Getting something free in America can still end up costing you something.
Those “free” T-shirts that credit card companies give to college students can sometimes result in paying on high-interest debt for years.
The invitation for a “free” meal that includes information about managing your money in retirement is often just a sales pitch for an investment product that is likely to be overpriced, unnecessary or, in the worst case, a scam.
In 2004, Oprah Winfrey famously gave a car to each of her 276 audience members to celebrate a season premiere of her talk show: “You get a car! You get a car! Everybody gets a car.”
But for many, the excitement turned to some disappointment when they realized that their new Pontiac G6 sedan would come with a hefty tax bill.
Turns out that the show’s giveaway was part of a promotion by General Motors for the now-defunct Pontiac brand. This made the $28,500 car a prize — not a gift.
When you win money, like in a lottery, or an item, like a car, you owe ordinary income taxes on the value of the prize.
Winfrey’s giveaway was intended for audience members who desperately needed a car, so it’s understandable that some weren’t completely happy about having to pay taxes on something they thought was free. Winners who worried about how to pay the tax could trade down for a less expensive model, thus reducing taxes owed; take out a loan to cover the tax bill using the car as collateral; or accept the vehicle and then sell it to raise the money needed to pay the IRS.
So when philanthropist and billionaire Robert F. Smith recently announced that he was paying off all the student loans for the 2019 graduating class of Morehouse College, I wondered whether this was a repeat of the Winfrey win.
Would Smith’s altruism still leave students with a debt to pay to Uncle Sam?
“My family is going to create a grant to eliminate your student loans!” Smith told the graduates during his Sunday commencement speech at the historically black college in Atlanta. Smith is founder and chief executive of Vista Equity Partners, a private-equity firm focused on investing in software and technology-enabled businesses.
But Smith’s largesse could be — depending on how the money is given — the rare gift that is truly free.
In the nonsensical tax code, it’s the giver — not the receiver — who might get a tax bill. Unlike Oprah’s audience, the Morehouse students may not receive a 1099-MISC IRS form, which is issued when a prize is valued at more than $600.
“The receipt of a gift is excluded from income regardless of the amount or the source,” said Eric Bronnenkant, head of tax at the online financial adviser Betterment. “Assuming the payment of the graduates’ student loans is classified as a gift, it would be income-tax free.”
The bar is pretty high for the average taxpayer to even be concerned about the 40 percent gift tax.
As of this year, donors are allowed to give up to $15,000 annually to an individual without triggering the reporting of the gift to the IRS. If you go over this amount, you are generally required to file a gift tax return (Form 709). But that doesn’t mean you’ll owe taxes on the gift. This is because the lifetime gift allowance right now is $11.4 million per individual. Double that for married couples.
The tax code does provide an exception to the gift rule for money paid directly to a qualifying educational institution for tuition, said Tyler Mickey, a certified public accountant and member of the American Institute of CPAs.
But “generally, the actual loan amounts for prior periods would not qualify for the exception,” Mickey said.
So would graduates incur taxes for the debt they won’t end up paying?
In general, if your debt is forgiven or discharged for less than what you owe, the amount of the canceled debt is treated as ordinary income and is taxable, according to the IRS.
“With respect to Mr. Smith’s gift, I don’t believe the students will need to pick up the amounts as income, since the lender didn’t actually forgive the debt,” said Michael Landsberg, a CPA and also an AICPA member.
Because Smith surprised the students and the school with his generosity, the specifics of how his gift will be handled, including any tax implications, are still being worked out, according to a statement from Morehouse.
But let’s say the gift does somehow trigger a taxable situation for the graduates. Whatever they might owe in taxes would still be considerably less than their current student debt obligation. And that’s a great graduation present nonetheless.