Church & Clergy Tax Guide

Introduction

Your Form 1040 begins (lines 1–9) with the reporting of gross income. This chapter will summarize those items of gross income that are of greatest relevance to ministers.

The tax code excludes several items from gross income. These exclusions (including the housing allowance) will be considered in Chapter 5 and Chapter 6. Exclusions are not reported on your tax return. After computing your gross income, you are permitted to claim certain adjustments that reduce gross income. Gross income less the total of all available adjustments yields adjusted gross income (AGI). AGI is an important figure for several reasons. AGI and the various adjustments of greatest relevance to ministers are discussed under “Adjustments to Gross Income” on page .

It is beyond question that ministers must report and pay federal income taxes on their taxable income. A number of ministers have attempted, unsuccessfully, to evade taxes through reliance on a variety of theories. Many of these theories are reviewed under “Clergy not exempt from federal income taxes” on page . The penalties for refusing to file income tax returns and for adopting frivolous positions on filed returns are reviewed under “Penalties” on page .

Before addressing specific items of income, three preliminary issues must be addressed: (1) unreasonable compensation, (2) revenue-based compensation arrangements, and (3) intermediate sanctions.

One of the requirements for exemption from income taxation under section 501(c)(3) of the tax code is that no part of the net earnings of the church “inures to the benefit of any private shareholder or individual” other than reasonable compensation for services rendered. As a result, a church will jeopardize its tax-exempt status if it pays unreasonable compensation to an employee.

Loss of exempt status

Loss of a church’s tax-exempt status would have several potential consequences, including the following:

Clearly, church leaders should avoid any activity that jeopardizes a church’s exemption from federal income taxation.

Unfortunately, the IRS and the courts have provided little guidance on the meaning of “reasonable” compensation. Summarized below are the key cases.

Church of Scientology v. Commissioner of Internal Revenue, 823 F.2d 1310 (9^th Cir. 1987)

One federal appeals court concluded that combined annual income of $115,680 paid by a religious organization to its founder and his wife was not excessive. Unreasonable compensation sometimes is associated with payment of ministers’ compensation based on a percentage of church income. For example, a small church with annual income of $20,000 agrees to pay its minister half of the church’s annual compensation. This amount is certainly reasonable. However, assume that within a few years the church experiences substantial growth and its annual income increases to $500,000. If the church has not changed its method of paying its minister (i.e., the minister now receives annual compensation of $250,000), the IRS (and the courts) would almost certainly conclude that this amounts to unreasonable compensation.

Heritage Village Church and Missionary Fellowship, Inc., 92 B.R. 1000 (D.S.C. 1988)

The bankruptcy court in the “PTL” case also addressed the critical issue of what constitutes reasonable compensation for a minister. The bankruptcy court ruled that reasonable compensation for Jim Bakker would have been $133,100 in 1984, $146,410 in 1985, $161,051 in 1986, and $177,156 in 1987. These are the same figures computed by the IRS, and the court openly expressed its reliance upon the IRS calculations.

The court found that Bakker’s actual compensation for the four years in question amounted to more than $7.3 million and that much of this was in the form of bonuses and fringe benefits. To illustrate, Bakker’s salary (as determined by the court) for the years in question was $228,500 in 1984, $291,500 in 1985, $265,000 in 1986, and $265,000 in 1987. However, the total amounts of compensation and benefits attributable to Bakker for the same years were $1.2 million in 1984, $1.6 million in 1985, $1.9 million in 1986, and $2.7 million in 1987.

How did the court in the PTL case determine what was reasonable compensation for Jim Bakker? This is both an interesting and relevant question since the IRS and the courts have provided little guidance in defining this significant term.

In answering this question, the court noted that “the highest paid head of a government agency in the State of South Carolina with a salary approved by the legislature is the president of the University of South Carolina who, for the years in question, had a salary under $100,000.” (The court undoubtedly overlooked the compensation paid to certain university football and basketball coaches—who also could be considered government employees.) The court also referred to the testimony of “expert witnesses” who had testified that normal salary of the highest compensated ministers “would run from $75,000 to $120,000” and that “bonuses were almost unheard of in the religious field, although fringe benefits would amount to about 30 percent of the salary.”

In responding to the view of one of Bakker’s witnesses that the Bible mandates that a minister should get 10 percent of all donations and a “high priest” should receive 20 percent, the court commented that such a view “defies common sense and rational judgment.”

The bankruptcy court’s ruling in the PTL case is also relevant because it helps to clarify the meaning of ministerial compensation. Ministers sometimes find it difficult to determine what benefits are includible in their income for tax purposes. The PTL bankruptcy court concluded that the following items were properly included in the income of Jim Bakker:

The IRS reached these same conclusions, but it added several additional items to Bakker’s compensation, including personal use of PTL automobiles; the fair rental value of Bakker’s “parsonage”; a “housekeeping and maintenance allowance” of $28,000 each year; the fair rental value of a PTL-owned condominium in Florida; and personal use by Bakker of the presidential suite in the Heritage Grand Hotel. Several important lessons can be learned from this case:

Truth Tabernacle, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 1989-451

The United States Tax Court addressed the issue of unreasonable compensation paid to ministers in an important decision. Truth Tabernacle was incorporated as an independent church in 1978. The church was a fundamentalist Christian congregation, and its doctrine included a belief in “the death, burial, and resurrection of the Lord Jesus Christ . . . ​the sovereignty of the Church of God . . . ​Jesus Christ as the head of the church . . . ​resurrection of the dead . . . ​and Jesus Christ coming back again to reign as King of Kings and Lord of Lords over all the earth.”

The church consisted of about 40 members and conducted worship services three times each week. Regular men’s and women’s Bible classes were held two or three times each month. Sunday-school classes were held every Sunday. Saturday night prayer services were conducted each week. The church’s pastor (who was an ordained minister) performed sacerdotal functions, including dedications of children, baptisms, funerals, and marriages.

The IRS audited the church in 1986 (the audit covered the years 1983, 1984, and 1985). At the conclusion of the audit, the IRS revoked the church’s tax-exempt status retroactively. The IRS alleged that (1) the church was not operated exclusively for religious purposes, and (2) the church paid unreasonable compensation to its minister.

The Tax Court rejected the IRS position and ruled in favor of the church. In rejecting the IRS claim that the church had not acted exclusively for religious purposes, the court observed: “Petitioner was a small church operating on a modest budget provided by the weekly contributions of its members. Essentially all of its contributions during the audit years were used to pay the mortgage, utility and maintenance expenses on the church building. Its activities primarily consisted of various worship services conducted in the church building and the performance of sacerdotal rites. In our view the [church is operated exclusively for religious purposes].”

The court noted that in 1983 the church received contributions of $10,700 and incurred expenses of $12,200. In 1984 it had contributions of $13,700 and expenses of $13,500. In 1985 it had contributions of $16,200 and expenses of $16,200. The major expenses each year were the mortgage payments, utilities, and repairs on the church building. The mortgage alone amounted to $5,000 of the church’s annual budget. In rejecting the IRS claim that the church paid unreasonable compensation to its minister, the court noted that the pastor was provided a car and an apartment free of charge (a custodian and a caretaker received rent-free apartments on the church’s property in exchange for 20 hours of service each week) but otherwise received no salary. The court observed that

[in determining] whether compensation is reasonable or excessive . . . ​one factor to consider is whether comparable services would cost as much if obtained from an outside source in an arm’s-length transaction. Applying that standard to the present case, and considering the meager benefits received by the [church’s] minister and grounds keepers in return for services that they performed, we find that the benefits were within the bounds of reasonable compensation for those services. Accordingly, there was no inurement of [the church’s] net earnings to any private individual.

It is difficult to comprehend why the IRS challenged the tax-exempt status of a church that so clearly qualified for exempt status. Clearly, if the exempt status of Truth Tabernacle could be challenged, then few churches are beyond challenge. The Tax Court’s decision will be a useful tool in combating similar efforts in the future.

Variety Club Tent No. 6 Charities, Inc. v. Commissioner, T.C. Memo. 1997-575 (1997)

The Tax Court addressed the issue of inurement in an important case. The case involved a charity that was organized to benefit disabled and underprivileged children. It conducted bingo games to raise funds. The IRS revoked the charity’s tax-exempt status on the ground that some of its earnings inured to the benefit of its treasurer and another officer. The IRS based its action on the following grounds: (1) the treasurer and another officer of the charity embezzled more than $130,000 of bingo earnings; (2) the charity paid the legal fees of the treasurer in defending himself against criminal charges associated with his embezzlement of bingo proceeds; and (3) the charity rented a building owned by its treasurer for the bingo games and paid him $26,000 in rent for eight months each year.

The charity appealed the IRS ruling. The Tax Court concluded that the embezzlement of a charity’s funds by its treasurer did not constitute prohibited inurement. However, the court concluded that the payment of the legal fees of an officer for acts unrelated to his or her official duties may constitute inurement that will jeopardize the charity’s exempt status. And even if a charity’s charter or bylaws contain an indemnification provision, a failure to comply with its conditions may constitute inurement and jeopardize the charity’s exempt status. Finally the court agreed that the charity’s payment of $26,000 each year to its treasurer to rent his building for bingo sessions might amount to prohibited inurement—but only if the fee was unreasonable.

EXAMPLE A school paid for the founding family’s automobiles, education, travel, expenses, insurance policies, and personal equipment. A federal court ruled that the expenditures were not ordinary and necessary expenses in the course of the school’s operations. The court also held that the payment of such personal expenses for the founder’s children by the school provided direct and substantial benefit to the founder of the school. The court held that these payments constituted prohibited inurement of the school’s earnings to the founder. John Marshall Law School v. United States, 228 Ct. Cl. 902 (1981).

IRS Tax Guide for Churches

The IRS published a revised Tax Guide for Churches and Religious Organizations in 2015 (Publication 1828) that addresses inurement and private benefit as follows:

Inurement to insiders

Churches and religious organizations, like all exempt organizations . . . ​are prohibited from engaging in activities that result in inurement of the church’s or organization’s income or assets to insiders (i.e., persons having a personal and private interest in the activities of the organization). Insiders could include the minister, church board members, officers, and in certain circumstances, employees. Examples of prohibited inurement include the payment of dividends, the payment of unreasonable compensation to insiders, and transferring property to insiders for less than fair market value. The prohibition against inurement to insiders is absolute; therefore, any amount of inurement is, potentially, grounds for loss of tax-exempt status. In addition, the insider involved may be subject to excise taxes. See the discussion of excess benefit transactions below. Note that prohibited inurement does not include reasonable payments for services rendered, or payments that further tax-exempt purposes, or payments made for the fair market value of real or personal property.

Excess benefit transactions

In cases where an [exempt] organization provides an excess economic benefit to an insider, both the organization and the insider have engaged in an excess benefit transaction. The IRS may impose an excise tax on any insider who improperly benefits from an excess benefit transaction, as well as on organization managers who participate in such a transaction knowing that it is improper. An insider who benefits from an excess benefit transaction is also required to return the excess benefits to the organization.

Private benefit

An [exempt] organization’s activities must be directed exclusively toward charitable, educational, religious, or other exempt purposes. Such an organization’s activities may not serve the private interests of any individual or organization. Rather, beneficiaries of an organization’s activities must be recognized objects of charity (such as the poor or the distressed) or the community at large (for example, through the conduct of religious services or the promotion of religion). Private benefit is different from inurement to insiders. Private benefit may occur even if the persons benefited are not insiders. Also, private benefit must be substantial in order to jeopardize tax-exempt status.

Some churches pay their minister a percentage of church revenue. Are such compensation arrangements legally permissible? The Tax Court addressed this issue in a 1980 ruling, People of God Community v. Commissioner, 75 T.C. 127 (1980). The court revoked the exempt status of the religious organization on the grounds that it paid its three ministers a percentage of gross revenue. However, the circumstances of this case reveal that payments to the three ministers were unreasonable apart from the percentage arrangement. The ministers’ salaries made up 86 percent of the organization’s budget; in addition, the ministers received no-interest loans. Further, the amount of the salaries paid to the ministers was well in excess of the average salary of comparable ministers. Therefore, this case should not be interpreted as an absolute prohibition of all compensation arrangements for ministers based on a percentage of income. Churches are free to pay their ministers reasonable compensation for services rendered. Compensation packages based on a percentage of income are reasonable and appropriate so long as the amount of compensation paid to a minister under such an arrangement is reasonable in amount.

An absolute rule characterizing all percentage-of-income compensation arrangements as unreasonable would lead to absurd results. For example, many ministers serve small congregations and receive all of the church’s income. In many cases, these arrangements result in compensation of less than $10,000 per year to a minister. There can be no doubt that such an arrangement is reasonable and permissible under these circumstances. Such arrangements are common, and neither the IRS nor any federal court has addressed the propriety of this specific issue.

On the other hand, there is no doubt that compensation arrangements based on a percentage of income would be impermissible and jeopardize a church’s exempt status to the extent that they result in excessive or unreasonable compensation. To illustrate, assume that Pastor B begins a new church with a few people and agrees to be paid 50 percent of the annual church revenue. For a few years this arrangement results in modest income to the pastor. However, the church prospers, and after a number of years the pastor is paid in excess of $1 million per year. There is no doubt that this constitutes unreasonable compensation, and it jeopardizes the exempt status of the church—not because of the percentage arrangement but because of the amount of compensation.

IRS regulations addressing intermediate sanctions

Intermediate sanctions refers to the excise taxes the IRS can assess against some persons who receive “excess benefits” from a church or other charity. The tax regulations state that compensation arrangements based on a percentage of a tax-exempt organization’s revenues do not necessarily constitute an excess benefit. Rather, “all relevant facts and circumstances” must be considered. The regulations note that relevant facts and circumstances include but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. 

The regulations contain the following additional clarification: “A revenue-sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.”

The application of the regulations to revenue-based pay is illustrated by the following examples.

EXAMPLE Pastor C serves as an officer and director of his church. The congregation has 300 members. His annual compensation is one-half of all church income. This year the church’s income was $600,000, and Pastor C was paid $300,000. The board is concerned that this compensation arrangement may trigger intermediate sanctions against Pastor C and the board members personally. The regulations clarify that not all revenue-based compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the relevant facts and circumstances must be considered. The regulations state that relevant facts and circumstances include, but are not limited to, (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Pastor C’s compensation may be excessive under these criteria since the IRS may conclude that the amount of Pastor C’s compensation is not proportional to the quantity and quality of the services he provides.

This is a difficult and somewhat subjective inquiry, but note the following: (1) It is unusual for the chief executive officer of any organization (nonprofit or for-profit) to receive half of all the organization’s revenue. While such arrangements may be justifiable when an organization’s revenue is modest, they become increasingly irregular as an organization’s revenue increases. Being paid half of a church’s revenue may be reasonable for a small congregation with revenues of $50,000. But the same cannot be said of a church with revenue of $600,000. (2) It is likely the IRS will assert that C’s compensation is excessive in light of the quality and quantity of services performed. It is true that Pastor C is providing professional and valuable services. However, these services must be placed in perspective. Few ministers serving a congregation of 300 members receive annual compensation of $300,000. As a result, Pastor C will have a difficult, if not impossible, task in demonstrating that his compensation is reasonably related to the value of his services. How can it be reasonable if few (if any) ministers serving congregations of similar size receive this level of compensation?

This conclusion is reinforced by the data presented on the ChurchSalary.com website. Any doubt with regard to the reasonableness of ministers’ compensation should be resolved on the side of caution because of the enormity of the sanctions that can be assessed against disqualified persons who are paid excessive compensation. In this example, if the IRS determines that reasonable compensation for Pastor C would have been $100,000, then he has an excess benefit of $200,000. He will face an excise tax of $50,000 (25 percent of the excess) and an additional tax of $400,000 if he does not correct the overpayment by returning it to the church in a timely manner. In addition, the church board members who authorized this arrangement may be assessed an excise tax of $20,000 (10 percent × $200,000), collectively, not individually. For more information about this tax, see “Tax on managers” on page .

EXAMPLE Same facts as the previous example, except that the congregation has more than 1,000 members and its revenue this year is $1.5 million, resulting in compensation to Pastor C of $750,000. It is possible that Pastor C’s compensation will be deemed excessive by the IRS and that Pastor C will be exposed to the 25-percent and 200-percent excise taxes discussed under “Intermediate sanctions” on page . In addition, the board is exposed to the 10-percent tax on managers. Furthermore, the tax-exempt status of the church is jeopardized if Pastor C’s compensation is deemed to be so unreasonable as to constitute prohibited inurement.

EXAMPLE A church with 200 members has annual revenue of $300,000. The board enters into a compensation arrangement with its pastor, Pastor E, under which Pastor E is paid an annual salary of $50,000 and receives a bonus of $25,000 if membership or revenue increases by 10 percent in any year. Assuming that Pastor E is a disqualified person, it is doubtful that this arrangement will result in an excess benefit leading to intermediate sanctions. The regulations clarify that not all revenue-based compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all the relevant facts and circumstances must be considered.

The regulations state that relevant facts and circumstances include but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Pastor E’s compensation will not be excessive under these criteria. First, the size of his compensation is reasonably related to the quality and quantity of services performed (i.e., full-time professional services). Second, Pastor E has only limited ability to control the activities generating church revenue (see the previous examples). Third, the regulations specify that “a revenue-sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.”

However, an example in the regulations clarifies that if additional compensation is based entirely on a “proportional benefit” to the charity, then the added pay is not an excess benefit. The example states that a manager of a charity’s investment portfolio, whose compensation consists of an annual salary plus a bonus equal to a percentage of any increase in the value of the charity’s portfolio, is not receiving an excess benefit. While the manager’s compensation (the bonus) is linked to the charity’s revenue, the arrangement gives the manager “an incentive to provide the highest quality service in order to maximize benefits.” Further, the manager “can increase his own compensation only if [the charity] also receives a proportional benefit. Under these facts and circumstances, the payment to [the manager] of the bonus described above does not constitute an excess benefit transaction.” It could be argued that Pastor E’s bonus is tied directly to a proportional benefit being received by the church (a 10-percent increase in membership or revenue) and therefore is not excessive.

Section 501(c)(3) of the tax code exempts churches and most other religious organizations and public charities from federal income taxation. Five conditions must be met to qualify for exemption. One is that none of the organization’s assets inures to the private benefit of an individual other than as reasonable compensation for services rendered. Churches and other tax-exempt organizations that pay unreasonable compensation to an employee are violating one of the requirements for exemption and are placing their exempt status in jeopardy. However, the IRS has been reluctant to revoke the tax-exempt status of charities that pay unreasonable compensation, since this remedy is harsh and punishes the entire organization rather than the individuals who benefited from the transaction. For example, should Notre Dame University lose its tax-exempt status because of the compensation it pays to its head football coach?

For many years the IRS asked Congress to provide a remedy other than outright revocation of exemption that it could use to combat excessive compensation paid by exempt organizations. In 1996 Congress responded by enacting section 4958 of the tax code. Section 4958 empowers the IRS to assess intermediate sanctions in the form of substantial excise taxes against insiders (called “disqualified persons”) who benefit from an “excess benefit transaction.”

Section 4958 also allows the IRS to assess excise taxes against a charity’s board members who approved an excess benefit transaction. These excise taxes are called “intermediate sanctions” because they represent a remedy the IRS can apply short of revocation of a charity’s exempt status. While revocation of exempt status remains an option whenever a tax-exempt organization enters into an excess benefit transaction with a disqualified person, it is less likely that the IRS will pursue this remedy now that intermediate sanctions are available.

Definition of a disqualified person

Since intermediate sanctions apply only to disqualified persons (and in some cases “managers”), it is important for church leaders to be familiar with this term. The regulations provide helpful guidance. They define a disqualified person as any person who at any time during the five-year period ending on the date of an excess benefit transaction was in a position to exercise substantial influence over the affairs of the tax-exempt organization, or any family member of such a person.

Substantial influence

The income tax regulations specify the following persons would be in a position to exercise substantial influence over the affairs of a tax-exempt organization:

Family members

The term disqualified person includes family members of a disqualified person. The income tax regulations define family members as

An exception

The income tax regulations specify that some persons are not in a position to exercise substantial influence over the affairs of a tax-exempt organization, including employees who receive annual compensation or other benefits from an exempt organization of less than the amount required of a “highly compensated employee” under section 414(q) of the tax code (for 2025, annual compensation of $155,000 during the lookback year of 2024) and who do not meet the definitions of family member or substantial influence as defined in the preceding paragraphs.

EXAMPLE Pastor T is senior pastor of a church and serves as president of the corporation and a member of the board (with the right to vote). Pastor T’s church salary for the current year is $50,000. Since Pastor T serves as both president and a member of the board, he is not automatically exempted from the definition of a disqualified person even though he is not a “highly compensated employee.” As a result, he will be subject to intermediate sanctions if the church pays him excessive compensation. However, Pastor T’s current level of compensation is not excessive. In summary, while he is a disqualified person, he is not subject to intermediate sanctions because his compensation is reasonable. However, he may be subject to penalties for automatic excess benefit transactions (addressed below).

EXAMPLE Pastor C is an assistant pastor. He does not serve on the church board and is not an officer of the church. His church salary this year is $40,000. In addition, the church board is considering a gift of the parsonage to Pastor C in 2025. The parsonage has a current value of $200,000 (and is debt free). The board is concerned that the gift of the parsonage to Pastor C will expose him to intermediate sanctions. They do not need to be concerned. It is true that Pastor C will be a highly compensated employee for 2025 if the parsonage is given to him if he had compensation of more than $155,000 for the lookback year of 2024). But this does not make him a disqualified person. The regulations require that he be able to exercise substantial influence over the affairs of the church. An assistant pastor who is neither an officer nor member of the board probably does not meet this test. Since Pastor C is not a disqualified person, he is not subject to intermediate sanctions. However, note that a church’s exemption from federal income taxation may be jeopardized by excessive compensation paid to a staff member even if the recipient is not a disqualified person under section 4958.

EXAMPLE Same facts as the previous example, except that Pastor C is a senior pastor who serves on the church board (with the right to vote). Under these circumstances, Pastor C will be deemed a disqualified person because of his status as a church board member. This will expose him to intermediate sanctions if he receives an excess benefit from the church. It is unlikely that the compensation paid to Pastor C would be deemed excessive, especially if he pastors a large church. See the website ChurchSalary.com for information on compensation paid to church staff.

Excise taxes

Intermediate sanctions consist of the following three excise taxes:

A disqualified person who benefits from an excess benefit transaction is subject to an excise tax equal to 25 percent of the amount of the excess benefit (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is paid by the disqualified person directly, not by his or her employer.

If the 25-percent excise tax is assessed against a disqualified person and he or she fails to correct the excess benefit within the taxable period (defined below), the IRS can assess an additional tax of 200 percent of the excess benefit. Section 4958 specifies that the disqualified person can correct the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The correction must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25-percent tax, or the date the 25-percent tax is actually assessed.

An excise tax equal to 10 percent of the excess benefit may be imposed on the participation of an organization manager in an excess benefit transaction between a tax-exempt organization and a disqualified person. This tax, which may not exceed $20,000 with respect to any single transaction, is only imposed if the 25-percent tax is imposed on the disqualified person, the organization manager knowingly participated in the transaction, and the manager’s participation was willful and not due to reasonable cause. There is also joint and several liability for this tax. A person may be liable for both the tax paid by the disqualified person and this organization manager’s tax in appropriate circumstances. This tax is explained more fully below.

Correcting an excess benefit transaction

Section 4958 specifies that a disqualified person who receives excess compensation is subject to an excise tax equal to 25 percent of the amount of compensation in excess of a reasonable amount. Further, if the excess benefit is not corrected, the disqualified person is liable for a tax of 200 percent of the excess benefit. The correction must occur within the taxable period.

The tax code defines taxable period as “the period beginning with the date on which the transaction occurs and ending on the earliest [sic] of (1) the date of mailing a notice of deficiency under section 6212 [of the tax code] with respect to the [25-percent excise tax] or (2) the date on which the [25-percent excise tax] is assessed.”

How can a disqualified person correct an excess benefit transaction? The regulations answer this question as follows:

An excess benefit transaction is corrected by undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the tax-exempt organization involved in the excess benefit transaction in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.

A disqualified person corrects an excess benefit only by making a payment in cash or cash equivalents (excluding payment by a promissory note) equal to the correction amount to the tax-exempt organization.

EXAMPLE A pastor is a member of his church’s governing board. Last year the pastor was paid a monthly car allowance of $400 and was not required to substantiate any business use of his car. Neither the church nor the pastor reported the allowances as taxable income. The pastor recently learned that these allowances may constitute automatic excess benefits, exposing him to substantial excise taxes. He is unable to send the church a check for $4,800, so he drafts a promissory note in which he promises to pay the church $4,800 within one year without interest. The IRS will not consider this promissory note to be a correction of the excess benefit.

A disqualified person may, with the agreement of the tax-exempt organization, make a correction by returning property previously transferred in the excess benefit transaction. In this case the disqualified person is treated as making a payment equal to the lesser of (1) the fair market value of the property determined on the date the property is returned to the organization; or (2) the fair market value of the property on the date the excess benefit transaction occurred.

The “correction amount,” with respect to an excess benefit transaction, equals the sum of the excess benefit and interest on the excess benefit.

Abatement of the penalty

If a disqualified person corrects an excess benefit transaction during the taxable period, the 25-percent and 200-percent excise taxes are abated as follows:

EXAMPLE A church pays its pastor a salary that the board later determines to have resulted in an excess benefit of $100,000. The board persuades the pastor to correct the arrangement by returning the excess amount to the church. This is not enough to correct the excess benefit transaction, so the pastor is exposed to the 200-percent excise tax ($200,000). The regulations clarify that a correction involves more than a return of the excess benefit. The recipient of the excess benefit must repay the church or other tax-exempt organization “the sum of the excess benefit and interest on the excess benefit.” In this example, this means that the pastor must pay the church an amount sufficient to compensate it for the earnings it would have received on the excess amount had it not been paid to the pastor.

EXAMPLE A federal district court in New York ruled that a nonprofit organization acted improperly in attempting to “correct” an officer’s excessive compensation by reducing some of his retirement benefits. Levy v. Young Adult Institute, 2015 WL 7820497 (S.D.N.Y. 2015).

Definition of excess benefit

Section 4958(c)(1)(A) of the tax code defines an excess benefit transaction as follows:

The term “excess benefit transaction” means any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. For purposes of the preceding sentence, an economic benefit shall not be treated as consideration for the performance of services unless such organization clearly indicated its intent to so treat such benefit.

Stated simply, an excess benefit transaction is one in which the value of a benefit provided to an insider exceeds the value of the insider’s services. The excess benefit can be an inflated salary, but it can also be any other kind of transaction that results in an excess benefit. Here are three examples:

Section 4958 states that certain benefits are not considered in determining whether a disqualified person has received an excess benefit. Such benefits include “expense reimbursement payments pursuant to an accountable plan.”

Reasonable compensation

An excess benefit occurs when a tax-exempt organization pays a benefit to an insider in excess of the value of his or her services. In other words, an excess benefit is a benefit that is paid in excess of reasonable compensation for services rendered. The income tax regulations explain the concept of reasonable compensation as follows: “The value of services is the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances (i.e., reasonable compensation).”

Compensation for purposes of determining reasonableness under section 4958 includes “all economic benefits provided by a tax-exempt organization in exchange for the performance of services.” These include but are not limited to

Nonaccountable expense reimbursements

Income tax regulations specify that certain benefits are disregarded under section 4958, meaning that they are not taken into account in determining whether an excess benefit transaction has occurred that would trigger intermediate sanctions. The benefits not taken into account include “expense reimbursement payments pursuant to accountable plans.”

Under an accountable reimbursement plan, an employer reimburses expenses of an employee only after receiving adequate records substantiating the amount, date, location, and business purpose of each reimbursed expense (including receipts for each expense of $75 or more). These strict substantiation requirements apply to all local transportation expenses (including the business use of a car), out-of-town travel expenses (including travel, lodging, and meals), entertainment, business gifts, and personal computers. Other business expenses can be substantiated under an accountable plan with slightly less detail.

An employer’s reimbursement of employee expenses that does not satisfy the strict requirements of an accountable plan is considered “nonaccountable.” Such reimbursements constitute taxable income for income tax reporting purposes, and no itemized deduction for these expenses is available after 2017, through 2025. They may constitute an excess benefit transaction, triggering intermediate sanctions. This issue was addressed by the IRS in an article in the January 2004 edition of its Continuing Professional Education text. This article, for the first time, recognizes the concept of “automatic” excess benefit transactions that can result in intermediate sanctions regardless of whether they are excessive or unreasonable in amount. This major development is discussed later in this chapter.

The presumption of reasonableness

Income tax regulations clarify that compensation is presumed to be reasonable, and a transfer of property or the right to use property is presumed to be at fair market value, if the following three conditions are satisfied:

If these three requirements are met, the IRS may rebut the presumption of reasonableness if it “develops sufficient contrary evidence to rebut the . . . ​comparability data relied upon by the authorized body.” Some of these important terms are further defined by the regulations, as noted below.

Authorized body of the tax-exempt organization. An authorized body means “the governing body (i.e., the board of directors, board of trustees, or equivalent controlling body) of the organization, a committee of the governing body . . . ​or other parties authorized by the governing body of the organization to act on its behalf by following procedures specified by the governing body in approving compensation arrangements or property transfers.”

An individual is not included in the authorized body when it is reviewing a transaction if that individual meets with other members only to answer questions and otherwise recuses himself or herself from the meeting and is not present during debate and voting on the compensation arrangement or property transfer.

A member of the authorized body does not have a conflict of interest with respect to a compensation arrangement or property transfer only if the member

Comparability data. An authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has sufficient information to determine whether the compensation arrangement is reasonable or the property transfer is at fair market value.

In the case of compensation, relevant information includes but is not limited to

In the case of property, relevant information includes but is not limited to current independent appraisals of the value of all property to be transferred and offers received as part of an open and competitive bidding process.

For organizations with annual gross receipts (including contributions) of less than $1 million reviewing compensation arrangements, the authorized body will be considered to have appropriate data as to comparability if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services. An organization may calculate its annual gross receipts based on an average of its gross receipts during the three prior taxable years.

IRS regulations contain the following examples.

EXAMPLE Z is a university that is an applicable tax-exempt organization for purposes of section 4958. Z is negotiating a new contract with Q, its president, because the old contract will expire at the end of the year. In setting Q’s compensation for its president at $600x per annum, the executive committee of the Board of Trustees relies solely on a national survey of compensation for university presidents that indicates university presidents receive annual compensation in the range of $100x to $700x; this survey does not divide its data by any criteria, such as the number of students served by the institution, annual revenues, academic ranking, or geographic location. Although many members of the executive committee have significant business experience, none of the members has any particular expertise in higher education compensation matters. Given the failure of the survey to provide information specific to universities comparable to Z, and because no other information was presented, the executive committee’s decision with respect to Q’s compensation was not based upon appropriate data as to comparability.

EXAMPLE Same facts as the previous example, except that the national compensation survey divides the data regarding compensation for university presidents into categories based on various university-specific factors, including the size of the institution (in terms of the number of students it serves and the amount of its revenues) and geographic area. The survey data shows that university presidents at institutions comparable to and in the same geographic area as Z receive annual compensation in the range of $200,000 to $300,000. The executive committee of the Board of Trustees of Z relies on the survey data and its evaluation of Q’s many years of service as a tenured professor and high-ranking university official at Z in setting Q’s compensation at $275,000 annually. The data relied upon by the executive committee constitutes appropriate data as to comparability.

EXAMPLE X is a tax-exempt hospital that is an applicable tax-exempt organization for purposes of section 4958. Before renewing the contracts of X’s chief executive officer and chief financial officer, X’s governing board commissioned a customized compensation survey from an independent firm that specializes in consulting on issues related to executive placement and compensation. The survey covered executives with comparable responsibilities at a significant number of taxable and tax-exempt hospitals. The survey data are sorted by a number of variables, including the size of the hospitals and the nature of the service they provide, the level of experience and specific responsibilities of the executives, and the composition of the annual compensation packages. The board members were provided with the survey results, a detailed written analysis comparing the hospital’s executives to those covered by the survey, and an opportunity to ask questions of a member of the firm that prepared the survey. The survey, as prepared and presented to X’s board, constitutes appropriate data as to comparability.

EXAMPLE Same facts as the previous example, except that one year later X is negotiating a new contract with its chief executive officer. The governing board of X obtains information indicating that the relevant market conditions have not changed materially, and it possesses no other information indicating that the results of the prior year’s survey are no longer valid. Therefore, X may continue to rely on the independent compensation survey prepared for the prior year in setting annual compensation under the new contract.

EXAMPLE W is a local repertory theater and an applicable tax-exempt organization for purposes of section 4958. W has had annual gross receipts ranging from $400,000 to $800,000 over its past three taxable years. In determining the next year’s compensation for W’s artistic director, the board of directors of W relies on data compiled from a telephone survey of three other unrelated performing-arts organizations of similar size in similar communities. A member of the board drafts a brief written summary of the annual compensation information obtained from this informal survey. The annual compensation information obtained in the telephone survey is appropriate data as to comparability.

Documentation. For a decision to be documented adequately, the written or electronic records of the authorized body must note

EXAMPLE A parachurch ministry’s board includes the president. If the IRS later asserts that the president was paid excessive compensation, the president will not be able to rely on the presumption of reasonableness because of his presence on the board. However, if he recuses himself from the board meeting in which his compensation is discussed (and so is not present for the debate and voting on the compensation arrangement), he may not have a conflict of interest that would preclude the presumption of reasonableness.

EXAMPLE Same facts as the previous example. The president does not serve on the board, but his wife does. The president recuses himself from the board meeting in which his compensation is determined, but his wife does not. The president will not be able to rely on the presumption of reasonableness, since one board member (the wife) is related to the president, and she did not recuse herself from the meeting that addressed her husband’s compensation.

EXAMPLE A church with 500 members and an annual budget of $1 million paid its senior pastor compensation of $200,000 in 2024. The pastor participated in the board meeting in which his compensation was determined. The church board is concerned that the pastor’s compensation may be excessive. They begin doing salary comparisons of other churches and businesses in the area with a similar membership or budget. Such efforts will serve no purpose if the board is attempting to qualify the pastor for the rebuttable presumption of reasonableness. The pastor’s presence on the board and his participation in the meeting in which his compensation was determined disqualify him for the presumption of reasonableness. However, salary surveys will be relevant in determining whether the pastor’s compensation is excessive.

EXAMPLE Same facts as the previous example, except that the pastor recused himself from the board meeting in which his compensation was determined. The board’s efforts to obtain salary comparisons may be helpful. If the board determines that similarly situated organizations, both taxable and tax-exempt, are paying persons in a functionally equivalent position a similar amount of compensation, this may establish a rebuttable presumption that the pastor’s compensation is reasonable. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any conflict of interest.

EXAMPLE Same facts as the previous example. Assume that the board learns that the average annual compensation paid to senior pastors by 20 similarly situated churches in the same area is $75,000. The board also determines that the average annual compensation paid by 10 local businesses with annual revenue of $1 million is $100,000. The results of the board’s salary surveys will not support the rebuttable presumption of reasonableness.

EXAMPLE A church pays its senior pastor annual compensation of $75,000 this year. The pastor serves as a member of the church’s governing board. The church board also provides the pastor with a new car (with a value of $25,000) in recognition of 30 years of service. The pastor recused himself from the board meetings in which his salary and the gift were approved. The gift of the car is fully taxable, so the pastor’s total compensation for this year will be $100,000. The board visits the website ChurchSalary.com for information on compensation paid to church staff and determines that senior pastors in comparable churches are paid an average of $85,000 per year. This information may be used to support a rebuttable presumption of reasonableness since the pastor’s compensation (including the gift of the car) is not substantially above the average. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any conflict of interest.

Tax on managers

An excise tax equal to 10 percent of the excess benefit may be imposed on the participation of an organization manager in an excess benefit transaction between a tax-exempt organization and a disqualified person. This tax, which may not exceed $20,000 with respect to any single transaction, is only imposed if the 25-percent tax is imposed on the disqualified person, the organization manager knowingly participated in the transaction, and the manager’s participation was willful and not due to reasonable cause. There is also joint and several liability for this tax. A person may be liable for both the tax paid by the disqualified person and this organization manager’s tax in appropriate circumstances.

An organization manager is not considered to have participated in an excess benefit transaction where the manager has opposed the transaction in a manner consistent with the fulfillment of the manager’s responsibilities to the organization.

A person participates in a transaction knowingly if the person has actual knowledge of sufficient facts so that, based solely upon such facts, the transaction would be an excess benefit transaction. Knowing does not mean having reason to know. The organization manager will not be considered knowing if, after full disclosure of the factual situation to an appropriate professional, the organization manager relied on a professional’s reasoned written opinion on matters within the professional’s expertise or if the manager relied on the fact that the requirements for the rebuttable presumption have been satisfied.

Participation by an organization manager is willful if it is voluntary, conscious, and intentional. An organization manager’s participation is due to reasonable cause if the manager has exercised responsibility on behalf of the organization with ordinary business care and prudence.

EXAMPLE A church board gives a retiring pastor the church parsonage (having a value of $300,000). The board members later learn about intermediate sanctions and are concerned that they may each be liable for up to $20,000 as managers. The regulations clarify that the board members will not individually be liable for the 10-percent excise tax (up to $20,000). Rather, they will collectively be liable for an excise tax (as managers) of 10 percent of the amount of the excess benefit up to a maximum tax of $20,000. The total tax assessed for this single transaction will be allocated to the board members who participated in the decision. However, the liability is joint and several, meaning that if some board members are unable to contribute, the others pay more. Board members who dissent from the transaction and whose dissent is reflected in the board minutes may avoid the penalty.

Effect on tax-exempt status

The regulations caution that churches and other charities are still exposed to loss of their tax-exempt status if they pay excessive compensation. The fact that excessive compensation may trigger intermediate sanctions does not preclude the IRS from revoking a church’s tax-exempt status based on inurement.

The tax regulations specify that “in determining whether to continue to recognize the tax-exempt status of a tax-exempt organization . . . ​that engages in one or more excess benefit transactions that violate the prohibition on inurement . . . ​[the IRS] will consider all relevant facts and circumstances, including, but not limited to,” the following:

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in repeated excess benefit transactions;

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and

(E) Whether the excess benefit transaction has been corrected . . . ​or the organization has made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transaction.

All factors will be considered in combination with each other. Depending on the particular situation, the IRS may assign greater or lesser weight to some factors than to others. The factors listed in paragraphs (D) and (E) will weigh more strongly in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction or transactions and takes action before the IRS discovers the excess benefit transaction or transactions. . . . ​Correction after the excess benefit transaction or transactions are discovered by the IRS, by itself, is never a sufficient basis for continuing to recognize exemption.

EXAMPLE The income tax regulations contain the following example: O is a large organization with substantial assets and revenues. O conducts activities that further exempt purposes. O employs C as its Chief Financial Officer. During Year 1, O pays $2,500 of C’s personal expenses. O does not make these payments under an accountable plan. In addition, O does not report any of these payments on C’s Form W-2 for Year 1. C does not report the $2,500 of payments as income on his individual federal income tax return for Year 1. O does not repeat this reporting omission in subsequent years and, instead, reports all payments of C’s personal expenses not made under an accountable plan as income to C. O’s payment in Year 1 of $2,500 of C’s personal expenses constitutes an excess benefit transaction between an applicable tax-exempt organization and a disqualified person. Therefore, this transaction is subject to the appropriate excise taxes. In addition, this transaction violates the proscription against inurement in section 501(c)(3). The payment of $2,500 of C’s personal expenses represented only a de minimis portion of O’s assets and revenues; thus, the size and scope of the excess benefit transaction were not significant in relation to the size and scope of O’s activities that further exempt purposes. The reporting omission that resulted in the excess benefit transaction in Year 1 is not repeated in subsequent years. Based on the application of the factors to these facts, O continues to be [an exempt organization] described in section 501(c)(3).

EXAMPLE In one of the first court cases to address intermediate sanctions, the Tax Court concluded: “The intermediate sanction regime was enacted in order to provide a less drastic deterrent to the misuse of a charity than revocation of that charity’s exempt status. . . . ​Although the imposition of [intermediate sanctions] as a result of an excess benefit transaction does not preclude revocation of the organization’s tax-exempt status, the legislative history indicates that both a revocation and the imposition of intermediate sanctions will be an unusual case.” Caracci v. Commissioner, 118 T.C. 379 (2002).

Application to churches

The regulations confirm that intermediate sanctions apply to churches, but they specify that the protections of the Church Audit Procedures Act apply. The Church Audit Procedures Act imposes detailed limitations on IRS examinations of churches. These limitations are explained fully under “The Church Audit Procedures Act” on page .

EXAMPLE A Maryland court ruled that a church did not necessarily act improperly in paying off the home mortgage loans of the church’s pastor and his son. A church congregation voted to sell the church property to another church for $900,000 in a duly called special business meeting. The congregation later convened another meeting to determine how to use the sales proceeds. A majority voted to use $400,000 to pay off mortgage loans on homes owned by the pastor and his son. Some of the church’s members filed a lawsuit contesting the use of the sales proceeds to pay off mortgage loans on the two homes. The church insisted that its payment of the mortgage loans represented compensation for past services for which the pastor and his son had not been adequately paid, therefore constituting reasonable deferred compensation.

A state appeals court agreed. It observed, “A religious or charitable corporation may take past services into consideration . . . ​in compensating an employee, as may a court when that compensation is challenged.” In support of its conclusion, the court noted that the tax code permits the IRS to assess substantial excise taxes (called intermediate sanctions) against the officers of a tax-exempt organization who benefit from an excess benefit transaction, and pointed out that the tax regulations specify that “services performed in prior years may be taken into account” in determining reasonable compensation in the current year. However, the court concluded that the church members had established a “prima facie case” of unreasonable compensation “through the substantial sums paid for the benefit of the church’s pastor and a member of his family.” As a result, it sent the case back to the trial court to further address the question of what was fair and reasonable compensation for all of the services of the pastor and his son, including past services, in light of the purposes of the church. First Baptist Church v. Beeson, 841 A.2d 347 (Md. App. 2004).

Automatic excess benefit transactions

An article titled “Automatic Excess Benefit Transactions under IRC 4958” appeared in the IRS publication Exempt Organizations Continuing Professional Education Technical Instruction Program for Fiscal Year 2004. This article is significant since it unexpectedly announced a new interpretation of section 4958. For the first time the IRS asserted that some transactions will be considered “automatic” excess benefit transactions resulting in intermediate sanctions regardless of the amount involved. Even if the amount involved in a transaction is insignificant, it still may result in intermediate sanctions. This is an important development since it exposes virtually every pastor and lay church employee to intermediate sanctions that until now had been reserved for a few highly paid charitable CEOs. The term excess has, in effect, been removed from the concept of excess benefits.

The IRS article laid down the following principles:

The IRS article provides the following examples (dates have been updated).

EXAMPLE A tax-exempt charity paid its president a salary of $50,000 per year. In 2024 it paid $35,000 for the president and the president’s spouse to take a vacation cruise around the world. The charity intended for this benefit to be additional compensation to the president, at the rate of $7,000 per year, for services the president performed from 2008 through 2024. During 2024, as to the $35,000 payment, the charity withheld additional federal income taxes and employment taxes from the president’s salary, reported the $35,000 payment as wages on its Form 941 for the appropriate calendar quarter, and paid the appropriate income taxes and employment taxes as to the $35,000. The charity reported $85,000 as compensation on the president’s Form W-2 for 2024. The president reported $85,000 as compensation on Form 1040 for 2024. The IRS concluded that the charity’s reporting of the $35,000 benefit satisfied the written contemporaneous substantiation requirements; therefore no automatic excess benefits occurred. Further, “whether the president is treated as having received compensation of $50,000 per year from 2007 through 2024 or as having received $85,000 of compensation in 2024, since neither amount was unreasonable, none of the $35,000 paid for the vacation cruise constituted an excess benefit transaction under section 4958.” See principle (2) above.

EXAMPLE Same facts as the previous example, except that the charity did not withhold additional federal income taxes or employment taxes from the president’s salary, did not report the $35,000 payment as wages on its Form 941 for the appropriate calendar quarter, and did not pay the appropriate income taxes and employment taxes as to the $35,000. The charity reported only $50,000 as compensation on the president’s Form W-2 for 2024. The president reported only $50,000 as compensation on Form 1040 for 2024.

In this example the charity did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid,” and therefore the benefit constitutes an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. See principle (3) above. So, even though the total amount would not have constituted an excess benefit had the charity reported it as taxable income, the fact that it did not makes the transaction an “automatic” excess benefit. This will result in (1) an excise tax of $8,750 (25 percent of $35,000), (2) an excise tax of $70,000 (200 percent of $35,000), and (3) a penalty for failing to file Form 4720 (assuming the president failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax under section 4958 is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to “reasonable cause” and was not due to “willful neglect.” For this purpose, reasonable cause means exercising “ordinary business care and prudence.” Not due to willful neglect means that the receipt of the excess benefit was not due to the disqualified person’s conscious, intentional, or voluntary failure to comply with section 4958, and that the noncompliance was not due to conscious indifference. If the president can establish that in 2024, when the charity paid $35,000 on the president’s behalf, this excess benefit transaction was due to “reasonable cause” and was not due to “willful neglect,” the IRS would abate the 25-percent excise tax. However, if the president cannot establish both of these requirements, the president would be liable for the 25-percent excise tax even though the president corrected the excess benefit transaction by paying $35,000 plus interest to the charity and paid federal income tax on the $35,000 as additional compensation.

EXAMPLE A charity paid its president a salary of $50,000 per year. It adopted an expense reimbursement program that qualifies as an “accountable plan.” In 2024 the president traveled in connection with business and incurred travel expenses of $2,500. In 2024 the charity reimbursed the president $2,500 for these travel expenses. During 2024 the charity did not withhold and pay employment taxes on the $2,500 of expense reimbursements paid to the president. In addition, it did not report this $2,500 as wages on its Form 941 for the appropriate calendar quarter in 2024 and did not include this amount as wages on the president’s Form W-2. The charity reported $50,000 as compensation on the president’s Form W-2 for 2024. The president reported $50,000 as compensation on Form 1040 for 2024. The IRS concluded that “since the charity paid its president $2,500 under an accountable plan, the $2,500 is disregarded for purposes of section 4958.” This means that the reimbursements do not constitute an “automatic” excess benefit.

EXAMPLE Same facts as the previous example, except that in 2024 the president traveled on a personal matter and incurred travel expenses of $2,500. The charity reimbursed the president $2,500 for these travel expenses, but did not withhold and pay employment taxes or additional federal income taxes as to the $2,500 of expense reimbursements. In addition, the charity did not report this $2,500 as wages on its Form 941 for the appropriate calendar quarter and did not include this amount as wages on the president’s Form W-2 for 2024. The charity reported only $50,000 as compensation on the president’s Form W-2 for 2024. The president reported $50,000 as compensation on Form 1040 for 2024.

The $2,500 reimbursement was nonaccountable, since the president failed to substantiate a business purpose. Neither the charity nor president “clearly indicated an intent to treat the benefit as compensation for services when the benefit was paid,” since the charity did not report the $2,500 nonaccountable reimbursement as taxable income on Form 941 or Form W-2, and the president failed to report the amount as taxable income on Form 1040. As a result, the IRS will treat the reimbursement as an “automatic” excess benefit transaction without regard to whether (1) the reimbursement was reasonable; (2) any other compensation the disqualified persons may have received is reasonable; or (3) the aggregate of the reimbursements and any other compensation the disqualified person may have received is reasonable. So, even though the $2,500 reimbursement would not have constituted an excess benefit had the charity reported it as taxable income, the fact that it did not makes the transaction an “automatic” excess benefit. This will result in (1) an excise tax of $625 (25 percent of $2,500), (2) an excise tax of $5,000 (200 percent of $2,500), and (3) a penalty for failing to file Form 4720 (assuming the president failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax under section 4958 is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to “reasonable cause” and was not due to “willful neglect.” For this purpose, reasonable cause means exercising “ordinary business care and prudence.” Not due to willful neglect means that the receipt of the excess benefit was not due to the disqualified person’s conscious, intentional, or voluntary failure to comply with section 4958, and that the noncompliance was not due to conscious indifference. If the president can establish that when the charity paid the $2,500 this excess benefit transaction was due to “reasonable cause” and was not due to “willful neglect,” the IRS would abate the 25-percent excise tax. However, if the president cannot establish both of these requirements, the president would be liable for the 25-percent excise tax even though the president corrected the excess benefit transaction by paying $2,500 plus interest to the charity and paid federal income tax on the $2,500 as additional compensation.

Four IRS Rulings

In 2004 the IRS issued four private letter rulings that apply the principle of automatic excess benefit transactions to a variety of benefits that were provided by a church to its pastor and members of the pastor’s family. These rulings are discussed separately below.

Ruling 1: IRS Letter Ruling 200435019

A church was founded by a pastor (Pastor B), who has been its only pastor and who also serves as the president and a director of the church. The church’s bylaws specify that directors are appointed by Pastor B and serve until their death, disability, resignation, or removal by Pastor B. The other members of the church’s board of directors are Pastor B’s wife (who also serves as secretary-treasurer) and one of his sons (who is the vice president). Pastor B has two sons, C and D. The IRS addressed the consequences of the following transactions in this ruling:

The IRS began its analysis by noting that intermediate sanctions under section 4958 only can be assessed against disqualified persons and that the regulations define a disqualified person as any person who at any time during the five-year period ending on the date of an excess benefit transaction was in a position to exercise substantial influence over the affairs of the tax-exempt organization, or any family member of such a person. Since Pastor B met the definition of a disqualified person, so did the members of his family, including his sons. As a result, the IRS could assess intermediate sanctions against his family members for any excess benefit paid by the church.

The IRS defined an excess benefit transaction (resulting in intermediate sanctions) as follows:

An excess benefit transaction is a transaction in which an economic benefit is provided by a tax-exempt organization, directly or indirectly, to or for the use of any disqualified person and the value of the economic benefit provided by the organization exceeds the value of the services received for providing such benefit.

Reimbursements of an employee’s expenses by the exempt organization are disregarded for purposes of section 4958 if the reimbursements satisfy all of the requirements of [an accountable reimbursement plan]. . . .

Expenditures of organization funds by an employee that satisfy the [business deduction] requirements under sections 162 and 274, including the substantiation requirements of those provisions and the regulations thereunder, do not constitute excess benefits under section 4958.

Any reimbursement of expenses by the organizations to an employee, or direct expenditures of organization funds by the employee, are automatic excess benefits to the extent that they do not satisfy the requirements of [an accountable reimbursement plan] or sections 162 and 274 of the tax code and the regulations thereunder, unless they are substantiated as compensation. . . .

In this case, Pastor B and his son expended church funds, and used church assets, in a variety of ways described below. . . . ​The son does not contend that these expenditures and uses were intended as compensation to himself or his relatives. In any event, there is no evidence in the record that would satisfy the contemporaneous substantiation rules of the regulations.

It follows that unless the son can satisfy the accountable plan requirements or the requirements of sections 162 and (to the extent relevant) 274 and the regulations thereunder for ordinary and necessary business expenses, the expenditures and use of church funds described below must be treated as automatic excess benefits.

The IRS analysis of each transaction is summarized in the following text.

The IRS noted, “The church retained its credit card statements and a few receipts. It did not note any business purpose or relationship with respect to the entries on such statements. It did not maintain any records, account books, diaries, etc., to establish the business purpose or relationship of such expenditures.” The IRS concluded:

[The tax code] provides that expenses must be ordinary and necessary to be a business deduction. The expenses must be contemporaneously documented with time, place, business purpose, and business relationship. The church maintained credit card statements and a few receipts. However, neither the church nor Pastor B’s son documented the business purpose or relationship of his expenditures. It does not appear that the son kept any account books, diary, or other records demonstrating that the charges he made on the church credit cards were for business purposes [emphasis added].

As a result, the IRS determined that the church’s reimbursements of the son’s credit card charges were nonaccountable, and since neither the church nor the son reported these reimbursements as taxable income, they constituted automatic excess benefits resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefits plus an additional 200 percent of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

While the son was personally liable for these intermediate sanctions, so was his father. The IRS observed:

We note that Pastor B was founder, president, and chief executive of the church. As a practical matter, he had total control of all the church’s expenditures. He either approved of the excess benefit transactions by his son or he acquiesced in them. If Pastor B had withdrawn funds from the church and given them to his family members, there would have been no question that such gifts would be taxable excess benefits to him. By authorizing or allowing his son and other relatives, the natural objects of his bounty, to make unlimited expenditures of church funds for personal purposes, without any substantiation or evidence of a business purpose, he in effect improperly removed charitable assets from the church and gave them to his relatives. Accordingly, he not only is liable for the excess benefit transactions from which he personally benefited, but also is jointly and severally liable for all the excess benefits [paid to his son and other members of his family].

The church provided the IRS with “voluminous records listing calls from the church’s cellular phones.” However, the documents “list only the telephone numbers, and do not indicate with whom the son spoke and the business reasons for their conversation. Aside from phone calls made to church phones that would most likely be church business, all other calls were not substantiated as required.”

As a result, the IRS determined that the church’s reimbursements of the son’s cell phone charges were nonaccountable, and since neither the church nor the son reported these reimbursements as taxable income, they constituted automatic excess benefits resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefits plus an additional 200 percent of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

The IRS found Pastor B and his son “jointly and severally liable” for the intermediate sanctions, meaning that the IRS could collect the excise taxes from either of them.

The IRS found Pastor B and his son “jointly and severally liable” for the intermediate sanctions, meaning that the IRS could collect the excise taxes from either of them.

Ruling 2: IRS Letter Ruling 200435020

This ruling involved the same church and pastor as Ruling 1 (summarized above). However, the transactions involved in this ruling were as follows:

The IRS applied the same definition of an excess benefit transaction (resulting in intermediate sanctions) that it used in Ruling 1. The IRS analysis of each transaction is summarized below.

The IRS noted, “The church retained its credit card statements and a few receipts. It did not note any business purpose or relationship with respect to entries on such statements. It did not maintain any records, account books, diary, etc. to establish the business purpose or relationship of such expenditures.” The IRS concluded,

The tax code provides that expenses must be ordinary and necessary to be a business deduction. The expenses must be contemporaneously documented with time, place, business purpose, and business relationship. The church maintained its credit card statements and a few receipts. However, neither the church nor Pastor B documented the business purposes of these expenditures. It does not appear that Pastor B kept any account books, diaries, or other records demonstrating that the charges the family made on church credit cards were for business purposes.

As a result, the IRS determined that the church’s reimbursements of Pastor B’s credit card charges were nonaccountable, and since neither the church nor Pastor B reported these reimbursements as taxable income, they constituted automatic excess benefits resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefits plus an additional 200 percent of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

The IRS concluded, “The car is kept at Pastor B’s personal residence, and he and his wife are the only people with access to it. Pastor B argued that he drove this car occasionally, and only on business. However, use of a vehicle is treated as personal use unless a taxpayer substantiates business use.” As a result, the IRS determined that Pastor B’s exclusive access to the church-owned car constituted personal use of church property, and since no taxable income was reported during the year in question by either the church or Pastor B, the annual rental value of the car constituted an automatic excess benefit resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefit plus an additional 200 percent of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

The IRS determined that no business purpose had been proven for any of these expenses; therefore, church assets had been used for personal purposes without having been reported as taxable income by the church, Pastor B, or Pastor B’s son in the year the benefits were provided. Thus they constituted automatic excess benefits resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefit plus an additional 200 percent of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

The IRS concluded this ruling with the following observation:

We note that Pastor B was founder, president, and chief executive of the church. As a practical matter, he had total control of all church expenditures. He either approved of the excess benefit transactions by his son or he acquiesced in them. If he had withdrawn funds from the church and given them to his family members, there would have been no question that such gifts would be taxable excess benefits to him. By authorizing or allowing his son and other relatives, the natural objects of his bounty, to make unlimited expenditures of church funds for personal purposes, without any substantiation or evidence of a business purpose, he in effect improperly removed charitable assets from the church and gave them to his relatives. Accordingly, he not only is liable for the excess benefit transactions from which he personally benefited, but also is jointly and severally liable for all the excess benefits [provided to members of his family].

Ruling 3: IRS Letter Ruling 200435021

This ruling involved the same church and pastor as Ruling 1 (summarized above). The transactions were identical to those described in Ruling 2, but in this ruling the IRS focused on Pastor B’s wife. Since she was a family member of Pastor B, she was a disqualified person subject to intermediate sanctions. Further, Pastor B was jointly and severally liable for her penalties.

Ruling 4: IRS Letter Ruling 200435022

This ruling involved the same church and pastor as Ruling 1 (summarized above). However, the transactions involved in this ruling were as follows:

The IRS applied the same definition of an excess benefit transaction (resulting in intermediate sanctions) that it used in Ruling 1.

The IRS analysis of each transaction is summarized below.

The IRS noted, “The church retained its credit card statements and a few receipts. It did not note any business purpose or relationship with respect to the entries on such statements. It did not maintain any records, account books, diaries, etc., to establish the business purpose or relationship of such expenditures.” The IRS concluded:

[The tax code] provides that expenses must be ordinary and necessary to be a business deduction. The expenses must be contemporaneously documented with time, place, business purpose, and business relationship. The church maintained credit card statements and a few receipts. However, neither the church nor Pastor B’s son documented the business purpose or relationship of his expenditures. It does not appear that the son kept any account books, diary, or other records demonstrating that the charges he made on the church credit cards were for business purposes [emphasis added].

As a result, the IRS determined that the church’s reimbursements of the son’s credit card charges were nonaccountable, and since neither the church nor the son reported these reimbursements as taxable income, they constituted automatic excess benefits resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefits plus an additional 200 percent of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

While the son was personally liable for these intermediate sanctions, so was his father. The IRS observed:

We note that Pastor B was founder, president, and chief executive of the church. As a practical matter, he had total control of all the church’s expenditures. He either approved of the excess benefit transactions by his son or he acquiesced in them. If Pastor B had withdrawn funds from the church and given them to his family members, there would have been no question that such gifts would be taxable excess benefits to him. By authorizing or allowing his son and other relatives, the natural objects of his bounty, to make unlimited expenditures of church funds for personal purposes, without any substantiation or evidence of a business purpose, he in effect improperly removed charitable assets from the church and gave them to his relatives. Accordingly, he not only is liable for the excess benefit transactions from which he personally benefited, but also is jointly and severally liable for all the excess benefits [paid to his son and other members of his family].

The church provided the IRS with “voluminous records listing calls from the church’s cellular phones.” However, the documents “list only the telephone numbers, and do not indicate with whom the son spoke and the business reasons for their conversation. Aside from phone calls made to church phones that would most likely be church business, all other calls were not substantiated as required.”

As a result, the IRS determined that the church’s reimbursements of the son’s cell phone charges were nonaccountable, and since neither the church nor the son reported these reimbursements as taxable income, they constituted automatic excess benefits resulting in intermediate sanctions in the amount of 25 percent of the amount of the excess benefits plus an additional 200 percent of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above). The IRS found Pastor B and his son “jointly and severally liable” for the intermediate sanctions, meaning that the IRS could collect the excise taxes from either of them.

Church compensation practices

Here are the key points that pastors, church treasurers, and church board members need to understand about intermediate sanctions:

The following examples will further illustrate these rules. Assume that each senior pastor in these examples meets the definition of a disqualified person.

Example 1 A church uses an accountable reimbursement arrangement for the reimbursement of its senior pastor’s business-related transportation, travel, entertainment, and cell phone expenses. The church only reimburses those expenses for which the pastor produces documentary evidence of the date, amount, location, and business purpose of each expense within 30 days. By the end of the year, the church has reimbursed $4,000 for expenses. Since the church’s reimbursement arrangement is accountable, neither the church nor the senior pastor is required to report the reimbursements as taxable income, and the reimbursements are not considered in deciding if the church has provided an excess benefit to the pastor.

Example 2 A church pays its senior pastor a salary of $45,000 this year. In addition, it reimburses expenses the pastor incurs for the use of his car, out-of-town travel, entertainment, and cell phone but does not require substantiation of the amount, date, location, or business purpose of reimbursed expenses. Instead, the pastor provides the church treasurer with a written statement each month that lists the expenses incurred for the previous month. The treasurer then issues a check to the pastor for this amount. This is an example of a nonaccountable reimbursement arrangement. Assume that the church reimburses $5,000 under this arrangement this year and that the amount is reported as taxable income by the church on the pastor’s Form W-2 for this year. Since the full amount was reported as taxable compensation by the church in the year the benefit was paid, it is not an automatic excess benefit resulting in intermediate sanctions. Rather, the IRS will consider the benefit along with any other compensation the pastor received to determine whether the total compensation was unreasonable (and therefore an excess benefit transaction resulting in intermediate sanctions). A salary of $45,000 plus $5,000 in reimbursements of nonaccountable expenses is not unreasonable, so the IRS will not assess intermediate sanctions.

Example 3 Same facts as Example 2, except that the church did not report the $5,000 as taxable income on the pastor’s Form W-2 in the year it was paid, and the pastor did not report it on his tax return (Form 1040) for that year. The church treasurer assumed that the pastor had “at least” $5,000 in business expenses, and so there was no need to report the nonaccountable reimbursements as taxable income. This is a dangerous assumption that converts the nonaccountable reimbursements into an automatic excess benefit and exposes the pastor to intermediate sanctions. An excess benefit is defined by section 4958 of the tax code as any compensation or benefit provided to a disqualified person in excess of the reasonable value of his or her services. It includes nonaccountable reimbursements of business and personal expenses—unless the reimbursements are reported as taxable compensation by the church or pastor in the year they are paid. Since the church did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid” (i.e., the benefit was not reported on the pastor’s Form W-2 or Form 1040), the benefit constitutes an automatic excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. So even though the total amount would not have constituted an excess benefit had the church reported it as taxable income, the fact that it did not do so makes the transaction an automatic excess benefit. This will result in (1) an excise tax of $1,250 (25 percent of $5,000); (2) an excise tax of $10,000 (200 percent of $5,000); and (3) a penalty for failing to file Form 4720 (assuming the pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect. For this purpose, reasonable cause means exercising “ordinary business care and prudence.” Not due to willful neglect means that the receipt of the excess benefit was not due to the disqualified person’s conscious, intentional, or voluntary failure to comply with section 4958 and that the noncompliance was not due to conscious indifference. If the pastor can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect, the IRS would abate the 25-percent excise tax. However, if the pastor cannot establish both of these requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $5,000 plus interest to the church and paid federal income tax on the $5,000 as additional compensation.

Note that managers (directors) who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively.

Example 4 Same facts as Example 3, except that the pastor is a church’s youth pastor. Assuming that the youth pastor is not an officer of the church, a member of the governing board, or a relative of someone who is, he is not a disqualified person and therefore is not subject to intermediate sanctions. While the nonaccountable reimbursements constitute taxable compensation, and the failure by the church and pastor to report them as such exposes the pastor to back taxes plus penalties and interest, they are not an automatic excess benefit resulting in intermediate sanctions, since the youth pastor is not a disqualified person.

Example 5 Same facts as Example 4, except that the youth pastor is the senior pastor’s son. Assuming the senior pastor is president of the church corporation or a member of the governing board, he is a disqualified person, and so is his son. As a result, the nonaccountable reimbursements not reported as taxable compensation are an automatic excess benefit resulting in intermediate sanctions. The senior pastor and his son are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person. Church board members who approved the excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively. See “Tax on managers” on page  for additional information

Example 6 A church’s senior pastor owns his home and is paid a salary and housing allowance each year by his church. The church owns a parsonage, and this year it allows the pastor’s son and daughter-in-law to use it as their residence at no charge (neither the son nor daughter-in-law is a minister or church employee). The annual rental value of the parsonage is $12,000, but the church does not believe this constitutes taxable income and so does not report it on the pastor’s Form W-2 or on any tax form issued to the son or daughter-in-law. The pastor does not report the $12,000 as taxable income on his tax return (Form 1040) for this year. The pastor, as president of the church corporation, is a disqualified person, and so is his son. The church’s decision to allow the pastor’s son to reside in the parsonage constitutes an excess benefit. Since the benefit was not reported as taxable income in the year it was provided, the rental value constitutes an automatic excess benefit resulting in intermediate sanctions. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount. This will result in (1) an excise tax of $3,000 (25 percent of $12,000); (2) an excise tax of $24,000 (200 percent of $12,000); and (3) a penalty for failing to file Form 4720 (assuming the pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect. See Example 3 for more information. However, if the pastor cannot establish both requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $12,000 plus interest to the church and paid federal income tax on the $12,000 as additional compensation. Also, note that the senior pastor and his son are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person.

Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively.

Example 7 A church sends its pastor and his wife on an all-expense-paid trip to Hawaii in honor of their 25th wedding anniversary. The total cost of the trip is $8,000. The church treasurer assumes that this amount is a nontaxable fringe benefit and so does not report any of the $8,000 on the pastor’s Form W-2. The pastor likewise assumes that the cost of the trip is a nontaxable benefit. The church’s payment of these travel expenses constitutes an automatic excess benefit resulting in intermediate sanctions since it was not reported as taxable income by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount. This will result in (1) an excise tax of $2,000 (25 percent of $8,000), (2) an excise tax of $16,000 (200 percent of $8,000), and (3) a penalty for failing to file Form 4720 (assuming the pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect. See Example 3 for more information. However, if the pastor cannot establish both requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $8,000 plus interest to the church and paid federal income tax on the $8,000 as additional compensation. Also, note that the senior pastor and his wife are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person.

Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively. For more information on this tax, see “Tax on managers” on page .

Example 8 A church collected a “love offering” from the congregation during the Christmas season last year. The congregation was informed that donations would be tax-deductible, and donations were reported on the annual contribution summary provided to each member. Last year the pastor’s love offering was $4,000. Both the pastor and church treasurer assumed that this amount was a nontaxable gift, so neither reported it as taxable income (on Form W-2 or Form 1040). The love offering constitutes an automatic excess benefit resulting in intermediate sanctions since it was not reported as taxable compensation by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount. This will result in (1) an excise tax of $1,000 (25 percent of $4,000), (2) an excise tax of $8,000 (200 percent of $4,000), and (3) a penalty for failing to file Form 4720 (assuming the pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect. See Example 3 for more information. However, if the pastor cannot establish both requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $4,000 plus interest to the church and paid federal income tax on the $4,000 as additional compensation.

Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively. For more information on this tax, see “Tax on managers” on page .

Example 9 A church pays its senior pastor a monthly car allowance of $400. The church does not require the pastor to substantiate that he uses the monthly allowances for business purposes and does not require him to return any excess reimbursements (the amount by which the allowances exceed actual business expenses) to the church. The church treasurer does not report these allowances as taxable income on the pastor’s Form W-2, since he assumes that the pastor has “at least” $400 of expenses associated with the business use of his car each month. The pastor reports none of the allowances as taxable income on his tax return (Form 1040).

An excess benefit is defined by section 4958 of the tax code as any compensation or benefit provided to a disqualified person in excess of the reasonable value of his or her services. It includes nonaccountable reimbursements of business and personal expenses—unless the reimbursements are reported as taxable compensation by the church or pastor in the year they are paid. Since the church did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid” (i.e., the benefit was not reported on the pastor’s Form W-2 or Form 1040), the benefit constitutes an automatic excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. So even though the total amount of the allowances ($4,800 per year) would not have constituted an excess benefit had the church reported them as taxable income, the fact that it did not do so makes the allowances an automatic excess benefit. This will result in (1) an excise tax of $1,200 (25 percent of $4,800), (2) an excise tax of $9,600 (200 percent of $4,800), and (3) a penalty for failing to file Form 4720 (assuming the pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect. See Example 3 for more information. However, if the pastor cannot establish both requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $4,800 plus interest to the church and paid federal income tax on the $4,800 as additional compensation.

Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively. For more information on this tax, see “Tax on managers” on page .

EXAMPLE 10 In Private Letter Ruling 201517014 (2015), the IRS revoked an organization’s tax-exempt status because of its compensation practices. The organization was run by its founder and his wife, who served as its CEO and CFO, and their daughter (collectively, the “officers”). The IRS audited the organization and found the following:

The IRS noted that “fact patterns suggesting inurement frequently suggest excess benefit transactions between an exempt organization and a disqualified person under section 4958” of the tax code. The IRS noted that the income tax regulations instruct the IRS to consider a variety of factors to determine whether revocation is appropriate when section 4958 excise taxes also apply:

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

(E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6)), or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction.

EXAMPLE 11 The United States Tax Court ruled that the wife of the founder of a medical missions charity had received an excess benefit from the charity, subjecting her to a “first-tier” penalty of 25 percent of the amount of the excess benefit and an additional “second-tier” tax of 200 percent of the excess, since it had not been returned to the charity. The court noted that the term excess benefit transaction is defined by section 4958 as any transaction in which an economic benefit is provided by a tax-exempt organization to a “disqualified person” if the value of the economic benefit provided exceeds the value of the services received for providing the benefit. Section 4958 further provides that an economic benefit is not treated as consideration for the performance of services unless the charity clearly indicates its intent to so treat it. Further, a charity “is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit at issue.” If an organization fails to provide this contemporaneous substantiation, any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit.” 

The “contemporaneous substantiation” requirement can be satisfied if the charity reports a payment to the disqualified person as compensation on a Form W-2. It can also be satisfied by “other written contemporaneous evidence” showing that “the appropriate decision-making body or an officer authorized to approve compensation approved a transfer as compensation for services in accordance with established procedures.” Such evidence includes “an approved written employment contract executed on or before the date of the transfer,” other documentation showing that “an authorized body contemporaneously approved the transfer as compensation for services,” and contemporaneous written evidence establishing “a reasonable belief by the . . . ​organization that a benefit was a nontaxable benefit.” The court concluded:

[The petitioner] received biweekly checks totaling $27,000, and monthly certified checks totaling $88,000, for a total of $115,000. If these constituted compensation for services provided by the petitioner to the charity, and were contemporaneously substantiated as noted above, then there would be no excess benefit transaction since section 4958 provides that an economic benefit is not treated as consideration for the performance of services unless the charity clearly indicates its intent to so treat it. And a charity “is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit at issue. . . . ​

[The petitioner] supplied no contemporaneous substantiation to show that [the charity] “clearly indicated its intent” to treat the $27,000, much less the $88,000, as compensation for her services. The charity did not report any of those payments as compensation to petitioner on a Form W-2, and petitioner did not report any of those payments as income on her Form 1040. . . . ​Nor did petitioner supply any other type of contemporaneous substantiation. Specifically, she offered no evidence (such as an employment contract or minutes of board meetings) showing that “the appropriate decision-making body or an officer authorized to approve compensation approved . . . ​her payments as compensation for services in accordance with established procedures.” In the absence of contemporaneous substantiation, “any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit.” Petitioner is thus foreclosed from contending that the $115,000 she received was not an “excess benefit” because paid in consideration of her performance of services.

The court concluded that the excess benefits had not been “corrected.” It noted that “correction” of an excess benefit transaction means “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The “taxable period” during which correction must occur (assuming the tax has not yet been assessed) is the period beginning with the date of the transaction and ending on “the date of mailing a notice of deficiency with respect to the tax imposed by section (a)(1)” (i.e., the 25-percent tax). The court noted that the “taxable period” during which petitioner was obligated to make correction “thus closed on August 13, 2018, when the notice of deficiency was mailed” to her by the IRS.

The court concluded: “Petitioner did not correct the excess benefit transactions within the ‘taxable period.’ There is no evidence that she returned to the charity, at any time, any portion of the $115,000 at issue. Nor did she show that she made any effort to place the charity ‘in a financial position not worse than that in which it would be if . . . ​she were dealing [with it] under the highest fiduciary standards.’ We accordingly hold that she is liable for a second-tier tax of $230,000 (200% × $115,000).”

The court noted that section 4962 provides for nonassessment or abatement of the first-tier tax (25 percent) in certain circumstances. To qualify for this treatment, “the disqualified person must establish two facts to the satisfaction of the IRS.” Specifically, she must show (1) that the taxable event was due to reasonable cause and not to willful neglect and (2) that the event was corrected within the correction period for such event.” The “correction period” for the first-tier tax is the same as for the second-tier tax. Ononuju v. Commissioner, T.C. Memo 2022-94 (2022).

EXAMPLE 12 An entity that was determined to be tax exempt by the IRS for its ostensible operation of a church was stripped of its exempt status after an examination revealed that, in fact, its primary activity was the provision of nonexempt behavioral health services, which services were provided in a commercial manner like that used by for-profit entities. Moreover, any church-related activities were secondary and incidental to its overall operations. An additional basis for revocation was that the entity’s earnings were inuring to the benefit of the entity’s officers and members of their families, and such “excess benefit transactions” had not been corrected as required by section 4958 of the tax code. PLR 202417022.

The most significant component of income for most ministers and church staff is compensation received for personal services. Church compensation paid to employees constitutes wages and is reported on Form 1040, line 1. Compensation paid to self-employed workers (independent contractors) constitutes self-employment earnings and is reported on line 3 of Schedule 1 (Form 1040) and Schedule C (Form 1040).

As noted in Chapters 5–7, some items of income are not included on Form 1040, line 1. These include a housing allowance, a church’s reimbursements of business expenses under an accountable reimbursement plan, and several kinds of fringe benefits.

Church compensation often consists of several items besides salary that must be included on the Form W-2 or Form 1099-NEC issued to the worker at the end of the year.

Addressed in the remainder of this section are several items of income that may be received by ministers and church staff.

Bonuses paid to a minister or staff member for outstanding work or other achievement are income and must be included on Form W-2 (if an employee) or Form 1099-NEC (if self-employed). Treas. Reg. 1.61-2(a)(1). Note that the bankruptcy court in the PTL case (see “Unreasonable compensation” on page ) remarked that “bonuses [are] almost unheard of in the religious field.” Heritage Village Church and Missionary Fellowship, Inc., 92 B.R. 1000 (D.S.C. 1988).

Ministers and lay church employees often receive special-occasion gifts during the course of the year. Examples include Christmas, birthday, and anniversary gifts. Church leaders often do not understand how to report these payments for federal tax purposes. There are two options: (1) the payments represent taxable compensation for services rendered and should be reported as income on the recipient’s Form W-2 (Form 1099-NEC if self-employed), or (2) the payments represent a nontaxable gift and are not reported on the recipient’s Form W-2 or Form 1099-NEC.

Are special-occasion gifts made to ministers and lay church employees tax-free gifts? Or are they taxable compensation for services rendered? While in most cases such distributions will represent taxable compensation for services rendered, in some cases a reasonable basis may exist for treating them as nontaxable gifts. The most relevant considerations are summarized below.

The Duberstein case

The United States Supreme Court, in a case involving a retirement gift made to a church treasurer, conceded that it is often difficult to distinguish between tax-free gifts and taxable compensation. The court did attempt to provide some guidance, however, by noting that “a gift in the statutory sense . . . ​proceeds from a detached and disinterested generosity . . . ​out of affection, respect, admiration, charity or like impulses. . . . ​The most critical consideration . . . ​is the transferor’s intention.” Commissioner v. Duberstein, 363 U.S. 278 (1960).

The court added that “it doubtless is the exceptional payment by an employer to an employee that amounts to a gift” and that the church’s characterization of the distribution as a gift is “not determinative—there must be an objective inquiry as to whether what is called a gift amounts to it in reality.”

The Bogardus case

In another ruling the Supreme Court attempted to provide further guidance in distinguishing between a tax-free gift and taxable compensation:

What controls is the intention with which payment, however voluntary, has been made. Has it been made with the intention that services rendered in the past shall be requited more completely, though full acquittance has been given? If so, it bears a tax. Has it been made to show good will, esteem, or kindliness toward persons who happen to have served, but who are paid without thought to make requital for the service? If so, it is exempt. Bogardus v. Commissioner, 302 U.S. 34, 45 (1936).

Section 102(c) of the tax code

Section 102(c) of the tax code specifies that the definition of the term gift shall not include “any amount transferred by or for an employer to, or for the benefit of, an employee.” There are two exceptions to this rule:

First, the tax code permits employees to exclude from income certain “employee achievement awards.” This exception is discussed later in this section.

Second, employees (including ministers) are still permitted to exclude from gross income (as a de minimis fringe benefit) the value of any gift received from an employer if the value is so insignificant that accounting for it would be unreasonable or administratively impracticable. IRC 132(e). To illustrate, a traditional employer holiday gift of low fair market value (a turkey, fruitcake, etc.) will continue to be excludable from an employee’s income.

EXAMPLE A federal appeals court affirmed the conviction of a pastor and his wife on several tax crimes based on various forms of church compensation they failed to disclose on their tax returns, including “gifts” from their church. The court observed: 

It is apparent that the relationship between an employer and employee is one that is commonly established for some kind of mutual benefit, a dynamic that is altogether different from the “detached and disinterested generosity” that normally prompts the tender of a gift. Commissioner v. Duberstein, 363 U.S. 278, 285 (1960). . . . ​Payments from an employer to an employee are not gifts, but are presumed to be included in gross income. A taxpayer must report as gross income “all income from whatever source derived” unless “excluded by law.” To be sure, section 102(a) of the Code excludes from gross income “the value of property acquired by gift.” But the Code is explicit that payments from an employer to an employee do not constitute gifts under § 102(a), which “shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.” I.R.C. section 102(c). United States v. Jinwright, 2012-2 U.S.T.C. ¶50,417 (4th Cir. 2012).

EXAMPLE In a case addressing the tax status of love gifts to a pastor, the Tax Court referenced section 102(c) of the tax code, which specifies that the definition of the term gift does not include “any amount transferred by or for an employer to, or for the benefit of, an employee.” However, the court noted that the IRS did not raise this issue or contend that the pastor was an employee of the church. Jackson v. Commissioner of Internal Revenue, T.C. Summ. 2016-69 (2016).

EXAMPLE The Tax Court dismissed the application and relevance of section 102(c) of the tax code in a case involving the tax status of love gifts made directly by church members to their pastor. The court noted that section 102(c) states that the definition of the term gift shall not include “any amount transferred by or for an employer to, or for the benefit of, an employee.” The court concluded that relying on section 102(c) to resolve this case was problematic since “we can’t say that the individual church members are [the pastor’s] employers.” Felton v. Commissioner, T.C. Memo. 2018-168 (2018).

Income tax regulations

The income tax regulations specify that Christmas bonuses paid by an employer are taxable income for the recipient. Treas. Reg. 1.61-2(a)(1).

The Banks case

The Tax Court ruled that special offerings made to a minister on her birthday, Mother’s Day, the church’s anniversary, and Christmas were taxable compensation for services rendered rather than nontaxable gifts. Banks v. Commissioner, 62 T.C.M. 1611 (1991). The offerings were in addition to the pastor’s salary and amounted to more than $40,000 annually. The minister considered them to be tax-free gifts and did not report any of them as income on her income tax returns. The IRS audited the minister and determined that the special offerings were personal income and not tax-free gifts. The Tax Court agreed. It based its decision entirely on the Supreme Court’s definition of the term gift announced in its Duberstein decision (mentioned above).

The Tax Court concluded that there simply was no way the special-occasion offerings in this case could be characterized as gifts under the Duberstein test, for the following reasons:

The Goodwin case

A federal appeals court ruled that congregational offerings collected on four special days each year and presented to a pastor represented taxable compensation rather than tax-free gifts. Goodwin v. United States, 67 F.3d 149 (8th Cir. 1995). About two weeks before each special occasion, the associate pastor made an announcement prior to the commencement of a church service that he would be collecting money for the special-occasion gift. The pastor and his wife were not present in the sanctuary during this announcement. People wishing to donate placed money in an envelope and gave it to the associate pastor or one of the deacons. The money was never placed in the offering plates passed during the services. Any checks received were returned in order to maintain anonymity. The money was never counted and was not recorded in the church book or records. The congregation was advised that their contributions would not be receipted by the church and were not tax-deductible.

The IRS audited the pastor’s tax returns for 1987–1989 and determined that the special-occasion gifts were in fact taxable compensation to the pastor. The congregational “gifts” to the pastor amounted to $12,750 in 1987, $14,500 in 1988, and $15,000 in 1989. The pastor’s salary (not counting the special-occasion gifts) was $7,800 in 1987, $14,566 in 1988, and $16,835 in 1989.

Despite the church members’ belief that they were giving to their pastor out of “love, respect, admiration and like impulses,” the court concluded that the payments constituted taxable compensation to the pastor. The court based its decision on the Duberstein case (discussed above), from which it derived the following principles: (1) the donor’s intent is “the most critical consideration,” and (2) “there must an objective inquiry” into the donor’s intent. The court concluded that the facts of the case demonstrated that the donors’ intent was to more fully compensate their pastor, and accordingly, the “gifts” represented taxable compensation. It based this conclusion on two factors:

The IRS proposed that the court adopt the following test to determine whether transfers from church members to their minister represent nontaxable gifts: “The feelings of love, admiration and respect that professedly motivated the parishioners to participate in the special occasion offerings arose from and were directly attributable to the services that [the pastor] performed for them as pastor of the church. Since the transfers were tied to the performance of services by [the pastor] they were, as a matter of law, compensation.”

The court rejected this test as too broad, noting that

it would include as taxable income every twenty-dollar gift spontaneously given by a church member after an inspiring sermon, simply because the urge to give was tied to the minister’s services. It would also include a departing church member’s individual, unsolicited five hundred dollar gift to a long-tenured, highly respected priest, rabbi, or minister, a result that is totally at odds with the opinions of all nine [Supreme Court] Justices in Bogardus v. Commissioner: “Has [the payment] been made with the intention that services rendered in the past shall be requited more completely, though full acquittance has been given? If so, it bears a tax. Has it been made to show good will, esteem, or kindliness toward persons who happen to have served, but who are paid without thought to make requital for the service? If so, it is exempt” [emphasis added]. Bogardus v. Commissioner, 302 U.S. 34, 45 (1936).

One additional aspect of the court’s ruling is significant. The court noted that section 102(c) of the Code prohibits employers from treating as a tax-free gift “any amount transferred by or for an employer to, or for the benefit of, an employee.” The court further noted that

although the legislative history suggests that [this section] was enacted to address other fact situations, its plain meaning may not be ignored in this case. That meaning seems far from plain, however. The church members are not [the pastor’s] “employer,” and the question whether their payments to the [pastor] were made “for” his employer seems little different than the traditional gift inquiry under Duberstein and Bogardus. We therefore decline the government’s belated suggestion that we affirm on the alternative ground of section 102(c).

This is a potentially significant observation since it raises some doubt as to the relevance and applicability of section 102(c) of the tax code to gifts made to ministers and lay church employees.

IRS Audit Guidelines for Ministers

In 1995 the IRS released its first audit guidelines for ministers pursuant to its Market Segment Specialization Program (MSSP). The guidelines were intended to promote a higher degree of competence among agents who audit ministers. In 2009 the IRS released a newly revised version of the guidelines (the Minister Audit Technique Guide). The guidelines instruct IRS agents in the examination of ministers’ tax returns.

The guidelines inform IRS agents that “gifts given to a minister, other than retired ministers, may actually be compensation for services, hence includable in gross income” for tax purposes. The guidelines provide agents with the following assistance in deciding if a church’s payment to a minister is a tax-free gift or taxable compensation for services rendered:

Conclusions

The legal precedents summarized above can be reduced to the following general principles.

Gifts from the general fund

Special-occasion gifts made to a minister or lay employee by the church out of the general fund should be reported as taxable compensation and included on the recipient’s Form W-2 or 1099-NEC and on Form 1040.

Person-to-person gifts

Members are free to make personal gifts to ministers or lay employees, such as a card at Christmas accompanied by a check or cash. Such payments may be tax-free gifts to the recipient (though they are not deductible by the donor), especially when small in amount. See the Goodwin case (above).

Gifts funded through members’ donations to the church

Many special-occasion gifts to ministers and lay church employees are funded through members’ contributions to the church (i.e., the contributions are entered or recorded in the church’s books as cash received, and the members are given charitable contribution credit). Such gifts should always be reported as taxable compensation and included on the recipient’s Form W-2 or 1099-NEC and on Form 1040. Members who contribute to special-occasion offerings pre-approved by the church board ordinarily may deduct their contributions if they are able to itemize deductions on Schedule A (Form 1040).

Gifts funded through personal checks to the recipient collected by the church

Some churches collect an offering for distribution to a minister or lay church employee on a special occasion and instruct donors that (1) cash and checks will be accepted, but checks must be made payable directly to the pastor or lay employee, and (2) no contribution will be receipted by the church as a charitable contribution. In other words, the church is merely collecting the individual gifts and then distributing them to the recipient. This ordinarily is done for convenience. A reasonable basis exists for treating such gifts as nontaxable to the minister or lay employee, so long as (1) the offering satisfies the definition of a gift announced by the Supreme Court in the Duberstein case (summarized previously); and (2) the offering consists of cash and checks made payable directly to the recipient, donors are not given any charitable contribution credit for their contributions, and the offering is not recorded as income in the church’s books of account.

Whether an offering will satisfy the Duberstein case will depend on several factors, including

Employee achievement awards

If you receive tangible personal property (other than cash, a gift certificate, or an equivalent item) as an award for length of service or safety achievement, you generally can exclude its value from your income. However, the amount you can exclude is limited to your employer’s cost and cannot be more than $1,600 ($400 for awards that are not qualified plan awards) for all such awards you receive during the year. Your employer must make the award as part of a meaningful presentation, under conditions and circumstances that do not create a significant likelihood of it’s being disguised pay. However, the exclusion does not apply to the following awards:

The term qualified plan award means “an employee achievement award awarded as part of an established written plan or program of the taxpayer which does not discriminate in favor of highly compensated employees [for 2025, those who earned annual compensation of $150,000 or more during the lookback year of 2024] as to eligibility or benefits.” IRC 274(j).

Examples

EXAMPLE A church board votes to award a “Christmas bonus” in the amount of $1,000 to Pastor C. The bonus is to be paid out of the church’s general fund. Under these facts, Pastor C has clearly received taxable compensation of $1,000, and the Form W-2 issued by the church to Pastor C should reflect this fact.

EXAMPLE A church collects an offering for its pastor once each year at Christmas. This practice has occurred for more than 25 years. A member of the church board announces the offering during a worship service, and members are advised that their contributions will be receipted by the church. The Christmas gift made to the pastor under these circumstances is taxable compensation and should be added to the pastor’s Form W-2 or 1099-NEC.

EXAMPLE Same facts as the previous example, except that a member of the board, in announcing the offering, informs church members that their contributions will not be receipted and will not be deductible. Members are informed that they will be making their gifts directly to the pastor and, accordingly, are instructed to make checks payable directly to the pastor and not to the church. The church collects the offering and transfers it to the pastor without receipting any contributions.

This example can be analyzed in two ways. The conservative approach, based on the Goodwin case (discussed above), would treat the Christmas gift to the pastor as taxable income. This was the view the IRS contended for in the Goodwin case, and presumably it reflects the IRS view on this issue.

A more aggressive approach would be to treat the gift to the pastor as a tax-free gift rather than as taxable compensation. This view is based on the following considerations:

Churches should not select the “aggressive approach” without the advice of a tax professional.

EXAMPLE A church collects an all-cash offering in commemoration of its pastor’s 25th year of service. Donors are told to contribute cash or checks payable directly to the pastor and are informed that the offering will be given directly to the pastor without being processed through the church’s accounts and that no charitable contribution credit will be received. See the previous example for the correct analysis.

It is common for churches to present a retiring minister or lay employee with a retirement gift. Sometimes these gifts are very generous. Should the church report such gifts as taxable compensation and include them on the recipient’s Form W-2? Or can the church treat them as nontaxable gifts?

Federal tax law requires all forms of compensation to be reported as taxable income unless specifically excluded by law. Gifts are one such exclusion. The question, then, is whether retirement gifts are taxable compensation for services rendered or tax-free gifts. The answer to this question is not always clear. All the relevant precedent is summarized below, followed by a series of conclusions.

Four cases from the 1950s

In a series of cases in the early 1950s, four federal appeals courts concluded that certain retirement gifts to ministers were tax-free gifts rather than taxable compensation. These four rulings are summarized below:

Schall v. Commissioner, 174 F.2d 893 (5^th Cir. 1949)

A federal appeals court ruled that a church’s retirement gift to its pastor represented a tax-free gift rather than taxable compensation. The pastor was forced to retire on the advice of his physician as a result of a long illness. He made no request of the congregation that any amount be paid to him after his resignation, and he had no knowledge that the church would agree to do so. He did not agree to render any services in exchange for the gift and in fact did not do so. The court concluded:

We are of opinion the Tax Court clearly erred in holding that the payments to [the pastor] were taxable income. Where, as here, all the facts and circumstances surrounding the adoption of the [gift] clearly prove an intent to make a gift, the mere use of the terms “salary” and “honorarium” do not convert the gift into a payment for services. Moreover, “a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient. . . .” Manifestly, these payments to [the pastor] were non-taxable gifts, within the orbit of the rule defining same, as enunciated by this court in [another case]: “That only is a gift which is purely such, not intended as a return of value or made because of any intent to repay another what is his due, but bestowed only because of personal affection or regard or pity, or from general motives of philanthropy or charity.”

Mutch v. Commissioner, 209 F.2d 390 (3^rd Cir. 1954)

A federal appeals court ruled that monthly retirement gifts made by a church to its retired pastor were tax-free gifts rather than taxable compensation. The court noted that the church’s action in providing for the monthly honoraria “was motivated solely and sincerely by the congregation’s love and affection for [the pastor].” The court described the church’s action as a “free gift of a friendly, well-to-do group who as long as they were able and because they were, wished their old minister to live in a manner comparable to that which he had enjoyed while actively associated with them.” The court also observed: “[The pastor] had been adequately compensated as far as money could for his services in the past. He was not being tied into any promise of services in the future. The installment gift, while it could be stopped or changed at any time by the trustees, had no conditions attached to its acceptance. The court concluded that no other ruling ‘justifies the taxing of this bona fide gift given [the pastor] with love and affection by his old congregation.’”

Kavanagh v. Hershman, 210 F.2d 654 (6^th Cir. 1954)

A federal appeals court, in a one-paragraph opinion, ruled that a distribution of funds to a minister was a tax-free gift rather than taxable compensation. The court based its decision on the Mutch decision (summarized above).

Abernathy v. Commissioner, 211 F.2d 651 (D.C. Cir. 1954)

The Abernathy case was a one-paragraph decision issued by a federal appeals court in 1954. The ruling addressed the question of whether a $2,400 retirement gift paid by a church to its pastor “as a token of its gratitude and appreciation” and “in appreciation of his long and faithful service” represented taxable income or a tax-free gift. The federal court concluded that the transfer was a tax-free gift. It cited (without explanation) the Schall, Mutch, and Kavanagh decisions (summarized above) along with Bogardus v. Commissioner, 302 U.S. 34 (1936) (discussed below).

IRS Revenue Ruling 55-422

In 1955 the IRS issued Revenue Ruling 55-422, in which it endorsed the four cases summarized above because of the following facts in each case: (1) “the payments were not made in accordance with any enforceable agreement, established plan, or past practice”; (2) the minister “did not undertake to perform any further services for the congregation and was not expected to do so” following his retirement; (3) “there was a far closer personal relationship between the [minister] and the congregation than is found in lay employment relationships”; and (4) “the available evidence indicated that the amount paid was determined in light of the financial position of the congregation and the needs of the recipient, who had been adequately compensated for his past services.”

Other cases addressing retirement gifts

Commissioner v. Duberstein, 363 U.S. 278 (1960)

In this case the United States Supreme Court addressed the question of whether a $20,000 retirement gift made by a church to a retiring lay officer was taxable compensation or a tax-free gift. The church board had authorized the gift in a resolution characterizing the gift as a “gratuity” and specifying that it had been made “in appreciation for services rendered.” The trial court concluded that the distribution was a tax-free gift, but a federal appeals court disagreed. The appeals court conceded that the courts had uniformly treated retirement gifts to ministers as tax-free gifts since “in such cases the parishioners are apt to be largely moved by gratitude for spiritual direction, kindness and affection and do not think in quantitative terms of whatever financial gains the pastor may have contributed to the [church].” Stanton v. United States, 268 F.2d 727 (2nd Cir. 1959). 

The case was appealed to the United States Supreme Court, which freely admitted the difficulty of distinguishing between tax-free gifts and taxable compensation. The Supreme Court did attempt to provide some guidance, however, by noting that “a gift in the statutory sense . . . ​proceeds from a detached and disinterested generosity . . . ​out of affection, respect, admiration, charity, or like impulses. . . . ​The most critical consideration . . . ​is the transferor’s intention.”

The court also observed that “it doubtless is the exceptional payment by an employer to an employee that amounts to a gift” and that the church’s characterization of the distribution as a gift is “not determinative—there must be an objective inquiry as to whether what is called a gift amounts to it in reality.”

Bogardus v. Commissioner, 302 U.S. 34 (1936)

Also relevant in resolving the issue of whether a particular distribution constitutes a tax-free gift or taxable compensation for services rendered is the following language from another Supreme Court decision in the Bogardus case:

What controls is the intention with which payment, however voluntary, has been made. Has it been made with the intention that services rendered in the past shall be requited more completely, though full acquittance has been given? If so, it bears a tax. Has it been made to show good will, esteem, or kindliness toward persons who happen to have served, but who are paid without thought to make requital for the service? If so, it is exempt.

Perkins v. Commissioner, 34 T.C. 117 (1960)

In 1960 the Tax Court ruled that pension payments made by the United Methodist Church to retired ministers constituted taxable compensation rather than tax-free gifts. The court concluded that the pension payments could not be characterized as tax-free gifts, since they did not satisfy all of the conditions specified by the IRS in Revenue Ruling 55-422 (discussed above). Specifically, the “pension payments were made in accordance with the established plan and past practice of the Methodist Church, there was no close relationship between the recipient [ministers] and the bulk of the contributing congregations, and the amounts paid were not determined in the light of the needs of the individual [ministers].”

Joyce v. Commissioner, 25 T.C.M. 914 (1966)

In 1966 the Tax Court ruled that retirement payments made by the General Conference of Seventh-Day Adventists to the widow of a former minister represented taxable income and not tax-free gifts. Upon retirement, ministers received monthly payments from the “sustentation fund” of the General Conference. Benefits were based upon the length of service of the minister. Benefits to the widow of a deceased minister were limited to three-quarters of the payment received by the deceased spouse. The General Conference issued the widow Forms 1099-MISC reporting the payments as taxable income. However, in reporting her taxes, the widow treated the payments as nontaxable gifts. The court noted that “the ultimate criterion” in resolving such cases is “the basic or dominant reason that explains the action of the transferor.” How is this “basis or dominant reason” to be determined? The court listed the following considerations:

The court acknowledged that “in determining that certain payments constituted gifts, courts have seized upon the following: that payments were made directly to the widow rather than to the estate; that the widow performed no services for the transferor; that full compensation had been paid for the services of the deceased husband; and that the transferor derived no benefit from the payment.”

The court stressed that “[t]he determination of the transferor’s dominant motive does not rest upon any single factor but is rather a conclusion reached after due consideration of all the relevant factors.” It concluded that the payments made to the widow in this case represented taxable income on the basis of the following considerations:

The court acknowledged that the payments were made directly to the widow and that she did not perform any services for the church. It rejected the widow’s argument that this factor required the payments to be treated as gifts to her, since she had otherwise failed to overcome all of the other factors supporting the court’s decision that the payments were taxable.

Brimm v. Commissioner, 27 T.C.M. 1148 (1968)

In 1968 the Tax Court ruled that a severance gift made by a church-affiliated school to a professor was a nontaxable gift rather than taxable compensation. The professor (the “taxpayer”) was employed by a church-related, two-year graduate school supported by the Southern Baptist Convention. It became apparent that the school would have to be closed because of the small student body and the high cost of operations.

Prior to the school’s dissolution, its board of trustees adopted a resolution authorizing “a gift equivalent to one year’s salary to each faculty member and staff member upon termination of his or her services with the school.” Pursuant to this policy, the taxpayer received a “gift” of $8,600 in two annual installments bearing the notation “severance gift.” The taxpayer did not report the two installments as taxable income on his tax returns since he regarded them to be a tax-free gift rather than taxable compensation for services rendered.

The IRS audited the taxpayer’s tax returns and determined that the severance gifts constituted taxable income. On appeal, the Tax Court concluded that the severance payments were in fact nontaxable gifts: “It is clear from the evidence that the board of trustees of the school took their action in declaring and making a severance gift to the taxpayer, as well as to other members of the small staff, because they were grateful and appreciative of the past faithful and dedicated service rendered to the school.” The court noted that the presence of affection, respect, admiration, and a deep sense of appreciation in the minds of trustees was demonstrated by the testimony of a member of the board who testified that the severance gifts were not intended to represent additional compensation, that they were authorized solely as a means of showing appreciation to the faculty, and that there was no expectation of additional services being performed in return for the severance gifts. The court concluded:

There is no doubt that the school’s trustees were motivated by gratitude for the taxpayer’s past faithful services, but, as the Supreme Court said in [the Bogardus case] “a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient.” Indeed, long and faithful service may create the atmosphere of goodwill and kindliness toward the recipient which tends to support a finding that a gift rather than additional compensation was intended. . . . ​We hold that the school intended to make, and did make, a gift which was made gratuitously and in exchange for nothing.

IRS Audit Guidelines for Ministers

In 1995 the IRS released its first audit guidelines for ministers pursuant to its Market Segment Specialization Program (MSSP). The guidelines were intended to promote a higher degree of competence among agents who audit ministers. In 2009 the IRS released a newly revised version of the guidelines (the Ministers Audit Technique Guide). The guidelines instruct IRS agents in the examination of ministers’ tax returns.

Perhaps the biggest surprise in the revised audit guidelines is the following statement: “There are numerous court cases that ruled the organized authorization of funds to be paid to a retired minister at or near the time of retirement were gifts and not compensation for past services. Revenue Ruling 55-422 discusses the fact pattern of those cases which would render the payments as gifts and not compensation.”

Revenue Ruling 55-422 is summarized above. In this 1955 ruling, the IRS endorsed four federal appeals court cases holding that retirement distributions from a church to a pastor were tax-free gifts due to the following four “fact patterns” in each case:

Conclusions

Consider the following conclusions in deciding whether to treat a retirement gift as taxable compensation or as a tax-free gift.

The current status of the four 1950s cases

The Schall, Mutch, Kavanagh, and Abernathy cases, summarized above, and Revenue Ruling 55-422, suggest that retirement gifts to ministers can, under limited circumstances, be treated as tax-free gifts rather than as taxable compensation so long as the four “fact patterns” mentioned in these cases (summarized above) are satisfied. The IRS has never officially revoked or even modified Revenue Ruling 55-422, and none of the four federal appeals court rulings has been qualified or overturned. However, three considerations have made such a conclusion questionable prior to the release of the IRS modified audit guidelines for ministers in 2009:

The IRS’s repudiation of Revenue Ruling 55-422 (1955) and the four federal appeals court rulings summarized above is belied by the following considerations:

First, in Revenue Procedure 89-14, the IRS provided the following information concerning revenue rulings:

A revenue ruling is an official interpretation by the IRS of the internal revenue laws and related statutes, treaties, and regulations. . . . ​Revenue rulings are issued only by the IRS national office and are published for the information and guidance of taxpayers, IRS officials, and others concerned. . . .

Taxpayers generally may rely upon revenue rulings and revenue procedures in determining the tax treatment of their own transactions and need not request specific rulings applying the principles of a published revenue ruling or revenue procedure to the facts of their particular cases. However, taxpayers, IRS personnel, and others concerned are also cautioned to determine whether a revenue ruling or revenue procedure on which they seek to rely has been revoked, modified, declared obsolete, distinguished, clarified or otherwise affected by subsequent legislation, treaties, regulations, revenue rulings, revenue procedures or court decisions.

The IRS has never revoked, modified, declared obsolete, or distinguished Revenue Ruling 55-422.

Second, Revenue Ruling 55-422 was quoted with approval as recently as 1995 by the United States Tax Court. Osborne v. Commissioner, 69 T.C.M. 1895 (1995). This is several years after the Duberstein case (1960) and the effective date of section 102(c) of the tax code (1987), both of which events were previously cited by the IRS as its rationale for no longer following Revenue Ruling 55-422.

Third, other federal courts have affirmed the tax-free status of gifts made to ministers. To illustrate, in Brimm v. Commissioner, 27 T.C.M. 1148 (1968), the United States Tax Court ruled that a severance gift made by a church-affiliated school to a professor was a nontaxable gift rather than taxable compensation. The professor (the “taxpayer”) was employed by a church-related, two-year graduate school supported by the Southern Baptist Convention. It became apparent that, because of low enrollment and the high cost of operations, the school would have to be closed. Prior to the school’s dissolution, its board of trustees adopted a resolution authorizing “a gift equivalent to one year’s salary to each faculty member and staff member upon termination of his or her services with the school.” Pursuant to this policy, the taxpayer received a “gift” of $8,600 in two annual installments bearing the notation “severance gift.” The taxpayer did not report the two installments as taxable income on his tax returns because he regarded them to be a tax-free gift rather than taxable compensation for services rendered.

The IRS audited the taxpayer’s tax returns and determined that the severance gifts constituted taxable income. On appeal, the Tax Court concluded that the severance payments were, in fact, nontaxable gifts: “It is clear from the evidence that the board of trustees of the school took their action in declaring and making a severance gift to the taxpayer, as well as to other members of the small staff, because they were grateful and appreciative of the past faithful and dedicated service rendered to the school.” The court noted that the presence of affection, respect, admiration, and a deep sense of appreciation in the minds of trustees was demonstrated by the testimony of a member of the board who testified that the severance gifts were not intended to represent additional compensation but were authorized solely as a means of showing appreciation to the faculty and that there was no expectation of additional services being performed in return for the severance gifts. The court concluded:

There is no doubt that the school’s trustees were motivated by gratitude for the taxpayer’s past faithful services, but, as the Supreme Court said in [the Bogardus case] “a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient.” Indeed, long and faithful service may create the atmosphere of goodwill and kindliness toward the recipient which tends to support a finding that a gift rather than additional compensation was intended. . . . ​We hold that the school intended to make, and did make, a gift which was made gratuitously and in exchange for nothing.

Fourth, the IRS audit guidelines for ministers (2009), summarized above, contain the following statement: “There are numerous court cases that ruled the organized authorization of funds to be paid to a retired minister at or near the time of retirement were gifts and not compensation for past services. Revenue Ruling 55-422 discusses the fact pattern of those cases which would render the payments as gifts and not compensation.” This appears to be an explicit recognition that Revenue Ruling 55-422 continues to accurately reflect the law.

Conclusion. For unknown reasons, the IRS, in its 2009 audit guidelines for ministers, has seemingly changed course in its treatment of gifts to clergy because of the following statement: “There are numerous court cases that ruled the organized authorization of funds to be paid to a retired minister at or near the time of retirement were gifts and not compensation for past services. Revenue Ruling 55-422 discusses the fact pattern of those cases which would render the payments as gifts and not compensation.”

Retirement gifts from the general fund

Retirement gifts made to a minister or lay employee by the church out of the general fund should be reported as taxable compensation and included on the recipient’s Form W-2 or 1099-NEC and on Form 1040.

Person-to-person retirement gifts

Some members make retirement gifts directly to ministers and lay employees without going through the church. Such payments may be tax-free gifts to the recipient, especially if they are of nominal value (though they are not deductible by the donor). See the Goodwin case in the previous section of this chapter.

Retirement gifts funded through members’ designated contributions to the church

Many retirement gifts to ministers and lay employees are funded through members’ contributions to the church that are specifically designated for the retirement gift authorized by the board or church membership. For example, it is common for churches to collect a special offering to commemorate the retirement of a pastor or lay employee. Such gifts should always be reported as taxable compensation and included on the recipient’s Form W-2 or 1099-NEC and on Form 1040. Members who contribute to such offerings may be able to deduct their contributions if they are able to itemize deductions on Schedule A (Form 1040). See “The Goodwin case” on page .

Retirement gifts funded through personal checks to the recipient collected by the church

Some churches collect a retirement offering for distribution to a minister or lay church employee and instruct donors that (1) cash and checks will be accepted, but checks must be made payable directly to the retiring pastor or lay employee; and (2) no contribution will be receipted by the church as a charitable contribution. In other words, the church is merely collecting the individual gifts and then distributing them to the recipient. This ordinarily is done for convenience. A reasonable basis exists for treating such gifts as nontaxable to the minister or lay employee, so long as (1) the offering satisfies the definition of a gift announced by the Supreme Court in the Duberstein case (summarized above); and (2) the offering consists of cash and checks made payable directly to the recipient, donors are not given any charitable contribution credit for their contributions, and the offering is not recorded as income in the church’s books of account. For larger gifts, legal counsel should be retained to provide guidance.

Whether an offering will satisfy the Duberstein case will depend on several factors, including the intent of the donors who contribute to the offering (e.g., if they are simply wanting to provide additional compensation to their minister in recognition of services rendered, the transfer ordinarily will be taxable compensation rather than a tax-free gift); whether a church adjusts its pastor’s compensation on the basis of the special-occasion offerings collected on his or her behalf; and whether the contributions were spontaneous and voluntary as opposed to fixed amounts established under a “highly structured program” for transferring money to the minister on a regular basis.

If a church allows an employee to buy property at less than fair market value, the employee ordinarily must report as taxable income the excess of the property’s fair market value over the bargain sale price. Treas. Reg. 1.61-2(d)(2).

EXAMPLE A church sells its parsonage to its pastor for a bargain price of $50,000 in cash. The parsonage has a fair market value of $150,000. The pastor realizes income of $100,000 from this transaction, and this income must be reflected on his Form W-2 or 1099-NEC and on his federal income tax return (Form 1040). Before making a bargain sale of church property to an employee, a church must also consider whether the employee’s total compensation is unreasonable in amount. If it is, this may constitute prohibited inurement of a church asset to the personal benefit of a private individual in violation of one of the conditions for tax-exempt status listed in section 501(c)(3) of the tax code. It also may expose the retired minister to substantial excise taxes known as “intermediate sanctions” (discussed earlier in this chapter).

Sick pay is a payment to you to replace your regular wages while you are temporarily absent from work due to sickness or personal injury. To qualify as sick pay, it must be paid under a plan to which your employer is a party. If you receive sick pay from your employer, income tax must be withheld (except for ministers, who are exempt from income tax withholding with respect to compensation received for ministerial services unless voluntary withholding is requested).

If you receive payments under a plan in which your employer does not participate (such as an accident or health plan where you paid all the premiums), the payments are not sick pay and usually are not taxable.

Social Security benefits are financed through two tax systems. Employers and employees each pay the Social Security and Medicare tax, which for 2024 is 7.65 percent of an employee’s taxable wages (a total tax of 15.3 percent). Self-employed persons pay the self-employment tax, which for 2024 is 15.3 percent of net self-employment earnings. Ministers always are considered self-employed as regards Social Security with respect to service performed in the exercise of ministry. This means they do not pay Social Security or Medicare taxes with respect to such services. Rather, they pay the self-employment tax (15.3 percent)—unless they have filed a timely application for exemption from self-employment taxes and have received written approval of their exemption from the IRS.

Because a minister pays a much higher Social Security tax than is required of employees, many churches agree to pay their minister an additional sum to cover a portion (e.g., one-half) of the minister’s self-employment tax liability. This is perfectly appropriate. However, note that any amount paid to a minister to help pay the higher self-employment tax must be reported as additional compensation on the minister’s Form W-2 and on the minister’s Form 1040. The amount paid by the church must be reported as compensation for Social Security as well. Revenue Ruling 68-507.

A fringe benefit is any material benefit provided by an employer to an employee (or self-employed person) apart from his or her stated compensation. Some fringe benefits must be valued and included in an employee’s gross income in computing income taxes and Social Security taxes, while others are specifically excluded from taxable income.

Generally, a fringe benefit must be valued and included in an employee’s gross income unless it is specifically excluded by law. Excludable fringe benefits are discussed in Chapter 5. This subsection will illustrate some taxable fringe benefits. One of the more common fringe benefits is an employer-provided car. Because of the complexity of valuing this benefit, it is addressed separately in the following subsection.

Moving expenses paid by the employing church

Employer reimbursements of an employee’s qualified moving expenses are no longer treated as a tax-free fringe benefit.

Miscellaneous

Many of the other components of income discussed in this chapter could be considered fringe benefits (e.g., Christmas gifts from the church, Social Security taxes paid by the church on behalf of its minister, and low-interest loans). In addition, some fringe benefits that ordinarily are excluded from gross income must be valued and added to income if they do not satisfy various conditions described in Chapter 5.

One of the more common taxable fringe benefits for ministers and church staff is personal use of a church-owned car. If a church provides a car to a minister or lay employee, the personal use of the car is a taxable noncash fringe benefit. The church must determine the value of this fringe benefit so it can be reported as taxable income on the employee’s Form W-2.

The church may use either general valuation principles or one of three special valuation rules to value the personal use of the vehicle. The employee must use general valuation principles unless the church chooses to use one of the three special valuation rules. If a church uses a special valuation rule, the employee may use that same valuation rule or the general valuation principles.

The three special valuation principles are (1) the annual lease valuation rule, (2) the cents-per-mile rule, and (3) the special commuting valuation rule. These rules are summarized below.

General valuation principles

Under the general valuation principles, the amount to add to a worker’s income equals (1) the amount a person would have to pay to lease a comparable vehicle on comparable terms in the same geographical area, multiplied by (2) the percentage of total vehicle miles for the period that were of a personal (rather than business) nature.

You ordinarily cannot use a cents-per-mile rate to determine the value of the availability of an employer-provided car unless the same or comparable vehicle could be leased on a cents-per-mile basis for the same period of time the vehicle was available to you (i.e., one year). In other words, if you have access to the car for an entire year and a comparable vehicle in your community would not be leased at a cents-per-mile rate for a similar period of time, then you cannot use a cents-per-mile rule to value the availability of the car to you. You must use the general rule that is applied in your community to determine the lease value of a car (such as a fixed rate per week, month, or year).

Special automobile lease valuation rule

Under this rule, you determine the value of an automobile provided to an employee by using its annual lease value. For an automobile provided only part of the year, use either its prorated annual lease value or its daily lease value.

If the automobile is used by the employee for business purposes, you generally reduce the lease value by the amount that is excluded from the employee’s wages as a working condition benefit. To do this, the employee must account to the employer for the business use. This is done by substantiating the usage (mileage, for example), the time and place of the travel, and the business purpose of the travel. Written records made at the time of each business use are the best evidence. Any use of a company-provided vehicle that is not substantiated as business use is included in income. The working condition benefit is the amount that would be an allowable business expense deduction for the employee if the employee paid for the use of the vehicle. However, you may choose to include the entire lease value in the employee’s wages.

Consistency requirements

If you use the lease value rule, the following requirements apply.

Annual lease value

Generally, you figure the annual lease value of an automobile as follows:

Fair market value (FMV)

The FMV of an automobile is the amount a person would pay to buy it from a third party in an arm’s-length transaction in the area in which the automobile is bought or leased. That amount includes all purchase expenses, such as sales tax and title fees. You do not have to include the value of a telephone or any specialized equipment added to or carried in the automobile if the equipment is necessary for your business. However, include the value of specialized equipment if the employee to whom the automobile is available uses the specialized equipment in a trade or business other than yours.

You may be able to use a safe-harbor value as the FMV. For an automobile you bought at arm’s length, the safe-harbor value is your cost, including sales tax, title, and other purchase expenses.

Items included in annual lease value table

Each annual lease value in the table includes the value of maintenance and insurance for the automobile. Do not reduce the annual lease value by the value of any of these services that you did not provide. For example, do not reduce the annual lease value by the value of a maintenance service contract or insurance you did not provide. You can consider the services actually provided for the automobile by using the general valuation rule discussed earlier.

Items not included

The annual lease value does not include the value of fuel you provide to an employee for personal use, regardless of whether you provide it, reimburse its cost, or have it charged to you. You must include the value of the fuel separately in the employee’s wages.

You may value fuel you provided at FMV or at 5.5 cents per mile for all miles driven by the employee. If you reimburse an employee for the cost of fuel or have it charged to you, you generally value the fuel at the amount you reimburse or the amount charged to you if it was bought at arm’s length. If you provide any service other than maintenance and insurance for an automobile, you must add the FMV of that service to the annual lease value of the automobile to figure the value of the benefit.

Four-year lease term

The annual lease values in the table are based on a four-year lease term. These values generally will stay the same for the period that begins with the first date you use this rule for the automobile and ends on December 31 of the fourth full calendar year following that date. Figure the annual lease value for each later four-year period by determining the FMV of the automobile on January 1 of the first year of the later four-year period and selecting the amount in column 2 or 4 of the table that corresponds to the appropriate dollar range in column 1 or 3.

If you provide an automobile to an employee for a continuous period of 30 or more days but less than an entire calendar year, you may prorate the annual lease value. Figure the prorated annual lease value by multiplying the annual lease value by a fraction, using the number of days of availability as the numerator and 365 as the denominator.

If you provide an automobile continuously for at least 30 days, but the period covers two calendar years, you may use the prorated annual lease value or the daily lease value.

If you provide an automobile to an employee for a continuous period of less than 30 days, use the daily lease value to figure its value. Figure the daily lease value by multiplying the annual lease value by a fraction, using four times the number of days of availability as the numerator and 365 as the denominator. However, you may apply a prorated annual lease value for a period of continuous availability of less than 30 days by treating the automobile as if it had been available for 30 days. Use a prorated annual lease value if it would result in a lower valuation than applying the daily lease value to the shorter period of availability.

Cents-per-mile rule

Under this rule, an employer determines the value of a vehicle provided to an employee for personal use by multiplying the standard mileage rate by the total miles the employee drives the vehicle for personal purposes. This amount must be included in the employee’s wages (or reimbursed by the employee). An employer can use the cents-per-mile rule if either of the following requirements is met.

A vehicle is regularly used for business purposes if at least one of the following conditions is met.

A vehicle meets the mileage test for a calendar year if both of the following requirements are met.

If a church or other employer uses the cents-per-mile rule, the following requirements apply:

EXAMPLE In 2024 a church purchased a car and permitted Pastor T to use it for business and personal use throughout the year. The car cost $37,000. The cents-per-mile method of valuing the personal use of the car can be used by either the church or Pastor T since the fair market value of the car when first provided to Pastor T was less than $62,000.

Special commuting valuation rule

If an employer provides an employee with a vehicle and requires the employee to commute to and from work in the vehicle, then the value of the commuting miles (which are always deemed personal rather than business) can be computed at a rate of $3 per round-trip commute or $1.50 per one-way commute. The employer includes the value of all commuting on the employee’s Form W-2. For this rule to apply, the following conditions must be satisfied:

The regulations define a control employee (for purposes of the commuting valuation rule) as an employee who qualified as any one or more of the following in 2024:

Special conditions applicable to special
valuation rules

An employer may not use any of the three special valuation rules unless one or more of the following four conditions is satisfied:

If none of these conditions is satisfied, the employer and employee must use the general valuation rule to value the personal use of an employer-provided car.

Unsafe conditions commuting rule

Under this rule the value of commuting transportation an employer provides to a qualified employee solely because of unsafe conditions is $1.50 for a one-way commute (that is, from home to work or from work to home). This amount must be included in the employee’s wages or be reimbursed by the employee. You can use the unsafe conditions commuting rule if the following requirements are met:

These requirements must be met on a trip-by-trip basis.

A qualified employee (for 2024) is one who

Unsafe conditions exist if, under the facts and circumstances, a reasonable person would consider it unsafe for the employee to walk or use public transportation at the time of day the employee must commute. One factor indicating whether it is unsafe is the history of crime in the geographic area surrounding the employee’s workplace or home at the time of day the employee commutes.

Reporting taxable income

The value of an employer-provided vehicle that is included in your income will be reported by your employer on your Form W-2 (or Form 1099-NEC if you are self-employed). On Form W-2 the amount of the benefit should be included in box 1 (wages, tips, and other compensation) and boxes 3 and 5 for nonminister employees. If an employer reports 100 percent of the annual lease value of a vehicle as taxable income for the employee, this amount also must be reported in box 14 of Form W-2 or in a separate statement to the employee so the employee can compute the value of any business use of the vehicle.

Employee reimbursements

The income tax regulations specify that if the employer and employee use one of the special valuation rules, the amount of reportable income is decreased by “any amount reimbursed by the employee to the employer.” The regulations further specify that “the employer and employee may use the special rules to determine the amount of the reimbursement due the employer by the employee. Thus, if an employee reimburses an employer for the value of a benefit as determined under a special valuation rule, no amount is includable in the employee’s gross income with respect to the benefit.” Treas. Reg. 1.61-21(c)(2)(ii)(B).

Tax withholding

Must a church withhold taxes on the personal use of an employer-provided vehicle? That depends. Ministers are exempt from income tax withholding with respect to compensation they receive from the performance of ministerial services unless they elect voluntary withholding, and they are not subject to Social Security or Medicare tax withholding on their ministry income. Nonminister employees generally are subject to withholding of income taxes and Social Security and Medicare taxes. Note that if a church filed a timely Form 8274, electing to be exempt from the employer’s share of Social Security and Medicare taxes, its lay employees are treated as self-employed for Social Security purposes, and no Social Security or Medicare taxes are withheld from their wages.

An employer may elect not to withhold income tax on the value of an employee’s personal use of an employer-owned vehicle. An employer does not have to make this election for all employees. However, an employer must withhold Social Security and Medicare taxes on such benefits for nonminister employees.

An employer electing not to withhold income taxes on the personal use of an employer-provided vehicle must notify the employee (in writing) of this election by the later of (1) January 31 of the year of the election, or (2) within 30 days after the date the employer first provides the employee with the vehicle. The election not to withhold taxes does not affect the employer’s responsibility to report the value of the benefit as taxable income on the employee’s Form W-2.

Section 7872 of the tax code treats certain loans in which the interest rate charged is less than the “applicable federal rate” (AFR) as the equivalent to loans bearing interest at the applicable federal rate, coupled with a payment by the lender to the borrower sufficient to fund all or part of the payment of interest by the borrower. Such loans are referred to as “below-market loans.”

Section 7872 deals with the treatment of loans with below-market interest rates. It specifically applies to what it terms “compensation-related loans,” which include below-market loans directly or indirectly between an employer and an employee. In general, section 7872 operates to impute interest on below-market loans. In the case of employer–employee loans, the employer is treated as transferring the foregone interest to the employee as additional compensation, and the employee is treated as paying interest back to the employer.

Different rules apply depending on whether a loan is a demand loan or a term loan. A demand loan is a below-market loan if it does not provide for an interest rate at least equal to the applicable federal rate. A term loan is a below-market loan if the present value of all amounts due on the loan is less than the amount of the loan (i.e., the yield to maturity is lower than the applicable federal rate). With respect to demand loans, the imputed interest payments and deemed transfer of additional compensation are treated as being made annually. With respect to term loans, the lender is treated at the time of the loans as transferring the difference between the loan amount and the present value of all the future payments under the loan as additional compensation. The term loan is then treated as having an original issue discount equal to the amount of the deemed transfer of additional compensation and, thus, is subject to the original issue discount provisions of section 1272 of the tax code.

There is a de minimis exception from the application of the section 7872 imputation rules if loans between the parties in aggregate do not exceed $10,000. The de minimis exception does not apply if one of the principal purposes of the loan is tax avoidance.

Exceptions

Consider the following exceptions to the rules on below-market loans.

Loans of $10,000 or less

The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to (1) gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and (2) pay-related loans if the avoidance of federal tax is not a principal purpose of the interest arrangement. This exception does not apply to a term loan that previously has been subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

Loans with no tax effect

Also exempted from the below-market loan rules are loans for which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower. Some of the facts the IRS considers in making such a decision include (1) the amount of the loan, (2) the cost of complying with the below-market loan rules, if they were to apply, and (3) any reasons other than taxes for structuring the transaction as a below-market loan. This exception may apply in some cases to ministers. Consider the following examples.

EXAMPLE Pastor G lived in the church parsonage for many years. In 2024 he purchased his own home. To assist in making the down payment on a new home, the church board loaned Pastor G $7,500 in 2024. The loan is a demand loan, at no interest. Neither the church nor Pastor G reported any foregone interest ($7,500 × the applicable interest rate) for 2024. Was this correct? Yes, since the amount of the loan was for less than $10,000. This assumes that tax avoidance was not the principal purpose of the arrangement.

EXAMPLE Same facts as the previous example, except that the amount of the loan was $20,000. The IRS audits Pastor G’s 2024 tax return and insists that he should have reported the foregone interest on the loan for that year at the applicable federal interest rate. Assuming that this rate was 3 percent, Pastor G would have to report an additional $600 of taxable income for 2024 ($20,000 × 3 percent). However, Pastor G argues that the no-interest loan had no significant effect on his federal tax liability. He points out that even if the church had charged him 3-percent interest, this amount could have been excluded from his taxable income as a housing allowance since it was an expense of home ownership.

EXAMPLE Same facts as the first example, except that the amount of the church loan was $100,000. Pastor G argues that the no-interest loan had no significant effect on his federal tax liability. It is unlikely that this argument will succeed, given the amount of the loan. As a result, it is likely that Pastor G will have to pay taxes on an additional $3,000 of income for 2024 ($100,000 × 3 percent).

Loans made by charitable organizations

The income tax regulations exempt loans made by a charitable organization if the primary purpose of the loan is to accomplish religious, charitable, or educational purposes. This exception ordinarily will not apply to below-market interest loans made by churches to ministers or lay employees, since the purpose of such loans is to assist or compensate the recipient rather than to fulfill specific exempt purposes. Treas. Reg. 1.7872-5T(b)(11).

Employee relocation loans

The regulations further specify that

in the case of a compensation-related loan to an employee, where such loan is secured by a mortgage on the new principal residence . . . ​of the employee, acquired in connection with the transfer of that employee to a new principal place of work . . . ​the loan will be exempt from [tax] if the following conditions are satisfied: (a) The loan is a demand loan or is a term loan the benefits of the interest arrangements of which are not transferable by the employee and are conditioned on the future performance of substantial services by the employee; (b) the employee certifies to the employer that the employee reasonably expects to be entitled to and will itemize deductions for each year the loan is outstanding; and (c) the loan agreement requires that the loan proceeds be used only to purchase the new principal residence of the employee. Treasury Regulation 1.7872-5T(c)(1).

EXAMPLE A church hires Pastor C as its music minister. Pastor C will be moving from another state and would like to purchase a home in her new community. The church board would like to assist her in making the down payment on a new home and loans her $25,000 at no interest, payable on demand. The church can help Pastor C qualify for the employee relocation exception to the below-market loan rules by having Pastor C sign a promissory note in the amount of $25,000 that is secured by a mortgage on the new home and by having Pastor C sign a loan agreement containing the following provisions: (1) the benefits of the interest arrangement are not transferable by Pastor C; (2) the benefits of the interest arrangement are conditioned on the future performance of substantial services by Pastor C; (3) Pastor C certifies that she reasonably expects to be entitled to and will itemize deductions for each year the loan is outstanding; and (4) the loan proceeds will be used only to purchase the new principal residence.

Other concerns

Low-interest or no-interest loans can create the following additional concerns:

Inurement. One of the requirements for tax-exempt status under section 501(c)(3) of the Internal Revenue Code is that none of a church’s assets can inure to the benefit of a private individual other than as reasonable compensation for services rendered. The IRS and the courts have ruled in a number of cases that low- or no-interest loans constitute prohibited inurement, which results in the loss of a charity’s tax-exempt status. See “Unreasonable compensation” on page .

Excess benefit transaction. According to section 4958 of the tax code, any benefit provided by a tax-exempt organization to an employee that exceeds the reasonable value of the employee’s services constitutes an excess benefit transaction that exposes the employee to substantial excise taxes (called “intermediate sanctions”) of up to 225 percent of the amount the IRS determines to be excessive compensation. This penalty only applies to “disqualified persons,” who are officers or directors of the charity or a relative of such a person. In addition, members of the organization’s board who approved the excess benefit are subject to an additional excise tax of 10 percent of the amount of the excess (up to a maximum penalty of $20,000 collectively). For more information about this tax, see “Tax on managers” on page .

Nonprofit corporation law. Most state nonprofit laws provide that board members who authorize a loan to an officer or director are personally liable for the repayment of that loan. To illustrate, if a state nonprofit corporation law contains such a provision, church board members who approve a $100,000 loan will remain personally liable for its repayment until it is paid in full.

In summary, below-market interest loans raise several complex and significant legal and tax issues that need to be addressed. Church leaders should seek legal counsel before pursuing such a transaction.

Debt forgiveness. Any agreement or understanding that would involve the church “forgiving” the loan obligation could result in the entire balance of the loan being realized as taxable income. It also might trigger the complex regulations that apply to nonqualified deferred compensation arrangements, since this arrangement might be deemed nonqualified deferred compensation under the expansive definition contained in the regulations under section 409A of the tax code.

Churches occasionally give a minister or lay employee property without charge. Examples include automobiles, homes, and equipment. Such transfers result in taxable compensation to the recipient that must be valued and reported on his or her Form W-2 and Form 1040. Generally, the amount to be included in income is the fair market value of the property less any amount paid by the recipient for the property. For example, a federal court has ruled that a minister had to include in his gross income for federal income tax purposes the value of a boat and trailer received in payment for services as a minister. Potito v. Commissioner, 534 F.2d 49 (5th Cir. 1976).

Ministers, like other taxpayers, occasionally attempt to “assign” income to a charity and thereby avoid income taxes on the assigned income. For example, Pastor G conducts services for two weeks at a church whose pastor is on vacation. The church wants to pay Pastor G income of $1,000 for these services, but Pastor G declines and requests that the money be applied to the church’s building fund. Does Pastor G have to pay tax on the $1,000? In many cases the answer will be yes. The United States Supreme Court addressed this issue in a landmark ruling in 1940. Helvering v. Horst, 311 U.S. 112 (1940). The Horst case addressed the question of whether a father could avoid taxation on bond interest coupons that he transferred to his son prior to the maturity date. The Supreme Court ruled that the father had to pay tax on the interest income even though he assigned all of his interest in the income to his son. It observed: “The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.”

The Supreme Court reached the same conclusion in two other landmark cases. Helvering v. Eubank, 311 U.S. 122 (1940); Lucas v. Earl, 281 U.S. 111 (1930).

EXAMPLE A taxpayer earned an honorarium of $2,500 for speaking at a convention. He requested that the honorarium be distributed to a college. This request was honored, and the taxpayer assumed that he did not have to report the $2,500 as taxable income, since he never received it. The IRS ruled that the taxpayer should have reported the $2,500 as taxable income. It noted that “the amount of the honorarium transferred to the educational institution at the taxpayer’s request . . . ​is includible in the taxpayer’s gross income [for tax purposes]. However, the taxpayer is entitled to a charitable contribution deduction.” The IRS further noted that “the Supreme Court of the United States has held that a taxpayer who assigns or transfers compensation for personal services to another individual or entity fails to be relieved of federal income tax liability, regardless of the motivation behind the transfer” (citing the Horst case discussed above). Revenue Ruling 79-121.

EXAMPLE A church member signed a real estate contract agreeing to sell a rental property he owned. At the real estate closing, the member insisted that 8 percent of the sales price be paid to his church for a building project. The Tax Court ruled that the member had to report the full amount of the sale price as taxable gain and that the attempt to assign 8 percent of the gain to the church did not reduce the member’s taxable gain. It observed that “the payment of part of the sales proceeds to the church was an anticipatory assignment of income which does not protect [the member] from taxation on the full amount of the gain realized on the sale.” The court stressed that the member could claim a charitable contribution deduction for the amount he paid to the church, but he had to report the full amount of the sales price as taxable gain. Ankeny v. Commissioner, 53 T.C.M. 827 (1987).

EXAMPLE No taxable income is incurred when a taxpayer performs purely gratuitous and volunteer services with no expectation of compensation. To illustrate, the IRS ruled that a professional entertainer who gratuitously rendered professional services as a featured performer at a fund-raising event for a charity did not receive taxable income, since he “was not entitled to, and received no payment for these services.” Revenue Ruling 68-503.

EXAMPLE A donor owned several shares of stock in Company A. Company B offered to purchase all shares of Company A at a huge premium over book value. The donor contributed several shares to his church and claimed a charitable contribution deduction for the inflated amount. The IRS conceded that a gift of stock had been made to the church. It insisted, however, that the donor should have reported the gain in the value of his stock that was transferred to the church. Not so, said the donor. After all, he never realized or enjoyed the gain but rather transferred the shares to the church to enjoy. The IRS asserted that the donor had a legal right to redeem his shares at the inflated amount at the time he transferred the shares to the church. As a result, he had “assigned income” to the church and could not avoid being taxed on it. The Tax Court agreed. It observed:

It is a well-established principle of the tax law that the person who earns or otherwise creates the right to receive income is taxed. When the right to income has matured at the time of a transfer of property, the transferor will be taxed despite the technical transfer of that property. . . . ​An examination of the cases that discuss the anticipatory assignment of income doctrine reveals settled principles. A transfer of property that is a fixed right to income does not shift the incidence of taxation to the transferee. . . . ​[T]he ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in the property at the time of transfer.

The court concluded that the donor had a “fixed right to income” at the time he donated the 30,000 shares to his church. Ferguson v. Commissioner, 108 T.C. 244 (1997).

EXAMPLE A taxpayer earned $100,000 that he had deposited in the bank account of a third party. The Tax Court ruled that the taxpayer should have reported the $100,000 as taxable income since his transfer of the income to the third party was “a classic assignment of income.” Further, “because such assignments are ineffective for federal income tax purposes [the taxpayer] remained the party taxable on the income generated by his services.” The court explained, “One of the primary principles of the federal income tax is that income must be taxed to the one who earns it. . . . ​Attempts to subvert this principle by deflecting income away from its true earner to another entity by means of contractual arrangements, however cleverly drafted, are not recognized as dispositive for federal income tax purposes. . . . ​The assignment of income rule applies with particular force to personal service income.” Johnston v. Commissioner, T.C. Memo. 2000-315 (2000).

EXAMPLE A “church” was organized in part to provide tax benefits to its “ministers.” It represented to its ministers that they could avoid all federal taxes by taking a vow of poverty, renouncing all their worldly possessions, and transferring the titles to all their property to the church. The church in turn transferred all of a minister’s property to a trust that paid his living expenses. Ministers also assigned to the church all income that they earned as a part of their normal secular employment. In some instances, the ministers received a paycheck from their employer and endorsed it in favor of the church. In other cases, their earnings, at the direction of the minister, were deposited directly into accounts controlled by the church. The church provided the ministers with a debit card for a church account from which they paid for their necessary living expenses. The church also paid the mortgage, if any, on the home and other related home expenses. The IRS claimed that the ministers’ assignment of their secular income to the church did not avoid taxation on that income. It quoted from a U.S. Supreme Court ruling addressing the “anticipatory assignment of income” doctrine:

A taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party. The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed ‘to those who earned them,’ a maxim we have called ‘the first principle of income taxation.’ The anticipatory assignment doctrine is meant to prevent taxpayers from avoiding taxation through arrangements and contracts however skillfully devised to prevent [income] when paid from vesting even for a second in the man who earned it.

In an ordinary case attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question. In the context of anticipatory assignments, however, the assignor often does not have dominion over the income at the moment of receipt. In that instance the question becomes whether the assignor retains dominion over the income-generating asset, because the taxpayer who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants. Looking to control over the income-generating asset, then, preserves the principle that income should be taxed to the party who earns the income and enjoys the consequent benefits. Commissioner v. Banks, 543 U.S. 426 (2005).

The Utah court concluded that the following factors are relevant in applying the assignment of income doctrine: (1) degree of control exercised by a church over its members, (2) ownership rights in a member’s property, (3) whether the member’s duties furthered the church’s purposes, and (4) dealings between the member and employer and between the church and the member’s employer. The court stressed that these factors must heavily predominate in favor of the taxpayer in order to avoid taxation: “To overcome the presumption that income accrues to the person who performs the work, a defendant must demonstrate that the aggregate of these factors weighs substantially in his favor. Indeed, even one factor weighing against a defendant could prove dispositive and disqualifying.” The court concluded that the church’s ministers did not satisfy this heavy burden, and so their assignments of income to the church did not avoid taxation on the assigned income. 2012 WL 830492 (D. Utah 2012).

EXAMPLE A federal appeals court observed: “A member of a religious order who earns or receives income therefrom in his individual capacity cannot avoid taxation on that income merely by taking a vow of poverty and assigning the income to that religious order or institution. The same rule applies to entities organized as corporations sole. An individual has received income when he gains complete dominion and control over money or other property, thereby realizing an economic benefit.” Gunkle v. Commissioner, 2014 WL 2052751 (5th Cir. 2014); Mone v. Commissioner, 774 F.2d 570 (2nd Cir. 1985).

EXAMPLE The Tax Court ruled that compensation a church paid to its pastor did not avoid taxation by being deposited in the account of a tax-exempt religious ministry the pastor had created and over which the pastor exercised complete control. The court further noted that the pastor’s “vow of poverty” did not shield the compensation from taxation. The court concluded that “a gain constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. A taxpayer had dominion and control when the taxpayer is free to use the funds at will. The use of funds for personal purposes indicates dominion and control, even over an account titled in the name of a church or other religious organization.” Cortes v. Commissioner, T.C. Memo. 2014-181, citing the United States Supreme Court’s ruling in Rutkin v. United States, 343 U.S. 130 (1952).

This section addresses two related issues: (1) refusing to accept one’s full salary, and (2) returning excess salary.

Refusal to accept full salary

Sometimes a minister or lay employee refuses to accept the full amount of his or her church-approved salary, often because the church is experiencing short-term financial problems. Should the church report the amount that is refused as taxable income to the minister or lay employee? The constructive receipt doctrine specifies:

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. Treas. Reg. 1.451-2(a).

A number of courts have ruled that this principle requires employees to include in their taxable income any portion of their stated salary that they refuse to accept. On the other hand, some courts have reached the opposite conclusion. Perhaps the most notable case is Giannini v. Commissioner, 129 F.2d 638 (9th Cir. 1942). This case involved a corporate president whose annual compensation was 5 percent of the company’s profits. In the middle of one year, the president informed members of his company’s board of directors that he would not accept any further compensation for the year and suggested that the company “do something worthwhile” with the money. The company never credited to the president any further compensation for the year, nor did it set any part of it aside for his use. The amount of salary refused by the president was nearly $1.5 million, and no part of this amount was reported by the president as taxable income in the year in question. The IRS audited the president and insisted that the $1.5 million should have been reported as taxable income. The taxpayer appealed, and a federal appeals court rejected the IRS position:

The taxpayer did not receive the money, and . . . ​did not direct its disposition. What he did was unqualifiedly refuse to accept any further compensation for his services with the suggestion that the money be used for some worthwhile purpose. So far as the taxpayer was concerned, the corporation could have kept the money. . . . ​In these circumstances we cannot say as a matter of law that the money was beneficially received by the taxpayer and therefore subject to the income tax provisions.

The court acknowledged that the United States Supreme Court has observed: “One who is entitled to receive, at a future date, interest or compensation for services and who makes a gift of it by an anticipatory assignment, realizes taxable income quite as much as if he had collected the income and paid it over to the object of his bounty.” Helvering v. Schaffner, 312 U. S. 579 (1941). However, the court distinguished this language by observing that “the dominance over the fund and taxpayer’s direction show that he beneficially received the money by exercising his right to divert it to a use.” This was not true of the corporate president in the present case, the court concluded.

In summary, a reasonable basis exists for not treating as taxable income the portion of an employee’s stated salary that is refused, particularly where the employee does not assign the income to a specified use but is content to leave the unpaid salary with the employer.

Returning excess salary

Some churches have paid an employee more than the salary authorized by the church board. In most cases this is due to an innocent mistake. But what happens if the church later discovers the mistake and attempts to correct it? Can the employee give back the excess to the church? And what if the mistake is discovered in the following year? How does a return of the excess affect the employee’s taxable income and the church’s payroll reporting obligations?

The IRS has listed the following tax consequences when employees return to their employer in “Year 2” excess salary received in “Year 1”:

It is a common practice for a congregation to set aside a sum of money in a discretionary fund and give a minister the sole authority to distribute the money in the fund. In some cases the minister has no instructions regarding permissible distributions. In other cases the congregation establishes some guidelines, but these often are oral and ambiguous. Consider the following examples.

EXAMPLE A congregation at an annual business meeting authorizes the creation of a “pastor’s fund” in the amount of $10,000 with the understanding that Pastor T, the congregation’s senior minister, will have the authority to distribute the fund for any purpose. Pastor T is not required to account to the congregation or church board for any distribution, and he is not prohibited from making distributions to himself. During 2024 Pastor T distributed the entire fund to members of the congregation who were in need. He did not distribute any portion of the fund to himself or to any family member.

EXAMPLE Same facts as the previous example, except that Pastor T distributed $5,000 to his adult daughter in 2024 to assist her with the purchase of a home.

EXAMPLE A church board sets aside $5,000 in a discretionary fund and authorizes Pastor D, its senior minister, to distribute the funds for “benevolent purposes.” Pastor D is required to account to the church board for all distributions and is prohibited from making any distributions to himself or to any family member.

Many ministers and church treasurers are unaware of the potential tax consequences of these arrangements. The tax consequences of some of the more common arrangements are summarized below.

Situation 1

The congregation (or governing board) establishes a discretionary fund and gives a minister full and unrestricted discretion to distribute it.

To the extent the minister has the authority to distribute any portion of the discretionary fund for any purpose, including a distribution to him or herself, without any oversight or control by the governing board, the following consequences occur.

Taxable income

The IRS could assert that the full value of the discretionary fund constitutes taxable income to the minister, even if the minister does not benefit from the fund. The mere fact that the minister could benefit from the fund may be enough for the fund to constitute taxable income. The basis for this result is the “constructive receipt” rule, which is explained in income tax regulation 1.451-2(a):

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

For a discretionary fund to constitute taxable income to a minister, it is essential that the minister have the authority to “draw upon it at any time” for his or her personal use. This means the fund was established without any express prohibition against personal distributions.

EXAMPLE The Tax Court ruled that a pastor was required to report as taxable income $182,000 in deposits to a church bank account over which he exercised complete dominion and control. This case supports the view that church contributions to discretionary funds over which a pastor has complete control represent taxable income to the pastor. 101 T.C.M. 1550 (2011).

Donations to the fund

The IRS likely would assert that donations by members of the congregation to the fund would not be tax-deductible as charitable contributions, since the fund is not subject to the full control of the congregation or its governing board. For a charitable contribution to be tax-deductible, it must be subject to the full control of the church or other charity. The IRS stated the rule as follows in an important ruling: “The test in each case is whether the organization has full control of the donated funds, and discretion as to their use, so as to ensure that they will be used to carry out its functions and purposes.” If a church sets up a discretionary fund and authorizes a minister to make distributions from the fund for any purpose without any oversight or control by the church, this fundamental test is not met.

EXAMPLE A Florida appeals court affirmed the conviction of a parish priest for embezzlement of church funds. A Catholic priest was charged with grand theft of funds from his church based on his use of church funds for his personal benefit rather than for the benefit of the church. A diocesan official testified that the priest was allowed to make distributions from parish accounts without permission of the bishop as long as the distribution does not exceed $50,000 and the distribution is “for the good of the parish.” However, priests were instructed to keep records of distributions, and these accounts devoted to charitable works were required to be reported to the diocese quarterly. The priest claimed that he believed he had unfettered control over church funds and was free to spend them as he wished, and as a result, he had no criminal intent to warrant his conviction of a crime. The court disagreed: 

In this case, the state presented evidence from officials of the diocese that a parish priest is supposed to use parish money only for parish purposes. [Diocesan officials] testified that the priest’s expenditures for [his former secretary and her son] and for vacations would not be valid parish purposes. Further, the forensic examiner testified that thousands of dollars in cash from the offertory were unaccounted for and that a significant amount of parish money was spent on items that [diocesan officials] testified were not parish related. Significantly, [these officials] testified that money collected from the offertory is collected from the parish members for parish purposes. There was also testimony from staff at the parish that fake deposit slips were used to cover up the fact that cash was taken from the offertory.

The state has introduced evidence inconsistent with the priest’s claim of innocence. The case rises and falls on the intent of the priest when he used parish money and removed cash from the weekly offertory and whether it was for his personal benefit, not related to parish purposes. Ultimately, intent is a question of fact to be decided by the jury. We find that there was sufficient competent evidence of grand theft for the jury to find the priest guilty.

The court also rejected the priest’s contention that the prosecution of this case led to an “excessive entanglement with religion” in violation of the First Amendment. It observed: “Purely secular disputes involving religious institutions and third parties do not create excessive entanglement of church and state when they involve neutral principles of law.” Guinan v. State, 65 So.3d 589 (Fla. App. 2011).

EXAMPLE A Florida court affirmed a pastor’s conviction for grand theft and money laundering because of his use of a church benevolence fund to pay more than $100,000 in personal expenses. The fund was to be used solely to help those in need, and the church gave the pastor sole control over the use of the account. Between 2007 and 2009, the pastor paid numerous personal bills with money from the benevolent account, so much so that it amounted to his essentially using the account as an extension of his personal checking account. Hardie v. State, 162 So.3d 297 (Fla. App. 2015).

Situation 2

The congregation establishes a discretionary fund and gives a minister the discretion to distribute it for any purpose, but the congregation’s governing board retains administrative control over the fund.

Under this scenario the fund may still constitute taxable income to the minister, but the donations of congregational members to the fund probably would be tax-deductible as charitable contributions since the congregational board exercises control over the funds. Board “control” could be established if the board simply reviewed all distributions to ensure consistency with the congregation’s exempt purposes.

Situation 3

The congregation establishes a discretionary fund and gives a minister the discretion to distribute it only for specified purposes (such as relief of the needy) that are consistent with the congregation’s exempt purposes. The minister does not qualify for distributions and is prohibited from making distributions to himself or herself. The congregation’s governing board retains administrative control over the fund.

If a discretionary fund is set up by a resolution of a congregation’s governing board that prohibits any distribution of the fund for the minister’s personal use, then the constructive receipt rule is avoided and no portion of the fund represents taxable income to the minister. In the words of the income tax regulations, “Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.” As a result, to avoid the reporting of the entire discretionary fund as taxable income to the minister, it is essential that the fund be established by means of a congregational or board resolution that prohibits any use of the fund by the minister for personal purposes.

To provide a reasonable basis for assuring donors that their contributions to the fund are deductible, the following steps should be taken: (1) the board resolution should specify that the funds may be distributed by the minister only for needs or projects that are consistent with the congregation’s exempt purposes (as set forth in the congregation’s charter); and (2) the congregational board must exercise control over the funds. As noted above, board “control” could be established if the board simply reviewed all distributions to ensure consistency with the congregation’s exempt purposes.

Definition of charity

Ministers who are authorized to distribute discretionary funds for benevolent purposes must recognize that the IRS interprets the term charity narrowly. More is required than a temporary financial setback or difficulty paying bills. Ministers should keep this in mind when making distributions from a discretionary fund. Also, the church board should scrutinize every distribution to ensure that this strict test is satisfied. The income tax regulations define charitable to include “relief of the poor and distressed or of the underprivileged.” The regulations define needy as

being a person who lacks the necessities of life, involving physical, mental, or emotional well-being, as a result of poverty or temporary distress. Examples of needy persons include a person who is financially impoverished as a result of low income and lack of financial resources, a person who temporarily lacks food or shelter (and the means to provide for it), a person who is the victim of a natural disaster (such as fire or flood), a person who is the victim of a civil disaster (such as civil disturbance), a person who is temporarily not self-sufficient as a result of a sudden and severe personal or family crisis (such as a person who is the victim of a crime of violence or who has been physically abused). Treas. Reg. 1.170A-4A(b)(2)(ii)(D).

Form 1099-NEC for recipients

In general, a Form 1099-NEC is issued only to self-employed workers who are paid compensation. Since most recipients of a minister’s discretionary fund do not perform any services for their distribution, no Form 1099-NEC is required. IRS Letter Ruling 9314014.

A church’s reimbursements of an employee’s business expenses under a nonaccountable arrangement represent taxable income, whether the employee reports income taxes as an employee or as self-employed. Reimbursed expenses are nonaccountable if the employee did not account to the employer for the expenses or return any excess reimbursements (employer reimbursements in excess of substantiated expenses) to the employer. Here are some examples of nonaccountable reimbursement arrangements:

In each of these cases, the church’s reimbursements are nonaccountable, meaning that they must be reported by the church as income to the recipient.

EXAMPLE Pastor H receives a monthly car allowance of $300. Pastor H is not required to account for the use of any of these funds. This is an example of a nonaccountable reimbursement arrangement. The church is reimbursing business expenses (through a monthly car allowance) without requiring any accounting or substantiation. It must report all of the monthly allowances ($3,600) as income on Pastor H’s Form W-2 (or Form 1099-NEC if self-employed). A failure to do so may convert the allowances into an automatic excess benefit transaction, exposing the pastor and possibly members of the church board to substantial excise taxes called “intermediate sanctions.” Automatic excess benefit transactions are explained in “Intermediate sanctions” on page .

As noted under “Travel expenses” on page , a church must report reimbursements of the travel expenses of a spouse who accompanies a minister on a business trip as taxable income (ordinarily, to the minister) unless the spouse’s presence on the trip serves a legitimate business purpose and the spouse’s expenses are reimbursed under an accountable arrangement.

Many churches have made loans to their minister. If the minister does not repay the loan and the church forgives the debt, taxable income is generated. Consider the following example:

EXAMPLE A church hires Pastor B as a youth pastor. Pastor B was recently married and is in need of housing. He would like to buy a home but lacks the $15,000 needed for a down payment. The church board votes to loan Pastor B $15,000. Pastor B signs a no-interest $15,000 promissory note agreeing to pay the church back the $15,000 in 60 monthly installments of $250. Pastor B pays all of the monthly installments for the first year, but in the second and third years he pays only half of the required installments. After three years Pastor B resigns his position to accept a pastoral position in another church. The balance due on his note is $9,000. Over the next several months, the church treasurer at Pastor B’s former church writes him on three occasions and requests that the note be paid in full. Pastor B does not respond to any of these requests. The church board eventually decides to forgive the debt and makes no further contact with Pastor B.

What should a church treasurer do under these circumstances? The forgiveness of debt ordinarily represents taxable income to the debtor. IRC 61(a)(11). As a result, if a church makes a loan to an employee and the debt is later forgiven by the church, the church should report the forgiven debt as income for the employee. Here are the rules to follow, using the same facts as in the example:

EXAMPLE An employer paid the moving expenses of newly hired employees to relocate them to the employer’s city. Employees were required to reimburse the employer for a portion of the moving expenses paid by the employer if they terminated their employment within one year after being hired. An employee voluntarily terminated her employment within one year of being hired, and the employer was unsuccessful in collecting $5,000 in moving expenses from the employee. The employer eventually wrote this amount off as uncollectible. The IRS ruled that the employer had to report the forgiven debt as taxable income for the former employee. It observed:

It is well settled that where an employee’s debt to his employer is satisfied by canceling such debt, income is realized by the employee. Therefore, the employee must include in gross income the total amount of the debt that was canceled by [the employer]. The income realized upon cancellation of indebtedness arose as a result of an employment relationship. Accordingly, Form W-2 should be used to report the amount of indebtedness canceled. This form should be used even if the debt is canceled in a year subsequent to the year of employment. IRS Letter Ruling 8315021.

EXAMPLE A minister failed to report the discharge of an educational loan as income on his tax return. The Tax Court ruled that the forgiven loan balance should have been reported as income. The court also upheld an IRS assessment of a negligence penalty against the minister. Parker v. Commissioner, 65 T.C.M. 1740 (1993).

Planned forgiveness of annual payments under a promissory note

A church wants to help its pastor purchase a new home, 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 10 annual installments. The church board assures the pastor that the church will forgive each annual installment on the date it is due, so the pastor will not have to pay back anything. Is this transaction legitimate? What are the tax consequences?

The IRS released an internal memorandum (a “field service advisory”) in 1999 that addresses the tax consequences of debt forgiveness. FSA 9999-9999-170. Here are the facts of the arrangement the IRS was addressing: A widow and mother of three adult children owned a partial interest in farmland. 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 farmland 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, 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 farmland 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.

Lessons from the IRS memorandum

Church leaders can learn important lessons 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 Form 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 wanted to help its pastor buy a new home, so it gave him $50,000 cash in March 2024 to assist with the down payment. In January 2025 the church treasurer is preparing the pastor’s Form W-2 for 2024 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 2024. 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 2024 or any future year. This is incorrect. The $50,000 cannot be treated as a nontaxable gift to the pastor.

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, so it comes up with the idea of treating the $50,000 as a non-interest bearing loan payable over 10 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 Form W-2 for 2024: (1) $5,000 (the amount of the first annual installment the church forgives); (2) $50,000 (the full amount of the loan); or (3) some other amount? The IRS memorandum addressed in this section 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 2024.

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 wanted to help its pastor buy a new home. The board loaned $50,000 to the pastor in September 2024 to assist with the down payment. It prepared a non-interest-bearing 10-year promissory note in the amount of $50,000, which the pastor signed. 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 Form W-2 for 2024: (1) $5,000 (the amount of the first annual installment 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, so the entire amount of the loan must be reported as income in the year of the transaction (2024).

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 Form W-2 for 2024: (1) $5,000 (the amount of the first annual installment 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 10 promissory notes for $5,000 each. The notes have “rolling” maturity dates, so that one note matures each year over the next 10 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 2021 Form 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, were evidence of “forgiveness in subsequent years.”

Many churches have entered into severance-pay arrangements with an employee. Such arrangements can occur when an employee is dismissed, retires, or voluntarily resigns. Consider the following examples:

EXAMPLE Pastor G is hired for a three-year term at an annual salary of $45,000. After two years the church membership votes to dismiss Pastor G. The church agrees to give Pastor G severance pay in the amount of $45,000 (the full amount of the third year’s salary).

EXAMPLE Pastor C is called by a church for an indefinite term. After 10 years Pastor C resigns to accept another position. The church board agrees to give Pastor C severance pay of $20,000.

EXAMPLE Pastor T accepts a call as a pastor of a local church. After one year she is dismissed and is replaced by a male pastor. Pastor T believes the church was guilty of sex discrimination. The church and Pastor T enter into a severance agreement in which Pastor T agrees to waive any claims she has against the church under state and federal law in exchange for its agreement to give her severance pay of $40,000 (representing one year’s salary).

EXAMPLE K has served as bookkeeper at her church for 20 years. She is 68 years old. The church board decides it is time for K to retire so that a younger person can take over her job. When the board learns that K has visited with an attorney, they offer a severance agreement offering to pay her one year’s full salary ($35,000) in exchange for her release of all legal claims against the church.

Taxable income

Is severance pay paid by a church taxable income to the recipient? In most cases the answer is yes. The tax code imposes the income tax on “all income from whatever source derived,” unless a specific exclusion applies.

One exclusion may apply in some cases. Section 104(a)(2) of the tax code specifies that gross income does not include the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) “on account of personal physical injuries or physical sickness.” However, there are two important exceptions to this exclusion. First, punitive damages are always taxable. Second, section 104(a) specifies that “emotional distress shall not be treated as physical injury or physical sickness” except for “damages not in excess of the amount paid for medical care . . . ​attributable to emotional distress.” As a result, jury awards and settlements for employment discrimination and wrongful dismissal claims are fully taxable to the extent that they are based on emotional distress.

Church leaders must determine whether severance pay is taxable so it can be properly reported (on Forms W-2 and 941). Also, taxes must be withheld from severance pay that is paid to nonminister employees (and ministers who have elected voluntary withholding). Failure to properly report severance pay can result in penalties for both a church and the recipient.

Nonqualified deferred compensation

Section 409A of the tax code imposes several complex requirements on nonqualified deferred compensation plans, including documentation, elections, funding, distributions, withholding, and reporting. If a plan does not meet these requirements, participants in the plan are required to include in income any compensation otherwise deferred under the plan and pay taxes on such income, including an additional 20-percent tax and a tax generally based upon the underpayment interest that would have accrued had the amount been includible in income when first deferred.

Nonqualified deferred compensation subject to the section 409A requirements is generally defined as compensation that workers earn in one year but that is not paid until a future year. Some exceptions apply. For example, section 409A does not apply to qualified plans (such as a section 401(k) plan) or to a section 403(b) plan.

Any agreement to pay compensation to a current or former employee may be subject to the 409A requirements. Such payments should not be approved without the advice of a tax professional to ensure that the potential application of section 409A is fully addressed. See “Section 409A” on page .

Housing allowance

A related question is whether a church can designate any portion of severance pay as a housing allowance. This question has never been addressed by the IRS or any court. Consider two possibilities:

First, an argument can be made that a church can designate a portion of severance pay as a housing allowance if the severance pay is treated as taxable compensation rather than as damages in settlement of a personal injury claim. If the severance pay represents taxable income, as the IRS will almost certainly insist in most cases, it is because the amount paid represents compensation for services. Since a housing allowance must be designated out of compensation paid to a minister for services performed in the exercise of ministry, it can be argued that a housing allowance can be designated with respect to taxable severance pay.

Second, many severance agreements provide compensation to an employee in exchange for the termination of employment. The employee in effect is being paid not to work. As a result, monies paid to the employee do not derive from the exercise of ministry, and so a housing allowance cannot be applied to them.

The first option is more aggressive and should not be adopted without consulting with a tax professional.

Designating severance pay as a housing allowance may be of little value if a minister transfers immediately to another church that designates a timely housing allowance. But a designation of a housing allowance will be useful in the case of a minister who is not immediately employed by another church or religious organization.

Also, note that housing allowances are not reduced by the portion of a minister’s compensation that represents vacation pay, even though the minister ordinarily is not performing services in the exercise of ministry during vacation. The same principle may support the availability of a housing allowance designated out of a minister’s severance pay.

The income tax regulations specify that “a rental allowance must be included in the minister’s gross income in the taxable year in which it is received, to the extent that such allowance is not used by him during such taxable year to rent or otherwise provide a home.” Treas. Reg. 1.107-1(c). This language suggests that the portion of a minister’s severance pay that is designated as a housing allowance must be included in the minister’s taxable income to the extent that it is not used in that same year. This rule may greatly diminish the tax benefit of designating some or all of a minister’s severance pay as a housing allowance late in the year. Deferring severance pay (and a housing allowance) to the following year may not help, since this may trigger the limitations on nonqualified deferred compensation arrangements set forth in section 409A of the tax code and the regulations thereunder (see “Section 409A” on page  for details).

Many churches have presented their minister with an all-expense paid trip to the Holy Land for the minister and the minister’s spouse. Often such trips are provided to commemorate some special occasion, such as a birthday or anniversary. In many cases the value of such a trip is treated as a nontaxable gift to the minister. Is this correct? Unfortunately, the answer is no if either or both of the following statements are true:

No deduction is allowed for costs of travel that would be deductible only on the ground that the travel itself constitutes a form of education (e.g., where a teacher of French travels to France to maintain general familiarity with the French language and culture, or where a social studies teacher travels to another state to learn about or photograph its people, customs, geography, etc.). . . .

The committee is concerned about deductions claimed for travel as a form of “education.” The committee believes that any business purpose served by traveling for general educational purposes, in the absence of a specific need such as engaging in research which can only be performed at a particular facility, is at most indirect and insubstantial. By contrast, travel as a form of education may provide substantial personal benefits by permitting some individuals in particular professions to deduct the cost of a vacation, while most individuals must pay for vacation trips out of after-tax dollars, no matter how educationally stimulating the travel may be. Accordingly, the committee bill disallows deductions for travel that can be claimed only on the ground that the travel itself is “educational,” but permits deductions for travel that is a necessary adjunct to engaging in an activity that gives rise to a business deduction relating to education.

As a result, the church’s payment of the cost of such a trip is treated as the payment of personal vacation expenses, and the full amount must be included as taxable income on the minister’s Form W-2 (or 1099-NEC if self-employed). This includes transportation, meals, and lodging. It also includes all the travel costs of the minister’s spouse (and children) if these are paid by the church.

Consider the following two very limited exceptions to the general rule summarized above.

Short-term mission trips

If a church sends a minister to the Holy Land (or any other foreign country) for the primary purpose of engaging in religious activities, then the church’s payment of the documented expenses incurred by the minister may be nontaxable as an accountable reimbursement of business expenses.

This exception will be interpreted narrowly, and the IRS will scrutinize such cases for evidence of abuse. A two-week vacation cannot be turned into a business trip because of a couple of speaking engagements. On the other hand, if a church sends a minister on a short-term mission trip to a foreign country and the minister performs several religious services or engages in evangelistic activities or teaching at a seminary, then a reasonable basis may exist for treating the trip as having a legitimate business purpose. In general, any element of personal pleasure (vacation, sightseeing, etc.) must represent less than 25 percent of the total trip time. See “Travel expenses” on page  for more information on foreign travel.

Study at a foreign university

If a minister travels to a university in a foreign country for an educational course that is reasonably necessary for the enhancement of his or her duties, then a church’s reimbursement of the costs of such a trip may constitute a nontaxable reimbursement of business expenses if adequate substantiation is provided. See “Educational expenses” on page  for additional information.

Churches sometimes pay an employee’s personal expenses. Such payments ordinarily constitute taxable income for the employee.

EXAMPLE A religious ministry purchased season tickets for a college football team for a minister-employee. The ministry also made scholarship pledges to the college on behalf of the minister. The Tax Court ruled that these purchases constituted taxable income for the minister. It noted that “a third party’s payment of a taxpayer’s personal expenses is income to the taxpayer.” Whittington v. Commissioner, T.C. Memo. 2000-296 (2000).

Pastors and other church staff members sometimes use church funds over which they have control to pay for personal expenses. All such expenditures should be reported as taxable income for the pastor or staff member who paid the personal expenses.

EXAMPLE The Tax Court ruled that the owner of a small company who used company checks to pay for personal purchases should have reported the value of those checks as taxable income. Some churches have checkbooks requiring the signature of only one person. Persons with such authority may write checks for personal purposes without authorization and justify their acts on the ground that their purchases were indirectly for church purposes or, in some cases, to compensate for a “substandard salary.” Whatever the reason, people who write church checks for personal purposes not only will generate taxable income, but they may face criminal charges for embezzlement and tax fraud (assuming that the amount of the checks is not reported as taxable income). Thompson v. Commissioner, T.C. Memo. 2004-2.

Ever since major airlines launched frequent-flier programs several years ago, uncertainty has existed concerning the tax treatment of frequent-flier miles—especially when those miles are earned by employees while engaged in business travel for their employer. Are employers required to report the value of these mileage awards as taxable income to employees? Or is this a tax-free fringe benefit?

Tax status of benefits

The IRS provided official guidance in 2002. It announced, “Consistent with prior practice, the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent-flier miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel. Any future guidance on the taxability of these benefits will be applied prospectively.”

The IRS cautioned that “this relief does not apply to travel or other promotional benefits that are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax avoidance purposes.” A “promotional benefit” is a program that allows travelers to accumulate frequent-flier miles through rental car companies or hotels. These promotional benefits may generally be exchanged for upgraded seating, free travel, discounted travel, travel-related services, or other services or benefits. The IRS did not address the tax status of such benefits. This means that the IRS could pursue a tax-enforcement program against these benefits, but most experts view this as unlikely. IRS Announcement 2002-18.

Using personal credit cards to purchase church supplies and equipment

Some church employees purchase church supplies and equipment using a personal credit card to earn frequent-flier miles awarded for purchases made using their card. For example, a church board has authorized the purchase of a new copy machine for the church at a cost of $10,000. The senior pastor purchases the copier using his personal credit card and then is reimbursed by the church. Is it appropriate for the pastor to purchase this church asset with his personal credit card to have the frequent-flier miles accrue to his benefit?

One of the requirements for a church to maintain its exemption from federal income taxation is that none of its income or assets inures to the benefit of a private individual other than as reasonable compensation for services rendered. There is no materiality requirement. Any distribution of a church’s income or assets for the private benefit of an individual may constitute prohibited inurement. The IRS has observed that “those in control may not, by reason of their position, acquire any of the charitable organization’s funds [or assets]. If funds [or assets] are diverted from exempt purposes to private purposes, exemption is in jeopardy. . . . ​The test is whether, at every stage of the transaction, those controlling the organization guarded its interests.”

It is certainly possible that the IRS would view the use of a pastor’s personal credit card to purchase church assets to divert frequent-flier miles to his or her account as an example of prohibited inurement. Because of this risk, church leaders are advised to consult with a tax professional before pursuing such an arrangement.

Thank-you points

Many banks offer thank-you points to valued customers as a means of expressing appreciation. A taxpayer in New Jersey accumulated a substantial amount of thank-you points from his bank and redeemed some of them for a round-trip domestic airline ticket. The bank later reported the value of the ticket, which it determined to be $668, as taxable income on a Form 1099-NEC it issued to the customer. The customer did not report this amount on his tax return based on his assumption that it did not represent taxable income. The IRS audited the customer’s tax return and determined that the market value of the ticket ($668) should have been reported as “other income” on Form 1040. The customer protested the inclusion of this amount in his taxable income and took his case to the Tax Court.

The Tax Court agreed with the IRS that the value of the airline ticket represented taxable income to the customer. The court noted that taxable income is defined broadly by the tax code to include “all income from whatever source derived,” and this included the airline tickets in this case.

The court stressed that it was not “dealing with the taxability of frequent flyer miles attributable to business or official travel, with respect to which the IRS Commissioner stated in Announcement 2002-18 that he would not assert that a taxpayer has gross income because he received or used frequent flyer miles attributable to business travel.”

The court distinguished awards given by airlines as frequent-flier miles from the thank-you points issued by banks as a reward for customer patronage and loyalty. It observed, “We proceed on the assumption that we are dealing here with a premium for making a deposit into, or maintaining a balance in, a bank account. In other words, something given in exchange for the use (deposit) of [the customer’s] money; i.e., something in the nature of interest. In general, the receipt of interest constitutes the receipt of an item of gross income. . . . ​Receipt of the airline ticket constituted receipt of an item of gross income, and the customer has failed to show that it was worth any less than $668, which the bank, which had purchased the ticket, said was its fair market value.”

The court noted that “neither party has addressed, nor do we consider, whether award of the thank-you points, itself, may have been the taxable event.”

In conclusion, the court took pains to distinguish air travel awards based on frequent-flier miles from airline tickets offered to bank customers in exchange for thank-you points. The latter are taxable according to the fair market value of the ticket, while the former are not taxable based on the announcement issued by the IRS in 2002, which has never been rescinded. Shankar v. Commissioner, 143 T.C. 5 (2014).

A sabbatical refers to a period away from one’s customary employment to pursue other interests. Sabbatical leave is a common benefit provided to professors by colleges and universities to enable them to teach at another institution or pursue advanced studies. Some churches provide their lead pastor with sabbatical leave, as do some denominational agencies for their officers. Usually, ministers and denominational officers are provided a sabbatical for rest and rejuvenation and, secondarily, for writing or sermon preparation.

Churches that provide a minister with a sabbatical usually continue the minister’s compensation in whole or in part during the sabbatical. Sabbatical pay represents taxable income to the minister because it constitutes compensation in recognition of services.

If a pastor travels on a sabbatical, are travel expenses tax-deductible? Generally, no. Congress enacted legislation in 2017 that suspends the itemized deduction on Schedule A for unreimbursed (and nonaccountable reimbursed) employee business expenses, including travel expenses. However, this expense may be deducted by self-employed workers on Schedule C (a rare status for church workers), and the amount of an employer’s reimbursement of this expense is not taxable to an employee if paid under an accountable plan. See the cautionary statement on page  and “Reimbursement of Business Expenses” on page .

The question of whether travel expenses incurred by a church employee while on sabbatical leave can be treated as a business expense that is deductible by the employee or reimbursable by the employing church under an accountable reimbursement arrangement is addressed under “Travel expenses” on page .

Can sabbatical pay be characterized as a nontaxable scholarship? Generally, this is not possible for two reasons. First, the income tax regulations specify that scholarships provided to employees by an employer as compensation for services cannot qualify as a nontaxable benefit. See “Scholarships” on page  for details. Second, few sabbaticals would meet the requirements for a nontaxable scholarship, as the following example illustrates.

EXAMPLE A professor was given a year off to pursue studies overseas. He was paid $27,000 during his sabbatical, and he treated this entire amount as a tax-free scholarship. The IRS ruled that the sabbatical income represented taxable income, and the Tax Court agreed. The court noted that scholarships are nontaxable only if certain conditions are met. The recipient must be “a candidate for a degree at an educational organization,” and the scholarship must be used for qualified tuition. The court noted that the professor’s sabbatical income was not a nontaxable scholarship since he was not a candidate for a degree and failed to prove that he used any portion of the income for qualified tuition expenses. This ruling will be useful to church leaders in evaluating the tax status of sabbatical income provided to pastors or other staff members. Kant v. Commissioner, T.C. Memo. 1997-217.

Ministers often receive “love gifts” from their employing church or directly from individuals. Love gifts from a church typically are funded by a “love offering” collected by the church from members. Whether collected in an offering or paid directly by members to their minister, the question is whether such payments represent taxable compensation or tax-free gifts. The tax code excludes gifts from taxable income. IRC 102. But it also broadly defines taxable income as “all income from whatever source derived, including (but not limited to) the following items . . . ​compensation for services, including fees, commissions, fringe benefits, and similar items.” IRC 61. This means that any “love gift” provided to a minister, whether from individuals or a church, constitutes taxable income if the transferor’s intent was to more fully compensate the pastor for services rendered.

In a landmark ruling, the U.S. Supreme Court provided the following guidance in distinguishing between a tax-free gift and taxable compensation:

What controls is the intention with which payment, however voluntary, has been made. Has it been made with the intention that services rendered in the past shall be requited more completely, though full acquittance has been given? If so, it bears a tax. Has it been made to show good will, esteem, or kindliness toward persons who happen to have served, but who are paid without thought to make requital for the service? If so, it is exempt. Bogardus v. Commissioner, 302 U.S. 34, 45 (1936).

This is an important clarification. If the intent of a donor in making a love gift to a minister is to more fully compensate the minister for services previously performed and for which the minister has been compensated, then the transfer is taxable compensation for services rendered rather than a nontaxable gift. This almost always will be the case, despite the donor’s feelings of affection and gratefulness.

The Supreme Court, in a case involving a retirement gift made to a church treasurer, conceded that it is often difficult to distinguish between tax-free gifts and taxable compensation. The court did attempt to provide some guidance, however, by noting that “a gift in the statutory sense . . . ​proceeds from a detached and disinterested generosity . . . ​out of affection, respect, admiration, charity or like impulses. . . . ​The most critical consideration . . . ​is the transferor’s intention.” Commissioner v. Duberstein, 363 U.S. 278 (1960). But the Court added that “it doubtless is the exceptional payment by an employer to an employee that amounts to a gift” and that the church’s characterization of the distribution as a gift is “not determinative—there must be an objective inquiry as to whether what is called a gift amounts to it in reality.”

EXAMPLE A pastor reported $28,000 as income from his church. The IRS audited the pastor’s tax return and concluded that he understated his taxable income by $24,000. The pastor insisted that the $24,000 of unreported income came from voluntary gifts or offerings from members of the congregation, which were not taxable. The IRS rejected this argument, and the pastor appealed to the Tax Court. The court agreed with the IRS that these “gifts” represented taxable income for the pastor. It conceded that gifts are not taxable but concluded that the distributions made by the church to the pastor were not gifts. It observed:

The evidence that we do have strongly suggests that the transfers were not gifts. . . . ​The transfers arose out of the pastor’s relationship with the members of his congregation presumably because they believed he was a good minister and they wanted to reward him. Furthermore, the pastor testified that without the gifts his activity as a minister was essentially a money losing activity. In short, as the pastor recognized, the so-called gifts were a part of the compensation he received for being a minister. As such, the transfers are not excludable from income.

The court assessed a negligence penalty against the pastor because he failed to make a reasonable attempt to comply with the tax law. Swaringer v. Commissioner, T.C. Summary Opinion 2001-37 (2001).

EXAMPLE A federal court rejected a couple’s claim that they were entitled to an exemption from federal income tax because they “labor for the ministry.” The court concluded, “Income received by ministers whether from the church itself or from other private employers or sources is not exempt from income tax. The income received by taxpayers must be included in gross income required to be reported for income tax purposes according to the Internal Revenue Code.” The court acknowledged that ministers’ income (from the exercise of ministry) is exempt from federal income tax withholding but noted that “while certain income of ministers may be exempt from withholding of income tax, the income received by ministers, even from religious activities . . . ​is not exempt from payment of income tax.” Further, “the fact that a church itself may be exempt from payment of income taxes does not mean that the income received by ministers is exempt.” Pomeroy v. Commissioner, 2003-2 USTC 50,568 (D. Nev. 2003).

EXAMPLE A federal appeals court ruled that a pastor was properly convicted and sentenced to prison for filing a fraudulent tax return because of his failure to report several items of taxable income. The court rejected the pastor’s claim that a $60,000 payment to him by the church represented a nontaxable love gift. 2009 WL 723206 (C.A.11 2009).

EXAMPLE A federal appeals court affirmed the conviction of a pastor and his wife on several tax crimes based on various forms of church compensation they failed to disclose on their tax returns, including “gifts” from their church. The court observed:

It is apparent that the relationship between an employer and employee is one that is commonly established for some kind of mutual benefit, a dynamic that is altogether different from the “detached and disinterested generosity” that normally prompts the tender of a gift. Commissioner v. Duberstein, 363 U.S. 278, 285 (1960). . . . ​Payments from an employer to an employee are not gifts, but are presumed to be included in gross income. A taxpayer must report as gross income “all income from whatever source derived” unless “excluded by law.” To be sure, section 102(a) of the Code excludes from gross income “the value of property acquired by gift.” But the Code is explicit that payments from an employer to an employee do not constitute gifts under § 102(a), which “shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.” I.R.C. section 102(c). United States v. Jinwright, 2012-2 U.S.T.C. ¶50,417 (4th Cir. 2012).

EXAMPLE The Tax Court ruled that “love gifts” made by a church to its pastor represented taxable compensation. The pastor had informed the church’s board of directors that he did not want to be paid a salary for his pastoral services but that he would not be opposed to receiving “love offerings,” gifts, or loans from the church.

The pastor and his wife managed the church’s checking account and jointly signed all the church’s checks. They signed numerous checks in 2012, made payable to the pastor, with handwritten notations such as “Love Offering” or “Love Gift” on the memo line. The church transferred “love offerings” to other members of the church, including the pastor’s wife.

In 2012 the church’s bookkeeper prepared and sent to the pastor a Form 1099-MISC reporting that he had received nonemployee compensation of $4,815 from the church. When the bookkeeper left the church in late 2015, the pastor’s daughter became the church’s bookkeeper. The pastor filed a joint federal income tax return for 2012. He did not include as an item of income the $4,815 of nonemployee compensation reported on Form 1099-MISC. Although the pastor did not dispute that he had received $4,815 from the church, he insisted that the amounts transferred to him were improperly reported as nonemployee compensation when in fact they were nontaxable “love offerings.” The IRS audited the pastor’s 2012 tax return and determined that the $4,815 represented taxable income, not a nontaxable love gift. On appeal, the Tax Court agreed with the IRS, noting that the facts unequivocally demonstrated that the intent of donors and the church was to compensate the pastor for services he performed. The court pointed to the following facts:

The court referenced section 102(c) of the tax code, which specifies that the definition of the term gift does not include “any amount transferred by or for an employer to, or for the benefit of, an employee.” However, it noted that the IRS did not raise this issue or contend that the pastor was an employee of the church. Jackson v. Commissioner of Internal Revenue, T.C. Summ. 2016-69 (2016).

EXAMPLE The Tax Court ruled that personal transfers from church members to their pastor constituted taxable income even though not receipted by the church. A church’s founding pastor received no salary for 13 years. He was financially sustained in three ways:

The pastor did not report any of the blue-envelope donations from members of his church as taxable income on his Form 1040. The IRS audited the pastor’s tax returns and claimed that these offerings were taxable income rather than nontaxable gifts. The pastor appealed to the Tax Court.

The court began its opinion by noting that the tax code defines taxable income to include compensation for services. The court conceded that the tax code exempts gifts from taxation but noted that this exclusion does not apply to “any amount transferred by or for an employer to, or for the benefit of, an employee.” IRC 102(c). But the IRS did not press this point, and the court concluded that “it’s unclear whether it could apply,” since “we can’t say that the individual church members are [the pastor’s] employers.”

The court noted that prior cases involving donations to clergy demonstrate that the following four factors are important in distinguishing between taxable payments and gifts:

The court concluded: “As another former seminarian is widely thought to have said: ‘Quantity has a quality all its own.’ When comparatively so much money flows to a person from people for whom he provides services (even intangible ones), and to whom he expects to provide services in the future, we find it to be income and not gifts.” Felton v. Commissioner, T.C. Memo. 2019-168 (2018).

Example The Tax Court used the same four-factor test it announced in the Felton case (see the previous example) in deciding that “love gifts” paid by a congregation to its pastor represented taxable compensation rather than tax-free gifts. Brown v. Commissioner, T.C. Memo. 2019-69 (2019).

Embezzled funds constitute taxable income to the embezzler. Here are the main points to consider:

Employers that are certain of the identity of the embezzler and the amount stolen may be subject to a penalty under section 6721 of the tax code for failure to report the amount on the employee’s Form W-2 or 1099. This penalty is $50 or up to the greater of $100 or 10 percent of the unreported amount in the case of an intentional disregard of the filing requirement. For employers that are certain how much was stolen and who intentionally fail to report it, this penalty can be substantial. To illustrate, assume that church leaders know with certainty that a particular employee embezzled $100,000, but they choose to forgive the debt and not report the stolen funds as taxable income. Since this represents an intentional disregard of the filing requirement, the church is subject to a penalty of up to 10 percent of the unreported amount, or $10,000. But note that there is no penalty if the failure to report is due to reasonable cause, such as uncertainty as to how much was embezzled or the identity of the embezzler.

In many cases, filing Form 3949-A with the IRS is a church’s best option when embezzlement is suspected.

In short, it does not matter that someone intended to pay back embezzled funds. This intent in no way justifies or excuses the crime. The crime is complete when the funds are converted to one’s own use—regardless of any intent to pay them back.

Also, note that recharacterizing embezzled funds as a loan would raise the concerns, addressed previously, pertaining to below-market loans, inurement, and excess benefit transactions. See “Below-market interest loans” on page .

Example A federal appeals court affirmed an eight-year prison sentence for a Catholic priest who embezzled $256,000 from three churches and who, by failing to report the embezzled funds on his tax return, was guilty of filing a false return. United States v. Garbacz, 33 F.4th 459 (8th Cir. 2024).

Contributions to church bank accounts over which a pastor exercises total control may represent taxable income to the pastor. This potential source of taxable income was addressed by the United States Tax Court. An ordained pastor established a church as a corporation sole under Utah law. He designated himself as “overseer” of the church. As overseer, he had full control over the corporation sole, including the authority to amend its articles of corporation sole and appoint his successor. He opened two bank accounts in the name of the church. The IRS audited the tax returns of the pastor and his wife (the “petitioners”) for two years and concluded that all money deposited into the church’s accounts (totaling $182,000) was income to the petitioners because they exercised full control over it and used it to pay personal expenses.

On appeal, the Tax Court observed:

We generally have held that . . . ​a taxpayer’s gross income includes deposits into all accounts over which the taxpayer has dominion and control, not just deposits into the taxpayer’s personal bank accounts. A taxpayer has dominion and control over an account when the taxpayer has the freedom to use its funds at will.

We have held that deposits made to a lawyer’s “cash management” accounts were income to the taxpayer where she was the only signatory on the account, used it to pay personal expenses, and did not disclose its existence to her law firm’s accountant. . . . ​Furthermore, we have held that deposits into the accounts of a purported trust for an investment project were income to a taxpayer where he had the power to make withdrawals, his Social Security number was the only one on the accounts, he was one of two signatories, his business address was on the accounts, and he made transfers into and out of the accounts. Finally, we have held that deposits made into the account of a purported church were includable in the taxpayers’ gross income where the taxpayers were the owners of the bank accounts, exercised complete control over the funds in the accounts, and used those funds for personal expenditures. [We noted] that it was unnecessary to disregard the separate existence of the purported church in order to reach our conclusion that funds deposited in the church’s accounts were income to the taxpayers. We stated: “It is not necessary to disregard the separate existence of the church or to challenge the tax status of the church as an entity in order to sustain [the IRS’s] determinations in this case. Whether they were entitled to the funds or embezzled the funds from the church, petitioners exercised complete dominion and control over deposits into the various bank accounts that were the basis of respondent’s determination. . . .”

It is undisputed that petitioners were the only signatories on the church bank accounts and that the address listed on those accounts was that of petitioners. The petitioners testified that they used the money in the church bank accounts for mission trips, mission expenses, other ministry expenses, and church expenses. Petitioners contend that the large number of checks written to themselves or to cash, totaling more than $70,000, were all for use on their mission trips, and they contend that the dates of those withdrawals line up with the dates of their mission trips. Yet many of the withdrawal dates bear little relationship to the dates of their mission trips. . . . ​Petitioners have supplied no receipts, records, or other evidence to substantiate their testimony regarding the use of the cash they withdrew from the church bank accounts.

The court conceded that some of the funds the petitioners withdrew from the church account were used for their missionary expenses. However,

the evidence also shows that petitioners sometimes used funds from the church bank accounts to pay their personal expenses, suggesting the likelihood that they also used some of the cash they withdrew from the church bank accounts for trips to pay their personal expenses. Petitioners produced no receipts or other documentation to show how the cash was used or how much money they spent on overseas mission trips. Because the burden of proof is on petitioners to produce such records and because petitioners have failed to produce any documentation, we conclude that petitioners have failed to meet their burden.

The court stressed that the petitioners

had unfettered access to the funds in the church accounts, and there is no evidence that the church congregation had any say over how those funds were used. Indeed, the only member of the church congregation who testified at trial had no knowledge of the church’s finances, suggesting that petitioners did not share any information about church finances with the congregation. The facts show that petitioners fully controlled the church accounts, used money in those accounts at will, including to pay personal expenses, and were not accountable to anyone in their congregation for their use of the church funds. Accordingly, we conclude that petitioners exercised dominion and control over the church bank accounts. Consequently, all deposits into those accounts, except those from nontaxable sources, are properly includable in petitioners’ gross income.

The court rejected the petitioners’ plea that their failure to supply records from the church to substantiate their testimony regarding the use of church funds should be excused because, pursuant to the Church Audit Procedures Act, the IRS cannot compel them to produce church records. The Act sets forth certain conditions the IRS must follow before it can obtain records of a church in connection with an examination of that church’s tax liability. However, the court noted that the Act does not apply to “any inquiry or examination relating to the tax liability of any person other than a church.” It observed: “Courts generally have held that where the IRS is examining the tax liability of an individual, such as a pastor, rather than the church itself [the Act] does not apply. We agree. Accordingly, petitioners’ failure to produce church records that would substantiate their testimony about how they used the cash withdrawn from the church bank accounts is not excused by [the Act].”

Petitioners claimed that even if some of the expenses paid from the church account were personal, those amounts are not includible in their taxable income because they were for the purpose of providing a home for the petitioner, a minister of the gospel, and therefore are exempt from taxation as a housing allowance. The court disagreed:

In order for a minister’s housing allowance to be exempt from taxation . . . ​it must be designated as a housing allowance by an official action of the church in accordance with section 1.107-1(b), Income Tax Regs., which provides: “The term [housing] allowance means an amount paid to a minister to rent or otherwise provide a home . . . ​if such amount is designated as [a housing] allowance pursuant to official action taken in advance of such payment by the employing church or other qualified organization. . . . ​The designation of an amount as [a housing] allowance may be evidenced in an employment contract, in minutes of or in a resolution by a church or other qualified organization or in its budget, or in any other appropriate instrument evidencing such official action. The designation referred to in this paragraph is a sufficient designation if it permits a payment or a part thereof to be identified as a payment of rental allowance as distinguished from salary or other remuneration.”

The court concluded that the petitioner received no official salary from the church, and “nothing in the record suggests that it took any official action to designate a housing allowance for him. Accordingly, petitioners’ argument that their personal housing expenses are exempt from taxation fails.” 101 T.C.M. 1550 (2011).

Ministers often receive fees directly from church members for performing personal services such as marriages, funerals, or baptisms. Are these fees, which are paid directly from members to a minister, taxable income to the minister? The answer is yes. The income tax regulations specify that “marriage fees and other contributions received by a clergyman for services” are income for the minister. Treas. Reg. 1.61-2(a)(1). Note, however, that such fees ordinarily will be self-employment earnings for a minister if received directly from members, and not employee wages. As a result, they must be reported on Schedule C (Form 1040).

Social Security benefits include monthly retirement, survivor, and disability benefits. They don’t include sSSI payments, which aren’t taxable. The net amount of Social Security benefits you receive from the Social Security Administration is reported in box 5 of Form SSA-1099 (Social Security Benefit Statement), and you report that amount on line 6a of Form 1040 or Form 1040-SR. The taxable portion of the benefits that is included in your income and used to calculate your income tax liability depends on the total amount of your income and benefits for the taxable year. You report the taxable portion of your Social Security benefits on line 6b of Form 1040 or Form 1040-SR.

Your benefits may be taxable if the total of one-half of your benefits plus all of your other income, including tax-exempt interest, is greater than the base amount for your filing status.

The base amount for your filing status is

If you are married and file a joint return, you and your spouse must combine your incomes and Social Security benefits when figuring the taxable portion of your benefits. Even if your spouse didn’t receive any benefits, you must add your spouse’s income to yours when figuring on a joint return if any of your benefits are taxable.

Generally, you can figure the taxable amount of the benefits in one of the following ways:

However, if you made contributions to a traditional Individual Retirement Arrangement (IRA) for 2021 and you or your spouse were covered by a retirement plan at work or through self-employment, use the worksheets in Publication 590-A (Contributions to Individual Retirement Arrangements) to see if any of your Social Security benefits are taxable and to figure your IRA deduction.

For additional help, see IRS Publication 915.

Section 61 of the tax code defines gross income as “all income from whatever source derived.” This is an expansive definition that results in the inclusion of several items not specifically itemized on lines 1–9 of Form 1040. Accordingly, “additional income” is reported on lines 1–9 of Form 1040 (Schedule 1). This amount is then carried over to Form 1040, line 8.

Some ministers have attempted to “split” their church income with their spouse. This often is done to soften the impact of the Social Security annual earnings test (which reduces Social Security benefits to workers under “full retirement age” who earn more than an amount prescribed by law). Do such arrangements work? That was the question addressed by the Tax Court in the following ruling.

Pastor Shelley attempted to shift some of his church income to his wife so she could make an annual IRA contribution. He also claimed his wife’s “income” as a business expense deduction on his tax return. He explained that his wife performed a variety of services, including visiting members of the congregation who were in the hospital or unable to leave their homes and assisting with weddings and funerals. Pastor Shelley acknowledged that his wife did not receive a paycheck but simply had access to the couple’s joint checking account. Mrs. Shelley was not employed elsewhere during the years in question.

The IRS insisted that Pastor Shelley’s “employment” of his wife was a “ruse” designed to generate compensation so that contributions to her IRA would be deductible. The IRS ruled that Mrs. Shelley’s wages should be removed from the couple’s joint tax return, and the deductions claimed for wages paid should not be allowed because Pastor Shelley failed to establish that an employment relationship existed between himself and his wife. Accordingly, the IRS concluded that Mrs. Shelley was not entitled to any IRA deductions and that the couple owed excise taxes for the excess contributions made to Mrs. Shelley’s IRA.

The Tax Court noted that whether Mrs. Shelley was entitled to deduct IRA contributions “depends on whether she was employed and received wages during the years in issue.” The court continued:

Section 162 [of the Code] allows the deduction of “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Compensation is deductible only if it is: (1) reasonable in amount, (2) for services actually rendered, and (3) paid or incurred. When there is a family relationship, the facts require close scrutiny to determine whether there was in fact a bona fide employer–employee relationship or whether the payments were made on account of the family relationship.

We find that [Pastor Shelley has] failed to substantiate that wages were actually paid to Mrs. Shelley or that a bona fide employer–employee relationship existed. [He] did not issue Mrs. Shelley a paycheck, nor did he document any of the services she performed. [He] was unable to offer any explanation for how Mrs. Shelley’s salary was determined, and there was no employment contract between [him] and Mrs. Shelley. [He] did not withhold income taxes from the alleged wages paid to his wife as required by [law] nor did he file employment tax returns (Forms 941). While we do not doubt that Mrs. Shelley contributed to church activities, there is little indication that this was done in the context of an employer–employee relationship. [Pastor Shelley’s] testimony strongly suggested that the deductibility of Mrs. Shelley’s IRA contributions was one of the principal reasons he employed her. [He] testified that he stopped employing her when she began working at Florida A&M University (FAMU). He did not, however, hire anyone to replace her. Similarly, there is no indication that once employed at FAMU, Mrs. Shelley stopped performing the services for the church that she previously had performed. [Pastor Shelley has] failed to establish that the alleged wages were actually paid, that any employment contract existed, or that Mrs. Shelley was treated as an employee. Therefore, we sustain [the IRS position] on this issue.

The Tax Court concluded that the Shelleys improperly claimed an excess contribution to Mrs. Shelley’s IRA and that they were subject to the 6-percent excise tax on such contributions. It did concede that the Shelleys’ maximum allowable IRA contributions for the years under examination was $2,250 per year (the amount allowed for a married taxpayer whose spouse earns no income).

Ministers occasionally attempt to shift income to a spouse. One common reason is to divert income from the minister in order to avoid the annual Social Security earnings test. The courts have ruled consistently that the Social Security Administration may disregard “fictitious arrangements” among family members. As the Tax Court noted in the Shelley case, there must, in fact, be an employment relationship. In making this decision, the court referred to several factors, which are summarized below.

Factors indicating an employment relationship

The spouse performed meaningful services, including visiting members of the congregation who were in the hospital or unable to leave their homes and assisting with weddings and funerals.

Factors indicating that no employment relationship existed

This aspect of the court’s decision will be relevant to those ministers who seek to divert a portion of their church income to a spouse in order to achieve one or more of the “benefits” summarized above.

The courts generally have been skeptical of attempts by taxpayers to shift income to a spouse. Here is an excerpt from a typical ruling:

Here the husband was in a position to control the business. His wife knew nothing about the duties of president of the company. The husband came into the office, he says to pay his own bills. But he also met with the company accountants. After he reached 70 years of age he admits he returned to work. . . . ​At that time he was exempted by regulation from any work deductions to his retirement benefits. Both he and his wife admitted that his wife performed the same services both before and after she began to receive a salary. She said she had drawn no salary prior to August 1977 so that her husband’s Social Security contributions would be higher, enabling him to receive higher benefits. . . . ​When the husband’s salary was shifted to his wife that salary did not reflect an increase in her services to the company. It is a fair inference that the salary she received was intended as indirect compensation to her husband. . . . ​Since the critical determination is whether the wife’s wages reflected the services she rendered, and there is no evidence to explain or justify the dramatic increase in her salary from nothing to $22,400, the finding of the Social Security Administration is supported by substantial evidence. The determination of the Social Security Administration is affirmed. [Emphases added.] Sutton v. Sullivan, 1990 WL 48027 (E.D.N.Y. 1990).

The message is clear—ministers should not attempt to obtain tax benefits by shifting income to a spouse unless the arrangement has economic reality. The guidelines provided by the Tax Court in the Shelley decision will be helpful in evaluating the likely success of such arrangements.