5 page double spaced research problem in taxation for individuals

I. Facts of the Research Problem:
As per the facts of the given case, John and Mary Smith are US taxpayers residing
in New State since 1995. In the year 2002, Mary Smith won a $6.24 Million price
in the New State Lottery and thereby became entitled to receive 20 annual
payments of $312,000 each and to be reduced by mandatory federal income tax
withholding. As per the rules of the New State Lottery, Mary was not given the
option of receiving a lump-sum payment, but got entitled to receiving the winning
amount in annual instalments. The first payment under the Lottery Rules was
made on May 1, 2002, and 19 subsequent instalments of $312,000 after reduced
by mandatory federal income tax withholding were scheduled to be paid on May 1
of each consecutive year. Further, in order to insure against fraud, the New State
Lottery Rules also provided that Mary could not transfer her right to receive all or
any portion of the future instalment payments without obtaining the prior approval
of the Superior Court. Near to July 2, 2011, and after obtaining the approval of the
Superior Court, Mary entered into an agreement with Lottery Payment Finance
Company, LLC („Finance‟) for the transfer of her rights. As per the terms of this
agreement, Mary sold all of her rights to receive the residual 10 instalment
payments of $312,000 each, and amounting to $3.2 million. She sold these in
exchange for a lump-sum payment by Finance to the tune of $2.125 Million. After
this transfer and the on the joint Form 1040 Return filed with her husband John,
Mary reported a long term capital gain of $2,124,599 resulting from the transfer.
The Internal Revenue Service does not agree with this reporting in the tax return.
It has proclaimed that there is a deficiency assessment and included penalties and
interest. The Internal Revenue Service has taken the view that the $2.125 Million
lump-sum payment is to be taxable at ordinary income rates, and not at rated
applicable to long term capital gains.
Further, it has been come to be known that the ticket was actually purchased by
Mary‟s sister, Rose. When the winning were declared, Rose asked Mary to claim
the prize money because she was about to go in for personal bankruptcy. At that
time, her assets were valued at $250,000 and her liabilities were $1,800,000. Mary
has, since then, kept record of the money received from the lottery and given
account of these along with any monies used by her to Rose. Rose has completed
her procedure for bankruptcy and has also been receiving money from Mary from
time to time. Both of them treat these transfers as “gifts” for Federal Income Tax
Purposes.
II. Identification of Question (‘Issue’) to be answered in order to resolve the
problem:
The advice is needed by John and Mary regarding the position taken by the
Internal Revenue Service in respect of the assertion of a deficiency assessment.
Therefore, the issue in question is whether John and Mary should fight the
position taken by Internal Revenue Service that the $2.125 Million lump-sum
payment is taxable at ordinary income rates. Secondly, the issue is whether John
and Mary are correct in their stand of filing joint Form 1040 Return and reporting
a long term capital gain of $2,124,599 from the transfer by Mary of her right to
receive the future instalment payments.
III. Answer to each Question...