Tax Planning for Military Personnel
Special Provisions for Unique Circumstances

By Stephen C. Gara

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NOVEMBER 2005 - Over 100,000 military personnel have been deployed to the Middle East and Central Asia; thousands of reservists and National Guard members have been called up in the global war on terror. Tax professionals are likely to encounter more individuals, either military personnel themselves or their dependents, with military tax issues. Preparers should be aware of the many tax provisions Congress has enacted for the benefit of military personnel.

While military personnel generally face the same tax filing and payment obligations as other U.S. citizens, Congress has enacted several specific provisions, such as the Military Family Tax Relief Act, including income exclusions, filing and payment extensions, and tax liability forgiveness. Military personnel are defined under IRC section 7701(a)(15) as including regular and reserve members of the Army, the Navy (sailors and Marines), and the Air Force, as well as the Coast Guard, now part of the Department of Homeland Security.

Military Compensation and Allowance Exclusion

The first step in analyzing the special tax treatment afforded to military personnel is understanding military compensation, which can be broadly separated into two categories: pay and allowances. Military pay includes basic pay, based upon a service member’s rank and years of service, as well as special or incentive pay, and bonuses. Basic pay comprises the largest portion of military pay, while special or incentive pay is directed to individuals serving in specialized fields or performing hazardous duty. Special pay includes flight pay, sea pay, pay for hostile fire duty, hardship duty, and submarine pay. Bonuses include one-time payments for enlistment and reenlistment.

Allowances are provided in kind as well as in cash. The two most significant allowances are the basic allowance for subsistence (BAS) and the basic allowance for housing (BAH). Both allowances vary each year with changes in the cost of food and housing, as well as in the number of dependents. Additionally, BAH varies regionally with the local cost of housing. Other allowances include a dependent travel allowance, moving expenses, insurance, uniforms, medical care, dependent educational expenses, burial services, and death gratuities. The 2003 Military Family Tax Relief Act increased the latter to $12,000.

The distinction between pay and allowances is vital. IRC section 134 provides that gross income does not include any qualified military benefit or military allowance. Thus, while military pay is included in an individual’s gross income, allowances are not. Only military pay appears on a service member’s W-2.

Example. Ensign Jones is a new naval officer stationed in Norfolk, Virginia, in 2004. He is single, with no dependents, and lives off base. Jones’ basic pay is $27,168 and he has a BAS of $2,100 ($175 per month) and a BAH of $11,028 ($919 per month for a single O-1 stationed in Norfolk). His total cash income for 2004 is, therefore, $40,296. His gross income for tax purposes, however, is only the $27,168 basic salary. Excluding both allowances, the tax savings is $2,299 (assuming that Jones files single, claiming the standard deduction and one personal exemption and no other income).

Combat Zone Exclusion

IRC section 112 provides military personnel with a gross income exclusion for combat zone compensation. The compensation must be earned while the individual is serving in a combat zone; the date of actual payment is irrelevant. Additionally, compensation earned during a period of hospitalization as a result of combat zone service, regardless of location, is excluded as well. IRC section 112(a)(2), however, terminates the exclusion for hospitalization two years after the end of hostilities and the subsequent recession of the combat zone designation. Treasury Regulations section 1.112-1(e) provides that personnel serving outside a designated combat zone will still qualify for the income exclusion if they serve in direct support of combat operations and are entitled to hostile fire or imminent danger pay, as determined by the Defense Department. Combat zone service also includes periods during which an individual is absent from duty due to illness, wounds, or internment by the enemy.

Combat zones are defined under IRC section 112(c)(3) as areas designated by the President, via executive order, in which U.S. military personnel are currently, or have recently, engaged in combat operations. The designation remains in effect until rescinded by the President. Three areas currently possess this designation: Afghanistan, and nearby Pakistan, Tajikistan, Uzbekistan, Kyrgyzstan, and Jordan; the Persian Gulf, plus the Red Sea, the Gulf of Oman, the Gulf of Aden, and part of the Arabian Sea, as well as the countries of Iraq, Kuwait, Saudi Arabia, Oman, Bahrain, Qatar, and the United Arab Emirates; and the former Yugoslavian nations, as well as Albania, the Adriatic Sea, and part of the Ionian Sea.

The exclusion is applied monthly, and serving a day in a combat zone triggers the exclusion for the entire month. Qualified compensation includes basic pay, special and incentive pay, and even bonuses, if earned during service in a combat zone. Even payments for accrued leave earned while serving in a combat zone are excluded.

Example. Sergeant Smith, an E-6 with 10 years of service, was stationed in Germany on January 1, 2004, earning $2,596 per month in basic pay. He was subsequently transferred to Iraq, a designated combat zone, on January 29, 2004. Sergeant Smith spent five weeks in Iraq before returning to Germany on March 5, 2004. He also voluntarily reenlisted on February 1, 2004, which resulted in a $5,000 reenlistment bonus, paid on June 1, 2004. Sergeant Smith’s basic pay for January 2004 through March 2004, $7,788, is excluded from gross income, as is the full $5,000 reenlistment bonus, because the reenlistment occurred while serving in Iraq. Additionally, any hostile fire or imminent danger pay earned during his service in Iraq is also excludible.

The IRC section 112 combat zone exclusion, however, is subject to two overall limitations. First, under Treasury Regulations section 1.112-1(f), none of the following types of service qualify for the exclusion: temporary presence in a combat zone while on leave from a duty station outside the combat zone; passage over or through a combat zone during a trip between two points outside the combat zone; and presence in a combat zone solely for personal convenience. Second, there is a cap on the exclusion amount for commissioned officers. Under IRC section 112(b) and (c)(5), commissioned officers may exclude only an amount that does not exceed the highest enlisted pay grade, currently $6,315 per month, plus any hostile fire or imminent danger pay the individual may be entitled to. No dollar limitation is imposed on enlisted personnel or warrant officers. Additionally, according to IRC section 112(c)(4), retirement pay and pensions are not eligible for the exclusion, even if due to service in a combat zone.

Similar to the IRC section 134 allowance exclusion, the combat zone exclusion is self-enforcing. IRC section 3401(a)(1) excludes qualified IRC section 112 compensation from withholding. Such compensation should not be reported in box 1 on Form W-2. If individuals believe that excludible income is mistakenly reported on their W-2, they must request a corrected W-2; otherwise, all income reported in box 1 must be reported. Moreover, according to IRS Notice 2003-21, the exclusion applies only for income taxes purposes, not for FICA taxes.

Filing and Payment Extensions

Treasury Regulations section 1.6081-5. Several provisions grant military personnel extensions for filing returns and for payment of taxes. While military personnel can use Form 4868 to request a four-month filing extension, Treasury Regulations sections 1.6081-5(a)(6) and (d) provide an automatic two-month filing and payment extension for military personnel stationed outside the United States and Puerto Rico. A statement claiming this automatic extension should be attached to the return when it is filed. Form 4868 may still be filed to claim an additional two months.

Revenue Procedure 57-25. Regardless of their duty station, military personnel may also be entitled to a deferment under Revenue Procedure 57-25. This provision provides that individuals serving in their initial period of enlistment, or officers serving during their first two years of service, and demonstrating an inability to pay, may defer payment of their tax liability. This deferment, based upon the Soldiers’ and Sailors’ Civil Relief Act, requires a written request supported by satisfactory evidence that the ability to pay has been materially impaired due to the military service. The taxpayer’s name, Social Security number, amount and source of pre-military income, amount of current military income, pay grade, and dates of enlistment and discharge must be included in this request. If granted, the period of deferment is limited to the period of initial military service plus six months, or 30 months for officers. A deferment under this provision is generally requested in response to an IRS notice and demand for payment.

IRC section 7508. Military personnel serving in designated combat zones are entitled to an extended deadline for payment, filing, and other tax matters under IRC section 7508. This extension provision is also applicable to personnel serving in direct support roles. Taxpayers covered by IRC section 7508 include Red Cross personnel, accredited correspondents, and civilians operating under military control.

Additionally, military personnel serving outside a combat zone but in a contingency operation (as designated by the Secretary of Defense) are also covered by IRC section 7508 even if they don’t qualify for the IRC section 112 exclusion.

According to IRC section 7508(a)(1), the deadline extension applies to:

  • filing an income, gift, or estate tax return;
  • paying income, gift, or estate tax (but not payroll-related taxes);
  • filing a petition with the tax court (or an appeal from a tax court decision);
  • filing a credit or refund claim;
  • bringing a credit or refund suit; and
  • any other act, such as making an IRA contribution, required or permitted by the Code.

The extension, however, also applies to the IRS. The government is granted an extension to: assess any tax; make or issue a demand for payment; collect any tax due; and bring suit for the collection of any tax due. This extension provided under IRC section 7508 is much broader than that provided under the first two provisions, covering a larger number of tax matters.

The extension period starts the day the taxpayer enters a designated combat zone or contingency operation, and lasts until 180 days after departure from it. Additionally, the deadline is extended by the number of days that were left to perform a required action, such as filing a return, when the taxpayer entered the combat zone. If a taxpayer is hospitalized, regardless of location, because of qualifying service, the deadline is extended 180 days after leaving the hospital. If the hospitalization occurs in the United States, however, the maximum extension is five years. Similar to IRC section 112, time spent classified as a POW (prisoner of war) or MIA (missing in action) is considered service in a combat zone or contingency operation.

This extension generally applies to spouses of individuals serving in combat zones or contingency operations as well, subject to two limitations. First, the extension does not apply to spouses for tax years beginning more than two years after the date the combat zone or contingency operation designation is rescinded. Second, the extension does not apply to spouses of service members hospitalized in the United States.

The extension under IRC section 7508 is automatic. If the IRS attempts examination or collection actions against a taxpayer covered by this provision, however, written notification should be provided claiming eligibility under IRC section 7508. No penalties or interest will be charged during the extension period, and the extension does not apply to withholding or employment taxes, similar to the combat zone exclusion.

Example. Ensign Amanda White’s ship entered the Persian Gulf on January 15, 2003. On February 15, 2003, White was injured and was flown to a U.S. hospital. She remained in the hospital through May 1, 2004. The deadline for her 2002 return is January 31, 2005, that is, 271 days (180 + 91) after her last day in the hospital (May 1, 2004). The 91 additional days are the days left in the 2002 filing period when she entered the combat zone (January 15, 2003–April 15, 2003). The deadline for her 2003 return is February 15, 2005, that is, 285 days (180 + 105) after May 1, 2004. The 105 additional days are the days in the 2003 filing period that were left when she entered the combat zone. The deadline for her 2004 return is not extended, because the 180-day extension period after May 1, 2004, ended on October 28, 2004, before the filing period began for her 2004 return (January 1, 2005–April 15, 2005).

Forgiveness of Tax Liability

According to IRC section 692(a), tax liabilities are forgiven for military personnel that die while serving in a combat zone or as a result of injuries, illness, or wounds suffered while serving. The forgiveness covers not only the year of death but also all prior years ending on and after the date the taxpayer first served in a combat zone. Any unpaid tax liability is forgiven, and any paid taxes are to be refunded or credited, presumably to the surviving spouse or estate of the deceased service member. Personnel serving outside a combat zone, but in direct support roles and qualifying for hostile fire or imminent danger pay, are also covered. Furthermore, the deadline for filing refund claims for any forgiven tax liability is extended under IRC section 7508. As a practical matter, the combat zone exclusion mitigates the usefulness of the waiver, as a deceased service member is unlikely to have a substantial tax liability to be waived.

IRC section 692(c) applies tax forgiveness to U.S. civilian and military employees that die as a result of a terrorist or military attack directed against the United States or one of its allies, regardless of the attack’s location, which partially overlaps with IRC section 692(a). Furthermore, IRC section 692(d) specifically covers persons killed as a result of the September 11, 2001, terrorist attacks; the April 19, 1995, Oklahoma City bombing; and the fall 2001 anthrax attacks; as well as astronauts killed in the line of duty. The period covered by forgiveness under IRC sections 692(c) and (d) includes the year of death and all prior tax years. Any unpaid tax liability for the affected years is forgiven, and refunds are allowed for the tax years affected. Taxpayers covered by IRC section 692(d), specifically terrorist victims, are entitled to a minimum $10,000 refund. The normal refund claim deadlines apply, however, as IRC section 7508 is generally inapplicable outside a combat zone. Claims under IRC section 692 are made using Form 1040 or 1040X. For joint filers, the waiver applies only to the tax liability of the deceased spouse. All returns filed under this provision must have “KIA” (killed in action) or “KITA” (killed in terrorist action) written across the top of the return and on the tax due line. A schedule showing the computation of the forgiven tax liability must be attached, along with certification from the Defense Department or State Department verifying the deceased taxpayer’s status and eligibility, and IRS Form 1310 (Statement of Person Claiming Refund Due a Deceased Taxpayer). Returns and claims for refunds based on section 692 should be sent to the IRS Service Center in Andover, Massachusetts.

In addition, IRC section 2201 provides a substantially reduced estate tax rate schedule for military personnel as described above (i.e., those whose death resulted from combat zone service, specified terrorist victims, and astronauts killed in the line of duty).

Miscellaneous Provisions

Sale of personal residence. IRC section 121 provides for an exclusion of up to $250,000 of gain ($500,000 for a joint return) realized on the sale of a home. Eligibility requires both ownership and use of the home for at least two years during the past five years. The five-year window ends on the date of the sale of the home. Military personnel are frequently forced to relocate due to changes in their duty stations, making compliance with the two-year ownership and use tests difficult.

A partial exclusion is available under IRC section 121(c) for taxpayers that are forced to sell their home before satisfying the two-year ownership or use requirement due to change in employment, health, or unforeseen circumstances. Additionally, the 2003 Military Family Tax Relief Act added IRC section 121(d)(9), which provides military personnel the option to roll the five-year window for up to 10 years, meaning that they must use and own the home for only two out of 15 years.

Travel and transportation expenses for Reserve and National Guard. Reservists and National Guard personnel often incur significant expenses traveling to and from drills and training duty. While business travel and transportation expenses are currently deductible under IRC section 162, there was uncertainty regarding the employment status of reservists and guardsmen. The 2003 Military Family Tax Relief Act added IRC section 162(p) clarifying that reservists and guard personnel are entitled to a deduction for travel and transportation expenses incurred to perform Reserve or National Guard duties. The requirement that the taxpayer travel overnight still applies. Moreover, the 2003 Act also amended IRC section 62 providing that expenses incurred to attend drills and other functions located over 100 miles away from home are not only deductible, but are an above-the-line deduction.

Signing returns. Taxpayers must normally sign their own tax returns (both spouses for joint returns), which is problematic for military personnel serving overseas in a combat zone. Part of the rationale behind the IRC section 7508 filing extension is that it allows military personnel to file when they return from a combat zone. If service members are unable to sign their returns, they may sign a Form 2848, Power of Attorney, granting their spouse or someone else the authority to sign on their behalf; it should be completed before military personnel depart for a combat zone. The designated power holder, usually the spouse, attaches the form to the tax return when it is filed. The IRS will also accept a written statement attached to the return which states that a taxpayer’s military spouse is serving in a combat zone.

If a military spouse dies during the year, whether in a combat zone or otherwise, the surviving spouse is entitled to file a joint return for the year of death under IRC section 6013, assuming the survivor has not remarried before the end of that year. Surviving spouses may sign on their own behalf and for the deceased spouse, unless a personal representative has been appointed. IRC section 6013(f) provides that an individual classified as MIA is still eligible to file a joint return, even if the individual had died prior to the tax-year covered by the return. A written statement noting MIA status should be attached to the joint return.

Putting It All Together

These unique provisions for military personnel and their families, along with existing provisions available to all taxpayers, can provide tax planning and compliance opportunities. These provisions can be broken down into two categories: substantive and procedural. Substantive provisions are concerned with income exclusions, deductions, and reduction of tax liabilities. Procedural provisions include filing and payment extensions and special rules for return signing.

The major substantive provisions include the income exclusion for qualified military allowances under IRC section 134 and the combat zone exclusion under IRC section 112. Both exclusions are automatic and are reflected in a service member’s W-2. For service members serving in a combat zone, or recently returned from one, however, a check of their W-2 is recommended; the combat zone exclusion applies only to income taxes, not FICA taxes. The IRC section 692 tax liability forgiveness provision is not automatic, requiring action by the surviving spouse or estate representative, but it does provide some financial support and a potential refund to the taxpayer’s family.

Military personnel that die as a result of wounds incurred in a combat zone are entitled to forgiveness under both IRC sections 692(a) and (c), but the provisions differ, requiring some analysis by the tax preparer. IRC section 692(a) forgives all years starting from the date of entry into the combat zone until death. IRC section 692(c) forgives all years from the year before the attack until the date of death.

The major procedural provision, the IRC section 7508 filing and payment extension, presents a unique and broad planning opportunity for military personnel. It covers both filing and payment obligations for an indefinite period of time during the taxpayer’s presence in a combat zone or resulting hospitalization. The extension covers not only return filing and payments, but also tax court and other court filings, refunds, collection activities, IRA contributions, and taxpayer elections. This provision is elective; if a taxpayer is due a refund, a claim may be filed before the extension period expires. This provision is of limited value to combat zone personnel but can be of benefit to spouses and non–combat zone personnel.

Finally, the extension under Revenue Procedure 57-25 applies to all military personnel as long their military service impairs their ability to pay during their first enlistment.

Impact of the Provisions

Congress enacted these provisions in recognition of the sacrifices servicemen and -women make and have made in the past. Given the increasing number of military personnel being deployed overseas and reservists being called up, tax professionals should be aware of these provisions. The IRS has responded to the unique requirements of military personnel by creating a separate e-mail address for military-related tax issues, combatzone@irs.gov.


Stephen C. Gara, PhD, CPA, is an associate professor of accounting at the college of business and public administration at Drake University, Des Moines, Iowa.

 

 

 

 

 

 

 

 

 

 

 

 


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