Lump Sum Cash for structured payments

[dyne]

Ads appear constantly on TV suggesting that people get cash NOW in exchange for their structured settlement payments. Have any of you preparers considered the tax implications of getting cash NOW instead of periodic payments and whether or not this could be a good idea?

[DaveO]

I recall a court case where a person sold their payment stream and claimed capital gain treatment. The IRS dissallowed, and he appealed. He lost.

[Burke]

During the period in which periodic payments are made, it is treated as ordinary income for income tax purposes as the annuity payments are received. Therefore, if a lump sum payment is made, it is all taxable as ord income in the year paid. If the annuitant dies while payments are still being made, the present value of future payments is included in the calculations for Estate tax (when there is one in effect.) Whether it is a good idea or not depends on many factors, the TP's tax bracket currently and in the future, how badly he needs the money, and how it may affect taxable Soc Security or other benefits, etc. etc. You can run the numbers. You should also calculate what the actual present value is, so that you can determine if the purchasing entity is offering a fair price. Of course, they expect to make a profit or they wouldn't make the offer.

[taxxcpa]

Cashing in installment sales

If you take a cash-out on an installment sale, it will constitute one big installment and the gain could cause a big increase in your tax bracket.

[JON]

Some of

the structured payments are from insurance settlements that are not taxable. All sales of those type are discounts, usually strong because the buyer knows they want a rate of return higher than you had. They also know the seller is in need for some reason.

[dyne]

Considering all of the TV commercials, there must be many people willing to settle for only a portion of the balance they would have received and to convert it from non-taxable income to taxable income along with the tremendous tax liability increase involved.

[Gary2]

I started researching this once, and discovered that it was counter-intuitive, at least for the case I had in front of me. It seemed that the taxpayer, as owner of the settlement, was still responsible for the taxes, even though the income stream had been assigned to the lump-sum company. Conversely, there were no tax consequences from receiving the lump sum. I believe there could have been some deductible investment interest expense, but the numbers involved were too small to justify it.

Tax-wise, it was roughly analogous to a secured loan with automatic payments, though legally it wasn't a loan at all. I still don't understand the legal structure that created this situation, but both the payer of the settlement and the lump-sum company agreed on the tax treatment (which took the form of a 1099-R from the payer to the taxpayer). This is not to say that all lump sum buy-outs would get this same treatment.

In my case, there was only one year left on the payout, so it didn't affect the taxpayer much, but I can imagine others being shocked to learn that they have to keep paying taxes on their settlement for years after they converted it to a lump-sum.

[Burke]

Considering all of the TV commercials, there must be many people willing to settle for only a portion of the balance they would have received and to convert it from non-taxable income to taxable income along with the tremendous tax liability increase involved.

The payment does not change its character. If it was taxable before, it is taxable upon redemption. I was thinking of lottery winnings. However, if it were a non-taxable payment of some sort as mentioned above, it would not be taxable just because it was liquidated. But it is possible that the taxable periodic payment would be so low as to not generate a tax liability each year, but a cash-out would be large enough to do so. Many people believe in the adage, ...."a bird in the hand,....". Then there are the viaticals. An entity or person might pay a policyholder the cash value of his life insurance, and then make themself the beneficiary once they own the policy, and await the death benefits. And I suppose there is the occasional person who feels he could invest the money to his better advantage than the annuity pays, since that is generally a fixed-interest bond. Many states who pay out lottery winnings now offer both options. Lump sum cash now at present value, or 20 years of payments.

[dyne]

IRC 130 exempts certain structured payments from tax. IRC 130(2)(B) prohibits such payments from being accelerated, deferred, increased or decreased. This suggests that an exchange for a lump sum payment would therefore be taxable. Several other websites inlcuding that of Susie Orman say an otherwise tax-free structured payment plan WILL become fully taxable if it is exhanged for a lump sum payout. It was reported that 44 states have enacted laws regarding this issue.

[Burke]

Very interesting. Apparently the payout of damages for personal injury takes the form of a structured payment in many cases, and usually falls under tax exempt status under IRC 104(a)(2). However, if it is deemed that the recipient has actual or constructive receipt (as in the case of a lump sum advance payout), it loses that protection and becomes taxable. See Revenue Ruling 79-220.

[gkaiseril]

And because of the discounting and fees the taxpayer gets even less money and that does not even include the additional taxes.

How do the fees compare to Pay Day Loans and RALs?

[Gary2]

Very interesting. Apparently the payout of damages for personal injury takes the form of a structured payment in many cases, and usually falls under tax exempt status under IRC 104(a)(2). However, if it is deemed that the recipient has actual or constructive receipt (as in the case of a lump sum advance payout), it loses that protection and becomes taxable. See Revenue Ruling 79-220.

It's not clear to me that 79-220 would apply, since that deals with a case where the person paying the damages bought an annuity to fund it, and the recipient had no legal rights on the annuity. The IRS treated the annuity entirely as an independent transaction by the person who owed the damages, with no effect on the recipient.

Similarly, IRC 130 also seems to deal with the payer's obligation, in this case an assignment of the obligation. That seems to be a situation where, for example, the person owing the damages and the recipient agree to let an insurance company assume the obligation in the form of an annuity. In that case, if the recipient went back to the insurance company and tried to convert it to a lump-sum, that would change the tax-free nature, because it changes the obligation of the entity owing the payments.

But in a lump-sum conversion through a third party, the person who originally owed the damages is out of the picture, while the entity paying out the annuity is still paying it out as annuity. They've just been directed to send the checks directly to the third party. The annuity still exists, and hasn't been accelerated at all. I can understand states prohibiting or regulating this, as a matter of consumer protection (and usury). It's still unclear to me how the taxation changes, since the original annuity is still paying out as an annuity.

[Burke]

But in a lump-sum conversion through a third party, the person who originally owed the damages is out of the picture, while the entity paying out the annuity is still paying it out as annuity. They've just been directed to send the checks directly to the third party. The annuity still exists, and hasn't been accelerated at all. I can understand states prohibiting or regulating this, as a matter of consumer protection (and usury). It's still unclear to me how the taxation changes, since the original annuity is still paying out as an annuity.

I think in the cases we have been discussing, it is the recipient of the annuity who is selling their right to those payments for a lump-sum settlement, which makes it taxable (if it qualified under 104(a)(2) previously.) They have therefore "accelerated" those payments to themselves and tax-free treatment is disqualified, a prohibited transaction same as in an IRA pledged for collateral, for instance. In addition, what happens to the tax treatment of the payments now received by the third party? It would no longer qualify under 104(a)(2), IMO. But I like the way you think.

[Gary2]

Thanks. What you say makes sense (not that the law is always sensible). I just hope I don't get another one of these where the question matters.