Are Merit Awards Taxable?
Usually, yes-- although there are ways to avoid owing taxes by giving the money away.
What if you're fortunate enough to win a merit award for your outstanding work and the award comes with prize money? Do you have to pay income tax on the amount? The short answer is "yes." Unsolicited merit awards or prizes are fully taxable. 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 and deduct the amount as a charitable contribution. For example, if you get a $10,000 award and donate the entire amount to charity, you'll be able to take a $10,000 charitable donation deduction on your taxes for the year, which will offset the amount of the award. However, if the award is extremely large, you may have to deduct it over several years because the annual deduction for charitable contribution is limited to 50% of your adjusted gross income.
But you can't give the money to just anybody--a family member for example. To be deductible, 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 also deductible.
Donations to individuals are not deductible, even if the person is poor or otherwise deserving. Thus, you get no charitable deduction if you give a portion of the award to a co-worker. You'll have to pay the full tax on the amount, but the co-worker won't have to pay anything.
If you elect to give the money to a charitable organization, there are two ways to go about it. First, you can cash the check and then disburse the funds yourself to your selected charity or charities. If you do this, you'll still have to report the award as income on your tax return. You won't owe any tax on this income because it is offset by your charitable deduction, but it will increase your total adjusted gross income (AGI) for the year. This can end up losing you other tax deductions you may be entitled to because many personal tax deductions have a percentage of AGI floor--for example, unreimbursed medical expenses are deductible only to the extent they exceed 10% of your AGI. Increasing your AGI raises this floor and limits these deductions.
Fortunately, there is a way to give an award away without having to report it as income on your tax return and thereby increasing your AGI. 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.
If you do all this, you need not report the award as income on your tax return and you may 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.