Spreading out the Taxes on Lottery Winnings

Cliff Ennico
Posted: Jul 26, 2011 12:01 AM

"I have an unusual question for you. If I win a large prize in the lottery, should/could I establish a nonprofit corporation to receive the prize? I asked a financial advisor about this, and he said that I could do this and also have the identity of the manager (me) hidden from the public.

"There are two reasons I have for wanting to do this. The first is to keep my identity secret, so that no one will know that I won the money. The second is to spread the winnings out over several years, thus possibly lowering the tax rate. According to him, the money will not be taxed when it is paid to the organization by the lottery commission, but only when it is dispersed by the organization.

"I am not so much worried about paying the taxes, but keeping my identity secret is very important. I have read and seen too many instances where families have been torn apart because there is no 'fair' way to share the money. Someone will always feel they did not get as much as they should have. Do you have any thoughts on this?"

First of all, this is a WONDERFUL problem to have. Congratulations!

Let's start with the basics: Lottery winnings are "income," and you must pay federal and state income taxes on them.

At the federal level, if you win more than $5,000 in the lottery, 25 percent must be withheld from your winnings for federal income tax purposes. You will receive a Form W-2G from the lottery commission showing the amount of lottery winnings paid to you during the year and the amount of federal and state income tax withheld.

You report your lottery winnings as income in the year, or years, you actually or "constructively" receive those winnings. If you're required to take the winnings in annual installments, you only report each year's installment as income for that year. Most states require you to choose between "lump sum" and installment payments when you buy your ticket; others will allow you to make the choice after you've won. But the choice usually must be made within a specified time period.

I think your financial advisor is recommending you set up a "private foundation" to claim the winnings. For a concise summary of the IRS rules on private foundations, see "The Life Cycle of a Private Foundation," at www.irs.gov/charities/foundations/article/0,,id=127912,00.html.

It isn't easy -- or quick -- to set up one of these. First, you must create the corporation, which will take a week or two. Then, the corporation will have to apply for exemption from federal and state income taxes under Section 501(c)(3). The IRS does not rush to grant these exemptions. In fact, it is currently "cracking down" on nonprofit abuses, and if they even suspect that your corporation does not have a bona fide charitable purpose, they will delay, and delay, and delay ...

Your financial advisor is correct that most states will not require you to disclose your identity when setting up the corporation, as long as you use a "registered agent" service such as National Corporate Research Ltd. (www.nationalcorp.com). This will cost between $100 and $200 a year. You should also plan to pay $5,000 to $10,000 a year (to your financial advisor, I suspect) to do the required legal and tax paperwork for your private foundation.

A cheaper, and quicker, way to preserve your secrecy is simply for you (and your spouse) not to say anything to family members about your winnings -- no law requires you to do so. And if word leaks out and creates divisions within your family, all I can say is "welcome to the upper class." These are issues that all wealthy people face, wherever their money came from. This is why all wealthy people (even "nouveau riche" like yourself) need to hire top-notch estate-planning attorneys to ensure that the division of wealth upon your death is as fair as possible. Frankly, if it were me, I would spend my money on that rather than a private foundation.

If the fear that your sudden wealth will destroy your family is simply unbearable, consider doing what Microsoft Corp. founder Bill Gates has said he plans to do: create separate "trust funds" for each of your kids (the same amount of money for each kid) with enough money to get each kid through college and graduate school ($300,000 apiece should do it).

Then, donate the rest of your winnings to a bona fide public charity (see IRS Publication 78 for a list of these). You will get a huge charitable deduction, you will receive tons of positive publicity, you will be seen as a "hero" in your community, and your kids probably won't hate you too much since they were treated equally.

As for your other family members, buy them lottery tickets ...

See these top stories from Townhall Finance:

Heidi Harris Hit the Girls and Make Them Cry
John Ransom The SEIU Pigs Fly
Mike Shedlock Four Players "All In" for Debt Ceiling Poker
Cliff Ennico Spreading out the Taxes on Lottery Winnings
Zacks Investment Research Abbott Laboratories- Growth and Income
Marita Noon New Environmental Regs the Costliest Gamble
Kathy Fettke The Good, the Bad and the Ugly Debt
Mike Koriwchak Why Should Doctors Trust the Government?
Lincoln Brown Shale Oil Works in Estonia...Yes, Estonia
Email Ransom thfinance@mail.com
Facebook http://www.facebook.com/bamransom
Twitter http://twitter.com/#!/bamransom