Healing Justice Tax Summary for Exonerees

GENERAL SUMMARY For How the Tax Law Applies to Your Facts, Seek Advice of a Tax Professional

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Exonerees like you may be entitled to compensation due to your wrongful incarceration.

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Usually, exonerees do not have to pay federal income taxes on this compensation as long as the compensation was given to you because of your innocence.

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Specifically, Section 139F of the Tax Code makes your compensation tax-free if you meet these criteria: (1) you were convicted of a crime; (2) you served all or part of your sentence; and (3) you were either freed on the grounds of innocence, or your conviction was overturned and the original charges were dropped or you were acquitted at a new trial.

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Generally, you are not eligible for tax-free compensation if you were never convicted in the first place, or if your release from prison was not based on innocence.

If your compensation is provided to you in payments over time (instead of all at one time), there are special rules that need to be followed in order for your compensation to be tax free: (1) the initial funds must first be placed in an

account that does not belong to you or carry your name; (2) you cannot change the amount of initial funds deposited or the payment interval or amount; (3) you are the only one who can receive the payments over time from those initial funds; (4) you cannot control or sell the account containing the initial funds; and (5) you cannot borrow money against future payments or have future payments sent to anyone else. §

The summary that follows provides more details about all of this.

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You should always consult with a tax advisor about whether you need to pay federal or state taxes on your compensation or report compensation you received to federal or state authorities.

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For additional information, you and your tax advisor should also consult a Wrongful Incarceration FAQ published by the IRS, available at https://www.irs.gov/individuals/wrongfulincarceration-faqs, and our in-depth legal memo on this issue, available at www.healingjusticeproject.org.

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Whether You Need To Pay Taxes On Your Compensation From Wrongful Incarceration Exonerees like you may be entitled to compensation due to your wrongful incarceration. Compensation could come in the form of lump sum payments, monthly payments, or educational benefits. The compensation could come from cities, states, or the federal government through a formal compensation program when you settle your case, or win a lawsuit in court. Usually, exonerees do not have to pay federal income taxes on compensation they get due to their wrongful incarceration. The rule that governs this is Section 139F of the Tax Code. This summary is meant to help you understand different issues affecting whether you have to pay taxes on any compensation you receive. You should consult with a tax advisor about whether you need to pay taxes or report compensation amounts based on your specific situation.

For additional information, you and your tax advisor may also consult the Wrongful Incarceration FAQ published by the IRS, available at https://www.irs.gov/individuals/wrongful-incarceration-faqs, and our indepth legal memo on this issue, available at www.healingjusticeproject.org.

Who is eligible for tax-free compensation?

Who is not eligible?

In order to be eligible for tax free compensation, you must meet the following criteria:

You are not eligible for tax free compensation if any of the following occurred:

1. You were convicted of a crime;

1. You were never incarcerated at all,

2. You served all or part of your sentence, and

2. You were released before trial and were not convicted of any crime, but you received some form of compensation (for example, for wrongful arrest),

3. either (i)

(ii)

You were pardoned, granted clemency, or granted amnesty on the grounds of innocence; or the conviction was reversed or vacated and (ii) the charges were dismissed or dropped or you were found not guilty at a new trial.

3. Your indictment was dismissed by the prosecutor before trial, 4. Your trial resulted in a hung jury, 5. You were granted clemency or a pardon on the basis of something other than factual innocence, or 6. Your sentence was commuted or reduced for reasons unrelated to innocence.

What other types of compensation may not be subject to tax?

Many different types of compensation received by exonerees may not be subject to tax because of exceptions in the Tax Code, including compensation for injuries, restitution, or other monetary compensation like statutory damages. But Section 139F only covers compensation related to your incarceration.

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Who can benefit from an exoneree’s tax-free compensation?

You, as the exoneree, can enjoy the tax benefits of Section 139F directly by not paying tax on compensation you receive if you meet the eligibility requirements. After you have passed away, your family can also benefit if your estate brings claims on your behalf.

In many cases, your family members or others related to you may have their own claims if you are found to be wrongfully incarcerated. For example, your spouse or children may have claims for time lost while you were wrongfully incarcerated. In these instances, the money received is theirs, not yours, and therefore is not tax free under section 139F.

Does how the compensation is received (for example, lump sum or periodic payments) affect whether you must pay taxes?

If you receive compensation for a wrongful arrest (as opposed to a wrongful conviction, that compensation is not covered by section 139F if you were never convicted. But a different rule may make that compensation tax free if it was based on your personal physical injuries or physical sickness.

Therefore, even if you do not meet the criteria of section 139F because you were not convicted, please discuss with your tax advisor whether other rules may relieve you from paying taxes on the compensation.

For more information, please see the IRS Wrongful Incarceration FAQs, Question 13.

Monetary compensation relating to wrongful incarceration can come in a number of forms, including onetime lump sum payments or periodic payments that are spread out over time. Sometimes, the form of the compensation is set by state law. In other cases, you can choose the form of the compensation, like when you settle the claims you brought in a lawsuit.

Section 139F can apply whether the payment is made as a lump sum or is paid over time. But, if payments are made over time, such as through annuities, the following rules must be met in order to avoid paying taxes on the portion of the payment related to interest income: 1. The funds must first be placed in a separate account that does not belong to you. The funds cannot go to you first to be deposited into an account. (i) For example, the government cannot give you a check for the full amount, and then you use the money to buy an annuity that will make payments to you overtime.

2. You cannot change the amount of funds you receive. Payment amounts must be set upfront and cannot change over time, unless covered by a prior agreement.

3. You must be the only person who receives the payments (except for providing for another beneficiary if you pass away).

4. You cannot control the management of the account used to fund the payments (but you can have complete control over the payments sent to you). (i) For example, you cannot tell the annuity manager what to invest the initial deposit in. But, once you have received your monthly payment, you can invest, give, or use that money however you please.

5. You cannot borrow money against future payments or have your future payments sent to anyone else.

6. You cannot sell the account funding the annuity.

7. You cannot sell the annuity payments to someone else.

8. The account funding future payments cannot be in your name, but instead must be held for your benefit in the name of another entity, for example, the state.

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Some of these conditions may not be standard. You and your advisor should confirm that the entity that will be making payments to you can meet these requirements. Some entities may have more experience in these types of annuities from their work with other exonerees or with tax-free workers compensation claims.

When thinking about which investment company to use when setting up the annuity, you may want to ask them about their experience with these types of accounts.

Do you need to report your compensation as income on your tax returns and what documentation do you need?

You should discuss your reporting and documentation requirements with your tax advisor and tax return preparer. Generally, if you and your tax advisor determine that the compensation you receive is covered by section 139F, and therefore, is not subject to tax, you can file your tax return without including the compensation on it. You must, however, keep the records related to the payments for at least three years. Also, you must still file a tax return for other income received in a year, such as income from a job, which is taxable. You should also consult with your tax advisor or preparer regarding state tax issues, discussed briefly below.

If the payments are tax free under section 139F, the entity sending you the payments will not need to report the payments made to you to the IRS by sending you a Form 1099 (which is a type of incomereporting form similar to a W-2 form sent when someone has income from a job). It is important to confirm that the entity making tax-free payments to you will not report the payments to the IRS.

Do you owe state taxes on your wrongful incarceration compensation?

Many states and the District of Columbia impose their own income tax that is separate from the federal income tax, so even if the compensation is tax free for federal purposes, you could still need to pay state income tax. Even so, many states use the federal definition of income as the starting point for calculating state income tax obligations. You and your advisor should carefully check if: 1. The compensation is excluded from state tax because the state uses the federal definition of income.

2. The state’s definition of income excludes compensation received by exonerees based on their wrongful incarceration.

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