Rev. Rul. 55-88

Further questions have been presented with respect to the treatment for Federal income tax purposes of retired pay received by retired members of the `uniformed services' under the provisions of the Career Compensation Act of 1949, 63 Stat. 802. Advice has also been requested relative to the withholding of tax under section 1622 of the Internal Revenue Code of 1939 from such retirement payments.

Section 22(b) of the Internal Revenue Code of 1939 relating to exclusions from gross income provides in part as follows:

(5) COMPENSATION FOR INJURIES OR SICKNESS.-* * * 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; * * *

Section 402 of the Career Compensation Act of 1949, supra , sets forth the requirements to qualify for disability retirement pay. Under this section it is necessary that the percentage of disability in accordance with the Veterans Administration rating schedule be 30 percent or more to entitle a member or members to disability retirement pay unless he has at least 20 years of active service in which case the percentage of disability may be less than 30 percent. Where the member has completed less than 8 years of active service he shall not be eligible for any disability retirement pay regardless of percentage of disability except when the disability results from an injury not the result of intentional misconduct or willful neglect of such member or was the proximate result of the performance of active duty.

Section 402(h) of the Act reads as follows:

That part of the disability retirement pay computed on the basis of years of active service which is in excess of the disability retirement pay that a member would receive if such disability pay were computed on the basis of percentage of disability shall not be deemed to be a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed service in the armed forces of any country within the meaning of section 22(b)(5) of the Internal Revenue Code, as amended.

Section 411 of the Career Compensation Act, supra , provides substantially that pursuant to such regulations as the President may prescribe certain members or former members of the uniformed services retired prior to October 1, 1949 for physical disability and who are now receiving or are entitled to receive retirement pay for physical disability may elect, within the 5 year period following October 1, 1949,

(A) To qualify for disability retirement pay under the provisions of this Act and, dependent on his qualification, shall be entitled to receive either the disability retirement pay or the disability severance pay prescribed in this title; * * * or

(B) To receive retired pay or retirement pay computed by one of the two methods contained in section 511 of the Act: * * *

A member or former member of the uniformed services retired for physical disability prior to October 1, 1949, who elects to have his retired pay or retirement pay computed by one of the two methods contained in section 511 of the Act may receive-`(a) the monthly retired pay, retainer pay, or equivalent pay in the amount authorized for such members and former members by provisions of law in effect on the day immediately preceding the day of enactment of this Act, * * * or (b) monthly retired pay, retirement pay, retainer pay, or equivalent pay equal to 2 1/2 per centum of the monthly basic pay of the highest Federally recognized rank, grade or rating whther under a permanent or temporary appointment, satisfactorily held, by such member or former member as determined by the Secretary concerned and which such member, former member, or person would be entitled to receive if serving on active duty in such rank, grade, or rating, multiplied by the number of years of active service creditable to him.'

The questions presented are set forth below: Reference to `the Act' means the Career Compensation Act of 1949, supra .

1. Will a member heretofore retired for physical disability who elects to have his retired pay computed in accordance with one of the two methods set out in section 511 of the Act be liable for Federal income taxes with respect to any part of such retired pay?

Assume that a member who was previously retired for disability resulting from active service elects to have his retired pay computed in accordance with one of the two methods set out in section 511 of the Act:

(a) If he elects to have his disability retired pay computed in the amount authorized therefor by provisions of law which were in effect prior to October 12, 1949, the pay is exempt under the provisions of section 22(b)(5) of the Code.

(b) If he elects to have his disability retirement pay computed on the basis of years of active service, it will, under the provisions of section 402(h) of the Act, be exempt under section 22(b)(5) of the Code to the extent that it does not exceed the disability retired pay that he would have received if such pay were computed solely on the basis of disability. The exemption granted by section 22(b)(5) of the Code does not apply to that part of the disability pay computed on the basis of years of active service which is in excess of the pay that he would receive if it were computed solely on the basis of percentage of disability.

2. Will a taxable portion of a lump sum received under an election retroactive to October 1, 1949, be taxable in (a) the year it is made, (b) the year when the lump sum is received, or (c) should it be allocated to the prior year or years for which paid?

Section 42 of the Code provides in part that all items of gross income shall be reported for the taxable year in which received by the taxpayer unless under the methods of accounting permitted by section 41 of the Code any such amounts are to be properly accounted for as of a different period. Inasmuch as a member or a former member would not have a legal right to the additional income prior to his election the taxable portion of the lump sum payment should be included in his gross income for the year in which it is received if he is on the cash basis and in the year of election if he is on the accrual basis.

3. Will an election retroactive to October 1, 1949 for the purpose of changing computation of disability retirement pay or the retired or retainer pay, be also retroactive so as to change the taxable status of such pay? For example: A who was retired prior to October 1, 1949, for physical disability has been receiving $550 a month nontaxable retired pay. On October 1, 1953 he elects to qualify for disability retirement pay and on the basis of 30 years of active duty is entitled to $716.06 a month (2 1/2 percent times $954.75 basic pay under the Act times 30) disability retirement pay. His percentage of disability at the time of his retirement in accordance with Veterans Administration rating schedule is determined as 30 percent. Under section 402(h) of the Act $286.43 of A's disability retirement pay would be excluded from gross income ($954.75 times 30 percent) and $429.63 a month would be included as part of his gross income. A would receive a lump sum payment in 1953 of $7,970.88 representing 48 times the difference between his previous pay of $550 and his newly determined pay of $716.06 a month. However, he has treated the $550 a month received for the 4-year period as nontaxable income. If the taxable status of A's disability retirement pay is retroactively changed, he would have been entitled during the 4-year period to an aggregate exclusion of only $13,749.64 whereas he actually excluded an aggregate of $26,400.00 from gross income during the 4-year period.

The amount of exempt retirement pay ($550 per month) received by A under prior law for the period prior to the date of the election, October 1, 1953, was properly treated as exempt from Federal income tax under section 22(b)(5) of the Code and the exemption thereof will not be disturbed for the years or months prior to the election. The amount of the new retirement pay ($716.06 per month) received for periods subsequent to the date of the election is exempt to the extent that it does not exceed the `percentage of disability' pay ($286.43 per month), and the balance ($429.63 per month) is subject to tax in accordance with the provisions of section 402(h) of the Act. The extent to which the statutory increase in the retirement pay for the period prior to the date of the election, October 1, 1953, is taxable depends on the extent to which the new pay based on years of service exceeds (1) the `percentage of disability' pay or (2) the exempt pay received under prior law, whichever is greater. The latter item, since it is already exempt under a prior law, cannot be disregarded in making the comparison for the purpose of section 402(h) of the Act. Thus, in the case of A, since the exempt pay under prior law, $550, exceeds his `percentage of disability' pay, $286.43, the difference of $166.06 per month ($716.06, new pay, minus $550, previously exempt pay) for 48 months (the period from October 1, 1949, to October 1, 1953), or $7,970.88 ($166.06 times 48), the entire amount of the lump sum payment is taxable in 1953 when received. However, had the exempt `percentage of disability' pay exceeded the exempt pay received under a prior law it is the proper amount to be compared with the new pay in determining the limitation applicable under section 402(h) of the Act to the retroactive pay received for the period prior to the election as well as for the periods subsequent to the election.

4. The Act of May 27, 1944, 58 Stat. 230, authorizes a member entitled to receive retirement pay for military service to waive as much of such retirement as he may be entitled to receive as a pension or compensation under laws administered by the Veterans Administration. See I.T. 3739, C.B. 1945, 61. Suppose in the case illustrated in question 3 A waived $90.00 of his disability retirement pay in order to receive a pension in like amount from the Veterans Administration under the above-cited law. His rate of disability at the time of his retirement is determined at 30 percent. Will he under section 402(h) of the Act be required to report as his gross income for Federal income tax purposes $429.63 or only $339.63? The $90 a month pension received from the Veterans Administration is, of course, nontaxable income.

He will be required to report $429.63 and may exclude from gross income the amount of $286.43 as in the preceding case. There is no statutory basis for assuming that the waiver of $90 applies to the taxable item of $429.63. A further exemption from income tax must be supported by an express statutory provision.

5. Section 402 of the Act provides that under certain circumstances members of the armed services shall be placed on the temporary disability retired list for a period of not longer than five years. Under subsection (d) thereof it is provided `That disability retirement pay of any member whose name is carried on the temporary disability retired list shall, for so long as his name is carried on such list, he not less than 50 per centum of the basic pay upon which the computation is based.' In a case where the rated disability is 30 percent, and the member had no more than 20 years of service, is the difference between the 30 percent of basic pay and the 50 percent of basic pay included in gross income within the meaning of section 402(h) of the Act, or would the entire 50 percent received be excluded from gross income under section 22(b)(5) of the Code.

Section 402(d) of the Act permits the member who is retired for disability resulting from active service to elect to receive disability retirement pay computed either on the basis of years of service or on the basis of percentage of disability, provided that the resulting pay shall be not less than 50 per centum of the basic pay upon which the computation is based. Where the pay computed on the method elected is less than the minimum 50 percent pay, the difference represents pay of the same character as the pay to which he is entitled under the method elected, i.e., pay based on percentage of disability or pay based on years of service, as the case may be.

If the former, the entire 50 percent pay received is excluded from gross income as exempt; if the latter, it is, under the provisions of section 402(h) of the Act, exempt under section 22(b)(5) of the Code to the extent that it does not exceed the disability retired pay that he would have received if such pay were computed solely on the basis of disability. Sec. I.T. 4017, C.B. 1950-2, 12. The exemption granted by section 22(b)(5) of the Code does not apply to that part of the disability pay computed on the basis of years of active service which is in excess of the pay that he would receive if it were computed solely on the basis of percentage of disability.

6. Further, continuing question 5, if the member had 24 years of service, which would give him 60 percent of basic pay, is the difference between the 60 percent and 50 percent minimum the taxable part under section 402(h) of the Act, or is the entire difference between the 60 percent and the 30 percent, which is his rated disability, taxable?

The entire difference between the 60 percent pay and the 30 percent pay, based on his rated disability, is taxable. See the last sentence in the answer to Question 5.

7. Will the withholding of income tax be based upon the total amount of disability retirement pay of the retired member or only that part which exceeds an amount computed on the basis of the member's percentage of disability?

Withholding will be required only on that part of the retirement pay which exceeds an amount computed on the basis of the member's percentage of disability. See section 402(h) of the Act of 1949, supra , sections 1621(a) and 1622(a) of the Code and Regulations 120, section 406.207(a)(2).

8. How should the withholding tax be computed on lump sum payments in cases where a retroactive election is made?

Withholding is required in the year in which the lump sum payments are made and only on that part which is held to be includible in gross income. See section 402(h) of the Career Compensation Act of 1949, supra , and the answer to question 2.

I.T. 4017, C.B. 1950-2, 12, amplified