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where "averageable income" exceeds $3,000. These rules are designed to ease the tax bite for taxpayers having unusual fluctuations of income. The computation must include an averaging of taxable income for the 4 preceding tax years; it will be made on a Schedule "G", Form 1040; and the tax is paid on the current year's return. Returns for previous years are not amended or revised in any way to accomplish the averaging.

Reservists who received readjustment pay and later serve on active duty and qualify for retirement on the basis of 20 years of active service may receive retired pay subject to an immediate deduction equal to 75% of the readjustment pay, without interest. Note that this does not apply to reservists who qualify for nonregular retirement pay at age 60 on the basis of completion of 20 years of active and inactive service.

The receipt of lump-sum severance pay by Regular Navy officers does not deprive them of any retirement benefits from the United States, except that there must be deducted from each retirement payment the amount attributable to the service for which severance pay was paid until the amount deducted equals the lump-sum.

If these people elected to take a reduced amount of retired pay in order to provide a Retired Serviceman's Family Protection Plan annuity for surviving widows and children, a question exists as to the precedence of this reduction and deductions made on account of previously received readjustment or severance pay lump sums. The question of precedence has yet to be decided by the Comptroller General of the United States. After his decision it may develop that further questions will be presented to the Internal Revenue Service. For example, will the portions of lump-sums deducted from retired pay constitute nonentitlement to pay so as to be excluded from gross income or will they require the member to itemize deductions in order to obtain any income tax benefit? The Internal Revenue Service has been contacting the military and naval services because it presently has this particular question under consideration. Another complication results from the fact that proposed legislation to revise the taxability of RSFPP may shed an entirely different light on the subject-but more will be said about this later.

6. The Retired Serviceman's Family Protection Plan (RSFPP) was thoroughly discussed, under its former name "Uniformed Services Contingency Option Act", in Volume XV, No. 2, JAG JOURNAL (March 1961).

RETIREMENT

NONDISABILITY FOR AGE OR YEARS OF SERVICE

Retired pay (if retired for reasons other than physical disability resulting from active service), retainer pay, and retired pay of enlisted members transferred from the Fleet Reserve to the retired list for reasons other than physical disability resulting from active service, is taxable in full and subject to withholding of Federal (but not State) income taxes. In some cases physical defects are noted but found neither to be disabling nor to disqualify a member from the performance of his duties, and the awarded nondisability retired pay is then fully taxable. Navy and Marine Corps officers not recommended for continuation on the active list under the so-called "Hump Act" receive a taxable lump-sum payment of $2,000, which lump-sum has not been found to cause severe income tax problems.

DISABILITY RETIREMENT

In general, a member who, while entitled to basic pay, incurs a physical disability of sufficient severity to render him unfit to perform the duties of his rank or rating, is eligible for transfer to a disability retired list with pay, provided he has the requisite amount of years of active service or a large enough percentage of disability. In this connection, during a period of national emergency, as has existed since December 1950, a disability of at least 30% is required. unless the member has performed 20 years of active service."

A member may be transferred directly to the Permanent Disability Retired List (PDRL), but more often he is transferred to the Temporary Disability Retired List (TDRL) where he may remain for a period not to exceed 5 years. He will be examined periodically while on the TDRL, and at any time during, or at the termination of, the five year period, may be found fit for duty, transferred to the PDRL, separated from the naval service and paid the disability severance pay discussed earlier, or be medically or administratively discharged from the naval service.

Disability retired pay is computed by multiplying the rate of a member's basic pay by either the percentage of his disability or the sum of his years of active service times 212%. A member is entitled to elect the method of computation which will provide the greater amount. While

7. 10 U.S.C. § 1201.

a member is on the TDRL, a minimum of 50% of his basic pay is payable to him, regardless of his percentage of disability or number of years of service. A provision in 37 U.S.C. 115 formerly granted a flat 75% of active duty pay he was receiving to a member who retired after having served in World Wars I and II, but that provision of law has now been repealed.

TEMPORARY DISABILITY RETIRED LIST

If a member has received a 30% disability rating and has accumulated eleven years of active service, his basic pay multipliers would be 30% based upon his disability and 2712% based upon his years of service. A tax problem arises in the matter of deciding which method of computation to elect, even though retired pay will be 50% of basic pay in either instance. Because of a revenue ruling, a member would exclude from gross income the entire 50% of basic pay if he were to elect to receive retired pay on the basis of percentage of disability, but could exclude only 30% of basic pay (not 30% of retired pay) if, for some reason, he were to elect to receive retired pay on the basis of years of active service.

Let us suppose a member has received a 10% disability rating and accumulated 24 years of active service. His retired pay when computed on the basis of the 10% disability rating would amount to a minimum of 50% of basic pay while he remained on the TDRL, and all of this pay would be excluded from gross income for Federal income tax purposes. He would not receive a Form W-2 withholding statement, for such retirement pay would not be reportable as wages or income. If, however, the member's retired pay were computed on the basis of his accumulated 24 years of active service he would be entitled to receive 60% of his basic pay as retired pay. What amount of this 60% can be excluded from gross income? Is the 50% tax-free minimum "locked in", that is to say, is the member irrevocably entitled to it, or can he exclude only 10% of basic pay? The Internal Revenue Department has ruled that he can exclude only 10%. In many instances this ruling might not adversely effect the member's tax situation, because "sick pay" and the retirement income credit could greatly reduce or even eliminate the tax bite. However, such would not be the case if the retired member were to lose his "sick pay" exclusion due to his being employed by the Federal Government or having earned income or social security benefits large enough to eliminate 8. 26 U.S.C. § 104 (a) (4), as limited by 10 U.S.C. § 1403.

37

the retirement income credit. More will be said about these matters later.

PERMANENT DISABILITY RETIRED LIST

PDRL disability retired pay is also computed by multiplying the rate of a member's basic pay by either the percentage of his disability or the sum of his years of active service times 212%. An exception arises in the case of a member retired after having served in World I and II, as discussed earlier. A second exception arises in the case of a member who retired prior to the enactment of the Career Compensation Act of 1949. Such a member was entitled to receive 75% of his base pay as disability retired pay, all of which was tax-exempt. Under the 1949 Act, a member so retired could elect to have his retired pay recomputed on the basis of his accumulated years of service times 212% times basic pay, which recomputation would sometimes result in an amount greater than the amount computed by the old base pay method.

As in the case of TDRL retired pay, PDRL retired pay computed on the basis of percentage of disability times rate of basic pay is totally tax-exempt. Note, however, that the 50% basic pay minimum which applies to members on the temporary list does not apply when the member is transferred to the permanent list. Retired pay computed on the basis of accumulated years of active service is also excluded from gross income in an amount equal to basic pay multiplied by percentage of disability.

The foregoing are illustrated by the following examples: If a member's percentage of disability is 60%, and his accumulated active years of service equals 22 years (22 years times 212%=55%), he should elect to receive the greater retired pay based upon the 60% disability, for his pay would then be entirely tax free. On the other hand, a member with 30 years of accumulated active service and a 10% disability rating should elect to receive 75% of basic pay based upon years of service (30 years times 212%=75%). He could exclude 10% of basic pay because of his disability rating. The Navy Finance Center computes this disability exclusion for members and does not withhold taxes therefrom or report the amount as wages on Form W-2 withholding tax statements. The excess is included in "wages" subject to withholding, but the retired member, as on the TDRL, may find some tax relief in the "sick pay" and retirement income credit provisions.

The nice thing about this percentage exclusion is that it does not terminate at "retirement

NOVEMBER-DECEMBER 1964

age" as does "sick pay" which will be discussed later. Both exclusions, however, are slated for close review by the Treasury and the Congress.

POST RETIREMENT

Various post retirement factors can reduce or eliminate Federal income taxes.

RETIRED SERVICEMAN'S FAMILY PROTECTION PLAN

A member who has a valid RSFPP election in force at retirement thereby receives a reduced amount of retired pay. Under present Internal Revenue Service rulings he gets no income tax exclusion for the amount by which his retired pay is reduced, but the aggregate of reductions constitutes recoverable annuity "cost" to his survivors. The entire "present worth" is included in a deceased retired member's estate, frequently at the cost of heavy state inheritance taxes and occasionally Federal estate taxes.9

The rulings were appealed in 1961 and met with a flat refusal. They were again appealed in 1962 and this resulted in promises by the Internal Revenue Service and the United States Treasury Department to fully support legislation to remedy the harsh tax burden imposed upon the serviceman's self and survivor retirement plan.

Subsequently the Treasury Department and Internal Revenue Service augmented DOD Legislative Proposal 88-50 to equate the Federal income and estate tax burden of the RSFPP to private and other governmental plans. They even provided transitional rules designed to make living retired members and surviving widows (and children) "whole", tax-wise, without the need for filing hundreds of thousands of refund claims. Not everyone can be made whole, such as the case in which a retired member was formerly employed at a large salary which put him in high Federal and state income tax brackets, and now is fully retired and in the low tax brackets.

The legislative item, which was transmitted to the 88th Congress on 8 April 1964, provided that the retired member and his survivor would each include in gross income only the amount each received. In nondisability cases the retired member would have included only his reduced retired pay in gross income, and his widow would have reported the amount she received. The widow of a disability retired member would have been entitled to exclude her annuity in the

9. Supra note 6.

same proportion that her husband's retired pay had been excluded. The "present worth” at a retired member's death would have been excluded from his gross estate as being attributable to the Government's contribution. The transitional rules were designed to enable retired members to recover amounts previously deducted from their retired pay. If death intervened before full recovery was made, the widows would have been entitled to the remainder. As it stands today, the proposal is slated for early introduction in the 89th Congress in 1965.

VETERANS ADMINISTRATION COMPENSATION Many retired servicemen qualify for Veterans Administration disability compensation and elect to waive an equal amount of retired pay in order to receive the tax-free compensation. This neatly reduces taxable nondisability retired pay. It has no effect upon disability retired pay computed solely on percentage of disability but runs into a snag when disability retired pay computed on years of service is only partly excludable on percentage of disability. The Internal Revenue Service holds that the waiver applies first to the tax-free portion, then to the taxable part. It goes without saying that a member would elect to receive Veterans Administration compensation in lieu of all of his retired pay if the former were greater.

SICK PAY

A "sick pay" exclusion is available where disability retired pay received on the basis of 21% % of basic pay for each year of service exceeds that excluded on percentage of disability. We call the excess "continued wages" for "sick pay" exclusion computations. The exclusion terminates at "retirement age", set out below, and does not apply unless disability retirement pay is attributable to a physical disability resulting from active service as distinguished from in line of duty. Many members are retired from the Fleet Reserve because of a nonservice physical disability, incurred in line of duty, but not resulting from active service. The exclusion also does not apply to nondisability retired pay even though the retired member is sick or hospitalized.

"Retirement age" is attained at the time when service would have been completed had a member continued on active duty, or the age, as indicated in the following tables:

Navy and Marine Corps:

Enlisted: 30 years service regardless of age.

Warrant Officers, Male: 30 years service or age 62 with 20 years service, whichever is earlier.

Warrant Officers, Female: 30 years service or age 55 with 20 years service, whichever is earlier. Commissioned Officers, Male: 40 years service or age 62,10 whichever is earlier. Commissioned Officers, Nurses:

30 years service or age 55, whichever is earlier, for Lieutenant Commanders and above at time of retirement for disability.

20 years service or age 50, whichever is later, for below Lieutenant Commander at time of retirement for disability.

Commissioned Officers, Others, Female: 30 years service or age 55, whichever is earlier, for Commanders and above, at time of retirement for disability; age 50 for below Commander.

Under current income tax law the exclusion of retired pay is limited to a weekly rate of $75 or the first 30 days, with a 7-day waiting period unless hospitalized before attaining "retirement age," if a member retires while performing active duty, and $100 per week thereafter. An extra computation is required if a member becomes absent from active duty on account of injury or sickness and is retired during the first 30 days of absence without returning to active duty.

The reason for this is that under 1964 rules no portion of wages continued by an employer during the first 30 days of absence is excludable as "sick pay" if the amount paid an employee exceeds 75% of his regular weekly rate of wages. Active duty pay, being 100% of regular wages, does not qualify for a sick pay exclusion during the first 30 days of a period of absence on account of sickness or injury. But a combination of active duty pay and the excess of disability retired pay over the percentage-of-disability exclusion must be added together and compared with the regular weekly rate of pay. If the total exceeds 75%, no exclusion is available for the first 30 days.

RETIREMENT INCOME CREDIT

Another tax benefit flowing from taxable retired pay is a retirement income credit which is available if a taxpayer received earned income of more than $600 in each of any 10 years prior to the current year. The maximum credit is equal to 17% of retirement income of $1,524 in 1964. It varies with changes in income tax rates and rate of Social Security benefits. The magic of the $1,524 figure is that it is equal to the highest rate of Social Security benefits for a worker.

Retired servicemen get a break in that they need not wait until age 65 to get the credit.

10. Except that for naval officers below the rank of Fleet Admiral who are retired for physical disability after the first day of the month following the month in which they have reached age 62, the age factor is 64.

People retired under public retirement systems, such as the Navy's, become eligible for the credit immediately upon retirement, while others do not qualify until 65 or older.

In common with all other retired taxpayers, however, a retired member's credit is reduced or even eliminated because of the receipt of Social Security benefits, nontaxable pensions such as the Veterans Administration Spanish American War nondisability pension, or earned income in excess of $900 if under 62, (one-half of the excess between $1,200 and $1,700 and all in excess of $1,700 if 62 but not yet 72). Veterans Administration disability compensation does not reduce the credit.

A special rule has been provided in the 1964 Revenue Act whereby it is possible for married taxpayers, both of whom are 65 or older, in common law states to compute the credit on a maximum $2,286 retirement income, subject to the reductions described above. Where each spouse is qualified in his and her own right, however, each would compute the credit separately on a maximum of $1,524 each. Residents of community property states continue to have an advantage in that each may claim the credit on community income.

DUAL COMPENSATION ACT

New employment opportunities were opened for retired Regular officers by the Dual Compensation Act.11 This act permits them to hold civilian office in any branch or instrumentality of the Government of the United States subject, with a number of exceptions, to a reduction of retired pay to an annual rate equal to the first $2,000 of such pay plus one-half of the remainder.

The receipt of Federal civilian pay automatically deprives a physical disability retired member of the "sick pay" exclusion from retired pay and undoubtedly will, in most cases, raise the earned income factor high enough to eliminate any retirement income credit.

Questions exist as to the effect of waivers of retired pay in favor of Veterans Administration compensation and reductions for RSFPP on the computation of reduced retired pay under the Dual Compensation Act. The Comptroller General has held 12 that a waiver of retired pay in favor of Veterans Administration compensation in effect reduces the amount of legally awarded retired pay under former dual compensation laws. Possibly this will hold true

11. Act 19 August 1964, Public Law 88-448, 78 Stat. 484. 12. 36 Decs. Comp. Gen. 799 (1957).

under the new law with the effect that a smaller dual compensation reduction will be required.

The taxability of the remaining retired pay raises interesting questions where disability retired pay computed on the basis of years of service is only partially excluded on the basis of percentage of disability. Under a 1950 ruling 13 the Internal Revenue Service held that a waiver of partially exempt disability retired pay in favor of nontaxable Veterans Administration compensation applies first to the nontaxable portion. The reason given for this ruling is that “a further exemption from income tax must be supported by an express statutory provision." It is generally understood that the foregoing does not prevent a reduction in the taxable part after the nontaxable portion has been exhausted.

Under this theory, isn't it reasonable to assume, since retired pay is reduced under the Dual Compensation Act in order to realize taxable wages, that the reduction in retired pay will apply first to the taxable portion? Don't raise your hopes too high. In the case of a waiver of disability retired pay under former dual compensation laws, it has been held that a member employed by the United States Government may exclude his reduced retired pay in the same proportion that his total retired pay is excludable.14

NONRESIDENT ALIENS

Our Filipino servicemen have special income tax problems after retirement. Their story is far too long to go into much detail, but suffice it to say that if during his career one became a United States citizen he is taxable as such after retirement. He may file a joint return with his wife if she is a citizen or resident of the United States, but not if she is a nonresident at any time during the year. He may claim exemptions for his children if they are United States residents or citizens. If they are nonresident aliens he may claim their exemptions only if the children are residents of Canada, Mexico or the Republic of Panama, or they are residents of the Republic of the Philippines and were born or adopted therein prior to 1 January 1956 while the taxpayer was a member of the Armed Forces.

Until recently a naturalized alien lost his United States citizenship by returning to the country of his birth and remaining there for a period of years. On 18 May 1964, however, the Supreme Court of the United States held in the

13. Rev. Rul. 54-88, Cum. Bull. 1954-1, 241. 14. Rev. Rul. 55-155, Cum. Bull. 1954-1, 245.

case of Angelika L. Schneider v. Dean Rusk 15 that in living abroad a naturalized citizen does not thereby lose his citizenship. Some of our retired naturalized citizens may be affected by this decision and the matter is under consideration by the Internal Revenue Service and the Navy Department.

Married nonresident alien retired members who are domiciled in a community property country have a happy tax situation in that each spouse may file a return on one-half of the taxable income. The taxable military retired pay of a nonresident alien is based upon the amount of his service in the United States. If he served 4 years out of 20 years of total service in the United States only 4/20ths, or 20% of his otherwise taxable retired pay would be included in his gross income from sources within the United States. The details of this computation are handled by the Navy Finance Center in Cleveland. NONRECOGNITION OF GAIN ON SALE OF HOME—

GENERAL

While the subject does not directly affect retired pay, retired personnel do frequently sell their principal residences bought and paid for with their service pay and buy a new one more suitable to their needs. Any loss sustained on the sale of the personal residence is not deductible, but nonrecognition rules may apply to the gain.

If the new house costs more than the amount realized on the sale of the old principal residence, the tax on the gain may be postponed. This is done by reducing the cost basis of the new principal residence by the profit excluded from gross income on sale of the old one. Expenses of "fixing-up" the old house help in reducing taxable profit if the work is done during the 90-day period ending on the date of the sales contract and paid for not later than 30 days after the sale.

The new principal residence must be purchased and occupied within one year before or after the sale of the old one, except that the after period is extended to 18 months if a taxpayer builds or contracts for a new home which is under construction within 12 months and is physically occupied within 18 months. Some retired members may have sold their old principal residences while on active duty, at which time they had up to four years within which to acquire a new one. That four-year period is cut-off upon retirement, however, and the re

15. 377 U.S. 163 (1964).

(Continued on Page 50)

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