To help reduce the tax burden of those who bravely serve our country, the Internal Revenue Code provides that a pension, annuity, or similar allowance for personal injury or sickness resulting from active service in the armed forces is generally excluded from taxable income. In 1991, a U.S. District Court ruled that disability severance pay received from the armed forces qualifies for the exclusion. However, the Code further states that the exclusion is only applicable if the amount paid is by reason of a combat-related injury or, if upon application, the veteran taxpayer would be entitled to receive disability compensation from the Veterans’ Administration (“VA”). This restriction has caused a practical problem in claiming exclusion for armed service disability benefits that are not combat-related, which has caused the IRS to mistakenly claim, in certain cases, that the payment of such benefits is included in taxable income.
In IRS Letter 2001-0011, IRS Assistant Chief Counsel Mary Oppenheimer identified this specific issue, and offered certain clarifications on the issue. Oppenheimer identifies that the applicable Department of Defense (DoD) Financial Management Regulation states that disability severance pay is not taxable or subject to withholding if:
- it resulted from a combat-related injury; or
- the member has official notification from the VA approving entitlement to disability compensation.
Oppenheimer notes that when the DoD grants a disability severance benefit, the DoD knows whether such disability arises from a combat-related injury, and thus can know in these instances if the benefit should be taxable and subject to withholding. However, for non-combat related injuries, the DoD cannot know at the time of the severance payment whether the VA will award disability compensation. Therefore, in those cases, “the tax treatment of a lump-sum disability payment is established after the payment is made.” Due to its inability to determine the taxability at the time of payment, the Defense Finance and Accounting Service (DFAS), which processes the payment, has taken the position that it will report as fully taxable all payments for non-combat related injuries for which VA benefits have not been awarded. DFAS reports disability severance pay to the IRS on Form 1099-R, and when reporting such payments as fully taxable, makes proper withholding from the payment.
Thus, DFAS places the responsibility on the veteran taxpayer to demonstrate that the payments should be excluded from taxable income. For individuals with a non-combat related injury, this determination may only be made after the payment of DoD disability severance, when a veteran taxpayer subsequently is approved or denied VA disability benefits. When the veteran taxpayer is approved for VA disability benefits, he or she should properly report the benefits on the tax return as excluded from income.
However, excluding the benefits from income can cause a problem for the veteran taxpayer. As discussed above, DFAS has reported the benefits to the IRS as fully taxable, because at the time of payment DFAS could not know whether the VA would award disability compensation. After identifying the discrepancy between the income reported to the IRS by DFAS, and the income reported by the veteran taxpayer on his or her tax return, the IRS will issue a notice of deficiency against the taxpayer. The taxpayer must then go through the arduous process of demonstrating to the IRS that the benefits were properly excluded from income.
To help avoid this issue, an individual who has received disability benefits from the armed forces for injuries that are not combat-related should consult his or her tax professional. While the issue can be resolved after receiving a notice of deficiency, the taxpayer can save substantial time and cost by making proper disclosure to the IRS when first reporting the benefits as excluded from income.