The Indiana Litigation Trust

The Problem

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% (The Trump tax cut complicated this; it is 100% for 2020 income, I think, going back maybe to 60% later; Biden will probably change 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.

The Idea

What can you do? My idea is the Indiana Litigation Trust. Set up a nonprofit entity, a trust or corporation, with 501c (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 also has the major advantage that other people can contribute to paying the legal fees tax deductibly, by contributing to the Trust. For other people to be able to contribute, however, one must run things carefully because I think that personal foundations (almost entirely funded by one person) have somewhat different rules than public charities. There is the requirement that a certain amount of funds be given away each year, but there may be other things too. That there is this other advantage might be important so that this scheme is not merely a way to reduce taxes, but also has a business purpose.

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.

Notes

I thought of this when I was suing Citigroup on behalf of the State of New York. If I won, I would get more money as a reward than I could ever spend, and, if I gave it away, more than I could ever deduct. Indeed, if I gave it away I would be bankrupted. I did not realize at that time that I could use the idea to deduct legal fees and expenses if I lost, alas. That suit, like many that people might bring for public-interest reasons, had a low chance of success but very high damages if it succeeded. I lost. See https://www.rasmusen.org/citigroup/ . No court ever said Citigroup didn't owe the taxes, but there were plausible procedural grounds for which my suit could be limited, and Jones-Day argued them well, wisely avoiding the substantive issue.

I researched the law of this quite a bit. The big issue is how the "assignment of income doctrine" applies. Courts say that if you give away the rights to damages to a charity while they are "inchoate", meaning while they are unsure, you can neither take a tax deduction for it nor be subject to the 60% cash charitable deduction limit. That's the right thing to do. The question arises as to when the damages become "choate", if I may coin a term. Definitely it is okay to give away the damages before you even file suit; definitely it is not okay if you've already won the suit and all appeals are exhausted, or if you have signed a settlement agreement. As I recall, courts are very generous, and the proceeds are still inchoate if you have won at trial but an appeal is proceeding.