Proposed Tax Hike Targets Lawsuit Funding: New Excise Tax Could Limit Access to Civil Court

The “Tackling Predatory Litigation Funding Act” introduces a massive new excise tax aimed squarely at third-party litigation financing—the practice where outside investors fund a lawsuit in exchange for a cut of the settlement. The bill, effective for tax years starting after December 31, 2025, essentially makes it much harder, and potentially impossible, for regular people and smaller businesses to use this funding mechanism to take on powerful, well-resourced opponents.

The New Tax Hit: Highest Rate Plus 3.8%

This isn't a small tax increase; it's a game-changer. Under Section 2, the bill adds a new Chapter 50B to the Internal Revenue Code, creating an excise tax on “qualified litigation proceeds.” If you are a party receiving money from a lawsuit funded by a third party, you would owe an annual tax on those proceeds equal to your highest individual income tax rate, plus an additional 3.8 percentage points. For those already in the highest tax bracket, this could push the effective tax rate on these proceeds well over 40%. Crucially, this tax applies to the gross profit received from the financing agreement, and the bill explicitly bans using any ordinary or capital losses from other activities to offset this amount. Think of it like this: if you win a significant settlement that was funded by an investor, the government is going to take a huge bite out of the profit before you even see it, and you can't use a bad year in the stock market to soften the blow.

Who Gets the Squeeze?

This bill directly hits the people who rely on litigation financing to access the courts. For many individuals or small companies pursuing complex claims—say, a small business suing a major corporation for patent infringement, or a family pursuing a complicated medical malpractice case—litigation funding is the only way to afford the multi-million dollar legal fees, expert witnesses, and discovery costs. By heavily taxing the returns on these investments, the bill makes these deals far less attractive to investors, which could dry up the funding pool. This means fewer people will be able to pursue potentially meritorious claims because they simply can't afford the upfront costs. The bill’s definition of a “Litigation Financing Agreement” is broad, covering any deal over $10,000 where a third party gets a claim on the payout, capturing most serious cases.

Mandatory Withholding and Financial Redefinition

The administrative side of this new tax is also complex. The law requires the “applicable person” (usually the law firm or the named party making the payment) to withhold 50% of the calculated tax rate from any payment made to the third-party financier. That’s a huge administrative burden and a potential source of conflict, as the paying party has to play tax collector. Beyond the tax rate, the bill also changes the fundamental nature of these financial arrangements. It specifically excludes these proceeds from being treated as a capital asset and prevents them from being excluded from gross income under certain common tax code sections (like Section 104(a)(2) for personal injury awards). This removes existing favorable tax treatments, ensuring the new, higher excise tax is the only game in town for these funds, further eroding the profitability of litigation funding.