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IRS fills in details regarding wrongful incarceration exclusion and refund claims

IRS Website “Wrongful Incarceration FAQs” (June 16, 2016).

In a News Release and in FAQs posted to its webpage, IRS has provided additional details regarding Code Sec. 139F, which exempts from taxation damages and other monetary awards for wrongful incarceration (Wrongful Incarceration Exclusion). The new information includes detailed procedures that taxpayers may use to claim refunds of taxes previously paid with respect to those types of damages, etc.

Background. Code Sec. 139F, which was enacted into law by the Protecting Americans From Tax Hikes Act of 2015 (2015 PATH Act, PL 114-113, 12/18/2015), is titled, “Certain amounts received by wrongfully incarcerated individuals.” Code Sec. 139F(a) provides, “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.” Code Sec. 139F(b) defines the term “wrongfully incarcerated individual,” and Code Sec. 139F(c) defines the term “covered offense.”

Code Sec. 139F applies to tax years beginning before, on, or after Dec. 18, 2015 (i.e., to any tax year). (Sec. 304(c) DivQ, PL 114-113, 12/18/2015) If the credit or refund of any overpayment of tax resulting from the application of Code Sec. 139F to a period before Dec. 18, 2015 is prevented, as of that date, by the operation of any law or rule of law (including res judicata, see below), the credit or refund may nevertheless be allowed or made if a claim is filed by Dec. 19, 2016. (Sec. 304(d) DivQ, PL 114-113, 12/18/2015) Without this special provision, refund claims for tax years 2012 and earlier would be barred in most cases.

The doctrine of res judicata (also known as “claim preclusion”) provides that a prior adjudication of a cause of action is a bar to any further litigation of the same cause of action between the same parties.

IRS provides additional details regarding the exclusion. In the News Release and FAQs posted to its website, IRS has provided the following additional details regarding the exclusion, including procedures that taxpayers may use to claim refunds of taxes previously paid with respect to compensation for wrongful incarceration damages.

Which amounts qualify for the exclusion. In addition to the amounts specified in Code Sec. 139F(a), above, compensatory or statutory damages and restitution that a wrongfully incarcerated individual receives in a criminal matter that relates to his incarceration for the covered offense for which he was convicted also qualify for the Wrongful Incarceration Exclusion. (FAQ 1)

A wrongfully incarcerated individual who was denied a refund or exclusion from income for an award that qualifies for the Wrongful Incarceration Exclusion may apply for a refund. (FAQ 10) And, payments received in settlement of an action for wrongful incarceration are considered “civil damages” under Code Sec. 139F(a). (FAQ 15)

But an individual who was wrongfully incarcerated but released before trial and not convicted of any crime may not exclude an award from income under the Wrongful Incarceration Exclusion. (FAQ 13) And, a spouse, child, parent, or other individual may not exclude from gross income an award he receives for derivative claims such as loss of consortium or loss of companionship of the wrongfully incarcerated individual. (FAQ 14)

Reporting and documentation requirements. There are no reporting requirements for receipt of an award qualifying for the Wrongful Incarceration Exclusion. This means that, for the year an award for wrongful incarceration is received, an award recipient is not required to report receipt of the award on his federal income tax return (Form 1040), or submit documentation to IRS, to claim the Wrongful Incarceration Exclusion. (FAQ 11)

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. (FAQ 12)

Refunds for amounts included in prior year taxable income. A wrongfully incarcerated individual seeking a refund for amounts included in prior year taxable income must file the claim for refund on an amended federal income tax return (Form 1040X) for the tax year the award was reported as income and write “Incarceration Exclusion PATH Act” across the top of the Form 1040X. (FAQ 7)

The Form 1040X must include two different types of documentation. The first type of documentation must establish that the award was previously reported in income, when it was reported, and in what amount. Examples of such documentation include copies of federal income tax returns, Forms 1099-MISC (Miscellaneous Income), and any other retained records relating to the reported income. However, if a wrongfully incarcerated individual no longer has documentation establishing that he previously reported the award in income, he must submit a written statement affirming that the income was reported and that he no longer has relevant records. (FAQ 8)

The second type of documentation must establish that the award was made on account of the wrongful incarceration. 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. (FAQ 8)

The wrongfully incarcerated individual generally must file the claim for refund within three years from the date the individual filed the income tax return that previously reported the award or two years from the date the individual paid the tax on the award, whichever is later. A wrongfully incarcerated individual who cannot meet the 3- or 2-year deadline must file his claim for refund by Monday, Dec. 19, 2016. (FAQ 6)

IRS has established a special filing address for amended returns claiming the wrongful incarceration exclusion. It is: IRS, 333 W. Pershing, Stop 6503 5th Floor, Kansas City, MO 64108. (FAQ 9)

Taxpayers should allow up to 16 weeks for processing. (IR 2016-88)

References: For exclusion of amounts received for wrongful incarceration, see FTC 2d/FIN ¶  J-5850  ; United States Tax Reporter ¶  139F4  ; TaxDesk ¶  188,022  ; TG ¶  13208.1  .

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