On May 20, 2025, Senator Thom Tillis (R-NC) introduced the Tackling Predatory Litigation Funding Act as an amendment to the Internal Revenue Code of 1986 (the "Code"), which would establish a new tax regime purportedly applicable to third-party litigation funding. A companion bill was introduced in the House of Representatives (the "House") on the same day by Representative Kevin Hern (R-OK). On May 21, 2025, the House passed the One Big Beautiful Bill Act, which would make significant changes to the Code but which did not contain the Tillis proposal. On June 16, 2025, the Senate Finance Committee released a draft Reconciliation Bill (the "Bill"), which included the Tillis proposal without substantial change. While the Bill purports to address litigation funding, if enacted, the Bill would have an impact on broader financial markets, injecting uncertainty into numerous ordinary course financing transactions and potentially chilling corporate credit and other credit markets. In addition, the legislation would set a troubling precedent for addressing perceived grievances relating to different sectors of the economy.
While the stated goal is to prevent foreign influence in the US court system and prevent frivolous lawsuits, the Bill goes far beyond simply imposing a special rate on qualified litigation proceeds and essentially creates an entirely new income tax system dedicated to the litigation finance industry. The Bill would depart from the traditional Code's longstanding flow-through approach to non-corporate entities, would completely disregard the tax characterization of the instrument under which qualified litigation proceeds are received and would seek to tax foreigners and tax-exempts (including US pension plans and other tax-exempt entities) in a manner that is inconsistent with the traditional US income tax system. There is little precedent for the establishment of an entirely new income tax system dedicated to a particular industry. Furthermore, under the wording of the legislative text, even ordinary course financing transactions (including secured and unsecured lending, securitizations and debtor-in-possession lending) could be picked up, potentially impacting broader financial markets.
Overview of the Proposed Tax
The Bill would add a new Chapter 50B to the Internal Revenue Code, imposing a tax on "qualified litigation proceeds" received by "covered parties" under a "litigation financing agreement." Key provisions include:
- Flat tax rate of 40.8% (equal to the current top individual tax rate of 37% plus 3.8%), on all qualified litigation proceeds. Qualified litigation proceeds include the realized gains, net income or other profit which is derived from, or pursuant to, any litigation financing agreement.
- Imposition of an entity-level tax, including for partnerships and S corporations, overriding traditional flow-through principles.
- Broad scope of "covered parties," includes individuals, corporations, partnerships, sovereign wealth funds and tax-exempt organizations (including US pension plans and other tax-exempt entities), regardless of US or foreign status.
- Expansive definition of "litigation financing agreement," includes not only traditional litigation funding contracts but also any agreement "which creates a direct or collateralized interest" in litigation outcomes. In addition, the Treasury would have authority to treat substantially similar arrangements, which are undefined, as subject to the tax. Therefore, any general asset financing provided to an entity that is a named plaintiff in a civil litigation could potentially be considered within the scope of the legislation, and it is unclear what other arrangements Treasury and/or the IRS might consider to be in scope.
- No offset for losses: Unlike typical taxable income, qualified litigation proceeds cannot be offset by other ordinary or capital losses, even those generated by other litigation financing arrangements.
- Overrides key traditional exclusions,
exemptions and preferences,
including:
- Section 104(a)(2): Exclusion for personal physical injury damages;
- Section 892: Exemption for income earned by foreign governments;
- Sections 871(h) and 881(c): Portfolio interest exemption; and
- No preferential capital gain treatment.
- New withholding regime: Any named party in a civil action or law firm affiliated with such civil action that has entered into a litigation financing agreement with respect to such civil action and has control, receipt or custody of proceeds with respect to such civil action must withhold 50% of the applicable tax rate (currently 20.4%) from all payments made to the funder. The withholding obligation is not based on net income or profit.
- Narrow exclusions for (i) fundings below $10,000, (ii) debt-like arrangements with interest rates capped at the greater of 7% or two times the average annual yield on 30-year Treasury securities and (iii) certain related-party transactions.
The bill would apply to taxable years beginning after Dec. 31, 2025 and would presumably apply even to existing litigation funding arrangements entered into prior to Dec. 31, 2025.
Impact of the Bill
If enacted, the Bill would create a completely new income tax regime, which purports to only apply to litigation financing transactions but would potentially have a much broader reach, likely resulting in significant uncertainty regarding its interaction with the traditional tax system and posing complex compliance challenges, including:
- Ambiguity for certain common commercial transactions: The definition of a "litigation financing agreement" could sweep in ordinary corporate credit transactions where the debtor is a party to a civil litigation, including whole business and other securitizations, purchases of subrogation claims from Insurance Companies, factoring deals and other unintended arrangements.
- Double taxation risk for investments through entities:
- Corporations:
- Ordinarily, earnings and profits of a US corporation that are distributed to individual shareholders are generally subject to a second level of tax at a maximum rate of 20% or 37%, depending on whether or not the distributions are "qualified dividends." In addition, dividends from a corporation are generally subject to a net investment income tax of 3.8%.
- Therefore, in the case of a litigation funding investment made through a US corporation, if the proceeds of the litigation funding are subject to a second level of tax when they are distributed from the corporation in the same manner as other distributed corporate earnings, the highest marginal effective federal rate applicable to individuals invested in the litigation financing through a corporation (including the tax imposed on the corporation itself) would be either 54.89% if the distributions are qualified dividends, or 64.95% if they are not.
- While the legislation would carve out qualified litigation proceeds from gross income, it is unclear whether this would also carve out qualified litigation proceeds from earnings and profits. Even if qualified litigation proceeds are not included in earnings and profits, it is likely that distributions of qualified litigation proceeds would reduce the shareholders' adjusted basis in their corporate shares.
- Partnerships:
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- Furthermore, there could be double tax on income from litigation funding even when the litigation funding investment is made through a partnership. In contrast with the traditional flow-through treatment of partnerships, the Bill would impose the tax on partnerships themselves. Since the legislation would carve out qualified litigation proceeds from gross income of the partnership, presumably, partners' basis in their partnership interests would not be increased by the qualified litigation proceeds.
- Consequently, proceeds from an investment in a litigation financing arrangement through a partnership would effectively be subject to double tax, once, upon receipt of the proceeds by the partnership, and again, upon distribution to the partners. Gains recognized under Section 731 on distributions from a partnership are generally subject to net investment income tax.
- Accordingly, the highest marginal effective federal rate on qualified litigation proceeds earned through a partnership would be 54.89% if the partners held their interests in the partnership for more than a year, or 64.95% if they did not.
- Tax-exempt investors, foreign governments and portfolio interest: The Bill would override a number of long-standing, traditional tax exemptions. The legislation would impose a tax on tax-exempt investors (including US pension plans and other tax-exempt entities) and on foreign governments that are both generally exempt from tax on various categories of passive income. In addition, the tax would override the portfolio interest exemption that generally exempts US source interest paid to foreign lenders from US withholding tax.
- Foreign investor exposure: The tax would apply to non-US investors even if the litigation financing income would be considered capital gain under general income tax principles, which would not ordinarily be subject to US tax.
- Foreign litigation: The legislation does not distinguish between US and foreign litigation. Therefore, both US and non-US investors that are covered persons would technically be subject to the tax even if the litigation funding relates to non-US litigation.
Takeaways
The Bill would establish a standalone income tax regime that departs from the traditional US income tax framework in both scope and structure and would override a number of long-standing income tax principles such as the treatment of partnerships and forward contracts, favorable tax treatment for tax-exempt entities and foreign governments, and the portfolio interest exemption. Although the legislation purports to only target litigation funding, if enacted the Bill would have an impact on broader credit markets (including secured and unsecured lending, securitizations and debtor-in-possession lending) and would set a troubling precedent for addressing other disfavored financial activities through inadequately considered tax legislation.
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