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A ‘Genius’ Way to Avoid Taxes

Sunday, April 14, 2013

Nobel Prize laureates are avoiding heavy taxes on their prize money via a loophole that benefits charities. President Obama and former vice president Al Gore both gave away their prize money — at the expense of the IRS.

President Reagan is best remembered for his policies based on the theory of supply-side economics. The Reagan White House claimed that its 1986 tax reform cut taxes for four out of five taxpayers. However, the reform also contained a much less publicized rule, aimed at increasing the “perceived and actual fairness of the tax system,” that imposed a tax on academic, scientific, or other prizes and awards, including the Nobel Prize.

Within a single year, the marginal tax rate on Nobel Prize winnings, which had traditionally been excluded from income for tax purposes, shot up from zero to almost 30 percent — the top marginal rate faced by millionaires at that time. This was a watershed moment for prize winners in the United States, which, even today, is the only country that imposes such a tax on prize money. In a sharply worded letter directed to Congress and printed in the New York Times in January 1988, the American Nobel Committee spoke out against the new law:

Everywhere we see evidence of conflict of values. The wealthy are able to acquire more wealth with low tax liabilities in the pursuit of nothing more than making money. Once in a lifetime our bravest and brightest achieve a moment of world recognition and financial award, and we snatch away a portion of their lifetime achievement through a punitive tax. Almost all of the Nobelists are salaried researchers at labs or universities. They pay their taxes since they have no means of sheltering their incomes the way investors do. They have few write-offs and share all the woes of the average taxpayer. With the new tax law, they do not even have the modifying opportunity of income averaging to reduce their tax on the prize money.

The tax on prize money remains a cause of gloom among some Nobel winners. In an NPR interview, the 2008 Nobel Prize Winner in Chemistry Martin Chalfie remarked, “the lion's share of the prize money, since the Reagan presidency, when the tax codes were changed, has gone to the government. Because before Reagan, the rule was if you won an international prize, you kept the money. It was tax-free. Now, it's taxed. So 50 percent of it went immediately to the city, the state, and the federal government. The rest of it is going to help put my daughter through college.”

For some laureates, more than 40 percent of their income will be paid out in taxes just because they won the prize.

Over the years, however, anecdotal evidence suggests that prize winners have figured out ways to either avoid the tax entirely or at least reduce its burden.

Nobel laureates can try to minimize their tax liability by giving the prize money to a charitable organization. Many laureates choose to donate a portion of their prize to organizations that have assisted in their accomplishments or that will further their work. However, the law only allows taxpayers to deduct charitable contributions that are 50 percent or less of adjusted gross income. That means that while the entire $1.4 million is given away, prize winners still need to pay tax on a big chunk of it.

Also, because the money pushes most laureates into a higher tax bracket, they are likely to lose deductions and personal exemptions that they would have been entitled to otherwise. For some, this means that more than 40 percent of their income will be paid out in taxes just because they won the prize.

But there is a loophole. IRS Publication 74(b) allows laureates to completely avoid the tax by assigning the prize money to a charity before they actually receive it. This is exactly what President Obama and former Vice President Al Gore did with their prize money. Gore donated 100 percent of the proceeds of the award to the nonprofit Alliance for Climate Protection. President Obama similarly asked the Nobel Committee to transfer the money directly to designated charities, so that the award never showed up in his tax return. Many recipients of the prize donate all the proceeds from their award to charity, and since Obama and Gore were wealthy even before their winnings, it is unlikely that their contributions were driven solely by a desire to avoid tax liability. That these charities were designated prior to the receipt of the awards does suggest, however, that both men had knowledge of the relevant tax code that allowed the award money to be tax exempt.

Did the 1986 tax law cause Nobel laureates to become more charitable? It is tough to say, given the volume of data and rigorous statistical analysis required to make such a claim. According to Michael Sohlman, executive director of the Nobel Foundation, “since many scientists already have a solid financial situation, they often give it [the money] away to charitable organizations.”

Some scientists give the money to universities or institutions where they have worked, as a token of gratitude. For example, neuroscientist Paul Greengard gave his 2000 Nobel Prize money to Rockefeller University, where he has been a professor since 1983. Physicist George Smoot of the University of California-Berkeley donated the money from his 2006 physics prize to a foundation that matched the funds to support scholarships and fellowships. Smoot said, “This was effective, as if I had taken the prize, the United States and California would have taxed away half of it … This way much more funds went to young people in a way that may change their lives in a major way to the good.” John Mather, who shared the prize with Smoot, donated his portion of the winnings to his John and Jane Mather Foundation for Science and the Arts.

‘Once in a lifetime our bravest and brightest achieve a moment of world recognition and financial award, and we snatch away a portion of their lifetime achievement through a punitive tax.’

Of course, many laureates simply use the money for personal purchases, mortgage payments, or to pay for their children’s education. British biochemist Richard Roberts reportedly built himself a croquet lawn with his 1993 prize money. In 1965, when physicist Richard Feynman won the award and was asked how he would spend the money, he said, “I’ll use it to pay my income tax for the next years, so that my income is tax-free.”

When Albert Einstein was divorced in 1919, he famously left all his Nobel money to his ex-wife and their two sons, despite the fact that this was two years prior to actually receiving the prize in 1921. In 1903, Marie Curie, the first female Nobel laureate, poured the money into her own research, yielding huge payoffs, as her daughter and son-in-law won a joint Nobel in 1935 and Curie herself won a second prize in 1911.

Alexander Fleming won the 1945 Nobel Prize for his discovery of penicillin. There is no mention of how he used the prize money, but when he later toured the United States, American chemical firms collected $100,000 and presented it to him in gratitude for his contribution to medical science; he used the funds for research at St. Mary’s Hospital Medical School.

It is certainly easier to find examples of charitable giving today than for the early part of the 20th century, but whether these differences are significant in any statistical sense is impossible to say. Further, whether differences are driven by tax rates or other factors, such as poor documentation, is even harder to pin down. However, anecdotal evidence does suggest that Nobel laureates behave as economists would predict. A 2011 paper by Jon Bakija and Bradley Heim suggests that charitable giving responds to changes in the tax price, with a negative elasticity of 0.7. In other words, when the tax benefit to charitable giving goes up, people engage in more giving. For Nobel laureates, the tax is unlikely to impact their decision to work, since their research and activities are motivated by more than just money or even fame. The award represents a recognition of a lifetime of work and confers significant prestige on the winners. However, the tax consequences could generate behavior that has real revenue impacts for the IRS.

The larger question is whether we really want to tax prizes awarded to this select group of thinkers, scientists, and innovators. In the words of the American Nobel Committee’s 1988 letter, “If America is ever to regain economic stability in the world market, it will need to encourage all the innovators it can. To advise our creative talent that when they achieve a lifetime recognition of the Nobel Prize that one third of it will be taken away sends a confusing message.”

Aparna Mathur is a resident scholar at the American Enterprise Institute.

FURTHER READING: Mathur also writes “How Taxing the Rich Harms the Middle Class,” “Race to the Top of the Laffer Curve,” and “Labor Laws Make Finding Work More Laborious.” Arnold Kling asks “What to Do with Super-Achievers?,” John R. Bolton comments “On That Nobel Peace Prize,” and Kevin Hassett contributes “How the Nobel Prize in Economics Can Help You Find Love.”

 

Image by Fred Wollenberg / Bergman Group

 

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