Wrongfully Incarcerated Individuals

The number of exonerations for wrongfully incarcerated individuals has increased for the third year in a row, according to The National Registry of Exonerations, with an average of over three exonerations per week across the United States.

Experts attribute this leap to a growing trend of accountability in prosecutorial offices around the country. How might this influx of exonerations impact the structured settlement market and how can we help plaintiff attorneys pursue justice for these recently liberated individuals?

The Small Business Job Protection Act of 1996 amended IRC Section 104(a)(2) of the Internal Revenue Code restricting its exemption from federal tax to “damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness.” The 1996 rewording made clear that punitive damages are taxable, regardless of the reason for the underlying claim. The other primary change was the addition of the word “physical.”

This rewording, however, did not settle all issues surrounding what is taxable or not taxable. Issues have arisen on a range of topics, including what constitutes “damages”?

Taxpayers and courts have continued to struggle with claims that do not involve an incident where physical injury is plainly evident, but emotional distress is asserted as a basis for damages and there also appear to be physical symptoms.

One such category of cases where this issue has been addressed by separate tax legislation involves wrongly incarcerated persons who are paid amounts because of their wrongful imprisonment.

On December 18, 2015, President Obama signed into law the Consolidated Appropriations Act (P.L. 114-113). One of its provisions, the Wrongful Convictions Tax Relief Act of 2015 (introduced as H.R. Bill 3086), prevents the taxation of civil damages or restitution awarded in wrongful conviction cases.

Prior to this legislation, taxation of wrongful incarceration cases typically created difficult factual issues. All wrongful conviction cases involve the physical acts of arrest and imprisonment. Tax exclusion, however, required some physical injury or physical sickness resulting directly from the arrest or imprisonment. When a released prisoner could not present the necessary evidence or causal connection, a settlement was deemed taxable.

A 2010 Memorandum from the IRS Chief Counsel concluded that a recipient of a wrongful incarceration settlement had the burden of establishing by documentation that the physical injury or physical sickness suffered arose from a claim, and that the payor intended to resolve the physical injury or sickness claim in paying particular sums. Only then could such payments be non-taxable to the taxpayer.

The 2010 Memorandum did not address whether, under certain conditions of wrongful incarceration, the very circumstances of an individual’s confinement and treatment could be deemed an injury to his or her person that was fundamentally physical in nature and thus eligible for excludability under IRC Section 104(a)(2).

Instead of addressing this question within the familiar context of IRC Section 104(a)(2), the Wrongful Convictions Tax Relief Act of 2015 amended the Internal Revenue Code by adding new Code Section 139F. IRC 139F provides that gross income does not include compensation received by an individual as a result of incarceration for an individual’s wrongful conviction of a crime.

IRC 139F defines “wrongfully incarcerated individual” as:

  1. an individual who was convicted of a criminal offense under federal or state law, who served all or part of a sentence of imprisonment relating to such offense, and who was pardoned, granted clemency, or granted amnesty because of actual innocence of the offense; or
  2. an individual for whom the conviction for such offense was reversed or vacated and for whom the indictment, information, or other accusatory instrument for such offense was dismissed or who was found not guilty at a new trial after the conviction was reversed or vacated.

While IRC 139F has eliminated some of the uncertainty for these cases, important issues are left unanswered:

    • Can IRC 139F compensation be paid via an IRC 130 qualified assignment, or must this be done via non-qualified assignment?
    • Are punitive damages excluded from gross income under Code § 139F?
    • If 139F compensation is paid to family members of the wrongfully incarcerated person, are those payments likewise excluded from gross income?

IRC 130 only applies to structured settlement transactions in which periodic payments made to the injured claimant will be excludable under Code Section 104(a)(2). Therefore, unless there is a reliable basis for establishing that the relevant portion of Section 139F compensation being paid is also on account of physical personal injury or physical sickness, the safest method for achieving a structured settlement of Section 139F compensation is with a non-qualified assignment.

In contrast to IRC 104(a)(2), which expressly does not apply to punitive damages, IRC 139F makes no reference to punitive damages. Similarly, further guidance is needed from the IRS as to whether IRC 139F compensation paid to family members of the wrongfully incarcerated person are excluded from gross income.

Regardless of the determination, the increase in exonerations poses an opportunity for the structured settlement community to partner with key professionals and organizations that specialize in exonerating the innocent.  Our industry’s message to injury victims of financial security through a structured settlement is likely to resonate in a similar way with individuals restarting their lives upon release from prison.

Portions of this article are excerpted with permission from “Structured Settlements and Periodic Payment Judgments” © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.