Monday, November 22, 2010

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.


Anonymous said...

I thought this might be the case when you commented on this in an article last week. I didn't think the IRS was going to give anyone a pass on not paying taxes on recovered lost wages. It's definitely taxable under the IRS code, and definitely taxable on court awards. The way the IRS sees it, wages are wages, whether you worked for them or not, are taxable.

However, those wrongly convicted might be able to whittle down their tax burden on these awards quite a bit. For instance, the part of any awards they had to pay in legal and attorneys fees is deductible.

And, there might also be some casualty and theft losses. However, these would have to be examined carefully.

Anonymous said...

It's compensating for the tort of false conviction

Herein lies the problem, and why this will probably be taxed.

Texas has several issues that deal with taxable income in several ways. The IRS has others. The IRS wins, when it comes to taxes.

In Texas, recovery for straight-up personal injuries is not taxable. That's because it's not for the compensation of lost wages or impairment or loss of earning capacity.

If you are a Plaintiff's lawyer and you do not make sure that any judgment or settlement agreement reflects that a recovery is for personal injuries only, you are committing malpractice.

Recovery for lost wages or loss of earning capacity, or any similar causeof action related to what you would have earned in the past or future, is 100% taxable. Lots of lawyers (and even a few judges) say that no award in a personal injury lawsuit is taxable, and they are completely wrong. The IRS will tax your income, or its substitute received in a lawsuit, period. Lots of people refuse to pay those taxes, usually on the advice of a lawyer, and they could very well get in hot water with the feds.

My bet is that they are very likely to view Texas' version of an award as compensation for time and income that they would have earned had they not been in jail. So, 7:13 is right that to the extent that they're for last wages, recoveries such as this are recoverable. To the extent that it is for the violation of their rights, it is not, because that sort of violation, like a personal injury, is not income and is a non-taxable recovery for an injury that is specific to that person. (The deduction for attorney's fees is little consolation, though, since the money is gone whether it's in taxes or to an attorney.)

So, whomever is fighting this in court had better couch it in terms or recovery for the personal injury/civil rights violation. If they don't, it will set a precedent for taxation.

And unfortunately, far too few lawyers know the difference.