The Strickland Decision (and IRR 78-161) and YouTaxes Veterans Benefits
What is the Strickland Decision?
First of all, it’s not the Strickland Act or Strickland law. The Strickland Decision is the result of a court case (Strickland versus the Commissioner). In the case Zebulon Strickland, COL (ret), USA, argued that he should not be taxed on retroactive VA disability compensation. The Tax Court disagreed and he lost. He appealed to the Fourth Circuit, Court of Appeals. He won the appeal (in 1976). The IRS did not dispute the appeal court ruling and adopted Internal Revenue Ruling (IRR) 78-161 which implemented the court’s decision.
Here are the basics of Strickland’s case. At the time of the ruling all retired military members had their military retirement reduced by one dollar for every dollar in VA benefits received (called VA offset). Strickland argued that he should be able to reduce his retired pay and hence his taxable income by the amount of VA offset that should have been taken during the retroactive time period. The appeals court agreed.
Just in case you were wondering, the case originated from an IRS imposed deficiency (tax due) of $380.99.
Does the Strickland Decision Apply to Me?
As my friends from the USAF Weapons School used to say, “It depends”. If you are retired, rated less than 50% disabled and the award of the rating is retroactive, you will qualify under Strickland and IRR 78-161. That is because for each dollar of VA disability compensation that you receive, your pension is reduced by one dollar and during the time that your claim was being adjudicated DFAS was classifying all your pay as taxable. And here is a surprise, DFAS won’t change that classification when the VA notifies them about your disability compensation. They’ll only accurately account for it going forward.
If you are retired, rated 50% or more disabled and the award of the rating is retroactive, it is likely that you will not qualify for anything under Strickland. Why is that? It has to do with Concurrent Retirement and Disability Pay (CRDP). For anyone rated 50% or more disabled that retired in 2014 or later the VA offset is not taken (for all practical purposes). You will receive your full retirement pay and the full VA disability compensation. Without an offset, there is no adjustment to make for the retroactive period.
There is one other scenario for those rated 50% or more disabled and it has to do with Combat Related Special Compensation (CRSC). CRSC applies if your disability is due to combat or combat related training. Getting CRSC, unlike CRDP, requires you to take additional action. You need to file for it with your parent service. CRSC, again unlike CRDP, is tax free. You can only receive CRDP or CRSC, not both. If you elect to receive CRSC and the start date is retroactive you should be able to reduce your taxable income by the amount of CRSC that should have been receive. It is worth noting that Strickland did not specifically address CRSC and to my knowledge, the adjustment to taxable income due to a retroactive CRSC award hasn’t been tested in the courts.
What Exactly Does the Strickland Decision Allow Me to Do?
The Strickland Decision (and IRR 78-161) allows you to do something that isn’t normally allowed. You can adjust the amount of income reported as taxable income on your return. But to avoid a letter from the IRS, you shouldn’t just put the reduced amount in the pension line on your tax return. Here is what you’ll do.
- Determine when the VA payments should have started. This is normally two months after your retirement date.
- Determine the date when DFAS starts taking the offset from your retired pay
- Multiply the number of months the VA offset wasn’t taken out of your pay times the monthly offset
- Report your retired pay as shown on your 1099-R on the pension line of your tax return (currently line 5 of Form 1040)
- On Schedule 1, Part 1, Line 8z enter the amount of offset that should have been taken as a negative number. Write IRR 78-161 in the comments (sorry, I don’t know how to do this in TurboTax…ask the box)
When Can I Take Advantage of the Strickland Decision?
You’ll definitely want to take advantage of the Strickland Decision in the year your disability claim is finalized. You can go back in time too and file an amended return if your VA claim spans more than one year. There are some time limits on how far you can go back though. Most taxpayers have 3 years from the time they filed their return to file an amended return. They can also file an amended return up to 2 years after paying the tax due, whichever is later. But there is a special rule for retired Disabled Veterans that could allow you to go past the 3/2-year limit. The law allows an extension of the statute of limitations to any taxable year which began 5 years or less than the date of the determination. Since it is extremely unlikely that the date of determination will be 1 Jan and since the vast majority of taxpayers’ tax year is a calendar year, that likely means you can amend the returns for the 4 tax years prior to the year of the letter.
There is another limitation. Amended returns based on this extension must be filed by 1 year after the letter of determination.
The courts have interpreted the law at least once and in Hass versus the United States, they came to the following determination
- Plaintiff (Haas) retired in 2001. VA rating decision on the plaintiff was issued on 1 Dec 09
- Plaintiff’s statute of limitations for filing his refund was extended one year from that date, or until 1 Dec 10
- The five-year maximum, limits the extended statute of limitation to the five tax years preceding the date of the determination
- Five years before the date of determination is 1 Dec 04
- Because the 2004 tax year began on 1 Jan 04, the 2005 tax year is the earliest year for which plaintiff may receive the benefit of the extended statute of limitations
- Plaintiff claim for refunds for 2001 -2004 are not subject to extension.
What if I Think I’ll Go Past the Statute of Limitations?
You don’t have to just take it, if you think you’ll go past the statute of limitations (make your decision early). You can file a protective claim. You file a protective claim if your right to a refund is contingent on future events (like the VA finishing the claim) and my not be determinable until after the time for filing a claim for refund expires. A protective claim preserves your right to claim a refund when the contingency is resolved.
The process for filing a protective claim is somewhat opaque. The IRS says a protective claim must:
- Be in writing and signed
- Include your name, address, social security number and other contact information
- Identify and describe the contingencies affecting the claim
- Clearly alert the IRS to the essential nature of the claim, and
- Identify the specific year(s) for which a refund is sought.
You file the protective claim the same place you would file a Form 1040X (amended return)
What the Strickland Decision Doesn’t Do
There is a rumor out there that as a result of the Strickland Decision if you are rated X% disabled you can exclude X% of your retirement pension from your taxable income. For example, if you’re rated 100% disabled, 100% of your retirement pension is tax free. When I hear about this people normally reference IRS Pub 525, page 18. I believe this to be a misinterpretation of the IRS Pub. People also say they’ve told DFAS to stop withholding, which DFAS does, and this proves the income is tax-free. If you ask DFAS to stop your withholding they’ll do it. That doesn’t mean that your income is tax-free. It just means DFAS is following your instructions (yes, it does occasionally happen). Update: The Tax Court recently ruled in line with what I believed.
Putting a Bow on the Strickland Decision
The Strickland Decision and IRR 78-161 apply in a relatively small number of cases (and if some proposed legislation is ever approved, it might not apply in any situations). But if it does apply to you, it could reduce your taxes significantly, especially if you have a large family. Since the end result of taking advantage of the Strickland Decision is a reduction of your Adjusted Gross Income (AGI), it could not only reduce the amount of your taxable income but it could increase the amount of credits you are eligible for. You could see tax reductions in excess of 30% of the amount you decrease your income.
Military Finances are Different
The Strickland Decision and IRR 78-161 is just one of the many unique tax and financial situations facing retired or retiring Senior Military Officers and NCOs. That’s why we think you should work with a financial planner or advisor that deals with military finances each and every day. Give us a call to chat about how the Strickland Decision applies to you or to see how we can help you get your financial life squared away.
If you found this article useful, you might like the following blog posts:
If You Get the VA Funding Fee Refunded, Do You Pay Taxes on It?
Can the VA Reduce My Disability Rating?
Is VA Long-Term Care a Replacement for Long-Term Care Insurance?