Tax and Financial Strategies for Windfalls.
Immediate Tax Consequences of a Windfall
Under federal law, the receipt of a windfall may be taxable or tax-free. The general rule is that income from any source is includible in gross income [Internal Revenue Code (IRC) section 61]; however, there may be an exclusion that transforms a particular type of recovery into tax-free income.
Damages. Unless paid for personal physical injury or sickness, damages from lawsuits, settlements, and awards are taxable [IRC section 104(a)(2)], For example, damages received for a nonphysical personal injury, such as defamation or workplace discrimination, are taxable. Punitive damages for any type of injury, including a personal physical injury, are also taxable, as are damages for back pay. Interest paid on a judgment is usually taxable.
Cases taken by attorneys on a contingency basis mean that the individual does not receive the full amount of damages; nonetheless, the individual is taxed on the entire award [Banks v. Comm'r, 543 U.S. 426 (2005)].
In the case of a wrongful death claim, damages typically include compensatory damages for physical and mental injury, as well as punitive damages for reckless, malicious, or reprehensible conduct by the wrongdoer. The portion for compensatory damages is tax-free; the portion for punitive damages is taxable. The recovery is fully excludable for federal income tax purposes, however, if the wrongful death claim is made under a state statute that treats all of the recovery as punitive damages, thereby precluding compensatory damages [IRC section 104(c)].
Are damages for emotional distress taxable or excludable? It depends. Damages for emotional distress resulting from a nonphysical personal injury, such as job discrimination, are excludable to the extent used for medical costs. "Soft injuries," such as headaches, insomnia, and weight loss, usually are treated as emotional distress, and allocable damages are taxable. In one recent case, a postal worker was taxed on damages for soft injuries arising from her discrimination action because the discrimination did not cause any physical injuries (Barbato v. Comm V, TC Memo 2016-23).
Whether damages for property losses are taxable depends on the basis in the property damaged or destroyed. The recovery is treated as a tax-free return of capital if it does not exceed the individual's basis in the property (IRC section 1001).
Legal fees related to obtaining damages may or may not be deductible. As a general rule, legal fees to recover a personal injury award or other tax-free damages are not deductible, while legal fees to recover taxable damages are deductible. Deductible legal fees related to personal injury are usually treated as miscellaneous itemized deductions, which means that only legal fees and other miscellaneous itemized deductions in excess of 2% of adjusted gross income are deductible by those who itemize [IRC section 67(a)]. Individuals subject to the alternative minimum tax (AMT), however, lose any of this tax benefit [IRC section 56(b)(l)(A)(i)]. Legal fees for certain discrimination actions are deductible as an adjustment to gross income, so no itemizing is required and the tax benefit is not lost for those subject to the AMT [IRC section 62(a)(20)].
Gifts and inheritances. Gifts and inheritances are tax tree, regardless of the amount (IRC section 102). Certain inheritances, however, ultimately result in income in respect of a decedent [IRC section 691(a)]. For example, a son who inherits a $ 1 million IRA from his mother is not taxed on the inheritance of the IRA, but must report income when distributions are taken. A tax deduction is allowed for the portion of federal estate tax allocable to income when the income is includable [IRC section 691(c)].
Lotteries, gambling, and prizes. Winnings from gaming--whether a casino, lottery, or game show--can be worth millions of dollars; these types of winnings are fully taxable. If a lottery winner opts to take the payout in installments, the winner is taxed only when installments are received [IRC section 451(h)].
Whistleblower awards. The government pays whistleblowers for information that leads to recoveries resulting from fraud in banking, government contracting, Medicaid, public securities, taxes, and more. Some whistleblower awards result when the government successfully pursues the whistleblower's information; the IRS has two such types of award (see the IRS informant award program at http://bit.ly/2gOS6Mb). Others are qui tam awards payable to private persons who bring an action on behalf of the government; for example, in June 2016 there was an SEC award to an individual of more than $17 million (http://bit.ly/2j507eN). Courts have routinely treated all whistleblower awards as taxable ordinary income despite claims that the awards should be characterized as capital gains for the sale of information [e.g., Patrick v. Comm V, 142 TC 124 (2014)].
Attorneys' fees relating to whistleblower awards are deductible from gross income [IRC section 62(a)(21)]; no itemizing is required.
The above information focuses on federal income tax law; state and local taxes should also be considered.
Business IPOs and buyouts. Entrepreneurs may turn a good idea into a potful of money when they sell to new owners or take their companies public. Because of the hard work put into building the company, they may not necessarily think they have reaped a windfall. Nonetheless, what they do with the money entails many of the same considerations for other windfalls.
Going public does not result in any immediate tax consequences for the owner, his holdings merely become more valuable. The sale of the corporation, however, usually produces capital gains for the owner. Taxable income may also result from asset sales (as opposed to stock sales) related to ordinary income property, such as inventory.
Tax Strategies for Offsetting Windfall Income
If a windfall is taxable, there are several ways to minimize taxes due.
Income splitting. Income splitting is a strategy in which income is shared so that it is taxed among several people. For example, if there is a winning lottery ticket, reporting multiple owners of the ticket spreads the resulting income accordingly. When trying to spread income within the family, however, the person holding the winning ticket must be able to show there was an agreement or arrangement in place to share the prize before the winning number was picked; otherwise, it is only an attempt by the winner to shift some of the tax burden to others.
In the spirit of shifting income, an individual may give cash or property to a family member so that the resulting income is taxed to the recipient. For example, an individual who is providing support to a parent may give dividend-paying stock to the parent so the parent collects the dividends and then uses them for her support. There are two considerations here:
* Federal gift tax rules. Gifts to individuals are free from federal gift taxes up to the annual gift tax exclusion ($14,000 in 2017). This can be used for as many recipients as desired. The person can also pay medical bills and tuition directly to a service provider (doctor/school) for another person with no dollar limit. The donor can also use his lifetime exemption amount ($5.49 million in 2017). Deciding how much to give away and to whom are important questions to answer.
* The tax situation of the recipient. Income shifting, for example, will not work well for a child who is subject to the kiddie tax because such income is effectively taxed to the child at the parent's marginal rate.
Charitable contributions. Someone receiving a windfall is in a position to give generously and take a charitable contribution deduction (IRC section 170). With large windfalls, setting up a charitable foundation may enable the person to obtain sizable tax deductions up front and oversee the disbursement of the funds for favored charitable purposes. Alternatively, individuals may give to donor-advised funds, such as Fidelity Charitable and Vanguard Charitable, to influence the organizations that will benefit from the donations.
In making charitable contributions, certain adjusted gross income (AGI) limits apply. Cash donations directly to qualified charities, including donor-advised funds, are capped at 50% of AGI. Cash donations to a private foundation are limited to 30% of AGI. Donations in excess of the AGI limit can be carried forward for up to five years.
Withholding and estimated taxes. Some windfalls, such as gambling winnings and lotteries, are subject to automatic withholding. If the winnings, minus the wager, exceed $5,000, then withholding of federal income taxes at a rate of 25% is required. The Tax Foundation has a map showing state-level withholding on lottery winnings (http://bit.ly/2gQfkBD). Most windfalls, however, do not have automatic withholding. It is up to the individual to ensure that sufficient estimated taxes are paid on a taxable windfall to avoid estimated tax penalties.
When determining withholding and estimated tax requirements for the year of the windfall, other related changes, such as quitting a job, having to repay the premium tax credit that was obtained on an advanced basis, and loss of a child's scholarship, may also have an effect.
When an individual receives a windfall, there is likely a need for comprehensive financial and estate planning. Below are some considerations.
What to do with the windfall How much of the windfall should be invested, how much donated, and how much spent? Unfortunately, many who obtain a windfall blow it on extravagant purchases, such as fancy cars, jewelry, and expensive trips.
Many financial advisors suggest that those who receive windfalls should take it slow. For example, in the case of an inheritance from a deceased spouse, advisors often suggest not making any big financial decisions for six months, to give the surviving spouse time to mourn and adjust to the concept of newfound wealth.
Investment strategies. Some windfalls may need to be invested safely in liquid assets, such as awards in personal injury actions that are needed for future medical costs. The size of the windfall may influence investment decisions; for example, a modest windfall may be invested for growth, while a sizable windfall may lead the individual to seek capital preservation. In many cases, municipal bond holdings may be more attractive than taxable investments. Revising asset allocations and holdings should be an ongoing process.
Insurance needs. The need for various types of insurance may change as a result of a windfall:
* Life insurance. Proceeds from life insurance to support a family may become unnecessary in light of a windfall; however, this insurance may be needed to provide liquidity for paying estate taxes.
* Long-term care insurance. This policy may no longer be needed, as the person can afford to pay nursing home or in-home care costs out of pocket.
* Umbrella policy. This type of added liability coverage may need to be obtained or increased, as wealthy individuals often become targets for lawsuits.
Estate tax planning. A windfall can mean that the person's gross estate will be larger than the federal exemption amount ($5.49 million in 2017) and thus subject to taxation, which can be minimized or avoided with estate tax planning.
State estate tax exemptions must also be factored into estate planning.
The windfall recipient should revise her will to reflect new testamentary disposition plans. She may also want to use a variety of trusts to accomplish certain financial and personal goals, such as a charitable lead income trust to provide income to a charity for a term of years or the life of the grantor, which generates a large upfront deduction while preserving assets for the grantor and family.
Living with the Consequences
Sudden newfound wealth can be emotionally as well as financially challenging. To avoid problems related to the receipt of a windfall, individuals need a team of advisors--attorneys, CPAs, financial planners, investment advisors--offering legal, tax, and financial advice on what to do. Windfall recipients should consult with this team on a regular basis to monitor their wealth and revise strategies when needs or goals change.
Sidney Kess, JD, LLM, CPA, is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman & Co., LLP. He is a member of the NYSSCPA Hall of Fame and was awarded the Society's Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Advisory Board. James R. Grimaldi, CPA, and James A.J. Revels, CPA, are partners at Citrin Cooperman.
Checklist for Windfall Recipients
--Have you put together a team of advisors (attorney, CPA, financial planner, investment advisor)?
--Have you paid sufficient federal and state income taxes (through withholding and estimated taxes) for the windfall?
--Have you set short-term and long-term goals now that your financial picture has changed dramatically?
--Have you decided on how much to spend frivolously?
--Have you settled up outstanding debts (e.g., credit card balances, student loans)?
--Have you decided how much to give to charity (and how to make the donations)?
--Have you decided which relatives and friends you'll give money to, and how much?
--Have you written or revised legal documents (wills, trusts, powers of attorney)?
--Have you reviewed insurance needs?
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|Title Annotation:||COLUMNS: The Financial Advisor|
|Author:||Kess, Sidney; Grimaldi, James R.; Revels, James A.J.|
|Publication:||The CPA Journal|
|Date:||Oct 1, 2017|
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