Addition to Disability Pension Received Based on Years of Service Not Excludable Under §104

The Ninth Circuit affirmed the Tax Court’s finding in the case of Sewards v. Commissioner, 2015 TNT 92-13, CA9, No. 12-72985 aff’g 138 TC No. 15 (2012).  The issue in this case was whether the taxpayer could exclude a portion of his pension as disability income received under a worker’s compensation act.

In the case in question the taxpayer was a law enforcement officer who retired due to a service related disability.  Under the disability rules applicable to individual employed in the county he was entitled to be paid monthly an amount equal to ½ of his pay at the time he was disabled. 

However, because he had completed over 30 years of service, the payment was increased to equal the amount he would have received had he retired with a standard service pension.  Mr. Seward did not report any of the amounts he received, arguing the entire payment arose from his disability and represented a worker’s compensation payment.

The Tax Court held that Mr. Seward could not exclude the amount of his payment that represented the “extra” he received due to years of service.  The key issue was the application of Reg. §1.104-1(b) which provides (in part):

Section 104(a)(1) excludes from gross income amounts which are received by an employee under a workmen's compensation act . . . or under a statute in the nature of a workmen's compensation act which provides compensation to employees for personal injuries or sickness incurred in the course of employment. . . . However, 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.

The taxpayer argued that while the “extra” payment was determined by reference to years of service because he was solely eligible for the payment because he was disabled.  His argument was that the provision only applies when a taxpayer qualifies for a retirement allowance based on years of service independent of any disability.

The Ninth Circuit did not agree with the taxpayer’s reading of the regulation.  The panel noted:

In our judgment, however, Sewards’s interpretation is not supported by the text of the regulation. Rather, the interpretation advocated by the Commissioner aligns with the most natural reading of the regulation.

The Court noted the IRS’s interpretation was the same one the IRS had advanced for many years, finding that (in reliance on the Supreme Court’s holding in United States v. Cleveland Indians Baseball Co., 532 US 200, 220 (2001)) “[t] he IRS’s long-standing interpretation of Treasury Regulation §1.104-1(b) through Revenue Rulings is reasonable, and thus entitled to substantial deference.”

The taxpayer argued that if, in fact, the regulation should be read as the IRS claims that the regulation is invalid, because it is inconsistent with the law (IRC §104(a)(1)) and therefore is beyond the IRS’s rulemaking authority.

The Ninth Circuit noted that generally a regulation will be deemed valid if two tests are met:

·      Does the precisely address the question at issue?  If it does then there is nothing for the IRS to define and any attempt to go beyond the unambiguous language in the law would be improper. 

·      As well, the regulation itself must represent a reasonable interpretation of the text of the statute.  Note that the issue is not whether there are other reasonable readings of the statute or even if the IRS’s reading is the best available—just whether it is reasonable.

The panel found that while §104(a)(1) provides that worker’s compensation payments made for injury or sickness are excludable, the statute did not provide a means for determining whether the payment was made for those reasons.  Thus Congress had not provided an unambiguous test for determining if a payment was made under a workers compensation program for sickness or illness. 

The first requirement being met (there is some ambiguity), the only remaining issue is whether the IRS’s interpretation is reasonable.  The Court found that the IRS regulation was a reasonable method of determining which payments qualified for the exclusion.  The panel noted:

The regulation does not, as Sewards argues, create a subclass of disability pension recipients. Rather, the regulation simply clarifies when a payment is made for personal injuries or sickness, and when it is made for some other reason, such as years of service. Accordingly, the regulation is consistent with the statute.

The panel sustained the Tax Court’s ruling, finding the “additional amounts were paid not based on his injuries, but based on his years of service, and thus were not excludable.”