Lawyer loses litigation with IRS on taxation of litigation financing

In the recently decided case, Novoselsky v. Commissioner¹, the U.S. Tax Court ruled that money received by a lawyer from third parties for litigation financing was deemed taxable income. Litigation financing provides resources to undercapitalized plaintiffs who otherwise cannot pursue meritorious legal claims or provides additional capital to in-progress cases where plaintiffs face financing shortages. A third party may engage in litigation financing for the potential of a large return.

Here, the third parties and lawyer signed an agreement that loans were made to the lawyer on a non-recourse basis in order for the lawyer to pursue certain litigation. If the litigation was successful, the advance from the third parties would be repaid at a very high rate of interest. However, if the litigation was unsuccessful, the advances would not be repaid.

The lawyer received litigation financing payments of $410,000 in one year and $1 million in a second year. For tax purposes, the lawyer treated all of the advances as nontaxable loans. Genuine loans accompanied by an unconditional obligation to repay do not constitute income. However, where an obligation to pay arises only on the occurrence of a future event, a valid debt does not exist for federal tax purposes. The court viewed the advances as contingent debt and, therefore, constituted income.

In addition to the advances being contingent, the court determined that the advances did not resemble valid indebtedness when: (a) there was no formal promissory note; (b) there was no fixed schedule for repayment; (c) the lawyer provided no collateral; (d) no payments of principal were ever made; and (e) no payments of interest were ever made. Therefore, the court concluded that all of the advances constituted taxable income and were not tax-free loan proceeds.

The tax treatment of loans, including bad debt deductions, is an issue frequently challenged by the IRS and litigated in the U.S. Tax Court.

Feel free to contact an attorney at Chuhak & Tecson, P.C. for advice on the tax treatment of loans or any other tax issue.

Client alert authored by David B. Shiner (312 855 4319), Principal, J.D., LL.M Taxation.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

¹ T.C. Memo 2020-68 (May 28, 2020)