According to recent news reports, a $1 million reward was being offered for information leading to the capture of Christopher Dorner, the former LAPD police officer who is suspected of killing 3 people and wounding 2 people in Southern California during the early part of this month.  The $1 million reward has been raised from private donations, police unions, businesses and city and county governments.

Over 700+ tips were made regarding the whereabouts of Christopher Dorner before the ultimate shootout in Big Bear on February 12, 2013.  Most notably are the tips from Jim and Karen Reynolds, the couple that was briefly held hostage by Dorner after he broke into their condo, bound and gagged the couple on Tuesday, before stealing their vehicle and fleeing the scene. Karen called 911, the Los Angeles Times explains, setting “in motion the chain of events” and adding “new details about some of Dorner’s movements in the apparent final hours of his life” that led to Christopher Dorner’s shootout with a state Fish and Wildlife warden and then later the standoff at the cabin that eventually went up in flames.

Since the presumed death of Christopher Dorner, there has been plenty of discussion regarding what is being considered the gigantic loophole in the payout of the reward, namely the necessity of capture. According to CBS News, LAPD Officer Alex Martinez says it’s unlikely anyone can claim it because the reward referred to Dorner’s capture and conviction.

Assuming the reward was to be paid to the Reynolds’ or any of the other tipsters, how much will they really receive? Notably, payments of this nature will likely come with a heavy tax due to Uncle Sam and California. Subject to a few minor exceptions, rewards are income.

Internal Revenue Code (“IRC”) § 61 defines gross income as income from whatever source derived.  IRC § 74 provides generally all prizes and awards are gross income unless it’s: (i) a qualified scholarship or (ii) transferred to a charity.  The charity exception includes additional requirements such as: (i) the prize or award is in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement; (ii) the recipient did  not have to perform services; and (iii) the recipient was selected without any action on his or her part.

The current IRC definition of gross income is the result of the 1955 seminal case, Commissioner of Internal Revenue v. Glenshaw Glass Co., in which the Supreme Court held a taxpayer has gross income when he has “an accession to wealth, clearly realized, and over which the taxpayers have complete dominion.”  Thus the inclusion of reward money in the definition of gross income clearly fits within the rubric of Glenshaw Glass; a recipient has an accession to wealth by receipt of the reward.

Income is much broader than wages earned from employment; income is any gain or net benefit to the taxpayer.  For example, if someone pays a bill for you or discharges your debt, these too are included your gross income.  The recipient realizes a net benefit, the accession to wealth, by not having to pay out money for these items.  The receipt of a prize or a reward is no different.  The recipient does something, could be anything such as entering a name in a drawing, and then receives some cash or non-cash prize or reward in return.

Income is taxable unless it can be offset by deductions and/or credits.  If someone accepts a reward, it is reported on their Federal and California Income Tax Returns and the recipient must pay tax on whatever marginal tax bracket it might bump them into.  Be wary, Federal and California marginal tax rates increased for 2013.

Just because you have income, it does not follow that you must pay tax on the total amount of the income.  Sometimes, certain taxpayers can deduct certain expenses.  Could a reward recipient deduct expenses associated with the production of information leading to the reward?  Like most tax questions, the answer is: it depends.  If the taxpayer’s job is bounty hunting or being a private detective, then the taxpayer can probably deduct his or her production of information leading to the capture of Christopher Dorner expenses as business expenses.  After all his or her efforts would be ordinary and necessary and lead to the production of income. However, most residents of Southern California are not in the business of finding suspects for the police. Thus, even if you spent the day looking for Dorner, the reward money would be a hobby, which can’t be deducted.  That means that if Private Eye got the reward, he or she would be able to partially offset the $1 mil. Nice gig.

What might be more alarming to taxpayers, it not loophole to be eligible to  receive the reward payment, but the cost to find Christopher Dorner which was lead by the joint task force made up of Los Angeles, Irvine and Riverside police, the FBI, and US Marshal’s office.  The Press Enterprise reports the joint task force had been working around the clock. Just how much has the manhunt cost the taxpayers?  According to reports in the Los Angeles Times, there is an L.A. tax measure that could help pay for raises for city employees, but what about all of the overtime for the work around the clock. Why increase tax, if the Christopher Dorner reward is not being paid to the Reynolds’ or any other tipster, the reward money should be used to offset the taxpayer’s cost of the around the clock police presence.  After all most of the money should have come in the form of donations and if there is no tipster, the joint task force should be considered the only ones who led to the demise of Dorner.

If the reward did go to the joint task force, the more interesting question is, would this reward be income to the officers?   Would it be double compensation to the officer because the officer is already getting paid to investigate?  The reward would be income to the officer but that the officer would not be able to deduct any of his business expenses.  First and foremost, the officer’s expenses should be covered by his or her job and if the officer did have additional expenses, they would likely be akin to a hobby. After all it’s difficult to devote your time and attention to two full time jobs.  Second, it’s not really double compensation, it’s not being paid by his or her employer it’s being paid by the Christopher Dorner reward fund that arguably has nothing to with the officers’ employment.  Thus, it would be compensation and reward which would collectively become part of the officer’s gross income.  Plus, no one complains about having too much income, we only complain about double taxation!

Before you accept any huge rewards, we suggest you consult with a tax professional in California.

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