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Tax Court Rules Vacation & Sick Pay Must Be Reported As Taxable Income

Valuations Include Everything

Recently the Tax Court ruled that vacation and sick pay are compensation items to be included as income tax when paid to a taxpayer.

In the facts, the taxpayer was a police officer on a city police force for 30 years. Unfortunately, he was badly injured and had to end his tenure with the department. Over the course of his career he accumulated 541 hours of unused vacation time and 800 hours of unused sick time. Initially after his injury he went on workers’ compensation.

When filing the income tax return for the appropriate year, the taxpayer purposefully excluded the worker compensation, vacation, and sick pay from the return. The IRS contended that the sick and vacation time was improperly excluded. The taxpayer used verbatim law from the Workers’ Compensation Act to justify his claim.

The Court ruled that the IRS was correct because the definition of income “as compensation for personal injury and sickness” did not include vacation and sick pay that is from the employer (covered under the Internal Revenue Code), The exclusion applies only to a narrow set of direct payments.

Editorial Comments

I’ve included because I find this to be daring on behalf of the taxpayer. The case even had merit! The Worker Compensation Act  specifically “…provides that the exclusion includes amounts received under a statute in the nature of the Workers’ Compensation Act”.

One reason the taxpayer was denied this exclusion was because the state statute did not provide for this exclusion. Had it, the outcome would have been different. This is what I would like to take away from this case: State law does have an effect on the way you pay federal income taxes.

By: Basi & Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors