When You Get a Piece of Their Disability Pension

Shannon Fernandez finds this out the hard way in the eponymous Tax Court full-dress opinion, 138 T.C. 20, filed 5/14/12. Judge Wherry is the bearer of the bad news in this case of first impression.

Shannon’s loved-once, Mr. Fernandez, was another disabled L. A. County Sheriff, like Jay Sewards (see my blogpost “Service Trumps Sickness”, posted 4/2/12), but unlike Jay, Mr. took the disability option because he didn’t have the 20 years of service he needed for full benefits. He and Shannon split, and Shannon gets a piece of Mr.’s pension.

L.A. gives Shannon a 1099-R but Shannon doesn’t report the income, replying on Section 402(e)(1)(A) as placing her in the shoes of Mr. as regards any distribution from an exempt trust, like the L.A. Sheriff’s retirement fund.

That’s fine, except neither Section 402 nor Section 72 (the annuity section) talks about Section 104 bodily injury payments. Judge Wherry: “Nowhere in section 402(a) or section 72 is section 104(a) mentioned. Section 402(e)(1)(A) explicitly provides: ‘For purposes of subsection (a) [of section 402] and section 72, an alternate payee who is the spouse or former spouse of the participant shall be treated as the distributee of any distribution or payment made to the alternate payee under a qualified domestic relations order ‘. If Congress had included section 104 in this portion of the statute, the result in this case might be different. However, without congressional approval we decline to expand the reach of section 402(e)(1)(A) beyond the sections specifically referred to in its text.” 138 T.C. 20, at pp. 6-7.

Going back to the earliest days of the income tax, the prehistoric, pre-IRC, Revenue Act days, Judge Wherry finds: “A version of section 104(a)(1) allowing an injured person to exclude disability income from his or her taxable income has been in the Code since the Revenue Act of 1918 when it was added because ‘Under the present law it is doubtful whether amounts received* * * as compensation for personal injury or sickness * * * are required to be included in gross income.’ H.R. Rept. No. 65-767 (1918), 1939-1 C.B. (Part 2) 86, 92. In all of the years since, to our knowledge, petitioner’s particular issue has not been before the Court. We note that petitioner did not suffer an injury, and the Senate explicitly stated ‘as compensation for personal injury’. In the case at hand the compensation was not for petitioner’s personal injury, but that of her former husband.” 138 T. C. 20, at pp. 7-8.

There’s no caselaw that anybody can find, so Shannon gets nailed. But “(T)his outcome should come as no surprise to petitioner. Although not controlling on this Court, we note that the order and stipulated division of retirement benefits stated that ‘[d]istribution under this Order shall be taxable to the Nonmember [petitioner] and not the Member [her former spouse].’ We further note that the State court did not decrease petitioner’s share of the disability payments because it believed that she would receive the money tax free.” 138 T. C. 20, at p.8, footnote 5.

But would the result been different had the State court in fact decreased Shannon’s share? I doubt it.