It has taken awhile (twenty-four years to be exact), but Congress enacted a relief provision to deal with the fact that the Department of Defense had been withholding taxes on lump-sum severance payments to combat-injured veterans despite that income being found to be excludable from taxable income under IRC §104(b)(3). The bill, the “Combat-Injured Veterans Tax Fairness Act of 2016” H.R. 5015 was signed into law on December 16.

In the case of St. Clair v. United States, 778 F. Supp. 894 (E.D. Va 1991) these one-time lump sum severance payments were held to be excludable from taxable income. However, per a Tax Analysts news article describing the bill, the Defense Finance and Accounting Service said an error with its payment system caused taxes to be improperly withheld from 14,000 veterans receiving these payments.

If those veterans had filed their returns noting that these payments were not taxable there would have been no harm—their tax liability would have been properly computed and any excess withholding would have been refunded. However, Congress determined that many veterans were not aware of the proper tax treatment and rather assumed that the information return they received from the Department of Defense that showed the payments as taxable income represented the proper treatment.

The bill requires the Department of Defense within one year after December 16, 2016 to identify:

The severance payments --
That the Department paid after January 17, 1991;
That the Department computed under section 1212 of title 10, United States Code;
That were not considered gross income pursuant to section 104(a)(4) of the Internal Revenue Code of 1986; and
From which the Department withheld amounts for tax purposes; and
The individuals to whom such severance payments were made.

Once the DOD has the list of affected veterans, the Department is required to send to the affected veteran:

Notice of --
The amount of severance payments which were improperly withheld for tax purposes; and
Such other information determined to be necessary by the IRS to carry out the purposes of this section; and
Instructions for filing amended tax returns to recover the amounts improperly withheld for tax purposes.

Since the vast majority of the returns affected by this erroneous withholding are closed to the filing of claims for refunds, the law provides a temporary extension of the time to file a claim for refund related to this issue.

Section 3(b)(1) of the law provides:

If a claim for credit or refund under section 6511(a) of the Internal Revenue Code of 1986 relates to a specified overpayment, the 3-year period of limitation prescribed by such subsection shall not expire before the date which is 1 year after the date the information return described in subsection (a)(2) is filed. The allowable amount of credit or refund of a specified overpayment shall be determined without regard to the amount of tax paid within the period provided in section 6511(b)(2).

Presumably the information the DOD sends to the veteran will provide that due date for filing a claim for refund.

The law also directs the DOD to act to ensure that taxes are no longer withheld from such payments.