I Won! Now What? What Is the Tax Price of Success? - Think Outside the Tax Box

I Won! Now What? What Is the Tax Price of Success?

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Lucky and talented folks win all sorts of prizes and awards. Often, the winnings have nothing to do with the winner’s business or profession, but sometimes there’s a professional or business connection.

You might view your career arcs as a series of applications, interviews, hiring, promotions with one or multiple employers. But some career paths – musicians (both instrumental and vocal), songwriters, and composers come to mind – involve frequent auditions with a healthy dose of competition.

The renown and visibility afforded to competition winners often open doors to career advancement – more and better engagements, management contracts, and media/recording opportunities.

Competition prizes and awards are taxable. But these winnings might also be subject to self-employment tax that can be up to 15.3 percent on the taxable amount. While most professional musicians are in the business of being musicians, very few consider themselves in the business of being competition participants. The distinction is important and allows for tax planning and savings opportunities.

To learn which is better for tax planning, keep reading.

Background

Although not specifically defined in the Internal Revenue Code (IRC), prizes and awards are discussed in IRC Section 74 and associated regulations. We distinguish them from scholarship and fellowship grants used to cover qualified tuition and related expenses.[1]

There are limited exclusions from gross income for certain prizes and awards transferred to charities (Former President Obama got this right with his $1.4 million Nobel Peace Prize in 2009),[2] employee achievement awards,[3] and Olympic and Paralympic medals and prizes (subject to adjusted gross income or AGI limits).

Still, most prizes/awards are taxable, and, for this article, we’ll assume ineligible for any of the exclusions. Prizes and awards are also taxable gifts, although they may seem like a figurative gift to the recipient. A Supreme Court Case in 1960 defined that a gift “proceeds from a ‘detached and disinterested generosity…’ out of affection, respect, admiration, charity, or like impulses.”[4]

Prizes and awards weren’t always taxed as broadly as they are today. Before 1986, many prizes were not taxable unless the recipients had to perform significant services to receive the award.

Many prizes and awards come with an extensive application/audition process. Others have no formal application and may come as a complete surprise to the recipient (the MacArthur “Genius Grant” is one of the better known examples).

Some competitions rise to the level of international media events. Many focus on a particular instrument, repertoire, style of music, or population. Some have specific parameters or “strings attached” to the winnings. Others, such as the MacArthur Fellowship, have no restrictions or guidance. We’ll assume, for this discussion, that the taxpayer receives a taxable prize/award of cash or property/goods/services with a readily determined fair market value (FMV).[5]

If you have good winning news, pop the cork, have a toast, and celebrate your success. Then, it’s on to accurately and completely reporting the income while using every lawful method to ensure they pay the lowest possible tax.

Initial Questions

How much? You may receive a Form 1099-MISC. You may not. If you’re a tax pro, it’s important to inquire about prize/award money as part of your client organizer or interview.

When? Sometimes prizes/awards are paid out across multiple tax years, so if you win $625,000 from the MacArthur Foundation, understand when you’ll receive the cash; you receive that ratably over five years.

Are any strings attached? Do you have to do anything as a condition of the prize/award?

Are there any restrictions or requirements? Did you pay other contractors?  If so, you may have a reporting requirement to file Forms 1099-NEC or 1099-MISC.

Further Analysis:

Is it self-employment income?

The disadvantage to an affirmative answer is that you may face an additional tax. 

Generally, self-employment tax applies to net earnings from a trade or business and is on both gross income and related expenses on Schedule C (or Schedule F for a farm). This strategy can bring some benefits, primarily you’re allowed to deduct your costs in generating your prizes. 

Professional gamblers, for example, can be in the business of gambling and can deduct expenses from their earnings in determining taxable income.  Is it possible to be in the business of entering and winning competitions? Facts and circumstances prevail, but generally, the prize/award is not compensation for goods and services.

Is it hobby income?

If it’s not trade or business income, subject to self-employment tax, is it considered an activity not carried on for profit as described in IRC Section 183 and associated regulations? A handy reference (although not substantial authority) is the IRS revised Audit Technique Guide Publication 5558 (9-2021). While the purpose of this guide is to help IRS agents conduct hobby loss audits to determine whether taxpayers can deduct losses (trade or business) or not (hobby), it’s always good to have the IRS playbook and its collective research.

Where to report the income

If you file a Form 1040,[6] report this income on Other Income line 8 on Form 1040 flowing from Schedule 1 line 10. For 2021, the IRS expands Schedule 1 line 8 to include subcategories a-z (skipping from r-z) with prizes and awards on line 8h.

Where to deduct the expenses

Artists often use their prize winnings to launch new projects and, therefore, have expenses to deduct against the prize income. Before the 12/2017 enactment of the Tax Cuts and Jobs Act (TCJA), we had a catch-all Schedule A deduction for miscellaneous expenses, even though most were subject to a limitation of 2 percent of AGI. TCJA eliminated most of the miscellaneous Schedule A deductions.

Could there be a taxpayer-friendly mismatch between the prize/award income not subject to self-employment tax and related business expenses deducted on Schedule C and reducing other income subject to self-employment tax? The U.S. Tax Court determined in Jorge Quintanilla v. Commissioner (TC Memo 2016-5) that the taxpayer (a stage technician) could deduct his business expenses on Schedule C even though the bulk of his income came from W-2/union contracts. Judge Mark Holmes states: “The big issue is whether Quintanilla correctly reported his business expenses on Schedule C (the schedule that people who are in business for themselves use to report their expenses) and not on Schedule A (the schedule that people who work for somebody else use to report business expenses). The distinction matters because the Code limits Schedule A deductions more than limits Schedule C deductions.” It mattered in 2016, and it matters even more since TCJA eliminated the miscellaneous itemized deduction option.

Example

Cassie Composer entered her work in a competition and won $70,000. There were no restrictions on how or when she used the funds. In the same tax year, Cassie used $35K to finance a new project. She hired musicians to perform, engaged a publicist, rented a concert venue, and paid for catering and other services related to the performance. Cassie reports the $70K as other income and deducts the $35K as Schedule C business expenses, reducing her other Schedule C net profit and associated self-employment tax.

Summary

Preparing for competitions is hard work. Deducting business expenses on Schedule C, reducing net profit subject to self-employment tax, while reporting the winnings as other income allows artists to maximize their winnings while minimizing their tax.

[1] IRC § 117. Watch out for taxable prizes and awards called scholarships or fellowships and vice versa. Ask for additional documentation as needed; many programs have robust web-based descriptions available online.

[2] IRC § 74(b).

[3] IRC § 74(c).

[4] Comm. v. Duberstein, 363 U.S. 278 (1960).

[5] The FMV of prizes and awards may not be readily determined. See Rev. Rul. 58-347, Rev. Rul. 67-40, McCoy v.

Comm., 38 T.C. 841, Turner v. Comm., T.C. Memo 1954-38, Wade v. Comm., T.C. Memo 1988-118.

[6] We also see U.S. prizes and awards granted to non-residents, a situation beyond the scope of this article, but if you encounter this scenario, please check for tax treaty provisions, especially the treaty articles pertaining to Artistes and Athletes #17, Visiting Professors and Teachers #20, Students, and Trainees, and Other Income #21.

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