Originally published on Forbes.com on August 9th, 2012
The proposal to exempt the cash awards of Olympic medal winners from taxation must have gotten Julian Block thinking about prizes and awards. He reminds us that prior to the Tax Reform Act of 1986, the fairly substantial cash awards connected to the Nobel Prize and other less well known awards were exempt. Now the exemption only applies if the awards are disclaimed to charity.
Award Winners Are Losers Under the Tax Code
As part of its unending quest for tax fairness, Congress keeps overhauling the Internal Revenue Code. One of the sneakier consequences of those efforts was evisceration of a long-standing break for outstanding American writers, scientists, artists and other individuals who receive prizes and awards that honor their accomplishments.
By way of background, the law authorizes the Internal Revenue Service to exact taxes from individuals who receive prizes from television game shows like Jeopardy! (more later on Jeopardy!) and Wheel of Fortune, lucky number drawings, beauty contests and similar events, just as the agency gets to tax employees who are the recipients of bonuses and other awards from employers for outstanding work or suggestions.
As explained below, prior law carved out an exception for writers and scientists, among others. It exempted them from paying taxes on awards that are bestowed primarily in recognition of their past achievements in literature and research, among other cultural and academic endeavors.
The Nobel Prizes are the best-known example of big-bucks awards undiminished by taxes. The prizes are bestowed by the Nobel Foundation. These being the tough economic times that they are, the Foundation announced a reduction by about 20 percent in the amount of cash (Swedish kronor) awarded with the prizes—from $1.4 million for previous years to about $1.1 million for 2012. “Ugly returns” on its invested capital compelled the Foundation to make the reduction, noted the New York Times of June 12, 2012. It added that “Even those charged with identifying the world’s greatest geniuses sometimes make bad investment decisions.”
That $1.1 million usually is split by two or three people. The Templeton Prize, which honors contributions to understanding spiritual dimensions of life, had been the largest monetary award given to an individual, $1.7 million for 2012.
Awards again were mentioned in the New York Times of July 31, 2012. It noted that bragging rights for the most lucrative prize in the world shifted from the Templeton Prize to the “Fundamental Physics Prize, established by Yuri Milner, a Russian physics student who dropped out of graduate school in 1989 and later earned billions investing in Internet companies like Facebook and Groupon.” Thanks to Mr. Milner, nine physicists each received $3 million in 2012 and, said the Times, became “instant multimillionaires.”
But will they still be multimillionaires after the IRS siphons off its share? Income of $3 million propels a person into 2012’s top bracket of 35 percent—taxable income of more than $388,350. Moreover, these physicists mostly work for universities in California, Massachusetts and New Jersey, states that impose hefty income taxes.
True, income taxes aren’t a concern for award recipients who qualify for what are known as “exclusions” from taxable income, meaning they needn’t list the awards on their 1040 forms. But both the old rules and the current ones mandate that recipients have to pass a two-step test. First, you were named the winner without any action on your part—that is, you didn’t specifically apply for the award by, say, entering the contest or proceeding. Second, you aren’t obligated, as a condition of receiving the award, to perform substantial future services, such as teaching or writing.
The Tax Reform Act of 1986 introduced a third requirement that, as a practical matter, makes the exclusion meaningless. Code Section 74(b) grants tax relief for your award only if you assign it away from yourself to a charity. Specifically, you must “designate”—that is, instruct the award-conferring organization to turn the proceeds over to one or more governmental agencies (at federal, state or local levels) or to certain charities, such as schools or churches. Unsurprisingly, the list of qualifying designees includes everyone’s favorite, the IRS.
The third requirement includes some fine print that you ignore at your peril. There’s a deadline for the designation. If you fail to meet it, you disqualify yourself for the exclusion and have to count the award as reportable income.
Here’s the drill on how to stay in the good graces of the IRS. Your designation and the awarding organization’s fulfillment of that designation must occur before any prohibited use by you of the money or other property awarded. In the case of a cash award, the designation/fulfillment has to take place before you spend, deposit, or otherwise invest the funds. Moreover, you run afoul of the prohibited-use rule and become liable for taxes if you allow use of the property by someone else, such as a family member, in advance of the designation/fulfillment.
Ah, but wait: Can you convert what’s supposed to be a restriction into a double break by combining tax-free treatment of the award with a charitable deduction for assigning the proceeds to, for example, your Uncle Sam or your alma mater? Not surprisingly, the feds anticipated that maneuver. The law specifically instructs the tax gatherers to disallow a charitable write-off for an assigned award.
When President Obama won the Nobel Prize in 2009, he sailed through Section 74(b). Mr. Obama immediately announced that he would donate the full 10 million Swedish kronor (about $1.4 million) to charities. So the award didn’t affect his tax liability.
Self-employment taxes. Suppose that, unlike Mr. Obama, you decide to skip the exclusion and report the award. Like those nine physicists, you’re liable for income taxes, but not for self-employment taxes, because neither they, nor you, are in the business of winning awards. Report your award on Line 21 (“other income”) on the front of Form 1040, not on Form 1040’s Schedule C. As the source of the income, specify “award” in the box to the left of where you enter the amount.
On a personal note, I appeared on The Match Game, hosted by Gene Rayburn, and was teamed with John Forsythe, best known to television audiences as the conniving patriarch on Dynasty. I won about $100 for my 1966 appearance, as did my wife who appeared on a later show and was teamed with Bennett Cerf, renowned as a panelist on What’s My Line? and as a publisher. As there are no exclusions for game show winnings, my wife and I made the required entries on Line 21, because we aren’t in the business of appearing on shows.
The following year, I was a Jeopardy! contestant for four games. Back then, the money amounted to much less; the host was Art Fleming. A check for $1,910 and a set of Compton’s Picture Encyclopedia arrived about a week after the birth of our first child; we have a photo of the check displayed on his chest. I made sure to enter $1,910 on Line 21 and was never dunned by the IRS for self-employment taxes.
My Jeopardy! winnings of $1,910 were chopped liver, compared to the $2,520,700 earned in 2004 by Ken Jennings. He was victorious on 74 episodes of the show, its longest winning streak. Did that many wins compel Ken to complete Schedule C, thereby obligating him to pay an enormous amount of self-employment taxes? Not if he’d asked me. I would’ve told him to stick with Line 21 and not to fret about his streak being surpassed by Cal Ripken.
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Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as: “a leading tax professional” (New York Times); “an accomplished writer on taxes” (Wall Street Journal); and “an authority on tax planning” (Financial Planning Magazine). Information about his books is at julianblocktaxexpert.com.
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I thought it would be nice to add some video to Julian’s piece. I found a clip of Ken Jennings “Final Jeopardy”, where he lost to Nancy Zerg
I can hear the Wandering Tax Pro chuckling all the way from Pennsylvania. It turns out that this fellow who made millions of dollars from his wealth of general knowledge did not have the name H & R Block pop into his head when asked to name the largest employer of seasonal white collar employees. Well, the guy was really smart, so you can feel pretty certain that was not where he was getting his returns done.
You can follow me on twitter @peterreillycpa.