Rev. Rul. 80-44

ISSUE

Are amounts received by an employee and the employee's survivors excludable from gross income under the provisions of either section 104(a)(1) or section 105(d) of the Internal Revenue Code under the circumstances described below?

FACTS

Under statutes adopted by City M, any individual employed by M may retire on account of a disability that is incurred in such employment and is compensable under the workmen's compensation act of the state, provided that written notice is given to the city board of the intended retirement and its effective date, and provided further that a medical examiner, after examining the individual, certifies that the individual is mentally or physically incapacitated for the further performance of duty, that the incapacity is likely to be permanent, and that the individual should be retired. The statutes provide in general, that the service-connected disability retirement allowance shall be an amount equal to the greater of (A) 60 percent of the individual's average final compensation, or (B) the amount to which the individual would be entitled under the ordinary, nonoccupational disability pension provisions of M's statutes (a pension based on years of service). Under these statutes the individual may elect to decrease the retirement allowance in order to increase the survivor's benefit to the employee's spouse.

Neither the occupational disability plan nor the nonoccupational disability plan is contributory.

As a result of a service-connected injury, A, an employee of M, retired in 1978 pursuant to the disability retirement provisions of the city plan. Because of years of service, A was entitled to an allowance of 80 percent of average final compensation. A elected to receive that allowance because it is greater than the disability retirement allowance of 60 percent of average final compensation. A's average final compensation was $200 per week.

LAW

Section 61(a) of the Code and the Income Tax Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived, including compensation for services.

Section 104(a)(1) of the Code provides, with certain exceptions not pertinent to this case, that gross income does not include amounts received under workmen's compensation acts as compensation for personal injuries or sickness.

Section 1.104-1(b) of the regulations states that section 104(a)(1) of the Code excludes from gross income amounts received by an employee under a workmen's compensation act or under a statute in the nature of a workmen's compensation act that provides compensation to the employee for personal injury or sickness if those curred in the course of employment. However, the exclusion under section 104(a)(1) does not apply to a retirement pension or annuity to the extent that it is determined by reference to the employee's age or length of service, or the employee's prior contributions, even though the employee's retirement is occasioned by an occupational injury or sickness.

Section 105(d) of the Code provides, subject to certain limitations, that gross income does not include amounts received by an employee through accident or health insurance for personal injuries or sickness in-amounts constitute wages or payments in lieu of wages for a period during which the employee is absent from work on account of permanent and total disability. Generally, for taxable years beginning after December 31, 1976, the exclusion is available only if the taxpayer is retired on disability, was permanently and totally disabled at the time of retirement, and has not reached age 65 before the end of the taxable year.

ANALYSIS AND HOLDINGS

The lifetime benefits in question here are authorized by a statute that provides benefits to a class restricted to employees with service-incurred disabilities. These benefits are thus payments for those disabilities. Accordingly, this statute is a statute in the nature of a workmen's compensation act. Rev. Rul. 72-291, 1972-1 C.B. 36; Rev. Rul. 72-44, 1972-1 C.B. 31.

The allowance received by an employee under the service connected disability retirement provisions of M's statutes is therefore excludable from a recipient's gross income under section 104(a)(1) of the Code to the extent that the allowance (before any reduction to increase the survivor's benefit) does not exceed 60 percent of the recipient's average final compensation. The excess of that allowance (before any reduction to increase the survivor's benefit), if any, is attributable to the length of service and is not excludable under section 104(a)(1). See Rev. Rul. 72-44.

A's average final compensation was $200 per week, so that A receives an allowance of $160 (80 percent of average final compensation). Of this amount, $120 (60 percent X $200) is treated as workmen's compensation and is excludable under section 104(a)(1) of the Code. $40 (20 percent X $200) is attributable to years of service and is not excludable under section 104(a)(1). However, this amount is excludable from gross income to the extent permitted by section 105(d) for years in which the requirements of that section are met. See Rev. Rul. 58-43, 1958-1 C.B. 45, which applies section 105(d) to military disability retirement pay in excess of the amounts that are excludable under section 104(a)(4).

If an employee elects to reduce the employee's lifetime allowance in order to increase the survivor's benefit, the reduction is attributable pro rata among the components of the lifetime allowance. Thus, if as a result of such an election A's lifetime benefit were to be reduced to $100 per week, $75 (120/160 X $100) of the amount is treated as workmen's compensation. The balance, $25, is attributable to years of service and is not excludable under section 104(a)(1) of the Code. This $25 is excludable to the extent permitted by section 105(d) for taxable years in which the requirements of that section are met.

The resulting increase in survivor's benefits is directly attributable to a reduction in the employee's lifetime benefits. The percentage of the increase equal to the percentage of lifetime benefits excludable under section 104(a)(1) of the Code is thus a continuation of lifetime section 104(a)(1) benefits. This percentage of the increase thus qualifies as payments under a workmen's compensation act to survivors of a deceased employee, and under section 1.104-1(b) of the regulations it is excludable from gross income under section 104(a)(1). As a result, 75 percent (120/160) of any increase in benefits to A's survivors is excludable under section 104(a)(1).