At the Foundation for Accounting Education's Taxation of Financial Instruments Conference on Jan. 10, Mark H. Leeds, a tax partner at law firm Mayer Brown, and Matthew Stevens, a principal in the national tax department of Ernst & Young, discussed the concept of litigation finance as a new asset class.

They began with an overview of how attorneys are taxed now. Currently, lawyers working on contingency fee cases generally cannot deduct expenses incurred for depositions, expert testimony and discovery until the conclusion of the case. Deductions for these expenses must wait until the lawyer receives the corresponding income at the conclusion of the case or the case otherwise concludes. Upfront payments received by the plaintiff or the law firm from a litigation funder for the sale of the underlying legal claim are immediately taxable as income to the party being funded.

Litigation funding from outside investors is historically more common in countries that, unlike the United States, have restrictions on contingent fee arrangements—but litigation funding is rapidly increasing in this country, they pointed out.

In an example of a typical transaction, the investor provides cash to a lawyer or plaintiff in exchange for a share of the contingent fee or litigation recovery. If the lawyer or plaintiff does not win or settle the case, the investor gets nothing. If the litigation succeeds, the investor's returns are calculated based on several different formulas.

Many investors have a strong desire to avoid debt treatment, and lawyers and plaintiffs have a strong desire to avoid sale treatment, they said.

They considered the case of Novoselsky v. Commissioner of Internal Revenue, in which the IRS successfully challenged a litigation finance transaction structured as a loan. The U.S. Tax Court ruled for the IRS, holding that the payments the lawyer received from the third parties constituted gross income to the taxpayer and not loans. Specifically, the payments were not loans because any obligation for the taxpayer to repay was contingent on future events, and therefore did not constitute debt for federal income tax purposes.

“I hope this opened up a new asset class for those who haven’t seen it,” Leeds said in concluding the session.