Lawyers Face New Tax on Litigation Funding

Lawyers who receive litigation funding must manage a complex tax on litigation funding that hinges on how the advance is documented.

Structure of a funding deal

Funding can come from a dedicated funder, a hedge fund, or a private investor. The provider supplies cash to a plaintiff, an attorney, or both, betting on the case’s outcome. Most arrangements are non‑recourse, meaning the recipient owes nothing if the suit fails.

Early funding deals mainly helped plaintiffs. Recently, large practices have become major users, sometimes obtaining cash alongside their clients. The funder may back a single case or a portfolio of several matters, spreading its risk across multiple outcomes.

Tax classification of the advance

Whether the advance counts as a loan, a sale, or a prepaid forward purchase agreement (PFPA) determines tax consequences. A minority of agreements are written as non‑recourse loans; in that scenario the cash is not income when received, but the loan‑interest rules can be unfavorable for both sides.

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Sale‑type contracts are also rare because the tax treatment often disadvantages one party. For the past fifteen years, most deals use PFPA structures, which are not debt instruments and carry no interest.

The IRS has ruled that a properly structured PFPA does not create taxable income at the time of the advance. Revenue Ruling 2003‑7, consistent with Section 61(a)(3) of the tax code, treats the advance as a purchase price for property that is not yet realized.

When the attorney’s right to fees becomes fixed—either by settlement or a final judgment—the firm reports ordinary compensation income on the total recovery.

The PFPA is then terminated.

The tax code, which is a bit of a maze, still forces the firm to treat each case separately when a portfolio PFPA is in place.

It allocates a portion of the funder’s advances to each case as it resolves, reporting the outcome in the year of settlement.

In practice, a single‑case PFPA ties the firm’s payment obligation to the eventual fee recovery from that client. The firm’s accounting method determines when the compensation is recognized, but the timing of the PFPA termination follows the case resolution.

Reliance on PFPA structures suggests that most firms will continue to defer taxation until the final recovery. This approach aligns with the goal of taxing only the net proceeds, not the upfront cash that must later be repaid.

Overall, the tax on litigation funding remains centered on the documentation. Accurate contracts that qualify as prepaid forward purchases allow attorneys to receive needed capital while postponing tax liability until the case concludes.