In the processing of giving some partially bad information, I learned this. The part that is right is that if you have a W-2, you must file the Severance Pay as income. You must request that DFAS revises your W-2 after your discharge if you receive VA compensation. Here is a JAG article on the topic.

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IRS publications 17 (Your Federal Income Tax) & 525 (Taxable & Non-taxable Income, page 17) both state that “if you receive a lump-sum disability severance payment and are later awarded VA disability benefits, exclude 100% of the severance benefit from your income.” But neither publication says how.

Who is eligible?
According to page one of an information paper published online by the Presidio of Monterey Staff Judge Advocate, veterans who have:

1. a designation of 10 a, b, or c on DA Form 199 (findings from the Physical Evaluation Board). The rest of this page will deal with the last situation -
2. a retroactive disability determination from the VA. (Information Paper). This last one means the VA has awarded a disability rating for the same condition for which someone is discharged.

This paper has limitations, and it is difficult to read. It basically states that the veteran needs to:

1. Get a VA disability rating for the same condition for which they received a discharge.
2. Request a corrected W-2 from DFAS indicating the non-taxable income.
3. Use that corrected W-2 to file a 1040X for said year. The IRS will return the overpayment of taxes.

But, DFAS will not issue a corrected W-2 indicating this non-taxable income unless the request is made within the same year as the original W-2 was issued. Most veterans know it is almost impossible to get a VA disability rating in less than a year.

How to get back your taxes paid on lump-sum disability severance pay:
Once you have a retrograde VA disability rating:

1. Fill out a 1040X subtracting the lump-sum disability payment from your taxable income. Make reference to Publication 525, Taxable & Non-Taxable Income.
2. Attach the following documentation:

a. The enclosed explanation letter, addressed to your IRS Regional Service Center.
b. A copy of your VA disability award documentation.
c. A copy of your separation orders.
d. A copy of your DD-214 (does not have to be notarized)
e. A copy of your original W-2 from the year the taxes were paid.
f. A copy of your federal tax return from the year the taxes were paid.

Here's a sample letter in which you can put your name, address, and other information: Click Here.

On the top of each page in the packet, write:
a. Your full name
b. Social Security Number
c. The phrase “St. Clair vs. the United States.”

Mail this packet to your IRS Regional Service Center. The address for each is in Publication 17, or online at www.irs.gov.
Note: The 1040X generally must be filed within 3 years of the original tax return. There are some exceptions, see your local IRS office or the instructions for Form 1040X. Once the tax refund is paid, your state taxes may be re-filed. Procedures vary by state.

Just wondering if anyone has tried this yet? I just found out about it a couple of weeks ago.

In reference the disability pay and taxes; the military has begun a new Joint DoD/VA Disability Evaluation System. And in my case is going to create a new set of problems for the service members, in my opinion. They are rushing everything through creating a great confusion as now the service member is faced with having to deal with the same problem twice. Not to mention the confusion in receiving medical care as both military and VA are concentrating on evaluation not care. In my case I would rather have the care in one facility and just like a relay race smoothly no matter how fast or slow transfer into the next step instead of both running at the same time passing the dizzy bat back and forth to each other. I have not yet gotten to the tax part of my evaluation and it’s been going on for more than a year now, not to mention that I have not received any pay since the process started. I can just imagine.
I wanted to post this comment because I believe this new program is creating a new box of problems, and no this are not challenges or learning opportunities they are problems.

Your post makes little sense. Health care and disability in the VA system are separate. I have been through the MEB/PEB process in the Navy, and a streamlined process should be good for all.

It also has nothing to do with the topic - severance pay and taxes.

Some background. I have already been through this and am currently going through an IRS audit in which they are trying to recoup the taxes that I claimed using article 525 of the tax code.

Now, just so you are aware. DFAS does not under any circumstances issue revised W-2s ( know this because I called numerous times). They also will not help get you information to recoup the hefty taxes taken from you military pay. In contacting the VA, you will be lucky to find a person that knows much about this topic (about a 30% chance for help). Lastly, if you contact the IRS for help filing, you will get shuffled around for a few hours only to be told how to file incorrectly. Which will get you in the same boat as me. Oh, and if you try to dispute using the name of the IRS individual who gave you the incorrect information, they do not care, it is still your fault. I will be finding out how to properly file this tomorrow morning. I will post more then. Hopefully it will help keep some people out of the same mess.