Editors’ Note: This article is a follow-up to the authors’ series, Demystifying Commercial Litigation Finance, which in turn is based on their article, A Guide for Plaintiffs & Commercial Litigators Seeking Funding in the United States (the “Guide”). This article was originally published in Thomson Reuters. View the original article in its entirety, including endnotes.

I. Executive Summary

If you're a plaintiff (or potential plaintiff), sometimes referred to in this article as a “fundee,” negotiating a commercial litigation funding agreement, you face two tax problems you may not have focused on yet. The first arises on the front end, when you receive the funding advances. The second arises on the back end, when (and if) you collect litigation proceeds. Both need to be addressed before the funding agreement is signed. After that, your options narrow considerably.

We discuss the front-end issue in Section II and the back-end issue in Section III.

II. The Tax Treatment of a Funding Advance

Assume you are a prospective fundee (whether a plaintiff or potential plaintiff who has not yet filed suit) seeking funding. Your funding agreement term sheet calls, among other things, for the funder to advance $1 million at closing. Will you pay tax on that $1 million? Does it matter if the money is going to you for operating expenses? Does it matter if the money is being paid to you directly as opposed to being paid directly to your attorney for legal fees?

A. The General Rule: Loan Proceeds Are Not Income

The threshold question is whether a litigation funding advance constitutes gross income to the recipient in the year received. If the advance is a bona fide loan, the answer is no. Loan proceeds have long been excluded from gross income on the theory that the borrower's receipt of cash is offset by a corresponding obligation to repay, producing no accession to wealth. Uncontroversial stuff- - provided the arrangement is, in substance, a loan. That’s a big “provided.”

The difficulty is that most commercial litigation funding agreements are not structured as conventional loans. As discussed at length in the Guide, the predominant structure is a non-recourse advance, in which the funder's right to repayment is entirely contingent on the outcome of one or more litigations. If the case(s) do not generate proceeds, the plaintiff owes nothing. That contingency is exactly what distinguishes litigation funding from conventional lending- - and exactly what creates the tax issue.

B. Novoselsky v. Commissioner: The Tax Court Rejects Loan Treatment

The leading case is Novoselsky v. Commissioner, T.C. Memo. 2003-68, in which the Tax Court squarely addressed whether upfront litigation support payments constituted excludable loan proceeds or includable gross income. Novoselsky is not a ‘bad’ case from the fundee's perspective. It simply marks a road you don't want to go down.

In Novoselsky, the taxpayer entered into arrangements with litigation support providers under which he received upfront cash payments documented as non-recourse "loans." The agreements provided that if the underlying litigation succeeded, the taxpayer would repay the advance plus a premium from the attorney fees received. If the litigation was unsuccessful, the taxpayer owed nothing. The taxpayer reported the advances as non-taxable loan proceeds and excluded them from gross income.

The Tax Court held for the IRS, finding that the advances were not bona fide loans and were includable in the taxpayer's gross income as prepaid income in the year of receipt. The court also sustained accuracy-related penalties.

The court reached its decision by applying two complementary analytical frameworks. First, it applied the unconditional repayment obligation test. Under longstanding authority, a transfer of funds constitutes a loan only if the recipient's obligation to repay is unconditional and not contingent upon some future event. Because the taxpayer's obligation to repay was entirely contingent on the successful prosecution of the underlying litigation, the arrangements failed this threshold test. Stated differently, the contingent nature of the repayment obligation meant the taxpayer had no fixed liability offsetting the cash received- - and therefore had an accession to wealth upon receipt.

Second, the court applied a multi-factor analysis examining the traditional indicia of indebtedness:

Whether or not there was a formal promissory note.
Whether or not there were provisions for security, interest, and a fixed repayment schedule.
The taxpayer's ability to repay the loan.
Whether loan repayments were in fact made.
Whether “the obligation to repay was unconditional and not contingent upon some future event.”

C. Novoselsky’s Relevance to Plaintiff-Fundees

Novoselsky involved an attorney, not a plaintiff, but the reasoning applies with equal force. The court's analysis turned not on the identity of the recipient but on the economic substance of the arrangement: was there an unconditional obligation to repay? If not, the advance is not a loan, and the exclusion for loan proceeds does not apply.

Back to our hypo (recall, you are a plaintiff (or claimant who has not yet sued) negotiating with a funder for financing that will include a $1 million advance). Novoselsky outlines the path to avoid. Is there a better one?

D. Does the Prepaid Forward Contract Structure Avoid the Problem?

One important thing to understand up front is that most commercial funding agreements are not structured as loans. Rather, they are structured as prepaid forward contracts or absolute assignments of a portion of the anticipated litigation proceeds (as discussed in Section III below and in the Guide). Under either structure, the parties' intended reporting position is that the advance is not a loan, no income is recognized upon receipt, and the tax consequences are deferred until the forward contract settles at the resolution of the litigation.

The prepaid forward characterization offers a more defensible path than loan treatment- - precisely because it does not depend on the fiction that a contingent, non-recourse advance is debt. Instead, it treats the advance as the purchase price for a forward interest in the litigation proceeds, with gain or loss recognized only upon settlement of the forward contract.

The IRS, to be clear, has not formally blessed this treatment in the litigation funding context. Novoselsky did not address it, and the IRS could challenge it (particularly where the underlying income, such as attorney fees or lost profits, is ordinary in character). This practice, however, is pervasive throughout the industry.

E. Does It Matter Whether the Advance Goes to the Plaintiff or to the Plaintiff's Lawyer?

Yes, potentially. Novoselsky involved advances paid directly to a lawyer, and the court treated the lawyer as the taxpayer who recognized the income. Where a litigation funder advances money directly to the plaintiff's attorney for legal fees (rather than to the plaintiff for operating expenses), the question arises whether the plaintiff or the lawyer is the proper taxpayer.

Under the anticipatory assignment of income doctrine discussed in Commissioner v. Banks, 543 U.S. 426, 435 (2005), a plaintiff cannot reduce gross income by directing that litigation proceeds be paid to a third party. But that is a different question.

Whether a plaintiff must include in income an advance that the plaintiff never receives because it is paid directly to counsel is less settled. The answer likely depends on whether the plaintiff is treated as having constructive receipt of the funds, or whether the arrangement is better characterized as a direct transaction between the funder and the lawyer in which the plaintiff is not a party.

As a practical matter, fundees negotiating the routing of advances should consider several steps. Where the advance is intended to cover legal fees, having the funder disburse funds directly to counsel pursuant to a separate fee-funding agreement between the funder and counsel (to which the plaintiff is not a party) may support the position that the plaintiff never had constructive receipt of those amounts. Conversely, where the advance is intended for the plaintiff's operating expenses, the funds should flow directly to the plaintiff, and the funding agreement should clearly document that the advance is for the plaintiff's own account and not as an intermediary. In either case, the funding agreement should specify the intended recipient, the purpose of each tranche, and the parties' agreed-upon tax reporting position with respect to each payment stream. Where a single funding agreement contemplates advances for both legal fees and operating expenses, the agreement should segregate the two categories and document the routing of each separately. These structural choices should be made, and memorialized in the funding agreement, before execution- - not retrofitted after the fact.

III. Dealing with Taxes Upon Receipt of Litigation Proceeds

The starting point is simple: a litigation recovery is generally includable in a plaintiff’s gross income for federal income tax purposes. Everything after that starting point is where the complexity arises. We go into more detail below, but here is a preview of why:

Litigation funding introduces an additional layer of risk. Commercial funding agreements are, as discussed at length above, commonly structured not as loans but as prepaid forward contracts or absolute assignments of a portion of the anticipated proceeds.
Under such a structure, the funder’s “investment return” may be characterized, pursuant to the parties’ intended reporting position, as generating a capital loss to the plaintiff upon settlement of the forward contract. Whether this creates a problem depends on the character of the underlying litigation recovery, an issue governed by the origin of the claim doctrine discussed in Section B below. Because most commercial litigation claims seek lost profits or similar compensatory damages, the recovery is typically ordinary income. A capital loss, however, cannot meaningfully offset ordinary income (IRC § 1211(b)(1) limits the offset to $3,000 per year for individuals). The result can be described as a character mismatch problem (discussed in Section C(3) below): the plaintiff is taxed on the full ordinary income recovery while the offsetting loss from the funding arrangement is largely stranded as a capital loss carryforward.
The most effective mitigation strategy for both the character mismatch problem and the phantom income problem discussed in Section B(3) below is to ensure that the record supports characterization of the litigation as arising from the plaintiff’s active trade or business. As explained in Section B, that characterization is critical for two reasons. First, it permits a current deduction for attorney fees under IRC § 162 (thereby avoiding the permanent bar on miscellaneous itemized deductions under § 67(g), which would otherwise eliminate any deduction for fees in non-business, non-capital claims). Second, it provides the strongest basis for treating litigation funding costs as ordinary business financing expenses rather than capital items- - ensuring that the deduction offsets ordinary income dollar-for-dollar rather than producing a largely unusable capital loss.

A. The General Rule: Gross Income Inclusion

As previewed in Section II (E) above, the Banks Court held that when a litigation recovery is taxable, the plaintiff’s gross income includes the full amount of the recovery, including the portion paid to litigation counsel under a contingent-fee arrangement. A fundee, thus, cannot net the recovery against fees at the outset. Instead, unless a statutory exclusion or above-the-line deduction applies, the fundee must report 100% of the taxable recovery as gross income and then look separately for a deduction or basis adjustment to offset it. The IRS frames the key question as what the payment was intended to replace, and that inquiry governs both the income-inclusion analysis and the character of any offsetting deduction.

The same logic extends, by analogy, to litigation funding costs. The Banks Court grounded its holding in the “quintessential principal-agent relationship" between attorney and client, a relationship in which the plaintiff retains ultimate dominion over the underlying claim. 543 U.S. at 436. A litigation funder is not the plaintiff's agent. But the broader principle still applies: a taxpayer cannot exclude economic gain from gross income by assigning the gain in advance to another party. The fundee's gross income includes the full judgment or settlement proceeds even if the defendant pays some or all of those proceeds directly to the funder. See Section III(C) for our full discussion.

B. Deductibility of Contingent Legal Fees: The “Origin of the Claim” Framework

Whether a plaintiff may deduct the contingent fee paid to litigation counsel depends principally on the origin of the underlying claim. United States v. Gilmore, 372 U.S. 39 (1963). Under the origin-of-the-claim doctrine, the nature and character of a legal expense are determined by the transaction or activity that gave rise to the claim, not by the form of the relief sought or its consequences to the plaintiff. The analysis applies equally to all costs of prosecution, including attorney fees, expert fees, filing fees, and discovery costs.

1. Trade or Business Claims (IRC § 162)

When litigation arises from a plaintiff’s active trade or business (such as a claim for breach of a revenue-generating contract, lost profits, misappropriation of trade secrets, or business torts related to ongoing operations), attorney fees are generally deductible as ordinary and necessary business expenses under IRC § 162. This treatment is available to C corporations, partnerships, and multi-member LLCs taxed as partnerships without significant complication. For individuals, the business connection must be tied to an activity reported as an active trade or business on the individual’s return (most commonly on Schedule C).

When § 162 applies, the plaintiff is effectively taxed only on the net recovery: gross income is recognized under Banks, but an equivalent deduction offsets it. The deduction is above the line (i.e., it reduces adjusted gross income), which is critical for purposes of the § 67(g) analysis discussed below.

2. Capital Claims (Capitalization Rather Than Deduction)

When the origin of the claim is a capital transaction (e.g., disputes over the acquisition or disposition of a business, ownership of assets, title, or the terms of a purchase price or earn-out), legal fees are generally not currently deductible. Instead, they must be capitalized (i.e., added to basis or treated as a reduction of the amount realized upon sale or disposition). Woodward v. Commissioner, 397 U.S. 572 (1970). Capitalization is not elective; it is required when the facts demand it.

Capitalization provides a deferred tax benefit because the capitalized fees reduce taxable gain when the underlying asset is ultimately sold. For a plaintiff whose recovery itself constitutes capital gain (for instance, a settlement effectively representing proceeds from a sale of business interests), this result may be economically equivalent to a current deduction. In other circumstances, the benefit is delayed and uncertain.

3. Non-Business, Non-Capital Claims: The Phantom Income Trap

The most adverse outcome arises when the plaintiff is an individual, the claim falls into neither the trade-or-business nor the capitalizable category, and the claim is characterized as relating to the “production of income” under IRC § 212. In this scenario, the fundee will be taxed on the gross recovery but will not receive a deduction for the fees paid to secure it. The result for an individual plaintiff with a non-business claim is a phantom income problem. Such a plaintiff will be taxed on 100% of the gross recovery, including the portion paid to counsel, with zero deduction for those fees. The effective rate on the net recovery (i.e., what the plaintiff actually keeps) substantially exceeds the nominal statutory rate.

The way out is to ensure the claims can be properly and honestly characterized as arising from an active trade or business. Read the prior sentence again. It's the whole ballgame.

4. The Above-the-Line Deduction Under IRC §§ 62(a)(20) and (21)

Congress created a narrow above-the-line deduction for attorney fees and court costs incurred in connection with certain specific categories of claims. § 703 of the American Jobs Creation Act of 2004, Pub. L. 108-357, added what is now IRC § 62(a)(20) (originally enacted as § 62(a)(19) and subsequently renumbered), which permits a deduction computed above the line as an adjustment to gross income for fees paid in connection with any action “involving a claim of unlawful discrimination” (as broadly defined in IRC § 62(e)), as well as certain whistleblower and False Claims Act matters. IRC § 62(a)(21) separately covers fees in connection with IRS and SEC whistleblower awards.

This above-the-line deduction is deliberately narrow and does not apply to ordinary commercial or business disputes. Claims for breach of contract, lost profits, trade secret misappropriation, fraud in a commercial transaction, and the like do not qualify. As Professor Nellen has observed, the proper tax treatment of attorney fees for individuals turns heavily on whether the fee fits within one of these narrow statutory categories or must instead be traced to the origin of the claim under general principles. For most commercial litigation plaintiffs, the § 62(a)(20) route is simply unavailable.

C. Tax Treatment of Litigation Funding Costs

Litigation funding costs require a separate analysis. Their tax character depends on the structure and classification of the funding arrangement.

1. The Characterization Question: Debt vs. Sale/Forward

Commercial funding agreements appear in numerous legal forms (e.g., loans, partnership interests, option contracts, prepaid forward contracts). From a tax perspective, however, most generally fall into one of two structural categories:

In the first, the funder advances funds in exchange for a contractual right to repayment upon resolution of the litigation, and the agreement is structured as a loan. If this characterization governs, the funder’s return constitutes interest on indebtedness, and the plaintiff may be entitled to an interest deduction under IRC § 163, subject to applicable limitations. This is an increasingly uncommon structure.
In the second, increasingly common structure, the parties characterize the arrangement as an absolute assignment of a portion of future proceeds- - either through a prepaid forward purchase contract or a true sale- - with the funder receiving a share of the proceeds only if and when there are proceeds (though bad boy guarantees are common). The fundee assumes no unconditional repayment obligation; the funder’s recovery is generally contingent on the outcome.

As discussed at length in the Guide, most commercial funding agreements adopt the second structure and make their characterization explicit, stating affirmatively that the transaction is to be treated as an open transaction under a prepaid forward contract, that the funding does not constitute indebtedness, and that the investment return payable to the funder upon resolution is to be treated as a disposition or termination of the contractual right within the meaning of IRC § 1234A.

Under this intended reporting position, there is no interest, and therefore no interest deduction, associated with the funding arrangement.

2. The Open Transaction / Prepaid Forward Structure and IRC § 1234A

Under an open transaction approach, the tax consequences of the funding arrangement are not recognized when the advance is received; rather, they are deferred until the transaction settles at the resolution of the litigation. At that point, the plaintiff recognizes gain or loss measured by the difference between the amount originally advanced by the funder and the amount ultimately paid to the funder from the recovery.

If the amount paid to the funder exceeds the amount advanced, which is the typical case when the litigation resolves favorably, the plaintiff recognizes a loss on the settlement of the forward contract. IRC § 1234A then becomes relevant: that provision treats gain or loss from the termination, cancellation, or abandonment of a right or obligation “with respect to property which is (or on acquisition would be) a capital asset” as capital gain or loss. IRC § 1234A(1).

The § 1234A reference in a funding agreement is therefore a deliberate structural choice, but it does not guarantee the intended result. Whether § 1234A actually applies depends on whether the property underlying the terminated right (i.e., the litigation claim) would be a capital asset in the plaintiff’s hands. Litigation claims that seek lost profits, compensatory damages for business interruption, or similar economic injuries are typically tied to ordinary income items, not to capital assets. Damages for breach of contract producing lost profits constitute ordinary income, and a settlement replacing such damages takes the same character as the income it replaces. In such cases, capital treatment under § 1234A may not be warranted and, if so, the agreement’s labeling of the transaction as within § 1234A reflects an aggressive reporting position that may not be sustained on audit.

3. The Character Mismatch Problem

Assuming the IRS respects the forward contract characterization and § 1234A applies to generate a capital loss, a critical structural problem arises when the underlying litigation recovery is ordinary income. This is the character mismatch.

Consider a fundee whose claim seeks compensation for lost profits: the litigation recovery is ordinary income under well-established principles. Under the forward contract structure, however, the payment to the funder results in a capital loss upon settlement. The problem is that capital losses cannot offset ordinary income in any meaningful amount. Under IRC § 1211(b), an individual taxpayer may use capital losses only to offset capital gains plus a de minimis $3,000 per year of ordinary income; unused capital losses carry forward indefinitely but retain their capital character. Fargo v. Commissioner, T.C. Memo. 2015-96 (illustrating the distinct treatment of capital and ordinary income baskets).

The practical result is that the fundee recognizes, and pays tax on, 100% of the gross ordinary income recovery (under Banks, including the portion ultimately paid to the funder), while the capital loss generated by the funding settlement provides no meaningful offset in the recovery year. The fundee is left holding a potentially substantial capital loss carryforward, usable only if the fundee has capital gains in future years. The offset is, thus, largely illusory.

4. The Preferred Alternative: Ordinary Business Expense Treatment

The most favorable tax treatment for a fundee is to have litigation funding costs characterized as ordinary and necessary business expenses, deductible under IRC § 162. In other words, as business financing costs rather than capital items or items governed by the forward contract/§ 1234A structure. If § 162 applies, the deduction is above-the-line, offsets ordinary income dollar-for-dollar, and avoids both the § 67(g) bar and the character mismatch under § 1234A.

This treatment is most defensible when (a) the litigation arises from the fundee’s active trade or business, and (b) the funding arrangement can be recharacterized as ordinary business financing, notwithstanding the parties' contractual agreement to treat the transaction as a prepaid forward contract under § 1234A. The IRS, however, will examine the substance of the arrangement rather than its form; a funding agreement that explicitly disclaims debt treatment and invokes § 1234A - provisions that serve legitimate business and tax purposes for both parties- - presents a substantial obstacle to any subsequent attempt by the fundee to claim § 162 treatment inconsistent with the agreed-upon characterization. Moreover, a plaintiff who adopts a reporting position that contradicts the express terms of the funding agreement will expose itself to a claim for breach of contract.

IV. Mitigating the Tax Risks: Practical Considerations

The tax exposure associated with commercial litigation funding can be meaningfully reduced. Here's how:

First, and most importantly, the record should affirmatively support (if true) the characterization of the litigation as arising from the plaintiff’s active trade or business. This means ensuring that the underlying commercial activity is properly documented as a business, that the plaintiff has filed returns consistent with the business activity, and that the litigation is framed in terms of harm to ongoing business operations rather than to investment value. If these facts are present, the § 162 deduction should be available for both attorney fees and, potentially, funding costs, and the phantom income problem is substantially mitigated.
Second, if the plaintiff is an individual or a single-member LLC, the distinction between active trade or business income and passive investment income is critical. The LLC wrapper does not transform the character of the underlying activity. The relevant inquiry is whether the individual owner is engaged in an active trade or business in which the litigation is rooted.
Third, plaintiff and its tax advisors should carefully evaluate whether the forward contract structure in the funding agreement, and the § 1234A characterization it implies, is the most favorable available reporting position-- or whether a different characterization (such as treatment of the funding as business indebtedness with deductible financing costs) would better serve the plaintiff’s tax interests. However, in practice, most better funders will only entertain a forward contract structure. So, this is less a choice than a fact of life.
Fourth, timing matters. Where litigation costs are incurred over multiple taxable years, questions arise about when expenses are properly deductible and whether costs advanced by litigation counsel, rather than by the plaintiff directly, are deductible by the plaintiff at all. These questions are fact- and contract-specific. The consistent answer is to have qualified tax counsel involved throughout the litigation, not just at settlement.

V. Summary of Key Tax Positions and Risks

The principal tax positions and associated risks for a plaintiff-fundee in a commercial litigation funding arrangement may be summarized as follows.

Gross Income Inclusion. The full litigation recovery, including amounts paid to counsel and to the funder, is gross income to the plaintiff. Commissioner v. Banks, 543 U.S. 426 (2005). See Section III(A).
Tax Treatment of the Funding Advance. A non-recourse litigation funding advance does not qualify as excludable loan proceeds (Novoselsky v. Commissioner). The prepaid forward contract structure offers a more defensible basis for excluding the advance from current income, though the IRS has not formally endorsed this treatment. See Sections II(B)–(D).
Routing of Funds. Whether the advance is paid to the plaintiff or directly to counsel may affect both the timing and character of the income-inclusion event. Routing and documentation should be evaluated with qualified tax counsel before execution. See Section II(E).
Attorney Fees/Trade or Business Claims. If the litigation arises from an active trade or business, attorney fees are currently deductible under IRC § 162, effectively producing taxation only on the net recovery. See Section III(B)(1).
Attorney Fees/Capital Claims. If the litigation is capital in origin, attorney fees must be capitalized and reduce taxable gain when the capital asset is ultimately disposed of. Woodward v. Commissioner, 397 U.S. 572 (1970). See Section III(B)(2).
Attorney Fees/Non-Business Individual Claims. For individual plaintiffs with non-business, non-capital claims, attorney fees are not deductible, and phantom income results. See Section III(B)(3).
Funding Costs/Forward Contract/§ 1234A Structure. Under the intended reporting position in most commercial funding agreements, the funder’s investment return is not interest and generates a capital loss to the plaintiff upon settlement of the forward contract. If the litigation recovery is ordinary income, IRC § 1211(b) severely limits the ability to use that capital loss, creating a character mismatch. A fundee who adopts a reporting position inconsistent with the contractual § 1234A characterization will also expose itself to a claim for breach of contract. See Section III(C)(2)–(3).
Funding Costs/Best Case. If the litigation arises from an active trade or business and the funding costs can be characterized as ordinary business financing expenses under IRC § 162, those costs are currently deductible against ordinary income. This mitigates both the phantom income problem and the character mismatch. See Section III(C)(4).

VI. Bottom Line

Bring a tax advisor to the table before you sign the funding agreement term sheet, not after you cash the settlement check. The cost of early planning is modest. The cost of phantom income and stranded capital losses is not.

Back to our hypothetical $1 million advance. You now know that how you receive it, how your funding agreement characterizes it, and whether your claim sounds in business or investment can each independently determine whether you end up with a manageable tax bill or an unpleasant surprise - the kind where you owe taxes on money you never actually kept.

The structural choices in a funding agreement (the § 1234A characterization, the express disclaimer of debt treatment) exist for good reason. They serve both sides. A fundee who ignores those choices at tax time is picking a fight on two fronts: with the IRS and with the funder. That’s not smart.

A Tax Guide for Plaintiffs Negotiating a Commercial Litigation Funding Agreement