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Megan C
Megan C, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 15462
Experience:  Licensed CPA, CFE, CMA, CGMA who teaches accounting courses at Master's Level
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Below is the actual case I am working on. I am preparing

Customer Question

Below is the actual case I am working on.

I am preparing a memorandum for a graduate taxation course. I have a lot of notes on it but I am unsure if I am correct.

Using the following problem, I have to identify and discuss the main issues, identify and discuss other issues, calculate the basis, identify and discuss the ethical issues and resolve the problem. Any guidance you can provide will be greatly appreciated.

I think some of the major issues are as follows:

1. What type of income is lottery prize money?
2. What is the tax treatment for this type of income?
3. Was the capital gain properly reported?
4. Should the transfers between the sisters be treated as gifts?
5. Is Mary really the owner of the prize money?
6. Did Rose realize the value of her gift?

Ethical issues:

Was Ruth's transfer of the lottery ticket to Mary ethical? No
Were Mary's actions ethical? No
As a tax professional, what is my ethical responsibility? Do I have a responsibility to report the fraudulent activity to the IRS?

Basis calculation

I am unsure how to calculate the basis.

Resolution

Correctly amend returns back to the beginning
Seek an attorney

Actual Case

John and XXXXX XXXXX are U.S. taxpayers. The Smiths have resided in New State since 1995. In 2002 XXXXX XXXXX was declared the winner of a $ 6.24 million prize in the New State Lottery. $1.00 was paid for the winning Lottery ticket which entitled its holder to participate in the bi-weekly drawings. Under the Lottery Rules, Mary became entitled to receive 20 annual payments of$ 312,000 each, less mandatory Federal Income Tax Withholding. The first payment was made on May 1, 2002 and 19 subsequent installments of$ 312,000 (reduced by Federal Income Tax withholding) were scheduled to be paid on May 1 of each successive year.

The New State Lottery rules did not offer Mary the option of receiving a lump-sum payment at the time she claimed the Lottery prize. Under the New State Lottery Rules, Mary could not transfer her right to receive all or any portion of the future installment payments without first obtaining the approval of the Superior Court. This provision was included in the law to insure against fraud.

On or about July 2, 2011, after obtaining the approval of the Superior Court, Mary entered into an agreement with Lottery Payment Finance Company, LLC ("Finance"). Under the Agreement, Mary sold all of her rights to receive the remaining 10 installment payments (10 x $ 312,000 = $ 3.2 million) in exchange for a lump-sum payment by Finance in the amount of$ 2.125 million. On the joint Form 1040 Return she filed with her husband John, Mary reported a long-term capital gain of$ 2, 124,599 from the transfer. The Internal Revenue Service has asserted a deficiency assessment, including penalties and interest. The Internal Revenue Service takes the position that the $ 2.125 million lump-sum payment is taxable at ordinary income rates.

John and Mary have requested your advice regarding the Internal Revenue
Service's position; they wonder whether they should they fight it? During your conference with them Mary tells you that the ticket was actually purchased by her sister, Rose. When Rose won she asked Mary to claim the prize money since Rose was about to declare personal bankruptcy (her assets were then valued at $ 250,000 and her liabilities were $ 1,800,000). Mary agreed and accepted the prize. Mary has kept track of the money received from the New State Lottery and accounted to Rose for any monies Mary used.

Rose has completed her bankruptcy action and receives money from Mary from time to time. Rose (and Mary) treat these transfers as "gifts" for Federal Income Tax purposes.
Submitted: 2 years ago.
Category: Tax
Expert:  Megan C replied 2 years ago.
I can do this but it will be tomorrow night before I can complete it. Is that ok
Expert:  William Ellis, CPA replied 2 years ago.
Hello and thank you for allowing us at Just Answer to assist you. The lottery funds are ordinary income and taxed at ordinary rates. There was no capital gain. The reduced payment received appears to be the remaining proceeds less interest. The transfers between the sisters are gifts. Since Mary has always presented herself as the owner including in the court filing and the claim has not been questioned, she is effectively the owner. It's hard to say whether Rose realized the value of the winnings because everyone's tax situation is different.

I agree with you that Rose's and Mary's actions were, at least, unethical because Rose's creditors may have been denied proper payments.

The ticket switch affected the bankruptcy. There doesn't appear to be any tax evasion since income and gift taxes were paid. I do not see where I would need to contact the IRS about this.

Thanks,
Bill
Customer: replied 2 years ago.
That sounds great! I am unhappy with the other response.
Customer: replied 2 years ago.
There was no court filing. Actually, I was asking if my questions for the memorandum were correct or should I ask other ones or better ones, etc. I am very disappointed with your response. There is a tax issue. It is obvious that Rose knew the value of the lottery winnings and she developed this scheme with her sister to prevent paying her creditors. When she transferred the ticket to her sister, she should have paid gift tax on the gift amount (less $1 million?).
Expert:  Megan C replied 2 years ago.
There is a serious tax issue. First, all lottery winnings are ordinary income, taxed at ordinary income rates - not capital gains. So, the IRS is correct in that respect and Mary should have paid the correct tax.

Also, if Rose was the actual winner of the ticket and didn't get the permission to give the winnings to Mary, then she violated provisions of the contract. Actually, the issue isn't really a tax issue it's a lottery fraud issue. If the lottery commission knew of this scheme, the ticket would have been voided.

This is the wording in the case that I find troublesome "Under the New State Lottery Rules, Mary could not transfer her right to receive all or any portion of the future installment payments without first obtaining the approval of the Superior Court. This provision was included in the law to insure against fraud. "

Mary and Rose did this, but BEFORE the prize was claimed.

Rose gave the winnings to Mary simply so she could go through Bankruptcy. This is bankruptcy fraud.

So, Mary and Rose have committed lottery fraud and bankruptcy fraud. They've also committed tax fraud as you say because Rose should have filed a gift tax return for the gift of the lotto winnings, however if she would have done that then she wouldn't have been able to finalize her bankruptcy and she wouldn't have been able to even transfer the ticket, because that's against state law too.
Customer: replied 2 years ago.
That's exactly how I see this. As a tax professional, what is my responsibility in this matter? I cannot give them legal advice. Should I refer them to see an attorney? Can you supply the actual codes of law so that I can reference them? Also, how can I gain access to the codes? Is there a website?

Thanks.
Expert:  Megan C replied 2 years ago.
Well, there is no tax code for bankruptcy fraud.

You could politely decline to assist them, and tell them that they need to seek the advice of a criminal lawyer that specializes in allegations of fraud.

Now if they hadn't shared all that information with you then you would have simply had to tell them that the lottery winnings are ordinary income and helped them negotiate with the iRS, and then made sure that any gift from Mary to her sister were properly accounted for for tax purposes.

http://www.law.cornell.edu/uscode/text/26 That's an online database where you can access IRS codes.
Expert:  William Ellis, CPA replied 2 years ago.
You both seem to be missing some of the details in the case. The transfers between Mary and Rose occur after the funds are received by Mary. The last line of the case, "Rose (and Mary) treat these transfers as "gifts" for Federal Income Tax purposes." indicates to me that gift taxes were probably paid on the transfers. I believe that bankruptcy fraud may have been committed, but, since I am not a judge, I am not qualified to say this. Nor are you. The last point--if the transfers were from Mary to Rose, Mary would be the one responsible for filing gift tax returns.
Expert:  William Ellis, CPA replied 2 years ago.
It doesn't appear that you agree with me, so I'm expecting you to accept my answer. If you have any questions, I will be happy to address them. I'm still not sure what MyVirtualCPA was reading since she advised you to decline to help the clients after you clearly wrote that this is a class assignment.

Or, maybe I missed some key detail somewhere myself. You can either respond here or send me a private message. I am more concerned with people getting accurate information than my getting paid for the answers.

Thanks again,
Bill
Expert:  Megan C replied 2 years ago.
The case is one where you pretend to help a client - she's playing the role of a tax preparer. So when you make reference to what to do with your client, that's a simulation.

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Megan C
Megan C
Tax Professional
15462 Satisfied Customers
Licensed CPA, CFE, CMA, CGMA who teaches accounting courses at Master's Level