Tax planning for a million dollar math prize?

Are you tired of reading about the tax problems of wealthy athletes?

How about the tax problems of mathematicians who win big prizes?

The math world is buzzing about the possibility that somebody might have solved another of the million dollar math problems.

What, you say, you didn't know you could win a million dollars for solving a math problem?

Well, here's the deal: in May 2000, the Clay Mathematics Institute established the Millenium Prize program by choosing seven classic math problems that mathematicians had been unsuccessfully trying to solve for many decades, in some cases for over a century. The foundation set aside seven million dollars in an account designated for the purpose of paying one million dollars to the first person who could solve each of these seven problems.

How hard are these problems?

Well, it took ten years before the first one was declared solved earlier this year. That prize was awarded to a rather eccentric and iconoclastic Russian mathematician, Grigori Perelman, but apparently he does not like to accept prizes, fanfare, or recognition. Last month, he just flatly refused to accept the million dollars the Clay Foundation tried to award him for proving one of the problems, the long-elusive Poincaré Conjecture. This is not the first time he has done such a thing. He had previously turned down the Fields Medal and its (smaller) associated prize money in 2006.

It is well-established in US tax law that prize winners have the right to turn down a prize they do not wish to accept without facing tax consequences. (That's a good option for game show winners who win oddball prizes and could otherwise be stuck paying the tax on weird stuff they don't actually want, but it's rare for someone to turn down a large monetary prize.) So that means that the IRS won't be coming after him for any taxes on the prize he turned down. (Of course, I don't know if the Russian tax laws will also excuse him from paying Russian tax on the prize money he turned down. In any case, it would be tough to collect much tax from him, since Pravda reports that he is unemployed and lives in poverty.)

But that was last month's buzz. This month's buzz is about Vinay Deolalikar, a computer scientist at Hewlett-Packard, who published last week what he believes could be the solution to a different one of the Millennium Math Problems, the so called P vs. NP problem.

Unlike the Poincaré Conjecture, where even the problem statement itself is hard for laymen to understand, the statement of the P vs. NP problem itself is actually pretty easy to explain, even though it's assuredly hard to solve. (Mathematicians have been working on it for decades, and some scientists believe that Deolalikar's recently published attempt may be flawed. It took years to validate Perelman's solution to the Poincaré problem, so even if it is correct, it will likely take a while before the scrutinizing mathematicians are satisfied with Vinay Deolalikar's solution to the P vs. NP problem. Errors may be found quickly, of course, but truth takes a while to establish for a problem this complex.)

You can read a really nice clear explanation of the P vs. NP problem on the Clay Foundation website. They even include a link to a great article with an example using the popular Minesweeper game.(widely available as freeware.)

But what does all this have to do with taxes? Well, it turns out that there are a lot of interesting tax issues involved with a possible prize award.

If Vinay Deolalikar does win the prize money and actually accepts the million dollars in cash, he will presumably owe income tax on the money.

He is an Indian citizen, but he currently lives and works in California. Presumably he will have to pay US income tax as well as California income tax on any prize money he might win.

India may also have some additional tax claims on his prize money as well. Though I'm not familiar with the details of other country's tax laws, it appears that Indian citizens who live overseas may be subject to income taxes on their foreign-source income, depending on a number of factors, possibly including the number of days they spend in India in a given year.

There are definitely a number of tax wrinkles here. For one thing, it's clear that the Clay Foundation does not make awards quickly. They want to be really sure the solution is bullet-proof, so it will be years before they formally award any prizes based on work submitted this year. (I mentioned Grigori Perelman's prize refusal of the prize awarded him earlier this year. That prize was based on work he published in 2003, so it took seven years for the Clay committee of mathematicians to verify it.)

If he does in fact win a prize seven years down the road, it seems likely that the applicable US income tax rates will be much higher than they are now.

On the other hand, he could decide to return to India before collecting his prize. The top income tax rate in India appears to be somewhat lower than the current US maximum rate. Then again, who knows whether that top Indian tax rate will change down the road.

It's also possible that India does not tax this type of prize. After all, the US taxes Nobel Prizes, but most (all?) other countries apparently do not tax Nobel Prize money. (Indeed, even the US itself did not tax this type of prize money until the Tax Reform Act of 1986.)

But even if he moves back to India to get more generous income tax treatment on his prize, and even if it turns out that a scientific prize is exempt from Indian income tax, he will also wind up paying Value-Added-Tax (VAT) if he decides to actually spend his money there. (Then again, there are folks who believe the US needs to enact a VAT. If they get their way, he might wind up paying VAT even if he stays in the US.)

Another wrinkle: even if he is living in India during the year in which the prize money finally arrives, might US and California tax authorities seek to tax the money anyway, on the grounds that the work to earn was actually carried out in California? Normally, individual taxpayers who are employees pay taxes on a "cash basis" rather than an accrual basis, but the circumstances are sufficiently unusual and the amount of money involved is so large that who knows what the tax authorities might do?

Yet another question occurs to me: suppose he decides he just wants to stay in the United States and do the same thing that President Obama did with his Nobel Prize money: just to have the Clay Foundation donate the prize money directly to a charity of his choice.

It is well-established that Nobel Laureates do not need to report and pay tax on their prize money if they follow the appropriate procedures to have the Nobel Foundation send the money directly to the qualifying tax-exempt charity of their choice.

The rules for this kind of thing are tricky, but President Obama's tax accountants apparently believe that they dotted all the i's and crossed all the t's necessary to have his 2009 Nobel Prize money excluded from his taxable income.

It's not totally clear that the Nobel Prize treatment would apply in the case of a Millenium Prize. In particular, the rules say that you can arrange this kind of tax-free directed donation only in the case of a prize awarded to you "without any action on your part to enter the contest or proceeding."

Does the mere fact of publishing a solution to one of the Millennium prizes constitute an "action" to enter their contest?

Inquiring minds are curious on this point.

My advice to anyone contemplating winning a Millennium Math Prize is "Get thee to a tax lawyer," but bear in mind that (a) you have a lot of time to plan and (b) tax laws could change a lot before you actually see any money.