Lesson From The Tax Court: The Interplay Of SSDI Benefits And The §104(a)(1) Exclusion

When Congress giveth a tax benefit with one hand, it sometimes taketh the other hand and slaps the taxpayer silly, eliminating the benefit the taxpayer thought they had.  Today's lesson is an example of that phenomenon.  It’s kind of like a bad joke, an appropriate lesson for April 1st.

Specifically, the one hand is found in §104(a)(1).  It promises taxpayers they can exclude from gross income those “amounts received under workmen’s compensation acts as compensation for personal injuries or sickness.”

The other hand comes in §86(d).  In Donald Ecret and Kristen Ecret v. Commissioner, T.C. Memo. 2024-23 (Feb. 14) (Judge Lauber), the taxpayers got slapped by that statute with the result that most or all of otherwise excludable workers compensation payments became taxable income.  In today's case Ms. Ecret received workers compensation from the state of New York after becoming medically disabled.  When she became entitled to Social Security Disability payments, she actually received only a fraction of the benefits she was entitled to receive because of a federal statute that requires the Social Security Administration (SSA) to offset the entitlements by sate workers compensation received.  Judge Lauber give a very well-written lesson on why the taxpayer must report even the unpaid federal benefits as gross income: it’s because of §86(d).  So, yes, technically the state benefits were still excluded under §104(a)(1).  But the practical effect of the SSA offset was to reduce the exclusion by forcing the taxpayer to include in income those unpaid SSDI benefits, withheld from the taxpayer because of the offset.  In effect, §86(d) transmogrifies the excludable state benefits into taxable Social Security benefits. Thanks Congress!

Details below the fold.

Background: The §104 Exclusion for Disability Payments
The workhorse exclusion statute for disability payments is §104.  It’s title broadly promises an exclusion for “Compensation for injuries or sickness.”

Section 104(a)(2) excludes “damages...on account of personal physical injuries or physical sickness.” Those damages can certainly include payments for physical disabilities. This is perhaps the most commonly litigated part of §104.  See e.g. Lesson From The Tax Court: Emotional Distress Is Not Physical Illness, TaxProf Blog (Sept. 27, 2021); and Lesson From The Tax Court: The §104(a)(2) Causality Rule, TaxProf Blog (Feb. 15, 2021).

Section 104(a)(3) provides that gross income does not include “amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness...”  This also can include disability payments.  We learned something about that in Lesson From The Tax Court:  Exclusion Rules For Disability Payments, TaxProf Blog (May 8, 2023).

And §104(a)(4) permits certain 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.”  We learned about that one in Lesson From The Tax Court: Only One Exclusion For Military Retiree Disability Payments, TaxProf Blog (May 16, 2022).

Today we learn a lesson about §104(a)(1), which seems to exclude all ““amounts received under workmen’s compensation acts as compensation for personal injuries or sickness.”  The language in §104(a)(1) has remained the same since Congress enacted the Internal Revenue Code in 1954.

But whatever it meant in 1954, it does not really mean what it says today, thanks to its interplay with Social Security Disability payments.  Let’s take a look first at the Workers Compensation Offset and then at the taxation of Social Security Benefits.

Background:  SSA Disability Payments and the Workers Compensation Offset
I confess this is not an area I am very familiar with, so I invite correction from readers!  But here's my understanding.

Congress first established the SSDI program in 1954.  See Richardson v. Belcher, 404 U.S. 78, 82 (1971).  At that time, payments received from Social Security were treated as excluded from gross income by §102(a)—the payments were a gift from the government!  See generally Research Note #12 from the SSA Historian’s Office.  So no payment from SSA was taxed, whether the payments were regular retirement or disability.

One recurring concern, however, was whether and to what extend the federal disability benefits should be pegged to what a state workers compensation program was paying.  Both sets of payments served a common purpose, to replace a worker’s lost income.  The concern was that if the federal payments did not account for the state payments, then workers would actually make more money by the combination of the state and federal payments than they had been making before their disability.  Richardson, supra, at 82-83.  For some reason Congress thought that was a bad idea.

In 1965 Congress addressed that concern by enacting what is called the “workers compensation offset,” now codified in 42 U.S.C. 424a.  Id.  That section basically provides that the sum of the payments an individual receives from SSA and state workers compensation should not exceed 80% of the individual’s deemed Average Current Earnings (“ACE”).  To the extent that the sum exceeds 80%, the statute requires SSA to ensure that the combination of benefits gets reduced.

Generally, that means SSA will reduce its payments by the amount of state benefits provided.  That’s called the workers compensation offset.  It essentially substitutes the state benefits for the otherwise payable federal benefits.

The wrinkle here is that some states reduce their payments to offset the the SSA payments.  Currently there are about 16 of these “reverse offset” states.  See SSA Office of Inspector General Audit Report: State Workers’ Compensation and Public Disability Benefits’ Reverse Offset Plans’ Impact on the Disability Insurance Trust Fund, A-02-19-50867. (Sept. 2023).  For those states, Congress has directed the SSA to not make any reduction in federal benefits. 42 USC §424a(d).  For example, in 2019, there were about 22,000 individuals living in those 16 reverse offset states whose SSDA payments were not reduced to the magic 80% because the states would reduce state payments to offset what SSA was paying. Id. at 3.

Again, in 1965, no payments from Social Security were considered gross income, so there was no need to worry about the how the tax treatment of such payments (zero tax) interplayed with the tax treatment of workers compensation payments that were being offset (also zero thanks to §104(a)(1)).  Whatever combination of state payments and federal payments an individual was receiving, none was counted as gross income.

All that changed when Congress started taxing Social Security payments in 1983.  Let’s take a look.

Background: Taxation of Social Security Benefits.
In 1983 Congress created §86 in the Social Security Reform Act, 97 Stat. 65, 80.  The idea was to keep Social Security payments tax-free for taxpayers whose gross income was below a certain threshold, but to impose a tax on up to 50% of those Social Security payments received by taxpayers whose income exceeded the threshold.  The threshold varied depending on filing status.  In 1993 Congress expanded the taxation of Social Security benefits in the Omnibus Budget Reconciliation Act of 1993, (OBRA), 107 Stat. 312.  Basically, it created a second, higher, threshold amount above which 85% of Social Security payments would be treated as gross income.

Importantly for today’s lesson §86 makes no distinction between regular SSA retirement payments and SSA disability payments. That is, §86(d)(1)(A) defines the term “social security to mean “any amount received by the taxpayer by reason of entitlement to...a monthly benefit under title II of the Social Security Act.” See also 2023 Tax Guide For Seniors.

In the 1983 legislation Congress also dealt with how to tax the Social Security disability benefits that were subject to the workers compensation offset rules over in 42 USC 424a, as I explained above.  The provisions applicable to today’s lesson have not changed in any relevant way since 1983.  Here’s the relevant language, found in in §86(d)(3):

“For purposes of this section, if, by reason of [42 USC 424a]...any social security benefit is reduced by reason of the receipt of a benefit under a workmen’s compensation act, the term “social security benefit” includes that portion of such benefit received under the workmen’s compensation act which equals such reduction.”

By this sleight of hand, unpaid SSA benefits were to be included as gross income for purposes of computing tax liability.  Apparently the reason for this was to treat taxpayers in the normal jurisdictions the same as taxpayers in the reverse offset jurisdictions.

To see the lesson, let’s first look at the facts of the case.

Facts
The tax year at issue is 2019.  In that year Ms. Ecret received around $42,000 in workers compensation from New York for a medical disability she had incurred in her job.  By that year Ms. Ecret had also successfully slogged through the arduous process of obtaining SSDI payments and was entitled to receive about $20,000 in SSDI for that year (she was entitled to more, but the IRS conceded that rest was attributable to prior years and so I’m not including it in the lesson).

Despite her entitlement to $20,000, however, she actually received only about $7,000 for that year, $6,000 paid directly and $1,000 in income tax withholding.  Nothing else was paid to her because of how SSA calculated the workers compensation offset.

Ms. Ecret and her husband reported as gross income 85% of what they actually received.  On audit the IRS said they should have reported as gross income 85% of the full $20,000 they were entitled to, despite the fact that about $13,000 of that was seemingly phantom income.

The Ecrets petitioned Tax Court.  They did not believe they should be taxed on income they never received.  They argued that they should instead be able to exclude under §104(a)(1) the workers compensation payments they actually did receive and that reduced their actual Social Security disability payments.  Why they lost gives us our lesson.

Lesson: Unpaid Social Security Benefits Are Still Gross Income
I cannot do better than Judge Lauber in explaining the lesson. Here’s what he teaches us:

"Thus, the amount of an individual’s Social Security benefits for section 86(d) purposes includes workers’ compensation payments to the extent those payments offset Social Security benefits to which the individual is entitled. See Moore v. Commissioner, T.C. Memo. 2012-249, 104 T.C.M. (CCH) 245, 246; Mikalonis v. Commissioner, T.C. Memo. 2000-281, 80 T.C.M. (CCH) 330, 332; see also H.R. Rep. No. 98-25, at 26 (1983), reprinted in 1983 U.S.C.C.A.N. 219, 244, indicating that Congress specifically anticipated this result). In enacting section 86(d)(3), Congress apparently sought to equalize the treatment of taxpayers in petitioners’ position with taxpayers residing in “reverse offset” jurisdictions, i.e., States where the receipt of Social Security benefits reduces workers’ compensation benefits. See Charles T. Hall, Social Security Disability Practice § 5:19 (2023)."

Judge Lauber the explains the result:

"[U]nder section 86(d)(3), petitioner wife must be treated as having received $19,866 in Social Security benefits for 2019. This amount includes that portion of petitioner wife’s workers’ compensation payments, or $12,666, that offset Social Security benefits to which she was entitled for 2019.”

Basically, the idea is that the workers compensation offset operates to convert the (excludable) workers compensation payments actually received into (taxable) Social Security payments even though those payments were not actually received!

Bottom line: Some workers compensation payments may become taxable gross income, despite §104(a)(1), if the taxpayer is also receiving any SSDI payments.

Comment: 
My blog posts are about learning the law, not about blogging on the most controversial Tax Court opinions, such as the recent reviewed opinion in Valley Park Ranch LLC et al. v. Commissioner, 162 T.C. No. 6 (Mar. 25, 2024) (7-2-4 decision holding Treas. Reg. 1.170A-14 invalid).  As tempting as it would be to opine on all the ways in which the Court’s majority in Valley Park got it wrong, wrong, wrong (!), who the heck cares what some West Texas tax nerd thinks?

Today’s post is about learning the law.  Judge Lauber’s opinion is absolutely non-controversial.  Not only does he get the law completely right, he does a terrific job (as usual) explaining the basis and rationale for the decision.

That does not mean, however, that we cannot question or comment on the law itself.  And I for one have a lot of questions here.  Perhaps some kind reader can help educate me on the following:

First, it seems inconsistent to treat Social Security disability payments as taxable while excluding state workers compensation payments especially since the interplay of state and federal payments is designed to restore only up to 80% of the worker’s pre-disability income.

The first concern does not necessarily mean that Congress should exclude SSDI payments from income.  Congress might instead revise the §104(a)(1) exclusion to match the policy choice made in §86:  leave all worker compensation payments untaxed for lower-income taxpayers but then tax payments that exceed a certain threshold.  Basically, I just cannot see the rational basis for treating one source of disability payments differently from another source.

I would welcome comments on this because, again, the thrust of §104 seems to be to exclude disability payments whether received from public (state) sources or private (insurance) sources.  That’s the one hand.  But §86 then slaps “taxable” status on disability payments simply because they come from the federal fisc.

Second, I do not understand the “reverse offset” concern given as a rationale for the rule in §86(d)(3).  State laws invariably create different federal tax consequences for the folks living in that state.  SALT comes to mind but I am sure there are other examples.  So I do not understand the rationale here.  Why does Congress believe that taxpayers in normal states should pay a price (taxed disability benefits!) for the decisions of other states that use reverse offset.

Finally, a question out of complete ignorance.  I would welcome education on whether all states use the 80% of ACE (“average current earnings”).  What if a reverse offset state uses 60% of ACE?  Or 90%?  Do all states use 80% just because that is what Congress told the SSA to use?  If not, then the current system would still create unequal results for taxpayers in the reverse offset states and taxpayers in other states. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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