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Funds must report payments to alternate payees as ordinary taxable income

So, your fund has been paying a service-connected disabled retiree a disability pension that is exempt from Federal Income Tax under Internal Revenue Code Section 104. But now your retiree is getting divorced and you just received a domestic relations order that directs that your fund pay some of that disability benefit to the former spouse/alternate payee. How will you report the annuity payments to the alternate payee, former spouse? The answer may surprise you.

 

 
Photo: iStock/Andrey Popov
By Gary Lawson
Contributor
Is she or he entitled to treat that qualified domestic relations order payment as exempt under the Internal Revenue Code Sec. 104 exemption, the same as when it was paid to the disabled retiree?  
 
The answer may surprise you. The answer is, no. You must report the payments to the alternate payee as ordinary taxable income.
 
In a 2012 Tax Court decision called Fernandez v. Commissioner of Social Security, the court held that the former spouse must report the pension she receives as taxable income. Again in 2015 the IRS won a similar case in a U.S. District Court decision, Walker, Helena v. U.S., (2015, DC MD) holding that accidental disability retirement benefits paid pursuant to eligible domestic relations orders to former spouses of state employees/participants in tax-qualified pension plans weren't excludible under Code Sec. 104(a)(1) from that former spouses' gross income. The court held that all income was taxable under Code Sec. 61 unless specifically excluded and Reg § 1.104-1(b) explicitly limited exclusion to employees and their survivors.
 
In addition, we found a similar interpretation in two IRS private letter rulings, or PLRs. While PLRs don't bind the IRS and are technically of no precedent value to any other taxpayer than the one to whom it was issued, PLRs are published to help us understand the IRS position on a tax question and sometimes there is nothing else available.
 
You may want to consider informing the lawyers for both sides if you face a similar issue.
 
But, you should be careful not to give either your member or the alternate payee any tax advice, as that can boomerang in any number of ways. Their lawyers might want to consider these cases and see if there is some alternative arrangement that might preserve the favorable tax treatment. Perhaps the member still gets paid 100 percent of the tax-exempt disability benefit and he/she (not the fund) pays the former spouse some other equal amount of money, as a nontaxable division of property?
 
As far as fund reporting, you should report any payment to the alternate payee as taxable income. 
 
When you have a tax or benefits question you might want to seek the advice of experienced pension tax counsel.

About the Author: Gary Lawson is a partner with law firm Fisher Broyles. He specializes in pension, executive compensation and transactional law and regularly represents government pension systems and other governmental entities in matters.

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