Friday, July 22, 2016

Immediate and Long-Term Tax Strategies for Windfalls


Individuals may have financial windfalls because of a variety of occurrences. Some windfalls result from good fortune, such as winning the lottery or selling a business, while others result from bad fortune, such as medical malpractice or an inheritance. Either way, there are tax consequences to consider. Some consequences are immediate, while others have a long-term impact.

Immediate Tax Consequences

The receipt of a windfall may be taxable or tax-free. The general rule is that income from whatever source derived is includible in gross income (Code Sec. 61). However, there are various exclusions that transform some recoveries into tax-free income.
Damages. Damages from lawsuits, settlements, and awards are taxable unless they are payable for a personal physical injury or sickness (Code Sec. 104(a)(2)). Thus, damages received for a non-physical personal injury, such as defamation or discrimination, are taxable. So too are punitive damages and damages for back pay and other taxable compensation. Interest paid on a judgment usually is taxable.
When an attorney agrees to represent an individual on a contingency basis and there is a recovery, the individual is taxed on the entire award (Banks II, S.Ct., 543 U.S. 426 (2005)). This is so even though the individual does not actually receive the entire award because one-third (or whatever portion was agreed upon) is disbursed directly to the attorney.
Damages for a wrongful death claim typically are comprised of 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 while the portion for punitive damages is taxable. However, if a wrongful death claim is made under a state statute that treats all of the recovery as punitive damages (i.e., precludes compensatory damages), the recovery is fully excludable for federal income tax purposes (Code Sec. 104(c)).
Damages for emotional distress resulting from a nonphysical personal injury, such as job discrimination, are excludible only 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 not tax-free. For example, in one recent case a postal worker could not exclude damages for these soft injuries arising from her discrimination action; the discrimination did not cause any physical injuries (Barbato, TC Memo 2016-23).
Damages received to compensate for property losses may be tax-free if the recovery does not exceed the individual’s basis in the property. The recovery is treated as a tax-free return of capital (Code Sec. 1001).
As a general rule, legal fees to recover tax-free damages are not deductible while legal fees to recover taxable damages are deductible. Deductible legal fees related to personal injury usually are treated as miscellaneous itemized deductions, which can be written off only to the extent total miscellaneous itemized deductions exceed two percent of adjusted gross income (Code Sec. 67(a)). Miscellaneous itemized deductions are not deductible for purposes of the alternative minimum tax (Code Sec. 56(b)(1)(A)(i)). However, legal fees for certain discrimination actions can be deducted as an adjustment to gross income (Code Sec. 62(a)(20)).
Gifts and Inheritances. The receipt of gifts and inheritances are tax-free, regardless of amount (Code Sec. 102). However, recipients of income in respect of a decedent must include it in their gross income when received (Code Sec. 691(a)). Thus, a person who inherits a $1 million IRA is not taxed on the inheritance of the IRA. However, when distributions are taken from the IRA, they are taxed to this beneficiary.
A person reporting income in respect of a decedent can take a deduction for federal estate tax allocable to income when the income is includible (Code Sec. 691(c)).
Lotteries, Gambling, and Prizes. Good luck can translate into millions of dollars. In January 2016, three winners split a Powerball jackpot of $1.6 billion, and in May 2016, one lucky winner hit the $429.6 million Powerball jackpot. These measures of good luck are fully taxable. In the case of lottery winnings, the only question is when the winnings are taken into income.
If a lottery winner opts for the lump sum, it is fully taxable in the year of the drawing (Code Sec. 451(a)). If the winner opts for the payment in installments, the winner is taxed only when installments are received (Code Sec. 451(h)).
Business IPO and Buyouts. Entrepreneurs may make it very big, taking their companies public or selling to new owners. While not necessarily thought of as a windfall because it may be years in the making, the resulting money from the deal presents similar challenges to these individuals.
Going public does not result in any immediate tax consequences for the owner. His or her holdings merely become more valuable. The sale of a business usually results in capital gains for the owner. However, asset sales (as opposed to stock sales) may trigger some ordinary income; ordinary income results from the sale of ordinary income property (e.g., inventory).
Whistleblower Awards. The government pays for information that leads to recoveries for fraud in Medicaid, government contracting, banking, taxes, public securities, and more. For example, there are two types of whistleblower awards from the IRS (Some of these are whistleblower awards where the government pursues information provided by individuals and then shares the recovery. Others are qui tam awards for private persons who bring an action on behalf of the government.
These awards can be in the millions of dollars. For example, an SEC award to an individual in June 2016 was more than $17 million ( Individuals receiving these awards have argued that they are capital gains, but the courts have routinely treated them as ordinary income (see, e.g.,Patrick, 142 TC 142 (2014), aff’d 2015-2 USTC ¶50,454 (7th Cir.)), where the courts rejected the taxpayer’s argument that he sold information and that his recovery was a capital gain).
Attorney fees relating to whistleblower awards are deductible from gross income (Code Sec. 62(a)(21)).

Offsetting Windfall Income

If a windfall is taxable, there are steps that can be taken to minimize taxes.
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. However, when trying to spread income in the family, 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 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 his/her support. There are two considerations here: (1) federal gift tax rules that may influence the size of the gift and (2) 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 (i.e., no tax savings for the family).
Charitable Contributions. Someone receiving a windfall is in a position to give generously and take a charitable contribution deduction (Code Sec. 170). With large windfalls, setting up a charitable foundation may make sense to enable the person to obtain sizable tax deductions up front and oversee the disbursement of the funds for favored charitable purposes.
Withholding and Estimated Taxes. Some windfalls (e.g., gambling winnings, lotteries) are subject to automatic withholding. Most others are not. It is up to the individual to ensure that sufficient estimated taxes are paid on a taxable windfall to avoid estimated tax penalties.

Long-Term Impact

When an individual receives a windfall, likely there is a need for comprehensive financial and estate planning. Here are some tax-wise considerations:
• What investments should be made with the windfall? Some windfalls may need to be invested safely in liquid assets (e.g., a windfall needed for future medical costs). In other cases, an individual may want to invest for growth or tax-free income. For example, municipal bond holdings may be more attractive than taxable investments because the windfall recipient has been pushed into a higher tax bracket.
• Is there a concern about death taxes? For example a windfall can mean that the person’s gross estate will be larger than the federal exemption amount ($5.45 million in 2016) and subject to estate tax; the tax can be minimized or avoided with estate tax planning. State death tax exemptions must also be factored into estate planning.


Practitioners who have clients that receive windfalls can provide valued advice on handling the new-found wealth. Consider not only federal income tax implications, but also state and local taxes.