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Disabled Coast Guard Veteran Can't Exclude Retirement Payments from Income.
(Parker Tax Publishing January 8, 2015)

A disabled Coast Guard veteran was unable to exclude, under Code Sec. 104(a)(4), retirement payments stemming from his disability as he was unable to prove he was qualified for disability compensation from the Veterans Administration. Campbell v. Comm'r, T.C. Summary 2014-109.

Background

In 1990, the U.S. Coast Guard granted Kevin Campbell temporary disability retirement after concluding he was unfit for duty due to a diagnosis of insulin dependent diabetes mellitus. The Coast Guard evaluated Campbell and assigned him a Department of Veterans Affairs standard schedule of rating disabilities (VASRD) rating of 40 percent, which entitled him to monthly retirement pay equal to his base pay multiplied by his disability rating. The Coast Guard also informed him that Federal income tax would be withheld from his monthly retirement payments. In 1995, the Coast Guard notified Campbell that his condition now qualified as a permanent physical disability and he would be permanently retired from the Coast Guard. The Coast Guard assigned him a new VASRD rating of 60 percent, and again informed him that Federal income tax would be withheld.

From 1992 to 1995, Campbell made several unsuccessful attempts to convince the Coast Guard that his retirement pay was exempt from federal tax. However, the Coast Guard continued to issue to Campbell Forms 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting that he had received taxable retirement pay. Campbell provided the Forms 1099-R to his accountant, who concluded that the retirement payments were not includable in income, and proceeded to exclude the payments on Campbell's tax returns.

Every few years, the IRS issued to Campbell a Notice CP-2000 proposing to increase his taxable income by the amount of his Coast Guard retirement pay. Mr. Campbell forwarded the notices to his accountant, who would promptly contact the IRS and assert that the retirement pay was exempt from tax. After these exchanges, Campbell normally received a "No Change" letter from the IRS accepting his tax return as filed.

In 2011, Campbell received Coast Guard retirement pay of $9,210. He timely filed a joint federal income tax return for 2011 on which he excluded the retirement pay. The IRS issued a notice of deficiency determining that Campbell's retirement pay was required to be included in gross income.

Analysis

Code Sec. 104(a)(4) provides that amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country are not included in gross income. However, Code Secs. 104(b)(1) and (2) limit the exclusion to an individual who would be entitled to receive disability compensation from the Veterans Administration (VA).

The Tax Court concluded that Campbell failed to prove his eligibility for the exclusion under Code Sec. 104(a), as the VA's disability benefits process was different from the Coast Guard's process and Campbell did not have enough information to prove he otherwise would have qualified for the exclusion under Code Sec. 104(b). The court reasoned that while the Coast Guard and the VA use the same VASRD rating system, the Coast Guard applies the VASRD system differently than the VA. In drawing this distinction, the court stated that the Coast Guard evaluates whether a service member is able to perform his or her military duties at a given time, while the VA rates disabilities by weighing the impact of an injury or illness on a veteran's earning capacity in a civil occupation over his or her lifetime.

Practice Tip: Even when a veteran receives a VA disability compensation award, reaping the initial tax benefits can be tricky. When the VA grants disability compensation, it normally backdates the award. This can have the effect of retroactively converting prior retirement payments from taxable income to nontaxable income. Because the retroactive effects can reach into previous years, a taxpayer receiving a VA disability compensation award is often in the position of having to file an amended return to garner the full tax benefit. See ¶15,385 for detailed guidance on preparing and amending tax returns involving VA disability awards.

Since Campbell was unable to provide documents or information related to a disability rating based on an earlier examination by the VA, the Tax Court concluded it was unable to determine whether Campbell otherwise would be entitled to VA disability benefits within the meaning of Code Sec. 104(b) and therefore Campbell could not exclude his Coast Guard disability retirement pay.

For a discussion of disability benefits resulting from military service, see Parker Tax ¶ 15,385. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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