Work-related disability benefits are partly tax-free, but DRO payments are taxable

Plain-English summary

A governmental pension administrator asked how IRC § 104(a)(1) applied to industrial disability, survivor, death, cost-of-living, and supplemental benefits under three plans. The IRS ruled that disability payments tied to work-related injury or sickness were excluded up to each plan's fixed percentage of final compensation. Amounts above that level that depended on service retirement or member contributions remained taxable under § 72. Survivor benefits and cost-of-living adjustments received the same exclusion proportion as the underlying disability benefit, while industrial death benefits paid because a member died in the performance of duty were excluded. Payments redirected to another recipient under a domestic relations order were taxable to that recipient.

Ruling snapshot

• Question: Which disability, death, survivor, adjustment, and domestic-relations-order payments under the governmental plans were excluded from income?
• Outcome: Mixed, qualifying work-related benefits were excluded within stated limits, but DRO payments and service-based excess benefits were taxable.
• Key authorities: IRC §§ 61, 72, 104(a)(1); Treas. Reg. § 1.104-1(b); Rev. Rul. 80-44; Rev. Rul. 85-104.

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201637006                                              Third Party Communication: None
Release Date: 9/9/2016                                         Date of Communication: Not Applicable
Index Number: 104.02-00
                                                               Person To Contact:
                                                               ----------------------------, ID No. --------------
-----------------                                              ----------------------------------------------------
-----------------------------------------------------          Telephone Number:
-------------------------------------------                    ----------------------
-------------------------                                      Refer Reply To:
-------------                                                  CC:TEGE:EB:HW
-------------------------------                                PLR-138960-15
                                                               Date: May 27, 2016




Legend

Taxpayer          =        ------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------

City              =        -----------------------------

Airport           =        --------------------------------------------------

Port              =        -----------------------------------------

Charter           =        ------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------

Statute           =        -------------------------------------------------

Plan A            =        -------------------------------

Plan B            =         -----------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------
----------------------------------

Plan C            =        ------------------------------------------------

Supplemental Benefit A = ---------------------

Supplemental Benefit B = -----------------------
PLR-138960-15                                   2

Dear ---------------:

This is in reply to your private letter ruling request dated November 19, 2015 and
subsequent correspondence concerning the tax treatment of certain disability and death
payments made by Taxpayer under section 104(a)(1) of the Internal Revenue Code (the
Code).

Taxpayer administers death, disability and retirement benefits that are paid to eligible
individuals who are members of Plan A, Plan B, or Plan C (the Plans) and pursuant to
the Charter and Statute. It is represented that the Plans are governmental pension
plans. Each plan has received a favorable determination letter from the Internal
Revenue Service. Membership in the Plans is limited to eligible employees and
covered individuals who work for the City, Airport, or the Port. Membership in Plan A,
Plan B, or Plan C is mandatory and a condition of employment for eligible employees
and covered individuals. The Plans provide for different categories of members - for
example, general member or executive member - based on an eligible employee’s date
of hire and job classification.

Industrial Disability

The Charter and Statute provide for a disability benefit to be paid to all eligible members
who incur an industrial disability. For members hired after -------------------------- and
before -----------------, the general standard for whether an individual has incurred an
industrial disability is the same for all the Plans. Generally, a member is treated as
incurring an industrial disability if (1) the member is permanently incapacitated from the
performance of duty, (2) the permanent incapacity is the result of injury or disease
arising out of the course of employment, and (3) the permanent incapacity renders the
member’s retirement necessary. The determination of an individual’s industrial disability
is made by an independent agent of Taxpayer.

Members of the Plans who are hired after -------------------------- will not be treated as
incurring an industrial disability for any injury or incapacitation that is the result of a pre-
existing medical condition or nervous or mental disorder.

In addition to the general standard for whether a member has incurred an industrial
disability, certain members of Plan A who are employed by City as of -----------------, are
treated as incurring an industrial disability if the member is a victim of a violent attack
using deadly force that occurs in the performance of his or her duties, and that causes
great bodily harm or a nervous or mental disorder.

A member who is determined to have incurred an industrial disability becomes entitled
to an industrial disability retirement. Plan A members may elect to receive a maximum
monthly benefit or a modified retirement allowance pursuant to §§ ------------ through -----
------------ of the Statute. As authorized by the Charter, Plan B and Plan C provide the
PLR-138960-15                                    3

same maximum monthly benefit and options for a modified retirement allowance. Plan
B, § ----------- and §§ ------- through -------, and Plan C, § ----------- and §§ ------- through -
-------.

When a retired member who is receiving an industrial disability benefit dies, § ------------
of the Statute provides that Plan A will provide a benefit equal to 50% of the member’s
monthly retirement allowance to the member’s surviving spouse, so long as the
surviving spouse was married to the member on the date of retirement and the surviving
spouse does not qualify for and receive the industrial death benefit. Plan B and Plan C
provide the same terms for the monthly retirement allowance paid to the member’s
surviving spouse or domestic partner. Plan B, § -------, and Plan C, § -------.

Section ------------ of the Statute provides that Plan A will provide industrial death
benefits to survivors of a member who dies from industrial causes as determined by the
Workers’ Compensation Appeals Board. The industrial death benefit is either a lump
sum payment, or the sum of a monthly allowance equal to one-half of the member’s
Final Compensation paid to the member’s surviving spouse for life, plus a monthly
annuity that is equal to the member’s Accumulated Additional Contributions on the date
the member died.

Plan B and Plan C similarly provide that the industrial death benefit is either a lump sum
payment, or a monthly allowance equal to one-half of the member’s “Final Average
Salary”, paid to the member’s surviving spouse or domestic partner for life. Final
Average Salary means the monthly average Base Compensation used to calculate the
amount provided to each member upon retirement based on a specific formula. Plan B,
§ ------- and Plan C, § -------.

Industrial Disability Retirement Allowance - Plan A

Under §§ ------------ and ------------ of the Statute, a Plan A member who has been
determined to have incurred an industrial disability shall be entitled to receive an
industrial disability retirement allowance paid in equal monthly installments. The
industrial disability retirement allowance shall equal 50% of the member’s “Final
Compensation” plus an annuity purchased with Accumulated Additional Contributions, if
any. In the case of a Plan A member who is eligible for a service retirement, the
industrial disability retirement allowance shall be the greater of the member’s industrial
retirement allowance, or the service retirement allowance reduced by an annuity
purchased with Accumulated Additional Contributions. Under Plan A, a member’s Final
Compensation means the member’s highest one-year period of “Base Compensation”
for the relevant period, the average of the member’s three highest years of “Base
Compensation” for the relevant period, or the average of a member’s three highest
years of “Base Compensation” for the relevant period.
PLR-138960-15                                4

Section ------------ of the Statute defines “Accumulated Additional Contributions” to mean
the sum of a member’s post-tax contributions and interest. Section --------------- provides
that any workers compensation amount that may be awarded to a member shall be
offset against any industrial disability retirement pension payments, and the offset does
not apply to the annuity of any industrial disability retirement allowance awarded.

Industrial Disability Retirement Allowance – Plan B

Under Plan B, § -------, a Plan B member who has been determined to have incurred an
industrial disability shall be entitled to receive an industrial disability retirement
allowance paid in equal monthly installments. The industrial disability retirement
allowance shall equal to 33 1/3 % of the member’s “Final Compensation” plus an
annuity that is the actuarial equivalent of the member’s “Accumulated Cost of Living
Annuity Contributions” and, if applicable, an annuity based on the Plan B member’s
“Accumulated Surviving Spouse” or “Domestic Partner Contributions” credited to the
member’s account at retirement. In the case of a Plan B member who is eligible for a
service retirement and the member’s service retirement allowance would be greater
than the member’s industrial disability retirement allowance, the member will receive:
(1) a disability retirement allowance equal to 33 1/3% of the member’s Final
Compensation paid in monthly installments plus (2) an additional allowance equal to the
difference between the industrial disability retirement allowance and the service
retirement allowance the member has earned. An industrial disability retirement
allowance is derived from an annuity based on that member’s “Accumulated Normal
Contributions,” plus an annuity which is the actuarial equivalent of the Plan B member’s
Accumulated Cost of Living Annuity Contributions, and if applicable, an annuity based
on the member’s Accumulated Surviving Spouse or Domestic Partner Contributions
credited to the member’s account at retirement, and a disability retirement pension
derived from contributions of the Airport.

Plan B, § ------- defines “Accumulated Cost of Living Annuity Contributions” to mean all
cost of living contributions credited to a Plan B member’s account and interest. Under
Plan B, a member’s Final Compensation means the member’s highest one-year period
of “Base Compensation” for the relevant period, or the member’s highest three-year
period “Base Compensation” earned for the 3 consecutive months preceding his or her
retirement for the relevant period.

Industrial Disability Retirement Allowance – Plan C

Under Plan C, § -------, certain Plan C members who are determined to have incurred an
industrial disability shall be entitled to receive an industrial disability retirement
allowance paid in equal monthly installments. The industrial disability retirement
allowance shall equal 50% of the member’s “Final Compensation.” In the case of a
Plan C member who is eligible for a service retirement and the member’s service
retirement allowance would be greater than the member’s industrial disability retirement,
PLR-138960-15                                    5

the member will receive (1) a disability retirement allowance equal to 50% of the
member’s Final Compensation paid in monthly installments, plus (2) an additional
allowance equal to the difference between the industrial disability retirement allowance
and the service retirement allowance the member has earned. For other Plan C
members, the provisions are the same except that the industrial disability retirement
allowance is equal to 33 1/3% of Final Compensation. Plan C, § ------- and -------.
Plan C, § ------- further provides that the industrial disability retirement allowance is
derived from an annuity based on a member’s “Accumulated Normal Contributions” and
a disability retirement pension derived from contributions of the Port.

Plan C, § ------- defines “Accumulated Normal Contributions” to mean the sum of all
normal contributions credited to a Plan C member’s account plus and interest. Under
Plan C, a member’s Final Compensation means the member’s highest one-year period
“Base Compensation” for the relevant period, or the member’s highest three-year period
Base Compensation for the relevant period.

Cost of Living Adjustments and Supplemental Benefits – Plan A

Section ------------ of the Statute provides for general cost of living adjustments (general
COLAs) to the Plan A industrial disability retirement allowances under §§ ------------, -----
------------, ------------ of the Statute, the industrial disability survivor allowances under §§ -
------------ through ------------ of the Statute, and the industrial death benefits under § ------
----------- of the Statute. The retirement allowance payable to members (or their
survivors) who retired prior to ----------------- are also increased for a supplemental cost
of living adjustment (supplemental COLA). A member’s benefit that includes the
supplemental COLA is the benefit that is further adjusted by the general COLA.

Plan A members who have started to receive Plan A benefits may be paid an additional
supplemental benefit based on a special formula. According to § --------------- of the
Statute, the additional supplement benefit, if any, shall include Supplemental Benefit A.
Section -------------- of the Statute provides that the additional supplemental benefit, if
any, that is paid shall include a specified annual increase of the member’s benefit
determined without regard to any other supplement or additional benefits.

Cost of Living Adjustments and Supplemental Benefits – Plan B

Plan B members who have started to receive Plan B benefits may be paid an additional
supplemental benefit based on a special formula. The additional supplemental benefit,
if any shall include Supplemental Benefit B. Supplemental Benefit B allows a covered
member to choose, at the time of the member’s retirement, to have the member’s basic
service retirement allowance calculated based on certain alternatives that can increase
the service retirement allowance for purposes of Plan B.
PLR-138960-15                                  6

Plan B, § ------- provides for general COLAs to the Plan B industrial disability allowances
under §§ -------, the industrial disability survivor allowances under §§ ------- through ------
-------, and the industrial death benefits under § -------. Plan B has a limit on the COLA
adjustment to a maximum of 2% in any one year pursuant to Plan B, § -------.

Cost of Living Adjustments and Supplemental Benefits – Plan C

Plan C members who have started to receive Plan C benefits may be paid an additional
supplemental benefit based on a special formula. The additional supplemental benefit,
if any, shall include Supplemental Benefit B. Supplemental Benefit B allows a covered
member to choose, at the time of the member’s retirement, to have the member’s basic
service retirement allowance calculated based on certain alternatives that can increase
the service retirement allowance for purposes of Plan C.

Plan C, § ------- provides for general COLAs to the Plan C industrial disability
allowances under § -------, § ------- § -------, and the industrial disability survivor
allowances under §§ ------- through -------, and the industrial death benefits under § ------
-------, as well as a Supplemental COLA Annuity for Plan C. Plan C has a limit on the
COLA adjustment to a maximum of 2% in any one year pursuant to § -------.

RULINGS REQUESTED

(1)    Industrial disability retirement allowances paid under Plan A, Plan B, and Plan C
to members who incur a disability through the performance of duty will not be
considered gross income to the recipient under section 104(a)(1) of the Code to the
extent such benefits are not based on the member’s age, length of service, or prior
contributions.

(2) Survivor benefits paid under Plan A, Plan B and Plan C to a survivor of an industrial
disability retirement retiree will not be considered gross income to the recipient under
section 104(a)(1) of the Code to the extent such benefits are not based on the
member’s age, length of service, or prior contributions.

(3)   Industrial death benefits paid under Plan A, Plan B, and Plan C to survivors of
members who die as a result of the performance of duty will not be considered gross
income to the recipient under section 104(a)(1) of the Code.

(4)   COLA benefits, supplemental COLA benefits, and Supplemental Benefit A
allowances paid to a member who is receiving industrial disability allowances under
Plan A, or a survivor of a member receiving industrial survivor or death benefits under
Plan A, will not be considered gross income to the recipient under section 104(a)(1) of
the Code. COLA benefits, supplemental COLA benefits, and Supplemental Benefit B
allowances paid to a member who is receiving industrial disability allowances under
Plan B or Plan C, or a survivor of a member receiving industrial survivor or death
PLR-138960-15                                7

benefits under Plan B or Plan C, will not be considered gross income to the recipient
under section 104(a)(1) of the Code.

(5)    Industrial disability retirement allowances paid under a domestic relations order
(DRO) (as applicable to government plans) will not be considered gross income to the
recipient under the DRO to the same extent that the underlying industrial disability
retirement allowance is not considered gross income to the member.

Section 61(a)(1) provides that, except as otherwise provided, gross income includes all
income from whatever source derived, including compensation for services.

Section 72(a) of the Code provides that, except as otherwise provided by law, gross
income includes any amount received as an annuity (whether for a period certain or
during one or more lives) under an annuity, endowment or life insurance contract.

Section 104(a)(1) of the Code provides that gross income does not include amounts
received under workmen’s compensation acts as compensation for personal injuries or
sickness.

Section 1.104-1(b) of the Income Tax Regulations states that section 104(a)(1) of the
Code excludes from gross income amounts received by an employee under a
workmen’s compensation act or under a statute in the nature of a workmen’s
compensation act that provides compensation to the employee for personal injury or
sickness incurred in the course of employment. However, section 104(a)(1) does not
apply to a retirement pension or annuity to the extent that it is determined by reference
to the employee’s age or length of service, or the employee’s prior contributions, even
though the employee’s retirement is occasioned by an occupational injury or sickness.
Section 1.104-1(b) of the regulations also states that section 104(a)(1) applies to
compensation which is paid under a workmen’s compensation act to the survivor or
survivors of a deceased employee.

In Revenue Ruling 80-44, 1980-C.B. 34, a statute in the nature of a workmen’s
compensation act provided for an allowance of the greater of (A) 60 percent of the
individual’s average final compensation, or (B) the amount to which the individual would
be entitled under the normal, years of service, retirement plan. The ruling concluded
that the benefits under the statute were excludable under section 104(a)(1) of the Code
to the extent that they did not exceed 60 percent of the final average compensation.
Any excess over 60 percent of final average compensation was attributable to length of
service, and therefore, not excludible from gross income. Rev Rul. 80-44 also holds
that benefits of the surviving spouse which are a continuation of the employee’s benefits
are excludible under section 104(a)(1) of the Code in the same percentage as the
employee’s benefits were excludible.
PLR-138960-15                                    8

Rev. Rul. 80-84, 1980-1 C.B. 35, considered section 183 of a Los Angeles, California
statute that provided benefits to survivors when “any member of the Fire or Police
Department shall die … after retirement, or while eligible for retirement from such
department on account of years of service …”. The ruling concluded that benefits paid
to employees’ survivors may qualify as paid under a statute in the nature of a
workmen’s compensation act where those benefits are a mere continuation of
employees’ section 104(a)(1) benefits.

In Rev. Rul. 85-104, 1985-2 C.B. 52, the Service considered a statute under which the
participants who were disabled due to work-related injury or sickness, receive the
greater of a fixed percentage of base salary or an amount computed on the basis of
years of service. The Service concluded that an amount up to the percentage of base
salary specified by the statute would be excludible from the participant’s gross incomes
under section 104(a)(1) of the Code but that any excess, computed on the basis of
length of service, would not be excludible under section 104(a)(1).

Section 104(a)(1) is strictly construed to conform to the general purview of section 61
that all income is taxable unless explicitly excluded. The industrial disability retirement
benefits are specifically paid to City employees for their work-related injury or sickness,
and not the work-related injury or sickness of the former spouses. Moreover, section
1.104-1 of the regulations explicitly limits the exclusion from income to employees and
their survivors. Similarly, no such exclusion is available for domestic partners. Neither
the Code nor the regulations provide an exclusion from income for amounts paid to
former spouses pursuant to a domestic relations order. See Fernandez v.
Commissioner, 138 T.C. 378 (2012).

Benefits paid under the Statute for industrial disability benefits are paid only for work-
related disabilities and those benefits are paid without regard to an employee’s age or
length of service, and are thus in the nature of a workmen’s compensation act.

Based on the representations made and authorities cited above, we conclude as
follows:

(1)      Industrial disability benefits paid under §§ ------------ and ------------ of the Statute
will not be gross income to the Plan A recipient to the extent the benefits do not exceed
50% of the member’s Final Compensation. Industrial disability benefits paid pursuant to
------------- -------, will not be gross income to the Plan B recipient to the extent that the
benefits do not exceed 33 1/3% of the member’s Final Compensation. Industrial
disability benefits paid pursuant to Plan C, § -------, will not be gross income to the Plan
C recipient to the extent that benefits do not exceed 50% of the member’s Final
Compensation. The portion of the benefit that exceeds that amount not included in
gross income, in each of the three Plans, will be gross income to the recipient under
section 72 of the Code.
PLR-138960-15                                     9

(2)      Industrial disability benefits paid to a survivor of a member pursuant to §§ ---------
----------- through ------------ of the Statute by Plan A, Plan B, §§ -------, and ------- - -------,
and Plan C, §§ -------, and ------- - -------, to a survivor of a member determined to have
an industrial disability will not be gross income to the recipient to the same extent the
allowance was payable to the member.

(3)      Industrial death benefits paid under §§ ------------ of the Statute by Plan A, Plan B,
§ -------, and Plan C, § -------, to survivors of members who die as a result of the
performance of duty will not be considered gross income to the recipient under section
104(a)(1) of the Code.

(4)     COLA benefits paid under §§ ------------ and ------------, and Supplemental COLA
Benefit A paid under §§ ---------------of the Statute to (i) a Plan A member who is
determined to have an industrial disability, or (ii) a survivor of a Plan A member under
subsection (i) receiving benefits under §§ ------------ – ------------, or industrial death
benefits under § ------------, will not be considered gross income to the recipient to the
same extent as the industrial disability allowance or survivor benefit is not considered
gross income to the recipient. COLA benefits paid under Plan B, § -------, and COLA
benefits paid under Plan C, §§ ------- and -------, including the Supplemental COLA
Benefit B, will also not be considered gross income to the recipient to the same extent
as the industrial disability allowance or survivor benefit is not considered gross income
to the recipient.

(5)    Industrial disability retirement allowances paid under a DRO will be considered
gross income to the recipient under the DRO.

No opinion is expressed as to the federal tax consequences of payments not expressly
covered in the requested rulings or the transaction under any other section of the Code
or Statute other than those specifically stated above.

This ruling is directed only to the Taxpayer requesting it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.


                                           Sincerely,



                                           R. Lisa Mojiri-Azad
                                           Assistant Branch Chief, Health & Welfare Branch
                                           Office of Associate Chief Counsel
                                           (Tax Exempt and Government Entities)