Portion of Disability Retirement Payments Based on Years of Service were Taxable.

(Parker Tax Publishing May 24, 2015)

The Ninth Circuit affirmed a Tax Court's ruling that because a portion of a taxpayer's retirement payments was based on his years of service, the amount exceeding what he would have received solely based on disability was subject to taxation. Sewards v. Comm'r, 2015 PTC 153 (9th Cir. 2015).

Background

Jay Sewards worked for the Los Angeles County Sheriff's Department until 2000, when he was placed on involuntary medical disability leave due to service-connected injuries. While on disability leave, he continued to receive his monthly $14,093 salary. Because he suffered his injury after more than 34 years on the job, Sewards was eligible for two types of retirement plans, one based on his length of service (service retirement) and a different plan based on his injuries (disability retirement).

In 2001, Seward requested, and the Los Angeles County Employees Retirement Association (LACERA) granted, that the service retirement take effect upon the expiration of his disability leave. The amount of Seward's service retirement payment was determined, by reference to his length of service, to be $12,861 a month.

In 2002, Sewards applied for and was granted disability retirement retroactive to the date upon which his service retirement took effect, replacing his service retirement. The disability retirement plan would provide him with at least one-half of his final monthly salary but would grant his full service retirement allowance if it was higher. Because half his monthly salary was only $7,046, Sewards received $12,861 under the disability retirement plan.

In each year from 2001 through 2005, LACERA sent Sewards a Form 1099-R indicating that the taxable amount of his retirement allowance was not determined; as a result Sewards paid no tax on the pension. In 2006, LACERA sent Sewards another Form 1099-R indicating that a portion of his retirement allowance was taxable. However, on his 2006 return, Sewards did not report any portion of the income from his disability retirement allowance.

The IRS issued a notice of deficiency determining that the portions of Seward's month disability retirement payments that exceeded the one half portion of his final monthly salary were taxable. Sewards petitioned the Tax Court, arguing that the entire benefit was excludable. However, the court noted that while the statute authorizing the disability retirement payments to Sewards was in the nature of a workers' compensation act, and he was guaranteed at least $7,046 a month under that statute, the $12,861 he received monthly was determined by reference to his length of service.

Thus, the Tax Court held that the portions of the monthly payments exceeding the guaranteed amount (which worked out to $5,815) were not excludable from income, and Sewards appealed to the Ninth Circuit.

Analysis

Code Sec. 104(a)(1) provides that retirement payments are excludable from gross income if they are received under a workers' compensation act or a statute in the nature of a workers' compensation act. Reg. Sec. 1.104-1(b) provides, however, that Code Sec. 104(a)(1) does not apply to the extent the payments are determined by reference to the employee's age or length of service or the employee's prior contributions, even if the employee's retirement is occasioned by occupational injury.

On appeal, Sewards argued that the payments he received from his disability retirement plan did not fall within the limitation in Reg. Sec. 1.104-1(b) because, even though the payments were calculated based on his years of service, he was eligible for retirement and the payments solely because of his disability. Sewards claimed that the regulation applied only where an individual qualified for a retirement allowance based on years of service, rather than because of a disability.

The IRS argued that the limitation applies when an individual who retires with a disability receives an allowance amount that is at least in part based on his years of service.

The Ninth Circuit Court rejected Stewards' argument, finding his interpretation was not supported by the text of the regulation. The court noted that like any other LA County employee who retired with a service-connected disability, Sewards was entitled to receive one-half his final salary based on his injuries. However, the court found that Sewards received additional amounts under his disability retirement plan to bring his pension up to what he would have received under the service retirement plan. Because that additional amount was determined in reference to his years of service, it was limited by Reg. Sec. 1.104-1(b), and was not excludable from income as a disability-related payment.

Sewards also argued that the IRS's interpretation of the regulation was inconsistent with Code Sec. 104(a)(1) and was thus invalid. The court disagreed, noting that while Code Sec. 104(a)(1) provides that workmen's compensation payments for injury or sickness are excludable, it leaves open the question of how to determine whether a payment is made for injury or sickness, as opposed to some other reason. The court stated the regulation simply clarifies when a payment is made for personal injuries or sickness, and when it is made for some other reason, such as years of service. Moreover, the court pointed out that the IRS's interpretation of the regulation was consistent with forty years of previous Revenue Rulings.

The Ninth Circuit held that the $7,046 portions of his retirement payments, equal to one half his monthly salary, were excludable disability payments, but because the additional $5,815 portions were paid based on his years of service, under Reg. Sec. 1.104-1(b) they were not excludable. Accordingly, the Ninth Circuit affirmed the Tax Court's ruling.

For a discussion of amounts received under workers compensation acts, see Parker Tax ¶75,905. (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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