1 BETTING ON AN UNCERTAIN FUTURE: THE TAX CONSEQUENCES OF LARGE THIRD-PARTY LITIGATION FINANCING TABLE OF CONTENTS I. INTRODUCTION ............................................................................................................ 2 II. LITIGATION FINANCE BASICS ...................................................................................... 5 A. TERMINOLOGY ..................................................................................................... 5 B. THERIUM AGREEMENT......................................................................................... 7 C. TAX GOALS........................................................................................................ 14 III. LITIGATION FINANCE TAX CHARACTERIZATION.................................................... 17 A. IMMEDIATE SALE OR EXCHANGE ....................................................................... 17 B. SUBSEQUENT SALE OR EXCHANGE .................................................................... 20 C. VARIABLE PREPAID FORWARD CONTRACT ........................................................ 26 D. UNAVAILING CHARACTERIZATIONS ................................................................... 34 E. THERIUM CHARACTERIZATION .......................................................................... 41 IV. CONCLUSION ......................................................................................................... 42
Transcript
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BETTING ON AN UNCERTAIN FUTURE: THE TAX CONSEQUENCES OF LARGE
THIRD-PARTY LITIGATION FINANCING
TABLE OF CONTENTS
I. INTRODUCTION ............................................................................................................ 2
II. LITIGATION FINANCE BASICS ...................................................................................... 5
A. TERMINOLOGY ..................................................................................................... 5
B. THERIUM AGREEMENT ......................................................................................... 7
C. TAX GOALS ........................................................................................................ 14
III. LITIGATION FINANCE TAX CHARACTERIZATION .................................................... 17
A. IMMEDIATE SALE OR EXCHANGE ....................................................................... 17
B. SUBSEQUENT SALE OR EXCHANGE .................................................................... 20
C. VARIABLE PREPAID FORWARD CONTRACT ........................................................ 26
D. UNAVAILING CHARACTERIZATIONS ................................................................... 34
E. THERIUM CHARACTERIZATION .......................................................................... 41
IV. CONCLUSION ......................................................................................................... 42
2
I. INTRODUCTION
It has never been easier to receive outside funding for a legal claim. Once upon a time, a
cash-strapped party who brought a lawsuit had few options. The litigant could have gone to a
plaintiff’s lawyer who would take a case on a contingent basis.1 But the litigant would not have
access to immediate cash nor could the party pick a lawyer not working on a contingent basis. A
contingent-fee lawyer who wanted to diversify their claims or get access to pre-judgment cash
likewise had no other options.
Enter third-party litigation financing. Also known as litigation finance, this financing
describes the “nonrecourse funding of litigation by a non-party for a profit.”2 Under a typical
financing agreement, the beneficiary of the funding (either the litigant or a contingent-fee
lawyer) receives cash from a third-party litigation fund (funder) in exchange for a percentage of
the potential claim. The litigant uses the proceeds to either pay for living expenses or costs of
litigation. The contingent-fee lawyer uses the proceeds to diversify risk and smooth out cash
flow.
To the chagrin of tax professionals, litigation finance defies an easy tax characterization.
Trying to define the claim is like putting a square peg into a round hole. To make matters worse,
the Internal Revenue Service (IRS) has not issued any substantive administrative guidance to
help taxpayers categorize the transaction.3 The lone IRS publication is a highly redacted and
1 See Robert W. Wood & Jonathan Van Loo, Investors Who Fund Lawsuits: Form and
“Wood, Investors”) (“When plaintiffs in the United States are unable to fund litigation,
contingent fees are the norm.”). 2 John Gamino, Taxing Nonrecourse Litigation Funding, 12 ATA J. OF LEGAL TAX RES.
85, 86 (2014). 3 See id. (noting that the IRS’s “lack of notice” regarding litigation financing has
“resulted in a lack of administrative guidance in the face of elemental federal income tax issues”
including “characterization and timing”).
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unhelpful memorandum issued in 2015.4 Some scholars and practitioners have started trying to
solve the tax characterization puzzle.5 No one has articulated a definitive view of what the
contract is for tax purposes.
Between 2013 and 2015, the number of lawyers who said they used litigation finance
grew four-fold, from seven percent to twenty-eight percent. 6 While the litigation finance market
started small – typically funding modest consumer injury claims – it has since grown to more
prominent commercial cases. Litigation finance companies now are funding high-dollar
corporate litigation claims for, among other things, patent infringement, breach of contract,
shareholder derivative, and class-action lawsuits.7 The demand for investing in these types of
claims keeps growing. The largest litigation finance fund, Burford Capital, raised and invested
$378 million in new cases in 2016 alone.8
But the largest litigation funds are pushing the limits on how they categorize the
transactions for tax purposes. Most funds, it seems, are labeling these contracts as “variable
prepaid forward contracts.” By using this definition, the funds have stretched the logical
4 I.R.S. Tech. Adv. Mem. 20154701F (November 20, 2015). 5 See e.g., Wood, Investors, supra note 1; Robert W. Wood & Donald P. Board, Monster
McKelvey Estate Tax Case and Litigation Finance, TAX NOTES TODAY, 2017 TNT 181-8, Tax
Notes Today, September 20, 2017 (hereinafter “Wood, McKelvey”); Robert W. Wood &
Jonathan Van Loo, Litigation Funding: The Attorney’s Perspective, TAX NOTES TODAY, 142
TNT 435 (Jan. 27, 2014) (hereinafter “Wood, Attorney”); Alan B. Morrison & Randy Haight,
The Tax Treatment of Alternative Litigation Funding: Some Answers, But Mostly Questions, 12
PITT. TAX REV. 1 (2014); Gamino, supra note 2. 6 See Joan C. Rogers, Litigation Funding on Rise in Big Cases, Panel Says, BLOOMBERG
LAW NEWS, (March 23, 2017), https://www.bna.com/litigation-funding-rise-n57982085617/
(“The percentage of U.S. lawyers who say their firm used litigation finance grew from 7 percent
in 2013 to 11 percent in 2014, and then to 28 percent in 2015, according to a report from legal
financing firm Burford Capital.”) (hereinafter “Litigation Funding Panel”). 7 Morrison & Haight, supra note 5, at 4. 8 See Paul Barrett, The Business of Litigation Finance Is Booming, BLOOMBERG
business-of-litigation-finance-is-booming (hereinafter “Business of Litigation Finance”).
4
limitations of a favorable revenue ruling issued in 2003 used to support that characterization.9
Without the IRS explicitly blessing or rejecting this characterization, the tax lawyers setting up
these agreements are changing the definition of prepaid forward contracts and shaping the future.
This “planning drift” is not good from a tax policy perspective.10 The tax community needs
more thoughtful dialogue as to whether these litigation finance contracts deserve this
categorization. This paper hopes to add to that discussion, and advocates for the IRS to provide
more certainty in the area.
Part II of this paper will introduce the basics of litigation finance. 11 It will describe
relevant characteristics of litigation finance claims, analyze a recently disclosed litigation finance
contract, and identify potential tax goals for the parties involved. Part III will categorize the
litigation finance contract for federal income tax purposes. This paper suggests that the litigation
finance contract analyzed is a capital asset and creates an immediate sale at the time of funding.
This paper will further suggest it is unlikely that claim does not create a subsequent sale or
exchange nor does it create a variable prepaid forward contract. Without either of these
characterizations, it is unlikely that the funders would receive preferential capital gains treatment
for their claim. This paper will also briefly explain why the contract does not create a
partnership or a secured debt instrument. Part IV will conclude. This paper recommends that the
IRS issue guidance on prepaid forward contracts to provide more certainty in this area.
9 See infra part III.C. 10 See generally Sloan G. Speck, Tax Planning and Policy Drift, 69 TAX L. REV. 549
(2016). 11 This paper focuses on the emerging corporate market, and the consequences of U.S.
taxable investors who invest in claims held by contingent-fee lawyers. For reasons discussed
below, the market for personal injury consumer injury litigation is more straightforward. See
infra notes 23, 76, & 175 and accompanying text. The tax consequences to litigants who sell a
portion of their claim and foreign investors that invest in those claims, while also interesting and
complex, are outside of the scope of this paper.
5
II. LITIGATION FINANCE BASICS
A. TERMINOLOGY
Litigation finance typically comes in two varieties: small funding for personal injury
cases and large funding for corporate litigation.12 The first type of funding usually involves a
funder advancing money to a litigant or contingent-fee lawyer in exchange for part of the rights
to future judgment or settlement.13 The amount of funding is typically less than thirty thousand
dollars.14 The funder usually does “not conduct extensive investigations before making the
advance” in these types of claims.15 Currently, more funders invest in the consumer market than
in the corporate litigation market.16
On the other hand, funding for “complex commercial disputes” often exceeds “several
million dollars.”17 The funding does not go directly to the plaintiff; rather, it goes to fund the
complex litigation.18 Before accepting or turning down an investment, investors “engage[] in
substantial due diligence.”19 The investors are often more experienced than the ones that invest
in personal injury claims.20 One of the most prominent litigation funds states that it “provides
strategic capital to the business community… [for] expensive, complex, high-risk commercial
12 Morrison & Haight, supra note 5, at 2. 13 Id. See also Wood, McKelvey (“The [litigation financing] contract may involve the
plaintiff selling a piece of his claim. Alternatively, it may involve the plaintiff's lawyer selling a
piece of the contingent fee he hopes to earn.”). 14 Gamino, supra note 2, at 88. 15 Morrison & Haight, supra note 5, at 3. 16 Id. 17 Id. at 4. 18 Id. 19 Id. 20 Business of Litigation Finance, supra note 8 (noting that the investors are “not
necessarily the Robin Hood affair” types because the number of sophisticated corporate investors
has increased).
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legal disputes… [which] is similar to other funding mechanisms available to businesses,
including bank financing and other forms of financing that might be collateralized.”21
One of the main differences between the personal injury funding and corporate funding is
that the latter is case dependent.22 While a smaller litigation fund may use an almost identical
contract to fund plaintiff’s lawsuits, a large litigation fund likely will not use the same agreement
for more than one party.23 This idea intuitively makes sense, as the dollar amount in each
corporate litigation finance claim is significantly higher.
But it is hard to generalize commercial litigation contracts. Most contracts “contain strict
confidentiality provisions” that make disclosure illegal.24 Moreover, the vast majority of courts
do not require parties to tell opposing counsel or the court about the third-party financing.25
21 Gamino, supra note 2, at 91 n. 14. 22 This paper will distinguish between the types of funding by whether the lawsuits are
homogenous or not. For example, it is possible to have a “smaller” funding for a multi-district
litigation case that focuses exclusively on a personal injury. Under this distinction, the lawsuit
would not be unique and would still be a “corporate funding” type lawsuit. See Alison Frankel,
mdl-judges-police-plaintiffs-funding-deals-idUSKBN1DK2IE (noting that a litigation funding
company “advanced the seven NFL retirees $1.63 million in exchange for rights to $3.43 million
of the cash they are expected to receive” in a settlement with the NFL over the prevalence of
traumatic brain injuries). 23 See Morrison & Haight, supra note 5, at 5 (“[W]hereas personal injury [litigation
finance has] standard form arranges, with only the specific amount advanced and the rate
charged being filled in, commercial [litigation finance] is different.”). 24 Gamino, supra note 2, at 92. 25 See Ben Hancock, How Jones Day Unmasked a Litigation Funding Deal and Won,
THE AMERICAN LAWYER (Oct. 29, 2017), https://www.law.com/americanlawyer/sites/
Agreement contemplated three tranches of funding to Patton Boggs that would total $15 million.
The first tranche, due November 1, 2010, was $4 million. The next two tranches, if funded, were
to consist of $5.5 million each. The Funding Agreement required the LAPs to request funding of
each subsequent tranche, which Burford could decline underspecified conditions. Burford's
funding was to be paid only and directly to Patton Boggs and held in a trust account, and
Tyrrell's personal approval was required for its disbursement.”). 33 Amended and Restated Litigation Funding Agreement at 70, Gbarabe v. Chevron Co.,
Case 3:14-cv-00173-SI (No. 186-4) (N.D. Ca. Sep. 16, 2016) (hereinafter “Therium Contract”),
available at https://www.law.com/americanlawyer/sites/americanlawyer/2017/10/29/how-jones-
day-unmasked-a-litigation-funding-deal-and-won/. 34 Id. 35 See Gbarabe article, supra note 25 (“The costs included everything from Perry and
Fraser’s travel to San Francisco for the initial case conference ($5,000), to Fraser’s trips to
Nigeria ($55,133), to the inspection and reports by Cleary’s company ($300,000-$500,000). It
said that, while Perry would essentially litigate on contingency, Fraser would have to “give up a
great deal of work to concentrate” on the Chevron case. The document proposed that he be paid
$15,000 per month “against final fees on judgement or settlement.”). 36 Id.
9
Initially, the contract called for Therium to invest one and a half million dollars into the
claim.37 Later, Therium increased that amount by two-hundred thousand dollars.38 This
significant amount of funding is not unusual for Therium. In 2015, a financial services company
invested 200 million pounds (roughly 265 million dollars) in Therium’s claims.39 The amount of
funding in this case, in contrast, looks small compared to the amount of the total amount that
Therium has available for investment.40
Therium likely undertook a significant amount of due diligence for this lawsuit. The
New York Times described a typical litigation finance company’s due diligence as follows:
[T]he work sits somewhere between banking and gambling. Lenders employ
experienced lawyers to judge the strength of cases. They consult databases showing
the results of similar lawsuits, just as appraisers value homes based on recent sales.
A corporate defendant may have a history of battling personal injury claims; or
juries in a specific county may have a history of siding with local employers. Then
they place their bets. Counsel will invest up to $10 million in a law firm.41
The litigation finance companies often sign non-disclosure agreements, and have an
exclusive period that allows the investment company to decide whether to invest in the litigation
without fear of another company investing before.42 Some due diligence lasts months,
37 Therium Contract, supra note 33, at 70. 38 Gbarabe article, supra note 25. 39 Jane Croft, Therium raises £200m in litigation funding, FINANCIAL TIMES (May 5,
2015), https://www.ft.com/content/5cd7053a-f033-11e4-aee0-00144feab7de. 40 See Gbarabe article, supra note 25 (“With over $300 million at its disposal, $1.7
million probably seemed miniscule.”). 41 Binyamin Appelbaum, Investors Put Money on Lawsuits to Get Payouts, NEW YORK
TIMES, November 15, 2010. See also How to Properly Structure a Litigation Finance
primiarlly look to the following factors when deciding whether to invest: “Strength of
Underlying Case (or Cases); Creditworthiness of the Defendant; Track Record of the Firm;
Politics, Regulatory and Legislative Issues; Headline Risk”). 42 Litigation Funding Panel, supra note 6.
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containing extensive meetings with the litigation fund and the lawyers.43 During the due
diligence period, the investment company typically prepares the funding agreement and asks for
approval for the investment from an investment committee.44
The funding is not without significant risk. As previously discussed, one of the leading
characteristics of litigation finance is that most funding is non-recourse. The plaintiffs or
lawyers are not on the hook for anything if the lawsuit is ultimately unsuccessful. Section 3.3 of
the Theirum agreement contains a non-recourse provision, stating:
If the Claimants do not recover any Proceeds in this case, the monies invested by
Therium are not required to be repaid. It is realised and understood by the Parties
that nothing in this Agreement contains a guarantee that any amounts will be paid
to Therium save in the event of recovery of Proceeds by the Claimants.45
In Therium’s case, it would not be able to recover its cost if the litigation was not
successful because the attorneys would not need to pay back any money to the fund.
b. Recovery
Section 1.1 also includes the most critical part of the contract to Therium: the definition
of “success fee,” or what the litigation finance company would get if the funding were
successful. The agreement states that Therium would have received “6x (six times) the total
Committed Funds, plus 2% of all Proceeds.”46 The small percentage of gross proceeds is typical
in litigation finance contracts. It is a way to align the interests of both the investment company
43 See Bogart Deposition, supra note 32, at 7 (“Burford thus began more significant
diligence and commenced commercial negotiations over investment terms. Our contacts for both
diligence and negotiation were generally With Danziger and/or Patton Boggs. The magnitude,
complexity and uniqueness of the Litigation and the duration and complexity of the economic
negotiations meant that there were substantial contacts extending over a number of months.”). 44 Id. 45 Therium Contract, supra note 33, at 76. 46 Therium Contract, supra note 33, at 70.
11
and the plaintiffs in settling the case as quickly as possible.47 The amount of the success fee,
however, is unusual. The success fee is much lower in other lawsuits, usually four times the
committed funds.48 Because this investment was particularly risky, Therium likely required a
high success fee as a prerequisite of investing.
In the event of a successful outcome, Therium would get priority to any money recovered
in the lawsuit. Under section 3.2 of the agreement, Therium would first recover the amount they
invested in the lawsuit and would then split the success fee with the Plaintiffs.49 It is unclear,
based on a reading of the agreement, whether Therium would get the six times committed funds
before splitting the rest of the proceeds from the arrangement. Most contracts created by U.S.
litigation funds have a more explicit ordering schedule for how the money recovery from a
successful litigation is distributed.50 Some litigation finance contracts even create a “security
47 Gbarabe article, supra note 25. 48 See e.g., Gamino, supra note 2, at 89 (noting the Transcapital Financial Corporation
funding in In re Transcapital Financial Corporation, 433 B.R. 900 (Bankr. S.D. Fla. 2010) was
“4 times the amount invested plus 1 percent of the …claims”) (internal citations omitted); Brief
of Appellants at 87, Cash Funding Network L.P. v. Anglo-Dutch Petroleum Int’l, Inc., No. 01-
05-00960-CV (Tex. App. Jan. 22, 2007), 2007 WL 929514 (noting the return on this agreement
is “the investment, plus an amount equal to one hundred percent of its investment plus a 100%
return of investment per annum,” which, assuming a $25k investment which settled after 700
days and a total recovery of $97,945, would be would a return of a close to 4 times the
investment). The recovery of over four times the committed funds is typical if the litigation is
risky. See Bogart Deposition, supra note 32 (“The Funding Agreement provided that Treca’s
interest in any eventual judgment proceeds is to be calculated based on a ‘Funding Compensation
Percentage’ of the ‘Net Recovery Amount,’ both of which are defined in the Funding
Agreement. The base Funding Compensation Percentage is 5.545% of the Net Recovery
Amount, which is defined as the difference between the proceeds of the judgment or settlement
amount (if the settlement is $1 billion or more) and certain costs and expenses. Treca's recovery
is calculated as the product of the Funding Compensation Percentage and the Net Recovery
Amount. If the case settles for less than $1 billion, then the Net Recovery Amount is deemed to
be $1 billion for purposes of calculating Burford's recovery.”). 49 Therium Contract, supra note 33, at 75. 50 Brief of Appellants at 88, Cash Funding Network L.P. v. Anglo-Dutch Petroleum Int’l,
Inc., No. 01-05-00960-CV (Tex. App. Jan. 22, 2007), 2007 WL 929514 (noting the “order of
payment schedule”).
12
interest” giving investors a right to the litigation proceeds in front of creditors in case the litigant
went bankrupt.51
Still, if the litigation were incredibly successful – for example, a settlement of a $100
million – the vast majority of the funds would have gone to the plaintiffs.52 In contrast, if the
litigation was moderately successful – for example, a settlement of $10 million – all of the funds
would have gone to the Therium,53 The plaintiffs would recover $85 million in the first scenario
and nothing in the second. This high hurdle creates an incentive for the plaintiffs not to settle
and to stay in the litigation for as long as possible.54 In this case, the breakeven point, whereby
the plaintiffs would likely not settle for anything less, would be $13.6 million. Below that
amount, the plaintiffs would not recover anything.
c. Obligations of Parties
Most litigation finance companies cannot shape the litigation. The companies cannot
“dictate whether certain motions are filed, who the client’s counsel is, or whether the client
accepts a settlement offer.”55 Most litigation finance companies negotiate for greater
information: requiring the litigant or the contingent-fee lawyer to tell the funder when something
happens in the lawsuit or if the parties change counsel.56 The funders can also leave the
51 Id. 52 Committed fund ($1.7M) plus six times the committed funds ($10.2) plus two percent
of the remainder ($1.72) for a total recovery of $13.6 million. The remaining $86.4 million
would go to the plaintiffs and lawyers. 53 The money would have not gone over the “hurdle rate” so all the recovery would have
gone to lawyers. 54 See Gbarabe article, supra note 25 (“That math naturally incentivizes lawyers to keep
pushing for a higher recovery–especially if there’s no downside risk of having to pay the funder
back if the case collapses.”). 55 Litigation Funding Panel, supra note 6. 56 Id. See also deposition, supra note 32 (“Burford was entitled under the Funding
Agreement to be informed of any facts known to the lawyers "reasonably likely to be material to
the Funder's assessment of the.”). However, this idea is often in conflict with the idea of
13
litigation if it “is no longer economically viable.”57 Some litigation finance executives believe
that the funder’s “role is less than the insurance company’s role often is in the litigation,” who
often can “influence how the case is litigation.”58
In Therium’s case, section 2 of the agreement states that the funder would not be liable
“to pay any part of the Defendant’s fees, costs, or expenses.”59 This section “establishes that if
the case goes awry…Therium would not be on the hook for those costs.”60 Therium can
challenge any costs that it thinks is unreasonable,61 walk away from the contract at any time,62
and assert that any of the other parties have breached the contract at any time.63 And Therium
can put restrictions on how the lawyers will use the funding.64
The parties also agreed to certain restrictions to what the lawyers could do or call the
lawsuit. Section 3.1.5 says that the lawyers give up the ability to enter into another litigation
attorney-client privilege. Litigation finance firms use the contract as a way to protect their rights
to important information about the claim. See Gbarabe article, supra note 25 (“Another point of
tension is what might be called information asymmetry. Attorney client privilege means there
are some things a funder simply won’t know. Funders try to set that knowledge gap through the
contract.”). 57 Therium Contract, supra note 33, at 77-84. 58 Id. 59 Therium Contract, supra note 33, at 74. 60 Gbarabe article, supra note 25. 61 Section 5.3 of the contract states: “If in the reasonably held opinion of Therium, any
Costs invoiced by the Lawyers or any other supplier of services are not Reasonable Costs,
Therium shall serve a Challenge Notice on the Claimant. with a copy to the relevant supplier,
within 20 Business Days of delivery of the relevant invoice.” Therium Contract, supra note 33,
at 76. 62 Id. at 85. See also Bogart Deposition, supra note 32 (noting that Buford walked away
from a litigation finance contract after discovering that the lawyers possibly engaged in a fraud
to conceal documents from the fund and the district court). 63 Therium Contract, supra note 33, at 85 (noting that Section 15.3 states that it is up to
what “Therium reasonably considers”). 64 Section 7.2 states: “Save as set out in clause 7.1 and subject to Therium’s prior
agreement to any proposed variation to the Project Plan, the Proceedings shall be prosecuted in
accordance with the Project Plan and the Lawyers shall use all reasonable endeavours to keep the
disbursements within the Project Plan budgets.” Id. at 78.
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funding contract.65 Section 25 of the contract explicitly states that the parties do not intent, by
entering into the contract, to create a partnership.66 Instead, the parties frequently use the term
“counterparty” to describe the relationship between the contingent-fee lawyer and the litigation
fund.67
C. TAX GOALS
The parties involved in the financing “do not necessarily have the same [tax] goals” as
the other.68 The goals will differ between the litigant, contingent-fee lawyer, and the funder.
First, the parties want to label the contract so as to not create a partnership or a debt instrument.
Most litigation finance companies mention this to avoid champerty laws, which are laws that do
not allow “investing in another person’s litigation in exchange for part of the recovery,”
maintenance laws, which do not allow a third party “supporting a lawsuit brought by another
person who has no valid right to be litigating it,” and usury laws.69 Most states do not have the
old English common-law restrictions, although some states still have them.70 Nevertheless,
many litigation finance executives believe the litigation finance contracts do not violate these old
65 Id. at 74. 66 Id. at 88. 67 Gbarabe article, supra note 25. 68 Wood, Investors, supra note 1, at 1239. 69 Litigation Funding Panel, supra note 6; See also Alison Frankel, CFPB signals
regulation of litigation funding industry, REUTERS NEWS (Feb. 8, 2017),
the IRS takes the position that litigation costs “incurred in a gross fee contract had to be
capitalized except in the Ninth Circuit where it was bound by Boccardo”) (citing 1997 FSA
442); cf. Boccardo v. Comm’r, 56 F.3d 1016, 1018-1019 (9th Cir. 1995) (holding that a law
firm’s immediate expense of litigation costs incurred in a lawsuit taken on a contingent basis was
proper because “it is hard to see how the label of ‘advances’ with its implication of ‘loans’ can
be applied as a matter of law to payments when there is no obligation on the part of the client to
repay the money expended”). 79 See I.R.C. § 1221 (2012) (“In general….the term "capital asset" means property held
by the taxpayer (whether or not connected with his trade or business), but does not include—
(1) stock in trade of the taxpayer or other property of a kind which would properly be included
in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the
taxpayer primarily for sale to customers in the ordinary course of his trade or
business...(4) accounts or notes receivable acquired in the ordinary course of trade or business
for services rendered or from the sale of property described in paragraph (1)). 80 I.R.S. Tech. Adv. Mem. 20154701F (November 20, 2015). 81 See generally Steven M. Rosenthal, Private Equity Is a Business: Sun Capital and
Beyond, TAX NOTES TODAY, 140 TNT 1459, 1468 (Sep. 23, 2013). 82 See generally id.
19
funds’ case is even stronger when considering the funds take even more of a passive approach
than the other investment funds and have little control over the course of the litigation. 83
Nevertheless, some commentators argue that the litigation claims are not capital assets.
First, some commentators argue that the claims are actually “inventory” under § 1221(a).84 The
commentators note that the definition of inventory is quite broader than the commonly
understood tax meaning of the word. The exception attempts to “distinguish between profits and
losses from the everyday course of business and appreciation in the value of property that
accrued over a period of time.”85 This argument is unpersuasive. As explained above, the
litigation funds do not have “customers” and do not “sell” their investments – the funds instead
receive cash proceeds if the investment is successful. It is also unlikely that litigation finance
funds have a “trade or business.”86
83 See supra note 55. 84 See Morrison & Haight, supra note 5, at 12. 85 Howard J. Rothman, “Capital Assets,” 561 Tax Mgmt. (BNA) U.S. Income, at IV-A
(citing Malat v. Riddell, 383 U.S. 569 (1966)). 86 In Therium’s case, it is likely that its activities do not rise to level of a trade or
business. Although Therium has a right to challenge costs and approval what the money is used
for, it does not have the right to develop the litigation strategy or otherwise change the course of
the litigation. See supra notes 55 - 66 and accompanying text. Therium likely would be able to
avoid the “trade or business” characterization if the company had a “tired partnership” structure,
which is commonly used in the investment fund context, by separating its investments in
different partnerships. See generally William B. Taylor, “Blockers,” “Stoppers,” and the Entity
Classification Rules, 64 TAX LAWYER 1 (2011) (discussing the use of tiered partnerships in the
real estate and mortgage context). As long as the corporate and partnership formalities are
followed, this would likely be respected and the litigation fund would not rise to the level of
trade or business. See Morrison & Haight, supra note 5, at 19 (recommending that a litigation
company set up a different entity for each lawsuit the company invests in). In fact, Buford, the
largest litigation finance fund generally creates new subsidiaries for each of its investments. See
Bogart Deposition, supra note 32 (“As is common practice in the investment fund world,
Burford typically creates a new subsidiary for each new investment. On October 26, 2010, just
prior to executing the Funding Agreement, Burford created Treca Financial Solutions, a Cayman
Islands company.”).
20
Second, some argue that the contract is an “accounts or notes receivable” under §
1221(a)(4). This prong of the capital asset test “is an issue that has found the IRS and taxpayers
at loggerheads for decades.”87 Under proposed regulations issued in 2006, a litigation contract
may have been brought into the breadth of § 1221(a)(4) because the financing would likely be
considered a receivable “originating” by the taxpayer.88 However, the Treasury withdrew the
proposed regulations due to “substantial taxpayer pushback.”89 One commentator has suggested
that the withdrawal of the temporary regulations, combined with the long-held IRS position of
“viewing ‘receivables’ in the hands of an originating lender as capital assets unless and to the
extent that substantial services…were performed,” should give taxpayers some comfort.90 And if
the claim is not an accounts or note receivable, it will likely be a capital asset.
B. SUBSEQUENT SALE OR EXCHANGE
Stopping the discussion of the tax categorization at the last point – that the claim is a
capital asset that was exchanged at the time of funding – would not be enough for funders. As
mentioned above, the funders want the preferential tax for long-term capital gains. In order to
get the preferential rate, taxpayers need to show that a) they have a capital asset under §1221, b)
there was a “sale or exchange” under §1223, and c) that the funder held the capital asset for more
than one year before the sale or exchange. Investors desire that preferential rate because it could
create millions of dollars of tax savings. For example, if Therium recovered $13.6 million on
87 Gamino, supra note 2, at 97. 88 See id. (noting that the proposed regulations said that “an account or note receivable is
not described in Section 1221(a)(4) on the grounds that the taxpayer’s act of acquiring (including
originating) the account or note receivable constitutes, or includes, the provisions of a service or
services to the issuer of the account or note receivable” (quoting Prop. Treas. Reg. §1.1221-
1(e)(2)) (emphasis in original). 89 Id. at 98. 90 Id.
21
the claim, the company would have saved $2.66 million by paying the preferential capital gains
rate as opposed to the ordinary rate.91
While it is likely that the litigation fund can establish that the claim is a capital asset and
hold the claim for one-year, the funder still needs to show that there is a “sale or exchange” when
the fund receives proceeds from the successful litigation claim. From a textual perspective, this
interpretation seems challenging.92 There is no simultaneous activity when the litigation fund
receives cash. The litigation fund is not paying cash, nor is it exchanging its right to the
proceeds to another party; the fund is merely receiving cash that it is legally entitled to receive.
The IRS said as much in its private letter ruling, holding that the litigation fund was not entitled
to preferential capital gains treatment because there was no sale or exchange.93 Without this
categorization, the litigation fund would recognize ordinary income on the gain the proceeds.
Nevertheless, the litigation finance company could have an argument for sale or
exchange under § 1234A. The flush language of the statute states:
Gain or loss attributable to the cancellation, lapse, expiration, or other termination
of—
91 Assuming the highest marginal ordinary and capital gains tax rate, but excluding other
taxes, like the net investment income tax. 92 The tax court, in Grodt & McKay Realty, Inc. v. Commissioner, provided a
comprehensive definition and explanation of a “sale”: “The term “sale” is given its ordinary
meaning for Federal income tax purposes and is generally defined as a transfer of property for
money or a promise to pay money... This is a question of fact which must be ascertained from
the intention of the parties as evidenced by the written agreements read in light of the attending
facts and circumstances… Some of the factors which have been considered by courts in making
this determination are: (1) Whether legal title passes; (2) how the parties treat the transaction;
(3) whether an equity was acquired in the property; (4) whether the contract creates a present
obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to
make payments; (5) whether the right of possession is vested in the purchaser; (6) which party
pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8)
which party receives the profits from the operation and sale of the property.” 77 T.C. 1221,
(1) a right or obligation…with respect to property which is (or on
acquisition would be) a capital asset in the hands of the taxpayer.
(2) a section 1256 contract…not described in paragraph (1) which is a
capital asset in the hands of a taxpayer,
shall be treated as gain or loss from the sale of a capital asset…94
The statute has provided quite a lot of confusion.95 Adding to this confusion is the fact that the
Treasury proposed, but did not finalize, regulations to clarify the statute.96 Questions persist in
the face of this confusion. The statute was enacted with financial products in mind, but is the
statute limited only to financial products? If the statute is limited to financial products, why did
Congress mention the §1256 contract (a type of product) in paragraph two? And if the statute is
not limited to financial products, does it apply to all property?
A Fifth Circuit case, Pilgrim's Pride Corp. v. Commissioner, provides the most
authoritarian view on the statute.97 The facts are complicated, but the relevant part is that the
taxpayer abandoned a capital asset – an option to buy a company at a certain stock price. The
taxpayer wanted to claim an ordinary loss and argued that § 1234A did not apply to the
abandonment; the IRS argued that § 1234A applied and that the taxpayer could only take a
capital loss.98 The plain meaning of §1234A does not identify whether “abandonment” is
covered under the breadth of the statute. The Fifth Circuit said:
94 I.R.C. § 1234A (2012). 95 Christopher Ocasal & L.G. “Chip” Harter, “U.S. Taxation of Notional Principal
Contract,” 189 Tax Mgmt. (BNA) U.S. Income, at III-B(2). 96 Id. (citing Prop. Treas. Reg. § 1.1234A-1(a)). 97 779 F.3d 311, 315 (5th Cir. 2015). 98Id. Another twist to the case: the taxpayer let the option expire because the present
after-tax benefit of the loss was greater than the actual value of the option. Given the statutory
rate of 35% at the time of the abandonment, the abandonment would have resulted in an after-tax
benefit of $34.1 million if § 1234A applied. The company received, but rejected a potential offer
to buy the option because it believed “that the tax benefit of an ordinary loss of $98.6 million far
exceeded the $20 million offer[].” Philip G. Cohen, Statutory Interpretation Lessons Courtesy of
Pilgrim's Pride, 25 U. MIAMI BUS. L. REV. 1, 9 (2017). If the taxpayer accepted the $20 million
offer, § 1234A would not have applied, and it would have recognized an $80 million capital loss,
23
By its plain terms, § 1234A(1) applies to the termination of rights or obligations
with respect to capital assets (e.g. derivative or contractual rights to buy or sell
capital assets). It does not apply to the termination of ownership of the capital
asset itself. Applied to the facts of this case, Pilgrim's Pride abandoned the
Securities, not a "right or obligation . . . with respect to" the Securities.99
The court criticized the IRS’s position that the abandonment “involves the termination of
certain rights and obligations ‘inherent in’ those assets.”100 Even though the statute does not say
as much, the IRS argued that Congress “chose to legislate that result by reference to the
termination of rights and obligations ‘inherent in’ capital assets.”101 But the Fifth Circuit did not
adopt the IRS’s position. It said that “Congress does not legislate in logic puzzles, and we do not
tag Congress with an extravagant preference for the opaque when the use of a clear adjective or
noun would have worked nicely.”102 Congress used the phrase “with respect to” to limit the
types of scenarios where § 1234A would apply.
The Court also said that the IRS’s position was inconsistent with the underlying
statute:
The Commissioner's interpretation of § 1234A(1) also would render superfluous §
1234A(2), violating the rule of statutory interpretation that we are obliged to give
effect, if possible, to every word Congress used…. Accordingly, the termination
of any Section 1256 contract which is a capital asset would be covered by the
Commissioner's version of § 1234A(1): the termination of the Section 1256
contract would terminate inherent rights and obligations “with respect to” the
Section 1256 contract, which is a capital asset in the hands of the taxpayer. As a
result, § 1234A(2) would not serve any function.103
which it would likely not be able to use due to the capital loss limitation rules. It is a bizarre
result from an economic perspective: the company rejected an offer to receive cash in order to
save money on its tax return. 99 Pilgrim's Pride, 779 F.3d at 315. 100 Id. 101 Id. 102 Id. 103 Id. at 316.
24
The Fifth Circuit vacated the Tax Court’s opinion. The Tax Court initially agreed with the IRS
and held that the abandonment was a termination under §1234. The Tax Court, citing the
Webster’s Third New International Dictionary, noted that the phrase “rights with respect to
property” logically “includes the rights inherent in the ownership of the property.” 104 The Tax
Court also focused on the Congressional intent, which it found supported an interpretation that
the abandonment should be included within the statute. It further said:
We think Congress' intent that section 1234A also apply to rights inherent in the
property is evidenced by the committee's example of the redemption of a bond
which, like a share of stock, is intangible property--a bundle of contractual rights.
…
Moreover, the Senate Finance Committee was critical of the existing law because
it taxed similar economic transactions differently and effectively provided
taxpayers with an election to sell the property right if the resulting transaction
results in a gain or extinguish the property right if the resulting transaction results
in a loss
…
In our view Congress extended the application of section 1234A to terminations
of all rights and obligations with respect to property that is a capital asset in the
hands of the taxpayer or would be if acquired by the taxpayer, including not only
derivative contract rights but also property rights arising from the ownership of
the property.105
In the litigation finance world, the analogy to the abandoned security in Pilgrim’s Pride,
even though not directly on point, is helpful. If future courts adopt the Fifth Circuit approach,
courts would likely say that the “inherent rights” in the contract are the right to proceeds. Those
rights would not be covered under § 1234A. As there are no other rights “with respect to” the
right to those proceeds that taxpayers could plausibly point to, the plain meaning of the statute
104 Pilgrim’s Pride Corp. v. Comm’r, 141 T.C. 533, 543 (2013), vacated, 779 F.3d 311,
would suggest that the litigation finance contracts do not apply within the gambit of the statute.
Funders would be unable to get sale or exchange treatment when they receive cash proceeds
from a successful litigation claim.
On the other hand, Litigation finance companies will likely win if future courts adopt the
Tax Court’s rationale. Under that logic, § 1234A would include “inherent rights,” like the right
to proceeds from a successful litigation claim. The funders would be able to argue that § 1234A
applies, and would therefore successfully argue that a sale or exchange applies when they receive
cash from the claim.
Because the Fifth Circuit opinion is only binding in courts under its jurisdiction, it is
unclear whether future courts will adopt the reasoning in the Fifth Circuit opinion or the Tax
Court’s opinion. Nevertheless, taxpayers would be hard pressed to find much comfort in the
reasoning of a vacated tax court opinion. Put differently, taxpayers should interpret the plain
meaning in § 1234A to suggest that it statute is not meant to cover “inherent rights” in the asset,
only those that occur “with respect” to the security.106 If the IRS and future courts adopt this
interpretation, the litigation funds would still not have a sale or exchange, and the litigation fund
would need to recognize ordinary income. But this plain meaning approach is not likely to stop
taxpayers from arguing that § 1234A applies.107
106 See Cohen, supra note 98, at 34 (“A textualist would be presumably pleased with the
Fifth Circuit’s persuasive analysis. I concur that it was the appropriate methodology in this
instance.”). Professor Cohen also argued noted that the IRS’s argument – which was adopted by
the Tax Court – “would require us to hold that § 1234A(2)’s [the section refereeing to §1259
contracts] only purpose is to address termination by offset, and that Congress chose a remarkably
convoluted way to effectuate that purpose.” Id. at 34-5. 107 Another possibility is that the litigation finance company sells the contract. Although
rare, some funds sell claims if there are claims of fraud, or if the litigation does not make sense.
See Bogart Deposition, supra note 32. Under this scenario, it is likely that the sale of an interest
qualifies as a “sale or exchange.” The asset, as described above, is likely a capital asset. As long
as the litigation fund held the interest for more than one year, the fund would get to pay a
26
C. VARIABLE PREPAID FORWARD CONTRACT
The above result in parts A and B would not be satisfying to either party: both the
character and the type of income are contrary to the character and timing tax goals of either
party. Most litigation finance firms, in an attempt to counteract these negative tax consequences,
label the funding claims as “variable prepaid forward contracts.”108 While neither the Code nor
the regulations provide a definition the term variable prepaid forward contract, the term has been
relatively accepted by the financial products industry.109
In a standard forward contract, two parties agree to a contract “for the purchase and sale
of property for a specified price on a future date.”110 In contrast, one party typically “prepays”
their obligation in the variable prepaid forward contract so that only one party would make a
payment or delivery on the settlement date. 111 For tax purposes, this variable prepaid forward
preferential capital gains rate on any gain it recognized. However, this scenario is unlikely to
occur except in unusual cases. In cases of fraud, for instance, it is likely that the litigation fund
would not receive a good sales price on the claim, especially under the circumstances and in light
of the illiquid market for litigation claims. To make matters worse, if the fund sold the interest
for a loss, it would only be able to recognize a capital loss instead of an ordinary loss. 108 See Wood, Investors, supra note 1, at 1240 (noting that the “prepaid forward contract”
characterization “appears to be how this growing industry is going.”); see also Jonathan
Friedland, Elizabeth Vandesteeg And Jeffrey Goldberg, Litigation Risk Mitigation Through the
Use of Third-Party Litigation Funding, LAW JOURNAL NEWSLETTERS (Aug. 2017),
mitigation-through-the-use-of-third-party-litigation-funding/ (noting that “[t]hird-party litigation
funders typically seek to structure their deals as prepaid forward contracts rather than loans” in
part because “the tax treatment and taxable event is deferred until the litigation is resolved”). 109 See generally David H. Shapiro, “Taxation of Equity Derivatives,” 188 Tax Mgmt.
(BNA) U.S. Income, at III-C. 110 Steven M. Rosenthal & Liz R. Dyor, Prepaid Forward Contracts and Equity Collars:
Tax Traps and Opportunities, 2 Tax’n Fin. Prod. 35, 35 (Winter 2000). 111 The Tax Court recently distinguished the variable prepaid forward contracts as: “[A]
variation of a standard forward contract, requiring the forward buyer (usually a bank) to pay a
forward price (discounted to present value) to the forward seller on the date of contract
execution, rather than on the date of contract maturity. A forward seller can use the upfront cash
prepayment however he or she deems fit, but the proceeds are often used by the forward seller to
27
contract characterization pushes the “sale or exchange” from the moment the parties enter into
the contract to the moment when the parties recover on the claim.112 Even if there no sale or
exchange when the litigation fund receives the cash, as long as the parties properly keep the
transaction “open,” the funding would not be a sale until the litigation is over.113
If the IRS respects this variable prepaid forward contract categorization, it would be the
most optimal tax perspective for both the funder and the contingent-fee lawyer. First, the
contingent-fee lawyer would not need to recognize ordinary income at maturity when the parties
enter into the contract. Second, because there is not a “sale or exchange” until the litigation fund
receives cash from the settlement, the litigation fund would recognize a capital gain at maturity.
The funder gets a holding period that is “tacked” to the date of the original investment.114 If the
initial investment were over a year from the date of the sale, the funder would get long-term
capital gain treatment. One significant downside to this categorization is that the litigation
funder would have capital loss rather than ordinary loss. And because the taxpayers cannot
argue substance over form, the taxpayers will likely fail on any attempt to argue for an ordinary
loss.115
diversify a concentrated stock position into other securities or financial instruments.” Estate of
McKelvey v. Comm’r, 148 T.C. No. 13, at *12-13 (2017). 112 See generally Rosenthal & Dyor, supra note 110. 113 Nevertheless, one could easily imagine an alternative to this counter-intuitive
characterization: “(1) a prepaid forward contract, and (2) a loan from the purchasing party to the
selling party (which is repaid by the selling party on the settlement date with “in-kind”
consideration (e.g., shares) of contingent value).” See generally David H. Shapiro, “Taxation of
Equity Derivatives,” 188 Tax Mgmt. (BNA) U.S. Income, at III-C. The IRS even considered
“the possibility of applying the substance over form doctrine to bifurcate a prepaid forward into a
conventional forward contract plus a debt instrument” in 1995 notice. Id. Given the lack of
guidance from the IRS and the time length from the notice, it seems like the agency has blessed,
or at least not stopped, the growth of this characterization. 114 Wood, Attorney, supra note 5, at 439. 115 See supra note 148 and accompanying text.
28
A recent case in Tax Court, Estate of McKelvey v. Commissioner, provides support for
the prepaid forward contract characterization.116 The case centered around a prepaid variable
contract that the former CEO of Monster.com entered into with Bank of America and Morgan
Stanley.117 The banks gave Mr. McKelvey a cash prepayment of $50 million.118 Mr. McKelvey
then agreed to exchange Monster.com shares, or the cash equivalent, at ten later dates.119 The
number of shares that Mr. McKelvey needed to exchange on the settlement dates varied
according to the stock price.120 In 2008, before the first settlement date, but a few months before
he passed away, Mr. McKelvey paid over $3.4 million to the banks to extend the settlement
dates.121
The Tax Court favorably cited Revenue Ruling 2003-7, and held that execution of the
extension for the variable prepaid forward contract was not a sale or exchange under § 1001.
While the actual holding of the case (that an extension of an existing contract that otherwise
satisfied Revenue Ruling 2003-7 also satisfies the Revenue Ruling) is not applicable here, the
rationale in the case is remarkable. The Tax Court reasoned:
Our holding is consistent with the rationale behind the open transaction treatment
afforded in Rev. Rul. 2003-7. As a general rule, taxation is imposed only on the
realization of gain or loss. In order to calculate gain or loss realized from a
particular transaction, a taxpayer must ascertain both an amount realized and an
adjusted basis. 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. See Burnet v. Logan, 283 U.S. 404 (1931) (applying open
transaction doctrine until a transaction closed). In these instances the component
that is known is held in suspense and gain or loss is not realized until the missing
116 148 T.C. No. 13 (2017). 117 Id. at *2-5. 118 Id. 119 Id. 120 Mr. McKelvey agreed to exchange the shares subject to the following formula:
“176,519 shares x BofA floor price/Stock closing price.” Id. at 3. 121 Id.
29
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.122
This discussion of the “open transaction” doctrine provides the best argument for the
variable prepaid forward contract categorization. The doctrine, which the Supreme Court
adopted in Burnet v. Logan, “applies in deferred payment cases with so much uncertainty that it
is impossible to determine whether any profit will be realized, because income is contingent
upon unknown factors.”123 Similarly, the amount owed in a litigation finance contract is far from
certain at the time of funding. Under the McKelvey rationale, a taxpayer could argue that as “a
rule of fairness,” the taxpayer should not be subject to immediate taxation when the amount
realized is unknown at the time of funding.
Nevertheless, this open transaction doctrine categorization has two significant
roadblocks. First, courts rarely apply the “open transaction” doctrine today. Since Burnet, there
have been a significant amount of enacted statutes and cases that are more “fair” to taxpayers.124
Courts seem less willing to apply the doctrine as a matter of fairness anymore.
122 Id. at 20-21 (internal citations omitted). 123 Patton v. United States, No. 96-37T, 2001 U.S. Claims LEXIS 60, at *9 (Fed. Cl. Mar.
20, 2001) (citing Burnet. v. Logan, 283 U.S. 404, 413 (1931). 124 See id. at *12 (“Since Burnet v. Logan, however, statutes, regulations and the courts
have severely limited the use of the open transaction method. The 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.”); see also Treas. Reg. §1.1001-1(g)(2)(ii) (noting
that when debt instruments are exchanged for property, “[o]nly in rare and extraordinary cases
will the fair market value of the contingent payments be treated as not reasonably ascertainable”
such that there would not be a sale or exchange).
30
Second, there is no basis apportionment problem; the adjusted basis of both the
contingent-fee lawyer and the litigation fund is known at the time of funding. Part of the
uncertainty in Burnett was that the Court did not know whether the payments constituted taxable
gain or recovery of basis.125 Some courts go a step further and say that Burnett only applies
when the adjusted basis is unknown and does not apply to cases where the amount realized is
unknown.126 In the litigation finance context, that uncertainty regarding the adjusted basis does
not exist. The contingent-fee lawyer would have a basis close to zero, while the litigation fund
would have a basis equal to the amount that they funded. There is no dispute about what should
or should not be income: everything that the contingent-fee lawyer receives will be income and
everything amount in excess of the litigation fund’s basis will be taxable. Put another way, it is
unclear why the character of the gain should change only because the amount of gain recognized
is unknown at the time of sale.
Litigation finance firms also point to Revenue Ruling 2003-7 for support for the variable
prepaid forward characterization.127 The Ruling considered whether “a shareholder [who]
receive[d] an upfront cash payment and [became] obligated to deliver a variable number of
shares of Y common stock to Investment Bank on a fixed date three years in the future” had a
realization event upon exchange.128 The Revenue Ruling held that there was no sale or exchange
125 See id. (citing Burnet, 283 U.S. at 413-14) (“Under these circumstances, the taxpayer
first applies any payments received to his or her basis. Once they have recovered their basis, they
report any additional payments as income. The taxpayer is not taxed on this income until there is
certainty as to the amount of payments, if any, that should be taxed.”). 126 See Tribune Pub. Co. v. United States, 836 F.2d 1176, 1180 (9th Cir. 1988) (noting
that a taxpayer cannot apply the open transaction to a case when the taxpayer would receive a
profit, but the amount of profit was unknown “because we read Burnet to apply only if there is
uncertainty as to whether the taxpayer will realize a profit from the transaction at issue.”). 127 Rev. Rul. 2003-7, 2003-1 C.B. 363. 128 David H. Shapiro, “Taxation of Equity Derivatives,” 188 Tax Mgmt. (BNA) U.S.
Income, at III-C.
31
when a shareholder received a “fixed amount of cash” and “simultaneously enter[ed] into an
agreement to deliver on a future date a number of shares on common stock that varies
significantly depending on the value of the shares on the delivery date.” 129 The IRS explained
that the holding was dependent on three conditions:
1) the amount of pledged shares is at least equal to the “maximum number of
shares” which “could be required under the agreement;”
2) the taxpayer “retains an unrestricted legal right to substitute cash or other
shares for the pleaded shares;” and
3) the taxpayer “is not economically compelled to deliver the pleaded shares.”130
The ruling provided a very taxpayer-friendly result.131 However, because the revenue
ruling is only binding on the IRS to the extent that the facts mimic the revenue ruling, it is
unclear how far the rationale extends. Many commentators have suggested that the fact-
dependent nature of these type of transactions makes it impossible to make broad
characterizations about variable prepaid forward contracts.132
The Tenth Circuit, in Anschutz Co. v Comm’r, declined to follow Revenue Ruling 2003-7
when a taxpayer simultaneously entered into a variable prepaid forward contract, sold the shares
to a bank, and borrowed back the shares from the bank.133 The court found that there was a sale
or exchange because the parties had effectively shifted the majority of the risk and the rewards of
owning the shares from the taxpayer to the bank.134
129 Rev. Rul. 2003-7, 2003-1 C.B. 363. 130 Id. 131 See generally David H. Shapiro, Taxpayer-Friendly Result In Rev. Rul. 2003-7 May
Create A False Sense Of Security, TAX NOTES TODAY, 98 TNT 1265 (Feb. 24, 2003). 132 Id. 133 664 F.3d 330 (10th Cir. 2011). 134 Id. (“The problem with petitioners' reliance on Revenue Ruling 2003-7 is that the
transactions at issue in this case, considered as a whole, are different from the entirety of the
transactions at issue in Revenue Ruling 2003-7. Whereas the circumstances underlying Revenue
Ruling 2003-7 involved only a [variable prepaid forward contract], in the instant case the parties
entered into a series of related transactions that included not only a [variable prepaid forward
32
If the taxpayer in Anschutz was unable to argue that the Revenue Ruling applied, it is
unclear how the litigation finance fund would also be able to successfully argue that point.
Whether the argument is successful may depend on how the transaction is defined. On one hand,
the claim could be a “right to recovery” on a successful claim. As long as the taxpayer could
“settle” the claim by delivering cash instead of the actual claim, then some would likely argue
that the claim would satisfy the requirements of Revenue Ruling 2003-7. 135 On the other hand,
it looks like the parties have shifted risk and rewards of the litigation like the taxpayer in
Anschutz. The contract is non-recourse and does not provide for a minimum recovery for the
fund.136 The litigation fund has significantly more of the upside and the potential downside than
the contract described in Revenue Ruling 2003-7.
Furthermore, the litigation finance claim is a fundamentally different type of asset than
publically-held common stock. Because the market for litigation finance claims is almost
illiquid, while publically traded securities are extremely liquid, the fund cannot easily sell the
claim, even if the litigation was successful. Therefore, the “right to recovery” is probably just a
contract], but also [a master share purchase agreement] and [] Share-Lending Agreements. The
result of these related transactions was that DLJ obtained possession, and most of the incidents of
ownership, of TAC's pledged shares. TAC, in turn, obtained cash payments and an elimination
of any risk of loss in the pledged stock's value at the end of the term of the transactions. Thus,
we conclude that petitioners' reliance on Revenue Ruling 2003-7 is misplaced.”). 135 Robert Wood defines the prepaid forward contract in terms of delivering a “portion of
a claim” not the “rights to recovery.” See Robert W. Wood, Prepaid Forward Contracts Aren’t
All Bad, TAX NOTES TODAY, 135 TNT 365, 367 (Apr. 16, 2012) (“That should be the case in a
forward sale of a legal claim involving: (1) the receipt of an upfront cash payment; (2) an
agreement to deliver a portion of the claim that varies significantly depending on its value at the
contract’s expiration date; (3) a pledge of the entire claim; (4) the right to deliver either cash or a
portion of the pledged claim on settlement; and (5) no apparent economic or legal compulsion to
deliver the claim itself rather than cash.”). 136 Compare Therium contract, supra note (failing to provide a minimum recovery for the
litigation fund), with infra note 120 (guaranteeing a minimum floor price for the bank in a
variable prepaid forward contract that satisfies Revenue Ruling 2003-7).
33
shorthand for cash, which the contingent-fee lawyer would be economically compelled to
deliver. Nevertheless, the litigation fund may argue that the logic in Anschutz is not applicable
because the “ownership” of the claim did not shift to the fund like it did in the Tenth Circuit
case.137
Without additional guidance from the IRS about what exactly is and is not a prepaid
forward contract, this paper is left to ponder what the difference is between a prepaid forward
contract and an immediate sale or exchange? When is an asset a variable prepaid forward
contract, and when is the asset just a sale with a contingent purchase price? While it is possible
that the IRS would grant similar treatment to a litigation finance contract under the logic of the
revenue ruling or the tax court case, it is also possible that the agency would find that litigation
finance contracts cannot be prepaid forward contracts. The future is unknown.
This uncertainty is unlikely to stop tax lawyers from the categorization the transaction as
a variable prepaid forward contract. Lawyers may need to squint as hard as they can, but with
the amount of uncertainty in the area, they will likely feel like the characterization is at least
plausible enough to get to a “substantial authority” position.138 Some commentators have
suggested that taxpayers try to draft around the Revenue Ruling to make the contract look more
137 Id. at 368 (“[Variable Prepaid Forward Contracts] that stick closely to the pattern set
out in Rev. Rul. 2003-7 and that do not involve a transfer or loan of the underlying property to
the counterparty, should still be on solid ground.”). 138 See generally Treas. Reg. §1.6662-4(d)(3).
34
like an actual option.139 This result is also unclear. It is hard to say whether a court or the IRS
would apply the substance over form to recast the transaction.140
D. UNAVAILING CHARACTERIZATIONS
1. Partnership Interest
At least one practitioner has suggested that arrangements between a contingent-fee
lawyer and a litigation fund may create a partnership for tax purposes.141 The contingent-fee
lawyer would contribute their claim to the lawsuit, while the litigation fund would contribute
cash. This contribution would be tax-free.142 The contingent-fee lawyer would likely not have
any basis in this partnership interest, while the litigation fund would have an initial basis equal to
its cash contribution. If the partnership made a distribution to the contingent-fee lawyer – for
example, to pay the lawyer for his or her services – that distribution would likely be taxable
under the disguised sale rules,143 or as a distribution in excess of basis.144
139 See Robert W. Woods & James L. Kresse, Is Litigation Finance Tax Treatment In
of section 1234A: The contract can be drafted to highlight that these rights and obligations
terminate upon settlement of the litigation and payment to the investor. Arguably, the payment
to the investor of their investment return relates to the termination of their rights and obligations
under the litigation finance agreement.”). 140 See generally David P. Hariton, The Frame Game: How Defining the "Transaction"
Decides the Case, 63 TAX LAWYER 1 (2009). One is reminded of a quote from Upton Sinclair
when the lawyers make this categorization: “It is difficult to get a man to understand something,
when his salary depends upon his not understanding it.” Paul Krugman, The greatness of
Keynes…, THE CONSCIENCE OF A LIBERAL BLOG (Nov. 30, 2008, 1:05),
https://krugman.blogs.nytimes.com/2008/11/30/the-greatness-of-keynes/ 141 See Wood, Attorney, supra note 5, at 435. 142 I.R.C. § 721 (2012). 143 See Wood, Attorney, supra note 5, at 435 (noting that if the claim is settled within two
years of funding, the funding and subsequent distribution of proceeds would likely fall into the §
707 disguised partnership sale rules). 144 I.R.C. §731 (2012).
35
Moreover, if the litigation was successful, neither the funder nor the contingent-fee
lawyer would get preferential capital gains. The contribution of the claim would likely be an
unrealized receivable under § 724(a), so any recovery that stems from that claim would be
ordinary income.145 If the litigation was unsuccessful, the partnership interest would likely be a
capital asset,146 so that the loss would be capital in nature.147
As discussed above, to avoid Champerty laws, the vast majority of litigation finance
parties explicitly state in the agreement that they did not intend to create a partnership with the
contract. And, as previously discussed, the parties cannot raise arguments under the Danielson
rule if the parties used another term in the contract.148 It is unlikely that the Government would
raise this argument either, as it would likely get more money in this categorization. Therefore,
this categorization is a likely a theoretical argument that neither party would raise at appeal or in
court.
Even if it is a theoretical argument, the Therium contract likely does not create a
partnership. The parties did not intend to create a partnership, and Therium has little control
over the actual course of the litigation. That is enough to say that the parties did not enter into a
partnership. On the other hand, some may argue because a partnership includes the sharing of
the profits, the contract is a partnership interest because Therium is undoubtedly getting a piece
of those potential profits if the litigation is successful. However, the fund is getting first right to
145 See Wood, Attorney, supra note 5, at 436. 146 Because it does not fall under one of the exclusions in I.R.C. §1221 (2012). 147 If the lawyer sold his or her partnership interest before the litigation was completed,
the lawyer would also recognize a significant amount of ordinary income. Although the
partnership interest is a capital asset which would generate capital gains, the lawyer would need
to recognize ordinary income to the extent of his or her share of § 751(a) “hot” assets. The
litigation finance claim would likely be considered an unrealized receivable, and would thus
force the lawyer to primarily recognize ordinary income. 148 See supra note 72.
36
recovery, and is getting a percentage of the gross proceeds, not the net proceeds. Additionally,
Therium holds the vast majority of the risk, as the lending is non-recourse and the contingent-fee
lawyer does not have any downside risk if the litigation is unsuccessful. In sum, it does not seem
like a good case for a partnership categorization.
2. Secured Lending Transactions
If the litigation finance contract is debt, the contingent-fee lawyer would not recognize
income at the time of borrowing.149 However, the funder will need to recognize interest income
every year, even if the contract does not contain an explicit interest rate.150 The contingent-fee
lawyer would get to recognize a corresponding interest deduction as the interest would likely be
connected with a trade or business.151 If the contract is debt, the funder would recognize
ordinary income.152 Even if the debt is “usurious” and illegal under state law, Treasury
regulations explicitly state that usurious income is still income.153 If the claim were successful,
any proceeds recovered by the litigant would likewise be ordinary income under the substitute
for ordinary income doctrine.154 If the litigation was unsuccessful, the contingent-fee lawyer
would recognize cancellation of debt (COD) income, which is the flipside of the borrowing
149 See generally Commissioner v. Tufts, 461 U.S. 300, 307 (1983). 150 Id. See also I.R.C. §1275(a)(1)(A) (2012) (noting the “original issue discount” rules
for recognizing income in debt without an explicit interest rate). 151 I.R.C. §163(a) (2012). 152 This would be because the debt is not considered a capital asset under I.R.C. §
1221(a)(4) (2012). 153 Treas. Reg. § 1.61-7(a). 154 See supra note 74.
37
exclusion.155 The funder should be able to recognize a bad debt loss under § 166. That
deduction would be ordinary and not subject to any limitations.156
The actual determination of whether the contract is debt or equity is a complicated
question to answer. It is also a question that comes up often.157 The Ninth Circuit recently
stated:
It’s a timeless and tiresome question of American tax law: Is a transaction debt or
equity? The extremes answer themselves. The classic equity investment entitles
the investor to participate in management and share the (potentially limitless)
profits—but only after those holding preferred interests have been paid. High risk,
high reward. The classic debt instrument, by contrast, entitles an investor to
preferred and limited payments for a fixed period. Low risk, predictable reward.
But a vast hinterland of hybrid financial arrangements lurks in the middle158
Creative tax lawyers willing to zealously advocate for their client by stretching the definition of
debt or equity do not create this conundrum; the problem is that we have a binary tax system that
treats something as either debt or equity, when, in reality, it is a mixture of both.159
Also making this determination difficult is the lack of clarity in the area of the law.
Courts across the country do not apply a consistent framework for what is either debt or
155 I.R.C. § 61(a)(12) (2012). But the litigant would not recognize COD income if the
party was insolvent under I.R.C. §108 (a)(1)(B) (2012). 156 Investors prefer ordinary losses and dislike capital losses because capital losses are
subject to strict limitations under §§ 1211(b) & 1212. 157 See Nathan R. Christensen, Comment, The Case for Reviewing Debt/equity
Determinations for Abuse of Discretion, 74 U. CHI. L. REV. 1309, 1310-11 (2007) (“When courts
of appeals encounter debt/equity determinations, judges often signal their familiarity with the
issue as if acknowledging an old acquaintance—or, perhaps more accurately, an annoying
neighbor.”). 158 Hewlett-Packard Co. v. Comm’r, Nos. 14-73047, 14-73048, 2017 U.S. App. LEXIS
22536 at *3-4 (9th Cir. Nov 9, 2017). 159 The Hewlett-Packard court said later on: “And, while such a free-floating inquiry
[into whether a transaction is debt or equity] is hardly a paragon of judicial predictability, it’s the
necessary evil of a tax code that mistakes a messy spectrum for a simple binary, and has
repeatedly failed to offer the courts statutory or regulatory guidance.” Id. at *9.
38
equity.160 Courts “have emphasized that the factors are advisory and of unequal weight, and that
no factor is entirely dispositive.”161 Appellate courts have used no less than thirty different
factors to make their determination.162 Some commentators have argued that these litigation
finance contracts are similar to plaintiffs’ attorneys who work on a contingent-fee basis.163 The
IRS usually takes the position in those agreements that the funds advanced to the client are loans
for US tax purposes.164
Even considering the categorization of legal fee advances from contingent-fee lawyers,
the Therium agreement does not look like debt. In particular, the following factors go weight
heavily against calling it debt: the absence of a fixed interest rate, no fixed maturity date, and the
fact that the payment would only be paid if the litigation were successful. The contract looks
“speculative and contingent” because “the degree of risk of non-payment was substantial.”165
Other litigation contracts may lead to an entirely different result. First, the rise of
“portfolio lending” – where a fund would invest in a portfolio of the contingent-fee lawyer’s
160 There is a circuit split of whether the determination of debt or equity is a legal
question (given de novo review) or a factual question (given a more deferential review). See
Christensen, supra note 157, at 1341 (“Though most circuits review for clear error, other circuits
utilize a de novo standard, a contingent review standard incorporating clear error and de novo,
and an abuse of discretion standard.”). 161 Id. at 1312-1313 (noting that the most common factors are “(1)Names given to the
financial instruments…(2)Fixed maturity date…(3)Source of payments…(4)Right or attempt to
enforce payment…(5)Increased participation in management as a result…(6)Status of the
contribution in relation to other corporate creditors…(7)Intent (subjective) of the
parties…(8)Capitalization (‘thin’ or adequate)…(9)Identity of interest between creditor and
stockholder…(10)Ability of the corporation to obtain loans from outside lending
institutions…(11)Extent to which the advance was used to acquire capital assets…(12)Failure of
the debtor to repay on the due date or to seek a postponement…(13)Risk involved…(14)Formal
indicia of the arrangement…(15)Voting power or control of the instrument holder…(16)Fixed
rate of interest…(16) Fixed rate of interest”). 162 Id. at 1313, table 1. 163 Gamino, supra note 2, at 95. 164 See supra note 78. 165 Gamino, supra note 2, at 90.
39
lawsuits, and in turn, would not demand as high of a recovery rate – tends to weight more
heavily toward debt.166 This type of funding has increased rapidly in the past few years.167
These lawyers can minimize their risk and provide for a steadier cash-flow. In return, the funder
gets more certainty for recovery in a successful litigation claim.168
Because the litigation fund would only not recover their proceeds if all the claims in the
portfolio were unsuccessful, the chances of success are relatively high. The portfolio is secured
against a portfolio of assets which are risky on its own, but less risky when taken together. The
funders look more like “shadow lenders” and less like “speculative and contingent” equity
investors.169 That transaction looks more like a borrowing secured against a risky asset.
166 James A. Batson, investment manager and legal counsel of Bentham IMF, said in this
kind of financing, the funder would: “provide[] a law firm with capital against a basket of at least
three cases that the firm has taken on a contingent fee basis. If one case isn’t successful, [the
funder’s] payment comes from the next case. The obligation is nonrecourse in the event all of the
cases are unsuccessful or don’t generate enough.” Litigation Funding Panel, supra note 6. 167 Some contingent-fee lawyers say that the only way they could afford to handle the
cases they are working on is by selling the portfolio of claims to a funder. See Business of
Litigation Finance, supra note 8 (“The only way Pierce Sergenian could afford to handle the 10
cases it has on board is by selling a separate interest in the potential recoveries to a financier,
John Pierce explains. Pravati Capital, a litigation funder in Scottsdale, Arizona, has promised to
underwrite the law firm’s current and future contingency cases.”). 168 See THERIUM GROUP HOLDINGS LIMITED, http://www.therium.com/ (last visited Dec.
7, 2017) (“In December 2014, Therium launched the UK’s first portfolio funding offering for
law firms. Working alongside leading firms and sharing risk and reward, Therium embeds into
its portfolio funding arrangements a collaborative culture and alignment of interests. This
enables clients to enjoy the benefits of a more efficient and joined-up litigation funding
process.”). 169 Paul R. Cody, president of Counsel Financial, a litigation finance company that
typically charges fifteen percent interest per year on its investments said, “If firms have access to
lower-cost financing, our first comment back to them is that you really shouldn’t be talking to us
… We’re not going to be competitive.” Appelbaum, supra note 41. See also Roger Parloff,
Have you got a piece of this lawsuit?, FORTUNE MAGAZINE (Jun. 28, 2011),
http://fortune.com/2011/06/28/have-you-got-a-piece-of-this-lawsuit-2/ (noting that a Burford
spokesman said that “[t[here is no suggestion in litigation that it … should be disclosed if a party
is paying for its litigation expenses with a credit line from Citibank. Burford is simply another
provider of corporate finance”)
40
Litigation finance companies are quick to compare this type of portfolio funding to other
commercially available debt instruments. Mr. Batson also said that “[p]ortfolio funding is
analogous to getting a bank line of credit that’s secured by contingent recoveries.”170 Buford
Capital has been making investments that look more like conventional lending that typical
contingent recoveries. It made both a “$100 million investment in a global law firm’s portfolio
of commercial litigation…a $50 million investment in another large firm’s arbitration cases,”
and a “$45 million” investment in “the litigation efforts of a single corporation, British
Telecommunications.”171 When the litigation financing firm develops a long-term relationship
with the law firm or a corporation, the funding looks more like conventional debt. The litigation
firm considers its investment based on the creditworthiness of the client, the prestige of the
client, and its prospects for future financial success. It is not merely investing in a single lawsuit
because of the merits of the case. The Therium agreement is not a portfolio funding agreement,
but rather a plain vanilla agreement to invest in a single lawsuit.
Second, many litigation contracts are significantly less risky than the Therium
agreement.172 An agreement that started at a post-judgment stage may look more like debt than
an agreement entered at the discovery phase.173 Third, a litigation contract that pegged the rate
170 Litigation Funding Panel, supra note 6. Litigation firms are quick to state this
comparison because of the ethical rules that disallow lawyers sharing profits with non-lawyers. 171 Business of Litigation Finance, supra note 8. 172 See Ken Belson, After N.F.L. Concussion Settlement, Feeding Frenzy of Lawyers and
Lenders, N. Y. TIMES, July 17, 2017 (noting that a wave of litigation finance firms tried to
convince NFL players to sign into contracts with the companies days after the settlement was
announced, whereby some recovery was virtually assured). 173 Therium highlights this type of financing on its website. See Therium website,
(“Having been a pioneer in the use of insurance to manage financial risk in commercial disputes,
Therium has delivered a variety of solutions to clients who wish to (i) de-risk their litigation, (ii)
remove the drain on cash flow and profit from financing litigation, or (iii) realise value from
their claim, judgment or award.”).
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of return on a per year basis would also likely be considered debt.174 In particular, litigation for
the consumer market is more likely than the corporate market to have “a time-based percentage
that looks like interest,” and would thus more likely to be considered debt.175 Furthermore, many
types of high-yield debt instruments have similarly high rates of interest.176
E. THERIUM CHARACTERIZATION
This paper concludes by suggesting the characterization of the Therium contract. Based
on the discussion above, it seems like the Therium contract is most likely considered a capital
asset. The contingent-fee lawyers likely sold an asset at the time that they entered into the
contract, and would have needed to recognize income at that time.177 Had the litigation been
successful, the proceeds would not have come from a “sale or exchange,” and therefore Therium
would not have received capital gains treatment. Therium would have recognized ordinary
income to the extent that the gain on the claim exceeds its basis (the amount of its initial
investment in the claim). The asset likely would not qualify as a variable prepaid forward
contract, because it does not meet the requirements under the only IRS guidance published on the
matter and does not qualify for “open transaction” because the parties’ adjusted basis is known at
174 Brief of Appellants at 87, Cash Funding Network L.P. v. Anglo-Dutch Petroleum
Int’l, Inc., No. 01-05-00960-CV (Tex. App. Jan. 22, 2007) (noting that the return on this
agreement is “the investment, plus an amount equal to one hundred percent of its investment plus
a 100% return of investment per annum”). 175 Morrison & Haight supra note 5, at 4. 176 See Wood, Investors, supra note 1, at 1240 (“Although the rate of interest may be
high, it appears to be in line with other high-risk debt obligations.”) 177 The lawyers would have, if they subsequently paid themselves for the legal services
they performed, received an above the line deduction for their work. Therefore, this paper
queries whether the immediate sale or exchange is really bad for the contingent-fee lawyer, who
would need to recognize income right away as it billed for its services. The immediate sale or
exchange is worse for plaintiffs who sell their claim and would likely not receive an immediate
deduction under §162 because they would not have a trade or business.
42
the time of funding. Nevertheless, because the litigation was unsuccessful and Therium was not
able to recoup any of its investment, it will be able to take an ordinary loss.
This paper summarizes the results for each of the potential characterizations to Therium
and the contingent-fee lawyer in the following table:
Therium Contingent-Fee Lawyer
Immediate
Sale or
Exchange
Would not recognize gain or
loss at the time of funding
Takes basis in a capital asset
equal to the amount that the
fund paid
Gross income from gain from
dealing with property under §
61(a)(3)
Recognize ordinary income
under Substitution for Ordinary
Income Doctrine
Receive a capital expenditure,
deductible when claim is settled
Subsequent
Sale or
Exchange
If subsequent sale or exchange:
receive capital gain or loss
If no subsequent sale or
exchange: ordinary income or
loss
N/A
Prepaid
Forward
Contract
Recognize capital gain or loss
when claim is settled
Holding period is “tacked” to
date of original investment
Recognize ordinary income and
take ordinary deductions when
claim is settled
Partnership
Interest Have initial basis equal to its
cash contribution
Would recognize ordinary
income at recovery because
claim is unrealized receivable
Contribution of claim to
partnership is tax-free
Contribution is an unrealized
receivable under § 724(a), any
recovery is ordinary income.
Secured
Lending
Transaction
Recognize ordinary interest
income every year
If unsuccessful, recognize bad
debt deduction under § 166
Recognize interest expense
every year
If unsuccessful, recognize COD
income
IV. CONCLUSION
This paper considered the possible tax consequences of litigation finance claims.
Because most litigation finance contracts are not public, this paper heavily relied on a recent
publically disclosed litigation finance. Based on this contract, this paper analyzed whether the
contract created an immediate sale or exchange at the time of funding, a subsequent sale or
43
exchange when the claim was settled, a prepaid forward contract, a partnership interest, or a
secured lending transaction. This paper concluded by arguing that the disclosed contract more
likely created an immediate sale or exchange at the time of funding. However, this
characterization is subject to a high degree of uncertainty given the lack of case law or IRS
guidance in the area.
This paper suggests that the tax result may be wrong from a policy perspective. It seems
theoretically inconsistent not to give preferential capital gains treatment to these litigation
finance claims when professional investors in other assets would receive those rates. Paying
ordinary instead of capital income tax rates on the proceeds would likely limit the massive influx
of investment flowing into these litigation finance firms.
The views on whether litigation financing should receive preferential tax treatment, and
the consequence of having less investment, may depend on the person’s outlook on the litigation
finance industry in general. If we believe that litigation funding provides a worthwhile benefit to
society, and without the capital gains preference more people would invest in the stock market
and not these claims, then we should extend the preferential capital gains treatment to litigation
finance investors.178 If we do not believe that litigation finance provides a useful societal goal,
then we may not care whether the funds get preferential treatment. It seems strange that the IRS
needs to decide the worthiness of an entire industry, but that is the uncertain world we live in.
A word of caution: the IRS should not rush to push out guidance to publish such
guidance. Because the prepaid forward contract market is so new, the lawyers working on the
prepaid forward market would likely incorporate any guidance that the IRS publishes by analogy
178 See e.g., The Ethics of Investing in Another’s Lawsuit, N.Y. TIMES (May 27, 2016)
