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Published: November 16, 2018   |   Last Updated: November 19, 2020

Veterans Face Challenges in Claiming Refunds for Taxes Improperly Withheld from Disability Severance Pay

With having celebrated Veteran’s Day this week, it is worth reflecting on the continuing challenges military taxpayers face.


In December 2016, lawmakers advised that a potential 13,800 veterans had had taxes mistakenly withheld from lump-sum disability separation pay and were due refunds. The term “disability severance pay” (DSP) refers to one-time lump sum payments made to service members separated due to medical disability. DSP is paid to service members who are separated specifically because they are not fit for duty due to their disability. To be eligible, service members must be found unfit for duty; have less than 20 years of service; and have a disability rating of less than 30 percent. (“Disability rating” refers to the percentage assigned to a veteran’s medical condition to determine the amount of military benefits he or she should receive.) By law, DSP is not taxable if it is paid for combat-related injuries determined by the military service at the time of separation, or the veteran is eligible for disability compensation from the Department of Veterans Affairs (VA).

The total cost of refunds associated with DSP was estimated to be less than $78 million. Only now, we know those projections were wildly off target. In July 2018, the Department of Defense (DoD) and the IRS announced that almost ten times that number of disabled veterans—just over 130,000—are due tax refunds under the 2016 law. The aggregate amount of taxes improperly withheld from active-duty veterans is nearly $717 million. That number would be even higher if we were able to calculate the taxes improperly withheld from veterans who served in the reserves. In the reserve component pay system, the federal withholding for DSP is not itemized separately from the federal withholding for other payments made at time of separation. While DoD can identify that taxes were withheld from an individual reservist’s DPS and provide them notice, the agency is unable to identify the aggregate dollar amount of taxes withheld for reserve veterans.

Prior to 2016, DoD generally treated DSP as taxable income subject to withholding, pending a disability determination by the VA, which had a separate disability evaluation process from DoD. To recoup wrongfully withheld funds, veterans could have filed an amended tax return with the IRS, but most of the thousands of veterans affected are outside of the three-year period in which they could file an amended tax return.

Congress found that DoD had been improperly withholding taxes from DSP to disabled veterans since 1991. In December 2016, the President signed into law the Combat-Injured Veterans Tax Fairness Act of 2016, which Congress passed to correct the flaw in withholding procedures for DSP. Beginning in 2017, DoD and the VA integrated their disability evaluation systems. As a result, DoD may now rely on a veteran’s proposed VA rating to determine taxability of DSP at the time of payment. The Defense Finance and Accounting Service (DFAS) analyzed all available automated information within the military pay systems, as well as available automated historical data, to identify the affected veterans.

In July 2018, the IRS mailed to affected veterans over 130,000 Letters 6060-A or 6060-D that contain instructions for submitting a claim for credit or refund. Veterans can either file a claim based on their actual DSP and actual taxes withheld, or a standard refund amount, as detailed in the letter. Importantly, the letters provide information for veterans on required timeframes for filing credit or refund claims. Under the new law, veterans may claim a refund within one year from the date of the letter, even if the normal three-year period of limitations has expired. The letters also provide a special IRS toll-free number (833-558-5245, ext. 378, between 7:00 a.m. and 7:00 p.m.) for veterans to call with questions about their claims.

However, these claims are not without problems.

Undeliverable Letters

Unquestionably, these refunds can make a profound and positive difference in the well-being of injured veterans. However, as of October 26, 2018, a quarter of the way through their one-year timeline for filing claims, only about 26,000 of over 130,000 veterans had made refund claims for their improperly withheld taxes—money that is legitimately due them. Of the letters the IRS mailed to veterans, about 13,000 have been returned undeliverable. Approximately 19,000 claims have been processed, and approximately 7,000 are waiting to be processed.

At present, it is not clear what the DoD or the IRS is doing to obtain a better address for the veterans whose letters have gone undeliverable. The IRS is using the last known address on the most recent return to contact veterans. However, it’s not uncommon for veterans to have not filed returns for several years since some did not have a filing requirement or had extensions to file while deployed in combat zones, and thus, the IRS has sent letters to obsolete addresses. How can the homeless veterans be reached, for instance? The IRS could look for alternate addresses by researching various commercial databases to which it has access, including, for example, state driver’s license databases. The IRS could send to the alternate address, instead of a copy of the returned Letter 6060, generic correspondence informing the veterans about potential eligibility for DSP-related refunds and directing them to its website with directions for filing claims. In that way, the IRS would avoid disclosing personal tax information in the second letter going to a potentially incorrect address.

Limitation Period for Making Claims

The good news is the IRS has advised TAS it is treating the issuance of the Letter 6060 as the starting point for the statutory period of limitations for making a refund claim. If the original Letter 6060 is returned undeliverable to the IRS, the IRS has advised the one-year refund period begins from the issuance date of a newly sent letter. In other words, the IRS will treat the original mailing as “not sent” for purposes of the limitation period. For those making claims who were not identified originally as one of the 130,000-plus eligible veterans, and who therefore never received a Letter 6060, the period of limitations will remain open indefinitely.

I’m very mindful that this is not a problem of the IRS’s making, and it has a lot on its plate this year, what with implementing major tax changes for the 2019 filing season. However, the IRS has decided to wait until the undeliverable letter receipts decline before annotating on the taxpayer’s account that the letter has been returned, rather than merely sent. I am concerned that the IRS’s decision to wait in updating its system to show these letters have been returned undeliverable could result in a veteran calling the IRS and being told by an assistor that he or she already received a letter and has missed (or is about to miss) the deadline for a claim, because that is what the system shows. That is, the failure to timely update the veteran’s records with a “return” notation could deprive the veteran of the extended refund claim period. The IRS should update its system and immediately search for alternate addresses for these veterans.

Rejected Claims

The IRS has begun rejecting some claims when IRS records indicate that the veteran never reported the lump sum DSP as taxable income. However, neither the IRS nor TAS can confirm with 100 percent certainty what occurred without third-party documents. The IRS system shows gross income and AGI, but it does not show what was reported to the IRS in the 1990s. The IRS provided a safe harbor by allowing veterans to claim a standard amount because of the difficulty veterans may have in locating old records, as well as the difficulty the IRS and DoD themselves would have in retrieving veterans’ complete financial records. I am concerned that by shifting this burden to veterans to produce records, the IRS is undermining congressional intent to do otherwise. The IRS is placing an impossible burden on this group of taxpayers:  disproving the IRS’s position as to what they did or did not do more than a quarter century ago. These outright rejections, without a complete picture, runs up against taxpayer rights to be informed, to pay no more than the correct amount of tax, and to a fair and just tax system.

No Appeal Rights

Additionally, the IRS letters rejecting veterans’ claims do not provide a mechanism for contesting the rejection, because none currently exists. The rejection letters also do not contain the IRS phone number dedicated for these refund claims. Absent TAS’s intervention, those veterans who received claim rejections are deprived of any recourse, violating their rights to challenge the IRS’s position and be heard, and to appeal an IRS decision in an independent forum.

Coast Guard

As we learned recently, the new law does not apply to Coast Guard members, who are employed by the Department of Homeland Security, not the DoD.  The legislation provides that it is the Secretary of Defense who will identify service members who were paid DSP that was improperly taxed. However, the Coast Guard does not fall under the Secretary of Defense for pay purposes. It was likely due to an unintentional oversight to exclude one branch of the Armed Forces when the law was passed. Therefore, I intend to recommend Congress extend the law to Coast Guard members to correct the mistake.

TAS Efforts

Improving the IRS’s assistance to the military has been TAS’s focus in the past two years. You can read more about our concerns associated with the IRS’s inadequate assistance to the military and recommendations to improve it in my 2017 report to Congress.

In the meantime, we are committed to filling in the gaps by delivering accurate, up-to-date information to service members and their families. TAS has developed comprehensive educational material dedicated to military tax issues for posting on www.TaxpayerAdvocate.irs.gov. We also selected the topic, Advocating for Military Clients, for TAS presentations at the IRS Nationwide Tax Forums to educate tax professionals about unique tax issues this population encounters. Additionally, TAS has initiated a widespread information campaign regarding DSP refund claims, considering the impending deadline for veterans who received a Letter 6060 to file their refund claims. TAS created detailed slides with instructions and background information for nearly 150 congressional staffers located across the country. Using the slides as a foundation, TAS briefed the staffers on how best to answer veterans’ questions on the topic. TAS also briefed multiple Low Income Taxpayer Clinic clinicians and Local Taxpayer Advocates (LTAs) on issues surrounding DSP refund claims by participating in four webinars. It was during the in-depth preparation of those briefings that TAS discovered some of the issues I have identified in this blog. Our military tax specialist will also present on the topic at the January 2019 American Bar Association, Section of Taxation Midyear Tax Meeting.

Closing Thoughts

It is staggering that for 25 years there were 130,000 or more disabled Service members and their families whose DSP was reduced by improper tax withholding—likely when they could have used the funds most. Almost inconceivably, many of these Service members have died before Congress passed the legislation that would mandate a tax refund to them.

These are the very people we cannot forget. And Veterans Day is a fitting holiday, not only to remember and celebrate our veterans for their willingness to serve and make sacrifices on behalf of the rest of us, but also to bring attention to the challenges facing these taxpayers. There are many moving parts to this refund program and I am hoping this blog will help bring all those parts together to ensure that all veterans entitled to their refunds actually get them. That is the very least we can do to show our gratitude.


The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.

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