Almost nightly you can turn on the television and see everyday people from all walks of life competing on television on game shows for cash and prizes. As each network competes for our attention by wisking contestants to exotic locations or daring them to complete audacious feats we become even more engaged in the fantasy of the new "reality tv." For example, on Sunday evening, CBS proclaimed twenty-five year old Amber Brkich from Beaver, Pennsylvania the winner of its latest season of "Survivor All Stars." As a result, Amber received a 2004 Chevrolet Malibu and a check for One Million Dollars.

The prospect of winning such a generous reward for a job well done is exciting enough to entice millions of viewers and prospective contestants to tune in each week to these fantastic competitions. However, the public view of these "reality" shows ends when the prize is awarded. In fact a strong dose of reality will hit the "winner" very soon after the award is received when the winner gets a call from his or her tax professional.

Although the rules, qualifications, location and required tasks may change from channel to channel, the hidden winner in each show is the same -- our dearly beloved Uncle Sam. As different as these spectacular prizes seem from the salary we bring home from work or the interest we receive on our bank accounts, it is taxed the same, as regular income.

The Internal Revenue Code excludes gifts and inheritances from ordinary income. These are taxed under a different system which has been the subject of previous columns. "Amounts received as prizes and awards" from contests and lotteries, however, are specifically included as ordinary income.

The form of payment does not impact its reporting. Whether it is cash, cars, furniture, vacations or homes, it is all "income" and all valued at its fair market value at the time it is received. This means the full retail price of the new car, home, jewelry, tools or furniture will be reported to the IRS as income and a 1099 for that amount will be issued to the recipient.

Using the example of the latest "sole survivor" above, assuming Amber has no other income or deductions and assuming a value for her new car of $25,000, her income in 2004 will be $1,025,000 plus any interest earned on her cash prize. Income tax rates are progressive. This means as your income increases, both the amount and rate of tax increases. Because Amber’s income is in excess of $1 million, a significant portion of her $1 million will be taxed at the highest federal and state tax rates (which for federal purposes is 35%). Her estimated federal tax liability, before deductions and exemptions, is $339,657.50 or almost one-third of her $1,025,000 earnings. These proceeds must also be reported to the appropriate state’s tax commission and taxed according to that state’s income tax rates.

Although the form of payment does not affect the taxes due, the timing of the payment is critical. If we assume Amber’s $1 million was not paid in a lump sum, but rather in ten annual installments of $100,000, then her taxable income for the current year would be only $125,000 (including the value of the new car) and in each of the next nine years it would be $100,000. Assuming no interest is paid on the subsequent installments, Amber’s federal tax liability for the current year will be approximately $29,627, and her federal tax liability in each subsequent year (assuming she has no other income and that the tax rates remain unchanged) will be about $22,627, for a ten year total of $233,270. The total tax due under the installment method is $106,387.50 less than that due under the lump sum arrangement. This example also illustrates the impact of our progressive tax rates because Amber’s effective tax rate on the lump sum payment was just over 33%, while her effective tax rate under the installment method was closer to 23%.

Because many recipients intuitively want to share their newly acquired wealth with friends or family, gift taxes can be another trap for the unwary award winner. Gifts, unlike prizes or awards, are not taxable income to the recipient, but are taxable transfers to the transferor if the gift exceeds the annual exclusion amount. The annual exclusion is designed to allow people to make gifts of reasonable amounts without burdensome tax reporting requirements. In 2004, the annual exclusion is $11,000, and it applies to any natural person regardless of relationship. Any gift to an individual in excess of $11,000 must be reported to the IRS, although no gift tax will be due unless total reportable lifetime gifts made by the transferor exceed the applicable exclusion amount (currently $1,000,000 for gifts). The income tax will not attach to and follow the gift, so the person making the gift will still be liable for income tax on any proceeds shared with others even though those proceeds have been irrevocably transferred.

Like the tax impact of the timing of the receipt of the prize, the timing of the transfer of the property can affect its taxability to the transferor. This is best illustrated with a lottery ticket. If the ticket holder transfers all or part of his interest in a lottery ticket to another person before it is declared to be a winning ticket, then the distribution of proceeds and consequently the income tax burden of the prize will be shared by the transferee. If the funds aren’t transferred until after the prize is received, the entire tax burden will be on the giver.

One situation in which a winner is allowed to share the wealth after it is received and receive favorable tax treatment is when the gift is to a qualified charitable organization. Gifts to charities reduce income tax liability by allowing the winner to deduct from his or her taxable income the fair market value of the gift. Stated differently, the winner will not pay income tax on amounts gifted to charity.

Should you find yourself in the winner’s circle, you’ll quickly learn that up to 28% of your prizes or awards will be withheld for income taxes. This withholding, though, doesn’t always mesh with the tax rates, which can be as high as 35%. For this reason and all the others discussed above, should you or a family member be the next lucky winner of a windfall that changes your life, be sure to consult a tax advisor as soon as possible to make sure you know your potential income tax liability before you get too comfortable with the full amount you have received. The only guaranteed winner in every contest is the IRS.