Recalculated Disability Pension Not Taxable

In a very important decision, the U.S. Court of Appeals for the Ninth Circuit has ruled that reduction of an individual's disability retirement benefits on the 25th anniversary of his date of hire was not a determination of benefits based on his length of service and therefore remained excludable from tax under IRC Section 104(a)(1). The key: the benefits were neither determined by reference to his age nor length of service and thus did not convert into a service retirement pension. Following provisions of the pension plan that permitted recalculation of disability benefits to an amount equal to the benefit that would have been received after twenty-five years of service, the city reduced a retired police officer's benefits from 75% to 50%. IRS (naturally) determined that the city's recalculation converted the pension from disability to service, thus disqualifying favorable treatment under IRC Section 104(a)(1), which excludes from gross income money received under workers' compensation-like acts that are not determined by reference to an employee's age and length of service. In some rather astute reasoning, the appellate court reversed the Tax Court ruling, holding that recalculated benefits were determined by date of hire rather than by reference to age or length of service. Reduction in benefits, creating parity between disabled and service retirees, did not, by itself, amount to a conversion of benefits. Bravo. Picard v. Commissioner, Case No. 97-70954 (9th Cir., January 26, 1999).