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Firefighter Is Taxable on Disability Retirement Converted to a Service Retirement

(Parker Tax Publishing July 2017)

The Tax Court held that disability retirement payments, which the taxpayer excluded from income as amounts received under a statute similar to workmen's compensation, should have been included in the taxpayer's income because they were paid from a state retirement pension and the payments were determined by reference to the taxpayer's age and length of service. Similarly, when such payments were converted to a service retirement allowance, they were also taxable. Taylor v. Comm'r, T.C. Memo. 2017-132.

Background

Jack Taylor was a North Carolina fireman for over 24 years before retiring on disability in 1991. At that time, he began receiving from the Local Governmental Employees' Retirement System of North Carolina (LGERS) a disability retirement allowance computed with reference to his age, length of service, and average final compensation. Subsequently, Taylor also began receiving a pension from the North Carolina Firemen and Rescue Squad Workers' Pension Fund (FRSWPF). When he turned 60 in August 2004, LGERS sent Taylor a letter notifying him that he was being transferred from disability retirement to regular service retirement, effective September 1, 2004.

For 2012, Taylor was paid approximately $35,000 in retirement benefits by LGERS and $2,000 in retirement benefits by FRSWPF. Taylor received information returns from LGERS and FRSWPF showing taxable distributions of those amounts but reported only $2,324 of taxable retirement income. The IRS issued a notice of deficiency and assessed additional income tax to reflect the amount of tax due after including Taylor's total retirement pay in taxable income.

Taylor argued that his retirement income from LGERS was nontaxable. He petitioned the Tax Court, contesting the inclusion of the LGERS payments in income. However, Taylor did not assert a dispute regarding the FRSWPF payment's taxability and so those payments were not at issue before the Tax Court.

Taxability of Retirement Income

Under Code Sec. 104(a)(1), gross income does not include amounts received under workmen's compensation acts as compensation for personal injuries or sickness. Reg. Sec. 1.104-1(b) provides that this exclusion also applies to statutes in the nature of workmen's compensation acts which provide compensation to employees for personal injuries or sickness incurred in the course of employment. The exclusion, however, does not apply to a retirement pension or annuity to the extent that it is determined by reference to the employee's age or length of service, or the employee's prior contributions, even though the employee's retirement is occasioned by an occupational injury or sickness.

LGERS Plan

LGERS is a defined benefit plan established under North Carolina law and funded by employer and employee contributions. Under the plan, an employee with at least five years of service may retire on a disability retirement allowance upon medical certification of incapacity for the further

performance of his duties. A beneficiary's payments are reduced if he is determined to be engaged in or be able to engage in a gainful occupation paying more than a certain amount. In lieu of this reduction, the beneficiary irrevocably may elect to convert his disability retirement allowance to a service retirement allowance calculated on the basis of his average final compensation and creditable service at the time of disability retirement and his age at the time of conversion to service retirement.

An employee retiring on disability after July 1, 1982, receives a service retirement allowance if he has qualified for an unreduced service retirement allowance. Otherwise, the allowance equals "a service retirement allowance calculated on the member's average final compensation prior to his disability retirement and the creditable service he would have had had he continued in service until the earliest date on which he would have qualified for an unreduced service retirement allowance." The service retirement allowance for an employee that is not a law enforcement officer retiring from service on or after July 1, 1990, but before July 1, 1992, equals 1.64 percent of the employee's average final compensation multiplied by the number of years of creditable service, provided that the service retirement date occurs (1) on or after his 65th birthday upon completing five years of service, (2) after completing 30 years of service, or (3) on or after his 60th birthday upon completing 25 years of service. The retirement allowance is reduced if the employee did not satisfy the minimum service requirements.

A former employee receiving a disability retirement allowance, upon reaching the earliest date on which he would have qualified for an unreduced service retirement allowance, is no longer subject to further medical reexaminations or a reduction in benefits by engaging in gainful employment with an employer not participating in LGERS. Furthermore, the former employee ceases to receive a disability retirement allowance and instead is considered a beneficiary in receipt of a service retirement allowance.

Taxpayer's Position

To support his contention that his LGERS retirement income was excludible from gross income, Taylor argued that the payments were neither a "retirement pension" nor an "annuity" as referenced in Reg. Sec. 1.104-1(b). Taylor pointed out that North Carolina law defines both "annuity" and "pension" as "payments for life." He likened his situation to that of the taxpayer in Picard v. Comm'r, 165 F.3d 744 (9th Cir. 1999), rev'g T.C. Memo. 1997-320, where the Ninth Circuit held in the taxpayer's favor on the excludability of disability retirement income. Taylor argued that, as was the case with the taxpayer in Picard, if he were determined to be fit for work, his disability retirement payments would cease. Because he was subject to medical re-examinations and his disability retirement allowance could be reduced if he were determined to be able to earn over a certain amount, Taylor maintained that his payments were not for life and so were not "a retirement pension or annuity" for purposes of Reg. Sec. 1.104-1(b).

Moreover, Taylor submitted that while North Carolina law allows disability beneficiaries to "convert" a disability retirement allowance to a reduced service retirement allowance if they are determined to be engaged in or able to engage in a gainful occupation paying more than a certain amount, another provision which also treats disability retirement beneficiaries as service retirement beneficiaries when they reach the earliest date on which they would have qualified for an unreduced service retirement allowance, uses a different word: "considered." To Taylor, this meant that beneficiaries are not transferred from one retirement system to another and, under Tax Court precedent, there is a requirement that there be a clear, unambiguous formal transfer of a taxpayer from one system to another.

IRS's Position

While the IRS admitted that Taylor was not eligible for an unreduced service retirement allowance under LGERS as of the date of his retirement (i.e., because he was only 46 years old with 24 years and 8 months of creditable service), it argued that, since Taylor's disability retirement allowance was calculated with reference to his age and length of service, it was includible in his gross income. According to the IRS, regardless of the initial classification of

Taylor's retirement income, Taylor was no longer receiving a disability retirement allowance. The IRS pointed out that, under North Carolina law, once a beneficiary in receipt of a disability retirement allowance becomes eligible for an unreduced service retirement allowance, he is deemed to be in receipt of the latter. This occurred, the IRS said, when Taylor turned 60 years old in 2004, eight years before the tax year in issue. The IRS cited several Tax Court cases in which disability payments initially were excludable but later became includible in gross income when the taxpayer would have qualified for a service retirement pension had he continued to work. As in those cases, the IRS said, Taylor's retirement payments are includible in his gross income as nondisability pension income.

The IRS also argued that the situation in Picard differed from Taylor's case in two respects:

first, Taylor's disability benefit and service retirement allowance both are computed with regard to his age and length of service and not his employment anniversary, and second, Taylor's disability retirement allowance converted to a service retirement allowance when he turned 60 years of age in 2004.

Tax Court's Decision

The Tax Court held that LGERS is a governmental plan within the meaning of Code Sec. 414(d). Accordingly, payments from LGERS are payments from a "retirement pension or annuity" as those words are used in Reg. Sec. 1.104-1(b) and Taylor's disability retirement allowance under LGERS was a retirement pension determined by reference to his age and length of service. As a result, the court said it did not need to address the extent to which Taylor was transferred from a disability retirement allowance to a service retirement allowance. Neither allowance was excludible from income as amounts received under a workmen's compensation act or a statute in the nature of such.

For a discussion of the exclusion from gross income of amounts received under workmen's compensation acts as compensation for personal injuries or sickness, see Parker Tax ¶75,905.

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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