Prior to the passage of this new law, in order to be exempt from taxation on wrongful-conviction awards, former prisoners and their lawyers would have to prove that the compensation was awarded due to injury or illness suffered while behind bars. If they couldn’t prove that, compensation was often considered a replacement for wages forgone during a period of incarceration, and like wages, it was taxed. But unlike wages, the provider of the compensation (usually the state) didn’t provide an option for withholding taxes. Instead, they would simply give the newly freed individuals a lump-sum check, and file notice of the payment with the IRS. And that type of payment system can be financially dangerous not only for the exonerated, but for anyone, says Harry Stein, a tax expert and the director of fiscal policy at the Center for American Progress. “The tax bill comes as a surprise. That’s always a problem, and I think the tax law should always try to avoid that,” he said. “I think certainly with wrongful convictions you can have this problem.”
While some might think that lawsuits over years spent behind bars can provide a payday big enough to ward off financial distress, lawsuits, Eldan says, are much trickier than they might seem. The formerly incarcerated can’t simply sue for a wrongful conviction since some in the judicial system, namely prosecutors, are granted significant immunity from such suits. Instead the wrongfully convicted and their lawyers would need to prove that something illegal happened during the course of a police work or investigation, not that law enforcement and the judicial system simply got the wrong person. And even if they do have grounds, such lawsuits can often involve years of legal battles that some exonerees aren't up for.
In cases when compensation was in fact taxable, that could create extreme difficulties for exonerees. If an exonerated individual spent a significant portion of their compensation on things like housing, clothing, and food, and then later faced a tax bill and possibly additional fines for nonpayment, what was he or she to do? To make matters worse, the lack of clarity in this area meant that even if an exonerated person sought out professional advice from a lawyer or accountant about his or her compensation, it was often difficult to get a correct answer since the law is so nebulous and interpretations can vary based on the case, compensation, or geography. The result is few tax experts are well versed in this particular area. (A fact that became apparent as I sought out sources for this story.)
The new tax law, passed at the close of 2015, should hopefully change all that. “This law seems quite clear in saying that if you’re compensated for wrongful conviction, that’s not taxable. It provides really meaningful tax relief to people who are in a terrible situation,” says Stein. He added that the clarity alone is significant, as it means exonerees have one fewer legal nightmares to navigate following their release.