Cross t’s and dot i’s for nontaxable disability benefits

Disability income is taxable for a military veteran – despite not being taxable in earlier years.

The U.S. Tax Court ruled that disability retirement pay received by Kevin M. Campbell was taxable income despite the fact that, in previous years, the Internal Revenue Service had treated it as nontaxable (Kevin M. Campbell and Pamela J. Campbell v. Commissioner, U.S. Tax Court, T.C. Summary Opinion 2014-109, Dec. 22, 2014).

Campbell enlisted in the Coast Guard on July 12, 1987. He was forced into disability retirement in 1990 because he was diagnosed with insulin-dependent diabetes and determined to be unfit for duty.

At first, Campbell received temporary disability status. A letter from the Coast Guard dated Sept. 20, 1990, informed him that he would receive monthly retirement pay equal to his base pay multiplied by his disability rating. His disability rating was 40 percent.

The Coast Guard also informed Campbell that it would withhold federal income taxes on the gross amount of the retirement/disability pay. At the end of each year, the Coast Guard sent him a Form 1099-R for the gross amount of retirement/disability pay he had received.

Campbell’s accountant reviewed the 1099-R when preparing his client’s income tax return. The accountant never included any of the 1099-R amounts on the tax return because he and his client felt that these amounts were nontaxable income.

Through the years, the IRS sent Campbell letters threatening to increase his taxable income by the amount of the Coast Guard retirement pay. Campbell forwarded these letters to his accountant.

The accountant contacted the IRS to explain that this income was nontaxable. A short time later, Campbell would receive a “no change” letter from the IRS, accepting his tax return as filed.

On April 6, 1995, Campbell received a letter from the Coast Guard informing him that his diabetes qualified as a permanent physical disability. His disability rating was determined to be 60 percent, an increase from the 40 percent rating he had received back in September 1990 when he had temporary disability status.

The Coast Guard again informed Campbell that this retirement pay was taxable and that it would withhold federal income tax on the pay.

Fast forward to 2012 when Campbell timely filed his 2011 income tax return. Coast Guard retirement pay of $9,210 was omitted from the taxable portion of the return as it had been in prior years. The IRS sent a letter of deficiency for the 2011 tax year.

The IRS has a general rule for military retirement pay. The rule states that amounts received as a pension, an annuity or a similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country are not included in gross income.

But the IRS has a limitation to this general rule. The limitation provides that the amount of military retirement pay considered nontaxable shall not be less than the maximum amount the individual would receive from the U.S. Department of Veterans Affairs as disability income.

Because the court had no evidence in the record that Campbell had applied to the VA for disability income, it considered the amount Campbell would receive from the VA as zero. Therefore, the court determined that all of the retirement pay from the Coast Guard for tax year 2011 was taxable and properly included in Campbell’s income.

If Campbell had documentation that he had applied for VA disability benefits and could show the court the amount of disability benefits the VA had determined that he was entitled to, this result might have been different. Unfortunately, Campbell had no such documentation.