IRS agrees that payments from VA work therapy program are not includible in income.
The VA administers therapeutic and rehabilitative activities under its Compensated Work Therapy (CWT) program. The CWT program is authorized under 38 USC Section 1718 (Section 1718). It provides therapeutic work opportunities to veterans who are otherwise unable to work and support themselves. A physician's prescription is necessary to participate in the program, which is supervised by medical personnel. The participants receive payments (referred to as "distributions" in the law and by the VA) for the work they perform in the program. The VA's stated goal is to help participants attain independence and vocational functioning as they return to the work environment.
In 2000, Roosevelt Wallace participated in the CWT program. Wallace did not include the payments he received for his program work in his income on his 2000 return. The IRS issued Wallace a notice of deficiency for tax on the payments, and Wallace challenged the IRS's determination in Tax Court.
Wallace argued that the payments were veterans' benefits that were excludible from income under 38 USC Section 5301 (Section 5301) and Rev. Rul. 72-605 because they were paid under Section 1718, a law administered by the VA. Section 5301 provides that "[p]ayments of benefits due or to become due under any law administered by the Secretary [of Veterans Affairs] ... made to, or on account of, a beneficiary shall be exempt from taxation." In Rev. Rul. 72-605, which involved the predecessor version of Section 5301, the IRS stated that "payments of benefits under any law administered by the Veterans' Administration are excludable from the gross income of a recipient under section 61 of the Code."
The IRS contended that only payments in the nature of social welfare benefit payments were excludible benefits under Section 5301. Because Wallace had to work to receive payments from the CWT program, the Service reasoned the payments were compensation for work that was includible in gross income under Sec. 61, not welfare benefits. In addition, the IRS pointed to Rev. Rul. 65-18, in which the IRS ruled that the payments a patient or member receives for work performed for the VA under 38 USC Section 618 (the predecessor provision to Section 1718) are taxable payments for services rendered even though the work is intended for therapeutic or rehabilitative purposes.
Tax Court's Decision
The Tax Court held that the payments were excludible from Wallace's income as veterans' benefits. As a threshold matter, the court found that under the plain meaning of Section 5301, if the payments under the CWT program were benefits, they were excludible from income. However, finding it unclear from the plain language of Section 5301 whether the CWT payments were benefits for purposes of that section, the Tax Court concluded it was necessary to analyze Section 1718 to find the answer.
The Tax Court first noted that Section 1718's placement in Title 38, Veterans' Benefits--among provisions dealing with medical benefits for veterans--supported the conclusion that the payments were benefits. Looking at the program itself, the court found that the VA program manual describes the program as medical rehabilitative therapy designed to help veterans who have psychiatric or substance abuse problems. The Tax Court also found that the legislative history surrounding Section 1718 and its predecessor, Section 618, and an opinion from the VA's general counsel showed that Congress and the VA understood the program to be medical treatment designed to psychologically and socially rehabilitate the participant veterans, and that payments to the participants were intended to be a motivational tool in the overall treatment, not compensation for the work they performed. Therefore, given Section 1718's placement within Title 38, the nature of the program, and the understanding and intent of both the VA and Congress with respect to the program, the Tax Court ruled that the payments made as part of the program were benefits for purposes of Section 5301.
Before reaching its final conclusion, the Tax Court also considered the IRS's arguments in favor of treating the payments as taxable compensation income. It stated that, although the CWT program payments did fit the description of an item normally classified as gross income under Sec. 61 (a), this did not mean that they were not exempted from income under Section 5301. With respect to Rev. Rul. 65-18, the Tax Court noted that it did not have to give deference to a revenue ruling and that in this case it would not do so because Rev. Rul. 65-18 did not analyze whether a CWT payment is a benefit for purposes of Section 5301. Because it found that CWT payments were benefits under Section 5301 and the IRS provided no persuasive reasons for treating the payments as compensation, the court held that the payments were excludible from income.
In Action on Decision 2007-05, the IRS announced its acquiescence to the Tax Court's decision in Wallace. The IRS did not provide any reasons for its acquiescence in the AOD, simply noting that the Tax Court had rejected its position as stated in Rev. Rul. 65-18.
Rev. Rul. 2007-69
Shortly after announcing its acquiescence to the Wallace case, the IRS issued Rev. Rul. 2007-69, which reiterated its new position that CWT payments are not included in income for federal income tax purposes. In its analysis, the IRS specifically ties its new position to Sec. 134, which was enacted in 1986. Sec. 134 states that "[g]ross income shall not include any qualified military benefit" and, according to the IRS, the legislative history of the section indicates that it applies to veterans' benefits under Section 5301. In the same ruling, the IRS also held that because CWT payments are exempt from federal income tax, they are not required to be reported on an information return (i.e., a Form 1099).
Although the Tax Court presents a compelling argument in support of its decision in Wallace, the IRS routinely refuses to acquiesce to decisions striking down positions that appear more tenuous than the one it took in this case. It seems likely the IRS determined that the possible adverse publicity that might be generated by continuing to aggressively litigate against disabled--and, in some cases, homeless--veterans was not worth the relatively small amount of tax at stake.
ACTION ON DECISION 2007-05, IRB 2007-44 (10/29/2007); REV. Rut. 2007-69, 2007-49 IRB 1083 (11/16/2007).
James Beavers, J.D., LL.M., CPA
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|Title Annotation:||GROSS INCOME|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 2008|
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