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June 03, 2012 The Tax Lawyer

The Cost of Freedom: Tax Treatment of Post-Exoneration Compensation Awards

Vol. 65, No. 1 - Fall 2011

Elaine Ellis


    In the last few decades, over 300 innocent prisoners have been exonerated in the United States based on DNA analysis, proof of prosecutorial misconduct, or other previously overlooked evidence. Because of technological advancements and recent enhancements to defendant access rights, use of DNA evidence has steadily increased the number of prisoners exonerated each year. Interest groups dedicated to exonerating innocent prisoners, such as the Innocence Project, have also helped increase exonerations granted and the public’s focus on exoneration issues. One of the issues receiving heightened attention is how to properly compensate exonerated prisoners.

    In 1948, the federal government began providing minimal compensation to prisoners exonerated of federal crimes. The movement to appropriately compensate exonerated prisoners (exonerees), however, has gained momentum in the last ten years. As part of the Innocence Protection Act of 2004, Congress considerably increased the amount of compensation provided under federal statute, and urged states to pass similar legislation of their own. Since 2000, 20 states have enacted legislation to compensate exonerees; today 27 states and the District of Columbia provide some type of statutory compensation (state-issued awards) to exonerated state prisoners.

    In states with statutes providing compensation, the awards vary drastically. Some states provide educational assistance only, while others compensate with monetary awards based either on the number of years the exoneree was incarcerated, or on a discretionary basis. Although each state compensates exonerated prisoners differently, every state that provides some form of compensation forces exonerees to deal with the difficult tax problem of whether the compensation should be included in their gross income. States that collect income tax are free to explicitly exempt the compensation they award under the authorizing statute. Alternatively, compensation may be excluded through an interpretation of the state’s income tax code. The question remains, however, whether these state-issued awards should be included in gross income for federal income tax purposes.

    The exception that would most naturally cover state-issued awards is section 104(a)(2) of the Code, which excludes damages received for personal physical injuries or sickness. Due to its evolving coverage, the section
104(a)(2) exclusion has led to confusion among exonerees about whether or not to include compensation awards in federal income calculations. The Service recently interpreted the application of the section 104(a)(2) exclusion, with regard to exonerees, to require proof of physical injury or sickness. As a result, under this interpretation, exonerees who receive state-issued awards are often forced to include the full award amount in federal gross income due to their inability to provide adequate proof of physical injury or sickness while imprisoned.

    Exonerees also face a constructive receipt problem. The constructive receipt doctrine forces a taxpayer to include in gross income in the current year any amount over which the taxpayer has control of the timing of its payment. Exonerees often elect to receive their compensation in a stream of payments over many years, instead of in an initial lump sum. The election of the timing of payment triggers the constructive receipt doctrine and often results in the entire compensation award being taxed fully in the first year.

    Because the Service interprets 104(a)(2) to require proof of physical injury or sickness and strictly adheres to the constructive receipt doctrine, exonerees are typically required to pay a large portion of their state-issued awards to the federal government in the form of federal income tax. The federal government’s taxation of these awards impedes states’ ability to appropriately compensate their citizens for the injustices done to them.

    This Comment will argue that compensation paid to exonerated prisoners should be fully excluded from income for federal income tax purposes under the section 104(a)(2) exclusion, because sustained incarceration should constitute a physical injury. This Comment will also explore other possible remedies that would help alleviate the tax burden on exonerees. Part II will provide context for the discussion by exploring the reality of life as an exonerated prisoner. Part III will present the relevant tax concepts as applied to exoneree compensation. Part IV will discuss why prolonged wrongful incarceration should constitute physical injury, and analyze how exonerees can obtain confirmation that wrongful incarceration is a physical injury. Part V will explain three proposed solutions and offer some additional original remedial measures.

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