Splitting hairs at the IRS over taxing compensation for false convictions

A tax lawyer warns that the IRS ruling mentioned last week may not completely end the requirement that wrongfully convicted people pay taxes on state compensation. Robert Wood argues that "this IRS ruling says only that a victim of wrongful imprisonment who 'suffered physical injuries and physical sickness while incarcerated' can exclude his recovery from taxes and can structure it just like other physical injury victims.  We already knew that." He continues in a blog post at Forbes:

I commend the IRS for saying what it did say in IRS Chief Counsel Advice 201045023.  But that isn’t the issue.  The IRS issued a series of rulings in the 1950s and 1960s, involving prisoners of war, civilian internees and holocaust survivors.  Sensibly, the IRS ruled their compensation was tax free irrespective of whether they suffered physical injuries.  Then the IRS “obsoleted” these rulings in 2007, suggesting the landscape has changed.

The IRS has still not addressed whether being unlawfully locked up is itself tax free.  This is a worry, since the Tax Court (affirmed by the Sixth Circuit) dangerously held in Stadnyk that persons who step forward saying they didn’t experience physical injuries or physical sickness will have a taxable recovery.  Stadnyk was a very short term incarceration case, but it may portend continuing adherence to the IRS canard that “there must also be physical injury.”

It is wrong as a matter of tax policy and as a matter of social justice to tax these recoveries.  It is also wrong to leave this area of the tax law to develop piecemeal so some people are paying tax.  The continuing myopic focus on the accompanying injuries or sickness will foment tax disputes about these issues. 

We'll know soon enough whether the IRS is going to be splitting this particular hair in practice, but he's right about the language in the ruling. Indeed, there's a straight-up factual error in the IRS ruling that seems to be the source of the misinterpretation Mr. Woods is lamenting: "The state enacted legislation to compensate individuals who were wrongfully convicted and incarcerated for their injuries, sickness, and economic losses flowing from the physical injuries and physical sickness (e.g., lost wages, future medical bills, etc.)." That's just not true. Compensation in Texas for wrongfully convicted persons is not in the least based on physical injuries or illnesses sustained while incarcerated: It's compensating for the tort of false conviction, and nothing in the statute requires that an individual be physically injured as well as falsely accused. Some were, but not all and that shouldn't be the determining factor.