Following up on last month’s post, Why Do We Tax Recoveries by Prisoners Freed From Wrongful Imprisonment? (Oct. 28, 2010): Forbes, Wrongful Imprisonment Tax Ruling Stirs Controversy, by Robert W. Wood (Wood & Porter, San Francisco):

[P]eople have been gleefully emailing me … Chief Counsel Advice 201045023.  Everyone seems to be reading it by the headline the tax press is (inappropriately) giving it, proclaiming “wrongful conviction recoveries are now tax free!” 

Since I’ve long argued for this view, I hate to be a killjoy.  Unfortunately, that’s not what it says—not by a long shot.  In fact, this IRS ruling says only that a victim of wrongful imprisonment who “suffered physical injuries and physical sickness while incarcerated” can exclude his recovery from taxes and can structure it just like other physical injury victims.  We already knew that. …

The IRS issued a series of rulings in the 1950s and 1960s, involving prisoners of war, civilian internees and holocaust survivors.  Sensibly, the IRS ruled their compensation was tax free irrespective of whether they suffered physical injuries.  Then the IRS “obsoleted” these rulings in 2007, suggesting the landscape has changed. 

The IRS has still not addressed whether being unlawfully locked up is itself tax free.  This is a worry, since the Tax Court (affirmed by the Sixth Circuit) dangerously held in Stadnyk that persons who step forward saying they didn’t experience physical injuries or physical sickness will have a taxable recovery.  Stadnyk was a very short term incarceration case, but it may portend continuing adherence to the IRS canard that “there must also be physical injury.”

It is wrong as a matter of tax policy and as a matter of social justice to tax these recoveries.  It is also wrong to leave this area of the tax law to develop piecemeal so some people are paying tax.  The continuing myopic focus on the accompanying injuries or sickness will foment tax disputes about these issues.