Veteran's Disability Retirement Benefits Were Excludable from Income

(Parker Tax Publishing June 2017)

The Tax Court held that a veteran who sustained a head injury in boot camp, which later led to a seizure disorder, could exclude his military disability retirement benefits from income. In rejecting the IRS's contention that the court should look at the taxpayer's subsequent computer science career, the court concluded that the taxpayer was entitled to the exclusion under Code Sec. 104 because he would have qualified for Veterans Administration disability benefits had he applied for them. Keeter v. Comm'r, T.C. Summary 2017-36.

Kent Keeter joined the U.S. Army in 1984. While in boot camp, he sustained a head injury that required several months of hospitalization and led to a seizure disorder. Keeter was placed on the temporary disability retired list in June 1984 with a disability rating of 40 percent. Approximately a year later, he was reevaluated at a military base and placed on permanent disability. Keeter permanently retired with an honorable discharge in July 1985. Around that time, he met with representatives for the Department of Veterans Affairs (VA). It was Keeter's understanding at that time that he would qualify for disability benefits from the VA, but he did not apply.

Keeter resumed college after his discharge and graduated with a computer science degree. He has worked in that field ever since. In 2012, he received disability retirement income of approximately $5,900 from the U.S. Army. He did not report this income on his tax return. Keeter filed petitions of redetermination on two prior occasions challenging the IRS's inclusion of his disability retirement income for prior years. The Tax Court entered stipulated decisions in Keeter's favor in both of those cases. With respect to the receipt of the disability retirement income in 2012, the IRS again determined that Keeter had to include the amount in income.

Under Code Sec. 61(a)(11), pensions and retirement income are included in income unless otherwise excluded. While military retirement pay falls under the definition of retirement income, it can be excluded under Code Sec. 104(a) if it is for personal injuries or sickness resulting from active service in the armed forces and if certain other conditions apply. Of the four limitations are imposed by Code Sec. 104(b)(1), only one was at issue in the instant case. Under Code Sec. 104(b)(1)(D), military disability retirement income is excludable from taxable income if the individual would be entitled to receive disability compensation from the VA.

While the military and the VA apply the same rating standard - the Veterans Affairs Schedule for Rating Disabilities (VASRD) - each approaches the question of disability ratings from a different perspective. In Stine v. U.S., 92 Fed. Cl. 776 (2010), the court noted that, whereas the military uses the VASRD to determine what compensation the service member is due for the interruption of his military career, the VA examines more holistically the individual's ability to engage in civilian employment. Keeter and the IRS disputed whether Keeter would have qualified under the VA's application of the VASRD.

Keeter argued that he was entitled to exclude his military disability benefits from his 2012 income under Code Sec. 104(b)(1)(D) based on his understanding that at the time of his discharge, he qualified for VA disability benefits. The IRS argued that the Tax Court should apply the VA's disability rating standard with the hindsight of knowing that Keeter had gone on to have a career in computers after he was discharged.

The Tax Court found in Keeter's favor. It based its decision on Keeter's testimony that he met with VA representatives and was told he would qualify for VA disability benefits. Having determined that this was a sufficient basis for its decision, the Tax Court declined to examine the VA standard and apply it to Keeter with the hindsight. Instead, the court said, it was basing its holding on the information Keeter had at the time of his discharge which was that he would qualify for VA benefits.

For a discussion of 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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