Taxing Litigation Finance

Abstract

The emerging litigation finance industry has the capacity to expand access to justice but also raises important legal and ethical questions. Although much has been said about the industry’s potential to increase frivolous lawsuits and permit improper control over a claim by the funders, scholarly discussion on the proper tax treatment of the parties involved has fallen by the wayside. The problem arises in classifying litigation finance contracts as either a nonrecourse loan, immediate sale, or variable prepaid forward contract, all of which discretely impact the timing and character of income. Unfortunately, courts have traditionally found it difficult to draw clear distinctions between these three categories for tax purposes, and the opaque industry combined with the complexity of the transaction enhances the confusion. The consequences are tax uncertainty and an opportunity for taxpayers to engage in aggressive tax planning by structuring transactions to obtain favorable tax treatment without altering their economic position. This Article proposes a customized, multifactor analysis to identify the true nature of litigation finance transactions and impose proper tax treatment. The bedrock of the proposal is the concept of tax ownership, which in the litigation finance context can be streamlined into two key factors: economic risk and legal control of the claim. Emphasizing the legal control factor may address the agency problems inherent in litigation finance. As the industry develops, this Article calls on tax policymakers and regulators to reduce the current tax uncertainty by integrating this multifactor analysis when issuing future guidance and imposing disclosure obligations