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Tax Breaks for Those in Military Service

(RIVERWOODS, ILL., January 2005) – Thousands of men and women in the military will realize tax breaks this year, including extra time to file, as a number of tax-related benefits are afforded to members of the armed services, according to CCH INCORPORATED (CCH), a leading provider of tax and accounting information, software and services (tax.cchgroup.com). And for service members on the most dangerous assignments, their military pay may be tax-free.

"In general, U.S. tax laws apply equally to civilians and members of the military," said Mark Luscombe, an attorney, CPA and principal federal tax law analyst for CCH. "But Congress has passed laws many times to make sure that people don’t suffer from a tax point of view as a result of their military service."

Members of the military who are on duty outside the United States or Puerto Rico, but who are not serving in a combat zone, have until June 15 to file their taxes. Interest will accrue from the normal due date until the time of payment, however.

If a service member is serving in a designated combat zone, is deployed in a "contingency operation" or is hospitalized outside the United States due to an injury received while serving in a combat zone or in a contingency operation, the due date of the service member’s return is postponed for the period of the combat service or hospitalization plus 180 days. In addition, no interest or penalties will be assessed.

The inclusion of "contingency operations" in determining eligibility for extended filing deadlines was made by the Military Family Tax Relief Act of 2003 (MFTRA). It expanded eligibility to service personnel in operations in which the Secretary of Defense determines that members of the armed forces may become involved in military actions, operations or hostilities against an enemy of the United States or against an opposing military force. It also covers call-ups during a war or during a national emergency declared by the President or Congress.

The combat zone/contingency operation filing extension (which also includes service in qualified hazardous duty areas) also applies to other tax-related time limits. This includes such things as paying income and estate taxes, instituting Tax Court proceedings, filing refund claims, making contributions to qualified retirement plans and taking distributions from IRAs.

"Taxpayers should write ‘Combat Zone’ across the top of returns and documents to bring these items to the immediate attention of the IRS or the Tax Court," Luscombe noted.

Normally, military pay is taxable. This includes compensation with all sorts of names: active duty pay, reserve training pay, enlistment or re-enlistment bonuses, incentive pay, readjustment pay and travel and per diem allowances.

Pay for service in a combat zone is an exception. All compensation for active service for any month in which a service member serves in a combat zone is exempt from income tax, up to the highest rate of enlisted pay, which was $5,882.70 per month in 2003. So if someone begins service in a combat zone on the last day in January and leaves the combat zone on the first day of December, the entire year’s pay is exempt.

In 2004, as part of the Working Families Tax Relief Act, Congress addressed another issue relating to combat pay. Since it is not taxed, combat pay is not considered "earned income," and this can lessen eligibility for the earned income tax credit and the child credit. Under the new law, members of the military can elect to have combat pay earned in 2004 counted as earned income for figuring both credits. But barring further congressional action, the election will end after 2005 in regard to the earned income tax credit.

It has long been felt that there is something wrong about taxing the earnings of those who pay the ultimate price in service to their country, so the law provides a total income tax exemption for the earnings of those who die as a result of wounds, disease or injuries incurred in a combat zone.

The exclusion applies to the service member’s entire income, not just military pay, and it applies to the entire calendar year in which the death occurs. For example, income taxes have been abated on a deceased service person’s share in a partnership’s income from the date of death to the end of the partnership’s fiscal year.

The exclusion also applies to prior years, back to the first year of service in a combat zone. This means that family members can file amended returns to have prior years’ taxes refunded, although a statute of limitations – usually three years from the normal due date of a return – applies.

Military death benefits, such as civilian life insurance proceeds, are now totally tax-free. Since 1991, due to a glitch in drafting a benefits increase, only half of the $6,000 death benefit had been free of tax. The Military Family Tax Relief Act increased the benefit to $12,000 and excluded the entire amount from tax for deaths occurring after September 10, 2001.

The MFTRA also ensured that certain special benefits extended to living members of the military and their families won’t be considered taxable income. Dependent care is one of these. The Department of Defense operates one of the largest child care programs in the United States and provides dependent care assistance to members of the Armed Forces. The new law makes it clear that beginning with the 2003 tax year, these benefits are excluded from income. Another special program involves military homeowners whose properties decline in value when a base closes or reduces operations. In cases where the government reimburses them for the loss they suffer on the private sale of their homes, the payments they receive are excluded from their income.

MFTRA also modified the exclusion on sales of personal residences to take account of the mobile nature of many military careers. Single filers can exclude up to $250,000 of gain from the sale of their principal residence while married taxpayers filing jointly can exclude up to $500,000 of gain. But the exclusion is subject to an ownership and use test.

The taxpayer has to own and use the property as his or her principal residence for at least two years during the five-year period that ends on the date of sale.

The Act created a special exception to the two-out-of-five-year rule for uniformed and foreign service personnel called to "qualified official extended duty" – any period of active duty for more than 90 days or for an indefinite time at a duty station that is at least 50 miles from the taxpayer’s principal residence.

In that case, they can elect to suspend the five-year test period. The maximum length of the suspension is 10 years, and it can only be made for one property. If the election is made, the five-year period ending on the date of the sale of a principal residence does not include any period up to 10 years during which the serviceman or woman, or his or her spouse, is on qualified official extended duty. The election may be revoked at any time.

Also as a result of Military Family Tax Relief Act, members of the Reserve and the National Guard can now take an above-the-line deduction for service-connected travel expenses in connection with trips that take them more than 100 miles away from home and that involve an overnight stay. The deduction is limited to the general federal per diem rate, which varies by locality. Up until 2003, this kind of deduction was available only to those who itemized their deductions and was subject to the limitation on miscellaneous itemized deductions.

The Act also provided relief to students who have received appointments at the United States Military, Navy, Air Force, Coast Guard and Merchant Marine academies and who have savings in tax-advantaged 529 accounts. Up until now, they have been caught in a tax Catch-22 because amounts in 529 accounts can only be withdrawn without penalty to pay for educational expenses – but students appointed to service academies technically are being paid for their services and have no educational expenses.

Beginning with the 2003 tax year, they could withdraw a pro-rata amount from the accounts each year they are in school without having to pay the 10-percent penalty. The amounts withdrawn are included in their gross income, however.

"The theme behind much of the Military Family Tax Relief Act was to fix situations in which the tax laws unwittingly had created penalties for people serving in the military," Luscombe noted. "In some cases, if people drafting legislation years ago had given a little more attention to the unique situations of military members and their families, the problems that the MFTRA tries to solve would never have arisen."

While much has been done to ease the tax bite on people in the military, some members of Congress believe there is still more to do. While relief regarding combat pay as earned income did become law in 2004, two other measures did not make it through the legislative process, but are likely to resurface this year.

A bill to allow reservists to tap their retirement plan assets without incurring the usual early-withdrawal penalties was passed in the House, but did not make it out of committee in the Senate. Another bill, sponsored by Senator Landrieu of Louisiana, provided tax credits to businesses that continued to pay their employees’ salaries while they served in the reserves.

"While neither of these measures has become law yet, their sponsors are sure to press for passage in the new Congress," Luscombe commented.

The rules for federal taxation of military pay and benefits can be complex, but at least they apply to all uniformly. Not so with the states.

Many states with an income tax use taxable or adjusted gross income from the federal return as a starting point in calculating the state tax. In those cases, items excluded for federal purposes normally also escape taxation at the state level.

One thing to watch for is whether a state adopts the federal rules as of a certain date. For example, for 2004 taxes, a state may adopt federal law as it existed on January 1, 2004. This means that unless the legislature acts, the provisions of the Working Families Tax Relief Act, enacted in October of 2004, can’t be used on 2004 returns.

"Some states exempt combat pay, some exempt pay for guard and reserve training, some exempt all military pay, some exempt a certain amount and some tax all of it," Luscombe said. "Fortunately, the web pages for many states’ departments of revenue address how military pay is taxed, but anyone with any doubts should consult a qualified tax professional with a knowledge of the specific state’s rules."

CCH INCORPORATED (tax.cchgroup.com), based in Riverwoods, Ill., is a leading provider of tax and accounting information, software and services. CCH has served tax, accounting and business professionals and their clients since 1913, providing them with the most authoritative, timely and comprehensive tax resources. CCH is a Wolters Kluwer company (www.wolterskluwer.com).

Wolters Kluwer is a leading multinational publisher and information services company. The company's core markets are spread across the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2003) of €3.4 billion, employs approximately 18,750 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its depositary receipts of shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices.

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