The telephone finally rings. It’s your agent.
“Way to go, baby. You got it--your first big part. No. 3 billing, $200,000 and your own dressing room on the lot.”
Congratulations. What do you do next?
Call your accountant. That’s more money than you’ve made in four years of bit parts combined, and it’s a whole new tax game. Windfall gains--whether they are from a sudden jump in income, the exercise of stock options or a Lotto jackpot--can bring windfall headaches.
Before 1986, a big bag of loot from out of the blue would have made your taxes very complicated. Today, it only means that you must plan the future more carefully.
In the past, preparers had to run through income-averaging formulas to decide how to handle the taxes on income far beyond the norm for an individual. Now, the extraordinary amount is usually counted as ordinary income, subject only to the maximum blended rate of federal and state taxes, which is roughly 37% in California.
“This isn’t a bad year to pay taxes on a windfall,” said Jeff Palmer, an accountant specializing in the entertainment industry at Parks, Palmer, Turner & Yemenidjian in West Los Angeles. “You’re going to walk away with 65 cents on the dollar, as opposed to as little as 45 cents just a few years ago.”
That is particularly good news for corporate executives who plan to be showered with sudden gusts of money after exercising incentive stock options.
The executive vice president of a company, for instance, might decide in 1988 that she needs enough money to pay for the first installment of her triplet daughters’ education in 1990 at a college that costs $15,000 a year. If she exercises options to buy 5,000 shares of her firm’s stock at $15 in 1989, and the stock is at $30 when she sells it a year later, she stands to gain $75,000.
Providing that the executive held the options for more than two years before exercising them and held the stock for one year before selling, the $75,000 would be taxed as a long-term capital gain, just as ordinary income, generally at 28%.
Sandy Phillips, a partner at Arthur Young Co. in Los Angeles, said if the executive has capital losses that year--for instance, stock market losses--with which to offset it, the losses can be applied to reduce the gain. Otherwise, since the amount is also subject to 9.3% state tax, the executive ends up with $47,025--enough for tuition, with a few dollars left over for a coffee maker and linens.
There are very few ways for the executive to minimize her tax liability, Phillips said. One possibility: She could pay next year’s state taxes this year--accelerating the deduction forward to reduce her unusually large federal tax exposure.
If the executive wished to make a charitable contribution this year instead of paying for her children’s education, she would have another choice. Rather than selling the stock after exercising the options, she could donate it to the charity. That way, she would have no income taxes to pay (the stock wasn’t sold), and she would earn a deduction for making the donation.
“Many of my wealthier clients give quite a bit of stock to charity,” Phillips said.
A third route: Instead of selling the stock after exercising the options, she could give the stock to her children or put it in a trust for them. The executive might have to pay gift taxes on it right away, Phillips said, but the future income from the stock--for instance, dividends or appreciation--would be taxed at the children’s rate. Among several obstacles to this is the “kiddie tax,” which requires the income of children under 14 years old to be taxed at the parent’s rate.
This method does, however, have the advantage of getting the money out of the parent’s estate, thereby escaping, in the long run, death taxes. “It is just good family planning,” said Edward Rosenson, another partner at Arthur Young, “anytime you can get growing assets out of your estate and into a son or daughter or grandchild’s name.”
Luckier, in more than one way, are Lotto winners.
Sure, the winner of a $1-million jackpot loses $280,000 to the federal government (but not the state) before he can let out a hoot. But because his windfall is counted as gambling gains, he can deduct all gambling losses for the year that he can document. That means a drawer containing 1,000 losing Scratchers becomes a drawer worth $1,000 in tax breaks. The deductions may only be applied against gambling gains, not ordinary income, Rosenson said. And the winner must have proof of his losses--an anecdote about the loss of $50,000 at a friend’s Sunday afternoon poker games won’t make it with an auditor.
Anyone who has such sudden gains might find it worthwhile to incorporate themselves. Palmer, the entertainment accountant, said he advises struggling artists to undertake the expense of having incorporation papers drawn up if their income suddenly jumps to more than $125,000 and it looks like it might stay there.
That way, he said, the artist can take advantage of certain benefits allotted to corporations that are not available to individuals, such as a pension plan. Of course, if the windfall is big enough it becomes more of an investment question than a tax question. Palmer said a client, a television actor in his early 20s, has seen his income jump to nearly $1 million this year from $100,000 in 1988.
“In a case like that, you just pay the tax,” he said flatly, and invest the rest of the money in a blended portfolio of tax-free bonds, corporate bonds, stocks, income real estate and a principal residence. He added: “We should all have such problems.”