FSA 9999-9999-170
Background. A church wants to help its pastor purchase a new home, and so it agrees to pay $50,000 of the purchase price. The pastor signs a promissory note agreeing to pay back the $50,000 in ten annual installments. The church board assures the pastor that the church will “forgive” each annual installment on the date it is due, and so the pastor will not have to pay back anything. Is this transaction legitimate? What are the tax consequences? Church treasurers need to understand the answer to these questions, since this kind of arrangement is common and often misunderstood.
An IRS memorandum. The IRS recently released an internal memorandum (a “field service advisory”) that addresses the tax consequences of debt forgiveness. Here are the facts of the arrangement the IRS was addressing. A widow and mother of three adult children owned a partial interest in farm land. She suffered a stroke and was later determined by a court to be incompetent. A guardian was appointed to handle her financial affairs. The guardian sold the farm land to the children in exchange for non-interest bearing promissory notes signed by each child. The sales agreement called upon each child to pay the guardian $10,000 annually. However, the agreement contained a “cancellation” provision specifying that the payments owed by the children each year would be “forgiven” by the guardian. The children and guardian recognized that these annual cancellations of debt constituted gifts, but they had no tax impact since they were not more than the annual gift tax exclusion of $10,000 for each child.
An IRS auditor determined that a completed gift had been made in the year the original sales agreement was signed, and not each year that the annual payments under the promissory notes were forgiven. As a result, the full amount of the notes represented a gift to the children in the year of the sale. Since these amounts were far more than $10,000, the children’s attempt to purchase their mother’s farm land without exceeding the annual gift tax exclusion failed.
The IRS national office was asked to evaluate this arrangement. Specifically, it was asked whether a gift to the children occurred when the property was transferred in exchange for the non-interest bearing notes. It also was asked to clarify its position “concerning taxpayers’ persistent use of the installment sale as an estate and gift tax avoidance technique.”
The IRS noted that the tax code imposes a “gift tax” on gifts, and that “the value of the property transferred, determined as of the date of the transfer, is the amount of the gift.” Further the code specifies that if property is transferred for less than full value “the amount by which the value of the property exceeds the value [received] shall be deemed a gift.”
The IRS observed:
If an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan. However, if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the donor will have made a gift only at the time of the forgiveness …. Transactions within a family group are subject to special scrutiny, and the presumption is that a transfer between family members is a gift.
Whether the transfer of property is a sale or a gift depends upon whether, as part of a prearranged or preconceived plan, the donor intended to forgive the notes that were received at the time of the transfer.
The IRS noted that the intent to forgive the notes was the determinative factor in this case, and that “a finding of a preconceived intent to forgive the notes relates to whether valuable consideration was received and thus to whether the transaction was in reality a bona fide sale or a disguised gift.”
The IRS pointed out that the children “did not execute separate notes” for each year, but rather “the indebtedness of each child … was represented by only one note.” The children insisted that their arrangement represented a valid installment sale. The IRS disagreed:
It is difficult to conceive of this exchange as an installment sale where the intent of the [children] to make a gift to themselves … is so clearly evident at the time of the [sale agreement]. The [children] have not come forward with evidence to show that the notes represented an obligation portions of which could be forgiven annually …. The [IRS auditor] in this case has appropriately treated this entire transaction as a sham …. It is axiomatic that questions of taxation are to be determined with regard to substance rather than form. An examination of the objective facts of this case, therefore, can only lead to the conclusion that the children are entitled to a gift tax exclusion for [one year] only.
The IRS national office conceded, in its internal memorandum, that “it is conceivable that a court would be inclined to treat this exchange as a bona fide transfer and strictly construe the relevant documents in accordance with their terms.” In other words, the children might persuade a court that the transaction was legitimate, and that they in fact made gifts each year in which the annual payments under the promissory notes were “forgiven.”
The IRS cautioned, however, that at a minimum the children had to prove “by some overt act” that the guardian had the “authority and discretion” to forgive the annual payments due under the promissory notes. It noted that an example of such an overt act “would be the cancellation by the [guardian] of a series of promissory notes on an annual basis.” The IRS concluded that such evidence was not present in this case. It acknowledged that the sales agreement contained a “cancellation” provision calling for the cancellation of the annual installment payments each year under the notes. However, the IRS concluded that “the conspicuous absence of any evidence of forgiveness in any of the subsequent years” effectively negated the legal effect of the cancellation provision. It observed:
The facts of this case clearly indicate that an intent to make a disguised gift for illusory consideration was formed at the time of the original transaction, and at no time subsequent …. In the absence of a showing that there was no prearranged or preconceived plan to forgive any indebtedness, a transfer of real property for non-interest bearing notes must be treated as a gift at the time of the original transfer. Further, the substance of a transaction must prevail over its form where an examination of the facts and circumstances of a transaction suggests that it lacks economic substance.
Relevance to church treasurers. There are important lessons for church treasurers to learn from the IRS memorandum. Consider the following:
No documentation
Many churches have advanced funds to a pastor to assist with the payment of a home. In some cases, there is no clear understanding as to the nature of the arrangement, and no documents are signed. It may not be until it is time for the church treasurer to issue the pastor a W-2 that the tax consequences of the transaction are addressed. If the amount advanced by the church is substantial, church leaders may attempt to characterize it as a “loan” to avoid reporting it as taxable compensation to the pastor. The IRS memorandum demonstrates that this may not be possible.
Example. A church wants to help its pastor buy a new home, and so it gives him $50,000 cash in September of 1999 to assist with the down payment. In January of year 2000, the church treasurer is preparing the pastor’s W-2 for 1999, and wonders whether to report the $50,000 as additional compensation. She presents this question to the church board, which is opposed to treating the full amount as taxable in 1999. They come up with the idea of treating the $50,000 as a tax-free gift. As a result, the treasurer reports no part of the $50,000 as additional compensation on the pastor’s W-2 for 1999 or any future year. This is incorrect. The $50,000 cannot be treated as a nontaxable “gift” to the pastor. See pages 111-114 in Richard Hammar’s 1999 church and Clergy Tax Guide for a full explanation.
Example. Same facts as the previous example, except that the pastor, treasurer, and board recognize that the $50,000 cannot be treated as a nontaxable gift. The board wants to minimize the tax impact to the pastor, and so it comes up with idea of treating the $50,000 as a non-interest bearing loan payable over ten years. They also agree informally to forgive each annual installment of $5,000. However, no documents are signed. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum addressed in this article suggests that the correct answer is (2). Why? The memorandum, which represents the thinking of the IRS national office, states that “if an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan.” Since such a “gift” must be treated as taxable compensation, the entire $50,000 represents taxable income in 1999.
Adequate documentation
The IRS memorandum makes it clear that the existence of adequate documentation may lead to a different result. Consider the following examples.
Example. A church wants to help its pastor buy a new home. The board agrees to loan $50,000 to the pastor in September of 1999 to assist with the down payment. It prepares a non-interest bearing ten-year promissory note in the amount of $50,000, which the pastor signs. The note is secured by a second mortgage on the pastor’s new home. The board minutes reflect the board’s intention that each annual payment ($5,000) will be forgiven when due. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum suggests that the correct answer is (2). The memorandum, which represents the thinking of the IRS national office, states that “if an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan.” The board minutes make it clear that there was a “prearranged” plan to forgive each year’s installment, and so the entire amount of the “loan” must be reported as income in the year of the transaction (1999).
Example. Same facts as the previous example, except there was no explicit understanding or agreement that the board would “forgive” each annual installment. Rather, the board left the question open. As a result, the board minutes contain no indication of any “prearranged” plan to forgive each annual installment. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum suggests that the correct answer is (1). The memorandum states that “if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the [church] will have made a gift only at the time of the forgiveness.” This means that income is realized by the pastor each year to the extent that the board decides to forgive the annual installment due under the promissory note. Of course, if the board forgives each annual installment in the year it is due, it becomes increasingly possible that the IRS might view the entire arrangement as “prearranged.” If so, the analysis of the previous example might apply.
Example. Same facts as the previous example, except that the church issues the pastor ten promissory notes for $5,000 each. The notes have “rolling” maturity dates, so that one note matures each year over the next ten years. The IRS memorandum suggests that this arrangement will have an even greater likelihood of avoiding the inclusion of the entire $50,000 amount as income on the pastor’s 1999 W-2. The IRS noted that to avoid treating the entire loan amount as a gift (or as income) in the year of the original transaction, the “borrower” must be able to prove “by some overt act” that the lender had the “authority and discretion” to forgive the annual payments due under the promissory note. It cited as an example of an “overt act” the cancellation by the lender of a series of promissory notes on an annual basis. Such acts, concluded the IRS, was evidence of “forgiveness in subsequent years.”
Key point. This article only addresses the tax consequences of a church’s “forgiveness” of a loan made to a pastor. It does not address the tax consequences of a church making a non-interest bearing loan to a pastor. That issue is addressed on page 122 of Richard Hammar’s 1999 church and Clergy Tax Guide.