Following up on last week's post, Taxation of Damages for Wrongful Imprisonment: Jim Maule (Villanova), Who Should Change the Tax Law?:

As to the policy issue, namely should false imprisonment damages be subject to income taxation, there are good arguments on both sides. In some ways, those arguments reflect the ones advanced on both sides of the debate about the exclusion generally of damages for personal physical injuries and sickness. My focus today is not on those arguments but on the issue of who makes the decision.

Section 104(a)(2) of the Internal Revenue Code makes it clear that the exclusion of damages from gross income applies only to damages received on account of personal physical injuries and sickness. … Surely it is the language of section 104(a)(2) that constrained the Tax Court, in a case affirmed by the Sixth Circuit, from extending the exclusion to damages received for false arrest. The court opined that “[p]hysical restraint and physical detention are not ‘physical injuries’ . . . Nor is the deprivation of personal freedom a physical injury.” Robert Wood has provided a very good analysis of this case in Why the Stadnyk Case on False Imprisonment Is a Lemon, an article worth reading by anyone with a serious interest in the issue. In 2010, the IRS issued CCA 201045023, in which the IRS advised that a falsely imprisoned person who suffered physical injuries and sickness while incarcerated can exclude from gross income the damages for those injuries and sickness. Though many people tried to interpret the CCA as justifying exclusion of all damages for false imprisonment, the CCA does not go that far, as carefully explained, again by Robert Wood, in Wrongful Imprisonment Tax Ruling Stirs Controversy.

In Tax-Free Wrongful Imprisonment Recoveries, Robert Wood argues that the IRS takes too narrow a view of what “physical injuries and sickness” means and suggests that the IRS could issue administrative guidance excluding all false imprisonment damages from gross income, and in Why the Stadnyk Case on False Imprisonment Is a Lemon, he provides observations on why the IRS may be reluctant to do so but urges that the IRS or Treasury issue guidance specifying which false imprisonment damages are excludable. Similarly, in Tax On Wrongful Imprisonment Needs Reform, Wood argues that “It’s time for the IRS or Congress to fix this.” Wood is not alone in thinking that the IRS can resolve the problem by adopting definitions of “physical” that reach beyond what the word means. See Expanding Section 104(a)(2)'s Tax Exclusion. On the other hand, in Did the Sixth Circuit Get It Right in Stadnyk?: What to Do About the § 104(a)(2) Personal Injury Damages Exclusion, the author calls on the Congress to fix section 104(a)(2) to settle the question and provide certainty to plaintiffs. In fact, bills have been introduced in Congress to make false imprisonment damages excluded from gross income. On December 6, 2007, the Wrongful Convictions Tax Relief Act of 2007 was introduced, and on March 3, 2010, the Wrongful Convictions Tax Relief Act of 2010 was introduced. Neither bill was passed by the Congress.

There is no question that section 104(a)(2) has flaws and needs to be revised. There is no question that the Congress needs to determine the scope of section 104(a)(2) and whether or not it applies to damages for false imprisonment and similar situations where physical injury or sickness is absent. Congress could, if it chose, to provide a definition of the word “physical” that extends beyond physical, but the better approach would be to provide more explicit parameters for the scope of the exclusion, assuming that the exclusion is maintained. To expect the IRS or the courts to step in and apply section 104(a)(2) as though it had been drafted in some other manner, even if it should be or have been drafted in a more helpful way, is to extend to the executive or judicial branch the responsibility for doing the work of the legislative branch. Congress needs to put aside the politics and get to work, on this and a long list of other matters that need its attention.