Copyright 2010 ProQuest Information and LearningAll Rights ReservedCopyright 2010 New York State Society of Certified Public Accountants The CPA Journal
TAXATION: FEDERAL TAXATION; Pg. 30 Vol. 80 No. 4 ISSN: 0732-8435
Tax Implications and Other Considerations of Winning a Lottery
Hyder, Stephanie M; Roush, Melvin L; Fay, Jack R.Jack R. Fay, PhD, CPA, is a professor of accounting at Pittsburg State University, Pittsburg, Kans. Stephanie M. Hyder is an accountant in the state and local tax department at Marks Nelson Vohland Campbell Radetic LLC in Overland Park, Kans. Melvin L. Roush, PhD, CPA, is a professor of accounting, also at Pittsburg State University.
ABSTRACTLotteries have a long history in the US. Early lotteries raised funds that assisted with the construction of toll roads, bridges, universities, schools, and churches. Most states now have lotteries. In general, the assessment of gift and estate taxes on lottery winnings is similar. The choice of whether to opt for an annuity or take a lump-sum payout may affect the tax liability of the winner. Lotteries divide the prize equally when there are multiple ticket winners: however, states vary on how they handle lottery pools. States also vary in how much information they disclose about winners but most do not let one remain anonymous. Winners may preserve a measure of anonymity if they are allowed to claim their lottery winnings as a legal entity. Winners of major lottery amounts are advised to consult with accountants, financial planners, and lawyers concerning the receipt, use, taxation, and disposition of their winnings. FULL TEXTCurrently, 43 states and the District of Columbia sponsor or participate in state or regional lotteries. Lotteries have a long history in the United States. As early as 1612, the Virginia Company used lotteries to raise funds for the settlement of Jamestown. In 1621, these lotteries generated nearly half of the Virginia Company's annual income. Early lotteries raised funds that assisted with the construction of toll roads, bridges, universities, schools, and churches. Lotteries helped build Harvard, Dartmouth, Yale, Brown, and other institutions of higher learning (Encyclopedia Britannica, 2005). The first "modem" lottery began in New Hampshire in 1964, and its proceeds supported education (Georgia Lottery Corporation).Multistate lotteries. Most states now have lotteries. All of the states that have lotteries (and Washington, D.C.) also participate in multistate lotteries. See Exhibit 1 for a list of the multistate lotteries and the particular games offered.The states that currently do not operate or participate in any lotteries are Alabama, Alaska, Hawaii, Mississippi, Nevada, Utah, and Wyoming. Reasons for not participating in a lottery range from protecting the state's citizens from the "deiroralizing influenee" of gambling to political pressure from otiier gambling associations that view a staterun lottery as unwelcome competition. Gift and Estate Tax Considerations on Lottery WinningsFor someone lucky enough to win a lottery, the first questions are: What do I do with the money? Do I give it away? What are die tax implications of such a generous impulse? What are the implications for my heirs? In general, the assessment of federal gift and estate taxes is similar. The top marginal rate for the gift/estate tax in 2007 tiirough 2009 was 45%. The estate tax has been eliminated for 2010, unless Congress decides to change tiie law retroactively, and the gift tax top marginal rate has decreased to 35% (TRS Publication 950).Gifts. Some gifts may be excludable from a lottery winner's gift taxes if the amounts fall under the limitations set forth by the IRC. A winner may gift $13,000 per person per year to an unlimited number of people without incurring a tax liability on the gifts. A married couple may give the same individual a total of $26,000 (IRS Publication 950, Introduction to Estate and Gift Taxes, for 2009).Other excludable gifts include those given to one's spouse, a political organization, a charity, or an educational or medical institution for tuition or medical expenses of another person. Under this exemption, a grandparent who wins tiie lottery could pay the tuition of grandchildren, and the gift would be untaxed."Gifts of future interest" must be included on a lottery winner's gift tax return. ERS Publication 509. Tax Calendars, defines a gift of future interest as "a gift that is limited so that its use, possession, or enjoyment will begin at some point in the future." Thus, a grandparent who won the lottery could purchase securities for grandchildren, but the gift would be taxable (IRS Publication 950).Estates. Generally, if a lottery winner dies prior to receiving the entire prize amount, the estate or beneficiary inherits the remainder. Arizona, Delaware, Maryland, Pennsylvania, and Virginia require a winner to name a beneficiary upon claiming the winning ticket, with the option of changing the beneficiary in the future. Michigan will award the remaining prize money to a surviving spouse and children in equal amounts, unless none exists, in which case the winnings become part of the estate.Most states will continue to make annual installment payments as scheduled after a winner's demise. In some states, however, the estate has the option to receive a lump-sum payout on the present value of the annuity. The states offering a cash payout option are Illinois, Minnesota, North Dakota, South Carolina, and Washington. In Rhode Island and West Virginia, the estate must take legal action to exercise the option. In Washington, D.C, the estate must petition the lottery's executive director to receive a lump-sum payout One state, Ohio, does not offer an option; the remainder of the prize is payable to the estate's executor, administrator, or trustee as a discounted lump-sum payment. Not all lottery annuities are transferable; the "Win for Life" or "Lucky for Life" game annuities cease when the winner dies.After the death of a lottery prizewinner, the executor must complete a final income tax return and possibly an estate tax return for the individual. For an estate tax return, the executor must calculate the gross estate Oess deductions) to determine the tax liability. The gross estate consists of the value of all property at tiie time of death, including life insurance and annuities payable to the estate. If a gross estate were to exceed the allowable exemption ($3.5 million in 2009), the executor should complete IRS Form 706 and attach a death certificate. Some of the deductions that are allowed for the estate include funeral expenses, debts owed, and property transferred to a spouse or charity (IRS Publication 950).Estates may also be subject to state tax obligations. The prizes of New York lottery winners are subject to state estate tax, and, if the estate is substantial, the entire estate may be subject to taxation. If a winner feels the estate tax liability (federal, state, or both) might be too burdensome for beneficiaries, there are some options, including opting for the cash option or purchasing a life insurance policy to cover the tax liability (Laurence I. Foster, "Here's How Hotline," Tax Hotline, May 2006).Federal and State Income TaxesIn general, winnings over $5,000 impose a 25% federal income tax withholding, deducted when paid to the winner and sent to the IRS on the winner's behalf. All winnings over $600 and at least 300 times the amount of the wager must be reported to the IRS. In either case, the winner will receive a W2-G at the time of payment or in January of the following year. The U.S. federal income tax rates depend upon the residency status of the winner:* 25% is withheld from winnings greater than $5,000; annuities are subject to this withholding rate if the total prize exceeds $5,000.* 28% is withheld from winnings greater than $600 and 300 times the amount of the wager, if the winner does not submit a taxpayer identification number (TJN) or Social Security card.* 30% is withheld from all winnings of nonresident aliens, reported on IRS Form 1042 and 1042-S (Stewart Rouleau, "Withholding on State Lottery Winnings," Federal, State and Local Governments Newsletter, December 2003).State income tax rates on lottery winnings vary widely, from zero to 10%. Several states have set-off programs that check for certain past financial obligations, such as child support and delinquent taxes, which are satisfied first before the remainder of the prize is released to the winner. Exhibit 2 lists state tax rates and relevant issues concerning withholdings.If an individual wins smaller amounts, the winner is required to report those prizes when filing an annual income tax return. In addition, if an individual's winnings include noncash prizes, the fair market value of the items won must be reported (ERS Publications 529 - Miscellaneous Deductions - and 505 - Tax Withholding and Estimated Tax).There are certain deductions allowed with regard to gambling winnings. Such deductions cannot exceed the amount of winnings, however, and are generally not available to nonresident aliens. Gambling losses are reported as itemized deductions and listed as "other miscellaneous deductions" on Schedule A. Thus, gambling losses are not beneficial to taxpayers who do not itemize (ERS Publication 529).The ERS recommends keeping a diary or receipts to provide supporting documentation for any amounts entered on IRS Form 1040 and Schedule A. A record log should include, at the rninimum, the date and type of bet the name and address of the institution where the taxpayer placed the wager, the names of any people present with the taxpayer, and the amount the taxpayer won or lost. Such records may not be practical, but they normally provide the best evidence. Taxpayers would be wise to keep any other documents related to wagers made and claimed, such as lottery tickets, cancelled checks, bank statements, payment slips, and statements of winnings (IRS Publication 529).Lump-sum Payout Versus Annuity The question of whether to opt for an annuity or take a lump-sum payout is a typical concern of lottery winners. The tax treatment is similar with either option; however, the choice made may affect the winner's tax bracket. All winnings are subject to taxes; however, winners may be liable for additional taxes if the withholding rate is lower than their current tax bracket (Farhad Aghdami, "The Morning After. Tax Planning for Lottery Winners," Journal of Taxation, April 1999).if the winner selects the lump-sum, or cash, payout, the taxpayer may land in a higher tax bracket and thus have less of the winnings available to spend or invest. The decision is not one to take Jightíy. A lottery winner should weigh the disadvantage of a higher tax liability with the possibility of investing the funds at a higher return than offered by the lottery commission. In general, lottery administrations invest in zero-coupon bonds or government securities. While considering which option to take, the winner must remember that lump-sum payouts are usually 40% to 50% of the advertised jackpots. The cash payout is the current value of the funds the lottery winner would have to invest at today's interest rates to reach the advertised jackpot (Aghdami 1999).In general, lottery commissions pay annuity options annually in equal amounts over a period of 10, 20, 25, or 30 years. In contrast, a graduated annuity increases progressively each year to allow for inflation, usually 4% per year. Powerball annuities are graduated annuities paid over 30 years - one payment upon claiming the prize and yearly thereafter, usually on the anniversary of the first payment Payment disbursements of lottery winnings that are 20- or 25-year annuities are similar to those of Powerball winnings.States are required to give the winner 60 days from the date of claiming the winnings to make the lump-sum/annuity decision, per IRC section 451(h). Winners should take heed that many prizes automatically become annuities if the winner has not made a decision within the time allowed. Only the annuity amount received each year creates a tax liability for that year (i.e., a 30-year annuity's taxable income for one year is approximately 1/30 of the jackpot amount). In general, taxes are due all at once with a lump-sum payout but an annuity is taxable as received.Another consideration is the sharing of the prize in the case of multiple wanning tickets. Several state lotteries reserve the right to elect a cash payout if the proportionate share of those who chose the same numbers is under a certain amount (i.e., less than $250,000 per share automatically becomes a lump sum payment upon the decision of the lottery commission). The actual jackpot amount may also be a consideration; if the jackpot is below a certain limit the lottery commission may opt for a lump-sum payout rather than an annuity.Certain lottery games do not give the winner the option of cash versus annuity. For example, the "Win for Life" and "Lucky for Life" games are annuities that pay out over the winner's lifetime.Lottery PoolsLotteries divide the prize equally when there are multiple ticket winners. Each state varies on how it handles lottery pools, that is, when multiple players pool meir funds to purchase lottery tickets on a regular basis. Some states only allow one person to claim a winning ticket, other states will award a prize to an entity such as an office pool, and others have no official policy at all.In general, states that allow lottery pools - or allow exceptions to the "one claimant" policy - have the winners complete the state lottery commission's multiple-winner form, IRS Form 5754, or both, for instructions on how to divide the tax liability. A brief summary of the policies on lottery pools for each state and for Washington, D.C, is given below; included are the types of claimant allowed and exceptions to any applicable one-claimant policy. The exception for some states is that the group must be a legal entity: a trust, partnership, or corporation. For convenience, states with similar policies are grouped together.* Arizona - each winner must submit a claim form, show a photo ED, and choose the same payment option (cash or annuity).* Arkansas - each winner must sign a request and release form and indicate her proportionate share of the prize. At least one person must sign the winning ticket.* California - winners complete a multiple-player ownership form (to ensure individual payments); if a player group does not qualify, members from the group should elect a representative to claim and distribute the funds.* Colorado - only one individual may claim the winning ticket; if multiple players are involved, it is the responsibility of the winners to divide the prize.* Connecticut, Delaware, Idaho, Kentucky, Louisiana, Maine, Montana, New Jersey - multiple winners are allowed, but the states have no official policy.* Florida - winners complete a multiwinner form and IRS Form 5754.* Georgia - will only pay one winner; however, the winner may be an individual or an entity. Groups may designate an individual to claim winnings, if desired.* Illinois - winnings of less than $600 will only be paid to one individual; winnings of $600 to $999,999 need one claimant and ERS Form 5754; winnings of $1 million or more may be entitled to form a partnership, in which case the partnership agreement must designate the members who are to receive individual payments (this agreement must be attached to the claim form).* Indiana, New Mexico - multiple winners are allowed and should be designated on the claim form.* Iowa, Washington, D.C. - winnings may be paid to either an individual or to an entity.* Kansas - multiple winners are allowed; one individual must claim but may submit IRS Form 5754 to designate who receives payments and properly distribute the tax liability.* Maine - multiple winners are allowed; winnings are distributed evenly among players.* Massachusetts - multiple winners are not allowed; winnings cannot be claimed in more than one name.* Michigan - winners may claim as individual or group; to form a group, TRS Form SS-4 must be completed, and ERS Form 5754 must be completed to claim winnings.* Minnesota - multiple winners are allowed; they must decide on one individual to claim winnings and compose a prizesharing agreement that designates the percentage of the winnings to which each member is entitled; each member must be entitled to over 1% of the winnings, and the lottery will assist with the composition of prize-sharing agreements.* Missouri - multiple winners are allowed; the claimant (signer of the ticket) designates who will receive winnings and how much they will receive.* Nebraska - multiple winners are allowed; if it is not a legal entity, the group must designate one individual to claim the prize; this individual determines the sole method of payment for the group.* New Hampshire - multiple winners are allowed; each winner signs the ticket and each individual must complete claim and tax forms.* New York - multiple winners are allowed only if they form a legal entity.* North Carolina - the individual or legal entity completes one claim form. If multiple winners are not a legal entity, they must check the "affidavit of multiple ownership" on the claim form, and each member must complete a claim form.* North Dakota - multiple winners are allowed; the claim form lists phone number to call for assistance.* Ohio - multiple winners are allowed; they should contact the nearest regional office for assistance.* Oklahoma - multiple winners are allowed; a group must designate a representative to fill out the claim form and "agreement to share" form. All members must provide two legible forms of ED; one must be a photo ED. Payments will be mailed to members not present unless written authorization is given to a representative.* Oregon - multiple winners are allowed; there is one claimant; however, a request and release form is available to designate shared winnings, which must be signed by all parties.* Pennsylvania - multiple winners are allowed on winnings over $600; the group must designate a representative to sign the winning ticket and to file a claim form with all members listed. "Win for Life" prizes may not be shared.* Rhode Island, West Virginia - multiple winners are allowed on some prizes; first payment will be made to the group representative; individuals and their respective shares will be reported for tax purposes; remaining payments on the annuity will be paid separately to each individual.* South Carolina - multiple winners are allowed; they must be designated on the claim form and attach IRS Form 5754.* South Dakota - only one claimant is allowed, but multiple winners may share winnings by firing IRS Form 5754.* Tennessee - multiple winners are allowed; payments are made to individuals or an entity. If claiming as an entity, the claimant must provide documentation of authority before the prize will be paid.* Texas - multiple winners are allowed; payment is made to an individual or entity. An entity claimant must have a Federal Employer Identification Number (FEIN).* Vermont - multiple winners are allowed for Powerball and Megabucks lotteries.* Virginia - multiple winners are allowed; the group must decide how to share the winnings upon claiming. "Win for Life" prizes may not be shared.* Washington - multiple winners are allowed; only one claimant will be paid, either an individual or legal entity. It is the winners' responsibility to share winnings; entities must have a FEIN.* Wisconsin - all of the following steps must be completed for multiple winners: The multiple claimants box on the claim form must be selected, each claimant must complete a claim form, and a court order must be obtained and sent with the claim to the Madison office. Withholdings will be taken out of each claimant's proportionate share; once filed, no one else may be added.Suggestions for maintaining the integrity of the lottery pool include drawing up a pool contract and supplying each member with a photocopy of the tickets. A lottery pool contract should include the members' names, contribution amounts, share of the winnings, and penalties for nonparticipation. Some states recommend signing the ticket with the entity's name, while other states recommend waiting until the group decides how to divide the winnings. Participants should remember that, whatever the decision, lottery tickets are "bearer instruments" and are payable to whoever presents them. As each state differs in its treatment of lottery pools, a group representative should contact the appropriate lottery commission for advice.AnonymityMost states do not allow a lottery winner to remain anonymous, due to public disclosure laws and the Freedom of Information Act. Nevertheless, there are alternatives when claiming a winning lottery ticket that will allow some degree of anonymity. Generally, information considered to be public knowledge includes the name of the winner, the city of residence, and the amount won. Exhibit 3 shows tiie information disclosed as public knowledge and other relevant details regarding publicity.Careful Tax and Financial PlanningLotteries throughout history have distributed property, awarded prizes, and raised funds for improvements and social programs. In general, the assessment of gift and estate taxes on lottery winnings is similar. The choice of whether to opt for an annuity or take a lump-sum payout may affect the tax liability of the winner. Lotteries divide the prize equally when there are multiple ticket winners; however, states vary on how they handle lottery pools. States also vary in how much information they disclose about winners but most do not let one remain anonymous. Winners may preserve a measure of anonymity if they are allowed to claim their lottery winnings as a legal entity.The information included above is intended to be an introduction to the topic; it should be verified as current before it is used to make individual decisions about specific lottery issues. When dealing with a large sum of money, it is wise to look at all the pertinent issues in order to make the smartest decision. Winners of major lottery amounts are advised to consult with accountants, financial planners, and lawyers concerning the receipt, use, taxation, and disposition of their winnings. SIDEBARWinners should take heed that many prizes automatically become annuities if the winner tes not made a decision within the time allowed.
PhotographsIMAGE TABLE, EXHIBIT 1, Participants in Multistate LotteriesIMAGE TABLE, EXHIBIT 2, State Tax Rates and Authorized State WithholdingsIMAGE TABLE, EXHIBIT 2, State Tax Rates and Authorized State WithholdingsIMAGE TABLE, EXHIBIT 3, Anonymity for WinnersIMAGE TABLE, EXHIBIT 3, Anonymity for Winners
April 21, 2010