Lesson From The Tax Court: Only One Exclusion For Military Retiree Disability Payments

My dad served as a doctor in the military for 30 years, 23 days. Starting this week, he will have been retired for longer than he served. When he first retired, he received a monthly pension check from the Defense Finance and Accounting Service (DFAS) and that was all.  A few years later he learned that his hearing loss, likely from his time in Vietnam, qualified him for disability payments from the Department of Veterans Affairs (VA).  He applied for, and received, a 30% disability rating.  He then started receiving two checks each month, one from DFAS and one from the VA.

My dad’s DFAS check is included in gross income but his VA check is not, thanks to §104(a)(4).  If he had never applied for the disability rating, however, §104 would still permit him to exclude part of his DFAS check to the extent he would have be entitled to a disability check from the VA.  Confused?  Today’s lesson will help! 

In Tracy Renee Valentine v. Commissioner, T.C. Memo. 2022-42 (Apr. 28, 2022) (Judge Gustafson), the taxpayer was a veteran and received two checks per month, one from DFAS and one from VA for disability compensation.  She wanted to exclude not only the VA disability check, but she also wanted to exclude part of her DFAS check.  But she mis-read §104(a)(4)’s interplay with §104(b).  Judge Gustafson teaches us the proper way to read the rules.  Basically, veterans get only one exclusion for their disability payments.  Details below the fold.

Law: The Exclusion of Service-Related Disability Payments
Section 104(a)(4) permits taxpayers to exclude “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.”  Section 104(b)(1), however, denies the (a)(4) exclusion “in the case of any individual who is not described in paragraph (2).”  Yep, that's a statutory double negative. Paragraph (2) describes four groups of taxpayers.  If a taxpayer is not in one of those groups then the taxpayer does not get the benefit of the §104(a)(4) exclusion.  Gosh, I don’t not mind double negatives.  Do you?

Let’s work through that statutory double negative.  Judge Gustafson explains it nicely: §104(b)(2) “provides no independent basis for exclusion. Instead, consistent with express legislative intent, it limits the classes of persons who otherwise might be eligible for the section 104(a)(4) exclusion.” Op. at 13 (quotes and cites omitted).  I think that’s a very helpful way to think about it.  After all, we always start with the question of whether the military pension payments are income.  That easy.  They are. §61.  We now look for an applicable exclusion and we see that we have to fit the pension payments under §104(a)(4) to exclude them.  That provision excludes pension payments to the extent they are received "for personal injuries...resulting from active service" in the military.  But what Congress gives with one hand, it takes away with another.  And that’s the point of §104(b)(1).  Re-stated as a positive, it says that the (a)(4) exclusion applies only to the persons described in paragraph (b)(2).

So who are those lucky persons described in (b)(2)?  There are four categories.  The first two are those who had a certain relationship with the military on or before September 24, 1975.  That’s in (b)(2)(A) and (b)(2)(B).  That’s an increasingly small group; we can ignore that here.  The second group are those who have suffered a combat-related injury and can link some portion of their military pension to that injury.  That’s in (b)(2)(C).  The fourth group are those who “would be entitled to receive disability compensation” from the VA if they only asked.  That’s in (b)(2)(D).  Notice the conditional language “would be entitled.”

To understand the convoluted language in §104(b) one must understand the convoluted intent of those who wrote this language.  It was introduced as part of the Tax Reform Act of 1976, P.L. 94-455, 90 Stat. 1520, 1567.  The Senate Finance Committee Report, No. 94-938 (sorry I cannot find a free link, not even to C.B. 1976-3 (Part 3)) explains, somewhat apologetically, that it “is concerned with two somewhat conflicting aspects of the exclusion of disability payments from gross income.”  The conflict was between preventing abuse of the exclusion while also recognizing the reliance interests of “present members” of the armed services.  Id. at 138.

So what was the abuse?  Double-dipping.  The Report explains:

“In many cases, armed forces personnel have been classified as disabled for military service shortly before they would have become eligible for retirement principally to obtain the benefits of the special tax exclusion on the disability portion of their retirement pay.  In most of these cases the individuals, having retired from the military, earn income from other employment while receiving tax-free disability payments from the military. The committee questions the equity of allowing retired military personnel to exclude the payments which they received as tax-exempt disability income when they are able to earn substantial amounts of income from civilian work, despite disabilities such as high blood pressure, arthritis, etc.”  Id. at 138.

But Congress was conflicted.  It still wanted to thank armed forces personnel for their service, especially recognizing that combat related injuries might be more truly deserving of tax-exclusion thanks than service-related injuries such as arthritis or tinnitus which, according to this veteran-friendly website, is currently the most common VA disability claim.  So it wanted to allow taxpayers to exclude military disability retirement payments from gross income when the payments were directly related to combat injuries. Id. at 139.  That is the group described in §104(b)(2)(C).  And Congress also wanted to allow an exclusion for taxpayers who “does not receive...disability benefits from the Veterans’ Administration” at least for the “amount equal to the benefits he could receive” from the VA. Id. at 139 (emphasis supplied).

As Judge Gustafson summarizes the law: “A retired service member may exclude a portion of her retirement distributions in an amount equal to the benefit that she ‘would be entitled to receive as disability compensation from’ the VA, § 104(b)(4) (emphasis added), but only if she is not currently receiving excludable disability benefits from the VA.... The legislative history supports this interpretation of section 104(b)(4).” Op. at 15.

Thus Congress chose to only partially close what it considered a loophole.  Taxpayers could still exclude payments actually made by the VA for a rated disability or that portion of payments from DFAS that represented what the taxpayer could have received from the VA.  The Senate Finance Committee Report emphatically assured us that “At all times, [VA] disability payments will continue to be excluded from gross income.” Id. at 139.  So taxpayers still get a pretty sweet deal; they can still “earn income from other employment while receiving tax-free disability payments” at least so long as the source of the disability payments is the VA.

Today’s case shows us the convoluted result of the confusing language implementing Congress's conflicting concerns.

Facts and Lesson: Only One Exclusion for Disability Payments
In 2016 Ms. Valentine was retired from the military and, like my dad, received both DFAS pension payments (about $24,000) and VA disability payments ($18,000).  For the first four months of 2016 she had a 60% disability rating.  In 2016 she got that upped to 90%.  Both of those ratings seem to entitle her to Concurrent Retirement and Disability Pay (CRDP) whereby she did not have to reduce her retirement pay by the amount of disability pay received.  I’m not totally sure about that—military retirement pay is not my area—snd I welcome comments from folks who know this area better.

But her 90% disability rating did not prevent her from working.  In 2016 the Air Force employed her as a civilian Equal Opportunity Employment Specialist.  The opinion does not say how much she earned but does say the Air Force reported withholding $4,730 from wages on her W-2.  So based on withholding tables for 2016, I'm guessing the gross was around $35,000.  She also received $2,500 in 1099 income from selling pre-paid legal service contracts for a company called Legalshield.

Yep, she was the kind of double-dipper described in the Senate Finance Committee Report: she earned income from post-retirement employment while receiving tax-free disability payments.  Doing that once is ok.  Congress actually approved of Ms. Valentine’s being able to exclude the VA disability payments!  But she wanted more.  She also wanted to exclude over $20,000 of the DFAS pension payments as being related to her disability ratings.  That was the concern that led Congress to limit taxpayers to only one exclusion for disability-related payments, and not two.

Judge Gustafson does a great job in explaining all of this, concluding that while she could exclude her VA payments, she could not then use the VA disability rating to further exclude her DFAS pension payments.  Judge Gustafson even works through an argument that Ms. Valentine apparently did not make: that the VA’s determination in 2016 to increase her disability rating to 90% should be “retroactive” to the start of 2016 and “that she was therefore entitled to disability payments greater than the FA ha actually paid her in 2016.”  Op. at 15.  Of course, since Ms. Valentine did not, actually, make that argument, she understandably provided no proof to the Court that the VA made any retroactive determination.  All her proof showed was that the VA increased her disability rating in May 2016 on a going-forward basis.

We thank you for your service.  But one exclusion is thanks enough.

Coda:  Recall that my dad did not apply for or receive VA disability benefits until some years after he had retired.  If I’m reading the law correctly, it appears my dad probably could have excluded part of the DFAS checks he received before he started getting VA disability payments on the basis of that “would be entitled to receive” language in §104(b)(2)(D).  See Strickland v, Commissioner, 540 F.2d 1196 (1976) and Rev. Rul. 78-161 (the “Strickland” Rev. Rul.)(disability determination by the VA made in 1967, made effective as of March 1966, entitled taxpayer to a partial exclusion from his 1966 retirement payments even though VA did not start making disability payments until the following year).  But I may be misreading the law and welcome comments or corrections on that from folks who know better than I.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law.  He invites readers to return each week to TaxProf Blog for another Lesson From The Tax Court.