Disability Retirement Pay May Be Taxable

I’m skipping today’s big Tax Court case, Judge Gustafson’s 143 page extravaganza anent the decline and fall of F. Lee Bailey, formerly of the O.J. Simpson Dream Team. Judge Gustafson rightly calls it an archeological expedition, and brings out no new principles; the only interesting point is that the Department of Justice and Mr. Bailey failed to put in writing a massive asset repatriation agreement that provoked years of litigation. It goes to show that sloppiness is not merely the province of the small taxpayer.

The case with a lesson for the preparer in the trenches is Jay Sewards and Frances Sewards, 138 T.C. 15, filed 4/2/12, Judge Foley telling the story in eight pages. Jay was a 34-year employee of the L.A. County Sheriff’s Department who suffered a career-ending line-of-duty injury. He had a choice of retirement plans: a length-of-service plan (with no reference to injury) or a service-connected plan (known as an SCD), where his injury was taken into account. He took the service option at first, but then applied for an SCD, which was awarded retroactive to the beginning of his service-connected plan.

Judge Foley spells it out: “Thus, his SCD retirement replaced his service retirement. Individuals were eligible for SCD retirement if they were permanently incapacitated because of an injury or disease arising from their county employment. The SCD retirement plan would provide him with one-half of his final compensation (i.e., $7,046) or his full service retirement allowance (i.e., $12,861), whichever was higher. Thus, Mr. Sewards received his full service retirement allowance of $12,861 per month.” 138 T.C. 15, at p. 4 (citations omitted.).

Jay first got 1099-Rs, showing his service-connected was taxable, but then L.A. County sent amended 1099-Rs for the same years, stating taxability not determined. This continued until, five years into the program, L.A. County told Jay that 50% of his pension would be taxable.

Jay never reported the income. SNOD and petition follow.

Section 104(a)(1) exempts from taxable income pensions like workers’ compensation or equivalent. No one says that part of what Jay is getting isn’t from a statute equivalent to workers’ compensation. But, as always, there’s an exception: “Section 104(a)(1) does not apply, however, 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. Sec. 1.104-1(b), Income Tax Regs.” 138 T.C. 15, at pp. 5-6.

Since the equalizer in Jay’s pension (the greater of one-half final compensation or full retirement allowance) is based on age and length or service, Judge Foley delivers the bad news: “SCD retirees were guaranteed an annual retirement allowance payable in monthly installments equal to 50% of their final compensation (guaranteed amount). If an individual qualified for a service retirement benefit that exceeded the guaranteed amount, however, that person was eligible to receive the higher amount. Accordingly, because Mr. Sewards’ service retirement benefit (i.e., $12,861) was higher than the guaranteed amount (i.e., $7,046), his SCD retirement benefit amount was increased to his service retirement benefit amount, which was determined by reference to his length of service. See sec. 1.104-1(b), Income Tax Regs.; cf. Picard v. Commissioner, 165 F.3d 744 (9th Cir. 1999) (holding that reduction of taxpayer’s disability retirement benefits was determined by reference to his date of hire rather than by his age or length of service), rev’g T.C. Memo. 1997-320. Thus, the portion exceeding the guaranteed amount is not excludable from income.” 138 T. C. 15, at pp. 6-7 (footnote and citations omitted.).

Now does Jay owe substantial understatement penalty? No, because L.A. County sent him inconsistent and variable statements of what was and was not taxable. Jay acted in good faith. He owes tax, but not penalty.