Active duty members of the U.S. armed forces have special tax considerations for both state and federal purposes. As a military spouse, the author has experienced three combat tours, military moves, and orders stationing her and her husband outside of their resident state.
This item is intended to address some issues regarding the treatment of both taxable and nontaxable income, taxability of housing options, and filing considerations. It also touches on the impact of the Servicemembers Civil Relief Act (SCRA) on military families' tax situations.
What Is Included in Gross Income?
For federal tax purposes, the U.S. armed forces includes personnel from both the reserve and regular units serving under the secretaries of Defense, Army, Navy, and Air Force, or in the Coast Guard (Sec. 7701(a)(15)). Members of the U.S. armed forces receive different types of income, reimbursements, and allowances. Each type must be carefully evaluated for inclusion or exclusion from the service member's gross income. Common types of income included in gross income include:
- Active duty pay;
- Special pay for foreign duty (outside the United States and District of Columbia, but not in a combat zone);
- Hardship duty pay;
- Enlistment/Reenlistment bonus pay; and
- Hazardous duty pay.
Certain types of pay that are excluded from gross income include:
- Combat zone pay;
- Disability compensation;
- Servicemembers Group Life Insurance received for injury or death (SGLI);
- Family separation pay;
- Basic Allowance for Housing (BAH);
- Moving allowances;
- Per-diem travel allowances; and
- Medical, dental, and legal care.
Specific guidelines define what constitutes a combat zone. Generally, combat pay can be excluded from income for tax purposes if the service member serves in an area that the president of the United States designates as such by an executive order (Sec. 112(c)(3)).
While combat pay is generally nontaxable, it is included in income for purposes of calculating the limits on contributions and deductions for an individual retirement account (IRA). In addition, a service member can elect to include combat pay in earned income when calculating the earned income tax credit.
It might not be clear to the service member what portion of his or her annual income is allocated to each income item. To determine if each portion of the service member's pay is reported properly and to his or her advantage, the service member should request from the military a Leave and Earnings Statement (LES) for the entire year. This document can be obtained from the Defense Finance and Accounting Service's website at mypay.dfas.mil/mypay.aspx.
Understanding Duty Station Moves
It is common for service members to be stationed away from their resident state and to make frequent official relocations under Permanent Change of Station (PCS) orders. Special rules apply with military moves, including allowances, sales of homes, and deductible expenses.
Service members may receive the BAH while stationed at their duty stations. The BAH is not included in gross income or on a Form W-2, Wage and Tax Statement, and the service member can still deduct mortgage interest and real estate taxes on his or her home, even if he or she pays the expenses with the BAH (Sec. 265(a)(6)(A)).
When service members receive PCS orders, they are either provided assistance to move their goods and families or reimbursed for the expenses. When considering the deductibility of these expenses, one should consider whether the service member has already been reimbursed.
If a service member is required to move due to PCS orders, he or she may have opportunities to avoid tax on the gain on the sale of a home. When a move is due to PCS orders, there are exceptions to the ownership and use tests during the five-year period prior to the home sale. If making a move due to PCS orders, a service member may choose to have the five-year test suspended for the time served on official extended duty. For example, if a service member moves over 50 miles from his or her home due to PCS orders and then sells the home at a gain a number of years later, he or she can suspend the time spent away from the home to meet the use and time tests. This period of suspension cannot last longer than 10 years and can be on only one property at a time (Sec. 121(d)(9)).
The IRS and state filing agencies have provided special benefits and regulations for service members' unique situations. For tax purposes and for tax planning, it is important to consider how a service member's and his or her spouse's residency impacts their tax liability, as well as where their income is earned. The SCRA covers this and other tax protections for military families. The SCRA provides certain protections for service members and their families. Its purpose is to keep service members' energy and focus on national defense as opposed to personal burdens. This act is not limited to taxes, but many of its provisions relate to taxes. Below are a few common examples.
A service member's residency is not based on where he or she is permanently stationed. Residency is based on the state the service member claims as a "home," typically the state in which he or she enlisted. Confirmation of a resident state can be found on the military member's LES.
Military spouses have the option to file either in his or her resident state or state of duty station. This choice becomes significant for community property valuation. Service members' spouses will not pay tax on any income earned while living in a nonresident state and, instead, will pay taxes to their resident state if they meet two requirements. The spouse of a service member must (1) be living in the nonresident state for the sole purpose of being with the service member, and (2) the service member must be stationed in the state subject to PCS orders (50 U.S.C. §571(c)). A practitioner should research the tax benefits offered by each state for which the client is filing, since benefits for active duty personnel are common, yet vary by state.
Service members have exceptions for when tax payments are due, as well as penalties and interest. If a service member's ability to pay an income tax liability is materially affected by his or her military service, tax is deferred up to 180 days after termination of service, without any accrual of interest or penalties for that period (50 U.S.C. §§570(a)-(b)).
For most tax situations, each spouse must sign the tax return or grant a power of attorney to someone to sign the return. There are exceptions for service members. However, merely being overseas does not grant a service member an exception to this rule. A deployed spouse will need to sign the return early or fill out a Form 2848, Power of Attorney and Declaration of Representative. However, if a service member is deployed to a combat zone, a power of attorney is not needed to sign the return on the deployed spouse's behalf. The other spouse must attach to the return a signed statement explaining the combat zone status. If a service member deployed to a combat zone is deemed missing in action, a joint return can be filed under the same rules for up to two years after the termination of the combat zone designation of the deployment location. The joint return will be considered valid even if it is later determined that the missing spouse died before the year covered by the return.
If a service member is unable to sign a return due to disease or injury but is able to give verbal authorization for the return, then the spouse can sign for the service member. IRS Publication 17, Your Federal Income Tax, recommends the spouse sign the service member's name and put next to it: "By (your name), Husband (or Wife)." The spouse should also attach a signed, dated statement with the return that explains why the service member could not sign the return and that he or she agreed to have the spouse sign the return.
Preparing active duty service member tax returns requires advance consideration of specific tax issues. It is common for service members to be in any or more than one of these tax situations at a given time. Understanding these tax situations allows practitioners to better serve military clients and create better tax planning opportunities. Practitioners can read the full IRS Publication 3, Armed Forces' Tax Guide, and the SCRA for more information.
Michael Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.