Somebody is arguing that distributions on account of disabilty are tax exempt?

I don't think so but don't have anything to dispute it (without doing some digging).

Incidentally, to broaden the question, what type of disability payments are tax exempt? For example, are the disability payments from an employment (under the disability insurance) taxable?

Look at Rev Rul 2004-55 for a basic outline of considerations. It will not answer your question directly.

Is "somebody" perhaps confused about the exemption from the 10% penalty tax for early distributions?

It is probably also worth noting that some courts have ruled that disability benefits are tax-free. (The IRS and most courts disagree.)

Might also be confusion between disability pension and disability insurance. (Disability insurance is tax-free if the premiums are paid for by the employee using after-tax dollars.)

Some DB plans are also accident and health plans I believe. I think to even have an arguement for tax-free disability benefits the plan has to have certain language showing the intent to provide such benefits (tax-free disability benefits) and even then I think it can only apply to very extrememe disability situations which are clearly spelled out in the plan.

That said, I agree the IRS has a very narrow tolerance on what might qualify as a tax-free disability benefit with the default being that they are taxable and the burden of proof would be on the disabled participant I would think.

I think in general, when it's part of a DB plan (vs. disability insurance) you have an uphill battle to provide them tax-free disability benefits but it may not be impossible if the language is there and it's limited to very extreme disabilities.

Seems like there was a big legal court case on this involving some Fire Fighters from Alaska or CA if memory serves.

Don't municipal DB plans have tax free disability provisions? Or is that a State issue?

Let me put it a different way, why is my State legislator (late 40's) on a tax free disability pension (former firefigher with a very low golf handicap BTW)?

The following recent IRS PLR and U.S. Tax Court opinion deal with exclusion of a governmental plan disability pension under IRC Section 104(a)(1):

http://www.irs.gov/pub/irs-wd/0809011.pdf

http://www.ustaxcourt.gov/InOpHistoric/Tateosian.TCM.WPD.pdf