IRS Memo Muddies the Water for Blackwater Employee

Originally published on Passive Activities and Other Oxymorons on February 10, 2011.
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Nathaniel J. Holmes v. Commissioner, TC Memo 2011-26

I have probably over used Dr. Johnson's observation that "Every man thinks meanly of himself for not having been a soldier or been to sea.", but I quote it again to account for my odd fascination with the combat pay exclusion.  From a logical tax policy viewpoint, it doesn't make a lot of sense.  Presumably you could figure out the tax effect it has, gross that number up and increase the bonus pay for being in a combat zone thereby simplifying the Code with no significant net effect on either the deficit or military compensation.  Somehow that seems emotionally unsatisfying, though.

You would think, however, that this is not something that could give rise to tax litigation since the people issuing your W-2 should know whether you qualify for the exclusion or not.  No such luck.  There is a regulation, for example, that if you are not assigned to a combat zone, but you go there for your own amusement while on leave from a non-combat zone you are not entitled to the exclusion.  Maybe they needed that rule because the night life in Saigon was so exciting.  Then we have cases like that of Charles Gasche.  He was a pilot for Braniff airlines transporting US military personnel to Vietnam.  He was issued a special card :

The purpose of this identification card was to accord plaintiff the privileges of the rank of major in the United States Air Force under "all applicable treaties, agreements and the established practice of nations" in the event of his capture by hostile forces in Vietnam.


That was just what you needed when you were checking into the Hanoi Hilton in 1968.

At any rate First Officer Gasche never needed the card that said he should be treated like a major and he was getting paid by Braniff, so he was not entitled to the combat pay exclusion.  There are quite a few similar examples.

The case of Nathan J. Holmes might be distinguishable from the airline pilots delivering the troops to Saigon in that he appears to have been performing actual combat duties.  Nonetheless he was not being paid directly by the Department of Defense and was not a member of the armed services.  He worked for a company called Blackwater.  Perhaps you have heard of them.

 Mr. Holmes did not get the exclusion.  A blogger who writes on military contractor issues groused a little about it in his post on the case noting that there is talk of subjecting contractors to the Uniform Code of Military Justice, but no prospect of them getting the favorable tax treatment granted to member of the military.  For a little perspective on that, Mr. Holmes was trying to exclude $98,400 for 2005.  In 2005 the maximum pay for an enlisted member of the military was $6,300 per month, which sets the limit for what officers are entitled to exclude (Along with the couple of hundred bucks a month they get for being in a combat zone).Enlisted personnel in a combat zone exclude their entire income, such as it is.  So Mr. Holmes was trying to exclude more than anybody in the official armed services was entitled to exclude.

The interesting part of the case is actually how it was that Mr. Holmes was not assessed a penalty.  He was relying on a copy of a memo.

While in Iraq, petitioner was given a memorandum issued by Robert L. Hunt, the Acting Deputy Director, Compliance Field Operations, Internal Revenue Service (IRS). This memorandum discussed the appropriate steps for civilian personnel to take when engaged in an IRS examination and collection activity involving a taxpayer deployed to a Qualified Combat Zone. Petitioner did not remember who gave the memorandum to him.


This memorandum was an internal memorandum written to give the Commissioner's employees field guidance for examination and collection activity involving taxpayers in Iraq. The memorandum, titled “Memorandum for Acting Deputy Director, Compliance Field Operations”, was issued by the Internal Revenue Service Small Business/Self- Employment Division on June 28, 2004. The memorandum states that civilian or military personnel who are in direct support of a combat zone military initiative and physically located in the combat area are entitled to the exclusion. It also states that time spent in a combat zone by an individual serving in support of the Armed Forces will be disregarded with respect to “certain acts required under the Internal Revenue Code.” It goes on to state that “This change in procedure will be reflected in the next revision of the IRM, which is in the process of being written
Petitioner satisfies all the criteria found in the memorandum. He was serving in Iraq alongside the military, provided security to Government officials, and aided in giving air support, medical aid, and emergency response assistance. Petitioner had no background in tax law and was given this memorandum written by an IRS employee while serving in Iraq. We believe that receiving this memorandum while serving in Iraq could give someone reasonable cause to believe that his payments from Blackwater were excluded from gross income. Therefore, petitioner is not liable for the addition to tax under section 6651(a)(1).

Respondent also determined a section 6651(a)(2) addition to tax. Section 6651(a)(2) imposes an addition to tax for failure to pay the amount shown as tax on a return on or before the due date prescribed unless the taxpayer can establish such failure was due to reasonable cause and not willful neglect. The amount of the addition is equal to 0.5 percent of the amount shown as tax on the tax return but not paid, with an additional 0.5 percent each month or fraction thereof during which the failure to pay continues (up to a maximum of 25 percent). See Cabirac v. Commissioner, 120 T.C. 163, 170 n.12 (2003). For the reasons stated above, we find that petitioner had reasonable cause and is not liable for the section 6651(a)(2) addition to tax.

I have been assiduously hunting for this magical memo.  Feral Jundi, the blogger I previously mentioned, posted this.  It appears to be the first page of the memo. I don't know whether that is the entire memo or not.   In 2007 a firm called Palazzo posted a warning about the memo indicating that it was being misinterpreted.

Everyone I know working overseas in a combat zone probably has seen this memo. Let me tell you once and for all this memo does not apply to civilian contractors working in combat zones. This memo was released for a very small group of Coalition Provisional Authority Personnel and the only thing it did was allow them additional time to file their tax returns. It did not provide a full Combat Zone tax exclusion. There is no such thing. It did not waive their 330 day overseas requirement. This still must be met every twelve months. The only exclusion of income must be earned by meeting the presence test or in some instances the bona fide residence test.

Apparently civilian contractors rather than writing "Kilroy was here" on all available blank walls spent their time photocopying an internal IRS memo that "proved" that their income was excludable.  Perhaps Mr. Holmes couldn't remember who gave him the memo, because he got it from more than one person.  Oddly enough, the tax court found his reliance on the memo reasonable.  It will be interesting to see if there will be a string of these cases in the next few months.