James A. Picard, Petitioner-appellant, v. Commissioner of Internal Revenue, Respondent-appellee, 165 F.3d 744 (9th Cir. 1999)

The appellant James A. Picard ("Picard") challenges the Tax Court's ruling that his disability retirement benefits are taxable under Internal Revenue Code ("I.R.C.") § 61(a). The Tax Court held that the reduction of Picard's disability-retirement benefits on the twenty-fifth anniversary of his date of hire constituted a determination of benefits by reference to length of service, thereby removing the benefits from tax exclusion under I.R.C. § 104(a) (1)'s exemption for disability compensation. We have jurisdiction pursuant to 26 U.S.C. § 7482(a) (1) and 28 U.S.C. § 1291, and we reverse.

Facts

On October 31, 1966, Picard became a member of the City of Oakland ("Oakland") police force. Approximately six years later, because of physical injuries sustained in the line of duty, Picard was granted a disability-retirement pension. Oakland's disability-retirement plan under the city's charter (the "Plan")¹  provided that Picard would receive an amount equal to 75 percent of his base salary as a disability retirement benefit. Picard would receive this amount until the date on which he would have completed twenty-five years of service. At that time, Picard would have qualified for service retirement had he rendered service without interruption. Although Picard had not been accruing service-retirement credit, the Plan provided that, as of such date, Picard would receive a benefit equal to the retirement benefit he would have received had he retired after having worked twenty-five years.

On October 31, 1991, twenty-five years from the date Picard joined the police force, Oakland reduced Picard's pension from 75 percent to 50 percent of his former base salary pursuant to the Plan.

The Commissioner of Internal Revenue (the "Commissioner") determined that, as of October 31, 1991, because the amount of Picard's disability benefit was determined by reference to his length of service, Picard did not qualify for the 26 U.S.C. § 104(a) (1) exemption he had formerly invoked; thus, Picard was required to report his 1992 disability pension as income. Picard did not file a 1992 income tax return.

After the Commissioner assessed a $3,169 deficiency in Picard's 1992 income tax, Picard challenged the deficiency in the United States Tax Court. The issue was submitted to the Tax Court based on stipulated facts. Both parties agreed that the disability-retirement benefits paid to Picard prior to October 31, 1991, were excludable from Picard's gross income under § 104(a) (1). With regard to payments after October 31, 1991, the Tax Court ruled for the Commissioner. The Tax Court held that Picard's reduced disability income was no longer excludable under § 104(a) (1) because the Plan's reduction of Picard's pension on the twenty-fifth anniversary of Picard's first date of employment was the equivalent of a benefits determination made by reference to Picard's length of service.

Discussion

Section 104(a) (1) excludes from gross income amounts received under workmen's compensation acts as compensation for personal injuries.²  More important to our analysis, Treasury Regulation 1.104-1(b) limits the scope of § 104(a) (1). It specifies that the § 104(a) (1) exclusion does not apply to a retirement pension "to the extent that it is determined by reference to the employee's age and length of service."³  Consequently, whether after October 31, 1991 Picard's recalculated benefits are excludable from gross income depends on whether the Plan determines Picard's benefits by reference to his length of service.

When a disability-based retirement formally transfers to service retirement on the attainment of a certain employment anniversary, the payments received thereafter are no longer in the nature of workmen's compensation but are fully taxable. See Wiedmaier v. Commissioner, T.C. Memo.1984-540, 1984 WL 15183 (1984), aff'd. 774 F.2d 109 (6th Cir. 1985). Here, Picard's disability benefits did not transfer to a service-retirement pension. Picard was neither transferred out of the Plan's section 2610(a) disability-retirement system nor placed into the Plan's section 2608 service-retirement system. His recalculated benefits were determined by his date of hire, not by reference to his "length of service." The reduction in Picard's disability benefits, creating parity between disability and regular service retirees, did not, by itself, amount to a conversion of his benefits. Cf. Givens v. Commissioner, 90 T.C. 1145, 1988 WL 59902 (1988); Dyer v. Commissioner, 71 T.C. 560, 1979 WL 3701 (1979) (both recognizing that parity among benefits does not per se remove benefits from the purview of worker's compensation).

Relying upon Mabry v. Commissioner, T.C. Memo.1985-328, 1985 WL 14951 (1985),⁴  and Wiedmaier v. Commissioner, T.C. Memo.1984-540, 1984 WL 15183 (1984), aff'd. 774 F.2d 109 (6th Cir. 1985),⁵  the Commissioner argues, and the Tax Court held, that Picard's benefits formally transferred to service retirement and thereby became taxable. Both Mabry and Wiedmaier, like the case at hand, involved arrangements by which disability-retirement payments were initially excludable under § 104(a) (1) and were subsequently recomputed on the date when the disabled employees would have qualified for service retirement had they continued to work uninterrupted. The recomputed payments were set at the reduced amount the employees would have received had they taken service retirement on that date, treating the time working and the time spent on disability as equivalent for this purpose. Mabry and Wiedmaier concluded that payments resulting from such a recomputation were "determined by reference to the employee's age or length of service" within the meaning of Treasury Regulation 1.104-1(b) and, therefore, taxable.

Mabry and Wiedmaier, however, differ materially from the present case. In Mabry, petitioner's retirement benefits were "shifted from disability-retirement benefits ... [and] changed to reduced payments under the regular retirement program...." Mabry, T.C. Memo 1985-328. The taxpayer "started to receive new and different payments based on his age and years of service ... under different provisions of the city Charter." Id. In other words, unlike here, the city's charter converted the payments in Mabry to service-retirement benefits.

Picard's benefits, on the other hand, could not be determined by reference to his age or length of service. The Tax Court attempted to reconcile this apparent distinction by determining that, in Picard's case, as in Mabry, the Plan "deem [s] time spent on disability as equivalent to time spent actively working, and counting both in setting the date when a disabled employee was treated as if he had taken service retirement, with a corresponding adjustment to his retirement payments." Picard, T.C. Memo.1997-320 (emphasis in original).

This attempted distinction misapplies the facts of this case. As Mabry notes, the fundamental question in determining whether benefits are excludable under § 104(a) (1) is "upon what basis were the retirement payments in question paid?" Mabry, T.C. Memo 1985-328. The taxpayers in Mabry and Wiedmaier, at the time their benefits were reduced, qualified for regular service retirement, regardless of their continued disability. Picard, on the other hand, qualified only for disability-retirement benefits. Had Picard become "able" just one day before his benefit reduction, he would have qualified for neither service nor disability retirement benefits. To hold in favor of the Commissioner in this case, we would have to do something that neither Mabry nor Wiedmaier do--namely, hold that benefits are determined by reference to length of service even though a beneficiary would not qualify for a nondisability-based retirement. The facts of this case do not permit such a holding.

We conclude that the reduction in Picard's payments on the twenty-fifth anniversary of his date of hire did not convert his disability pension into a retirement pension. Because Picard's benefits were determined neither by reference to his age nor his length of service, his recalculated benefits remain excludable from income under I.R.C. § 104(a) (1).

REVERSED.