Tax Court rules veteran’s retirement disability income not taxable

Editor: Mark G. Cook, CPA, CGMA

The Tax Court held in a summary opinion (Keeter, T.C. Summ. 2017-36) that the taxpayer’s military disability retirement income was excludable from his gross income. A deciding factor in the ruling was that the taxpayer’s military disability retirement income met the income exclusion rules under Sec. 104, particularly Sec. 104(b)(2)(D), which limits the exclusion to individuals who are entitled to receive disability benefits from the Department of Veterans Affairs (VA).

Background

Kent E. Keeter began service with the U.S. Army in 1984. In basic training, he sustained a head injury that required hospitalization for approximately three months. The head injury caused Keeter to suffer from a seizure disorder. After his partial recovery, the Army placed him on its temporary disability retired list, with a disability rating of 40%.

Subsequently, he was reevaluated and placed on permanent disability. In 1985, Keeter was permanently retired at his then-current grade with an honorable discharge. Around that time, he met with VA representatives. He testified before the Tax Court that it was his understanding from that meeting that he would qualify for disability benefits from the VA, but he did not apply for them. After Keeter’s discharge, he continued his higher education studies that he had begun prior to enlistment. He eventually graduated and from then until the time of trial worked in the computer science field.

During 2012, the taxpayer received disability retirement income from the U.S. Army of nearly $6,000, which he did not report as gross income. The IRS then determined that the benefits were includible in his gross income.The taxpayer had twice previously filed petitions for redetermination with the Tax Court that challenged the IRS’s inclusion of the benefits. The court had entered stipulated decisions in his favor in both cases.

Military disability payments

Pensions and retirement income are includible in gross income and generally taxable unless specifically excluded, as provided by Sec. 61(a)(11) and Regs. Sec. 1.61-11(a). Also, when the taxpayer did not contribute to the cost of the pension, the full amount is included in gross income. The Tax Court has previously determined that military retirement pay falls within the definition of retirement income (see Wheeler, 127 T.C. 200 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008)).

Under Sec. 104(a)(4), gross income does not include amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces. Sec. 104(b)(1) limits this exclusion to certain individuals specified in Sec. 104(b)(2), which includes those who would be entitled to receive disability compensation from the VA if they applied for it. The court noted that the VA and military use the same rating standard to determine disability, although the VA uses it to determine an individual’s ability to engage in civilian employment, while the military uses it to determine what compensation the individual should receive for the interruption to his or her military career.

Analysis

The pivotal point in this case is that the Tax Court accepted the taxpayer’s testimony that he understood from his meeting with VA representatives at the time of his discharge that he was qualified to receive disability benefits from the VA. The court rejected the IRS’s request to apply the VA rating standard in hindsight to determine whether the taxpayer was disabled under the VA’s standard. Instead, the Tax Court based its decision on the information that the taxpayer had at the time he was discharged and therefore held that the taxpayer could exclude his military disability retirement income from gross income.

EditorNotes

Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.