A U.S. Tax Exclusion Many Dual Citizens Miss
Families coping with the trauma of a terror attack or a war injury have already endured more than enough loss and stress. They should not face the burden of unnecessary tax complications on top of their recovery.
A U.S.-Israeli dual citizen who receives disability compensation from Israel after a terror attack or a combat injury may be able to exclude some or all of that payment from U.S. taxable income, depending on the nature of the injury, the underlying incident, and the type of compensation received.
That surprises many people because U.S. citizens are taxed on worldwide income. If you are a U.S. citizen living in Israel, the default rule is that income from Israel still belongs on your U.S. tax return.
But U.S. tax law contains specific exclusions for certain injury-related disability payments, including some payments tied to terrorism and some tied to injuries from military service. These exclusions can apply even when the payment comes from a foreign government agency, such as Misrad HaBitachon or Bituach Leumi, provided the U.S. requirements are met.
The key is not whether you received a Form W-2, Form 1099, or any U.S. tax document. The key is why the payment was made, and whether it fits one of the specific exclusions in U.S. law.
It is equally important to be clear about what this does not mean. Not every Israeli war- or terror-related payment automatically qualifies, and some situations involve genuine gray areas. This article explains where the exclusion may apply and what needs to be reviewed; it is not a blanket rule.
1. The Wrong Assumption: “No U.S. Form Means No U.S. Issue”
Many U.S. citizens in Israel assume that if an Israeli agency does not issue a U.S. tax form, the payment is invisible or irrelevant for U.S. tax purposes. That assumption is incomplete.
U.S. citizens generally file U.S. tax returns reporting worldwide income, even when the income comes from Israel. Israeli agencies usually will not issue Form W-2, Form 1099-R, or Form 1099-MISC, so the taxpayer and preparer must classify the payment based on the law and the supporting documents.
The absence of a U.S. tax form does not decide whether the payment is taxable; the legal character of the payment decides.
Example (fictional): A U.S.-Israeli dual citizen receives a monthly disability award from Bituach Leumi after being injured in a terror attack. No U.S. tax form arrives in January. That does not end the U.S. analysis; the return preparer still must decide whether the payment is taxable income, excluded disability income, qualified disaster relief, or another type of payment.
IRS Publication 3920 explains that disability payments for injuries incurred as a direct result of a terrorist attack directed against the United States or its allies are excluded from income. It also instructs taxpayers to attach supporting documents when they cannot obtain a corrected U.S. tax form, which is exactly the practical issue many Israeli recipients face. (irs.gov)
2. The Core Rule for Terror Victims: Section 104(a)(5)
Internal Revenue Code section 104 excludes several categories of injury-related payments from gross income. Section 104(a)(5) covers “disability income” attributable to injuries incurred as a direct result of a terroristic or military action, as defined in section 692(c)(2). (law.cornell.edu)
Section 692(c)(2) defines that term in two parts, and the difference between them matters for Israelis. The first part covers terroristic activity that a preponderance of the evidence indicates was directed against the United States or any of its allies. The second part covers military action involving the U.S. Armed Forces and resulting from violence or aggression against the United States or any of its allies. (law.cornell.edu)
The terrorism prong expressly reaches activity directed against U.S. allies, wherever it occurs. The military-action prong is narrower: it generally requires involvement of the U.S. Armed Forces.
Example (fictional): A dual citizen injured in a terrorist attack in Israel receives Israeli government disability compensation because of the injury. The U.S. tax question is not “Was this paid by the United States?” The better question is: “Is this disability income attributable to injuries incurred as a direct result of terroristic activity directed against the United States or one of its allies?” If the answer is yes, the payment may qualify for exclusion.
IRS Publication 525 describes the exclusion in similar terms, noting that it can apply to qualifying attacks whether they occur within or outside the United States. (irs.gov)
Why war injuries are different. Because the military-action prong generally requires U.S. Armed Forces involvement, most war-related injuries in Israel will not fit that part of the definition. An injury from a rocket attack, an infiltration, or an attack by a terrorist organization during wartime may still be analyzed under the terrorism prong, but whether a particular incident qualifies depends on the facts. Injuries suffered by IDF soldiers in combat are often better analyzed under a different provision, discussed in Section 4.
3. Israel and the “Ally” Language: Strong Support, Not an Automatic Answer
For U.S.-Israeli dual citizens, the words “or its allies” are what connect the terrorism exclusion to Israel-related payments. The Code does not define “ally,” but Israel is designated a major non-NATO ally of the United States, and there is a strong argument that terrorism directed against Israel falls within the statute.
The IRS explains that a terrorist action is one directed against the United States or any of its allies, including a multinational force in which the United States participates. It also explains that military action involves the U.S. Armed Forces and actual or threatened violence or aggression against the United States or its allies, excluding training exercises. (irs.gov)
Israel’s status as a U.S. ally provides a strong basis for applying the terrorism exclusion to qualifying Israeli disability compensation, but each payment still has to satisfy the U.S. requirements.
Example (fictional): A U.S. citizen living in Jerusalem receives Bituach Leumi payments after being injured in a terror attack recognized as a hostile action. The payment is not from the VA, and it is not reported on Form 1099-R. But if the payment is disability income directly attributable to injuries from terroristic activity directed against a U.S. ally, the taxpayer may have a strong basis to treat the payment as excluded under section 104(a)(5).
Israeli recognition helps, but it is not the test. A determination by Bituach Leumi or Misrad HaBitachon that someone is a victim of hostile action (peulot eivah) is important supporting documentation. However, Israeli eligibility rules and U.S. tax rules are not the same. Israeli law may recognize incidents, injuries, or payment types that do not fit the U.S. definitions, so the U.S. requirements must be analyzed on their own.
4. IDF Soldiers: A Separate Exclusion May Apply Under Section 104(a)(4)
Disability payments to IDF soldiers and veterans, including reservists, are often better analyzed under section 104(a)(4) than under the terrorism rule. Section 104(a)(4) excludes amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country. The words “of any country” mean the provision is not limited to the U.S. military. (law.cornell.edu)
There is an important limitation. Under section 104(b), for most people who were not already receiving these payments or serving in the armed forces as of September 24, 1975, the exclusion generally applies only to amounts received by reason of a combat-related injury. A combat-related injury is a personal injury or sickness incurred as a direct result of armed conflict, while engaged in extrahazardous service, or under conditions simulating war, or one caused by an instrumentality of war.
For IDF veterans, the key questions are whether the payment is a disability pension or similar allowance, and whether the underlying injury was combat-related.
Example (fictional): A U.S.-Israeli dual citizen was wounded in combat during reserve duty and receives a monthly disability allowance from Misrad HaBitachon’s Rehabilitation Department. That payment may qualify for exclusion under section 104(a)(4) as a combat-related disability allowance. By contrast, a soldier injured in an ordinary non-combat accident during routine service may receive a similar Israeli payment, but the U.S. exclusion may not apply, depending on the circumstances.
This mirrors the treatment of U.S. military benefits. MyArmyBenefits explains that military retirement pay based on age or length of service is generally taxable, while military disability retirement pay and veterans’ benefits, including service-connected disability pension payments, may be partially or fully excluded. (MyArmyBenefits)
5. Separate the Payment Types: Disability, Disaster Relief, Pension, and Income Replacement
The most common mistake is grouping every payment under one label. U.S. tax law uses different rules for different payment types.
Even when the underlying incident qualifies, the type of payment still matters. The exclusions discussed above apply to disability compensation, meaning payments for the injury itself. They do not automatically extend to every payment that follows an attack or a war injury.
Disability payments that meet the requirements of section 104(a)(4) or 104(a)(5) may be excluded. Qualified disaster relief payments may also be excluded when they cover reasonable and necessary personal, family, living, funeral, home repair, or similar expenses caused by a terrorist attack. Publication 3920 states that qualified disaster relief payments are not subject to income tax, self-employment tax, or employment taxes, and that no withholding applies. (irs.gov)
Other payments require separate analysis. Lost-wage or income replacement benefits, unemployment-type benefits, survivor and dependent benefits, regular pensions based on age or length of service, and general welfare or assistance payments may not qualify for exclusion, even when they arise from the same event.
The stronger your documentation of the payment’s purpose, the stronger your U.S. tax position.
Example (fictional): A family receives three different Israeli payments after a terror attack: a disability allowance for bodily injury, reimbursement for home damage, and a temporary lost-income benefit. These should not be treated the same way. The disability allowance may fit section 104(a)(5), the home damage reimbursement may fit the qualified disaster relief rules, and the lost-income benefit requires closer review because Publication 3920 says income replacement payments, such as lost wages or unemployment compensation, are not qualified disaster relief payments. (irs.gov)
6. How to Report It When There Is No W-2 or 1099
Israeli agencies usually do not prepare U.S. tax reporting forms. That means the taxpayer should keep a clear file and be ready to explain any exclusion claimed.
The file should include the Israeli agency approval letter, the legal basis for the award, medical or disability determination documents, documentation of the incident that caused the injury (for example, a terror attack versus a combat injury during military service), and a translation if the documents are in Hebrew. The taxpayer should also keep a yearly payment summary showing the shekel amount, dates received, and exchange rate method used.
For a U.S. return, the safest practical approach is to document the exclusion even when the amount is not included in taxable income.
Example (fictional): A taxpayer receives ₪120,000 during the year from Bituach Leumi as disability compensation for injuries from a terror attack recognized as a hostile action. If the facts support the exclusion, the preparer may treat the amount as excluded but should retain a workpaper citing section 104(a)(5), section 692(c)(2), and the Israeli documents showing the reason for the award. For an IDF combat injury, the workpaper would instead rely on section 104(a)(4) and section 104(b). Where the position is less certain, a tax professional may also consider whether disclosure on the return is appropriate.
If an amount was previously reported as taxable and later determined to qualify for exclusion, Publication 3920 describes using Form 1040-X to amend the return and attaching supporting documents. It specifically addresses situations where the taxpayer cannot obtain corrected U.S. tax forms and says to explain that fact and attach documents supporting the claim. (irs.gov)
Three Practical Takeaways
- Do not assume Israeli war or terror disability payments are taxable just because you are a U.S. citizen. Section 104(a)(5) may exclude disability income tied directly to terrorism directed against the United States or its allies, and section 104(a)(4) may exclude combat-related disability payments from service in the armed forces of any country, including the IDF.
- Do not assume every payment is excluded. Whether a payment qualifies depends on the nature of the injury, the underlying incident, and the type of compensation received. Israeli recognition is helpful evidence but does not by itself decide the U.S. question.
- Build the file before the IRS asks. Keep Israeli approval letters, medical determinations, hostile-action or combat-injury recognition, payment summaries, translations, and a short tax memo explaining why the amount was excluded.
Sources
IRS Publication 525, Taxable and Nontaxable Income. (irs.gov)
Internal Revenue Code §104, Compensation for Injuries or Sickness. (law.cornell.edu)
Internal Revenue Code §692(c)(2), Terroristic or Military Action. (law.cornell.edu)
IRS Publication 3920, Tax Relief for Victims of Terrorist Attacks. (irs.gov)
MyArmyBenefits, Federal Taxes on Veterans’ Disability or Military Retirement Pensions. (MyArmyBenefits)
Disclaimer: This article is for general educational purposes only and is not tax or legal advice. Whether a particular payment qualifies for exclusion depends on the specific facts, including the nature of the injury, the incident that caused it, the Israeli law under which the payment is made, and the type of compensation received. Some of these situations involve questions that are not fully settled, and the IRS may take a different view in a given case. Readers should consult a qualified tax professional before taking a filing position. Reading this article does not create a client relationship with Cole & Waxman Tax Services.