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| The Basics | And the winner is you . . . and the IRS
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So when you win a trip, a car or cash, thank your lucky stars and pay the tax man. Whether your good fortune is won or bartered, the IRS probably considers it taxable income.
By Jeff Schnepper
A friend recently sent me a news article about someone of modest means who had won a trip to Africa valued at more than $20,000.
I was of two minds about the winners luck. If the winner makes $30,000 a year, a trip to Africa is a once-in-a-lifetime experience, and he should enjoy it. But what about the tax bill hell get stuck with?
Taxes? Yes, the taxes. The safari winner may, in fact, owe the federal government much as $5,000
Yes, sometimes, even when you win, you can still lose. Everyone knows that income is taxable, but theres lots of stuff you really didnt know that counts as income and could add to your tax bill. Heres a rundown.
If you win, you pay
If you enter a contest and win, your winnings are taxable income. It doesnt make any difference how you win the prize. You can win a drawing at the county fair. Your final answer may actually win you the million bucks on Who Wants to Be a Millionaire. Ditto for a beauty pageant. You may get $1 million because your cure for cancer won the Nobel Prize for medicine. You invent the next new hot bit of software and get a huge bonus.
How you get the prize -- whether it's cash or a new Mercedes -- makes no difference to the Internal Revenue Service; its all taxable.
Cash prizes have one big advantage over non-cash prizes. They give you the liquidity to pay your fiscal fine.
Bartering
If you get audited, one of the first questions youll be asked is whether you did any bartering. Bartering is the exchange of goods or services directly for other goods and services.
If I do my neighbors taxes in exchange for his mowing my lawn all summer, we both have income. He should be taxed on the value of my preparing his taxes, and I should be taxed on the value of his mowing my lawn.
Its done all the time -- you can use my sailboat if I can use your cottage in the mountains for the weekend. Again, we both have taxable income equal to the value of what we receive.
Most people dont report this informal income because they dont even realize its income, and it would just about impossible for the IRS to trace all of those informal exchanges. But the IRS can and does track bartering clubs, which are now required to issue 1099 forms for exchange transactions.
Can you beat the IRS?
There arent many ways to keep your good fortune from the taxman. Probably the best way is to have the prize or award directly given to the charity of your choice. But you dont get the charitable-donation deduction. You simply exclude it from income. Its as if you never got the award.
There is another, more-subtle way to limit your tax exposure. You include prizes and award winnings as income on your return at their fair market value to you. This is very important. Its not the general fair market value, but rather the fair market value to you.
Lets say you already have two new attach cases and, on a quiz show, win a third that normally retails at $200. The value of that third attach case toyou may be negligible. It clearly wouldnt be its full retail-selling price.
So you could try to run a new, lower price by the IRS. The burden, however, is on you to prove the reduced value.
If you sell the item, the amount received is normally deemed to be its fair market value. If, for example, youre awarded a car that retails for $20,000 and you immediately sell that car to someone else in town for $15,000, the amount you would include in your income should only be the lower amount, or $15,000.
Be careful here, though. If you sell the car to a relative, the IRS will argue that you received $20,000 in income and made a nondeductible gift of $5,000 to your relative. Sorry.
Some taxpayers have tried to get around this problem by selling to someone to whom theyre not related. That person turns around and sells to your relative. I dont advise this idea. If theres any prearranged agreement, the IRS will collapse the two transactions, deem the first sale to be a sham and successfully establish the true nature of the gift to your relative.
Sticky questions
The courts have defined income to include all accession to wealth clearly realized, over which you have dominion. Essentially, what that means is that income is anything of value that you receive to do with as you please, for which you do work or because it is obligated by contract. And, unless its excluded as income by the constitution or by statute (like municipal bond interest), its taxable!
Where defining whats income gets complicated and confusing involves the issue of making whole or return of capital.
The idea is this: if the dollars you receive are only to bring you back to your original position, those dollars arent really income.
The simplest example of this comes with a stock investment. When you sell your stock, youre not taxed on the whole amount you receive, just on the amount in excess of what that stock cost you. Since you didnt get a deduction when you bought the stock, only the gain should be taxable. Thats only reasonable.
However, I must warn you: anyone who lives in expectation of our tax system being reasonable is going to be sorely disappointed.
Heres a taste of what I mean. Sometimes, damages awarded in suits for wrongful termination, sexual or age discrimination or personal injuries are taxable income; sometimes theyre not. It depends on what kind of lawsuit is filed and the exact language of the award. A suit involving physical damages (personal or otherwise) generally produces damages that are nontaxable. A judgment in a contract dispute can be taxable.
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