when an Alabama waitress received the lottery ticket as a tip, as she had regularly received from a particular patron on a regular basis, and then won big. Her first challenge was to avoid the patron’s claims as he had apparently formed a different recollection of his original intentions, along with avoiding claims of her co-workers who had developed a theory of a sharing agreement. After protracted litigation, the state courts ruled in her favor on those matters. While those issues were still in the courts, however, she took steps to spread some of her new-found wealth around to family members, assuming at the time that she would ultimately win in state court. She did so by forming an S Corporation under the Internal Revenue Code with herself as the president and several family members listed as shareholders. What she didn’t count on that maneuver accomplishing was the IRS issuing a deficiency notice for $771,000 to her for gift tax she now owed. There was no dispute as to the applicable income tax liability. This was a gift tax case and the lucky waitress had made the gift. The now less fortunate taxpayer predictably appealed to the Tax Court for relief.
Gift Tax Due, But with a Discount
The Tax Court eventually determined that the taxpayer’s transfer of a winning lottery ticket to a family-controlled S Corp was a gift. The court found there was no enforceable contract among family members to transfer the lottery ticket to the S Corp.
Code Sec. 2501(a)(1) generally imposes a tax irrespective of whether the gift is direct or indirect. A transfer of property to a corporation for less than adequate consideration represents gifts to the other individual shareholders of the corporation to the extent of their proportionate interests.
The court rejected the taxpayer’s argument that there was no gift because a family contract required transfer of the ticket. The court found that there was no pooling of money. There were no predetermined sharing percentages. There was no implied partnership. At most, the family had an unenforceable “agreement to agree” s much like that of her now unhappy co-workers.
Moral of the Story: Some Deeds go Partially Punished
Although the court found for the IRS, the decision was not a total loss for the taxpayer. At the time the gift was made to the S Corp, there was still that competing and yet un-resolved claim to the lottery prize made by her co-workers. The court found that a hypothetical buyer would not have paid full value for the ticket given the uncertainties surrounding the possibility of collecting at the time of transfer. Therefor, the court concluded that an appropriate discount for the portion of the ticket subject to the competing claim would be 67 percent, which resulted in a $1.1 million gift to the S Corp and not the $2.4 million gift determined by the IRS.
This illustrates the importance of seeking good advance professional advice (tax as well as legal) so that unintended consequences do not become an unfortunate stumbling block later.
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