The Tax Side of Litigation Funding Transactions

Litigation funding sounds simple until the tax bill walks into the room wearing reading glasses. A plaintiff, lawyer, or law firm gets cash before a case ends. The funder takes a slice of the recovery if the case succeeds. If the case fails, the recipient often owes nothing. That sounds like financing, but for federal tax purposes, the label on the agreement only starts the conversation. The IRS cares about the actual economics. And that is where the whole thing can get messy fast. For CPAs, tax advisers, law firms, and finance teams, litigation funding now sits in an uncomfortable place: useful cash tool, aggressive tax structure, and potential legislative target all at once.

Is It Really a Loan, or Just Wearing a Loan Costume?

The first tax question sounds basic: did the plaintiff or lawyer receive a loan, sell part of a future recovery, or enter into a prepaid forward contract? That answer drives everything. If the deal qualifies as a true nonrecourse loan, the recipient usually does not recognize income when the money arrives. Debt proceeds do not count as gross income because the borrower has a repayment obligation. Fine, clean, familiar. The problem comes when repayment depends entirely on litigation success. If the case loses and the recipient owes nothing, the IRS may ask the obvious question: Where exactly is the debt?

That issue landed hard in Novoselsky v. Commissioner. A lawyer received upfront litigation support payments and treated them as loans. The Tax Court disagreed. The court focused on the contingent repayment obligation and found the payments taxable as current income. The IRS also won on accuracy-related penalties. For firms advising attorneys or claimants, this means documentation needs more than polished language. A real loan needs loan behavior: a note, interest, a repayment schedule, creditor rights, reasonable repayment expectations, and conduct that matches the paper.

Can Prepaid Forward Contracts Save the Day?

Many litigation funding deals avoid loan treatment and use prepaid forward purchase agreements instead. The practical goal sounds like every taxpayer’s favorite phrase: money now, taxes later. Under a properly structured prepaid forward contract, the funder advances cash today in exchange for a future variable share of litigation proceeds. The tax theory relies on open transaction treatment. The recipient should not recognize income immediately because the final amount remains uncertain until settlement, judgment, or another resolution event. IRS Revenue Ruling 2003-7 supports that general concept in the variable prepaid forward contract context. The IRS concluded that no current sale or constructive sale occurred where the taxpayer received cash upfront, agreed to future delivery of a variable amount of property, retained meaningful rights, and lacked economic compulsion to deliver the pledged shares.

Litigation funding borrows from that logic. The structure works best when the future recovery remains uncertain, the funder lacks a fixed return, and the recipient does not guarantee repayment. If the agreement starts to look fixed, guaranteed, or economically predetermined, the deferral argument gets weaker. That is the tax tightrope. Too much certainty can turn the arrangement into a current sale. Too much loan language without real debt features can create the Novoselsky problem. Somewhere in the middle sits the carefully drafted prepaid forward agreement, and even that needs disciplined facts.

Congress Suddenly Checking the Receipt

The policy fight over third-party litigation funding has moved from courtrooms into tax-writing rooms. The Tackling Predatory Litigation Funding Act, introduced in 2025, would impose a major new tax on qualified litigation proceeds received by covered third-party funders. The proposed rate equals the top individual tax rate plus the 3.8% net investment income tax, currently 40.8%. That number matters. A U.S. corporation that might otherwise face a 21% federal corporate rate could face a 40.8% tax on covered litigation funding income. The bill also reaches partnerships, S corporations, tax-exempt investors, certain retirement investors, and non-U.S. investors. It would impose withholding at 20.4% on payments tied to covered litigation financing arrangements.

The bill includes exceptions, including small agreements under $10,000 and certain pure loan arrangements with limited returns. Still, the proposal aims at the core economics of the funding model: fund capital today, collect a large litigation-linked return later, and seek favorable tax treatment on the spread.

What Should CPAs Watch Before the Case Settles?

The tax risk starts when the funding agreement is drafted, not when the settlement check arrives.

CPAs should focus on three things:

1. Review the actual contract. Is it structured as a loan, sale, or prepaid forward arrangement? Does repayment depend entirely on litigation success? Do the economics match the labels?
2. Model multiple tax outcomes. Consider both the intended treatment and the possibility that the IRS recharacterizes the transaction as current taxable income.
3. Analyze each party separately. Plaintiffs, law firms, and funders may face different tax consequences depending on the nature of the claim and the funding structure.

The takeaway: litigation funding can ease cash flow pressures, but weak structuring can create significant tax risk.

The Funding Deal Is Also a Tax Deal

Litigation funding has grown because lawsuits cost real money and contingent recoveries can take years. For plaintiffs and law firms, funding can keep a strong case alive. For funders, it can create returns that do not move with the stock market. That part explains the appeal. The tax story needs more caution. Current law leaves room for prepaid forward structures, but only when the facts support deferral. Novoselsky shows that the IRS can attack weak loan treatment and win. The proposed 40.8% tax shows that Congress may target funder economics directly, especially where lawmakers view the current rules as too generous.