the Contingency Option Act program should be accorded the favorable tax treatment afforded pension plans which qualify under section 401 of the Internal Revenue Code (26 U.S.C. 401), thereby making the program considerably more attractive. If it qualifies under section 401 as an employees' trust the entire value at death would be excluded from the gross estate under provisions of section 2039 (c) of the Internal Revenue Code.

even

A RECENT JAG JOURNAL article 20 considered the effect of the "Hump" Law (P.L. 86-155; 10 U.S.C. 5701 note) on Contingency Option Act elections. It was there explained that revocation of an election under Contingency Option is effective if made at any time before involuntary retirement under "Hump". However, a change of election would not be effective unless the officer concerned could have served the requisite five-year period 21 after the change if he had been retired under permanent involuntary retirement law, though earlier retired under "Hump." 22 These rules have been slightly modified by "White Charger", 23 approved on 12 July 1960. This law amends the "Hump" Law to provide that, in spite of the provisions of the Contingency Option Act concerning changes and revocations, both a change or revocation of election is effective when made by an officer retired under "Hump" or an officer who retires voluntarily after being selected for non-continuation under "Hump", if made at such a time that it would have been effective had he been retired under permanent involuntary retirement law.24 The effect of this amendment is to provide uniform treatment for changes and revocations of election, and to extend the beneficial provisions of section 3 of "Hump" to those voluntarily retired after selection for non-continuation as well as to those actually "Humped". Section 13 of "White Charger" grants retired officers in the former category six months from the date of enactment of that Act to affirm, or make effective, a change or revocation of election made before retirement if it would have been effective under section 3 of "Hump" but for the voluntary retirement. This is, of course, a retroactive application of the broader coverage of amended section 3 of "Hump" to those retired voluntarily after not being selected for continuation.

The first question which anyone will ask about the Contingency Option Act is, "how much will

20. Lynch, The Hump Law, JAG JOURNAL, May 1960, p. 11. 21. 10 USC 1431(c).

22. P.L. 86-155, sec. 3, 10 USC 5701 note.

23. P.L. 86-616.

24. Sec. 12.

it cost?" Abridged percentage reduction tables are available in convenient form in NAVPERS 15867, which includes tables for both physical disability and non-physical disability retirement, and for all options except option three. The latter may be derived mathmatically with a maximum error of 12% of gross retired pay. The unabridged percentage reduction tables are available through your personnel officer. Information as to the member's age, the age difference of the two spouses, and the age of the youngest child, as appropriate, is applied in reading the tables. All information is applicable as of the date of retirement, since the reduction factor is computed as of that time. The tables will yield a four digit number, which, when prefaced by a decimal point and multiplied by the member's gross monthly retired pay, will give the amount to be subtracted from gross retired pay to get the reduced retired pay. The annuity payable to each class of dependents will be oneeighth, one-quarter, or one-half of this reduced retired pay, as appropriate. No matter how slight the physical disability, retirement therefor with less than 20 years service involves a materially greater reduction in retired pay. For this reason, a member with a slight disability which has no effect on his life expectancy, might think twice about electing an annuity.

NEW PERCENTAGE COST tables are soon to be promulgated, according to BUPERS NOTICE 1750 of 25 November 1960. Under these revised tables all retired members will be divided into three groups. The first will consist of all members retiring after 1960 with over 20 years of service, regardless of the cause of retirement. Only slightly higher reduction factors than in the present nondisability tables will apply. The second group will consist of disability retirees with less than 20, but over 17 years of service. The rates are only slightly 'less favorable that in the present disability table. The third group consists of members. who are retired for disability after 1960 with less than 17 years of service and who have not made an election prior to 1961. The present disability tables will apply to such members electing prior to 1961 and retiring prior to 1966. Reduction factors are appreciably higher for this third group, in which adverse selection has taken place since such members are not required to elect in advance. These revised tables, of course, result from an attempt to keep the cost of participation in the program in proportion to the benefits received, short of legislation. (Continued on page 31)

HERE ARE MANY facets and intricate phases to retirement programs being offered to members of the Armed Forces. This article is written, not with the intent of enlightening members on all of the problems which might be encountered upon their retirement, but to give a detailed analysis of only one problem involved after retirement-Federal taxation of the retired pay and survivor annuity where a member elected to receive a reduced amount of retirement pay under the Uniformed Services Contingency Option Act of 1953, now incorporated in Title 10, Chapter 73, of the United States Code. For a commentary dealing with the broad features of Contingency Option Act the reader is referred to Lieutenant Mead's companion article in this issue of the Journal.

The instant article is broadly broken into two parts. PART I presents in the main descriptive materials for demonstrating to the reader the computation of his federal taxes under varying conditions of retirement. PART II compares the nature of the tax treatment of the Uniformed Services retirement and survivor plan to the commercial and Civil Service plans. PART I

ON 25 NOVEMBER 1960 the Bureau of Naval Personnel advised in BUPERS NOTICE 1750 that tables of percentage reduction in retired pay to provide Uniformed Services annuities were being revised. In brief, the general effects on three groups of personnel are as follows. Group One: members with 20 or more years of service who retire after 1960 on account of physical disability will realize a sub

*Mr. Jalmer Rolfson is the Head of the Income Tax Branch of the Office of the Judge Advocate General. He received his LL.B. from the George Washington University in 1957 and is a member of the Bar of the District of Columbia. Mr. Rolfson also holds the B.C.S. and the M.C.S. degrees in Accounting and has a wide and varied experience in the Federal and State tax field. He is a Commander in the Naval Reserve.

**Lieutenant (jg) Robert J. Hawk, SC, USNR, is presently assigned to the Income Tax Branch of the Office of the Judge Advocate General. He received the B.S. degree from the University of Tennessee in 1957 and graduated from the Navy Supply Corps School in 1958. Lieutenant Hawk has served as supply and disbursing officer aboard the USS INVESTIGATOR.

stantial saving. The reduction factors for them will be the same as the new factors for nondisability retirement, which in turn will be slightly higher, about 1/2 of 1 percent on an average, over the old nondisability factors. Thus, the Federal income tax savings attributable to disability retirement will not be offset by larger reductions in retired pay. These new rates will not apply to those members who retired before 1961 and were subject to the previous higher reduction factors for physical disability.

A second group, which consists of members who retire on account of physical disability after completing 17 but less than 20 years of service, will be subject to new reduction factors which are on the average less than 1/2 of 1 percent higher than the old factors. A savings provision preserves the old factors to those who made an election before 1961 and who retire after 1960 and before 1966 on account of physical disability and with less than 17 years of service.

A third group consists of members who retire after 1960 on account of physical disability and with less than 17 years of service. Unless they had made an election prior to 1961, they will be subject to appreciably higher reduction factors if they thereafter elect to participate. The old physical disability factors, however, are applicable to those members who made an election prior to 1961.

The following selected reduction factors for members who elect options 1 and 4 to provide a 12 annuity for their surviving widows two years younger, and who retire after 1960 with 20 years or more of service, will give you an idea as to how the new factors may effect your election:

A complete table of reduction factors is being distributed by the Bureau of Naval Personnel. THE FEDERAL TAX impact upon reduced retired pay, gross estates, and annuities under current rulings is illustrated in the following examples and paragraphs. First consider the situation which existed in 1960 for members who retired under the old reduction factors: Navy Captain A, age 64 on 1 January 1960, with a spouse two years younger, was retired at age 63 on 1 January 1959 with no disability after 29 years service. A has no dependents and receives interest income of $1,000 annually. Captain B, in identical circumstances, retired with 30% disability. Both Captains have selected Options 1 and 4 for 1⁄2 annuity. The retirement pay for each, computed at 721⁄2% × $985.00 per month is $714.13 per month or $8,569.56 per year.

Several items may interest you when comparing the above figures. The factor for disability retirement is approximately 4914 per cent higher than for nondisability retirement, which lends itself to a greater monthly reduction in both retired pay and survivorship benefits. Also note that the dollar yield per dollar of reduction in nondisability retirement pay is 66% higher than for disability retirement ($2.41-1.45-$.96÷1.45-66%).

From the figures thus far presented it appears that member A, with no disability, has a substantial financial advantage over disabled member B. Before such a conclusion can be accepted, further aspects must first be analyzed. The Federal income tax liability, under current laws, may cast additional light upon this hazy subject as follows: A-Nondisability

$8,569.56

B-30% Disability

$8, 569. 56

The above points out an important aspect of disability retirement. Even though B may exclude $3,546.00 per year from gross income on account of 30% disability, the reduction in his retired pay to provide an annuity is $724.08 more annually than for nondisability retirement. As a result B's "spendable" income is $21.97 less than if not retired for disability.

SO MUCH FOR A and B in 1960 at age 64, but

let us see what the difference was for 1959 when B was entitled to a "sick pay" exclusion. Since B was not employed by the Federal Government and had not reached "retirement age" of 40 years or age 64 for a commissioned officer of his rank who retired after reaching age 62, he was entitled to a "sick pay" exclusion under section 105 (d) of the Internal Revenue Code of 1954 of up to $100 per week of the portion of his retired pay which exceeds the $3,546.00, excluded for 30% disability. Thus, B was able to exclude an additional $5,023.56 as "sick pay" which resulted in a total exclusion of his disability retired pay, and his Federal income tax was zero, computed as follows:

Annual Retired Pay....

Less: Exclusion for 30% Disability..
Sick Pay Exclusion..........

Gross Income From Retired Pay.
Interest Income___

Adjusted Gross Income---

Tax from Tax Table..

$8, 569. 56 -3,546. 00 -5, 023. 56

0

$1,000.00

$1,000.00

0

Annual Retired Pay....
Less: Disability exclusion

(30% of $11,820 annual
basic pay)

Gross Income from Retired

Pay.

Interest Income...

Adjusted Gross Income__

Standard Deduction.......
Remainder..

-1,200.00 Exemptions (2) -----

Taxable Income...

$5, 023. 56

+ 1,000.00

$6, 023. 56

- 602. 36

$5, 421. 20

- 1,200.00

$4, 221. 20 $608.66

Their Federal income taxes, at current rates, remain the same-$1,310.77 for A, $0 for B during the period while entitled to a "sick pay" exclusion and $608.66 thereafter. The monetary benefit to B over A is equal to his income tax savings.

The comparisons given thus far have intentionally avoided one of the most questioned aspects of taxation under the subject Act-what comprises reportable gross income, statutory retired pay or the reduced amount thereof? That is, why do the illustrations include the difference between statutory retired pay and the reduced amount thereof in gross income? In Civil Service and commercial retirement annuities which qualify as employees' pension trusts under section 401 of the Internal Revenue Code of 1954, only the reduced amount would be includible in gross income. However, the Internal Revenue Service has held in Revenue Ruling 54144, C.B. 1954-1, 15, that the amount by which Uniformed Services retired pay is reduced in order to provide an annuity for eligible survivors does not constitute an allowable deduction from gross income for Federal income tax purposes. The reasoning is that the awarded retired pay is includible in gross income because the difference in amount between awarded retired pay and reduced retired pay constitutes a premium paid for the purchase of an annuity.

PART II

MANY READERS MAY believe that the tax consequences resulting from making an election should be re-evaluated to compare the income and estate tax treatment of payments made un

Note that of B's statutory retired pay of $8,569.56, only $5,023.56, or 58.62%, is includible in gross income after the exclusion attributable to 30% disability. If the C.O.A. reduction is to be apportioned to the nondisability and disability portions of his retired pay in the ratio that they bear to each other, then $1,288.00, or 58.62% of the $2,197.20 reduction would further reduce B's taxable retired pay to $3,735.56. A's taxable retired pay would be $7,096.44 after reducing his statutory retired pay of $8,569.56 by $1,473.12, and the Federal income tax computations for A and B would be:

$7, 372.36 -372.40 $6,999.96

$7, 077.34 Available to Spend..... Thus A would have $291.67 more to spend per year, and B would have $236.26, if only the reduced amounts of retired pay were required to be reported as under Civil Service and commercial plans.

WHILE THEY HAVE not prevailed with the

Internal Revenue Service, there are strong arguments in favor of requiring only the reduced amount of retired pay to be reported. These are set forth below in the hope that they will prevail by either future judicial interpretation or legislative revision of the Contingency Option Act. In the case of Charles L. Jones and Ersie C. Jones v. Commissioner of Internal Revenue (2 T.C. 924 (1943)) the court did not hold for the Commissioner who had concluded, on the premise that Jones' own annuity was compensation for services rendered, that Jones was taxable upon the portion which is currently used to purchase an annuity for Jones' wife. Instead, the court rendered its decision on the premise that amounts by which an employee retirement annuity are reduced to provide a survivor annuity are not includible in the retired employee's gross income.

A recent decision gives us a clue as to the present thinking of the courts in situations where an employee has entered into a contract to provide retirement remuneration for himself and/or his widow. In George W. Drysdale and Jeanette Drysdale v. the Commissioner of Internal Revenue (277 F. 2d 413, C.A. 6th (1960)) decided by the Sixth Circuit Court on April 20, 1960, the court held that payments made to a trustee under a contract negotiated at arm's length did not result in constructive receipt of income for the reason that the taxpayer did not have any right to immediate possession or enjoyment. This theory would seem to make a stronger case for a tax change under the uniformed services "retirement-and-annuity" system since there is no payment of funds over to a trustee for eventual payment to the retired member which would defend a position of constructive receipt.

Additional support may be gained from the statement of the Chairman of the United States Civil Service Commission in a letter to the Chairman, Committee on Armed Forces [Senate] dated July 13, 1953:

Under the terms of the Civil Service Retirement Act a retiring employee may elect a reduced annuity with a continuing benefit to his surviving spouse. No reason is apparent why the proposal as suggested should not be extended to the military.

Prior to this statement the Comptroller General of the United States in a recommendation contained in a letter to the Chairman, Committee on Armed Services [Senate] dated July 8, 1953 said:

As indicated in the committee print, the purpose of the bill is to establish a plan whereby officers and enlisted personnel of the Regular and Reserve components of the uniformed services may elect to receive, upon entering a retired status, a reduced amount of their retired pay during their lifetime in order to provide annuities for their surviving widows and chil dren. It thus would provide for uniformed services personnel substantially similar benefits in that respect to those now provided for Federal civilian employees by the Civil Service Retirement Act of May 29, 1930, as amended.

It would appear from the above implications that persons electing retirement in the two programs under consideration are entitled to similar tax benefits. This is not the case at present. A civil service employee, in providing an annuity for qualified survivors, need include in gross income only the "amount received" (his elected reduced annuity), subject to recovery of his cost. A member of the Armed Forces must include all retired pay as gross income, to the extent not excludable for disability under sections 104 (a) (4) and 105 (d) of the Internal Revenue Code of 1954. Yet the annuities in both cases are provided by elections of the person to receive reduced retirement income.

In the event the retired member survives his spouse or child, the prior reductions in his retired pay are forfeited (except upon removal from the temporary disability retirement list for reasons other than retirement) even though the retired member has had to include them in gross income (to the extent not otherwise excluded). Some members may find it necessary to include the reductions in gross income for years after the time when they have no eligible beneficiaries. This treatment is not consistent with the equitable taxability of Civil Service employee annuities whereby the reductions are forfeited but the annuitant need not include them in gross income.