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

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 benefits, creating parity between disability and regular service retirees, did not, by itself, amount to a conversion of his benefits. The IRS argued, and the Tax Court held, that P's benefits formally transferred to service retirement and thereby became taxable.

P's benefits, however, were not determined by reference to his age or length of service. The Tax Court attempted to reconcile this apparent distinction by determining that, in P's case, the Plan "deem[s] time spent on disability as equivalent to time spent actively working, and counting both in setting the date when a disabled employee was treated as if he had taken service retirement, with a corresponding adjustment to his retirement payments"

This attempted distinction misapplies the facts of this case. The fundamental question in determining whether benefits are excludible under Sec. 104(a)(1) is "on what basis were the retirement payments in question paid?" At the time his benefits were reduced, P qualified only for disability retirement benefits. Had P become "able" just one day before his benefit reduction, he would have qualified for neither service nor disability retirement benefits. To hold in favor of the Service, we would have to hold that benefits are determined by reference to length of service, even though a beneficiary would not qualify for a nondisability-based retirement. The facts of this case do not permit such a holding.

We conclude that the reduction in P's payments on the twenty-fifth anniversary of his date of hire did not convert his disability pension into a retirement pension. Because P's benefits were determined neither by reference to his age nor his length of service, his recalculated benefits remain excludible from income under Sec. 104(a)(1).

James A. Picard, 9th Cir., 1/26/99, rev'g TC Memo 1997-320