Lawyers Face New Litigation Tax Rule

Litigation funding involves a third party providing funds to a lawyer or plaintiff in exchange for a portion of the potential recovery. This funding can be provided on a nonrecourse basis, meaning that if the litigation is unsuccessful, the plaintiff or lawyer does not owe the funder anything.

Lawyers and law firms have become significant consumers of litigation funding, with some large firms obtaining funding for multiple cases.

Taxation of Litigation Funding

The taxation of litigation funding transactions depends on the documentation of the agreement. Some transactions are documented as nonrecourse loans, while others are structured as prepaid forward purchase agreements (PFPAs).

If the documents support treating the arrangement as a loan for tax purposes, the loan proceeds are not income to the lawyer. However, the tax treatment of a loan is generally disadvantageous to both the funder and the lawyer.

Most litigation funding transactions are documented with PFPAs, which are not debt instruments and do not have interest payments. The IRS has approved the tax treatment of PFPAs in Revenue Ruling 2003-7.

Prepaid Forward Purchase Agreements

In a PFPA, the funder makes one or more cash advances to the law firm in exchange for the law firm’s promise to sell the funder a variable portion of the attorney fees and costs that the law firm hopes to receive under its contingent fee agreement with its client.

The law firm’s right to payment does not accrue until the case is resolved, and the law firm should report its recovery as compensation in accordance with its method of accounting.

The accrual of the law firm’s payment right entitles the funder to a portion of the recovery under the PFPA, and the law firm calculates and reports its gain or loss under the contract.

The law firm’s gain or loss is generally equal to the difference between the advances received and the sum of the law firm’s payments to the funder, and the law firm’s basis in the PFPA.

Portfolio Funding

In a portfolio funding transaction, the law firm enters into a single PFPA requiring it to sell the funder a portion of its recoveries from multiple cases. The law firm should generally report the results of settling its obligations with respect to any particular case in the year that case is resolved.

To calculate the law firm’s gain or loss, an appropriate portion of the funder’s advances should be allocated to the case in question as the amount realized in that sale.

Considering the broader context of litigation funding is essential, as it can help reduce risk for clients and lawyers, albeit with a cost of funding that is usually commensurate with the degree of risk the funder is taking on.

The unique structure of PFPAs can achieve the goals of delaying taxation and ensuring that taxes are paid on net recoveries, not on the money paid to the funder. This is because the law firm is paying tax only on the funds that it gets to keep from the case, not on the amount it owes the funder.

Properly structured PFPAs can provide tax advantages to both the law firm and the funder, making them a popular choice for litigation funding transactions.