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Please see for reference IRS publication 525 page 17 right column - http://www.irs.gov/pub/irs-pdf/p525.pdf
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. However, you must include in your income any lump-sum readjustment or other non disability severance payment you received on release from active duty, even if you are later given a retroactive disability rating by the VA.
Special statute of limitations. In most cases, under the statute of limitations a claim for credit or refund must be filed within 3 years from the time a return was filed. However, if you receive a retroactive service-connected disability rating determination, the statute of limitations is extended by a 1-year period beginning on the date of the determination. This 1-year extended period applies to claims for credit or refund filed after June 17, 2008, and does not apply to any tax year that began more than 5 years before the date of the determination.
Generally you should be able to claim the money back from DFAS if you timely act before 31 December in the year you receive the severance payment. As you did not do that - your only option to request the tax money back from the IRS. When you prepare your 1040X form - subtract the lump-sum disability payment from your taxable income and make a reference to Publication 525 page 17 as above.
Attach copies of the following documents (do not send originals!):--VA award documentation --Separation orders --DD Form 214 stating your severance pay amount before taxes --W-2 from the year the taxes were paid.--your original federal tax return from that year.On the top of each page write: your name, SSN and the phrase "St. Clair vs. the United States."If you do not feel comfortable dealing with the IRS - you may use any tax preparation service.
However - there should not be any issues if you act on your own.
Let me know if you need any help.
If that was nontaxable income - it should not be reported as taxable.
If it was reported as taxable to the IRS - on form 1099R box 2a - you may contact the payer and ask for correction.
However - it is very unlikely that DFAS will agree to issue a corrected form.
Thus - if you want to claim that compensation as not taxable - you may apply to the IRS as I suggested above.