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U.S. for about a decade. As MarketWatch reports, third-party investors are pouring up to $100 billion into funding lawsuits as a way to seek returns that can far surpass equity and fixed-income investments. Plus, as Forbes Tax Contributor Robert W. Wood points out, “Litigation funders help to level the playing field, just as contingent fee arrangements for lawyers did a generation ago.”

Taxes on litigation financing can also be deferred, if you follow the right steps.

One way to finance litigation is through a loan, which is inherently tax deferred since the money must be paid back. But, once the case resolves, the IRS will tax the entire amount as income. If litigation spans over a tax year (which it often does), deductions can be limited to the point at which you may end up paying taxes on money that was never in your hands in the first place.

That’s a key reason many attorneys and their plaintiffs prefer prepaid forward contracts. Like loans, prepaid forward contracts aren’t taxed immediately. Because these are treated as sales, they’re subject to far fewer usury and regulatory requirements. In addition, the “buyer” of this contract (it could be an affiliate of the attorney, who is self-financing these cases anyway) could convert ordinary income tax (at 37%) to long-term capital gains (at 23.8%), a difference of more than 13%!

The correct documentation is important, though, as are factors such as modifications, which Monster.com’s Founder Andrew McKelvey recently discovered using these instruments to “sell” the stock. In that case, a simple modification to extend the contracts triggered $41 million in capital gains that would have otherwise been eliminated. Since lawsuits can drag out for some time, this is an important factor to note.

For questions on the tax treatment of prepaid forwards, feel free to contact us

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