Seeking Better Tax Treatment on Litigation Funding

In the past decade, the nascent litigation funding entrepreneurs entered with an appealing nomenclature of offering to litigation parties and attorneys “non-recourse loan:” namely, the funding loan needs not be repaid if the underlying litigation produces no monetary recovery or proceeds.

On the obligation to repay, a typical non-recourse provision reads:

If the claimant does not recover any Proceeds in this case, the monies invested by [Litigation Funder] are not required to be repaid. It is realized and understood by the Parties that nothing in this Agreement contains a guarantee that any amounts will be paid to [Litigation Funder] save in the event of recovery of Proceeds by the Claimant.

This “non-recourse loan” labeling also attempts to take advantage of loan’s legal character of being not immediately taxable to the parties or litigation attorneys who sold future fees—loan proceeds are not taxable income. However, in the first modern reported case directly addressing the US tax treatment of litigation funding, the Tax Court in Novoselsky v. Commissioner resolutely disregarded the form, and framed issue as to whether litigation funding payments should be treated as “loans” by asking whether the taxpayer’s obligation to repay was “unconditional and not contingent upon some future event.” As the very risk and essence of litigation funding payoff is “contingent” on recovery upon successful litigation, it is no surprising, following the test, the Court found  that Novoselsky’s litigation funding payments received were immediately taxable ordinary income, not loans. Novoselsky v. Commissioner, T.C. Memo. 2020-68 (U.S.T.C. May 28, 2020)

The Novoselsky Court, in effect, looked through the funding forms, and found a disguised sale.

It is no surprising, therefore, tax attorneys and professionals advising litigation fundings have long abandoned the “non-recourse loan” characterization, instead and increasingly rely on the “Prepaid Variable Forward Contract (PVFC)” construct.

In Revenue Ruling 2003-7, the “Prepaid Variable Forward Contract” construct is analyzed and blessed under the “open transaction” doctrine. The issue is framed as follows:

Has a shareholder either sold stock currently or caused a constructive sale of stock under §1259 of the Internal Revenue Code if the shareholder (1) receives a fixed amount of cash, (2) simultaneously enters into an agreement to deliver on a future date a number of shares of common stock that varies significantly depending on the value of the shares on the delivery date, (3) pledges the maximum number of shares for which delivery could be required under the agreement, (4) has the unrestricted legal right to deliver the pledged shares or to substitute cash or other shares for the pledged shares on the delivery date, and (5) is not economically compelled to deliver the pledged shares?

In finding no immediately taxable sale or exchange under Code §1001(c), and no constructive sale, the Revenue Ruling cites cases, and concludes:

[…O]n the [PVFC] Execution Date, Shareholder received a fixed payment without any restriction on its use and also transferred in trust the maximum number of shares that might be required to be delivered under the Agreement. Like the taxpayers in Miami National Bank and Richardson, but unlike the taxpayer in Hope, Shareholder retained the right to receive dividends and exercise voting rights with respect to the pledged shares. Also unlike Hope, the legal title to, and actual possession of, the shares were transferred to an unrelated trustee rather than to Investment Bank. Moreover, Shareholder was not required by the terms of the Agreement to surrender the shares to Investment Bank on the Exchange Date. Rather, Shareholder had a right, unrestricted by agreement or economic circumstances, to reacquire the shares on the Exchange Date by delivering cash or other shares.[] Accordingly, the execution of the Agreement did not cause a sale or other disposition of the shares.

The importance and implication of Revenue Ruling 2003-7 cannot be overstated. In the context of litigation funding, like the Shareholder who pledge and entrust the common stocks, Claimant arguably agrees to deliver, at maturity of the forward contract, to deliver recovery proceeds, or portion of the Claim, that vary significantly depending on its value at conclusion or contract expiration, has the right to deliver either cash or portion of the pledged Claim on settlement, and more importantly, has no apparent economic or legal restraint to deliver the Claim itself rather than cash.

This sort of contract drafting may safely and nicely place litigation funding in the PVFC construct, resulting no immediate federal income tax on Code §1001(c) “sale or exchange.”

The Tax Court reasoned in the recent case of Estate of McKelvey v. Commissioner, 148 T.C. No. 13 (2017):

Certain transactions, such as [variable prepaid forward contracts], are afforded “open” transaction treatment because either the amount realized or the adjusted basis needed for a Section 1001 calculation is not known until contract maturity. [] In these instances the component that is known is held in suspense and gain or loss is not realized until the missing component is determined and the transaction is properly closed. The open transaction doctrine is an exception to the usual treatment arising from a sale or exchange of property for cash or other property. [] The open transaction doctrine is a “rule of fairness designed to ascertain with reasonable accuracy the amount of gain or loss realized upon an exchange, and, if appropriate, to defer recognition thereof until the correct amounts can be accurately determined.”

Nonetheless, as applied to litigation funding, Revenue Ruling 2003-7 is thin ice to skate on. Estate of McKelvey notwithstanding, Courts rarely apply the “open transaction” doctrine today. Statutes, regulations and courts have severely limited its application. The “open transaction” doctrine now applies only in “rare and extraordinary cases” and is generally rejected “in favor of the best estimate of fair market value which the circumstances allow.”

More important, in litigation funding contracts, the tax adjusted basis for Claims, contingent fees and funders are known, fairly ascertainable—which take aways much of the “uncertainty” that justified “fairness” argument. And, while the exact amount of recovery Proceeds, therefore the litigation funding gain, is unknown and held in suspense, the application of “open transaction” or “fairness” doctrine does, though probably should not, magically change the tax character of the gain.