Tax Planning for Military Personnel

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Special Provisions for Unique Circumstances

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-l(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. …