Gifts that Aren’t Free

Receiving cash or property at no cost to you is a good thing. But not all of the bounties you receive in this way are tax free. Here are some gifts or other no-cost items that you may receive that will cost you in tax dollars.

Gifts from Your Employer

Gifts from family, friends, or even strangers given from the generosity of their hearts are tax free to you, regardless of the size of the gifts. However, gifts from your employer are usually taxable as additional compensation (and usually are subject to FICA taxes as well). It has long been settled in the tax law that there cannot be such detached generosity in an employer-employee situation. Some examples of taxable gifts include:

• Year-end bonuses
• Holiday gifts in cash in any amount (including gift certificates and gift cards)
• Employee achievement awards other than those made under a written plan that does not discriminate in favor of highly compensated employees, and which average $400 or less during the year.

Exception: Gifts of nominal value, such as a box of mixed nuts or a holiday turkey or ham, are not taxed.

Withholding. Gifts by employers are subject to withholding. If your employer opts to “gross up” a noncash gift to cover the taxes, the additional payment is also taxable income (there is a formula that your employer will use to figure this amount). Withholding on noncash gifts can be made at a flat 25% rate.

Inherited IRAs and Other Untaxed Income

Inheritances are tax free, but there’s a catch when that inheritance involves untaxed income from retirement plan benefits, IRAs, and commercial annuities. In this case, receiving the inheritance is tax free, but receiving the funds from the inheritance is taxable. For example, say you inherit a $100,000 traditional IRA in August 2010. You are not taxed on this inheritance when you receive it. In 2011, you withdraw $25,000 from the IRA, so you must include $25,000 in your income next year.

Tip: If the inheritance is subject to federal estate tax, you can claim an itemized deduction for the portion of the tax related to the income you report. This miscellaneous itemized deduction is not subject to the 2%-of-adjusted-gross-income limit.

Prize Winnings

Publishers Clearing House, The Price Is Right, or gifts for being a guest on Oprah may not cost you anything to win, but it will cost you income taxes. The winnings or other gifts are includible in your gross income.

Prizes in merchandise are taxed at their fair market value. What “fair market value” is may not always be clear. Your fair market value may be less than the sponsor’s retail value. The Tax Court allowed one winner of a car to be taxed on what he could receive if he immediately resold it, which is something less than the full retail value.

Tip: Check the value reported to you by the sponsor on Form 1099-MISC. If you don’t agree because you believe it to be too high, contact the sponsor and ask for a revised form or proof of its valuation. For example, you win a trip that the form says is worth $8,000, but you found a vendor online who was selling the same trip for $6,000. If the sponsor won’t reissue the form, you can ask the IRS to send the sponsor Form 4598, Form W-2 or 1099 Not Received, Incorrect, or Lost (you can’t simply download the form; you must call the IRS to request that they send it). This may prompt a revision of the form. Alternatively, you can report the value as it is reported to you, but enter an adjustment to reflect what you believe the value to be. This may be a red flag to the IRS, so retain proof of your valuation in case your return is questioned.