If taxpayers are temporarily disabled and receive payments for unused vacation and sick leave as part of their workers’ compensation, they must provide the IRS with adequate substantiation.
In a recent case, the U.S. Tax Court found that payments received by a retired police officer for unused vacation and sick time could not be excluded from income.
Clarence Speer retired from his job as a detective with the Los Angeles Police Department (LAPD) in 2009. During his decades-long career, he was on temporary disability on a few occasions.
When he retired from the LAPD, he was paid $30,773 for 541 hours of unused vacation time and $22,740 for 800 hours of unused sick time. The leave payments totaled $53,513 and were included on Speer’s 2009 Form W-2, Wage and Tax Statement.
Speer and his wife filed a joint return for 2009 and elected not to include the leave payments of $53,513 on their return. They included a note with the return explaining that they were excluding the leave payments from income because the payments were received under a workers’ compensation act. They cited California Labor Code Section 4850.
After some discussion, Speer and the IRS agreed that the section cited did not apply in this case. However, Section 4.177 of the Los Angeles Administrative Code (LAAC) did apply.
LAAC 4.177 discharges the obligations of the city of Los Angeles under the Workers’ Compensation Act to members of its fire and police departments who are either temporarily or permanently disabled by reason of duty-connected illness or injury.
While LAAC 4.177 is similar, it is not considered to be an actual workers’ compensation act. This distinction has some importance to it.
Internal Revenue Code Section 61(a) provides that lump-sum payments received by an employee for accrued vacation and sick leave are compensation for services and therefore gross income. An exception to this general rule provides that gross income does not include amounts received under workers’ compensation acts as compensation for personal injuries or sickness.
Part of Speer’s argument has some merit. He argued that the vacation and sick time that had accrued to him while he was on temporary disability should not be taxable income.
The problem is that most of the accrued vacation and sick time was earned while Speer was on active duty. Speer did not have detailed records to show which portion of the $53,513 was earned while on active duty and which portion was earned while on temporary disability.
Had the taxpayer kept the appropriate detailed records, the court would have considered treating the small portion of the $53,513 payment related to the periods of time when he received temporary disability as nontaxable.
Speer elected to exclude from taxable income all of the $53,513 instead of just that portion related to the time when he was on temporary disability and was receiving disability income payments under the provisions of LACC 4.177.
LACC 4.177 is not a workers’ compensation act. But, because it is similar, the court would have overlooked this technicality if the taxpayer had proved which portion of the $53,513 in payments was related to vacation and sick time accrued during the temporary disability periods of Speer’s career.
The taxpayer did not have this type of detailed documentation. Therefore, the court ruled that the entire payment amount was taxable income (Clarence William Speer and Susan M. Speer v. Commissioner, 144 T.C. No. 14, April 16, 2015).