Tax planning for armed forces personnel.

EXECUTIVE SUMMARY

* Tax liability forgiveness is available for MAFs in a variety of circumstances.

* For a deceased MAF who filed jointly, the amount of tax liability forgiven is determined by use of a formula.

* A MAF may qualify for an automatic extension to file and pay until June 15 without filing Form 4868.

Clients serving in the U.S. Armed Forces are subject to many special rules that may provide tax savings opportunities. Part II of this two-part article examines forgiveness of tax liability, filing requirements and extensions and recent developments.

U.S. Armed Forces personnel are subject to many special rules that may provide tax savings opportunities. Part I of this two-part article, in the last issue, examined income inclusions and exclusions, the special exclusion for combat zone duty, various adjustments to income, dependency exemptions and itemized deductions. Part II, below, analyzes forgiveness of tax liability, filing requirements, extensions and recent developments.

Forgiveness of Tax Liability

Combat Zone

Under Sec. 692(a)(1)and Regs. Sec. 1.692-1(a), if a U.S. Armed Forces member (MAD dies while in active service in a combat zone (as determined under Sec. 112) or from wounds, disease or other injury received there, his income tax liability is forgiven for the tax year in which death occurred and for any earlier tax year ending on or after the first day he served in a combat zone in active service. According to Sec. 692(a)(2),if the forgiven tax liability has been previously paid, the tax is credited or refunded. Unpaid taxes from prior years are forgiven; prior years' taxes paid after the date of death (DD) are credited or refunded. A reduction in estate taxes under Sec. 2201 is also available for MAFs dying under the above circumstances.

For MAFs serving outside a combat zone, tax liability is forgiven under Sec. 692(c) and Regs. Sec. 1.112-1(e)(1) if the service was (1) in direct support of military operations in a combat zone and (2) qualified for special military pay for duty subject to hostile fire or imminent danger.

Sec. 692(b) provides that the DD for a MAF in a missing status (as defined in Sec. 6013(f)(3)(A), either as missing in action or as a prisoner of war) is the date the MAF's name was removed from missing status for military pay purposes, regardless of the actual DD.

Terroristic or Military Action

Tax liability forgiveness is also available under Sec. 692(c)(1) for a taxpayer who (1) was a military or civilian U.S. employee on the DD and (2) died from wounds or injuries incurred while a U.S. employee in a terroristic or military action outside the U.S. This rule applies to the tax year in which the individual died and to any earlier tax year beginning with the year before the one in which the wounds or injuries occurred.

A "terroristic or military action" is defined by Sec. 692(c)(2) as any (1) terroristic activity outside the U.S. directed against it or its allies or (2) military action outside the U.S. involving the U.S. Armed Forces resulting from violence or aggression against the U.S. or its allies. A U.S. "ally" includes any multinational force in which the U.S. is a participating member, according to Sec. 692(c)(3).

Claiming Tax Forgiveness

Rev. Proc. 85-35(16) should be followed to claim tax forgiveness for MAFs who have died in a combat zone or as a result of terroristic or military action outside the U.S. Form 1040 needs to be fried if a tax return has not been filed for the tax year. If a tax return has been fried, a claim for refund on Form 1040X, Amended U.S. Individual Income Tax Return, should be filed for each year subject to forgiveness. The appropriate returns are sent to: Internal Revenue Service Center, P.O. Box 267, Covington, KY 41019, Attn: Stop 2.

A statement should be attached to the return that includes a computation of the decedent's tax liability before deducting the amount forgiven and the amount to be forgiven under Sec. 692(c). Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, should also be attached.

A certification from the Department of Defense or State should also be attached. The certification from the Department of Defense is authorized by Form DOD 1300, Report of Casualty, for its military and civilian employees. For civilian employees of other agencies, certification is by letter signed by the Director General of the Foreign Service, Department of State or appropriate representative. The certification must include the decedent's name and Social Security number, the date of injury, the DD and a statement that the individual died in a combat zone or from terroristic or military action outside the U.S. If the individual died from terroristic or military action, the statement must also include the fact that he was a U.S. employee at the date of injury and at the DD.

If the decedent fried a joint return, only his share of the combined income tax liability is eligible for forgiveness.(17) To determine the decedent's part, the individual filing the claim must:

1. Compute the income tax for which the decedent would have been liable had a separate return been fried.

2. Compute the income tax for which the spouse would have been liable had a separate return been fried.

3. Multiply the joint tax liability by a fraction, the numerator of which is (1) above and the denominator of which is the sum of (1) and (2) above. The result is the decedent's tax liability eligible for forgiveness.

Example: M and P filed a joint income tax return for 1999. M died in 2000 while in active service in a combat zone. M's tax forgiveness for 1999 is computed as follows:

                      Total income  M's income  P's income

Income                $75,000         $50,000     $25,000
Standard deduction      7,200           3,600       3,600
Exemption(s)            5,500           2,750       2,750
Taxable income        $62,300         $43,650     $18,650
Income tax            $11,848         $ 9,424     $ 2,798

M's tax forgiveness           $9,424/$12,222 x $11,848 = $9,136

Filing Requirements

Where to File

Generally, a Federal income tax return is sent to the service center for the area in which the taxpayer lives, regardless of his permanent home address. For MAFs with an APO or FPO address, the return should be sent to: Internal Revenue Service Center, Philadelphia, PA 19255-0215.(18)

Extensions

According. to Regs. Sec. 1.6081-5 (a)(6) and (d), MAFs may qualify for an automatic extension until June 15 without filing Form 4868, Application for Automatic Extension of Time to File U.S. Income Tax Return, if either of the following applies:

1. The taxpayer lives outside the U.S. and Puerto Rico and his main place of business or post of duty is outside those areas.

2. The taxpayer is in military or naval service on an assigned tour of duty outside the U.S. and Puerto Rico for a period that includes the entire due date of the return.

Unlike most filing extensions, this rule applies to both filing the return and paying any tax due. Regs. Sec. 1.6081-5 (b) requires a statement to be attached to the return (when filed) stating that the above requirements were met. The Form 4868 instructions state that an additional two-month filing extension to August 15 may be requested by filing Form 4868 by June 15 and writing "Taxpayer Abroad" across the top.

Taxpayers can request an additional two-month filing extension beyond August 15 by filing Form 2688, Application for Additional Extension of Time To File U.S. Individual Income Tax Return. This extension is not automatic; Regs. Sec. 1.6081-1(b) requires a statement containing the reasons for requesting the additional extension. Form 2688 must be filed before the expiration of the previously extended due date.

Combat zone personnel: Sec. 7508(a) states that, for MAFs serving in a combat zone (or individuals serving in support of the Armed Forces), the deadline for filing returns and refund claims and paying taxes is extended. ("Support personnel" includes Red Cross personnel, accredited correspondents and civilian personnel acting under the direction of the Armed Forces.) The IRS's deadlines for examinations, assessments and collections are also extended when a taxpayer is a MAF in a combat zone. The deadline is extended for at least 180 days after the later of the last day (1) the taxpayer was in a combat zone (or the area qualified as a combat zone) or (2) of any continuous qualified hospitalization for injury from service in the combat zone.(19) According to Pub. 3, the deadline is additionally extended by the number of days left as of the date a MAF entered the combat zone to perform a required act or take action with the IRS.

Sec. 7508(a)(1) and Pub. 3 state that the deadline extension provision applies to (1) filing an income, estate or gift tax return (except employment and withholding tax returns); (2) paying income, estate or gift tax (except employment and withholding taxes); (3) filing a petition with the Tax Court for redetermination of a deficiency or for review of a Tax Court decision; (4) filing a claim for credit or refund; (5) bringing suit for a claim for credit or refund; (6) assessment of tax by the IRS; (7) giving or making notice or demand by the IRS for the payment of tax or for liability for tax; (8) collection by the IRS of tax due; (9) bringing suit by the U.S. for tax due; or (10) any other act required or permitted under the Code (e.g., making a qualified retirement contribution to an individual retirement account).

For the deadline extension to apply, hospitalization must be the result of an injury received while serving in a combat zone. "Qualified hospitalization" is defined by Sec. 7508(g) to include hospitalization outside the U.S. and the first five years of hospitalization in the U.S.

Sec. 7508(c) and (g), flush language, provide that the deadline extension applies to the spouse of a MAF serving in a combat zone (or support personnel), but does not apply to a spouse for any (1) tax year beginning more than two years after the date the area ceases to be a combat zone or (2) period the qualifying individual is hospitalized in the U.S. for injuries incurred in a combat zone.

Reservists on active duty and MAFs not in a combat zone may nevertheless be eligible to defer the payment of back taxes. To be eligible, Rev. Proc. 57-25(20) states that the taxpayer generally must be serving in his initial period of service and show that his ability to pay the back taxes has been materially impaired.

The term "initial period of service" means (1) the period of active duty for which a taxpayer is inducted into the service, (2) the period of active duty under the first enlistment of a taxpayer in the armed service, (3) the period of service, prior to any reenlistment, following recall of the taxpayer to active duty from an inactive reserve or National Guard unit or (4) the first period of reenlistment (for a taxpayer who has been out of the service for one year or more). For officers, the initial period of service is limited to the first two years following entry into the service under 1-4 above.

Deferment is premised on the taxpayer's written request, accompanied by satisfactory evidence, that his ability to pay has been materially impaired due to his military service. The request must include the taxpayer's name, Social Security number, monthly income and source before military service, current monthly income, military rank, date military service was entered and the date the taxpayer is eligible for discharge. If the request is granted by the IRS, deferment is limited to the initial period of service, plus six months.

Example 1(21): J entered a combat zone on Dec. 1, 1.997 and remained there through March 31,1999, when she returned to the U.S. J was not injured and did not return to the combat zone. The due dates for filing J's 1997-1999 returns are as follows:

Ford's 1997 return, the due date is Jan. 10,2000,285 days (180 + 105 days) after her last day in the combat zone (March 31, 1999). The 105 additional days are the number of days in the three-and-a-half-month filing period that were left when she entered the combat zone (January 1-April 15).

For J's 1998 return, the due date is also Jan. 10, 2000, 285 days (180 .+ 105 days) after J's last day in the combat zone (March 31, 1999).

For J's 1999 return, there is no extension. The 180-day extension period after March 31, 1999 ended on Sept. 27, 1999, before the start of the filing period for the 1999 return.

Example 2(22): B entered a combat zone on Jan. 5,1998 and remained there until Feb. 15, 1998, when he was injured and returned to a hospital in the U.S. B remained in the hospital through April 21, 1999. The due dates for filing B's 1997-1999 returns are as follows:

For B's 1997 return, the due date is Jan. 27, 2000, 281 days (180 + 101 days) after his last day in the hospital (April 21, 1999). The 101 additional days are the number of days in the three-and-a-half-month filing period that were left when he entered the combat zone (January 1-April 15).

For B's 1998 return, the due date is Jan. 27, 2000, 281 days (180 + 101 days) after his last day in the hospital (April 21, 1999).

For B's 1999 return, there is no extension. The 180-day extension period after April 21, 1999 ended on Oct. 18, 1999, before the start of the filing period for the 1999 return.

Signing Returns

Generally, both a husband and wife must sign a joint return, under Regs. Sec. 1.6013-1(a)(2). However, if a spouse cannot sign because of disease or injury, oral permission may be granted, allowing the well spouse to sign the return for the ill spouse. The ill spouse's name is signed on the appropriate line, followed by the words "By [name], Husband (or Wife)"A dated and signed (by the well spouse) statement should be attached to the return that includes the form number, tax year, reason the ill spouse could not sign the return and the fact that the ill spouse consented to the signing of the return.(23)

According to Regs. Secs. 1.6061-l (a) and 1.6012-1(a)(5), if a spouse cannot sign the return for reasons other than disease or injury (e.g., he is overseas on military duty), the U.S. spouse may sign for the absent spouse by filing Form 2848, Power of Attorney and Declaration of Representative, designating that the spouse who remains in the U.S. can sign the return for the absent spouse. A copy of Form 2848 should be attached to the return.

Sec. 6013(f)(1) and (2) provide that a MAF declared to be in a missing status in a combat zone can file a joint return, even if the missing spouse died before the tax year subject to the joint return.

A surviving spouse can file a joint return for the year a decedent spouse died. In the Form 1040 signature area, "Filing as surviving spouse" should be written. If an executor or administrator has been appointed, he signs on the line in which the decedent would have signed the return.(24)

Regs. Sec. 1.6081-1(b)(4) states that, when it is not possible for a MAF's spouse to obtain his signature to either file a joint return or complete Form 2848, the IRS will accept a written statement attached to the return explaining that the spouse is serving in a combat zone.

Recent Developments

Operation Joint Endeavor

Under P.L. 104-117,(25) a "qualified hazardous duty area" is treated as if it were a combat zone, retroactive to Nov. 21,1995. The qualified hazardous duty area includes Bosnia and Herzegovina, Croatia and Macedonia.

MAFs deployed overseas away from their permanent duty station and serving as support personnel for Operation Joint Endeavor (now Operation Allied Force) are treated as if in a combat zone for deadline extension purposes. Such personnel are not entitled to other combat zone tax benefits.

Operation Allied Force

Under P.L. 106-21,(26) a "qualified hazardous duty area" is treated as if it were a combat zone, retroactive to March 24, 1999. The qualified hazardous duty area includes the Federal Republic of Yugoslavia (Serbia/Montenegro), Albania, the Adriatic Sea and the Ionian Sea north of the 39th parallel. MAFs deployed overseas away from their permanent duty station and serving as support personnel for Operation Allied Force are treated as if they are in a combat zone for the deadline extension purposes. Such personnel are not entitled to other combat zone tax benefits.

Conclusion

Present law suspends the period of time for performing various acts under the Code for MAFs serving in an area designated as a combat zone. With the current presence of MAFs at various locations throughout the world, tax advisers need to be aware of the special rules that may apply.

(16) Rev. Proc. 85-35, 1985-2 CB 433

(17) Regs. Sec. 1.692-1(b); Rev. Rul. 85-103,1985-2 CB 176, amplifying Rev. Rul. 78-1, 1978-1 CB 199

(18) See IRS Pub. No. 3, Armed Forces tax Guide (1998) (hereinafter, "Pub. 3"), "Where to File."

(19) See id., "Extension of Deadline."

(20) Rev. Proc. 57-25, 1957-2 CB 1092.

(21) Adapted from an example in Pub. 3, note 18 supra, "Extension of Deadline."

(22) Id.

(23) Regs. Sec. 1.6012-1(a)(5); Rev. Rul. 70-216, 1970-1 CB 265.

(24) See IRS Pub. No. 17, Your Federal Income Tax (1998), "Married Filing Jointly."

(25) P.L. 104-117, Legislation Regarding Tax Treatment of U.S. Peacekeeping Personnel Sewing in Bosnia, 104th Cong., 2d Sess. (1996).

(26) P.L. 106-21, Legislation to Extend the Tax Benefits Available with Respect to Services Performed in the Federal Republic of Yugoslavia (Serbia/Montenegro) and Certain Other Areas, 106th Cong., 1st Sess. (1999).

Larry R. Garrison, Ph.D., CPA Professor of Taxation University of Missouri--Kansas City Kansas City, MO