The Tax Court agreed with the IRS that a disabled Army veteran could only exclude from income the designated disability payments she received from the Veterans’ Administration, while the payments she received separately as part of her military retirement payments were taxable in the case of Valentine v. Commissioner, TC Memo 2022-42.[1]

IRC §104 and Military Disability Income

The case revolves around special provisions related to those disabled due to active service in the military.  IRC §104(a)(4) reads as follows:

(a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—

…

(4) amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980;

IRC §104(b) provides special rules related to this provision.  The relevant provisions for this case are reproduced below:

(b) Termination of application of subsection (a)(4) in certain cases.

(1) In general. Subsection (a)(4) shall not apply in the case of any individual who is not described in paragraph (2).

(2) Individuals to whom subsection (a)(4) continues to apply. An individual is described in this paragraph if—

…

(C) he receives an amount described in subsection (a)(4) by reason of a combat-related injury, or

(D) on application therefor, he would be entitled to receive disability compensation from the Department of Veterans Affairs.

Paragraph 104(a)(2) refers to the general exclusion from income for damages received for physical injuries and reads as follows:

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

The opinion outlines how these provisions are potentially applicable in the case of Ms. Valentine as follows:

Section 104(a)(4) provides the general rule that amounts received as a pension, annuity, or similar allowance are not included in gross income when they arise from personal injuries or sickness resulting from active service in the armed forces of any country. As the Commissioner concedes, this is the provision that, in conjunction with section 104(b)(2)(D), entitles Ms. Valentine to exclude from gross income her disability payments from the VA. She attempts to extend this exclusion to her retirement distributions from the DOD, but section 104(b) limits the exclusion prescribed in subsection (a)(4), as relevant here, to an individual who either “receives [a pension, annuity, or similar allowance] by reason of combat-related injury”, § 104(b)(2)(C) (emphasis added), or “on application therefor . . . would be entitled to receive [not “is receiving”] disability compensation from the Veterans' Administration,” § 104(b)(2)(D) (emphasis added). In the latter case, the amount excludable from gross income is “not . . . less than the maximum amount which such individual, on application therefor, would be entitled to receive as disability compensation from the Veterans' Administration.” § 104(b)(4) (emphasis added).[2]

The opinion continues with an analysis of why these provisions at IRC §104(b) exist:

The restrictions imposed in section 104(b) are discussed in the legislative history underlying the Tax Reform Act of 1976, Pub. L. No. 94-455, § 505(b), 90 Stat. 1520, 1567, in which Congress explained the restrictions as follows:

At all times, Veterans’ Administration disability payments will continue to be excluded from gross income. In addition, even if a future serviceman who retires does [*9] not receive his disability benefits from the Veterans’ Administration, he will still be allowed to exclude from his gross income an amount equal to the benefits he could receive from the Veterans’ Administration. Otherwise, future members of the armed forces will be allowed to exclude military disability retirement payments from their gross income only if the payments are directly related to “combat injuries.”

S. Rep. No. 94-938, at 139 (1976), 1976-3 C.B. (Vol. 3) 49, 176–77 (emphasis added); see also Reimels v. Commissioner, 123 T.C. 245, 257 (2004), aff’d, 436 F.3d 344 (2d Cir. 2006); Kiourtsis v. Commissioner, T.C. Memo. 1996-534. (Ms. Valentine was, by way of contrast, a retiree who did “receive [her] disability benefits from the Veterans’ Administration”.)[3]

The Court goes on to detail how various situations work under these rules:

A retired service member may receive both a disability pension from the VA (which is excludable from income) and retirement distributions (such as a service pension) from her respective branch of the armed forces; but payments under retirement plans should generally be included in income regardless of the existence of a VA disability determination, except where certain exceptions may apply. See Lambert v. Commissioner, 49 T.C. 57 (1967); Sidoran v. Commissioner, T.C. Memo. 1979-56, aff’d, 640 F.2d 231 (9th Cir. 1981). We have held that where a petitioner already receives an excludable disability benefit from the VA, “a VA disability determination does not prove that a portion of [additional retirement distributions are] received for injuries sustained during active service” for the purpose of section 104(a)(4). Holt v. Commissioner, T.C. Memo. 1999-348, 78 T.C.M. (CCH) 625, 627 (noting that a percentage of disability determination had already resulted in a disability benefit which was excluded from the taxpayers’ income).

A retired service member who did not receive a disability determination from the VA and who is not currently receiving disability benefits may exclude from gross income a portion of her retirement benefits under section 104 if she can prove that she would qualify for a disability determination from the VA. See S. Rep. No. 94-938, at 139, 1976-3 C.B. (Vol. 3) at 176–77. Similarly, a service member who receives a retroactive disability determination by the VA may exclude from gross income a portion of the retirement benefits she received during the retroactive period equal to the percentage of her disability determination (if she did not already exclude them prior to the determination). See, e.g., Strickland v. Commissioner, 540 F.2d 1196 (4th Cir. 1976), rev’g T.C. Memo. 1974-188; see also Rev. Rul. 78-161, 1978-1 C.B. 31.[4]

The Taxpayer’s Facts

The court recited the facts of the taxpayer’s case as follows, beginning with payments that were not in dispute as to their taxability:

For 22 years Ms. Valentine served her country in the U.S. Army. She was honorably discharged in 2002, and thereafter she received monthly disability payments from the Veterans’ Administration (since 1989 the Department of Veterans Affairs, with both entities referred to as the “VA”), for “service-connected disabilities”. The amount of each monthly disability payment correlated with a service-connected disability determination (stated as a percentage of total disability) issued by the VA to Ms. Valentine. In 2014 her combined “service-connected” disability rating was 60%; and in 2016 she received, pursuant to the VA’s determination, payments of approximately $1,100 per month in January, February, March, and April. Effective May 1, 2016 (and reported to her by letter of May 27, 2016), the VA increased her combined “service-connected” disability rating to 90%, and thereafter she received payments of approximately $1,700 per month for the remainder of 2016, for a total of $18,000 for the year.

The parties agree that these disability payments are not taxable. The VA’s determinations made no reference to Ms. Valentine’s disability being “combat-related”.[5]

However, the taxpayer was arguing that other payments could be excluded from her income that she received related to her military service:

In addition to her disability payments, Ms. Valentine received retirement distributions from her Army-based retirement plan in 2016 totaling $23,801. (It is unclear whether her retirement distributions were calculated on the basis of years of service or otherwise.) She received from the U.S. Department of Defense Accounting and Finance Services (“DOD”) a Form 1099–R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.”, reporting the entire amount of the retirement distributions as “taxable”.

The taxability of these retirement distributions is in dispute.[6]

Ms. Valentine reported only $3,158 of this payment as taxable.  Her return did not explain how she had determined the taxable and nontaxable portion of that distribution.[7]

The Tax Court’s Decision on How the Law Applied in This Case

The opinion begins by stating Ms. Valentine’s arguments for expanding her exclusion beyond simply the amounts designated as disability payments by the VA:

Ms. Valentine argues that the disability determination she received from the VA entitles her to exclude from gross income not only her disability payments (which the Commissioner concedes, pursuant to section 104(a)(4) and (b)(2)(D)) but also a portion of her retirement distributions.[8]

While the Court notes that Ms. Valentine does not cite any specific provision in IRC §104 that would allow for her expanded exclusion, the opinion points out:

… the two available contentions appear to be that the amounts were received by reason of a combat-related injury, § 104(b)(2)(C), (b)(3), or that the amounts are those that the service member “would be entitled to receive as disability compensation”, § 104(b)(2)(D), (b)(4).[9]

The opinion goes on to consider whether either of these two exclusions might apply in these facts.

Taxpayer Fails to Provide Information to Show a Combat Related Injury

The opinion first looks at the combat related injury exclusion that would be available under IRC §104(b)(2)(C).  The opinion notes that, before trial, Ms. Valentine made the following reference to combat:

[I]n 2015 or ‘14, I was made aware that my retirement income from the Army [is excluded from gross income], if I’m a disabled vet, combat-service related — and there’s other stipulations, but that’s the one I fall under. [Emphasis added.][10]

The court was not clear if Ms. Valentine was asserting the contention that she had a combat related, injury as she “conflates two concepts in the exclusion provided in section 104 — payments on account of injury “resulting from active service in the armed forces”, § 104(a)(4) (emphasis added), and payments “by reason of a combat-related injury”, § 104(b)(2)(C), (b)(3) (emphasis added).”[11]

But the Court concludes that if she was asserting the combat related injury exclusion applied, she failed to produce any evidence of such a combat-related injury:

…[I]f she did intend the additional or alternative contention that her Army retirement payments were “by reason of a combat-related injury”, then this contention fails for lack of evidence.

Ms. Valentine made no showing that the Army or the VA ever determined that she had a “combat-related injury”. Rather, the letters Ms. Valentine received from the VA detail her “service-connected disability compensation” (emphasis added), without reference to “combat”. Assuming that the Tax Court could make a “combat-related” finding in the absence of such a ruling by the military, Ms. Valentine did not provide evidence to support such a finding. She did not allege (or provide evidence to support a contention) that her injuries were “combat-related” as required by section 104(b)(2)(C) and (b)(3) (emphasis added). In her sworn trial testimony, Ms. Valentine made no reference to combat. She offered no documentary evidence that refers to combat. As to the disability that she suffers, she made no explanation of it that would enable us to infer what caused it.[12]

Ms. Valentine Was Already Receiving What She Was Entitled to Receive as Disability Compensation

Ms. Valentine asserts that she should be able to exclude most of her Army retirement distributions reported on Form 1099R due to the VA disability determinations:

Ms. Valentine contends that, on account of her 60% and 90% VA disability determinations, she is entitled to exclude from gross income 60% of her Army retirement distributions for each of the first four months of 2016 and 90% of her Army retirement distributions for the last eight months of 2016.[13]

However, the Court notes that this is not how the law works in her case:

In so arguing, Ms. Valentine multiplies her retirement distributions by her 60% and 90% disability ratings and thereby radically misconstrues the text and meaning of section 104(a)(4) and (b)(2)(D). A retired service member may exclude a portion of her retirement distributions in an amount equal to the benefit that she “would be entitled to receive as disability compensation from” the VA, § 104(b)(4) (emphasis added), but only if she is not currently receiving excludable disability benefits from the VA, as Ms. Valentine was receiving. The legislative history supports this interpretation of section 104(b)(4). See S. Rep. No. 94-938, at 138–39, 1976-3 C.B. (Vol. 3) at 176–77.

The evidence shows that Ms. Valentine was already receiving — as disability payments from the VA — the entire amount that she was entitled to receive from the VA. A 60% disability determination (made in 2014) was applied to the first four months of 2016; and a 90% disability determination (made in May 2016) was applied to the remaining eight months of 2016. These facts indicate that in 2016 Ms. Valentine received from the VA the entire amount that she was “entitled to receive as disability compensation from the Veterans’ Administration”, for purposes of section 104(b)(4). She suggests no basis for concluding otherwise.[14]

The opinion now looks to another issue Ms. Valentine raises—that there was a retroactive determination of her disability:

At trial Ms. Valentine seemed to complicate the question by characterizing as “retroactive” the VA’s determination of her disability. A retroactive disability determination reflects the VA’s decision that a prior disability determination had been incorrect and should be corrected with retroactive effect; and it may indicate that previous payments that were deemed not allocable to a disability when paid should have been so allocated. Therefore, upon receipt of an actually retroactive disability determination from the VA, a service member may be entitled to exclude a portion of the retirement benefits that she received during the retroactive period and that (in hindsight) were mischaracterized as taxable. See Rev. Rul. 78-161.[15]

Again, the Court puts forward the facts that might support such a finding:

Ms. Valentine's “retroactive” contention might be: that after she had received her 60% and 90% disability payments, she received a retroactive determination that her disability was greater; that she was therefore entitled to disability payments greater than the VA had actually paid her in 2016; and that therefore a portion of her Army retirement paid should be excluded from gross income pursuant to section 104(b)(4).[16]

But, again the Court finds that she failed to produce evidence that any such retroactive determination had been made:

The VA made no “retroactive” disability determination for Ms. Valentine after 2016 that was “retroactive” to 2016. What Ms. Valentine’s evidence shows is only that a determination of 60% made in 2014 was applied prospectively to the first four months of 2016, and that an increased 90% determination made in May 2016 was applied contemporaneously to that month and the remaining months of 2016.

Ms. Valentine did not offer evidence to show — nor did she even allege — that the VA made any post-2016 determination of her disability, nor does she argue that any such post-2016 disability determination should be retroactively applied to 2016. Rather, the letters from the VA that she offered as evidence outline only the “current” disability benefits paid to her as of their dates of April 15 and May 27, 2016. The effective dates of her then-current disability ratings were December 1, 2014 (effective for the first four months of 2016), and May 1, 2016 (effective for the last eight months of 2016); and there is no evidence to support a contention that either of these determinations or any other was retroactive. Section 104(b)(2)(D) and (b)(4) therefore provides no basis for the exclusion she claims; and we hold that the retirement distributions Ms. Valentine received of $23,801 are properly includible in her gross income pursuant to section 61(a)(11).[17]

Misinterpreting an IRS Publication

In a footnote to the opinion, the Court did hint that Ms. Valentine may have misread an IRS Publication to come to her conclusions.  The footnote states:

Ms. Valentine cites IRS Publication 525, “Taxable and Nontaxable Income” (2016), to support her position regarding the nontaxable nature of her retirement distributions. Administrative guidance contained in IRS publications is not binding on the IRS, nor can it change the plain meaning of tax statutes. Miller v. Commissioner, 114 T.C. 184, 195 (2000).[18]

This discussion of the fact that IRS Publications aren’t binding on the IRS or the courts is standard any time a publication is raised to support a position without citing back to other, authoritative guidance.  Essentially, even if Ms. Valentine’s interpretation of what is written in the Publication is reasonable, it is only binding if the law actually reads as the Publication suggests.[19]

But in this case it turns out that we aren’t looking at a situation where the Publication was wrong about the underlying law.  Rather, the taxpayer misconstrued what she read.

Even so, Ms. Valentine misconstrues IRS Publication 525 to support her contention that a portion of her retirement distributions is nontaxable. IRS Publication 525 provides an example of the disability payment exclusion under section 104(a)(4) and corresponding limitation under section 104(b)(2)(D) and (b)(4). The paragraph entitled “Retroactive VA determination[s]” states that

[i]f [a taxpayer] retire[s] from the armed services based on years of service and [is] later given a retroactive service-connected disability rating by the VA, [the taxpayer's] retirement pay for the retroactive period is excluded from income up to the amount of VA disability benefits [the taxpayer] would have been entitled to receive.

IRS Publication 525, at 18 (emphasis added). That circumstance can be contrasted with that of a retiree who timely received a prospective disability rating and who in the first instance received from the VA the disability payments appropriate for that rating, and who was not granted any retroactive correction of that disability rating and was therefore not entitled to any retroactive disability payments.[20]

[1] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/disabled-veteran-can%e2%80%99t-exclude-retirement-payments-from-income/7dflh (retrieved April 29, 2022)

[2] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[3] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[4] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[5] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[6] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[7] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[8] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[9] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[10] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[11] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[12] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[13] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[14] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[15] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[16] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[17] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022

[18] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022, Footnote 4

[19] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022, Footnote 4

[20] Valentine v. Commissioner, TC Memo 2022-42, April 28, 2022, Footnote 4