Should False Imprisonment Damages Be Taxable - July/August 2009

Claims for false imprisonment may be brought in various ways under federal or state law. An individual who has been wrongfully incarcerated may sue under 42 U.S.C. § 1983 for a violation of his or her constitutional rights. The individual may also sue under state tort law, making claims for the traditional torts of false imprisonment, malicious prosecution, or abuse of process. Furthermore, many states now expressly provide a statutory scheme for addressing false imprisonment claims. At the root of all these causes of action is a fairly common fact pattern: a plaintiff is arrested or convicted, spends time behind bars, is later exonerated, and then seeks redress for these injuries. Prosecutorial misconduct may or may not be involved. Although there may well be nuances between the differing legal bases upon which such a claim may be brought, I have argued that the commonality of this fact pattern should mean that such recoveries should be excludable from income under Section 104 of the Code.1 I will not re-state all of those arguments here, but will endeavor to summarize them briefly. Section 104 Authorities The Internal Revenue Code has excluded personal injury damages from income for 80 years. For most of this time, damages for any personal injury (or for sickness) could be excluded from income, whether or not the injury or sickness was physical. In 1996, the statute was narrowed, with the new requirement that the personal injuries or sickness must be “physical” to give rise to an exclusion. Since 1996, Section 104 has excluded from gross income damages paid on account of physical injuries or physical sickness. The Internal Revenue Service (IRS or the “Service”) has interpreted this rule as requiring observable bodily harm in order for an exclusion to be available.2 In appropriate cases, however, the IRS is willing to presume the existence of observable bodily harm. Thus, in Chief Counsel Advice Memorandum 200809001,3 the IRS considered the tax treatment of a settlement for sex abuse. The abuse had occurred while the plaintiff was a minor, and the settlement was paid by the institution many years later, by which time the abuse victim had reached the age of majority. Not surprisingly, by that time there were no physical signs of any abuse, injury or sickness. Nevertheless, the IRS ruled that the entire settlement was excludable under Section 104. Although the taxpayer had failed to demonstrate any signs of physical injury, the IRS found it reasonable to presume there had (at some point) been observable signs of physical injuries in such case.4 It is unclear how important it was to the reasoning of the ruling that the victim was a minor at the time of the abuse and had reached the age of majority when he received a settlement. Arguably, it should be irrelevant, as the situation could be just as compelling without the age factor. Yet one senses that the Service was trying to eke out a narrow exception from its “we must see it” mantra. Significantly, the Service failed to back off on the notion that Section 104 requires an outward sign of injuries. Nevertheless, it still gave the taxpayer relief on an unquestionably sympathetic fact pattern. In essence, the IRS ruled that at least under some circumstances, while it would not dispense with its view that one must be able to observe the bodily harm, one could occasionally presume the injuries. That is clever. It may appear to be a tiny step, but it is also a significant step.