Almost nobody likes dealing with tax questions. They are usually complicated, rely on endless pages of code, and are expensive to answer. Kids, if you want a high paying job, become a tax attorney.
Interestingly, plaintiff funding presents an interesting tax question that many in the industry take different sides on.
Here is the question: If a plaintiff gets an advance on her settlement, and loses her case, is that income on which she has to pay taxes, and therefore, do attorneys send 1099 to clients?
To give that question more context, let’s start with an example and state what we know.
- Melissa is hurt in an MVA. She has significant injuries.
- Her lawyer values the case at $100,000 and expects it to take a while to resolve.
- When Melissa gets her settlement, she won’t have to pay income tax on it since there is a special exception for personal injury settlement money in the Internal Revenue Service (IRS) code.
- To pay her bills while she’s out of work ABC Funding gives her $5,000.
- It is well established that this is not a taxable event for Melissa.
- It turns out the driver who hit her is uninsured and Melissa gets nothing from her settlement payment.
- Since plaintiff financing is nonrecourse, ABC Funder lost its investment. Melissa gets to keep the $5,000.
Now the question: Does Melissa need to pay taxes on the $5,000 and does ABC have an obligation to send her a 1099?
Unlike the mortgage crisis when mortgage companies foreclosed on millions of Americans and sent them form 1099-NEC for forgiveness of debt, it is clear that because legal funding is an investment and not a loan, this is not a forgiveness of debt situation.
Still, legal funding companies are split over how to categorize the monies paid out when plaintiffs losecases.
- Issue a 1099, classifying it as miscellaneous income to the plaintiff
- Don’t issue a 1099, since it’s not forgiveness of debt or anything else that would require 1099 be issued
Here’s a deeper dive into the nuances surrounding both sides of the issue.
1099 – Legal Funding on Lost Cases Is Income
In the case of legal funding on eventually lost cases, one view is that these funds should be documented as income.
A senior official at a large funding company, via a bevy of tax advisors who were in agreement, believes that all funding companies are should issue plaintiffs the form 1099-MISC, the catchall 1099 for income in excess of $600, if they lose their case.
Other industry insiders agree-if not with this categorization of legal funding as miscellaneous income, then at least with the decision to err on the side of caution, and thus documentation.
According to retired Judge Anthony P. Calisi on personal injury funds, “The IRS is unlikely to criticize anyone for issuing more of the ubiquitous little forms. In fact, in the Internal Revenue Service’s view, the more Forms 1099 the better. Perhaps for that reason, it is becoming common…to issue Forms 1099 to clients even where they are not strictly necessary.”
For others, however, issuing 1099s isn’t part of the job, and here’s why.
No 1099 – Legal Funding as an Intangible Asset
According to another legal funding industry official, legal funding should be defined an investment in the purchase of an asset. If that asset disappears, in the event that the legal action is lost or abandoned, there is no asset for which to issue Form 1099.
The asset, in this case, is the potential settlement payment, which would serve as legal claim, and, because settlements from personal injury cases are not taxable, they’re forgiven. No 1099 IRS form is needed.
This argument also suggests that issuing 1099s to be cautious might actually put plaintiffs in an even worse situation. For example, Melissa above was not only hurt in an accident, couldn’t recover what her case was worth because the driver who hit her was uninsured, but now has to pay income tax on the money she received as an advance – even though if she got that money as a personal injury settlement it would be tax free.
Administrative Responsibilities Must be Negotiated
If you and your tax counsel determine that a 1099 form is necessary in those cases, you must make sure your administrative processes are established, and fast.
One thing that makes plaintiff funding unique is that the financing is determined based on the merits of the case, not on a plaintiff’s personal credit. Some funders don’t even take plaintiffs’ full social security numbers since they aren’t running credit.
If a law firm wants to send a 1099 IRS form, a social security number is required and would necessitate the additional collection of that information upfront.
Not only that, but the administrative burden of figuring out a plaintiff’s new address years after a funder may have funded them, and other burdensome processes are daunting for many people – especially people who (hint, hint) don’t have a well-organized data structure and reporting structure.
Written ByJosh Schwadron
Chief Executive Officer
About the author
Joshua is a lawyer and tech entrepreneur who speaks and writes frequently on the civil justice system. Previously, Joshua founded Betterfly, a VC-backed marketplace that reimagined how consumers find local services by connecting them to individuals rather than companies. Betterfly was acquired by Takelessons in 2014. Joshua holds a JD from Emory University, and a BA in Economics and MA in Accounting from the University of Michigan.
About the reviewer