Overview
Section 139F1 provides that monetary awards received by exonerees in connection with their wrongful incarceration are generally not subject to tax. However, there is little guidance on the scope of this income exclusion The lack of guidance can be challenging as exonerees try to understand the tax implications of any monetary awards they receive, particularly because monetary awards can take different forms (e.g., lump sum payments, annuities, escrows) and can be received under different circumstances (e.g., statutory compensation systems, jury verdicts, settlements)
This memo2 is meant to provide professionals representing exonerees an overview of the requirements of section 139F and alert such representatives to potential issues in connection with the section 139F exclusion. This memo discusses the scope of section 139F and how it (and other relevant tax doctrines) could affect the tax treatment of monetary awards received by wrongfully incarcerated individuals. Although lump sum payments are generally excluded from income under section 139F, the treatment of periodic payments and annuities a common form of awards to exonerees can depend on the particular terms of the agreements. We discuss how the terms of these agreements can influence how the IRS is likely to treat these monetary awards and provide some relevant examples. We also discuss other limitations on the applicability of section 139F and provide some suggestions for how future guidance could expand the coverage of section 139F to a broader range of exoneree awards. Finally, we discuss briefly how states may tax awards paid to exonerees.
Background
In December 2015, Congress enacted the Protecting Americans from Tax Hikes Act of 2015, which added section 139F and provided that monetary awards paid to wrongfully
1 All references to “section” or "§" refer to a section of the Internal Revenue Code, Title 26 of the United States Code, unless specified otherwise.
2 Please note that this memorandum does not constitute an opinion as to the tax matters discussed herein. The use of the terms “is,” “will,” “should,” “would,” “likely,” or similar terms herein is for ease of understanding and reference and should not be construed as a legal conclusion with respect to the matters set forth herein. Although this memorandum discusses generally the expected application of certain rules, any definitive conclusion with respect to the U.S. federal income tax and state and local tax consequences of the matters discussed herein would need to rely on the particular facts of any monetary award received by a wrongfully incarcerated individual. Exonerees and their counsel should discuss the tax implications of any monetary award with a tax preparer.
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incarcerated exonerees are excluded from the individual’s gross income.3 The Joint Committee on Taxation explained that under the current law “[t]he taxability of damages . . . depends upon the nature of the underlying claim.”4 For example, damages relating to lost wages are generally taxable, but damages related to personal injury claims are excluded under section 104.
Section 139F creates a broad exclusion for certain monetary awards to wrongfully incarcerated individuals:
In the case of any wrongfully incarcerated individual, gross income shall not include any civil damages, restitution, or other monetary award (including compensatory or statutory damages and restitution imposed in a criminal matter) relating to the incarceration of such individual for the covered offense for which such individual was convicted.5
Section 139F defines a wrongfully incarcerated individual as someone who 1. was convicted of a covered offense; 2. served all or part of his or her sentence for the covered offense, and 3. either a. was pardoned, granted clemency, or granted amnesty for the covered offense because the individual was innocent; or b. had (i) the judgment of conviction reversed or vacated and (ii) the accusatory instrument dismissed or was found not guilty at a new trial after the judgment of conviction was reversed or vacated.6
A covered offense means “any criminal offense under Federal or State law, and includes any criminal offense arising from the same course of conduct as that criminal offense.”7
There is little formal guidance or case law explaining or interpreting section 139F. There are no regulations or other administrative guidance. Only three court opinions cite section 139F: two (a trial court decision and appeal in the same case) address whether the section applies to
3 Section 139F is effective for tax years beginning before, on, or after December 15, 2015, and provides a limited waiver of the statute of limitations related to refund claims Application of the statute of limitations waiver should be addressed on a case by case basis.
4 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029 (Rules Committee Print 114 40), JCX 144 15, 2015 WL 9942030, at *10 (Dec. 17, 2015).
5 Section 139F(a).
6 Section 139F(b).
7 Section 139F(c)
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proceeds received by parties related to an exoneree and the other merely cites its existence in a footnote.
However, in March 2018 (soon after section 139F was amended), the Internal Revenue Service (the “Service”) provided answers to a set of wrongful incarceration FAQs on section 139F.8 The FAQs discuss, among other things, whether (i) the section 139F exclusion applies to settlements and compensatory or statutory damages; (ii) the exclusion applies to the wrongfully incarcerated individual and his or her estate; and (iii) the wrongfully incarcerated individual is required to retain documents associated with the award for three years.9 The answers to the FAQs did not detail how different forms of awards (for example, lump sum, periodic payments, annuities) would be taxed under section 139F.
Application of Section 139F
In order to provide guidance to exonerees, we evaluate below how different forms of awards lump sum and various types of periodic payments may be treated under the tax law. The form of these payments can impact whether they are fully excluded from the exoneree’s taxable income.
Lump Sum Payments
In many cases, an exoneree receives an award in one lump sum payment for his or her wrongful incarceration When there is a lump sum payment delivered immediately to the exoneree, the tax treatment is relatively straightforward because there are no timing issues. Provided the exoneree meets the definition of a “wrongfully incarcerated individual,” the total amount of the payment is excluded from the exoneree’s income under section 139F.
Periodic Payments
In other circumstances, however, the exoneree’s award may include payments over time. For example, state or local law may require that any payments be in the form of an annuity10 or be placed in an account for the exoneree’s benefit such that the exoneree receives payments every month for a set, or indefinite, time. Further, in the course of settling a matter,
8 Section 139F was solely amended to extend the period of the statute of limitations waiver.
9 IRS, Wrongful Incarceration FAQs, Question 12, https://www.irs.gov/individuals/wrongful incarceration faqs (last visited Apr. 7, 2022).
10 An annuity is a form of insurance or investment that entitles the investor or the beneficiary of the investment to receive a set sum of money at specified intervals of time. The principal amount is placed into an account that generates income that should ensure that the specified sums are delivered as scheduled.
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the exoneree and defendant may agree to a settlement that includes an annuity or periodic payments. When a portion of the award is used to purchase an annuity, there is a question as to whether the full amount of the annuity payments would be excluded from the exoneree’s taxable income or whether a portion of the payment related to interest income would have to be included in the exoneree’s taxable income.
As explained in Section II, there is limited guidance on section 139F. The FAQs that have been provided by the Service do not address how to account for periodic payments that are received by exonerees. Absent additional guidance, practitioners seeking to understand how section 139F treats periodic payments have looked to section 104(a), which provides for the exclusion of compensation for personal injuries from gross income. The sections have similar wording. Section 104(a) states in relevant part, “gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”11 However, one major difference is that section 104 explicitly excludes from income “lump sums or . . . periodic payments” on account of personal injuries.12
Because the language of section 139F is not as explicit as section 104, there is an open question as to whether a portion of the annuity received by an exoneree is interest income that is subject to tax. The annuity received by the exoneree could be treated in different ways. The exoneree could be treated as receiving a lump sum amount (tax free under section 139F) that he or she uses to purchase the annuity for himself or herself. This treatment could lead to the exoneree being taxed on the interest associated with the annuity. In contrast, the exoneree could be treated as receiving the periodic payments or annuity as the specific award such that the entire award would be tax free under section 139F and none of the interest associated with the annuity would be taxable to the exoneree. The difference in this treatment is important as the exoneree may not understand the tax consequences of this type of award or be prepared to pay the tax expense.
As section 139F and related guidance provided by the IRS does not provide additional direction, exonerees and their counsel often look to other tax principles to try to ensure that these periodic payments will not create taxable income. General tax principles dictate when the income is received by the exoneree. Receipt then determines when the income is taxable and, in the case of section 139F, excludable from gross income. 11 Section 104(a). 12 Id.
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Actual Receipt
An individual taxpayer, as a cash method taxpayer, has income when the income is actually or constructively received. The distinction relates to the beneficiary’s ability to control the funds. Actual receipt is evident, the taxpayer receives the funds and then has actual control over how to use those funds
For example, in Revenue Ruling 65 29, the IRS concluded that the investment income from a lump sum payment that was invested in an annuity was included in the claimant’s income because the claimant “ha[d] unfettered control” of the lump sum payment that was awarded.13 The taxpayer received the money and then used that amount to purchase an annuity The interest from the annuity was thus income and taxable. In Revenue Ruling 79 220, however, the IRS concluded that the full amount of the monthly payments from an annuity related to a stipulated settlement was excludable from the claimant’s income.14 The claimant was not required to include in income any “investment income” related to each payment.15 The IRS distinguished this conclusion from its conclusion in Revenue Ruling 65 29 because the beneficiary never had control of the award and was only entitled to receive a set amount per month, regardless of the yield of the annuity. The only amount over which the taxpayer had actual control was the amount the taxpayer received each month.
In Private Letter Ruling 8204023, the claimant received a lump sum settlement with respect to a personal injury claim and then used a portion of the lump sum amount to purchase an annuity.16 It was determined that one quarter of the annuity payment was non taxable, but that the remaining amount of the monthly payment was taxable. The claimant then tried to restructure the annuity to receive more non taxable monthly income. The IRS concluded that only the taxpayer’s lump sum payment received from the settlement was excludable, not the monthly benefits. Once the settlement was paid, the payor had no continuing obligation or interest and the claimant controlled the investment of, and had actual receipt of, the settlement proceeds.
Constructive Receipt
Pursuant to the constructive receipt doctrine, a taxpayer that has control over an amount that is income is required to include the amount in gross income, even if the taxpayer has not yet actually received the income. Treasury Regulation section 1.451 2(a) explains that:
13 Rev. Rul. 65 29, 1965 1 C.B. 59.
14 Rev. Rul. 79 220, 1979 2 C.B. 74.
15 Id.
16 I.R.S. Priv. Ltr. Rul. 8204023 (Oct. 27, 1981).
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Income although not actually reduced to a taxpayer’s possession is constructively received by him [(or her)] in the taxable year during which it is credited to his [(or her)] account, set apart for him [(or her)], or otherwise made available so that he [(or she)] may draw upon it at any time, or so that he [(or she)] could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.17
Courts and the Service thus weigh the limitations and restrictions on a taxpayer’s ability to control the payments to determine if the income is constructively received. In Revenue Ruling 2003 115, the IRS concluded that the monthly payments claimants received as part of the September 11th Victim Compensation Fund of 2001 were excludable from the claimant’s income 18 The fund permitted each claimant to select whether their payment would be a lump sum payment versus a monthly check, but once the selection was made, the claimant no longer had control over the amounts. The Service concluded that if the claimant elected to receive a monthly payment, the claimant did not have constructive receipt of the lump sum amount that could have been received by the claimant.
In Private Letter Ruling 20083601919 the IRS determined that a claimant’s scheduled periodic payments were only included in income when actually received. The employee could not change the timing or amount of the payment, could not sell or encumber the payments, and a third party controlled the monthly payments. Thus, the employee was not in constructive receipt of the periodic payments prior to actual receipt.
Because section 139F does not expressly anticipate periodic payments, exonerees must be vigilant to ensure that they are not in constructive receipt of funds that they do not actually receive
Reporting of the Payments
Exonerees and their counsel must be diligent in negotiating with any prospective annuity provider. Counsel should advocate that the annuity company not issue a Form 1099, including a Form 1099 R, for amounts paid to the exoneree that qualify under section 139F. Form 1099 documents “miscellaneous income” that a taxpayer receives from any non employer payor in excess of $600.20 Form 1099 R specifically documents certain distributions received by individuals, including with respect to certain annuities. Issuing a Form 1099 or Form
17 Treas. Reg. § 1.451 2(a).
18 Rev. Rul. 2003 115, 2003 2 C.B. 1052.
19 I.R.S. Priv. Ltr. Rul. 200836019 (Sept. 5, 2008).
20 See Section 6041.
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1099 R to an exoneree could cause the IRS to look for this income to be reflected on a tax return. Because payments qualifying for section 139F do not need to be reported as income, the exoneree could be subject to an audit because of the mismatch in income. Although the triggering of an audit is not certain, issuance of one of these forms could be a complicating factor for the exoneree.
Annuity providers may argue that they are required to submit a Form 1099 and specifically a Form 1099 R citing section 6041 or Treas. Reg. § 1.6041 1(d)(1), but these forms need not be issued when the payment is not income for the taxpayer. In the context of section 104(a), the IRS has confirmed on multiple occasions that Form 1099s are not necessary when “damages are excluded from gross income.”21 In one such situation, the IRS was asked whether the payee had to issue information returns for payments the payee made to victims 22 The IRS concluded that because “the damages are excluded from gross income under § 104(a)(2), they are not income under § 6041. Thus, under § 6041, Taxpayer is not required to file information returns or furnish copies of information returns with respect to distributions of damages to Victims.”23 The IRS’s analysis did not change when the beneficiary received periodic payments.24 In that scenario, an insurance company placed part of the settlement proceeds due to the taxpayer into an annuity to make monthly payments for 20 years 25 The insurance company owned the annuity and had control over the annuity.26 The taxpayer died within the 20 year period and the payments continued to the taxpayer’s estate after his death. The IRS concluded that the payments remained exempt from tax pursuant to section 104(a)(2), and that the insurance company had no obligation to report the payments on Form 1099.27
The same analysis should apply for payments received by an exoneree regardless of whether they are lump sum, periodic or both. The state of Hawaii and at least one large insurance company, Prudential, have also read the Code the same way. The state of Hawaii explains that Form 1099 R is only sent if a portion of the taxpayer’s pension benefits are taxable 28 For example, the taxpayer would not receive one for service connected disability retirement
21 See, e.g., I.R.S. Priv. Ltr. Rul. 200925039 (June 19, 2009); I.R.S. Priv. Ltr. Rul. 200835017 (Aug. 29, 2008); I.R.S. Priv. Ltr. Rul. 200835016 (Aug. 28, 2008); I.R.S. Priv. Ltr. Rul. 200834011 (Aug. 22, 2008); I.R.S. Priv. Ltr. Rul. 200834009 (Aug. 22, 2008); I.R.S. Priv. Ltr. Rul. 200816014 (Apr. 18, 2008).
22 I.R.S. Priv. Ltr. Rul. 201311006 (Mar. 15, 2013).
23 Id.
24 See I.R.S. Priv. Ltr. Rul. 7905017 (Oct. 31, 1978).
25 Id. 26 Id. 27 Id.
28 Hawaii Employees' Retirement System, FAQs 1099 R Tax Form, Question 16, https://ers.ehawaii.gov/wp content/uploads/2012/03/FAQs 1099 v2017.pdf (last visited Apr. 7, 2022).
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benefits.29 Prudential’s Frequently Asked Questions explain that it issues a Form 1099 when “the distribution results in taxable income.”30 Exonerees and their counsel should insist that no Form 1099 be issued if their payments qualify for section 139F. As exonerees discuss these issues with annuity providers, they should explain that many annuity providers already have annuity products in the workers’ compensation/section 104(a) area where no Form 1099s are issued.
How to Structure Periodic Payments to Increase the Likelihood of a Section 139F Exclusion
As explained above, there are a number places for missteps by an exoneree that may make the payments received after release includable in gross income. Although no one method is guaranteed to be determinative, taking the following steps should help alleviate risk of taxation:
1. Ensure discharging documents note that exoneree is adjudicated innocent.
2. Determine if payment will be by lump sum or periodic payments.
3. If payments will be periodic, ensure the following:31
a. The settling entity places the funds into the account. The funds should not go to the exoneree to be deposited or for the purchase of an annuity.
b. Payments are predetermined and do not change, other than as expressly contemplated by the original agreement
c. The exoneree is only a beneficiary of the annuity and has no control over the management of the annuity
d. The exoneree does not otherwise have the ability to change the amounts received.
e. The exoneree may not encumber the payments or direct the payments to anyone else.
f. The exoneree may not have the ability to sell or assign his or her rights to another.
g. The annuity is held by another entity (e.g., the state) for the benefit of the exoneree.
h. The annuity holder does not issue a Form 1099 for the periodic payments made to the exoneree.
29 Id.
30
Prudential, Help and Support ("Annuities Tax Related"), “Q. Will I Receive a 1099 R Form from Prudential for this tax year?,” https://www.prudential.com/links/faq (last visited Apr. 7, 2022).
31 The listed terms are not necessarily standard for an annuity. The exoneree and his or her counsel should confirm that the annuity issuer can provide an instrument that meets the requirements specified herein.
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If counsel determines that the payment falls within the ambit of section 139F, the exoneree or his or her tax return preparer may exclude the payment from income without making a special filing or election. The exoneree must, however, keep records related to the payment for three years.32 The exclusion of these payments on account of the exoneree’s wrongful incarceration does not affect the filing requirements for or taxation of other income the exoneree may receive in a year.33
ExamplesThis section presents several examples of the ways an exoneree may receive payments from a state or municipality arising from their wrongful incarceration.34 In each scenario, we provide an analysis of the possible tax outcome of the receipt of payment. We determine whether section 139F may apply and thus result in no increase in gross income to the exoneree. For purposes of these examples, the exoneree receives the payment from a state after a jury award unless stated otherwise The same analysis is likely to apply whether the payment was as the result of a jury award or a settlement or a statutory compensation regime, and whether the paying entity is the state, a subdivision of the state (i.e., a county or city), or an instrumentality of the state (i.e., an employee).
Example 1: a lump sum payment
Example 2: a lump sum that is subsequently invested
In many situations an exoneree receives a lump sum payment from the state when his or her case is resolved. Provided that the other requirements of section 139F are satisfied, section 139F is likely to apply. Therefore the payment is excluded from gross income, and the exoneree receives the payment tax free.
At times, when the exoneree receives a lump sum, he or she, with the advice of counsel, may decide to put the money in an account that will make periodic payments to the exoneree over time (e.g., an annuity). This may be done for a number of reasons, including to ensure the funds are available over time and to generate interest from the funds. In these cases, the initial sum paid to the exoneree by the state is tax free under section 139F. The income generated by
32 See IRS, Wrongful Incarceration FAQs, Question 12 (“To substantiate the Wrongful Incarceration Exclusion, the individual must retain documents establishing that the award was made on account of wrongful incarceration. Generally, these documents must be retained for three years from the date the return is filed. Examples of such documentation include copies of federal or state court orders awarding the compensation, signed settlement agreements accepting the amount of the award, and letters by governmental agencies or private payment sources that may have accompanied the payment of the award that include an explanation of the reason for the payment.”).
33 This memo does not address an exoneree’s tax filing obligations. The exoneree or his or her counsel should consult a tax return preparer regarding the tax filing requirements for each item of income in any taxable year.
34 These examples are not exhaustive and there are other issues that arise in this area that are not addressed herein For example, this memo does not comment on the interaction of section 139F and various litigation financing arrangements.
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Example 3: a state funded annuity required by law35
the account is likely taxable. Even though the exoneree immediately deposited the funds into the account and only receives a monthly payment, the exoneree actually received the funds at the initial payment, chose to place the payment in the account, and had unilateral control over the restrictions placed on the account. As a result, the IRS would likely argue that any interest or other income generated from the account thereafter does not fall under section 139F and would be subject to tax.
In some instances, a state may require by law that the funds due to the exoneree be paid via periodic payments rather than a lump sum. When this happens, the state often sets up an annuity where the state deposits the funds into an account maintained by a third party and the exoneree is a beneficiary of the account. Under this arrangement, the third party distributes payments to the exoneree over the life of the annuity. The payment amounts do not change even if there are increases in the value of the account because of interest. Under these circumstances, the exoneree does not have actual receipt of any money until he or she receives a periodic payment. The exoneree also likely does not have constructive receipt of the money in the annuity because he or she cannot determine when to receive payments, how much the payments should be for, or how to invest or maintain the underlying principal to generate more interest. The IRS is likely to find that this arrangement of an exoneree as the beneficiary of a state funded annuity falls under section 139F, and the exoneree therefore is not taxed on the annuity payments (either the amounts attributed to principal or the amounts attributed to any interest associated with the annuity).
Following settlement negotiations between representatives of a state and an exoneree, the parties reach a settlement agreement, which includes an annuity established for the benefit of the exoneree. As required by the terms of the settlement, the state purchased an annuity for the benefit of the exoneree with terms like in Example 3. The exoneree never received the funds used to purchase the annuity. Following the same logic as in Example 3, the exoneree is likely not subject to tax on the annuity payments.
Example 5: a state funded annuity with exoneree rights and control
Following settlement negotiations, the parties agree that an annuity will be established for the benefit of the exoneree. The terms of the annuity give the exoneree significant rights and control over the annuity and its payments, such as the ability to determine when, how, and whether to receive payments. In this case, the amount used to purchase the annuity (i.e., the principal) is not taxable as a result of section 139F. However, due to the exoneree’s ability to direct and control annuity payments, the interest attributed to the annuity is likely to be taxable.
35 States by statute can provide for compensation for persons who were wrongfully convicted of crimes. Each state designates who is an exoneree and how much they can receive.
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Example 4: a state funded annuity negotiated in a settlement
The above examples conclude that section 139F likely applies to periodic payments received by an exoneree if the state chooses or is required to purchase an annuity that benefits the exoneree. However, the result is less certain if the state chooses as part of a settlement or is required by law to fund a separate account (e.g., an escrow) for the benefit of the exoneree. For example, if the state were required to fund a separate escrow account for the benefit of the exoneree and the escrow earned a fixed rate of interest, the exoneree may be subject to tax on the interest earned by the fund. In this instance there is uncertainty as to whether the economic benefit doctrine created by case law results in the exoneree being deemed to have received the benefit of a present property interest in the fund (which presumably would be excluded from income under section 139F) so that the exoneree is then subject to tax on the earnings from the fund. Under the economic benefit doctrine, a taxpayer is required to include an amount in income where (1) money or property representing income is placed in a fund for the benefit of the taxpayer; (2) the fund is irrevocable and beyond the reach of the creditors of the party who transferred the money or property to the fund for the benefit of the taxpayer; and (3) the taxpayer’s rights to the fund is fully vested and conditioned only on the passage of time. See e.g., Sproull v. Comm’r, 16 T.C. 244, 247 48 (1951), aff’d, 194 F.2d 541 (6th Cir. 1952). In contrast, in Private Letter Ruling 200836109, the IRS held that a taxpayer was not required to include an amount in income under the economic benefit doctrine where the taxpayer was owed periodic payments and the obligor of the payments, in exchange for consideration, assigned the obligation to make the periodic payments to a third party (i.e., the obligor purchased an annuity on behalf of the taxpayer).
Other Potential Limitations to the Applicability of Section 139F
Although the largest potential pitfall for exonerees involves the accounting of funds received via periodic payments, there are other areas for missteps. Careful attention should be paid as to whether the payments exonerees receive meet the criteria specified in section 139F. For example, if the funds relate to actions that happened pre conviction section 139F will not apply if there is not a conviction. Similarly, section 139F would not apply if the exoneree does not receive a grant of innocence. A failure to meet any element of section 139F may require the exoneree to include the payment in gross income. Furthermore, parties related to the exoneree, like their families, may have received funds. In those cases, section 139F may not be met and the family taxpayers may have to include any payments in gross income. These potential barriers are addressed below.
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Limitations on Which Claims and Awards Are Excludable Under Section 139F
People who are wrongfully arrested may pursue legal action against the offending officers or municipalities. When those persons recover an award or receive a settlement payment, those payments are not covered under section 139F if there is no later conviction Section 139F only excludes from gross income payments made for wrongful convictions. The Service clarified this in its 2018 FAQs. The Service explained that a person released before trial or not convicted of any crime, may not exclude an award from income pursuant to section 139F. A pre trial formal abandonment of the indictment by the prosecutor (nolle prosequi) or a hung jury would not result in the application of section 139F as the exoneree was not convicted. The IRS noted, however, that section 104(a)(2) may provide an avenue for relief if the damages received were on account of personal physical injuries or physical sickness. 36 Therefore, persons who do not meet the criteria of section 139F because they were not convicted should consider whether other statutory provisions may grant relief.
A related question arises in regards to which claims brought by an exoneree are covered under section 139F. For example, an exoneree may pursue multiple claims related to his or her wrongful incarceration injuries sustained from a wrongful arrest before trial, rights violations and injuries while detained, post release claims, or deficiencies at trial or on appeal Section 139F states, “[i]n the case of any wrongfully incarcerated individual, gross income shall not include any civil damages, restitution, or other monetary award (including compensatory or statutory damages and restitution imposed in a criminal matter) relating to the incarceration of such individual for the covered offense for which such individual was convicted.” Although the “relating to the incarceration” language is broad, there is no guidance on the breadth of claims that are covered under section 139F. It is therefore unclear exactly which claims would and would not be covered under section 139F.
Payments When There Has Been No Grant of Innocence
In some cases, exonerees may be released without being adjudicated innocent. Section 139F states that the exoneree must have been pardoned, granted clemency, or granted amnesty for the covered offense because the individual was (i) innocent or (ii) (a) the judgment of conviction was reversed or vacated and (b) the accusatory instrument was dismissed or was found not guilty at a new trial after the judgment of conviction was reversed or vacated. Even if the exoneree is released after his or her conviction is overturned on appeal, if the case is not dismissed, the exoneree does not qualify for section 139F’s exclusion. 36 IRS,
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Wrongful Incarceration FAQs, Question 13.
For example, if a prisoner is released because a governor or the president grants a pardon, this release may not count as an adjudication of innocence. Although the governor or president may have thought the person should be released because of limited evidence, without a formal finding of innocence, any payment arising from the prison sentence will not fall under section 139F’s purview. Similarly, if a prisoner is released because his sentence is commuted or sentencing guidelines have changed, any funds received from a case related to his prison time will not qualify for exclusion under section 139F because there was no finding of innocence or reversal of the underlying conviction.
In these situations, the prisoner has little to no control over what the releasing documents or court decision notes as the basis for relief. In order to be afforded tax relief pursuant to section 139F, counsel for the exoneree should be diligent to make sure that relevant documentation (e.g., a releasing document or court decision) states all bases for release including actual innocence. Pardons for compassion or on other grounds are not sufficient to qualify a payment as excluded from income pursuant to section 139F.
Recovery by Non-Exonerees
In many cases, the family members or parties otherwise related to an exoneree have rights to recovery if an exoneree is found to be wrongfully convicted. For example, the spouse and children of an exoneree may have rights to loss of consortium for time lost while the exoneree was wrongfully detained. In these instances, any funds recovered by family members for their individual claims are not covered by section 139F. The court confronted this exact scenario in Elkins v. United States. 37
In Elkins, the bankruptcy estate of a deceased exoneree sought a refund of the amounts that had been taxed. The family of a deceased exoneree had obtained the settlement proceeds from a wrongful incarceration lawsuit in 2011. As part of that suit, the family members received funds for the claim of loss of consortium. The family had filed for bankruptcy in 2005, so the proceeds from the loss of consortium claim and the resulting tax on the settlement was taken out of the bankruptcy estate. Years later, when section 139F was passed in 2015, the bankruptcy estate tried to seek a refund of the tax paid because section 139F retroactively applied for one year to all amounts that would qualify but for the date of enactment. The bankruptcy court refused to reopen the bankruptcy case though concluding that section 139F applied to the exoneree’s claims only and not the loss of consortium claims, and thus no refund would be due.
37 Nos. 05 65317, 05 69543, 2016 WL 3414823 (Bankr. N.D. Ohio June 14, 2016), aff'd, 562 B.R. 685, 690 (N.D. Ohio 2016).
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On appeal, the district court agreed. The court found that: the title of the statute, as well as the plain language of the first clause of the single sentence that constitutes § 139F(a) (i.e., ‘[i]n the case of any wrongfully incarcerated individual’) defines the type of person to whom the statute applies, and it unequivocally states that its application is limited to wrongfully incarcerated individuals, not others with derivative claims. 38
The bankruptcy estate argued that section 104(a)(2) was sufficiently similar to section 139F and because section 104(a)(2) was not limited to the injured, section 139F should also not be construed to be limited to the exoneree. The court found, however, that the language in section 104(a)(2) did not specifically limit its application to the injured, while section 139F expressly stated that it was payments to exonerees that were excluded.39 The payment must relate to the exoneree’s cause of action for the bankruptcy estate to receive the benefit of section 139F
Elkins is the only case to expressly determine to whom section 139F applies. But in 2018, the Service affirmed this reading of section 139F.40 On its Frequently Asked Questions page, the Service explained that the spouse, child, parent, or other individual receiving funds pursuant to a derivative claim of the wrongfully incarcerated person like loss of consortium or loss of companionship is not entitled to exclude that award from income.41 On the other hand, if the bankruptcy estate pursues a claim on behalf of the deceased exoneree in regards to a wrongful incarceration, the bankruptcy estate can benefit from the section 139F exclusion.42
38 562 B.R. 685, 690 (alteration in original)
39 Id. at 691 92 ("[Section] 104(a)(2) does not have a clause or term that defines or limits the type of person whom may exclude a payment from gross income under it. The Court [found] that § 139F was provided to insure that wrongfully incarcerated individuals may exclude payments that they receive for their wrongful incarceration, even when the payments would not be excludable under §104(a)(2) because it cannot be established that the payments were paid on account of physical injury or physical sickness that they suffered while incarcerated as required by § 104(a)(2). Moreover, that Congress and the President enacted [§ 139F] as a new statute instead of amending § 104(a)(2), which is not limited to a particular type of taxpayer, is a strong indication that they intended to strictly limit the exclusion from income in § 139F only to wrongfully incarcerated individuals.")
40 Elkins does not address the scenario in which the estate of the deceased exoneree received an award for pursuing or completing a claim on behalf of the exoneree. Elkins also does not address the scenario in which an exoneree passes while receiving annuity payments. Depending on the terms of the annuity, it is possible that in this situation the exoneree’s estate could receive a lump sum payment closing the annuity tax free. See IRS, Wrongful Incarceration FAQs, Question 18. We do not address the effect that different annuity closing methods would have on section 139F’s application.
41 IRS, Wrongful Incarceration FAQs, Question 14.
42 Id., Question 18.
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Potential Legislative and Regulatory Changes to Section 139F
Greater clarity could be provided through Congress or Treasury (e.g., issue regulations or sub regulatory guidance such as a revenue rulings or revenue procedures), expanding on the responses that the Service provided in its Section 139F FAQs After having reviewed section 139F and related authorities in more detail, and consistent with enlarging the scope of section 139F to cover an expanded range of payments that may be made to wrongfully incarcerated individuals, we believe it would be helpful for future legislation and guidance to:
§ Confirm that section 139F applies to both lump sum and periodic payments.
§ Clarify the types of reasons for overturning a conviction that will be considered as a conclusion that the individual was innocent.
§ Clarify that section 139F extends to payments received by an exoneree from a broad range of claims that are related to the exoneree's wrongful incarceration (e.g., rights violations while detained, injuries sustained during the wrongful incarceration, and deficiencies at trial or on appeal).
§ Expand section 139F to include recoveries obtained by an exoneree’s family for their own claims related to the wrongful incarceration
§ Require that an individual be classified as innocent for section 139F purposes (treating the case as dismissed) if the prisoner is not retried within two years of the verdict being overturned on appeal.
State Application of 139F
Virtually all states and the District of Columbia impose a personal income tax that is administered separately from the federal income tax. States generally impose a tax on their residents based upon all income regardless of its source. Most states also impose a personal income tax on nonresidents that have income arising from a source within the state. The tax base in each state is different as are the rules on how the source of income should be determined.
Section 139F excludes from gross income payments made to exonerees arising out of their conviction for federal income tax purposes. Many states use the federal definition of gross income or federal adjusted gross income, as the starting point for the calculation of its income tax base. Exonerees subject to tax in such a state, either because they are a resident at the time they receive such payments or because they are receiving payments from the jurisdiction where they were incarcerated but are residents in another state, would not include such payments in their state income tax bases, absent some other specific statute providing
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otherwise. Below we consider the taxing regimes in California, the District of Columbia, Illinois, Maryland, New Jersey, New York, and Virginia as examples of the analysis exonerees should conduct when determining if they may owe state income tax on the money received.43
The first question for an exoneree, or his or her counsel, to answer is whether the relevant taxing jurisdiction or jurisdictions compute their tax base by reference to the federal definition of gross income or adjusted gross income. For federal income tax purposes, section 139F excludes qualified payments from the computation of gross income. Thus, if the state computes its tax base by reference to the federal definition of gross income, any payments received that qualify for exclusion from income under section 139F would likewise be excluded from the state tax base.
Of the states in our review, all but one follow the federal definition of gross income or adjusted gross income. California and the District of Columbia compute their state tax base for residents and nonresidents by starting with gross income calculated for federal income tax purposes, and thus conform with the federal income tax treatment of payments to exonerees under section 139F.44 Illinois, Maryland, New York, and Virginia compute their state tax base for residents and nonresidents by starting with adjusted gross income calculated for federal income tax purposes and thus also conform with the federal income tax treatment of payments to exonerees under section 139F.45
New Jersey, however, does not conform to federal gross income or adjusted gross income in determining its tax base. When analyzing the law of a state such as New Jersey the exoneree, or his or her counsel, should research whether the state tax law otherwise specifically excludes such payments from its tax base. New Jersey, for example, only includes certain enumerated types of income in its tax base such as wages, interest, dividends and net profits from business activities. As the New Jersey Division of Taxation has noted, payments to exonerees are not a category of income that is subject to New Jersey tax 46 Thus, New Jersey excludes such income from its tax base.47
43 States can and do change the definition of gross income. The discussion below is applicable as of the date of this memorandum.
44 See Cal. Rev. & Tax Code § 17071; D.C. Code Ann. § 47 1803.02(a).
45 See 35 ILCS 5/202; Ill. Admin. Code tit. 86, § 100.2050; Md. Code Ann. Tax Gen. § 10 201 et seq.; N.Y. Tax Law § 612; Va. Code Ann. § 58.1 322.
46 N.J. Rev. Stat. § 54A:5 1; New Jersey Treasury Div. of Taxation, NJ Income Tax Exempt (Nontaxable) Income, https://www.state.nj.us/treasury/taxation/njit12.shtml (last updated May 14, 2021); 2021 Instructions for the NJ 1040, at 8, https://www.state.nj.us/treasury/taxation/pdf/current/1040i.pdf.
47 None of the written guidance in New Jersey addresses how to account for periodic payments made to exonerees from interest bearing accounts, such as payments made from an annuity. Although it is not clear how the New Jersey Division of Taxation would view such payments, it is likely they would follow the general tax
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(cont’d)
