George LATTERA; Angeline Lattera, Appellants v. COMMISSIONER OF INTERNAL REVENUE., United States Court of Appeals, Third Circuit., 437 F.3d 399, No. 04-4721., Filed Feb. 14, 2006., Argued Jan. 9, 2006., Filed Feb. 14, 2006., As Amended April 5, 2006

George LATTERA; Angeline Lattera, Appellants v. COMMISSIONER OF INTERNAL REVENUE.

United States Court of Appeals, Third Circuit.

437 F.3d 399

No. 04-4721.

Filed Feb. 14, 2006.

Argued Jan. 9, 2006.

Filed Feb. 14, 2006.

As Amended April 5, 2006.

Mark E. Cedrone, (Argued), Cedrone & Janove, Philadelphia, PA, for Appellants.

Eileen J. O'Connor, Assistant Attorney General, Regina S. Moriarty, (Argued), Richard Farber, United States Depart╜ment of Justice, Tax Division, Washington, DC, for Appellee.

Before BARRY and AMBRO, Circuit Judges, and DEBEVOISE,* District Judge.

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* ═ Honorable Dickinson R. Debevoise, Senior District Court Judge for the District of New Jersey, sitting by designation.

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AMBRO, Circuit Judge.

Lottery winners, after receiving several annual installments of their lottery prize, sold for a lump sum the right to their remaining payments. They reported their sale proceeds as capital gains on their tax return, but the Internal Revenue Service (IRS) classified those proceeds as ordinary income. The substitute-for-ordinary-in╜come doctrine holds that lump-sum consid╜eration substituting for something that would otherwise be received at a future time as ordinary income should be taxed the same way. We agree with the Com╜missioner of the IRS that the lump-sum consideration paid for the right to lottery payments is ordinary income.

I. Factual Background and Procedural History

In June 1991 George and Angeline Latt╜era turned a one-dollar lottery ticket into $9,595,326 in the Pennsylvania Lottery. They did not then have the option to take the prize in a single lump-sum payment, so they were entitled to 26 annual install╜ments of $369,051.

In September 1999 the Latter as sold their rights to the 17 remaining lottery payments to Singer Asset Finance Co., LLC for $3,372,342. Under Pennsylvania law, the Latteras had to obtain court ap╜proval before they could transfer their rights to future lottery payments, and they did so in August 1999.

On their joint tax return, the Latteras reported this sale as the sale of a capital asset held for more than one year. They reported a sale price of $3,372,342, a cost or other basis of zero, and a long-term capital gain of the full sale price. The Commissioner determined that this sale price was ordinary income. In December 2002 the Latteras were sent a notice of deficiency of $660,784. ¹

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^1. ═ The parties' stipulation of facts states this number as $660,748, but the notice of deficiency reads $660,784.

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In March 2003 the Latteras petitioned the Tax Court for a redetermination of the deficiency. The Court held in favor of the Commissioner. The Latteras now appeal to our Court.

II. Jurisdiction and Standard of Review

The Tax Court had subject matter juris╜diction under I.R.C. ╖ 7442. Because its decision was final, we have appellate juris╜diction under I.R.C. ╖ 7482(a)(1). The Latteras reside in our Circuit, so venue is proper under I.R.C. ╖ 7482(b)(1)(A).

We review the Tax Court's legal determinations de novo, but we do not disturb its factual findings unless they are clearly erroneous. Estate of Meriano v. Comm'r , 142 F.3d 651, 657 (3d Cir.1998).

III. Discussion

The lottery payments the Latteras had a right to receive were gambling winnings, and the parties agree that the annual pay╜ments were ordinary income. Cf. Comm'r v. Groetzinger, 480 U.S. 23, 32 n. 11, 107 S.Ct. 980, 94 L.Ed.2d 25 (1987) (calling a state lottery "public gambling" in a case treating gambling winnings as ordinary in╜come). But the Latteras argue that, when they sold the right to their remaining lot╜tery payments, the sale gave rise to a long-term capital gain.

Whether the sale of a right to lottery payments by a lottery winner can be treat╜ed as a capital gain under the Internal Revenue Code is one of first impression in our Circuit. But it is not a new question. Both the Tax Court and the Ninth Circuit Court of Appeals have held that such sales deserve ordinary-income treatment. Unit╜ed States v. Maginnis, 356 F.3d 1179, 1181 (9th Cir.2004) ("Fundamental principles of tax law lead us to conclude that [the] assignment of [a] lottery right produced ordinary income."); Davis v. Comm'r, 119 T.C. 1, 1, 2002 WL 1446631 (2002); see also Watkins v. Comm'r, 88 T.C.M. (CCH) 390, 393 (2004); Clopton v. Comm'r , 87 T.C.M. (CCH) 1217, 1217 (2004); Boehme v. Comm'r, 85 T.C.M. (CCH) 1039, 1041 (2003).

The Ninth Circuit's reasoning has drawn significant criticism, however. See Mat╜thew S. Levine, Case Comment, Lottery Winnings as Capital Gains, 114 Yale L.J. 195, 197-202 (2004); Thomas G. Sinclair, Comment, Limiting the Substitute-for-Or╜dinary Income Doctrine: An Analysis Through Its Most Recent Application In╜volving the Sale of Future Lottery Rights, 56 S.C. L.Rev. 387, 421-22 (2004). In this context, we propose a different approach. We begin with a discussion of basic con╜cepts that underlie our reasoning.

A. Definition of a capital asset

A long-term capital gain (or loss) is cre╜ated by the "sale or exchange of a capital asset held for more than 1 year." I.R.C. ╖ 1222(3). Section 1221 of the Internal Revenue Code defines a capital asset as "property held by the taxpayer (whether or not connected with his trade or busi╜ness)." This provision excludes from the definition certain property categories, none of which is applicable here. ²

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^2. ═ Section ╖ 1221, as it read when the Latteras sold their lottery rights, contained five excep╜tions (stock in trade of the taxpayer, deprecia╜ble trade or business property, copyrights, accounts receivable acquired in the ordinary course of trade or business, and Government publications). The provision was amended in December 1999 to exclude also commodities derivative financial instruments held by deal╜ers, hedging transactions, and supplies used or consumed in trade or business. Tax Relief Extension Act of 1999, Pub.L. No. 106-170, tit. V, ╖ 532(a), 113 Stat. 1860, 1928-30. These exclusions are not applicable to this case; the amendments did not apply to trans╜actions entered into before December 17, 1999, see id . ╖ 532(d), 113 Stat. at 1931, and the Latteras sold their lottery rights in Sep╜tember 1999.

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A 1960 Supreme Court decision suggest╜ed that this definition can be construed too broadly, stating that "it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capi╜tal asset." Comm'r v. Gillette Motor Transp., Inc., 364 U.S. 130, 134, 80 S.Ct. 1497, 4 L.Ed.2d 1617 (1960). The Court noted that it had "long held that the term ▒capital asset' is to be construed narrowly in accordance with the purpose of Con╜gress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year." Id. But the Supreme Court's decision in Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 108 S.Ct. 971, 99 L.Ed.2d 183 (1988), at least at first blush, seems to have reversed that narrow reading. Arkansas Best sug╜gests instead that the capital-asset defini╜tion is to be broadly construed. See id. at 218, 108 S.Ct. 971 ("The body of ╖ 1221 establishes a general definition of the term ▒capital asset,' and the phrase ▒does not include' takes out of that broad definition only the classes of property that are spe╜cifically mentioned.").

B. The substitute-for-ordinary-income doctrine

The problem with an overly broad defi╜nition for capital assets is that it could "encompass some things Congress did not intend to be taxed as capital gains." Maginnis , 356 F.3d at 1181. An overly broad definition, linked with favorable capital-gains tax treatment, would encourage transactions designed to convert ordinary income into capital gains. See id. at 1182. For example, a salary is taxed as ordinary income, and the right to be paid for work is a person's property. But it is hard to conceive that Congress intends for taxpay╜ers to get capital-gains treatment if they were to sell their rights ( i.e., "property held by the taxpayer") to their future pay╜checks. See 2 Boris I. Bittker & Law╜rence Lokken, Federal Taxation of In╜come, Estates and Gifts ╤ 47.1 (3d ed.2000).

To get around this problem, courts have created the substitute-for-ordinary-income doctrine. This doctrine says, in effect, that " ▒lump sum consideration [that] seems essentially a substitute for what would otherwise be received at a future time as ordinary income' may not be taxed as a capital gain." Maginnis, 356 F.3d at 1182 (quoting Comm'r v. P.G . Lake, Inc., 356 U.S. 260, 265, 78 S.Ct. 691, 2 L.Ed.2d 743 (1958)) (alteration in origi╜nal).

The seminal substitute-for-ordinary-in╜come case is the 1941 Supreme Court deci╜sion in Hort v. Commissioner, 313 U.S. 28, 61 S.Ct. 757, 85 L.Ed. 1168 (1941). Hort had inherited a building from his father, and one of the building's tenants canceled its lease, paying Hort a cancellation fee of $140,000. Id. at 29, 61 S.Ct. 757. Hort argued that the cancellation fee was capital gain, but the Court disagreed, holding that the cancellation fee was ordinary income because the "cancellation of the lease in╜volved nothing more than relinquishment of the right to future rental payments in return for a present substitute payment and possession of the leased premises." Id. at 32, 61 S.Ct. 757.

The Supreme Court bolstered the doc╜trine in Lake. P.G. Lake, Inc. was an oil and gas-producing company with a work╜ing interest in two oil and gas leases. 356 U.S. at 261-62, 78 S.Ct. 691. It assigned an oil payment right "payable out of 25 percent of the oil attributable to [Lake's] working interest in the two leases." Id. at 262, 78 S.Ct. 691. Lake reported this as╜signment as a sale of property taxable as capital gain. Id. But the Court disagreed, holding that the consideration received was taxable as ordinary income. Id. at 264, 78 S.Ct. 691. The Court's reasoning gave full voice to the substitute-for-ordi╜nary-income doctrine: "The lump sum con╜sideration seems essentially a substitute for what would otherwise be received at a future time as ordinary income." Id. at 265, 78 S.Ct. 691.

Our Court has rarely dealt with this doctrine. We have only cited Lake twice-once in 1958, Tunnell v. United States, 259 F.2d 916, 918 (3d Cir.1958), and once in 1974, Hempt Bros., Inc. v. United States, 490 F.2d 1172, 1176, 1178 (3d Cir. 1974) (citing Lake with approval, but de╜ciding the case under a ╖ 351-nonrecog╜nition of transfers of property for corpo╜rate stock-analysis).

The Latteras argue that the substitute-for-ordinary-income doctrine, which takes "property held by the taxpayer" outside the statutory capital-asset definition, did not survive Arkansas Best. But although Arkansas Best ostensibly cabined the ex╜ceptions to the statutory definition, it made clear that the Hort-Lake "line of cases, based on the premise that ╖ 1221 ▒property' does not include claims or rights to ordinary income, ha[d] no application in the present context." Arkansas Best, 485 U.S. at 217 n. 5, 108 S.Ct. 971. The Tax Court has several times confirmed that Arkansas Best "in no way affected the viability of the principle established in the [ Hort-Lake ] line of cases." Davis, 119 T.C. at 6 (citing cases). And the Ninth Circuit agrees. Maginnis, 356 F.3d at 1185. We follow suit, holding that the substitute-for-ordinary-income doctrine re╜mains viable in the wake of Arkansas Best.

But there is a tension in the doctrine: in theory, all capital assets are substitutes for ordinary income. See, e.g., William A. Klein et al., Federal Income Taxation 786 (12th ed. 2000) ("A fundamental principle of economics is that the value of an asset is equal to the present discounted value of all the expected net receipts from that asset over its life."); see also Lake, 356 U.S. at 266, 78 S.Ct. 691 (noting that the lump-sum consideration-held to be ordinary in╜come-paid for an asset was "the present value of income which the recipient would otherwise obtain in the future"). For ex╜ample, a stock's value is the present dis╜counted value of the company's future profits. See, e.g., Maginnis, 356 F.3d at 1182; cf. United States v. Dresser Indus., Inc ., 324 F.2d 56, 59 (5th Cir.1963) (apply╜ing this concept to the value of land). "[R]ead literally, the [substitute-for-ordi╜nary-income] doctrine would completely swallow the concept of capital gains." Le╜vine, supra, at 196; accord 2 Bittker & Lokken, supra, ╤ 47.9.5, at 47-68 ("Unless restrained, the substitute-for-ordinary-in╜come theory thus threatens even the most familiar capital gain transactions."). Also, an "overbroad ▒substitute for ordinary in╜come' doctrine, besides being analytically unsatisfactory, would create the potential for the abuse of treating capital losses as ordinary." ³ Levine, supra, at 197. The doctrine must therefore be limited so as not to err on either side.

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^3. ═ Note that our holding in this case does not consider the substitute-for-ordinary-income doctrine in loss transactions.

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C. The lottery cases

Even before the Ninth Circuit decided Maginnis, the Tax Court had correctly answered the question of whether sales of lottery winnings were capital gains. In Davis v. Commissioner, lottery winners had sold their rights to 11 of their total 14 future lottery payments for a lump sum. 119 T.C. at 3. The Tax Court found that the lump-sum payment to the lottery win╜ners was the "discounted value . . . of cer╜tain ordinary income which they otherwise would have received during the years 1997 through 2007." Id. at 7. The Court held, therefore, that (1) the purchaser of the lottery payment rights paid money for "the right to receive . . . future ordinary in╜come, and not for an increase in the value of income-producing property"; (2) the lot╜tery winners' right to their future lottery payments was not a capital asset; and (3) the lump-sum payment was to be taxed as ordinary income. Id .; see also Watkins, 88 T.C.M. (CCH) at 393 (following Davis, in a post-Maginnis decision); Clopton, 87 T.C.M. (CCH) at 1219 (citing Tax Court cases following Davis ).

In 2004 the Ninth Circuit decided Mag╜innis, the first (and so far only) appellate opinion to deal with this question. Magin╜nis won $9 million in a lottery and, after receiving five of his lottery payments, as╜signed all of his remaining future lottery payments to a third party for a lump-sum payment of $3,950,000. Maginnis, 356 F.3d at 1180. The Ninth Circuit held that Maginnis's right to future lottery pay╜ments was not a capital asset and that the lump-sum payment was to be taxed as ordinary income. Id. at 1182.

The Court relied on the substitute-for-ordinary-income doctrine, but it was concerned about taking an "approach that could potentially convert all capital gains into ordinary income [or] one that could convert all ordinary income into capital gains." Id. The Court opted instead for "case-by-case judgments as to whether the conversion of income rights into lump-sum payments reflects the sale of a capital as╜set that produces a capital gain, or wheth╜er it produces ordinary income." Id . It set out two factors, which it characterized as "crucial to [its] conclusion," but not "dis╜positive in all cases": "Maginnis (1) did not make any underlying investment of capital in return for the receipt of his lottery right, and (2) the sale of his right did not reflect an accretion in value over cost to any underlying asset Maginnis held." Id. at 1183.

But two commentators have criticized the analysis in Maginnis, especially the two factors. See Levine, supra , at 197-202; Sinclair, supra, at 421-22. The first factor-underlying investment of capital-would theoretically subject all inherited and gifted property (which involves no in╜vestment at all) to ordinary-income treat╜ment. See Levine, supra, at 198. It also does not explain the result in Lake, where the company presumably made an invest╜ment in its working interest in oil and gas leases, yet the Supreme Court applied or╜dinary-income treatment. Id .

The second factor also presents analyt╜ical problems. Not all capital assets expe╜rience an accretion in value over cost. For example, cars typically depreciate, but they are often capital assets. See Sinclair, supra, at 421. Levine criticizes the second factor for "attempt[ing] to determine the character of a gain from its amount." Le╜vine, supra, at 199. The Maginnis Court held that there was no accretion of value over cost in lottery winnings because there was no cost, as "Maginnis did not make any capital investment in exchange for his lottery right." 356 F.3d at 1184. But if Maginnis's purchase of a lottery ticket had been a capital investment, would the sec╜ond factor automatically have been satis╜fied? (That is, the "cost" in that scenario would have been $1, and the increase would have been $3,949,999.) Our first instinct is no. Moreover, the second factor does not seem to predict correctly the result in both Hort (where a building was inherited for no "cost") and Lake (where the working interest in the oil lease pre╜sumably had a "cost"), in both of which the taxpayer got ordinary-income treatment.

Thus, while we agree with Maginnis' s result, we do not simply adopt its reason╜ing. And it is both unsatisfying and un╜helpful to future litigants to declare that we know this to be ordinary income when we see it. The problem is that, "[u]nless and until Congress establishes an arbi╜trary line on the otherwise seamless spec╜trum between Hort-Lake transactions and conventional capital gain transactions, the courts must locate the boundary case by case, a process that can yield few useful generalizations because there are so many relevant but imponderable criteria." 2 Bittker & Lokken, supra, ╤ 47.9.5, at 47-69 (footnote omitted).

We therefore proceed to our case-by-case analysis, but in doing so we set out a method for analysis that guides our result. At the same time, however, we recognize that any rule we create could not account for every contemplated transactional varia╜tion.

D. Substitute-for-ordinary-income analysis

In our attempt to craft a rubric, we find helpful a Second Circuit securities case and a recent student comment. The Sec╜ond Circuit dealt with a similarly "seam╜less spectrum" in 1976 when it needed to decide whether a note was a security for purposes of section 10(b) of the 1934 Secu╜rities and Exchange Act. See Exch. Nat'l Bank of Chi. v. Touche Ross & Co., 544 F.2d 1126, 1138 (2d Cir.1976). The Court created a "family resemblance" test, (1) presuming that notes of more than nine months' maturity were securities, (2) list╜ing various types of those notes that it did not consider securities, and (3) declaring that a note with maturity exceeding nine months that "does not bear a strong family resemblance to these examples" was a se╜curity. Id. at 1138, 1137-38. The Su╜preme Court, adopting this test in 1990, added four factors to guide the "resem╜blance" analysis: the motivations of the buyers and sellers, the plan of distribution, the public's reasonable expectations, and applicable risk-reducing regulatory schemes. Reves v. Ernst & Young, 494 U.S. 56, 65-67, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990).

We adopt an analogous analysis. Several types of assets we know to be capital: stocks, bonds, options, and curren╜cy contracts, for example. See, e.g., Ar╜kansas Best, 485 U.S. at 222-23, 108 S.Ct. 971 (holding-even though, as noted above, the value of a stock is really the present discounted value of the company's future profits-that "stock is most naturally viewed as a capital asset"); see also id. at 217 n. 5, 108 S.Ct. 971 (distinguishing "cap╜ital stock" from "a claim to ordinary income"); Simpson v. Comm'r, 85 T.C.M. (CCH) 1421, 1423 n. 7 (2003) (distinguish╜ing "currency contracts, stocks, bonds, and options" from a right to receive lottery payments). We could also include in this category physical assets like land and au╜tomobiles.

Similarly, there are several types of rights that we know to be ordinary income, e.g., rental income and interest income. In Gillette Motor, the Supreme Court held that ordinary-income treatment was indi╜cated for the right to use another's proper╜ty-rent, in other words. See 364 U.S. at 135, 80 S.Ct. 1497. Similarly, in Midland-Ross, the Supreme Court held that earned original issue discount should be taxed as ordinary income. See United States v. Midland-Ross Corp., 381 U.S. 54, 58, 85 S.Ct. 1308, 14 L.Ed.2d 214 (1965). There, the taxpayer purchased non-interest-bear╜ing notes at a discount from the face amount and sold them for more than their issue price (but still less than the face amount). Id. at 55, 85 S.Ct. 1308. This gain was conceded to be equivalent to in╜terest, and the Court held it taxable as ordinary income. Id. at 55-56, 58, 85 S.Ct. 1308.

For the "family resemblance" test, we can set those two categories at the oppo╜site poles of our analysis. For example, we presume that stock, and things that look and act like stock, will receive capital-gains treatment. For the in-between transactions that do not bear a family re╜semblance to the items in either category, like contracts and payment rights, we use two factors to assist in our analysis: (1) type of "carve-out" and (2) character of asset. ⁴

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^4. ═ We borrow these factors from Thomas Sin╜clair's comment, see Sinclair, supra , at 401-03, but we differ from him slightly in the way we apply the character factor.

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1. Type of carve out

The notion of the carve-out, or partial sale, has significant explanatory power in the context of the Hort-Lake line of cases. As Marvin Chirelstein writes, the " ▒substi╜tute' language, in the view of most com╜mentators, was merely a short-hand way of asserting that carved-out interests do not qualify as capital assets." Marvin A. Chirelstein, Federal Income Taxation ╤ 17.03, at 369-70 (9th ed.2002).

There are two ways of carving out interests from property: horizontally and vertically. A horizontal carve-out is one in which "temporal divisions [are made] in a property interest in which the person own╜ing the interest disposes of part of his interest but also retains a portion of it." Sinclair, supra, at 401. In lottery terms, this is what happened in Davis, Boehme, and Clopton-the lottery winners sold some of their future lottery payment rights ( e.g. , their 2006 and 2007 payments) but retained the rights to payments fur╜ther in the future ( e.g., their 2008 and 2009 payments). See Clopton, 87 T.C.M. (CCH) at 1217-18 (finding that the lottery winner sold only some of his remaining lottery payments); Boehme, 85 T.C.M. (CCH) at 1040 (same); Davis, 119 T.C. at 3 (same). This is also what happened in Hort and Lake; portions of the total interest (a term of years carved out from a fee simple and a three-year payment right from a work╜ing interest in a oil lease, respectively) were carved out from the whole.

A vertical carve-out is one in which "a complete disposition of a person's inter╜est in property" is made. Sinclair, supra, at 401. In lottery terms, this is what happened in Watkins and Maginnis -the lottery winners sold the rights to all their remaining lottery payments. See Maginnis , 356 F.3d at 1181 (noting that the lottery vv inner assigned his right to receive all his remaining lottery payments); Wat╜kins, 88 T.C.M. (CCH) at 391 (same).

Horizontal carve-outs typically lead to ordinary-income treatment. See, e.g., Mag╜innis, 356 F.3d at 1185-86 ("Maginnis is correct that transactions in which a tax╜payer transfers an income right without transferring his entire interest in an un╜derlying asset will often be occasions for applying the substitute for ordinary in╜come doctrine."). This was also the result reached in Hort and Lake. Lake, 356 U.S. at 264, 78 S.Ct. 691; Hort, 313 U.S. at 32, 61 S.Ct. 757.

Vertical carve-outs are different. In Dresser Industries , for example, the Fifth Circuit distinguished Lake because the taxpayer in Dresser had "cut[ ] off a ▒verti╜cal slice' of its rights, rather than carv[ed] out an interest from the totality of its rights." Dresser Indus., 324 F.2d at 58. But as the results in Maginnis and Wat╜kins demonstrate, a vertical carve-out does not necessarily mean that the transaction receives capital-gains treatment. See, e.g., Maginnis, 356 F.3d at 1185 (holding "that a transaction in which a taxpayer sells his entire interest in an underlying asset with╜out retaining any property right does not automatically prevent application of the substitute for ordinary income doctrine" (emphasis in original)); see also id. at 1186.

Because a vertical carve-out could signal either capital-gains or ordinary-income treatment, we must make another determi╜nation to conclude with certainty which treatment should apply. Therefore, when we see a vertical carve-out, we proceed to the second factor-character of the as╜set-to determine whether the sale pro╜ceeds should be taxed as ordinary income or capital gain.

2. Character of the asset

The Fifth Circuit in Dresser Industries noted that "[t]here is, in law and fact, a vast difference between the present sale of the future right to earn income and the present sale of the future right to earned income." Dresser Indus., 324 F.2d at 59 (emphasis in original). The taxpayer in Dresser Industries had assigned its right to an exclusive patent license back to the patent holder in exchange for a share of the licensing fees from third-party licen╜sees. Id at 57. The Court used this "right to earn income"/"right to earned income" distinction to hold that capital-gains treatment was applicable. It noted that the asset sold was not a "right to earned income, to be paid in the future," but was "a property which would produce income." Id. at 59. Further, it disregard╜ed the ordinary nature of the income gen╜erated by the asset; because "all income-producing property" produces ordinary in╜come, the sale of such property does not result in ordinary-income treatment. Id. (This can be seen in the sale of bonds, which produce ordinary income, but the sale of which is treated as capital gain.)

Sinclair explains the distinction in this way: "Earned income conveys the concept that the income has already been earned and the holder of the right to this income only has to collect it. In other words, the owner of the right to earned income is entitled to the income merely by virtue of owning the property." Sinclair, supra, at 406. He gives as examples of this concept rental income, stock dividends, and rights to future lottery payments. Id. (Of course, in the wake of dividend tax reform, stock dividends are now taxed as capital gains. I.R.C. ╖ 1(h)(11).) For the right to earn income, on the other hand, "the hold╜er of such right must do something further to earn the income . . . . [because] mere ownership of the right to earn income does not entitle the owner to income." Sinclair, supra , at 406. Following Dresser Indus╜tries, Sinclair gives a patent as an example of this concept. Id.

Assets that constitute a right to earn income merit capital-gains treatment, while those that are a right to earned income merit ordinary-income treatment. Our Court implicitly made this distinction in Tunnell v. United States, 259 F.2d 916 (3d Cir.1958). Tunnell withdrew from a law partnership, and he assigned his rights in the law firm in exchange for $27,500. Id. at 917. When he withdrew, the partnership had over $21,000 in uncollected accounts receivable from work that had already been done. Id. We agreed with the District Court that "the sale of a part╜nership is treated as the sale of a capital asset." Id. The sale of a partnership does not, in and of itself, confer income on the buyer; the buyer must continue to provide legal services, so it is a sale of the right to earn income. Consequently, as we held, the sale of a partnership receives capital-gains treatment. The accounts receivable, on the other hand, had already been earned; the buyer of the partnership only had to remain a partner to collect that income, so the sale of accounts receivable is the sale of the right to earned income. Thus, we held that the portion of the pur╜chase price that reflected the sale of the accounts receivable was taxable as ordi╜nary income. Id. at 919.

Similarly, when an erstwhile employee is paid a termination fee for a personal-ser╜vices contract, that employee still possess╜es the asset (the right to provide certain personal services) and the money (the ter╜mination fee) has already been "earned" and will simply be paid. The employee no longer has to perform any more services in exchange for the fee, so this is not like Dresser Industries's "right to earn in╜come." These termination fees are there╜fore rights to earned income and should be treated as ordinary income. See, e.g., El╜liott v. United States, 431 F.2d 1149, 1154 (10th Cir.1970); Holt v. Comm'r, 303 F.2d 6 87, 690 (9th Cir.1962); see also Chirelstein, supra, ╤ 17.03, at 376-77 (noting that "courts have held consistently that pay╜ments made to an employee for the sur╜render of his employment contract are or╜dinary").

The factor also explains, for example, the Second Circuit's complex decision in Commissioner v. Ferrer, 304 F.2d 125 (2d Cir.1962). The actor Jose Ferrer had con╜tracted for the rights to mount a stage production based on the novel Moulin Rouge. Id. at 126. In the contract, Ferr╜et obtained two rights relevant here: (1) the exclusive right to "produce and pres╜ent" a stage production of the book and, if the play was produced, (2) a share in the proceeds from any motion-picture rights that stemmed from the book. Id . at 127. After a movie studio planned to make Moulin Rouge into a movie-and agreed that it would feature Ferrer-he sold these, along with other, rights. Id . at 128-29. Right (1) would have required Ferrer to have produced and presented the play to get income, so it was a right to earn income-thus, capital-gains treatment was indicated. Right (2), once it matured ( i.e., once Ferrer had produced the play), would have continued to pay income simply by virtue of Ferrer's holding the right, so it would have become a right to earned in╜come-thus, ordinary-income treatment vas indicated. The Second Circuit held as such, dictating capital-gains treatment for right (1) and ordinary-income treatment for light (2). Id . at 131, 134. ⁵

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^5. ═ One well-known result that these factors do not predict is the Second Circuit's 1946 opin╜ion in McAllister v. Commissioner, 157 F.2d 235 (2d Cir.1946). In that case, a widow was forced to sell her life estate in a trust to the remainderman. Id. at 235. Thus, she re╜ceived a lump-sum payment in exchange for her right to all future payments from the trust. Although this was a vertical carve-out, susceptible to both types of treatment, she gave up her right to earned income, because she would have continued receiving payments simply by holding the life estate. Thus, the sale proceeds should have received ordinary-income treatment. The Court held instead that capital-gains treatment was indicated. Id. at 236.

But the result in McAllister has been round╜ly criticized. The Tax Court in that case had held that ordinary-income treatment was proper, id. at 235, and Judge Frank entered a strong dissent, id. at 237-41 (Frank, J., dis╜senting). The McAllister Court relied on a case that did not even discuss the capital-asset statute. Id. at 237 (majority opinion). Chirelstein writes that the "decision in McAlli ster almost certainly was wrong." Chirel╜stein, supra, ╤ 17.03, at 373. And a 2004 Tax Court opinion did not even bother to distin╜guish McAllister, stating simply that it was "decided before relevant Supreme Court deci╜sions applying the substitute for ordinary in╜come doctrine" (referring, inter alia, to Lake ). Clopton, 87 T.C.M. (CCH) at 1219.

We consider McAllister to be an aberration, and we do not find it persuasive in our deci╜sion in this case.

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E. Application of the "family resemblance" test

Applied to this case, the "family resemblance" test draws out as follows. First, we try to determine whether an asset is like either the "capital asset" cate╜gory of assets ( e.g., stocks, bonds, or land) or like the "income items" category ( e.g., rental income or interest income). If the asset does not bear a family resemblance to items in either of those categories, we move to the following factors.

We look at the nature of the sale. If the sale or assignment constitutes a horizontal carve-out, then ordinary-income treatment presumably applies. If, on the other hand, it constitutes a vertical carve-out, then we look to the character-of-the-asset factor. There, if the sale is a lump-sum payment for a future right to earned income, we apply ordinary-income treatment, but if it is a lump-sum payment for a future right to earn income, we apply capital-gains treatment.

Turning back to the Latteras, the right to receive annual lottery payments does not bear a strong family resemblance to either the "capital assets" or the "income items" listed at the polar ends of the ana╜lytical spectrum. The Latteras sold their right to all their remaining lottery pay╜ments, so this is a vertical carve-out, which could indicate either capital-gains or ordinary-income treatment. But because a right to lottery payments is a right to earned income ( i.e. , the payments will keep arriving due simply to ownership of the asset), the lump-sum payment received by the Latteras should receive ordinary-in╜come treatment.

This result comports with Davis and Maginnis. It also ensures that the Latt╜eras do not "receive a tax advantage as compared to those taxpayers who would simply choose originally to accept their lottery winning in the form of a lump sum payment," something that was also impor╜tant to the Maginnis Court. Maginnis, 356 F.3d at 1184. ⁶

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^6. ═ We do not decide whether Singer, who pur╜chased the right to lottery payments from the Latteras, would receive ordinary income or capital gain if it later decided to sell that right to another third party. See Maginnis, 356 F.3d at 1183 n. 4. Such a determination would need to be made on the specific facts of the transaction. For example, if Singer bought and sold such rights as part of its business, the lottery payment rights could theoretically fall under the inventory exclusion to the capital-asset definition. Cf. Arkansas Best, 485 U.S. at 222, 108 S.Ct. 971 (suggesting that if Arkansas Best had been a dealer in securities, its bank stock might have fallen within ╖ 1221's inventory exclusion).

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IV. Conclusion

The lump-sum consideration paid to the Latteras in exchange for the right to their future lottery payments is ordinary in╜come. ⁷ We therefore affirm.

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^7. ═ The Latteras appear to argue that their lot╜tery ticket was itself a capital asset. We do not need to address this issue, as we note that the Latteras did not sell their winning ticket to Singer. Instead, they relinquished it in 1991 to the Pennsylvania State Lottery so they could claim their prize. They sold Singer eight years later not the physical lottery ticket but their right to the annual lottery payments.

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