The IRS has released information regarding how taxpayers who received payments for wrongful incarceration that Congress retroactively made not subject to income tax as part of the Protecting Americans from Tax Hikes Act of 2015. The IRS issued both a news release (IR-2016-88) and a set of frequently asked questions regarding new IRC §139F.

The new provision provides for an exclusion from income for “any civil damages, restitution, or other monetary award” related to incarceration of an individual for a “covered offense” for which the taxpayer was convicted.

A covered offense is “any criminal offense under Federal or State law” which represents a broad definition. Wrongful conviction under IRC §139F(b) is defined as:

Who was convicted of a covered offense,
Who served all or part of a sentence of imprisonment relating to that covered offense, and
- Who was pardoned, granted clemency, or granted amnesty for that covered offense because that individual was innocent of that covered offense, or
- For whom the judgment of conviction for that covered offense was reversed or vacated, and
- For whom the indictment, information, or other accusatory instrument for that covered offense was dismissed or who was found not guilty at a new trial after the judgment of conviction for that covered offense was reversed or vacated.

Congress also provided that, regardless of when the taxpayer received this income, a claim for refund may be filed up to one year after the date of enactment (December 18, 2015) even though the statute for claiming a refund on the year would otherwise be closed. [Act Section 304(d)]

The new guidance indicates that a taxpayer will need to file a Form 1040X for each year in which a damage award was received. The deadline for filing the claims for years otherwise not closed to claims for refund is Monday, December 19, 2016.

The IRS has also provided a special address to which the claims are to be mailed:

Internal Revenue Service
333 W. Pershing,
Stop 6503 5th Floor,
Kansas City, MO 64108

The FAQ indicates that the claim for refund should contain the following information:

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 or she previously reported the award in income, then he or she must submit a written statement affirming that the income was reported and that he or she no longer has relevant records. 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.

The FAQ also contains information on records that the taxpayer must maintain who claims this exclusion.

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.

Merely being incarcerated and later having it determined the taxpayer was innocent isn’t enough to earn this exclusion—there must be a conviction. But, as the FAQ explains:

However, section 104(a)(2) excludes from gross income damages received on account of personal physical injuries or physical sickness. Individuals who received a damage award generally may exclude an award from income to the extent the award was received on account of a personal physical injury or physical sickness. See IRS Publication 4345, Settlements — Taxability, for more information.

The FAQ also notes that only the wrongly incarcerated individual’s damages qualify:

The Wrongful Incarceration Exclusion does not apply to damage awards an individual receives for derivative claims such as loss of consortium or loss of companionship of the wrongfully incarcerated individual.

The IRS also warns that processing of the claim may take up to 16 weeks. The IRS also notes that in the future no reporting of such awards will be required under the law.