Question: My husband and I recently won the grand prize from my State’s lottery. Can you provide some guidance on how we will be taxed on our lotto winnings?
Answer: Lottery payments are subject to tax as ordinary income. While there is little you can do to avoid this income tax, there are steps you can take to minimize the tax burden.
The first decision you need to make is who the real winner of the lottery is. If you happen to have friends or family members that contributed to your lottery ticket purchases, you can establish a partnership arrangement as the lottery winner. Partnerships are not subject to Federal income tax at the entity level; any income earned by the partnership flows through and is taxed to the partners in the partnership on their personal income tax returns. The Internal Revenue Code allows partnerships to be established in writing by the due date, without regard for extensions, of the tax return for the year in which the partnership is established. Accordingly, there should be ample time for you to establish a written partnership agreement.
Based on the Federal progressive tax rate structure whereby income tax rates increase as income increases, the income tax rates arising from partnership lottery winners may collectively be taxed at lower rates. The highest marginal income tax rate for a married couple filing a joint income tax return is 37% and that tax rate is reached at approximately $700,000 of taxable income. A partnership with multiple owners will allow more income to be taxed at lower tax brackets.
If a partnership is identified as the lottery winner, you need to consider which if any States impose an income or similar tax on partnership income. Depending on the nature of the State tax, you may be able to minimize or eliminate the State imposition. Federal tax law allows a partnership to elect not to be treated as a partnership for tax purposes in certain instances, an election which most if not all States will recognize. If your State of residence imposes some type of imposition on partnerships, you should consider having the partnership make an election out of partnership status for Federal income tax purposes. This election will not impact the Federal taxation of lottery winnings.
Another critical decision is whether to accept the lottery winnings in one lump sum payment or in installments, payable over a period of years. Although the lump sum option protects the winner against the risk of a State becoming unable to make future payments, the installment option offers better tax and other benefits. Where lottery payments are made in installments over a period of years, the lottery winnings will be taxed as payments are received each year, thereby permitting the recipient to benefit by not having most of the payments taxed at the highest marginal tax bracket in the year the lottery ticket is presented for payment. The lump sum option usually comes with a significant discount meaning something less than the stated lottery earnings will be paid if the payment is made at one time. For the unsophisticated lottery winner, the installment option may serve as a safeguard from imprudently spending the entire winnings at one time. Lottery winners whose investment and personal needs are in excess of the first year’s annual payment can explore borrowing money from a bank or other lender who may be willing to loan funds to a borrower who will be receiving a guaranteed stream of payments for a period of years.
The installment option also offers a lottery winner the option to migrate to a different State with lower or perhaps no income tax rates. Currently, nine states do not impose an income tax, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. If, for example, a lottery winner resides in a high-tax State, barring some nuance in State law, a lottery winner can change his or her domicile to a State that does not impose an income tax and thereby avoid State income tax on payments received after the move.
While congratulations are in order for the good fortune you have experienced, you should recognize that there are significant tax and other obligations that await you as a lottery winner. Careful consideration of your available options is necessary to address the tax and other burdens you will face.
The Tax Corner addresses various tax, estate, asset protection, and other business matters. Should you have any questions regarding the subject matter or if you have questions, you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.