A Case of Wrongful Imprisonment

“Wrongful imprisonment” can result when a person is erroneously convicted of a crime from which, through subsequent investigation or the discovery of exculpatory information, they are later found innocent.

The wrongfully convicted and newly released from prison face entirely new sets of problems which include: unemployability , no money, no housing, no transportation, no health services or insurance, pretty much none of the basics essential to modern life “on the outside.”

This, of course, begs the question: how should a wrongfully imprisoned person be compensated? The federal government, the District of Columbia, and 32 states have compensation statutes of some form on their books.

(1) In New York State, the Court of Claims determines what amount will fairly and reasonably compensate the wrongfully convicted person.

(2) In many cases, the amount and method of payment can be negotiated.

As with any exchange of money, questions arise as to how these statutory or compensatory damages will be taxed. Few people have advocated that these recoveries should be taxed, but until recently there had been no clear guidance or exemption affirmed. The discussion centered on Section 104 of the Internal Revenue Code which excludes recoveries on account of personal physical injuries, physical sickness, and emotional distress arising from either. If a payment is for emotional distress not arising out of the physical injuries or physical sickness, income tax is ordinarily applicable.

In the case of Stadnykv. Commissioner(3), the Tax Court and the Sixth Circuit ruled that physical restraint and physical detention are not “physical injuries” for purposes of §104(a)(2). In this matter, Mrs. Stadnyk was held at a local sheriff’s office for approximately eight hours. She suffered no observable bodily harm and admitted that she was never injured or roughed up. The Tax Court concluded that the deprivation of personal freedom is not a physical injury for purposes of §104(a)(2) and her recovery of $50,000 was therefore taxable.

That is until 2015 when Congress added a new exclusion from gross income under section 139F of the Internal Revenue Code.

Now that it is settled that an exoneree can receive their recovery free from income tax, the question remains: can they structure their settlement in the same way that we structure ordinary settlements for victims of personal physical injury? Well, technically, there are some wrinkles.

Most of you remember that modern structures involve two steps: the creation of a promise from the defendant to plaintiff of periodic payments and then the transfer of that promise to a third party so that defendant retains no liability for future payment and may take an immediate and full deduction of the expense. The plaintiff looks to the assignee for all future payments (typically funded by annuity contract making payments directly to the plaintiff).

The “catch” here is that such assignments are typically governed by Section 130 of the tax code which requires qualification under Section 104 which then re-introduces the requirement that the injury by “physical” to be excluded from income.

The good news is that we have several “workarounds” which enable us to structure a wrongful imprisonment case, in line with the intent of new Section 139F:

• If a claim is made for physical injuries or illness in the complaint and can be substantiated, some or all of the recovery can be allocated and structured under normal §104(a)(2)/§130 arrangement.

• If not, then a so-called “non-qualified” structured settlement annuity and assignment may be used. This method provides the same guaranteed and reliable payments at a competitive rate of return on a tax-free basis to the claimant, so long as there is no constructive receipt or economic benefit to the exonerated person.

• The defendant can elect to skip the assignment and retain ownership of the funding instrument (annuity) provided the issuing life insurers are willing to issue a policy for use in Section 139F cases. The law is new and therefore under review.

Clearly, the issues surrounding the resolution of wrongful imprisonment cases are extensive and complex.