The IRS and Your Lottery Winnings

February 13, 2013 by Bart Chepenik

The odds of winning the recent Power Ball jackpot were somewhere around 1 in 175 million. While the chances of hitting that $575 million dollar jackpot were absurdly low, the odds of winning a smaller jackpot are much less daunting. If you are one of the lucky to hit a lottery jackpot, do not get lost in the excitement. The money is not yours free and clear. All lottery winnings constitute income under the Internal Revenue Code, and, therefore, come with tax implications. Have no doubt, lottery winnings are taxable income, and Uncle Sam needs to get his taste of the action. Lottery winnings are taxed at a marginal rate of 35% to the winner or winners. There can also be gift taxes associated with sharing the winnings with friends, family members, or a group that purchased the winning ticket. Thus, with the excitement of hitting the jackpot, comes the necessity for planning.

How you claim your lottery prize can make a difference. Do you want to take the annuity? Or the lump sum? Do you want to claim the prize personally? Or set up a trust? Or set up a business entity like a limited liability partnership? What happens when there is a group who contributed to the winning ticket?

Looking at the classic scenario where coworkers in an office or family members contribute to the winning lottery ticket, what can the group do to help alleviate all of the tax issues that come with their winnings? Creating a partnership could help solve two of the biggest tax issues – the income tax and the gift tax. A partnership is taxed as a see through business entity, meaning that the partnership itself does not pay taxes; rather, the individual partners personally pay the taxes on the income to the partnership. This has the effect of splitting up the income between the partners, so each partner can save on the income tax because they can each be taxed at a lower bracket rate before reaching the highest marginal rate. With large jackpots, like the recent Powerball, this might not make a difference, but it could with smaller winnings.

A partnership can also help alleviate potential gift tax issues. If one winner comes forward to claim the prize on a ticket purchased by the group, that person is going to face major tax implications when they distribute the money to the other members of the group. There is only a certain amount of money a person can give away tax free. After that, monetary gifts are taxed at a rate of 35%. So, when a partnership claims a prize based on a ticket purchased by a group, the partnership can classify the purchase of the ticket as a group investment and possibly avoid a very hefty gift tax.

If all of this sounds too easy or too good to be true, that is because it may well be. Our friends at the IRS are no fools, and they know that partnerships like the ones mentioned above are often set up as a means to avoid the large taxes associated with lottery winnings. The IRS wants its money, and, make no mistake, they will get it. If audited, there can be serious consequences to setting up a sham partnership to claim lottery winnings. One thing the IRS will inevitably ask for is for proof the partnership was set up prior to purchasing the ticket. They will want to see the documentation supporting this, and the IRS will also be curious about the money each member of the group contributed and the group’s lottery ticket purchasing history. The IRS will be aiming to verify that it is a valid partnership and not just one that was set up to avoid the taxes associated with winning the lottery.

Whether you, your family, your co-workers, or friends, are habitual lottery players or only play those rare mega-jackpots, playing the lottery and winning has consequences. This is also true if you hit it big in Vegas. Gambling winnings are subject to the same taxes. Proper planning can help ensure that you get the most money out of your winnings. The experienced legal team at Chepenik Trushin can help you minimize the tax consequences of winning and help you keep as much of your winnings as possible.