Why it’s time to close the litigation funder tax loophole

There’s a multibillion-dollar hustle hiding in the legal system—and no, it’s not just ambulance chasers or billable-hour lawyers. It’s litigation funding, the financial industry's best-kept open secret. These firms bankroll lawsuits the same way VCs fund startups. Except when things go sideways, they get a tax break you and I could never dream of.

Litigation funders are allowed to deduct their expenses—like lawyer fees and court costs—as ordinary business expenses. That’s right: they can treat a failed lawsuit as a write-off just like rent or payroll. But when the case hits big? They claim capital gains treatment on their profits. The result? Losses get cushy tax relief. Gains get low-tax upside.

This is a setup that looks less like “access to justice” and more like Wall Street playing dress-up in a judge’s robe. And unless the loophole gets closed, taxpayers are effectively subsidizing high-risk legal speculation while regular investors, gig workers, and founders eat full-risk exposure.

Let’s be clear: this isn’t your cousin loaning you $5,000 for small claims court. This is institutional capital—hedge funds, private equity firms, and dedicated litigation finance players like Burford Capital—pumping tens or hundreds of millions into legal claims for a share of the proceeds.

A typical setup looks like this: a company or plaintiff lacks the cash (or appetite) to fund a long legal battle. A litigation funder steps in, covering the upfront costs—attorney retainers, expert witnesses, discovery tools—and takes a contractually agreed slice of any eventual judgment or settlement. If the case fails? The plaintiff owes nothing, and the funder eats the loss. If the case wins? The funder could walk away with 30–50% of the proceeds.

This is non-recourse lending meets speculative investing. It’s not inherently evil. But when these bets are treated as tax-advantaged business operations instead of what they are—capital speculation—it creates a distortion.

Litigation funding firms typically claim tax deductions on the money they put into legal cases as “business expenses.” These include lawyer fees, court costs, travel, data services, and more. It’s treated like overhead, even though these costs are essentially bets on future payouts. Now here’s the flip: if the case succeeds, the payout is often structured in a way that allows the firm to claim long-term capital gains—taxed at 20%, not the ordinary income rate of up to 37% in the US.

Compare that to your investment experience:

• You buy shares of a startup. If it tanks, you might be able to deduct capital losses—up to $3,000 per year against ordinary income.
• If it wins big, you pay capital gains tax—but only after years of lockup and risk.

Litigation funders? They get to write off failed cases as routine operating costs (with no cap) and still claim gains at preferential rates. That’s tax arbitrage dressed up as legal fairness.

You might be thinking, “Okay, so some hedge funds are using a tax break. Why should I care?” Here’s why: tax rules don’t just collect revenue—they shape incentives. And right now, those incentives are pushing the legal system into becoming a profit-driven asset class.

When you subsidize speculative litigation via tax policy, you:

• Encourage funding of borderline or low-merit cases
• Create pressure on plaintiffs to settle based on financial models, not fairness
• Increase the leverage of funders over legal strategy and case management
• Distract from the core function of courts: resolving disputes, not generating yield

Think of it this way: what happens when funders start treating lawsuits like leveraged ETFs? You get volatility, moral hazard, and an ecosystem that prioritizes IRR over integrity.

The biggest players in litigation finance aren’t mom-and-pop operations. They’re global firms backed by institutional capital. Take Burford Capital, the publicly listed litigation funder that made headlines for its massive bet on the Petersen Group’s claim against Argentina. Or Omni Bridgeway, another global player with offices across Australia, the US, Europe, and Asia.

Their clients include:

• Patent trolls trying to weaponize IP claims
• Plaintiffs in mass tort cases (e.g., talcum powder or Roundup)
• Companies suing rivals over commercial disputes
• Sovereign claimants in international arbitration

The returns? Often 20% to 30% annually, according to firm disclosures—higher than most private equity portfolios, and certainly higher than your average ETF. But none of those returns account for the soft risk pushed into the public system: clogged court dockets, increased litigation costs, and a chilling effect on companies trying to innovate without getting sued.

Litigation funders love to say they’re democratizing the legal system—helping underdogs take on powerful corporations. And yes, there are cases where that’s true. But when you look at the portfolio strategies, it’s clear most funders prefer high-dollar, long-tail commercial claims. The reason? That’s where the returns are. Not in helping a tenant sue their landlord or a gig worker fight wage theft.

In other words, “access to justice” is the marketing. Yield is the product. If these firms really wanted to operate like public-interest vehicles, they’d be nonprofits—or at least structured as B Corps with capped returns. But they’re not. They’re financial firms, pure and simple. And they should be taxed like it.

Litigation funding isn’t just a US phenomenon. It’s booming across Europe, Australia, and increasingly parts of Asia. But here’s the catch: most of these markets are still debating how to regulate the practice—and how to tax it. In the UK, funders faced a setback in 2023 when the Supreme Court limited their ability to recover returns in certain types of class actions. In Australia, there’s been growing concern about “open class” lawsuits being driven by funder incentives, not claimant needs.

And in the US, the Federal Trade Commission and Congress have started poking at the opacity of the industry—especially the way funders can influence legal decisions while staying hidden from public view. Tax policy may not be as flashy as regulatory reform. But it’s arguably more powerful. Ending the deduction loophole would put a hard floor under the risk these firms take—and force them to price their bets accordingly.

No one’s saying funders shouldn’t exist. But they shouldn’t be allowed to game the tax system while pretending to be legal service providers.

A better framework might look like this:

• Treat litigation funding expenses as capitalized investments, not operating deductions
• Limit the use of passthrough structures that convert income into capital gains
• Require disclosure of funder participation in cases over a certain financial threshold
• Apply financial sector tax rules (e.g., base erosion and anti-abuse tests) to prevent regulatory arbitrage

It’s not about punishment. It’s about parity. If you invest in lawsuits for profit, you should be treated like an investor—not a law firm.

You don’t need to be a litigation funder to feel the effects of this distortion. When capital gets cheaper for risky bets like lawsuits—but stays expensive for small business, housing, or infrastructure—it changes how markets behave.

Imagine if startups could write off their entire burn as business expenses, then pay just 20% tax on exits. That’s effectively what funders are doing. Meanwhile, real-world entrepreneurs are grinding it out under tougher conditions. Worse, litigation-driven stock volatility can spook average investors and skew price discovery. Companies facing multiple funded lawsuits often see valuation hits, even before a court rules. That’s fine if you’re shorting them. Not so great if you’re a long-term investor holding through the noise.

In an era where tax fairness is already under scrutiny, defending a carve-out for litigation hedge funds isn’t exactly popular politics.

We’re talking about firms that:

• Make double-digit profits during recessions
• Obscure their involvement in court documents
• Have little to no fiduciary duty to plaintiffs
• Avoid banking regulations while operating like shadow lenders

Not exactly the heroes of financial democracy.

Closing the tax loophole isn’t just smart economics. It’s political common sense. And if lawmakers don’t act soon, it’s only a matter of time before public outrage forces a heavier-handed solution.

Litigation funding isn’t going away. But the current tax treatment gives it an edge it doesn’t deserve—and creates systemic risk most people don’t even see. If you're a retail investor, you should be asking why your failed investments get capped write-offs while funders write off losses like they’re lunch receipts. If you're a taxpayer, you should be asking why you’re subsidizing lawsuits that often have little to do with justice. And if you're a lawmaker, it’s time to call this what it is: a financial product wrapped in legal theater.

Shut the loophole. Force transparency. And let the litigation funders play—but with the same tax rules as the rest of us. Because right now, it’s not access to justice. It’s access to alpha.