The IRS last week (November 12) issued a Chief Counsel Advice memorandum (CCA)* that says compensatory damages paid to people wrongly convicted of crimes may not be taxable – but only in very limited circumstances. According to the CCA, the payment must be for injuries, sickness or economic losses from “physical injuries or physical sickness” of people wrongly convicted and incarcerated.
Put another way, wrongful-imprisonment restitution is taxable unless the person can prove that they suffered physical injuries or illness while imprisoned. Someone who “just” receives a restitution payment as a form of state apology or make-good for being wrongfully imprisoned would have to pay taxes on the restitution. While this seems contrary to good law (and common sense), that is the way things currently are.
And I should also point out that the term “physical injury or illness” does NOT include psychological trauma unless the taxpayer can prove that the psychological trauma stems from a physical injury or illness. So someone who goes into depression for being wrongfully imprisoned and receives restitution would have to pay taxes on that restitution.
The same “logic” applies to court settlements – settlements for physical injuries are not taxable, but settlements for psychological trauma can be taxable, unless it can be proven that the psychological trauma was caused by physical injuries. So someone who receives psychological damages in a discrimination lawsuit will probably have to pay taxes on the settlement. But that’s another blog post for another day. (Note from Jason: this last paragraph is a vast simplification of the tax treatment of court settlements; like I said, another blog post for another day!)
*-Like “Private Letter Rulings,” CCA’s are not precedent-setting and apply only to the taxpayer who requested the ruling, but they do give us some insight into how the IRS views certain issues.