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Lessons from the Courts: Tax angles on accrued benefits

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in Small Business Tax

Generally, amounts received to compensate an individual for personal injury are taxable, unless the payment is attributable to an actual physical injury or sickness. For instance, payments under workers’ compensation laws are usually exempt from tax. This is a matter that is contested frequently in the courts.

In a recent case, a retired police detective claimed that a portion of his vacation time pay had accrued under a workers’ compensation law while he was on temporary disability leave, so it should be tax free. But the Tax Court had other ideas.

Facts of the case: During a long career as a detective at the Los Angeles Police Department (LAPD), Mr. Speer was granted periods of temporary disability leave as a result of duty-related injuries or sickness. While he was on temporary leave, Speer received temporary disability compensation equal to his base salary. Also, he continued to earn vacation and sick leave during these periods of temporary disability.

Speer’s entitlement to pay and benefits upon his retirement was governed by a memorandum under a collective bargaining agreement. Among other things, the memorandum established entitlement to a cash payout for earned, but unused, vacation and sick time.

Upon his retirement from the LAPD in 2009, Speer was paid $30,773 for 541 hours of unused vacation time (400 carried over from 2008 and 141 earned in 2009) and $22,740 for 800 hours of unused sick leave, totaling $53,513. The payments for unused leave were included in the wages reported on Speer’s W-2.

However, Speer didn’t report the unused leave payments as income on his 2009 return. He argued that amounts attributable to vacation and sick leave benefits earned while on temporary disability leave were received under a workers’ compensation act and, therefore, should be excluded from taxable income.

Tax outcome: First, the Tax Court determined that the memorandum was not in the nature of a workers’ compensation act. Furthermore, even if Speer could show that it was, he failed to reveal how many hours, if any, were accumulated during leaves of absence and how many remained at retirement. The Court would have to know Speer’s entire sick and vacation leave histories—which it did not. Accordingly, the payments for unused leave constituted taxable income. (Speer, 114 TC No. 14, 4/16/15)

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