Lawsuit Lending – The Matter of Tax Reporting for Industry Practitioners

It may sound strange to hear the phrase ‘investing in lawsuits’, but the practice of legal funding is fast taking root both in the US and the world over. As a result, the more ‘mainstream’ professions are becoming more accommodative of the industry, which has attracted many investors as well as career practitioners from various fields within the financial sector.

Legal funding is a practice that much resembles contingent fee law, i.e., the lawyer only gets paid when he/she wins the lawsuit. This of course is more common for plaintiffs and less popular with defendants since it provides greater financial backing to the plaintiff’s side of the case.

The Law

However unpopular and misunderstood, lawsuit funding companies fulfill a real need in society today and provide plaintiffs with a chance to gain real justice, especially where they file suits against wealthy corporations and individuals with clout.

No matter how good an attorney’s intentions may be, they need cash to litigate effectively, as does the client, especially in personal injury cases where they have lost an income stream. Because of this, more and more investors are channeling their wealth towards the industry, which means lucrative career opportunities for those interested in venturing into these exciting but risk-filled waters.

Two ways of funding: Sale vs. Loan

Legal funding can be provided in two ways – with the contract phrased as a loan/cash advance, or a sale where the lawyer and/or plaintiff sell part of their claim over the lawsuit to the lending company.

In the case of the loan, clients and lawyers gain the advantage of not having to pay tax since the sum will be paid back, and is therefore technically not an income. All taxes are therefore deferred. However, this could become complicated where the legal matter spills over to the following year of tax reporting.

Lawsuit

A different method of providing legal funding to plaintiffs involves structuring the sum as a prepaid forward contract, or simply a sale. The sale may involve both lawyer and plaintiff, or plaintiff alone. In terms of tax, this is a better method of phrasing. This is because the client offers to sell a portion of their future settlement, or the lawyer a portion of their contingent fee, at the point of suit resolution.

However, until the case is resolved, the sale is not deemed complete since the final return will remain unclear until that point. Therefore, the income will only be reported in the year the case actually resolves, eliminating the former predicament.

Some lawyers prefer documenting the fund as a loan since this is easier, but this introduces the challenge of determining where they stand in regards to regulations related to loans and usury. However, the fact that they are non-recourse (secured on the basis of a successful lawsuit hence paid-out claim), loans would actually be an incorrect way of phrasing.

Most legal funding companies today opt for the latter method of presentation, i.e., prepaid forward contracts which offer tax exemption on the up-front payment received, now that tax is only due when the sale closes which does not occur until the case is resolved. However, care must be taken in the documentation to ensure that the structure presents the contract in the right way to avoid tax traps in future.