<strong><em>Scarce v. Commissioner</em>, 21 T.C. 830 (1954)</em></strong>

Military retirement pay is taxable unless it is explicitly based on personal injuries or sickness resulting from active service in the armed forces.

<strong>Summary</strong>

The case of <em>Scarce v. Commissioner</em> addresses the taxability of military retirement pay under Section 22(b)(5) of the Internal Revenue Code of 1939. The taxpayer, a retired naval commander, argued that his retirement pay should be excluded from gross income because it was essentially compensation for injuries or sickness. The Tax Court disagreed, holding that since the taxpayer’s retirement was based on length of service and not on any physical disability, the retirement pay was taxable. The court distinguished this case from <em>Prince v. United States</em>, where the taxpayer could have originally retired for disability, highlighting the importance of the basis of the retirement for tax purposes.

<strong>Facts</strong>

Marshall Sherman Scarce, a commander in the Navy, was retired from active duty on June 30, 1931, based on length of service. He later received retirement pay calculated at 2.5% of his years of service multiplied by the pay of a commander. The taxpayer’s retirement status was never altered to reflect a disability retirement. Scarce did not appear before a retirement board to establish that he could have been retired for disability.

<strong>Procedural History</strong>

The Commissioner of Internal Revenue determined that the taxpayer’s retirement pay was taxable. The taxpayer appealed to the United States Tax Court, arguing that his retirement pay should be excluded from gross income. The Tax Court heard the case and ruled in favor of the Commissioner, resulting in the denial of the appeal.

<strong>Issue(s)</strong>

1. Whether retirement pay received by a member of the armed forces is excludable from gross income under Section 22(b)(5) of the Internal Revenue Code of 1939 when the retirement is based on length of service, rather than on physical disability arising from active service.

<strong>Holding</strong>

1. No, because the retirement pay was based on length of service and not upon injuries or sickness, it is not excludable from gross income under section 22(b)(5).

<strong>Court's Reasoning</strong>

The court’s decision rested on a strict interpretation of Section 22(b)(5) of the Internal Revenue Code of 1939, which permits the exclusion from gross taxable income of pay allowances to members of the armed services where such allowances are based upon sickness or personal injuries arising from active service. The court emphasized that the statute makes no provision for the exclusion of allowances based on length of service. The court stated, “We must view the situation as it is.” The court distinguished the case from <em>Prince v. United States</em> by noting that in <em>Prince</em>, the taxpayer could have retired for disability, which was not the case here. The court stated it would not “decline to follow the Court of Claims in Prince and adhere to the principles enunciated” in other similar cases where the pay was based on the type of service.

<strong>Practical Implications</strong>

This case clarifies that military retirement pay is generally subject to federal income tax unless it is explicitly linked to injuries or sickness incurred during active service. This has significant implications for military personnel, retirees, and tax advisors. Taxpayers seeking to exclude retirement pay must demonstrate a direct causal link between the payment and a service-related injury or illness, not just the fact that the recipient served in the military. The <em>Scarce</em> case emphasizes the importance of the specific basis for retirement in determining the taxability of retirement pay. This case also guides the IRS in auditing and assessing taxes on military retirement pay. It is important to note that this case was decided under a specific statute. This case has been distinguished in later cases based on whether a physical disability retirement was available.