What Does IRC 74 Say About Taxable Prizes and Awards?

Winning a prize or receiving an award can be exciting, but it often comes with tax implications. The IRS considers many types of prizes and awards as taxable income, meaning recipients may owe taxes on their value. Understanding these rules helps individuals and businesses comply with reporting requirements and avoid penalties.

The Internal Revenue Code (IRC) Section 74 outlines when prizes and awards are subject to taxation and the few exceptions that apply.

What Qualifies as Taxable Prizes

The IRS treats most prizes and awards as taxable income, whether received in cash or another form. This includes winnings from contests, sweepstakes, raffles, and game shows. Employer-awarded prizes, such as bonuses for outstanding performance, are also considered taxable compensation. The fair market value (FMV) of any prize must be reported as income in the year it is received.

Lottery winnings are taxable regardless of whether the payout is a lump sum or an annuity. Federal tax withholding on large lottery prizes is typically 24%, but the actual tax liability may be higher depending on the winner’s total income. Additionally, state taxes may apply, with rates varying by location.

Academic and athletic awards can also be taxable if they exceed tuition and required expenses. A student who wins a cash prize in an academic competition must report it as income. Similarly, athletes who earn prize money in competitions must include those earnings on their tax returns.

Noncash Valuation

When a prize is awarded in a form other than cash, determining its taxable value can be more complex. The IRS requires recipients to report the FMV of noncash prizes, which is the price an item would sell for on the open market. If someone wins a car, vacation package, or valuable merchandise, they must include its FMV in their taxable income for that year.

For items with established market prices, such as vehicles or electronics, FMV is generally based on the manufacturer’s suggested retail price (MSRP). However, discounts, rebates, or regional pricing variations can affect this valuation. If a contestant wins a car with an MSRP of $40,000 but dealerships typically sell it for $37,000, the IRS may accept the lower figure as FMV. If the winner immediately sells the car for $35,000, that amount could be considered the taxable value instead.

For prizes without a standard retail price, such as travel packages, FMV is determined using comparable pricing from travel agencies or online booking platforms. If a trip is valued at $10,000 by the awarding entity but similar packages are available for $8,500, the lower amount may be a more accurate FMV. Documentation, such as price quotes or receipts, can help substantiate the valuation if questioned by the IRS.

Collectibles, artwork, and rare items may require professional appraisals. The IRS may challenge valuations that appear inflated or inconsistent with market trends. If a winner receives a painting valued at $15,000 but similar works by the same artist typically sell for $12,000, the lower figure might be more defensible. Taxpayers should retain appraisal reports and relevant sales data to support their reported income.

Exceptions for Certain Awards

While most prizes and awards are taxable, the IRS provides specific exemptions. One applies to certain employee achievement awards. Under IRC Section 274(j), an employer can give a tax-free award for length of service or safety achievements if it is tangible personal property and does not exceed $1,600 under a qualified plan. Cash, gift cards, and similar cash equivalents do not qualify. If an employer gives a $2,000 watch as a service award, only $1,600 is excluded, with the remaining $400 treated as taxable income.

Another exemption applies to awards for significant public service or scientific, literary, or charitable achievements. Under IRC Section 74(b), these awards can be excluded from income if the recipient was selected without any action on their part, does not have to perform future services, and directs the prize’s proceeds to a tax-exempt organization. For example, if a researcher wins a $50,000 humanitarian award and donates the full amount to a 501(c)(3) charity, they do not need to report it as taxable income. However, if they keep any portion of the funds, that amount becomes taxable.

Olympic and Paralympic athletes may also qualify for an exclusion under IRC Section 74(d), known as the “Olympic Medal Tax Exemption.” Athletes who win medals and receive prize money from the U.S. Olympic and Paralympic Committee can exclude these earnings if their adjusted gross income is below $1 million ($500,000 for married individuals filing separately). This provision helps athletes who compete at the highest level but may not have significant endorsement deals or other income sources.

Filing and Documentation Issues

Proper tax reporting for prizes and awards requires accurate record-keeping and adherence to IRS guidelines. When an individual receives a taxable prize, the entity granting it may issue a Form 1099-MISC or Form W-2, depending on the nature of the award. Form 1099-MISC is used for non-employee prizes exceeding $600, while Form W-2 applies when an award is given by an employer as part of compensation. Ensuring these forms are correctly filled out and submitted helps avoid discrepancies that could trigger IRS scrutiny.

Taxpayers must report the income in the appropriate section of their tax return, usually on Form 1040, Schedule 1. If the prize is related to self-employment or business activities, it might be reported on Schedule C, potentially allowing for deductions against related expenses. For example, if an independent contractor wins an industry award that includes a monetary prize, they may be able to deduct costs incurred in pursuing the award, such as travel or promotional expenses, reducing their taxable income.

If a prize is subject to withholding, the payer must remit the withheld amount to the IRS and provide the recipient with documentation reflecting the deduction. Failure to receive or properly review these documents can lead to underreporting, resulting in unpaid tax liabilities and penalties. Keeping copies of all relevant forms, correspondence, and valuation records ensures accurate reporting and provides a defense in case of an audit.

Consequences of Improper Reporting

Failing to report taxable prizes and awards can lead to financial penalties, interest charges, and potential audits. The IRS monitors discrepancies between reported income and the information provided by third parties, such as contest organizers or employers. If a taxpayer omits a prize from their return and the IRS detects the omission through a Form 1099-MISC or W-2, they may receive a notice of underreported income, requiring them to pay additional taxes along with interest.

Significant underreporting can result in penalties. The accuracy-related penalty under IRC Section 6662 applies when income is understated by more than 10% of the correct tax liability or $5,000, whichever is greater. This penalty is typically 20% of the underpaid tax. If the IRS determines that the omission was intentional, fraud penalties under IRC Section 6663 could apply, leading to a penalty of 75% of the underreported amount. Repeated failures to report prizes may also increase the likelihood of an audit, where the IRS could scrutinize other areas of the taxpayer’s finances.