Veteran's Service-Related Pension Was Taxable, Despite a VA Disability Determination

(Parker Tax Publishing August 2022)

A district court held that an Army veteran who received a pension from the Department of Defense (DOD) could not claim a refund under Code Sec. 104(a)(4) for the taxes withheld on the pension because there was no determination by the Veteran's Administration (VA) that the payments were due to service-connected disabilities even though the VA declared the veteran 100 percent disabled five years after he was discharged from the Army. The court found that there was no evidence that the taxpayer's DOD pension stemmed from a personal injury or sickness resulting from active service and the court noted that the taxpayer produced no evidence of a retroactive determination from the VA that recharacterized his DOD pension benefits as nontaxable. Sylvester v. U.S., 2022 PTC 231 (S.D. Ga. 2022).

Background

Byron Sylvester was discharged from the Army in 2006. In 2011, the VA declared him 100 percent disabled. In 2012 and 2018, Sylvester received ''Summary of Benefits" letters from the Veteran's Administration (VA) describing the benefits he was currently receiving as well as other benefits he was entitled to claim "as the result of a total and permanent service-related disability he suffered on April 27, 2011." These Summary of Benefits letters described Sylvester's "VA Benefit Information" and did not explicitly purport to describe any DOD benefits. Each letter stated that it was an "official record of [Sylvester's] VA entitlement." The letters also stated that Sylvester was "considered to be totally and permanently disabled due to [his] service-connected disabilities."

Sylvester received Department of Defense (DOD) pension payments of $36,909 and $37,069 in 2016 and 2017, respectively, which were subject to federal income tax withholdings. On his Form 1040 individual income tax returns for those years, Sylvester reported the DOD pension benefits as taxable while reporting his VA benefits as nontaxable; however, he later filed amended returns seeking a refund of the income tax withholdings on his DOD pension benefits because - as he claimed - they were not taxable income. In 2019, the IRS denied the refunds. Sylvester filed suit for the refunds in a district court.

Under Code Sec. 104(a)(4), taxable gross income does not include "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." IRS Publication 525, Taxable and Nontaxable Income, states that "if your retirement pay is based on age or length of service, it's taxable and must be included in your income as a pension." However, Publication 525 also states that if the pension qualifies for the Code Sec. 104(a)(4) exclusion for a service-connected disability, the portion of the pension that the taxpayer would have received if the pension had been based on a percentage of disability is excludable, while the rest of the pension should be included in income. Under the heading "Retroactive VA determination," Publication 525 explains that if a taxpayer retires from the U.S. Armed Forces based on years of service and later receives a retroactive service-connected disability rating from the VA, the taxpayer's retirement pay for the retroactive period is excluded from income up to the amount of VA disability benefits to which the taxpayer would have been entitled.

Sylvester argued that as a result of his 2011 VA 100 percent disability rating, his DOD pension should have been excluded from his taxable income in 2016 and 2017, and that the court should now allow him to recover his alleged overpayments as tax refunds from those years. The IRS responded by filing a motion for summary judgment. The IRS argued that (1) Sylvester received Forms 1099-R from the DOD confirming that his pension benefits were taxable in the years they were received, (2) his DOD pension benefits did not fit within the definition of a "pension, annuity, or similar allowance for personal injuries or sickness resulting from active service," and (3) Sylvester could not produce a retroactive determination from the VA that recharacterized his DOD pension benefits as nontaxable.

Analysis

The district court granted the IRS's motion for summary judgment after finding that Sylvester failed to show why his DOD pension should have been excluded from his taxable income.

The court explained that under Code Sec. 104(a)(4) and Publication 525, if a pensioner receives a disability rating from the VA after receiving his or her pension, he or she is entitled to a refund of any tax paid on that pension income "up to the amount of VA disability benefits [he or she] would have been entitled to receive" had his or her VA disability rating been in effect during that retroactive period. However, the court said that this rule does not generally permit retirement pensions to be excluded from taxable income - only those sums "for personal injuries or sickness resulting from active service."

The court found that Sylvester provided no evidence that his DOD pension stemmed from a personal injury or sickness resulting from active service. While Sylvester was correct that his DOD pension was presumably "service-related," the court found that it did not necessarily follow that the payments resulted from any personal injuries or sickness that occurred due to that service. In the court's view, without a retroactive determination from the VA stating that his DOD pension benefits were retroactively excluded, there was no evidence his VA disability determination was not considered by the DOD in the calculation of his DOD pension benefits. It appeared to the court that, because Sylvester was categorized as 100 percent disabled before his DOD pension benefits were paid, the DOD would have already had notice of his disability and VA benefits at the time they calculated his pension.

The court found that Sylvester's assertions regarding retroactivity misinterpreted the statute. The post-hoc exclusion of certain pension benefits from a disabled veteran's taxable income, the court stated, allows the veteran to reduce his or her taxable income in years the veteran would have been entitled to disability benefits from the VA, but did not receive those benefits in fact. As the court explained, this is true because had the veteran received his or her disability rating before receiving a pension, the VA would have paid excludable disability payments while the DOD would have reduced the pension dollar-for-dollar. The court said that essentially, the statute provides a tax refund to veterans who received taxable pensions when they would have received tax-free disability payments instead, had they received their VA disability rating before receiving their pension.

However, the court found that in this case, Sylvester did not allege he failed to receive disability payments from the VA, nor could he - the evidence showed that he was receiving those benefits. Further, the court found that there was no reason to believe the DOD failed to consider any such benefits or his disabled VA designation when calculating his DOD pension. Therefore, the court concluded that Sylvester failed to show why his DOD pension should have been excluded from his taxable income.

For a discussion of the exclusion for amounts received for injuries or sickness resulting from military service, see Parker Tax ¶75,920.

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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