Assignment of a claim

[MtnGalCPA]

I have a client, who's a former employee of Nortel, that's currently in bankruptcy, as you know. Client had a perfected claim for severance pay and wages, but instead of waiting for the bankruptcy to close, he chose to assign his claim to an investment firm to receive the cash in advance. He got the lump sum in 2013 and while I have the calculation, frankly I'm not sure how to report those numbers. Can anyone shed some light on this subject for me? Thanks.

[Burke]

Did he receive a W-2 or other reporting form for these funds? If it was severance pay and wages, it is income to him. He cannot "assign" it to someone else and avoid paying the taxes on it.
Or are you talking about the payment from the investment firm?

[MtnGalCPA]

No, he has not received a W-2 and is unlikely to until the bankruptcy proceedings finalize, which is estimated to be 2015. My understanding is that the firm advanced the cash on several of these claims for those who did not want to wait that long on the money. According to my client's notes, the advice from the firm that advanced the cash (not tax professionals, I know) was that the client had a choice: either claim the money in 2013 and pay taxes or, wait for W-2 from Nortel Bankruptcy. I have a copy of the "Notice: Filing of Transfer of Claim" where client transfers his claim to the firm and I have a copy of the calculation. The firm estimated 35% tax withholding and subtracted that but there wasn't any tax remitted on the client's behalf.

While I recognize the fact that he received income, I fail to see how a 2013 reporting would be accurate or appropriate. My most logical thought process would be that the proceeds when the bankruptcy finalizes will go to the investment firm. They would "settle up" with the client if the tax withholding was different, perhaps, and then the client would report the income in the year the W-2 received. That feels like my best option but since these situations are obscure and I'm the owner of a small practice, I just wanted to bounce this off someone else. Thoughts?

[JohnH]

This is strictly off the top of my head, but it appears to be a loan against the eventual settlement.

[Burke]

That's what I was thinking too. I would not report it in 2013 and guess at the withholding. It won't process anyway since no withholding has been sent to the IRS. Until then it is a sort of loan, and I am sure it was discounted or the investment firm would not have done it. (They are getting the interest up front by doing that.) Anyway, when the monies are actually disbursed by the bankruptcy court, he should receive a W-2 and he would report normally at that time. He does not report any funds from the investment company on his tax return.

[JohnH]

I'm also thinking he may have a bit of a tax problem in that the entity advancing him the money is going to take a sizable chunk of the final payment as a fee for their services. But he may not be able to reduce the amount on which he pays tax to account for their fees.

I do think it is odd that they suggest the possibility of an option to report the payment on his 2013 tax return. Guess we would need to read the whole document to determine what's behind this transaction and whether it's really in his best interests. I'm wondering if the investment company is engaging in a type of transaction similar to the thought process/business plan underlying viatical settlements which were pretty popular a few years ago.

Edit: Here's a 2012 WSJ article that a quick search turned up - there are many others.

http://blogs.wsj.com/bankruptcy/2012/07/23/blood-in-the-bankruptcy-waters-draws-claims-traders-to-ex-nortel-employees/

Looks like he's being offered 70-80% now on what is essentially a sure thing if he chooses to wait. Plus he will likely pay tax on the 20-30% discount he accepted, since it doesn't look like the discount was paid to protect income. Or to look at it another way, his total net transaction cost will have been somewhere between 25-45%, depending upon his tax bracket.

[Burke]

Looks like he's being offered 70-80% now on what is essentially a sure thing if he chooses to wait. Plus he will likely pay tax on the 20-30% discount he accepted, since it doesn't look like the discount was paid to protect income. Or to look at it another way, his total net transaction cost will have been somewhere between 25-45%, depending upon his tax bracket.

I am betting he will receive the W-2 for the total amount allocated to wages and that is what he will report on his tax return and pay tax on. So in effect, he will pay tax on the discounted amount from the investment firm, as you say. It just won't be shown separately. The discount will not be deductible either, since it really represents "interest" and is a personal expense.

[JohnH]

That's probably the year when he is going to be a difficult client.
Try explaining this to the average taxpayer after-the-fact.
I think I'd be warning him now, maybe in writing.

[Burke]

I agree. From the website, it appears this may be deferred compensation. In that he is lucky, as the SS taxes were paid when it was granted. Only the federal and state taxes should be an issue now.

[MtnGalCPA]

Okay, great. That's what I was thinking. When I went through the documentation and saw that his claim was perfected, so that couldn't be reduced like a materialman's lien's could, I thought he was crazy to take the discounted offer, which, by the way, the firm took 16% of the claim amount AND a flat $3000 in addition. He didn't contact me before this transaction, I might add, so yeah, I think warning him in advance of the W-2 arrival will definitely be on my list. "It's my money and I want it now.." comes with a price. THANK YOU so much!!