Lately, I’ve been hearing more regularly about plaintiffs
who sell their legal claims, and I am increasingly being
asked about the tax impact. Sales or assignments of legal
claims have always been an interesting and quirky topic. I am
only a tax lawyer, so it is important to caution that there may
be a variety of other laws implicating these issues including
what types of claims can actually be transferred, and what
legal niceties need to be observed. There may be a variety of
practical issues too.

Is a sale, assignment or other transaction going to be
effective for non-tax purposes in the litigation? Are there some
kinds of claims that cannot be transferred, or that may deeply
prejudice the case if they are? Will the court or the defendant
respect the transfer? And how will it influence the attorney
client relationship and the lawyer’s legal right to a fee when
the case is resolved?

Depending on the case, timing and circumstances,
some or all of these may be important issues, and they may be
thorny. However, assuming that you get past the nontax issues,
what happens taxwise? First, it’s important to stress that not
every contract is the same. I am sometimes asked how a sale or
assignment will be taxed without being provided with a
document.

But I have learned the hard way that you can’t fairly
analyze the tax treatment of a transaction without looking at
the pertinent contract. For one thing, some people talk of
assigning or selling their claim in an understandable
shorthand, but the contract may not be a sale or assignment
when it comes to taxes. Here is a range of possibilities that it
might be.

Assignment
Outside the commercial context, sometimes plaintiffs
transfer some or all their claim to someone else as part of their
own financial and tax planning. Likely suspects are family
members, a family entity (such as a partnership or LLC), or
even a charity. The idea, typically, is to shift some or all the
income to someone other than the plaintiff—usually someone
in a lower tax bracket–before the case is resolved and money
is paid.

Whether it will be effective for tax purposes depends
on timing, and other factors, including continuing involvement
by the plaintiff. It may be necessary to value the claim at the
time of transfer, and to treat it as a gift for tax purposes. Unless
the plaintiff is assigning the claim to his wholly owned entity, it
may be a gift or a sale for tax purposes, and timing is
important. For example, suppose that you file a complaint, and
shortly thereafter, assign the claim to a family LLC?

There may be few tax worries if the case is not
resolved by settlement or judgment for three years. The
transferee may pay tax on the recovery without incident. In
contrast, the original plaintiff may be stuck paying all the taxes
if the transfer happens a month before settlement, despite the
transfer. The assignment of income doctrine is a classic tax
rule, and many tax cases give the IRS the ability to disregard a
purported transfer if you have already earned—or almost
earned—the income. More about that issue below, after we
review the other choices.

Sale
Some transfers are to unrelated third-party buyers, such as
where a commercial buyer offers a plaintiff a flat fee to take
over any entitlement the plaintiff has. A common fact pattern
involves a class action where recoveries are expected but still
face appeals or other procedural hurdles. Some plaintiffs may
not want to wait months or years before receiving any
payment. It may also be clear that a settlement will be paid out
in installments when it eventually arrives.

In such cases, plaintiffs may find it attractive to sell
their claim at a discount and to collect a lesser amount without
delay. Properly documented, these can be among the simplest
transactions to analyze from a tax viewpoint. The
seller/plaintiff receives money and pays tax on it in the year of
receipt. Usually, seller/plaintiffs are taxed on the sales price
the same way that they would have been taxed had they held
onto their claim and ultimately received a settlement or
judgment from the defendant. For example, if the underlying
claim is about royalties or interest, when selling the claim, the
plaintiff should have royalty or interest income.

The buyer then typically stands in the shoes of the
selling plaintiff, and is paid out and taxed (though not
necessarily in the same way as the original plaintiff) when the
case finally resolves—assuming that the defendant treats the
sale as effective and agrees to pay the buyer. This kind of sale
usually raises no special tax issues. But what if the contract
isn’t as clear as this?

Loans
What if the “sale” document is really a nonrecourse
loan? Loans may be used for several reasons, including if the
plaintiff cannot agree to an outright sale of the claim for nontax
reasons. The loans might function a little like a sale, if it is clear
the loan never has to be paid back. But what happens for tax
purposes?

Technically, even a nonrecourse loan is still a loan.
And that means the plaintiff still owns the claim and is still
entitled to the settlement or judgment when the case is
ultimately resolved, subject to the rights of the lender. On the
positive side, it also means that the loan proceeds are not
income to the plaintiff, so should not trigger taxes when they
are received.

Sometimes, such loans involve lockboxes or other
payment protections, so that the lender collects what is due
without the plaintiff having the chance to divert the funds. For
tax purposes, this is most likely a loan, but the IRS can treat it
as a sale in some cases. Assuming that the form of the loan is
respected, the upfront loan money is not taxable to the
plaintiff, but the later settlement payment will be—even if it
goes directly to the lender.

Hopefully, the plaintiff will have enough money to pay
the tax. Unfortunately, a large part of the settlement is likely to
go to the lender for interest. And under surprisingly complex
tax rules about what interest payments are and are not
deductible, some plaintiffs may not be able to claim a tax
deduction for the full amount of a large interest payment.

Prepaid Forward Contract
Another type of contract is what’s known as a variable
prepaid forward purchase agreement, or prepaid forward
contract. It is a sale document, but with a curious twist. It calls
for an advance payment, a kind of deposit, of the purchase
price. However, the amount of property that the buyer will
actually purchase is not determined under the contract until
later, when the sale closes. These contracts are popular in the
securities industry, and with many litigation funders.
The idea is that the plaintiff still owns the claim and
receives a nontaxable deposit representing the purchase price
under a sale contract. How could the advance payment not
trigger immediate tax? The trick is that the contract has a price
with conditions involving timing and amount that prevents the
sale from being taxed immediately, as it would be if the
identity and amount of the property being sold were already
fixed. Done properly, the deposit is not immediately taxable,
and the plaintiff still owns the claim.

Then, when the case is resolved, the sale contract
closes, and the plaintiff is paid. But as in the loan example,
usually there’s a payment mechanism so that the funder
actually collects the money. Taxwise, the plaintiff is still
required to take the full amount of the settlement payment
into account.

The plaintiff takes the payment to the funder into
account, but he does so separately, as part of the settlement of
the prepaid forward contract. In most cases, the plaintiff
reports ordinary gain or ordinarily loss from the settlement of
the contract equal to the difference between the amount the
funder paid at the outset (the advance) and the amount the
plaintiff paid to the funder when the claim was resolved. In
cases where the payment to the funder results in a loss, the
plaintiff should generally be able to use the loss to offset all or
a portion of the income he reports from the settlement of his
litigation claim.

In cases where the claim generates a disappointing
recovery, the plaintiff may end up paying the funder less than
the amount of the advance. If the litigation is a total bust, there
will be a zero recovery and the plaintiff usually pays the funder
nothing. In that case, the plaintiff will have no taxable recovery
to report, but he will have to report an ordinary gain under the
contract equal to the funder’s advance.

This illustrates the deferral element in these
transactions. The plaintiff was not taxed on receipt of the
advance, but he later pays tax on that amount when he settles
the prepaid funding without having to pay anything to the
funder. If the litigation is unsuccessful and no more coming is
coming to the plaintiff, he still must pay tax on the advance,
albeit in that later tax year.

Timing Concerns
Let’s turn back to the timing question and the
assignment of income tax authorities. These are usually not a
concern in the case of loans or in the case of prepaid forward
contracts. In both of those cases, the plaintiff should still be
treated as owing his claim despite a funding transaction. But in
the assignment or the sale, the first two items we discussed
above, the goal is for the plaintiff no longer to be taxed on the
recovery.

Can that goal be achieved? It depends on the
formalities observed and on timing. Tax lawyers are
accustomed to worrying about the assignment of income
doctrine. When income is too close to being earned, it typically
cannot be transferred to someone else without tax effects.
That’s why it doesn’t work taxwise when an independent
contractor finishes a job and says, “don’t pay me, please pay
my cousin instead.” In fact, in some cases, the act of assigning
the item can accelerate the income, making a bad situation
worse.

Under the assignment of income doctrine, a taxpayer
who earns or otherwise creates a right to receive income will
be taxed on any income or gain realized from it. If you transfer
the right after you earn it, but before receiving the income, it
remains your income. See, e.g., Doyle v. Commissioner, 147 F.2d
769 (4th Cir. 1945) (taxpayer who assigned judgment award
after it was affirmed on appeal was required to include the
proceeds in income). A review of the tax case law shows that
the assignment of income doctrine can require the transferor
to include the proceeds of the claim in gross income when
recovery on the transferred claim is certain at the time of
transfer.

Conversely, that is not required when recovery on a
claim is doubtful or contingent at the time of transfer.
Accordingly, in general, one who transfers a claim in litigation
to a third person before the expiration of appeals is not
required to include the proceeds of the judgment in income. If
the plaintiff assigns his entire interest in the case while it is on
appeal and before any settlement or final judgment, it is
usually okay (although it still may trigger gift tax
consequences).

As a practical matter, some plaintiffs may think that
the assignment of income doctrine cannot apply to them. In
that sense, whatever tax advisers may say, most assignment of
income tax issues may arise in unfortunate audits where it is
the IRS saying, “hey wait a minute, we think you are still
taxable on this.” If you are someone who transferred your
claim and didn’t get the money, that can ruin your day, so
getting tax advice before any transfer is best. Fortunately, the
assignment of income doctrine is more of a concern with
family transactions and gifts, rather than with commercial
parties and arm’s length sale contracts.