Reduction in Payments on Anniversary Date Did Not Convert Disability Pension into Retirement Income.

• Author: PICARD, JAMES A.

P was a police officer. Six years after he began, P was granted a disability retirement pension (due to injuries suffered in the line of duty). Under his city's disability plan (the Plan), P received 75% of his base salary until the date on which he would have completed 25 years of service. (At that point, P would have qualified for retirement had he worked continuously.) As of that date, P would receive a benefit equal to his retirement benefit. Thus, on Oct. 31, 1991, P's pension was reduced to 50% of his former base salary.

The IRS held that, as of Oct. 31, 1991, P no longer qualified for exemption under Sec. 104 and was required to report his disability pension as income. The Service assessed a deficiency against P, which he challenged. The Tax Court ruled for the IRS, but the Court of Appeals (opinion Thompson, J.) reverses; because P, at no time, qualified for regular service retirement, his recalculated benefits were still excludible.

Sec. 104(a)(1) excludes from gross income amounts received under workers' compensation acts as compensation for personal injuries. More importantly, Kegs. Sec. 1.104-1(b) limits the scope of Sec. 104(a)(1). It specifies that the Sec. 104(a)(1) exclusion does not apply to a retirement pension "to the extent that it is determined by reference to the employee's age and length of service" Consequently, whether, after Oct. 31, 1991, P's recalculated benefits are excludible from gross income depends on whether the Plan determines P's benefits by reference to his length of service.

When a disability-based retirement formally transfers to service retirement on the attainment of a certain employment anniversary, the payments received thereafter are no longer in the nature of workers' compensation but are fully taxable. P's disability benefits did not transfer to a service retirement pension. P was neither transferred out of the Plan's disability retirement system nor placed into the Plan's service retirement system. His recalculated benefits were determined by his date of hire, not by reference to his "length of service." The reduction in P's disability...