Windfalls and the Taxman

A windfall is a sudden, unexpected good fortune. It usually is a sum of money and/or property, and it could be substantial. Taxwise, the windfall may be tax-free income, fully taxable, or something in between.

Gifts and Inheritances

When you receive a gift or an inheritance, you are not taxed on this windfall. There is no dollar limit on the amount you can receive tax free. For example, if you’re getting married, your wedding gifts, including cash, are fully tax free regardless of amount.

Caution: Do not confuse gift and estate tax rules imposed on the transferor (the party giving you the property) with income tax rules imposed on the recipient (you). Even though the annual gift tax exclusion is $13,000, this has no effect on your tax-free treatment.

Life Insurance

If you receive life insurance proceeds as the beneficiary of a life insurance policy, the proceeds usually are tax free. Again, there is no cap on the amount you can receive free from any income tax.

However, if a policy was transferred to you “for value,” you may be taxed on the proceeds (in excess of what you paid for the policy). “Value” can include an outstanding loan on the policy that you, in effect, take over.

For example, say an elderly parent no longer needs life insurance. He borrows some of the cash value and then gives the policy to his adult child. The child will be taxable on the proceeds received on the parent’s death (over the value paid, which is the outstanding loan amount).

Lottery and Other Gambling Winnings

Any gambling winnings, including lottery payoffs, are fully taxable as ordinary income. Say you win a lottery jackpot that’s payable in annual installments over a number of years. If you sell your right to the payoffs for a lump sum now, you still realize ordinary income even though you’ve made a sale. You can’t convert what would have been ordinary income (the lottery installments) into capital gains by selling the right to receive the installments.

You cannot offset gambling winnings by gambling losses to report only the net amount. Instead, you must report all winnings and then claim an itemized deduction for losses (up to the extent of winnings for the year).

Lawsuit Awards

If you successfully recovery money through a lawsuit-either by a settlement or a court decision-the tax treatment depends on the nature of the lawsuit. Here is a partial list of the types of actions and the treatment of the awards:

• Personal physical injury or illness-award is tax free.
• Personal nonphysical injury (e.g., defamation)-award is taxable.
• Punitive damages for any type of injury are taxable.
• Contract disputes-awards are taxable.

Demutualization of Life Insurance Companies

If you’ve been a policyholder and the company has “demutualized” (from a customer-owned company to a stock company), the shares you receive upon demutualization are not taxable. This is viewed by the tax law as a tax-free transaction because you are giving up certain rights in exchange for the stock.

When you sell the shares, any gain in excess of basis is taxable to you. But what is your basis in this case? The IRS says that basis in this case is zero (as explained in the 2009 instructions to Schedule D of Form 1040). However, courts have concluded that there is some basis on the shares received upon demutualization. There is no clarity about what the basis should be. Some options: the value of the stock on the date of demutualization or the amount of premiums paid for the policy. Work with a tax advisor if you are selling shares received in a demutualization.

Estimated Taxes

Don’t let a taxable windfall cost you unexpected tax penalties. Be sure to figure the taxable windfall amount into your estimated taxes for the year.

You may be able to reduce your tax exposure for the year by giving some of your windfall to charity. Be sure to note adjusted gross income (AGI) limits on charitable contribution deductions (usually, deductions for cash contributions can’t exceeds 50% of AGI).