Are Merit Awards Taxable?

What if you're fortunate enough to win a merit award for your outstanding contributions to science, art, or your community? Do you have to pay income tax on the amount? The short answer is "yes." Unsolicited merit awards or prizes are fully taxable, subject to one exception for prize money received from the United States Olympic Committee on account of competition in the Olympic Games or Paralympic Games.

This may not seem fair, but the IRS and state tax agencies simply don't care that you didn't ask for the award, or that you got it only after years of hard work that benefits society. To them, money is money, and they want their cut.

If located in the United States, the entity that issued the award will have to report the amount it paid you to the IRS, so you can't pretend you never got it. If you fail to report it on your income tax, the IRS computer will catch you and send you a tax bill. However, whether or not you will actually pay tax on the award will depend on how you use the money.

If you pocket all the money, you'll owe the full income tax on it. The tax will be due for the year in which you actually receive the money. How much you'll have to pay depends on your top tax bracket.

You can avoid having to pay income tax on an award if you give the money away. But you can't give the money to just anybody--a family member for example. The money must be donated to a bona fide tax-exempt charitable organization (also known as a Section 501(c)(3) organization based on the section of the Internal Revenue Code governing such entities). These include any nonprofit organization operated exclusively for scientific, educational, religious, or other charitable purposes, such as relief for the poor. Contributions to government units such as the National Institute of Health are count.

Claim a Charitable Deduction

One strategy is to cash the check, disburse the funds to your selected charity or charities, and deduct the amount as a charitable contribution. If you do this, you'll have to report the award as income on your tax return. But, if you qualify to deduct the contribution, the deduction will offset the additional income you report.

Example: Charles receives a $10,000 award from the American Actuarial Society for his contributions to actuarial science. He cashes the check and then donates the full amount to a 501(c)(3) charity. He includes the $10,000 in his annual income on his tax return for the year. He is able to itemize his personal deductions, so he deducts the $10,000 from his taxes as a charitable contribution. This offsets the $10,000 in income from the award he reported.

However, under the Tax Cuts and Jobs Act ("TCJA") which went into effect on January 1, 2018, it is much more difficult for many taxpayers to deduct their charitable contributions. This is because to do so you must itemize your personal deductions on IRS Schedule A, instead of taking the standard deduction. Your personal deductions include your charitable contributions, home mortgage interest, up to $10,000 in state and local taxes, and a couple other items. The TCJA almost doubled the standard deduction over prior law to $12,000 for single taxpayers and $24,000 for married couples filing jointly. As a result, far fewer taxpayers will itemize and be able to claim charitable deductions because the threshold for exceeding the standard deduction amount is so high.

Example: Assume that Charles from the above example is married. He and his spouse are entitled to a $24,000 standard deduction. Including their $10,000 charitable contribution, their total personal deductions amount to $20,000, so they should not itemize their deductions. As a result, Charles cannot deduct his $10,000 contribution.

If the award is extremely large, you may have little difficulty itemizing your personal deductions. Be aware, however, that the annual deduction for charitable contributions is limited to 60% of your adjusted gross income. So you might have to deduct a very large award over several years.

Exclude the Award From Your Income

Fortunately, there is a way to give an award away without having to report it as income on your tax return and thereby having to deduct it as a charitable contribution. A special tax rule provides that a person who receives a prize in recognition of accomplishments in scientific, educational, literary, religious, artistic, or civic fields need not include the money in his or her income if:

• the award was unsolicited
• you are not required to perform any substantial future services as a condition of receiving the award, and
• before the award is presented, you designate in writing to the entity giving the award that the money be transferred directly by it to a tax-exempt charitable organization or governmental unit (which you may select). The money should never be in your hands. (IRC Sec. 74(b).)

If you do all this, you need not report the award as income on your tax return and you need not take a charitable deduction for it. In other words, for tax purposes, it's as if the award was never made. If you want to give the money to charity, this is definitely the way to go. President Obama did this when he was awarded $1.4 million along with the Nobel Peace Prize in 2009. You can do it too.