Tax planning for armed forces personnel.

Clients serving in the U.S. Armed Forces are subject to many special rules that may provide tax savings opportunities. Part I of this two-part article examines income inclusions and exclusions, the special exclusion for combat zone duty, various adjustments to income, dependency exemptions and itemized deductions.

EXECUTIVE SUMMARY

* MAFs are defined as commissioned officers or enlisted personnel in all regular and reserve units under jurisdiction of the Secretaries of the Defense, Army, Navy or Air Force (including the Coast Guard).

* "Service in a combat zone" includes any period a MAF is absent from duty due to sickness, wounds, leave or internment by the enemy or other lawful cause.

* A dependency exemption generally cannot be claimed for a person who is a MAF or in attendance at an Armed Forces academy.

Due to the recent deployment of U.S. Armed Forces personnel in the Balkans and their continuing presence in the Persian Gulf region, tax practitioners need to know the special tax provisions applicable to members of the U.S. Armed Forces (MAFs). Part I, below, addresses income inclusions and exclusions, combat zone exclusions, adjustments to income, exemptions and itemized deductions.

Definition

For Federal tax purposes, MAFs are defined by Sec. 7701 (a)(15) and Regs. Sec. .301.7701-8 as commissioned officers or enlisted personnel in all regular and reserve units under jurisdiction of the Secretaries of the Defense, Army, Navy or Air Force (including the Coast Guard).

Income

Generally, payments received by MAFs are taxable for Federal income tax purposes. However, under special rules, certain items of income may or may not be includible.

Inclusions

According to IRS Pub. 3, Armed Forces' Tax Guide, the following items received by a MAF are includible in gross income (unless the combat zone exclusion applies, as discussed below):

* Basic pay: active duty; attendance at a designated service school; back wages; drills; reserve training; training duty.

* Special pay: aviation career incentives; diving duty; foreign duty (i.e., outside the 48 contiguous states and Washington, DC); hostile fire; imminent danger; medical and dental officers; nuclear-qualified officers; special duty assignment pay.

* Bonuses: enlistment; reenlistment.

* Other payments: accrued leave on separation; mustering out; personal allowances paid to high-ranking officers; student loan repayment from certain programs (i.e., General Educational Loan Repayment Program).

Exclusions

Sec. 134(a) states that gross income does not include any "qualified military benefit" defined by Sec. 134(b)(1) as any allowance or in-kind benefit (other than personal use of a government-provided vehicle) received by a MAE former MAF or his dependent. The following items are excludible from gross income, according to Armed Forces' Tax Guide:

* Living allowances: basic allowance for housing (BAH); basic allowance for subsistence (BAS); housing and cost-of-living allowances abroad (whether paid by the U.S. or a foreign government); variable housing allowance. (Sec. 265(a)(6) provides that mortgage interest and real estate taxes on a personal residence are deductible even if paid from a BAH.)

* Family allowances: certain educational expenses for dependents; emergencies; evacuation to a place of safety; separation.

* Death allowances: burial services; death gratuity payments (up to $3,000) to eligible survivors; travel of dependents to burial site.

* Moving allowances: dislocation; move-in housing; moving household and personal items; moving trailers or mobile homes; storage; temporary lodging and related expenses.

* Travel allowances: annual round trip for dependent students; leave between consecutive overseas tours; reassignment in a dependent-restricted status; transportation for a MAF and his dependents during ship overhaul or inactivation.

* Other payments: defense counseling; disability; group-term life insurance; professional education; ROTC educational and subsistence allowances; survivor and retirement protection plan premiums; uniform allowances; uniforms furnished to enlisted personnel.

* In-kind military benefits: legal assistance; space-available travel on government aircraft; medical and dental care; commissary/exchange discounts.

Foreign-Source Income 

The Sec. 911(a)(1) foreign earned income exclusion does not apply to earned income of military and civilian employees of the U.S. Government. For this purpose, "U.S. Government employees" include those working at Armed Forces post exchanges, officers' and enlisted personnel clubs and embassy commissaries, and similar personnel paid from nonappropriated funds. However, foreign-source income earned by military or civilian employees or their spouses from sources other than the U.S. Government may be eligible for the foreign earned income exclusion. The items listed above as excludible continue to be excludible regardless of the availability of the foreign earned income exclusion. For 1999, the foreign earned income exclusion is $74,000, under Sec. 911(b)(2)(D)(i).

Combat Zone Exclusion

MAFs serving in a combat zone can exclude certain payments from income.

Definition: Under Sec. 112(c), a "combat zone" is any area the President designates by Executive Order (EO) as an area in which the U.S. Armed Forces are engaging or have engaged in combat. The EO also designates the dates on which the area becomes and ceases to be a combat zone.

Sec. 112(a) and (b) permit the total exclusion of such compensation paid to personnel and commissioned officers. Regs. Sec. 1.112-1 (b) (4) provides that a payment can be excluded whether or not received while in a combat zone, during hospitalization or in a year different from that in which the service was rendered. The rule is merely that the payment must have fully accrued in a month during any part of which the MAF served in the combat zone or was hospitalized anywhere as a result of wounds, disease or injury incurred while serving in a combat zone. (The hospitalization exclusion is not available for compensation received for service more than two years after the President declared the termination date of combatant activities in the combat zone.)

According to Armed Forces' Tax Guide, enlisted personnel, warrant officers and commissioned warrant officers can exclude the following from income:

1. Active duty pay earned in any month of service in a combat zone.

2. Imminent danger or hostile fire pay.

3. Reenlistment bonus, if the voluntary extension or reenlistment occurs in a month of service in a combat zone.

4. Pay for accrued leave earned in any month of service in a combat zone.

5. Pay received for duties as a MAF in clubs, messes, post and station theaters and other nonappropriated fund activities. The pay must be earned in any month of service in a combat zone.

6. Awards for suggestions, inventions or scientific achievements submitted in a month of service in a combat zone.

7. Student loan repayments attributable to a period of service in a combat zone.(1)

According to Regs. Sec. 1.112-1(a)(1)(i), the entire month's pay is excluded, even if combat zone service was for less than an entire month. Sec. 112(c)(4) clarifies that the combat zone exclusion does not apply to retirement pay and pensions.

Timing' Regs. Sec. 1.112-1(b)(4) states that the actual time and place of payment are irrelevant in considering whether compensation is excludible; rather, the time and place of the entitlement to the compensation determine whether it is excludible. Thus, the timing of certain payments may be adjusted to qualify for the combat pay exclusion.

Example 1: While serving in a combat zone, X, an enlisted MAE submitted an employee suggestion eligible for a cash award. X was awarded cash for the suggestion three years after he last served in a combat zone. The award is excludible from income as combat zone compensation; X completed the actions necessary to win the award while serving in a combat zone.(2)

Example 2: While serving in a combat zone, Y, an enlisted MAE voluntarily reenlisted. He received a reenlistment bonus when he was no longer serving in a combat zone. The bonus is excludible from income as combat zone compensation, because Y completed the actions necessary for entitlement to the reenlistment bonus while serving in a combat zone.(3)

Service in a combat zone: Regs. Sec. 1.112-1(b)(1) defines "service in a combat zone" to include any periods a MAF is absent from duty due to sickness, wounds, leave or internment by the enemy or other lawful cause. A MAF who becomes a prisoner of war or missing in action in a combat zone is deemed to continue in active service therein as long as he remains so classified. According to Regs. Sec. 1.112-1(e)(1), service in a combat zone includes service (1) in direct support of military operations in a combat zone or (2) that qualifies for special pay for duty subject to hostile fire or imminent danger.

Regs. Sec. 1.112-1(a)(4) provides that military pay received for the above services qualifies for the combat zone exclusion if the requirements are otherwise met. The following military service is deemed performed in a combat zone and does not qualify for the Sec. 112 exclusion:

1. Presence in a combat zone while on leave from a duty station located outside the combat zone.

2. Passage over or through a combat zone during a trip between two points outside a combat zone.

3. Presence in a combat zone solely for personal convenience.

Under Sec. 3401 (a)(1), military pay attributable to service in a combat zone should not be included in Form W-2, Box 1, marked "wages, tips, other compensation" If otherwise excludible pay is reported on Form W-2, a corrected Form W-2 should be requested from the appropriate finance officer. Military pay for service in a combat zone is subject to Social Security and Medicare taxes, however.

Exclusion amount: Sec. 112(b) and (c)(5) state that, for commissioned officers (other than commissioned warrant officers), the exclusion amount is limited to the highest rate of basic pay at the highest pay grade applicable for that month to any enlisted MAE plus any imminent danger or hostile fire pay received for each month during any part of which the officer served in a combat zone or was hospitalized as a result of service therein.

Regs. Sec. 1.112-1(c)(1) and (3) state that, if a MAF is hospitalized while serving in a combat zone, the wound, disease or injury will be presumed to have been incurred therein unless there is clear evidence to the contrary. A wound, disease or injury may be determined to have been incurred during service in a combat zone, even though the MAF was not hospitalized until after he left the combat zone.

Telephone excise tax: Sec. 4253(d) provides that the Sec. 4251 telephone excise tax is not imposed on any toll telephone service that originates in a combat zone. For calling card or collect calls, an exemption certificate must be furnished to the telephone service receiving payment for the call. The certificate may be obtained from the telephone service provider.

Adjustments

Two "above the line" adjustments to income may particularly affect MAFs.

IRAs

For individual retirement arrangement (IRA) purposes, Sec. 219(g)(6)(A) provides that MAFs (including members of reserve units) who have served more than 90 days on active duty are deemed to be active participants in an employer-maintained retirement plan. MAFs and taxpayers serving in support of the Armed Forces in a designated combat zone are granted a 180-day extension under Sec. 7508(a) to make qualified retirement contributions to an IRA.(4)

Due to the combat zone exclusion, a MAF may have little or no taxable compensation for the tax year and may not be eligible to make IRA contributions. Excess contributions made during the year should be withdrawn to avoid the Sec. 4973 6% excise tax.

Moving Expenses

Under Sec. 217(g), MAFs required by military order to relocate due to a permanent change of station do not have to meet the usual time and distance tests to deduct moving expenses. Regs. Sec. 1.217-2(g)(3) defines a permanent change of station to include:

1. A move from home to the first post of active duty.

2. A move from one permanent post of duty to another.

3. A move from the last post of duty to home or to a nearer point in the U.S., if the move occurs within one year of ending active duty or according to the Joint Travel Regulations (37 USC Sections 404-411).

Regs. Sec. 1.217-2(g) (5) states that, if a MAF's spouse or dependent moves to or from a different location than does the MAE he is deemed to have commenced work at a new principal place of work within the same general location as the location to which the MAF moved.

If a MAF deserts, is imprisoned or dies while on active duty, a permanent change of station for the spouse or dependent includes a move to the place of enlistment or to his member's, his spouse's or dependent's home of record or nearer point in the U.S.

Allowances and reimbursements: Under Regs. Sec. 1.217-2(g)(2), the. value of moving and storage services provided to a MAE spouse or dependent by the government in connection with a move to a permanent change of station is not includible in income. Any reimbursement of such expenses is likewise excludible, except to the extent it exceeds the actual expenses incurred. The respective moving expenses are not deductible, except to the extent they exceed the reimbursement received.

Deductible moving expenses: Unreimbursed moving expenses may be deducted under Sec. 217(b) if incurred for the taxpayer and members of his household. According to Armed Forces' Tax Guide, deductible moving expenses are limited to the following:

1. The cost of moving household goods and personal effects, including expenses for hauling a trailer, packing, crating and in-transit storage and insurance.

2. Reasonable travel and lodging expenses from the old home to the new home, including actual automobile expenses (or 10 cents per mile) and airfare. Meal expenses are not deductible.

Foreign moves: Under Regs. Sec. 1.217-2(h), a foreign move is a relocation from (1) the U.S. or its possessions to a foreign country or (2) one foreign country to another. A foreign move is not a move from a foreign country to the U.S. or its possessions. A foreign move permits deduction of the moving expenses described above, plus:

1. Cost of moving household goods and personal effects to and from storage.

2. Storage costs for part or all of the period during which the new place of work continues to be the principal place of work.

Exemptions

Under Sec. 151, for 1999, a $2,750 exemption may be claimed for the taxpayer, his spouse and each dependent. According to Sec. 151 (d) (2), a dependent for whom an exemption is claimed cannot claim a personal exemption on his own return.

Requirements

A dependency exemption can be claimed if all the following five tests are met(5):

1. Member of household or relationship test (Sec. 152(a)).

2. Gross income test (Sec. 151(c)(1)(A)).

3. Joint return test (Sec. 151(c)(2)).

4. Citizenship test (Sec. 152(b)(3)).

5. Support test (Sec. 152(a)).

The citizenship test and the support test may be of special interest to MAFs.

Citizenship Test

To meet the Sec. 152(b)(3) citizenship test, the person claimed as a dependent must be a U.S. citizen or resident, or a resident of Canada or Mexico. Generally, children are citizens or residents of the country of their parents. If a taxpayer was a U.S. citizen when his child was born, the child is a U.S. citizen for Federal income tax purposes, even if the other parent was a nonresident alien and the child was born in a foreign country.(6) If the child lives abroad with a nonresident alien parent, the taxpayer can claim a dependency exemption for the child if the child is a U.S. citizen and the other tests are met. Sec. 152(b) states that if a taxpayer legally adopts a child who is not a U.S. citizen or resident, he can claim a dependency exemption for the child if the other tests are met.

Support Test

To meet the Sec. 152(a) support test, the dependent must receive more than half of his support from the taxpayer during the year. "Support" includes, under Regs. Sec. 1.152-1(a)(2)(i), amounts spent to provide food, shelter, clothing, education, medical and dental care, recreation, transportation and similar necessities. Special rules apply for children of divorced or separated parents.

MAFs Can authorize an allotment from their pay for the support of their dependents. The amount authorized is considered provided by the taxpayer in determining whether he furnished more than half of the dependent's support.(7) If an allotment is used to support persons other than those the taxpayer designates, the taxpayer can claim dependency exemptions for those persons if the other dependency tests are met.

A dependency exemption generally cannot be claimed for a person who is a MAF or in attendance at an Armed Forces academy. A MAF or academy student will not be an eligible dependent, because the government will be furnishing more than half of his support. However, if the dependent receives only partial support from the Armed Forces, a dependency exemption can be claimed if the taxpayer provides more than half of the support and the other tests are met.(8)

Itemized Deductions

The following deductions may be of interest to MAFs who itemize.

Travel Expenses

A taxpayer can deduct under Sec. 162(a) (2) unreimbursed travel expenses incurred while traveling away from home on work-related business, Travel expenses incurred to visit family members while on furlough, leave or liberty are nondeductible personal expenses.

The travel must be away from home. For this purpose, home is the permanent duty station, regardless of where the MAF or his family lives.(9) Sec. 162(a) (2) travel expenses include reasonable expenses necessary and directly attributable to the conduct of the taxpayer's business. Examples include travel fares, meals (subject to the 50% limit), lodging and other incidental expenses, under Regs. Sec. 1.162-2(a). If a period of temporary employment is for more than one year, expenses for travel away from home are not deductible.

Reservists: A MAF serving on temporary active duty in the reserves can deduct travel expenses if he keeps his regular job while on active duty, returns to that job after release and is stationed away from the general area of his regular job or business. Deductible travel expenses include meals and lodging incurred at the official military post to the extent they exceed the BAH and BAS.(10)

Transportation Expenses

Transportation expenses include expenses of traveling from one workplace to another, but not those of traveling away from home. Unreimbursed transportation expenses are deductible if incurred by the taxpayer going from one workplace to another while on duty. However, the expenses of going to and from a regular place of work are nondeductible commuting expenses.(11)

Educational Expenses

Certain educational expenses may be deductible. According to Regs. Sec. 1.162-5, education expenses that qualify include tuition, books, related supplies, transportation expenses, meals (subject to the 50% limit) and lodging. (Education services provided in-kind, including base-provided transportation to or from class, are not deductible.) Education expenses are deductible if the education (1) maintains or improves skills required in the taxpayer's present position or (2) is required by an employer or by law or regulations for the taxpayer to keep his salary, status or job. Educational expenses are nondeductible if the education (1) is necessary to meet the minimum educational requirements needed to qualify the taxpayer in his current trade or business or (2) qualifies the taxpayer for a new trade or business.

Example: A U.S. Navy line officer's assignments involved command and administration of personnel. He incurred educational expenses in pursuing a Master of Arts in Personnel Administration. He could deduct his educational expenses; the courses were closely related to his employment duties and served to maintain or improve the skills required in his current position.(12)

Uniforms

Generally, under Regs. Sec. 1.262-1(b) (8), expenses for uniform cost and maintenance are nondeductible, because the uniforms must be worn while on duty and may be worn when off duty. However, if military regulations prohibit the wearing of certain uniforms while off duty, their cost and maintenance are deductible to the extent they exceed any allowance or reimbursement.(13) Clothing that does not replace regular clothing (e.g., insignia of rank, corps devices, epaulets, aiguillettes and swords) are deductible.(14) Reservists' uniforms are deductible if they can be worn only while performing reservist duties.(15)

Conclusion

In the January 2000 issue, Part II of this article will discuss forgiveness of tax liabilities and filing requirements and extensions.

(1) See Rev. Rul. 73-187, 1973-1 CB 51, amplifying Rev. Rul. 71-343, 1971-2 CB 92.

(2) Regs. Sec. 1.112-1(b)(5), Example 4.

(3) Regs. Sec. 1.112-1(b)(5), Example 5.

(4) See IRS Pub. 3, Armed Forces' Tax Guide, "Extension of Deadline."

(5) These tests are discussed in Koski, "Parental Support Tax Savings Opportunities," 30 The Tax Adviser 792 (November 1999).

(6) See Rev. Rul. 71-44, 1971-1 CB 49.

(7) See Rev. Rul. 70-87, 1970-1 CB 29.

(8) See Rev. Rul. 55-347, 1955-1 CB 21.

(9) See Rev. Rul. 67-438, 1967-2 CB 82, modifying Rev. Rul. 55-571, 1955-2 CB 44.

(10) See Rev. Rul. 63-64, 1963-1 CB 30.

(11) See Rev. Rul. 90-23, 1990-1 CB 28, amplified by Rev. Rul. 94-47, 1994-2 CB 18.

(12) See Rev. Rul. 69-199, 1969-1 CB 51.

(13) See Rev. Rul. 67-115, 1967-1 CB 30; IRS Letter Ruling 8120036 (2/18/81).

(14) See Rev. Rul. 62-122, 1962-2 CB 12.

(15) See Rev. Rul. 55-109, 1955-1 CB 261.

Larry R. Garrison, Ph.D., CPA Professor of Taxation University of Missouri--Kansas City Armed Forces Kansas City Personnel (Part 1)