When plaintiffs sell their legal claims, who pays taxes and when?

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 ordinary 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.