This section explains many types of employee compensation followed by a detailed explanation of Fringe Benefits and Sickness and Injury Benefits.

If you are an employee, you should receive a Form W-2 from your employer showing the pay you received for your services. Include your pay on line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ, even if you do not receive a Form W-2.

If you are not an employee, you generally will not receive a Form W-2. Nonemployee compensation is generally reported on Form 1099-MISC, Miscellaneous Income. For information on reporting nonemployee compensation, see the instructions on the back of Form 1099-MISC.

Child-care services.
If you provide child care, either in the child's home or in your home or other place of business, the pay you receive must be included in your income. If you are not an employee, you are probably self-employed and must include payments for your services on Schedule C or Schedule C-EZ of Form 1040. You are generally not an employee unless you are subject to the will and control of the person who employs you as to what you are to do and how you are to do it.

Babysitting.
If you babysit for relatives or neighborhood children, whether on a regular basis or only periodically, the rules for child-care providers apply to you.

Miscellaneous Compensation

This section explains many types of employee compensation. The subjects are arranged in alphabetical order.

Advance commissions and other earnings.
If you receive advance commissions or other amounts for services to be performed in the future, and you are a cash method taxpayer, you must include these amounts in your income in the year you receive them.

If you repay unearned commissions or other amounts in the same year you receive them, reduce the amount to include in your income by the repayment. However, if you repay the unearned commissions or other amounts in a later tax year, you can deduct the repayment as an itemized deduction on your Schedule A (Form 1040), or you may be able to take a credit for that year. See Repayments in chapter 13.

Allowances and reimbursements.
If you receive travel, transportation, or other business expense allowances or reimbursements from your employer, get Publication 463. If you are reimbursed for moving expenses, get Publication 521, Moving Expenses.

Back pay awards.
Include in gross income amounts you are awarded in a settlement or judgment for back pay. This includes payments made to you for damages, unpaid life insurance premiums, and unpaid health insurance premiums. They should be reported to you by your employer on Form W-2.

Bonuses and awards.
Bonuses or awards you receive for outstanding work are included in your gross income and should be shown on your Form W-2. These include prizes such as vacation trips for meeting sales goals. If the prize or award you receive is goods or services, you must include the fair market value of the goods or services in your income. However, if your employer merely promises to pay you a bonus or award at some future time, it is not taxable until you receive it or it is made available to you.

Employee achievement award.
If you receive tangible personal property (other than cash, gift certificate, or equivalent item) as an award for length of service or safety achievement, you can exclude its value from your income to the extent of your employer's cost for all such awards you receive during the year up to $1,600 ($400 for awards that are not qualified plan awards). Your employer can tell you whether your award is a qualified plan award. Your employer must make the award as part of a meaningful presentation, under conditions and circumstances that do not create a significant likelihood of it being disguised pay.

However, the exclusion does not apply to the following awards.

• A length-of-service award if you received it for fewer than 5 years of service or if you received another length-of-service award during the year or the previous 4 years.
• A safety achievement award if you are a manager, administrator, clerical employee, or other professional employee or if more than 10% of eligible employees previously received safety achievement awards during the year.

Government cost-of-living allowances.
Cost-of-living allowances are generally included in your income. However, these allowances are generally not included in your income if you are a federal civilian employee or a federal court employee who is stationed in Alaska, Hawaii, or outside the United States.

Allowances and differentials that increase your basic pay as an incentive for taking a less desirable post of duty are part of your compensation and must be included in your income. For example, your compensation includes Foreign Post, Foreign Service, and Overseas Tropical differentials. For more information, get Publication 516, U.S. Government Civilian Employees Stationed Abroad.

Holiday gifts.
If your employer gives you a turkey, ham, or other item of nominal value at Christmas or other holidays, you do not have to include the value of the gift in your income. However, if your employer gives you cash, a gift certificate, or a similar item that you can easily exchange for cash, you include the value of that gift as extra salary or wages regardless of the amount involved.

Note received for services.
If your employer gives you a secured note as payment for your services, you must include the fair market value (usually the discount value) of the note in your income for the year you receive it. When you later receive payments on the note, a proportionate part of each payment is the recovery of the fair market value that you previously included in your income. Do not include that part again in your income. Include the rest of the payment in your income in the year of payment.

If your employer gives you an unsecured note as payment for your services, payments on the note that are credited toward the principal amount of the note are compensation income when you receive them.

Railroad retirement annuities.
The following types of payments are treated as pension or annuity income and are taxable under the rules explained in chapter 11.

1. Tier 1 railroad retirement benefits that are more than the "social security equivalent benefit."
2. Tier 2 benefits.
3. Vested dual benefits.

Restricted property received for services.
Generally, if you receive property for your services, you must include its fair market value in your income in the year you receive the property. However, if you receive stock or other property that has certain restrictions that affect its value, you may not have to include the value of the property in your income in the year you receive it. For details, see Restricted Property Received for Services in Publication 525.

Dividends received on restricted stock.
Dividends you receive on restricted stock are extra compensation to you. Your employer should include these payments on your Form W-2. If they are also reported on Form 1099-DIV, Dividends and Distributions, you should list them on Schedule B (Form 1040), Interest and Ordinary Dividends, with a statement that you have to include them as wages. Do not include them in total dividends received.

Stock you chose to include in income.
Dividends you receive on restricted stock you chose to include in your income in the year transferred are treated the same as any other dividends. You should receive a Form 1099-DIV showing these dividends. Do not include the dividends in your wages on your return. Report them as dividends. For a discussion of dividends, see chapter 9.

Retirement plan contributions.
You must include in income amounts you pay into a retirement plan through payroll deductions. You recover your contributions tax free when you retire and receive benefits from the plan. See chapter 11 for more information about the tax treatment of retirement plan benefits.

Employer's contributions to qualified plan.
Your employer's contributions to a qualified retirement plan for you are not included in income at the time contributed. (Your employer can tell you whether your retirement plan is qualified.) However, the cost of life insurance coverage included in the plan may have to be included. See Group-Term Life Insurance, later, under Fringe Benefits.

Elective deferrals.
If you chose to set aside part of your pay for retirement under a qualified deferred compensation arrangement (for example, a section 401(k) plan), the amount you set aside is treated as an employer contribution to a qualified plan, subject to a limit. For 1999, this limit is $10,000 for all elective deferrals. If you set aside more than $10,000, the excess must be included in your income for that year. See Publication 575 for a discussion of the tax treatment of corrective distributions of excess deferrals.

Elective deferrals are not excluded from wages for social security and Medicare taxes and benefits.

If you are a federal employee, this treatment applies to your contributions to the Thrift Savings Plan.

Employer's contributions to nonqualified plan.
If your employer pays into a nonqualified plan for you, you generally must include the contributions in your income as wages for the tax year in which the contributions are made. However, if your interest is subject to a substantial risk of forfeiture (you have a good chance of losing it) at the time of contribution, you do not have to include the value of your interest in your income until it is no longer subject to a substantial risk of forfeiture.

Severance pay.
Amounts you receive as severance pay are taxable. A lump-sum payment for cancellation of your employment contract is income in the tax year you receive it and must be reported in gross income.

Accrued leave payment.
If you are a federal employee and receive a lump-sum payment for accrued annual leave when you retire or resign, this amount will be included on your Form W-2.

If you resign from one agency and are reemployed by another agency, you may have to repay part of your lump-sum annual leave payment to the second agency. You can reduce gross wages by the amount you repaid in the same tax year in which you received it. You should attach to your tax return a copy of the receipt or statement furnished by the agency to which you make repayment to explain the difference between the wages on the return and the wages on your Forms W-2.

Outplacement services.
If you choose to accept a reduced amount of severance pay so that you can receive outplacement services (such as training in resumé writing and interview techniques), you must include the unreduced amount of the severance pay in income.

However, you can deduct the value of these outplacement services (up to the difference between the severance pay included in income and the amount actually received) as a miscellaneous deduction (subject to the 2% limit) on Schedule A (Form 1040).

Sick pay.
Amounts you receive from your employer while you are sick or injured are part of your salary or wages. You must include in your income payments made by any of the following.

1. Your employer.
2. A welfare fund.
3. A state sickness or disability fund.
4. An association of employers or employees.
5. An insurance company, if your employer paid for the plan.

However, if you paid the premiums on an accident or health insurance policy, the benefits you receive under the policy are not taxable.

Railroad sick pay.
Payments you receive as sick pay under the Railroad Unemployment Insurance Act are taxable and you must include them in your income. However, do not include them in your income if they are for an on-the-job injury.

If you received income because of a disability, see Sickness and Injury Benefits, later.

Social security and Medicare taxes paid by employer.
If you and your employer have an agreement that your employer pays your social security and Medicare taxes without deducting them from your gross wages, you must report the amount of tax paid for you as taxable wages on your tax return. You must also treat the payments as wages for figuring your social security and Medicare taxes and your social security and Medicare benefits. However, these payments are not treated as social security and Medicare wages if you are a household worker or a farm worker.

Stock appreciation rights.
Do not include a stock appreciation right granted by your employer in income until you exercise (use) the right. When you use the right, you are entitled to a cash payment equal to the fair market value of the corporation's stock on the date of use minus the fair market value on the date the right was granted. You include the cash payment in your income in the year you use the right.

Stock options.
If you receive a nonstatutory option to buy stock or other property as payment for your services, you will usually have income when you receive the option or when you exercise (use) the option. However, if your option is a statutory stock option (an incentive stock option or an option granted under an employee stock purchase plan), special rules generally delay the tax until you sell or exchange your shares of stock. Your employer can tell you which kind of option you hold. For details, get Publication 525.

Unemployment compensation.
You must include in your income all unemployment compensation you receive. You should receive a Form 1099-G, Certain Government and Qualified State Tuition Program Payments, showing the amount paid to you. Generally, you enter unemployment compensation on line 19 of Form 1040, line 12 of Form 1040A, or line 3 of Form 1040EZ.

Types of unemployment compensation.
Unemployment compensation generally includes any amount received under an unemployment compensation law of the United States or of a state. It includes the following benefits.

1. Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund.
2. State unemployment insurance benefits.
3. Railroad unemployment compensation benefits.
4. Disability payments from a government program paid as a substitute for unemployment compensation. Amounts received as workers' compensation for injuries or illness are not unemployment compensation.
5. Trade readjustment allowances under the Trade Act of 1974.
6. Benefits under the Airline Deregulation Act of 1978.
7. Unemployment assistance under the Disaster Relief Act Amendments of 1974.

Governmental program.
If you contribute to a governmental unemployment compensation program and your contributions are not deductible, amounts you receive under the program are not included as unemployment compensation until you recover your contributions.

Supplemental unemployment benefits.
Benefits received from an employer-financed fund (to which the employees did not contribute) are not unemployment compensation. They are taxable as wages and are subject to withholding for income tax and social security and Medicare taxes. Report these payments on line 7 of Form 1040 or Form 1040A or on line 1 of Form 1040EZ.

You may have to repay some of your supplemental unemployment benefits to qualify for trade readjustment allowances under the Trade Act of 1974. If you repay supplemental unemployment benefits in the same year you receive them, reduce the total benefits by the amount you repay. If you repay the benefits in a later year, you must include the full amount of the benefits received in your income for the year you received them.

Deduct the repayment in the later year as an adjustment to gross income on Form 1040. (You cannot use Form 1040A or 1040EZ.) Include the repayment on line 32 of Form 1040, and put "Sub-Pay TRA" and the amount on the dotted line next to line 32. If the amount you repay in a later year is more than $3,000, you may be able to take a credit against your tax for the later year instead of deducting the amount repaid. For more information on this, see Repayments in chapter 13.

Private unemployment fund.
Unemployment benefit payments from a private fund to which you voluntarily contribute are taxable only if the amounts you receive are more than your total payments into the fund. Report the taxable amount on line 21 of Form 1040.

Payments by a union.
Benefits paid to you as an unemployed member of a union from regular union dues are included in your gross income on line 21 of Form 1040.

Guaranteed annual wage.
Payments you receive from your employer during periods of unemployment, under a union agreement that guarantees you full pay during the year, are taxable as wages.

State employees.
Payments similar to a state's unemployment benefits may be made by the state to its employees who are not covered by the state's unemployment compensation law. Although the payments are fully taxable, do not report them as unemployment benefits. Report these payments on line 21 of Form 1040.

Repayment of unemployment compensation benefits.
If you repaid in 1999 unemployment compensation benefits you received in 1999, subtract the amount you repaid from the total amount you received and enter the difference on line 19 of Form 1040, line 12 of Form 1040A, or line 3 of Form 1040EZ. Also, enter "Repaid" and the amount you repaid on the dotted line next to line 19, line 12, or line 3. If, in 1999, you repaid unemployment compensation that you included in gross income in an earlier year, you may deduct the amount repaid on Schedule A (Form 1040) if you itemize deductions. For more information, see Repayments in chapter 13.

Tax withholding.
You can choose to have federal income tax withheld from your unemployment compensation. To make this choice, complete Form W-4V, Voluntary Withholding Request, and give it to the paying office. Tax will be withheld at 15% of your payment.

If you do not choose to have tax withheld from your unemployment compensation, you may be liable for estimated tax. For more information on estimated tax, see chapter 5.

Union benefits and dues.
Amounts deducted from your pay for union dues, assessments, contributions, or other payments to a union cannot be excluded from your gross income.

You may be able to deduct some of these payments as a miscellaneous deduction subject to the 2% limit if they are related to your job and if you itemize your deductions on Schedule A (Form 1040). For more information, see Union Dues and Expenses in chapter 30.

Strike and lockout benefits.
Benefits paid to you by a union as strike or lockout benefits, including both cash and the fair market value of other property, are usually included in your income as compensation. You can exclude these benefits from your income only if the facts clearly show that the union intended them as gifts to you.

Fringe Benefits

Fringe benefits you receive in connection with the performance of your services are included in your gross income as compensation unless you pay fair market value for them or they are specifically excluded by law from your income. Abstaining from the performance of services (for example, under a covenant not to compete) is treated as the performance of services for purposes of these rules.

Accounting period.
You must use the same accounting period your employer uses to report your taxable noncash fringe benefits. Your employer has the option to report taxable fringe benefits by using either of the following rules.

1. The general rule: benefits are reported for a full calendar year (January 1- December 31).
2. The special accounting period rule: benefits provided during the last 2 months of the calendar year (or any shorter period) are treated as paid during the following calendar year. For example, each year your employer reports the value of benefits provided during the last 2 months of the prior year and the first 10 months of the current year.

Your employer does not have to use the same accounting period for each fringe benefit, but must use the same period for all employees who receive a particular benefit.

You must use the same accounting period that you use to report the benefit to claim an employee business deduction (for use of a car, for example).

Form W-2.
Your employer reports your taxable fringe benefits in box 1 (Wages, tips, other compensation) of Form W-2. The total value of your fringe benefits may also be noted in box 12. The value of your fringe benefits may be added to your other compensation on one Form W-2, or you may receive a separate Form W-2 showing just the value of your fringe benefits in box 1 with a notation in box 12

Accident or Health Plan

Generally, the value of accident or health plan coverage provided to you by your employer is not included in your gross income. Benefits you receive from the plan are generally taxable, as explained later under Sickness and Injury Benefits.

Long-term care coverage.
Contributions by your employer to provide coverage for long-term care services are generally not included in income. However, contributions made through a flexible spending or similar arrangement (such as a cafeteria plan) must be included in your income. This amount will be reported as wages in box 1 of your Form W-2.

Contributions you make to the plan are discussed in Publication 502, Medical and Dental Expenses.

Medical savings account (MSA) contributions.
Contributions by your employer to your medical savings account are not included in your income. This amount will, however, be reported in box 13 of Form W-2 with code R designating that the amounts are excludable from income. You must report this amount on Form 8853, Medical Savings Accounts and Long-Term Care Insurance Contracts, and attach the form to your return.

If your employer does not make contributions to your MSA, you can make your own contributions to your MSA. These contributions are discussed in Publication 969, Medical Savings Accounts (MSAs). Also, see Form 8853, Medical Savings Accounts and Long-Term Care Insurance Contracts.

Adoption Assistance

You may be able to exclude from gross income amounts paid or expenses incurred by your employer for qualified adoption expenses in connection with your adoption of an eligible child. The amounts must be paid or the expenses must be incurred before January 1, 2002, as part of an adoption assistance program. See Publication 968, Tax Benefits for Adoption, for more information.

Adoption benefits are reported by your employer in box 13 of Form W-2 with code T. They are also included as social security and Medicare wages in boxes 3 and 5. However, they are not included as wages in box 1. To determine the taxable and nontaxable amounts, you must complete part III of Form 8839, Qualified Adoption Expenses. Attach the form to your return.

Group-Term Life Insurance

Generally, the cost of up to $50,000 of group-term life insurance coverage that is provided to you by your employer (or former employer) is not included in your income. However, you must include in your income the cost of employer-provided insurance to the extent it is more than the cost of $50,000 of coverage reduced by any amount you pay towards the purchase of the insurance.

For exceptions to this rule, see Entire cost excluded and Entire cost taxed, later.

If your employer provided more than $50,000 of coverage, the amount included in your income is reported as part of your wages in box 1 of your Form W-2. It is also shown separately in box 13 with code C. See Your payment, later.

Group-term life insurance.
This insurance is term life insurance protection (insurance for a fixed period of time) that:

1. Provides a general death benefit,
2. Is provided to a group of employees,
3. Is provided under a policy carried by the employer, and
4. Provides an amount of insurance for each employee based on a formula that prevents individual selection.

Permanent benefits.
If your group-term life insurance policy includes permanent benefits, such as a paid-up or cash surrender value, you must include in your income, as wages, the cost of the permanent benefits minus the amount you pay for them. Your employer should be able to tell you the amount to include in your income.

Accidental death benefits.
Insurance that provides accidental or other death benefits but does not provide general death benefits (travel insurance, for example) is not group-term life insurance.

Figuring the taxable cost.
You figure the taxable cost for each month of coverage by multiplying the number of thousands of dollars of insurance coverage for the month (figured to the nearest tenth), less 50, by the cost from the following table. Use your age on the last day of the tax year. You must prorate the cost from the table if less than a full month of coverage is involved.

Insurance Provided Before July 1999:

Insurance Provided After June 1999:

You figure the total taxable cost by multiplying the monthly taxable cost by the number of full months coverage at that cost.

Your payment.
If you pay any part of the cost of the insurance, your entire payment reduces, dollar for dollar, the amount you would otherwise include in your income. However, you cannot reduce the amount to include in your income by:

1. Payments for coverage in a different tax year,
2. Payments for coverage through a cafeteria plan, unless the payments are after-tax contributions, or
3. Payments for coverage not taxed to you because of the exceptions discussed later under Entire cost excluded.

Example.
You are 51 years old and work for employers A and B. Both employers provide group-term life insurance coverage for you for the entire year. Your coverage is $35,000 with employer A and $45,000 with employer B. You pay premiums of $4.15 a month under the employer B group plan. You figure the amount to include in your income for the insurance provided before July 1999 as follows:

 

You figure the amount to include in your income for the insurance provided after June 1999 as follows:

  

The total amount to include in income for the cost of excess group-term life insurance is $78 ($61.50 + $16.50). Because neither employer provided over $50,000 insurance coverage, the wages shown on your Forms W-2 do not include any part of that $78. You must add it to the wages shown on your Forms W-2 and include the total on your return.

Entire cost excluded.
You are not taxed on the cost of group-term life insurance if any of the following apply.

1. You are permanently and totally disabled and have ended your employment.
2. Your employer is the beneficiary of the policy for the entire period the insurance is in force during the tax year.
3. A charitable organization (defined in chapter 26) to which contributions are deductible is the only beneficiary of the policy for the entire period the insurance is in force during the tax year. You are not entitled to a deduction for a charitable contribution for naming a charitable organization as the beneficiary of your policy.
4. The plan existed on January 1, 1984, and--
   1. You retired before January 2, 1984, and were covered by the plan when retired, or
   2. You reached age 55 before January 2, 1984, and were employed by the employer or its predecessor in 1983.

Entire cost taxed.
You are taxed on the entire cost of group-term life insurance if either of the following apply.

1. The insurance is provided by your employer through a qualified employees' trust, such as a pension trust or a qualified annuity plan.
2. You are a key employee and your employer's plan discriminates in favor of key employees.

Transportation

If your employer provides you with a qualified transportation fringe benefit, it can be excluded from your gross income, up to certain limits. A qualified transportation fringe benefit is:

1. Transportation in a commuter highway vehicle (such as a van) between your home and work place,
2. A transit pass, or
3. Qualified parking.

Cash reimbursement by your employer for these expenses under a bona fide reimbursement arrangement is also excludable. However, cash reimbursement for a transit pass is excludable only if a voucher or similar item that can be exchanged only for a transit pass is not readily available for direct distribution to you.

Exclusion limit.
The exclusion for commuter highway vehicle transportation and transit pass fringe benefits cannot be more than a total of $65 a month, regardless of the total value of both benefits.

The exclusion for the qualified parking fringe benefit cannot be more than $175 a month, regardless of its value. If the benefits have a value that is more than these limits, the excess must be included in your income.

Commuter highway vehicle.
This is a highway vehicle that seats at least six adults (not including the driver). At least 80% of the vehicle's mileage must reasonably be expected to be:

1. For transporting employees between their homes and work place, and
2. On trips during which employees occupy at least half of the vehicle's adult seating capacity (not including the driver).

Transit pass.
This is any pass, token, farecard, voucher, or similar item entitling a person to ride mass transit (whether public or private) free or at a reduced rate or to ride in a commuter highway vehicle operated by a person in the business of transporting persons for compensation.

Qualified parking.
This is parking provided to an employee at or near the employer's place of business. It also includes parking provided on or near a location from which the employee commutes to work in a commuter highway vehicle or carpool. It does not include parking at or near the employee's home.

Employer-provided vehicles.
If your employer provides a car (or other highway motor vehicle) to you, your personal use of the car is usually a taxable noncash fringe benefit.

Sickness and Injury Benefits

Generally, you must report as income any amount you receive for personal injury or sickness through an accident or health plan that is paid for by your employer. If both you and your employer pay for the plan, only the amount you receive that is due to your employer's payments is reported as income. However, certain payments may not be taxable to you. For information on nontaxable payments and payments for sickness and injury other than disability pensions and annuities, see Military and Government Disability Pensions, later, and Other Sickness and Injury Benefits in chapter 13.

Cost paid by you.
If you pay the entire cost of an accident or health plan, do not include any amounts you receive from the plan for personal injury or sickness as income on your tax return. If your plan reimbursed you for medical expenses you deducted in an earlier year, you may have to include some, or all, of the reimbursement in your income. See Reimbursement in a later year in chapter 23.

Cafeteria plans.
Generally, if you are covered by an accident or health insurance plan through a cafeteria plan, and the amount of the insurance premiums was not included in your income, you are not considered to have paid the premiums and you must include any benefits you receive in your income. If the amount of the premiums was included in your income, you are considered to have paid the premiums and any benefits you receive are not taxable.

Disability Pensions

If you retired on disability, you must include in income any disability pension you receive under a plan that is paid for by your employer. You must report your taxable disability payments as wages on line 7 of Form 1040 or Form 1040A until you reach minimum retirement age. Minimum retirement age generally is the age at which you can first receive a pension or annuity if you are not disabled.

You may be entitled to a tax credit if you were permanently and totally disabled when you retired. For information on this credit, see chapter 34.

Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity. Report the payments on lines 16a and 16b of Form 1040, or on lines 11a and 11b of Form 1040A. The rules for reporting pensions and annuities are explained in chapter 11.

Retirement and profit-sharing plans.
If you receive payments from a retirement or profit-sharing plan that does not provide for disability retirement, do not treat the payments as a disability pension. The payments must be reported as a pension or annuity. For more information on pensions, see chapter 11.

Accrued leave payment.
If you retire on disability, any lump-sum payment you receive for accrued annual leave is a salary payment. The payment is not a disability payment. You must report it as wages in the tax year you receive it.

Military and Government Disability Pensions

Certain military and government disability pensions are not taxable.

Service-connected disability.
You may be able to exclude from income amounts you receive as a pension, annuity, or similar allowance for personal injury or sickness resulting from active service in one of the following government services.

1. The armed forces of any country.
2. The National Oceanic and Atmospheric Administration.
3. The Public Health Service.
4. The Foreign Service.

Conditions for exclusion.
Do not include the disability payments in your income if any of the following conditions apply.

1. You were entitled to receive a disability payment before September 25, 1975.
2. You were a member of a listed government service or its reserve component, or were under a binding written commitment to become a member, on September 24, 1975.
3. You receive the disability payments for a combat-related injury. This is a personal injury or sickness that:
   1. Results directly from armed conflict,
   2. Takes place while you are engaged in extra-hazardous service,
   3. Takes place under conditions simulating war, including training exercises such as maneuvers, or
   4. Is caused by an instrumentality of war.
4. You would be entitled to receive disability compensation from the Department of Veterans Affairs (VA) if you filed an application for it. Your exclusion under this condition is equal to the amount you would be entitled to receive from the VA.

Pension based on years of service.
If you receive a disability pension based on years of service, you generally must include it in your income. But if it is a result of active service in one of the listed government services and one of the listed conditions applies, do not include in income the part of your pension that you would have received if the pension had been based on a percentage of disability. You must include the rest of your pension in your income.

Retroactive VA determination.
If you retire from the armed services based on years of service and are later given a retroactive service-connected disability rating by the VA, your retirement pay for the retroactive period is excluded from income up to the amount of VA disability benefits you would have been entitled to receive. You can claim a refund of any tax paid on the excludable amount (subject to the statute of limitations) by filing an amended return on Form 1040X for each previous year during the retroactive period.

If you receive a lump-sum disability severance payment and are later awarded VA disability benefits, do not include in your income the portion of the severance payment equal to the VA benefit you would have been entitled to receive in that same year. However, you must include in your income any lump-sum readjustment or other non-disability severance payment you received on release from active duty, even if you are later given a retroactive disability rating by the VA.

Terrorist attack.
Do not include in your income disability payments you receive for injuries resulting directly from a violent attack that occurs while you are a U.S. government employee performing official duties outside the United States. For your disability payments to be tax exempt, the Secretary of State must determine the attack was a terrorist attack.

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