FAQs explain the wrongful incarceration exclusion

Wrongfully incarcerated individuals are now permitted to exclude from income “any civil damages, restitution, or other monetary award” that they receive as compensation for their wrongful incarceration, thanks to new Sec. 139F, which was added to the Internal Revenue Code last December. In its first guidance under the new law, the IRS issued frequently asked questions (FAQs) on Thursday to explain how taxpayers can qualify for and claim refunds based on the new provision (Wrongful Incarceration FAQs). The IRS is also allowing eligible individuals to file amended returns for closed years, as long as they file their claim for refund by Dec. 19, 2016.

The FAQs explain that the exclusion is available for civil damages, restitution, and compensatory and statutory damages relating to wrongful incarceration for any criminal offense under federal or state law.

A wrongfully incarcerated individual is defined as someone who was convicted of a covered offense, served all or part of a sentence of imprisonment for the covered offense, and meets any one of these requirements:

1. The individual was pardoned, granted clemency, or granted amnesty because the individual was innocent;
2. The judgment of conviction was reversed or vacated and the indictment, information, or other accusatory instrument was dismissed; or
3. The judgment of conviction for the individual was reversed or vacated and the individual was found not guilty at a new trial.

A covered offense is any criminal offense under federal or state law, including any criminal offense arising from the same course of conduct.

The exclusion from income covers awards received in the past, currently, or in the future. For a current year or future year, the individual is not required to report the award on his or her Form 1040, U.S. Individual Income Tax Return, but must maintain records to substantiate the amounts excluded.

For earlier years for which the individual had included these amounts in income, the individual can claim a refund by filing Form 1040X, Amended U.S. Individual Income Tax Return, and writing across the top of the form “Incarceration Exclusion PATH Act.” The FAQ provides a special mailing address for these refund claim forms.

Refund claims must be filed by the normal deadline of the later of three years after the return was filed or two years after the tax was paid, but a special rule waives the limitation period for claims filed by Dec. 19, 2016.

The Form 1040X must include two types of documentation. First, it must document the amount that was included in income in earlier years, but if the taxpayer doesn’t have this proof, he or she can submit a written statement affirming that he or she no longer has those records. Second, it must show proof that the award was made on account of the wrongful incarceration.

The IRS also explained that individuals whose claims for refunds of tax on these amounts were previously denied can apply again for a refund under these provisions.

The IRS notes in the FAQs that individuals who were wrongfully incarcerated, but not convicted of a crime, are not eligible to exclude any resulting damage award under Sec. 139F, although they may be eligible to exclude portions of the damages under Sec. 104(a)(2). The IRS also notes that the Sec. 139F exclusion does not apply to damage awards received by other individuals, such as spouses, children, or parents of the wrongfully incarcerated individuals.

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.