In conversation with Mark Leeds: Accounting for litigation and the tax implications of legal finance

Liz Bigham: Mark to start us off, could you address what legal and finance executives from businesses that are considering using commercial legal finance need to know about its tax and accounting treatment?

Mark Leeds: Yes, absolutely. The very first question that a law firm, a plaintiff or a business that's receiving or entering into a litigation finance transaction needs to be concerned about is whether or not the upfront payment that it receives is immediately taxable. If it is immediately taxable, that's going to reduce the amount of net cash that they have either to take home or to use in the litigation itself by approximately half.

If it's in the US, our ordinary income rate for non-corporate entities is 37% plus the 3.8% Medicare tax plus state and local taxation, which usually comes out to about 50%. So, the first and foremost criteria that's going to be important for a company receiving finance upfront is whether or not it can be structured in a way that the upfront payment is only taxable after the matter is resolved and the payment is made.

Upfront taxation results in what is frequently referred to as reverse tax shelter because rather than being able to have the cash immediately for use in the litigation, when so much of it is being used for the payment of upfront taxes, that can be a real impediment to getting a transaction done. The next question that is of equal importance is whether or not it's possible to structure the litigation finance transaction in a way such that any ultimate recovery is going to give rise to an ordinary business deduction or whether or not it's going to give rise to a capital loss. In other words, the character of the payment for the person receiving funding when it ultimately makes that payment is very important. Almost as important as the upfront taxation itself. 
So the absolute sweet spot to be in, if you can get there, is for the upfront payment to be deferred. But then when it is taken into account in income, it results in an ordinary deduction that can be used against the amounts that are received in the litigation or the fees that are received by the plaintiff's attorney.

LB: Can you next address any unofficial guidance provided by the IRS or any cases in which tax courts have made rulings on legal finance tax issues?

ML: The most important decision that we've had from the courts is a case called Novoselsky. Novoselsky involved an attorney who received litigation finance ostensibly in the form of a loan. The loan would have certainly met the objectives that we just discussed. The upfront loan payment would not have been taxable, and then while repayment wouldn't have been taxable at all, that was a match, because as you don't mind that your repayment of a loan isn't taxable when the upfront receipt of the loan proceeds was non-taxable. Novoselsky unfortunately as a case blew a big hole through the ability of the market to treat these transactions as loans. And that has resulted in a variety of other formats being used, including variable prepaid forward contracts, transactions that may be counterintuitively or treated as swap transactions or notional principal contracts.

Before the Novoselsky decision, which was rendered in 2020, there was a series of cases and other authorities that really did directly address litigation finance. There's the Bercaw case from 1948, where the question was whether or not a deduction was permitted for litigation finance costs that were advanced and not repaid, Estate of Paine from 1963. Again, in that case, a deduction was permitted for litigation finance costs that were advanced but not repaid. There was the Long case from 2002 where a sale of litigation rights was treated as capital gain, but no deduction was permitted for the repayment of refunding. And then there was an audit advice memo called the Field Service Advice Memorandum from 2015, where the application of a look through was challenged by the Internal Revenue Service. In my view, that last piece of authority is very suspect.

So, while unfortunately we don't have a coherent body of law addressing litigation finance payments, there is enough case law and at least one authority issued by the IRS that provides guideposts for how we should treat these transactions.

LB: If I understand you correctly, you're saying that there are options available to potential users of commercial legal finance and that, as with Burford, clients can indicate how their capital provision can be structured from a tax perspective to meet their particular business needs.

ML: I think that's absolutely true, Liz, that the documentation can be structured in such a way to meet client needs. It can be structured so that the client receives an ordinary deduction when the repayment of the amount advanced upfront is repaid. It can also be structured in certain to give rise to a capital loss as well. And so, depending on the nature of the item being financed getting the documentation right to ensure that the tax character of any repayment follows the recovery in the litigation is going to be important, but certainly doable.

LB: From a tax and accounting perspective, what do you see as the most important best practices for law firms using funding and for businesses using funding?

ML: Best practices for law firms and businesses may actually be a little bit different because the nature of the underlying claims are different. With respect to a law firm, in general, it's always going to be fee income. And so, structuring the variable forward contract in the first instance so that it isn't treated, what as what we call in tax world as a substitute for ordinary income is going be really important because the receipt of substitute for ordinary income is generally immediately taxed. So, it's going to be very important for law firms to structure the transactions as derivatives and not as an ownership interest in the fee income. With respect to a business, it really is going vary depending on what the litigation is about. 

In the context of patent litigations, which is frequently a source of litigation funding, if the recovery that the business is going to be received is in the nature of a substitute for royalty incomes that wasn't paid, which will be ordinary income, ensuring that the variable forward gives rise to an ordinary deduction is going to be very important. Whereas if the underlying claim is more in capital, in nature, ensuring that the funding gives rise to a capital loss is going to be key. To say it more in plain English, the most important feature of structuring these agreements is to ensure that the character of the payment made back to the funder follows the character of the income which is going to be recognized in the litigation. So, if you have a capital asset, you're going to want the litigation funding to give rise to a capital off, which can offset that. And if it's ordinary income, you're going to want to ensure that the repayment of the litigation funding gives rise to an ordinary deduction.

This video was recorded in March 2024. 

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