Taxation of Service-Connected and Non-Service-Connected Disability Benefits under Governmental Plans (Posted on December 12, 1998 by )


Carol V. Calhoun, Counsel
Venable LLP
575 7th Street, NW
Washington, DC 20004
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Carol V. Calhoun

  1. SERVICE-CONNECTED DISABILITY — BEST CHARACTERIZATION FOR TAX PURPOSES

    1. Tax status — Service-connected disability benefit under a “statute in the nature of a workmen’s compensation act” is nontaxable under Internal Revenue Code section 104(a)(1).

    2. Requirements:

      1. Disability benefit must be provided under a statute.

        1. Statute need not be entitled “worker’s compensation”; disability benefits can be provided under an insured or self-insured disability plan, or under a retirement plan. In fact, benefits can be in excess of normal worker’s compensation benefits, Rev. Rul. 68-10, 1968-1 C.B. 50, or can be provided in addition to worker’s compensation benefits. Private Letter Ruling 9801007 (September 24, 1998).

        2. Regulations which have the force and effect of law are considered “statutes” for this purpose. Dyer v. Commissioner, 71 T.C. 560, 562 (1979), acq. in result, 1979-2 C.B. 1.

        3. Statute can incorporate other documents (e.g., a union contract) by reference (Rev. Rul. 81-47, 1981-1 C.B. 55), but a union contract which is merely permitted by a statute is not enough. Rev. Rul. 83-77, 1983-1 C.B. 37.

      2. Disability benefit must be available only for service-connected disability.

        1. Presumption that a particular type of disability is service-connected:

          1. Rebuttable presumption that certain disabilities are service-connected is acceptable. Rev. Rul. 85-105, 1985-2 C.B. 53.

          2. Irrebuttable presumption that a disability is service-connected will prevent favorable taxation. Take v. Commissioner, 82 T.C. 630 (1984), aff’d, 804 F.2d 553 (9th Cir. 1986); Private Letter Ruling 9701042 (October 4, 1996).

        2. Statute which provides benefits for both service-connected disabilities and non-service-connected disabilities:

          1. If the benefits are provided under different provisions of the statute, even if the benefits are identical, benefits provided under the service-connected disability provision will meet this rule. Rev. Rul. 85-104, 1985-2 C.B. 52; Rev. Rul. 74-582, 1974-2 C.B. 34.

          2. If a single provision covers disability benefits, regardless of the cause, the benefits will not be excludable, even if the particular employee’s disability is service-connected. Rev. Rul. 83-77, 1983-1 C.B. 37.

        3. Death benefits

          1. A death benefit provided only for service-connected deaths meets this requirement. The benefit need not be provided under a statute which also provides disability benefits during life. Rev. Rul. 72-291, 1972-1 C.B. 36.

          2. A death benefit which is provided for non-service-connected deaths can still meet this requirement if it is provided only to those who are on service-connected disability at the time of their death. Rev. Rul. 80-84, 1980-1 C.B. 35.

        4. Benefits to volunteers – Benefit can be treated as “service-connected” even if the service was uncompensated. Rev. Rul. 72-291, 1972-1 C.B. 36.

      3. Disability benefit must not be based on employee contributions.

        1. If amount of benefit is based on employee contributions, it will not qualify. Treas. Reg. § 1.104-1

        2. However, an overall retirement plan which provides service-connected disability benefits, and which also provides for employee contributions, is acceptable so long as an employee cannot increase or decrease service-connected disability benefits through elections as to the amount of contributions. Private Letter Ruling 9716008 (January 13, 1997).

      4. Disability benefit must not be based on years of service or age:

        1. A benefit which is entirely calculated under a formula which is based on years of service or age will not qualify. Rev. Rul. 85-104, 1985-2 C.B. 52.

        2. If a disability benefit is based on salary and percentage of disability, taking age and/or years of service into account in determining the percentage of disability will not disqualify the benefit. Rev. Rul. 85-104, 1985-2 C.B. 52.

        3. If a service-connected disability provision provides a benefit based on age and/or years of service, subject to a minimum which is not based on age or years of service, the benefit will be broken into two parts:

          1. Only the minimum benefit can qualify as a service-connected disability benefit. Rev. Rul. 85-104, 1985-2 C.B. 52.

          2. The remainder of the disability benefit is subject to the provisions described below for a non-service connected disability benefit.

  2. NON-SERVICE-CONNECTED DISABILITY

    1. Paid by retirement system:

      1. Fully taxable, unless employee made after-tax contributions to the retirement system. Since current regular contributions are all pretax due to a pickup arrangement, this would apply only to the extent the member participated before 1985 (the first year the pickup arrangement was in place), or made after-tax contributions to purchase service credit.

      2. IRS interpretation, as set forth in Publication 17 and Publication 575, is that even if an employee has made after-tax contributions to the retirement system, the member’s disability pension is fully taxable until the member reaches minimum retirement age, i.e., the age at which the member can first receive a pension or annuity if s/he is not disabled.

      3. Upon attainment of minimum retirement age, benefits for an employee who has made after-tax contributions are divided between nontaxable amounts (the return of the employee’s own after-tax contributions) and taxable amounts (all other amounts distributed). Notice 98-2, 1998-1 C.B. __, sets forth the method for determining this division.

      4. Employee contributions which are paid on a pretax basis through an arrangement described in Code section 414(h)(2) (“pick-up arrangement”) are not treated as employee contributions for this purpose.

    2. Paid under long-term disability policy or self-funded disability plan:

      1. Taxable except to the extent the employee paid premiums for disability coverage on an after-tax basis. Code sections 104(a)(3) and 105(a).

      2. If premiums are paid through a combination of after-tax employee contributions and other sources, the percentage of the benefits which is nontaxable is equal to the percentage of the contributions over the three years preceding the disability which was paid by the employee. Treas. Reg. § 1.105-1(d)(1).

      3. Employee contributions which paid on a pretax basis through a plan described in Code section 125 (sometimes referred to as a cafeteria plan, flexible benefits plan, or premium conversion plan) are not treated as employee contributions for this purpose. This makes disability one of the few benefits which is not necessarily treated more favorably from a tax perspective if it is provided through a cafeteria plan than if it is provided through employee after-tax contributions.