Tax Season 2019: Disabled veteran's nontaxable disability severance pay

This Just In! The Military Taxpayer

          After the text went to print a new development was finally implemented by DFAS and the IRS. In December the Combat-Injured Veterans Tax Fairness Act of 2016 (See Attachment 1) was signed into law. This law codifies the decision in United States District Court, E.D. Virginia, Richard C. ST. CLAIR and Gudrun E. St. Clair, Plaintiffs, v. UNITED STATES of America, Defendant. 778 F. Supp 894 (or the St. Clair opinion), dealing with veterans discharged from active service since 1991 with a medical lump sum disability severance. This affects veterans discharged between 1991-2016, the DFAS started reporting the lump sum severances correctly on W2’s in 2017 and forward.
          When a military member is discharged from service due to a medical issue they are many times given a lump sum severance based on the disability and length of service. Until the St. Clair opinion in 1991 the IRS held the position that this was taxable income regardless of the fact most of these veterans had to have an equal amount withheld from the Veterans Administration Disability Pension to “repay” the severance over the course of future years. Veterans in this situation were able to make a claim under the Right of Repayment (§1341) in the future years that the VA withholding occurred. Unfortunately, for the most part, this did the veteran no good due to the rules of that code section.
          In 1991 when the St. Clair opinion was issued the US District Court for the Eastern District of Virginia ruled that Mr. St. Clair’s severance was not taxable in the year received and he was due a refund for the taxes on that sum. The IRS did not acquiesce on this decision and, while we have been able to file amendments claiming the St. Clair decision, the acceptance by the IRS has been hit and miss. This Act will correct that problem.
          Many taxpayers and tax professionals have been using the “St. Clair Claim” as a coverall for every veteran discharged who then receives a VA disability award later and this has been part of the problem with the IRS consistency in processing these claims. The requirements under St. Clair and this new act are very specific and targeted at disability discharges for specific causes.
          To qualify for the new Act or under St. Clair the veteran’s severance must be for a disability AND the disability must meet one or the other of the below listed circumstances:

1. You have a combat related injury or illness as determined by your military service at separation that:

· Resulted directly from armed conflict; or

· Took place while you’re engaged in extra-hazardous service; or

· Took place under conditions simulating war, including training exercises such as maneuvers; or

· Was caused by an instrumentality of war.

2. You are receiving VA disability compensation, or you have received notification from the VA approving such compensation.

Since 1991 the US Armed Forces have done several Reduction In Forces programs where service members were offered a lump sum severance to leave the service early. These programs do not qualify under this Act, even if they later receive a VA Disability award unless that award directly attributes their disability award to be related to circumstance 1 above. In this case the veteran will NOT get a letter from DFAS and will need to provide a copy of their VA Disability Award letter to prove eligibility and a copy of their separation letter or DD214 to prove the amount of the lump sum severance.

Veterans who have already been deemed eligible should receive a letter from DFAS in July/August 2018 (see sample Attachment 2) that includes instructions and the dollar amount of their eligible severance. If the separation date is outside of the normal statute of limitations for filing an amendment, they have an extended date for filing that is one year after the date on their DFAS letter. That means it has a short life span for the veterans with older separation dates.

The IRS has given veterans a safe harbor to use a standard refund amount based on the year of separation. This is the quick and easy way to claim the refund and can help if the veteran cannot obtain a copy of their tax return for the year in question. The safe harbor amounts are:

· $1750 for tax years 1991-2005

· $2400 for tax years 2006-2010

· $3200 for tax years 2011-2016

The 1040X is a shell with the personal information, line 15 and line 22 completed. (See Attachment #3 for a sample).

This is the quickest and easiest route for the veteran to use to receive their refund, however, this amount may be larger or smaller than the actual tax depending on individual facts and circumstances.

If the veteran cannot obtain the tax return or other substantiation of return information for the year in question this may be the only alternative. But, if the veteran can provide the return or a transcript then then a full amended return should be calculated to see if the actual amount of the refund would be more then the safe harbor amount. See attachment #4 for an example of how much a difference this can make.

Also, if the taxpayer filed an original MFJ return and is no longer with that spouse and cannot get cooperation in signing an amendment from that spouse they may have to use the safe harbor. However, they may be able to use IRS Rev. Rul. 80-8 to file the amendment with just one signature and have the refund directed solely to the veteran.

Regardless of the method used to calculate the refund the return should have “Veterans Disability Severance” or “St. Clair Claim” across the top of both pages of the 1040X, an explanation in Part three, and attach a copy of the DFAS letter or other substantiation.

If the claim is for a year out of the statute of limitations it is advisable to attach a clearly marked copy of the original return for substantiation as the IRS processors may or may not be able to access the original return, remember we are talking about claims as far back as 1991.

We have no information currently about any of the individual states concurrence on the extended statute of limitations for filing amendments in connection with this Act. The best advice is to check with your individual state for an opinion from their legal department.

DFAS Guidance

Combat-Injured Veterans Tax Fairness Act of 2016

On December 16, 2016, the President of the United States signed into law the Combat-Injured Veterans Tax Fairness Act of 2016, which provides eligible veterans the right to seek a refund of taxes they may have paid on Disability Severance Pay. The Defense Finance and Accounting Service (DFAS) and the Internal Revenue Service (IRS) are jointly responsible for ensuring that affected separated members receive notification of their rights under this new law.

During July 2018, DFAS and the IRS sent letters to approximately 130,000 separated military members who had received disability severance pay as income and with federal tax withholding applied.

In accordance with IRS’s current policy, IRS agreed to forward these letters to separated members on behalf of DFAS because DFAS does not have current addresses for individuals affected by the new law. The IRS has not disclosed address or any other tax information to DFAS.

A small number of potentially affected individuals do not have mailing address information available to the IRS. Veteran and retiree organizations are being asked to share this information with their membership to inform their members who received disability severance pay so they will be able to take advantage of the IRS instructions below and recover withholdings which are now considered non-taxable.

ELIGIBILITY

Eligibility to file an amended federal tax return to receive a refund from the IRS depends on the circumstances of your separation.

Disability Severance Pay is not taxable or subject to federal income tax withholding for members meeting 1 or 2 below:

1. You have a combat related injury or illness as determined by your military service at separation that:

· Resulted directly from armed conflict; or

· Took place while you’re engaged in extra-hazardous service; or

· Took place under conditions simulating war, including training exercises such as maneuvers; or

· Was caused by an instrumentality of war.

2. You are receiving VA disability compensation, or you have received notification from the VA approving such compensation.

STATUTE OF LIMITATIONS

The amount of time for claiming these tax refunds is limited. However, the law grants veterans an alternative timeframe - one year from the date of the letter from DoD. Veterans making these claims have the normal limitations period for claiming a refund or one year from the date of their letter from the DoD, whichever expires later. As taxpayers can usually only claim tax refunds within 3 years from the due date of the return, this alternative time frame is especially important since some of the claims may be for refunds of taxes paid as far back as 1991.

If you believe you are eligible for or would like to request a refund of taxes, you must seek a refund from the IRS by following the IRS’s instructions below.

WHAT TO DO

Complete and mail IRS Form 1040X, Amended U.S. Individual Income Tax Return, for the year you received Disability Severance Pay, along with a copy of this letter (See note below), to the IRS’s Kansas City address at:

Internal Revenue Service
333 W. Pershing Street, Stop 6503, P5
Kansas City, MO 64108

NOTE: Veterans eligible for a refund who did not receive a letter from DoD may still file Form 1040X to claim a refund but must include both of the following to verify the disability severance payment:

* A copy of documentation showing the exact amount of and reason for the disability severance payment, such as a letter from the Defense Finance and Accounting Services (DFAS) explaining the severance payment at the time of the payment or a Form DD-214, and

* A copy of either the VA determination letter confirming the veteran's disability or a determination that the veteran's injury or sickness was either incurred as a direct result of armed conflict, while in extra-hazardous service, or in simulated war exercises, or was caused by an instrumentality of war.

ATTENTION: Veterans that did not receive the DoD letter and do not have the required documentation to file a claim for refund should contact the National Archives, National Personnel Records Center, or the Department of Veterans Affairs.

You can submit a claim based on the actual amount of your Disability Severance Pay by completing Form 1040X and following the instructions carefully. Don’t request a refund based on the actual amount if you have previously done so.

You can choose instead to claim the standard refund amount listed below that reflects the year you received your Disability Severance Pay. Simply write “Disability Severance Pay” on Form 1040X, line 15, and enter the standard refund amount listed below on line 15, column B, and on line 22, leaving the remaining lines blank.

· $1,750 for tax years 1991-2005

· $2,400 for tax years 2006-2010

· $3,200 for tax years 2011-2016

Claiming a standard refund amount is the easiest way to request a refund because it doesn’t require you to find your original tax return or ask the IRS for information from the return. This may be larger or smaller than the refund based on the actual amount from your return. You can submit a claim for the standard refund amount even if you already filed a claim for the actual amount. If you do this, you can only claim the difference between the standard refund amount above and the amount you previously claimed that was attributable to Disability Severance Pay.

HOW TO FILE YOUR CLAIM

Please write either “Veteran Disability Severance” or “St. Clair Claim” across the top of the front page of the Form 1040X that you will be submitting and provide an explanation in Part III of why the Disability Severance Pay is not taxable to you.

ADDITIONAL INFORMATION

You can get more information on this issue at IRS.gov. You can also get Form 1040X online or by calling 800-TAX-FORM (800-829-3676). If you have questions, visit the Recent Developments section of the Form 1040X web page or call the IRS toll-free at (833) 558-5245, ext. 378, between 7 a.m. and 7 p.m. (Alaska and Hawaii follow Pacific time). If you prefer, you can write to the IRS at the Kansas City address above.

Exhibit 1 - Letter from the IRS on behalf of the DoD