July 1, 2025
Third-Party Litigation Funding (TPLF) has quietly become one of the most profitable and under-regulated corners of the legal and financial world. In this arrangement, hedge funds or private investors fund lawsuits in exchange for a cut of any settlement or court award. While this may sound like a niche practice, its ripple effects are being felt across multiple industries, but most notably the insurance industry.
As part of a recent legislative push in the Big Beautiful Bill (BBB), the Tackling Predatory Litigation Funding Act (S.1821) aims to rein in what many see as a major tax loophole by taxing TPLF profits more fairly and bringing much-needed transparency to this part of the financial investment sector.
Currently, there is no special tax regime for third-party litigation funders. These entities typically structure their investments so that profits are taxed at favorable capital gains rates or, in some cases, not taxed at all. These structures often:
Because of the lack of IRS guidance and enforcement, the result is an extremely low effective tax rate on high-risk, high-return litigation investments.
The BBB includes a set of reforms to ensure TPLF profits are taxed more fairly and transparently. Key provisions include:
TPLFs would be required to recognize income in the year a settlement or judgment is finalized, closing loopholes that currently allow funders to defer income, sometimes indefinitely.
Litigation-based profits would be taxed as ordinary income, not capital gains, regardless of whether the funder structures their return as a loan or equity interest. In addition to this income being subject to the highest ordinary income tax rates, any qualified litigation proceeds received by these funders would be subject to an additional 3.8% net investment income tax.
Pass-through entities (like partnerships or s-corporations) that are engaged in litigation funding would be taxed at the entity-level, rather than at the individual partner or shareholder level.
The BBB provision, as it currently stands, would exclude individual civil actions in which the third-party funder will receive less than $10,000. In addition, repayment on the principal of a loan or reimbursement of attorney’s fees are also excluded from these proposed rules.
This proposed provision in the BBB signals a congressional push to clamp down on complex pass-through and foreign entity tax avoidance strategies. However, the implications go far beyond tax compliance and reporting. The TPLF loophole has real-world costs, especially for the insurance industry — and most notably, mutual insurance companies.
Mutual insurers, which are owned by their policyholders, operate on thin margins and exist to provide affordable and reliable coverage. The rise of third-party litigation funding has dramatically driven up claim costs. Not necessarily because cases have more merit, but because third-party funders press for higher settlements and drag out proceedings to increase their returns. Every frivolous case and inflated settlement:
Because TPLF profits are currently taxed more favorably than normal income, it gives outside funders a structural advantage, while mutual insurers and their policyholders are left holding the bill. The BBB’s proposed reforms would help level the playing field, protect the court system from misuse, and reinforce the core mission of mutual insurers: serving the long-term interests of their policyholders, not subsidizing high-risk litigation bets by global hedge funds.
If you have questions about how these changes might affect your business or your clients, our team at Larson & Company is here to help you navigate this evolving tax landscape with clarity and confidence. Larson and Company has developed a suite of services specifically to serve the needs of companies of all sizes in a wide range of industries.