UTBAS,
This is what AR 635-40, 4-19 has to say about it:
"k. Disability compensation excluded from gross income.
(1)
The Tax Reform Act of 1976 . Prior to the enactment of Tax Reform Act of 1976 (TRA 76) (Title 26, United States Code, Section 104, (26 USC 104)), military disability retired pay or disability severance pay was excluded from
gross income for Federal tax purposes. (Disability retired pay is that portion of retired pay based on a person’s disability percentage rating. Disability severance pay is a lump sum payment based on years of service.) With the passage of TRA 76, one of two conditions listed below must be satisfied for military disability retired or severance pay to be exempt from Federal taxation.
(a)
On 24 September 1975, the individual was a member (including RC membership) of the armed forces of any country, the National Oceanic and Atmospheric Administration (NOAA and formerly the Coast and Geodetic Survey),the U.S. Public Health Service (USPHS), or was under binding written agreement to become such a member. (Soldiers retired or separated by reason of disability on or before the cited date are not affected by TRA 76.)
(b)
The disability pay is awarded by reason of a combat-related injury. Within the meaning of 26 USC 104, combat related injuries cover those disabilities attributable to the special dangers associated with armed conflict or the preparation or training for armed conflict.
1.
A Soldier may be performing extrahazardous service even if not directly engaged in combat. Extrahazardous service includes but is not limited to the following activities: Aerial flight duty, parachute duty, demolition duty,experimental stress duty, and diving duty.
2.
Conditions simulating war include, but are not limited to, the following activities: performance of tactical exercises such as the squad or platoon in the assault; airborne operations; leadership reaction courses; grenade and live
fire weapons practice; bayonet training; hand-to-hand combat training; repelling; and negotiation of combat confidence and obstacle courses.
3.
Unlike the provisions for Civil Service retention preference (5 USC 3501), the injury resulting from an instrumentality of war need not have occurred during a period of war as defined by law.
(2) Entries on DA Form 199. The entries made on DA Form 199, blocks 10B and 10C, concern disability compensation excludable from gross income.
(a)
If the PEB can establish the fact (from available records) that the Soldier was or was not a member or obligated to become a member of one of the designated organizations on 24 September 1975, the board will make the proper entry in block 10B. If such a decision cannot be made, the PEB will enter a statement after the last entry in block 8 to reflect that fact and leave block 10B blank.
(b)
In block 10C, the board will record its determination of whether the injury was combat-related as defined by 26 USC 104."