Thursday, November 18, 2010

Compensatory Damages Received By Exonerated Prisoner Are Excludable

Chief Counsel Advice 201045023

In Chief Counsel Advice (CCA), IRS has determined that compensatory damages received by an exonerated prisoner pursuant to state legislation enacted to compensate wrongfully incarcerated individuals for their physical injuries, sickness, and economic losses flowing from their injuries and sickness are excludable from gross income under Code Sec. 104(a)(2).

Background. Under Code Sec. 104(a)(2), non-punitive damages received by a taxpayer in a suit or agreement as compensation for personal physical injury or personal physical sickness are excluded from income. If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow from that injury or sickness are treated as payments received on account of physical injury or physical sickness. For example, back pay and other lost income meet the requirement that damages have been received on account of a personal injury if the recovered back pay, etc., relates to a period of time during which the taxpayer was incapacitated for work as a result of the personal injury.

Facts. An individual was wrongfully convicted of a crime and incarcerated for several years before the state exonerated the individual of the crime. While incarcerated, the individual suffered physical injuries and sickness. The state enacted legislation to compensate individuals who were wrongfully convicted and incarcerated for their injuries, sickness, and economic losses flowing from their injuries and sickness, such as lost wages and future medical bills. The exonerated prisoners were allowed to receive their compensation either in a lump sum and/or in periodic payments.

IRS's analysis. IRS stated that compensatory damages for physical injuries and physical sickness that the individual receives from the state for wrongful conviction and incarceration, including damages received for economic losses flowing from the physical injury or physical sickness, are excluded from gross income under Code Sec. 102(a)(2). These compensatory damages are excludable regardless of whether the individual receives them in a lump sum or in periodic payments. But, IRS noted that if an individual receives title to, constructive receipt of, or economic benefit of the corpus or assets used to fund future periodic payments, then some portion of the future periodic payments may not be excludable. Also, IRS emphasized that punitive damages and interest don't qualify for exclusion and are included in gross income.

Conclusion. IRS concluded that, consistent with its analysis, the individual was entitled to exclude from gross income compensation received from the state for wrongful conviction and incarceration.

References: For exclusion of income for damages received for personal physical injury, see FTC 2d/FIN ¶J-5801; United States Tax Reporter ¶1044.02; TaxDesk ¶182,001; TG ¶13201.

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