The Indiana Legal Trust
Suppose you want to sue somebody and to donate the proceeds to charity? This takes careful tax planning. Ordinarily in life, you shouldn’t count your chickens till the eggs are hatched. Tax law is the opposite. Count your chickens before they’re hatched, or you’re going to lose a lot of chicks to the Internal Revenue Service.
Here is the problem. Suppose you know that you can sue Badguy at a cost of $300,000 in hourly legal fees and with 80% probability you will win $1,000,000 in damages, and you want to give the damages to charity. The federal government--- and probably the state—will make you pay income tax on what you collect, except in special cases such as personal injury or wrongful death damages (which, admittedly, are giant special cases). Let’s suppose for convenience that your tax rate is 20%, though if your income for the year is $1,000,000, it’s going to be a lot higher.
First problem: if you lose, you may not be able to deduct the legal fees. (I will have to research that.)
Second problem: even if you win, you may not be able to deduct the legal fees, and I’m pretty sure you can’t deduct all of them (I will have to research that—it may be you can deduct them after the first 2%, the first $20,000.)
Third problem: there is an annual limit of something like 60% (I will have to look it up; the Trump tax cut changed it) on cash charitable donations. Thus, you can only deduct $600,000. This means you may have to pay $300,000 in legal fees, and 20% on the $400,000 left over after you take your deduction, so you will be out $380,000 (= $300,000 + $80,000) as a result of your charitable impulses and the IRS and lawyers may come and repossess your house.
To be sure, you can carry over your unused charitable deductions to future years--- the $400,000—and use them up gradually, but if you are wealthy and over 60, you may be hitting the 60% limit each year till you die anyway.
What can you do? My idea is the Indiana Litigation Trust. Set up a nonprofit entity, a trust or corporation, with 501© (3) status. Transfer to it the rights to your lawsuit damages, in exchange for paying the legal fees, but do not transfer control of the lawsuit. Lend it the money for legal fees, at zero interest. If you lose, forgive the debt and take a tax deduction. If you win, collect the debt.
This seems to be a new idea. I will have to research all the angles. Note that one advantage is that if anybody else wants to help with legal fees, they can do so and take a tax deduction, unlike with a GoFundMe campaign.
This is completely ethical. You can’t make money from it, because the whole idea is that you’re giving all the profits to charity. You can, however, achieve the goal of the charitable deduction statute, which is to allow people to give away income and not be taxed on it. The legal maneuvering here is just to achieve that goal despite the obstacle the IRS has, for good reasons, set up to make it hard for people to fraudulently take advantage of charitable deductions. The only result of this is that you can’t end up a net loser because of your altruism, and the charity gets your full donation rather than some of it going to the government.
I hope to write this up as a law review article at some point. I think the IRS should not object to it, and I will propose draft regulations they might promulgate to let people know it is safe to use it. I think it is legal under existing statute and regulations anyway, but it would be nice to have the safety of IRS endorsement.
