The Tax on Innocence
Few things in life are as scary as the thought of going to prison for a crime you didn’t commit. Prison is nasty and brutal enough for those who actually deserve to be there — but it can’t be any more cruel than it is for someone wrongly accused and convicted. And yet, a recent court case makes these tragedies even worse for those who manage to clear their names.
Advocacy groups like The Innocence Project have made great strides publicizing the plight of innocent incarcerated people. There have been 265 post-conviction DNA exonerations in the U.S., including 17 who had been sentenced to death. We all celebrate when those exonerated people who have served an average of 13 years are cleared. Frequently, they go on to win settlements from state and local governments responsible for their incarceration.
You know who really celebrates when an innocent prisoner walks away with a well-deserved settlement? That’s right, the good old IRS. You would think those sorts of false imprisonment settlement payments are tax-free. Surprisingly, they aren’t.
Internal Revenue Code section 104(a)(2) and its accompanying regulations and caselaw set out the general rule on tax-free damages. And that rule lets you exclude damages from taxable income if:
the underlying cause of action giving rise to the recovery is based on tort or tort-type rights (essentially, an unintentional or negligent wrongful act that results in injury to another’s person, property, or reputation), and
the damages are sustained through personal injury or physical sickness (but not including emotional distress).
The IRS issued a recent Chief Counsel Advice holding that exonerated individuals can exclude any part of compensatory damages they receive for actual physical injury or sickness suffered while incarcerated. But the Tax Court recently issued a decision in the Stadnyk case holding that mere physical restraint and physical detention are not “physical injuries” — thus, they remain taxable. Talk about adding insult to injury!
Taxing false imprisonment settlement payments seems as blatant a miscarriage of justice as wrongfully imprisoning someone in the first place. Various lawmakers have introduced legislation like the Wrongful Convictions Tax Relief Act of 2010, but none of those efforts worked. It’s time to fix this problem, and now.
We certainly hope that none of you reading this wind up falsely convicted! But it’s worth pointing out that minimizing your taxes doesn’t just mean using the law. Sometimes it means changing the law. Eliminating tax on false imprisonment settlement claims seems as righteous a place as any to start.