Proposed Tax Hike Targets Lawsuit Investors: Funders Face New High Tax Rate Starting 2026

The “Tackling Predatory Litigation Funding Act” introduces a major shake-up to how lawsuits are financed in the U.S. Essentially, this legislation creates a brand new federal tax on the profits made by third-party investors—known as litigation funders—who bankroll legal cases in exchange for a cut of the settlement or judgment. The core of the bill imposes a hefty tax on these investors: it’s the highest individual income tax rate, plus an additional 3.8 percentage points, on what the bill calls “qualified litigation proceeds.” This new structure is set to kick in for tax years starting after December 31, 2025.

The High-Stakes Tax on Lawsuit Profits

For litigation funders, this bill is a game-changer because of the sheer tax burden. If a funder backs a major class-action suit and collects a profit, that profit is now subject to one of the highest tax rates available. The bill also specifies that these investors cannot use ordinary or capital losses from other activities to offset these litigation profits; the tax hits the gross amount received. This is a significant economic hurdle designed to restrict the profitability of the litigation funding industry, which critics argue drives up frivolous lawsuits. However, the flip side is that this increased cost could make it harder for plaintiffs with legitimate, complex, or expensive cases—like whistleblowers or victims of corporate negligence—to find the capital needed to take on deep-pocketed defendants.

When Lawyers Become Tax Collectors

One of the most complex provisions involves mandatory withholding. If a plaintiff’s law firm or the named party in a suit enters into a financing agreement, they become the “applicable person” responsible for collecting the tax. When the lawsuit wraps up and the funder is paid back, the law firm must withhold a staggering 50% of the applicable tax rate from that payment and send it to the IRS. Think of it like this: your lawyer, who is focused on winning your case, now also has the administrative burden and liability of being a tax collector for the funder’s profits. Failure to withhold this tax correctly could expose law firms to penalties and interest, adding significant compliance risk and potentially making them hesitant to work with funders at all.

Tax Relief for the Plaintiff

While the bill places a massive tax burden on the funders, it offers a major benefit to the actual party in the lawsuit—the plaintiff or claimant. Under a new tax code section (139J), any “qualified litigation proceeds” received by the party to the suit are explicitly excluded from their gross income. This means if you win a lawsuit and receive a settlement or judgment, that money is now entirely tax-free at the federal level. For an individual who wins a significant recovery—say, for personal injury or wrongful termination—this is substantial relief, as it ensures they keep the full amount of their recovery without having to worry about a large tax bill at the end of the year. This benefit, however, only applies if the case was financed under one of these specific “Litigation Financing Agreements.”

What Doesn’t Get Taxed

The bill carves out a couple of important exceptions. First, very small funding deals—those providing less than $10,000 for a single case—are exempt from the new tax rules. Second, if the financing is structured like a traditional loan, where the funder’s return is limited to repaying the principal plus interest (where the interest rate is capped at 7% or twice the 30-year Treasury yield), it also avoids this high tax. These exclusions suggest the law is specifically targeting investors who take a large, equity-like stake in the outcome of the litigation, rather than simple small-scale loans or standard attorney fee arrangements.