Whatever one thinks about the policy of allowing huge hedge funds, some of which are foreign-owned, monetize our court system through third-party litigation funding (and we don’t think much of it), the United States Senate Finance Committee version of the federal tax bill takes the position that if we’re going to let people profit off the misery of others, they should at least have to pay for the privilege.
The pertinent language can be found in § 70605 of the 549-page tome. Rather than attempt to paraphrase it, we give the following summary from the committee section-by-section analysis.
Sec. 70605. Third party litigation funding reform.
Current Law: Third-party litigation financing arrangements – where outside investors fund legal claims in exchange for a share of the recovery – are generally taxed under ordinary income or capital gains rules. These proceeds may be subject to general partnership, corporate, or individual taxation rules, and there is no specific tax regime or withholding requirement applicable to litigation finance income. Gains may, in some cases, be classified as capital assets unless otherwise excluded under Section 1221. In addition, there is no statutory exclusion from gross income for litigation finance proceeds, nor any special withholding mechanism tied to such proceeds.
Provision: The provision creates a new framework addressing income received by third-party entities under litigation financing agreements. Specifically, a new tax is imposed on qualified litigation proceeds received by covered parties, which include third-party investors, domestic or foreign, who fund litigation in exchange for a contingent financial interest. The tax would be equal to the highest individual income tax rate plus 3.8 percent and would apply at the entity level for pass-through entities. Qualified litigation proceeds would be excluded from capital asset treatment under Section 1221 and excluded from gross income under Section 139L. Additionally, the proposal disallows loss offsets and overrides Sections 104(a)(2) and 892(a)(1) exclusions.
The proposal imposes a withholding obligation where any named party or affiliated law firm that has executed a litigation-financing agreement is required to deduct and withhold, from any distribution to the covered party an amount equal to 50 percent of the applicable percentage specified in proposed Section 5000E-1(b). The proposal requires the withholding agent to be liable for the withheld taxes and receives a creditable offset against its own tax liability, though ultimate liability remains with the recipient if there is an underwithholding. There is a $10,000 de minimis exception, a carveout for non-contingent loan arrangements and an interest rate safe harbor. The provision also covers indirect financial interests through instruments substantially similar to litigation financing agreements (e.g., swaps, forwards, or options).
The provision applies to taxable years beginning after December 31, 2025.
The highest individual income tax rate is 37%, so the hedge funds will hopefully have to cough up more than 40% of their ill-gotten gains to the federal treasury. We also like the withholding provision. It’s about time for some real accounting in this business. Perhaps we should propose a parallel state tax and use it to pay judges and jurors more money. That would seem to be the least we can do for allowing these people to exploit of our civil justice system.
