Background. An Ohio court ruled that a church could not avoid paying a subcontractor that provided labor and materials for a church construction project on the ground that the subcontractor failed to file a mechanic’s lien.
In 1995, a church entered into a contract with a general contractor for the construction of a new worship facility. The contract provided that the worship facility would be constructed over a period of seven months for a total cost of $852,650. Payments to the general contractor were to be made in installments upon approval by an independent architect. Over the next several months, substantial work on the project was completed. The architect approved four payment requests from the general contractor, totaling $321,365.05, and the church paid these amounts.
The general contractor later accepted a bid for the fabrication and installation of certain steel structures for the worship facility, and the steel subcontractor fabricated and installed the steel structures in accordance with the terms of its agreement with the general contractor. The steel subcontractor sent the general contractor an invoice for $25,500 for the work and materials it supplied. A few weeks later, the general contractor submitted a request for a fifth payment in the amount of $87,531.10. The architect recommended that the church withhold $58,328, but approved $29,203 of the request. The church in turn paid out $20,000 to those subcontractors who held mechanic’s liens on its property. It did not pay the steel subcontractor because it never perfected a mechanic’s lien on the church property.
The steel subcontractor sued the church, demanding payment for the labor and material that it supplied on the basis of the legal theory of “unjust enrichment.” The church insisted that it was not required to pay the steel subcontractor anything since it had failed to protect itself by filing a mechanic’s lien on the church’s property.
What the court said. A trial court ruled in favor of the steel subcontractor. It concluded that “it would, indeed, be unjust to permit [the church] to pick and choose who it decided to pay and for what services to the detriment of [the steel subcontractor] who dealt in good faith with [the church] and did everything required of it.” The trial court further found that its decision was not by barred by the steel subcontractor’s failure to file a mechanic’s lien on the property, and that the subcontractor was entitled to relief on the basis of its unjust enrichment claim. A state appeals court agreed.
The court noted that to recover under the theory of unjust enrichment, the steel subcontractor had to prove that (1) it conferred a benefit upon the church, (2) the church had knowledge of the benefit, and (3) it would be unjust for the church to retain that benefit without payment. The church insisted that the steel subcontractor could not prove the third requirement. It pointed out that it ultimately paid in excess of the contract price for the completion of the project and paid the general contractor all amounts it was entitled to under the terms of the contract.
The court concluded that the steel subcontractor could pursue a claim of unjust enrichment against the church even though it had failed to file a mechanic’s lien. However, it also acknowledged that if the church had paid the general contractor in full for all performance rendered at the construction site, then it had not received a benefit for which it did not pay and it would not be liable to the steel subcontractor on the basis of unjust enrichment. The key question, then, was whether or not the church had fully paid the general contractor. The court concluded that it had not done so. It noted that the architect had approved only $29,203 of the $87,531.87 requested by the general contractor for its fifth payment, and this is the amount the church paid. Since the church had not fully paid the general contractor for all amounts due under the contract, it would be unjustly enriched if it was not required to pay the steel subcontractor.
Relevance to church treasurers. Most churches enter into construction contracts on occasion. In some cases, a church is constructing a new worship facility, as in this case. In others, a church is remodeling its present facility. Under most construction contracts, the church will be responsible for paying the general contractor the contract price. It is then the general contractor’s responsibility to pay its subcontractors. In some cases, a subcontractor that provides labor or material in a construction project is not paid by the general contractor. Subcontractors can protect themselves against nonpayment by filing a mechanic’s lien against the church’s property. Such a lien enables the subcontractor to sell the church’s property in order to obtain payment for any labor or material that it provided. But subcontractors do not always file mechanic’s liens. This case illustrates the following important points:
Subcontractor files a mechanic’s lien
If a subcontractor files a mechanic’s lien, then its right to payment for any labor or materials that it provided will be protected by state law. If the general contractor does not pay the subcontractor, then the church will be required to do so. If it does not, the subcontractor can sell the church’s property in a foreclosure sale to obtain payment for the labor or materials that it provided.
Key point. Churches can protect themselves from having to pay twice for the same services or material in various ways. Here are some common precautions: (1) Only deal with reputable contractors who have been in business in your community for several years and who have an excellent reputation. Many churches use a contractor who is a member of their congregation. (2) Require the contractor to provide you with “lien waivers” from all suppliers and workers before making payments for the job. (3) Hold back a portion of the contract price until you are assured that all suppliers and workers have been paid. (4) Ask the contractor to submit bills from suppliers and workers directly to the church, and inform the contractor that the church will pay these bills directly. (5) If you sign a contract, you may want to address some of these options in the contract. The assistance of an attorney is essential.
Subcontractor does not file a mechanic’s lien
The fact that a subcontractor fails to file a mechanic’s lien does not necessarily prevent the subcontractor from seeking payment from a church. If the general contractor fails to pay the subcontractor, then the subcontractor may sue the church for payment on the basis of the legal doctrine of “unjust enrichment.” This court made the following two conclusions regarding unjust enrichment:
(1) If the church has paid the full contract price to the general contractor, then it has not received a benefit for which it did not pay and it has not been unjustly enriched. According to this court, the church would not be legally required to pay the subcontractor again.
(2) If the church has not paid the full contract price to the general contractor, then it has received a benefit for which it did not pay. Under these circumstances, the court concluded that the church had been unjustly enriched, and as a result it was required to pay the subcontractor’s claim. Wickford Metal Products v. Tri-Village Church of Christ, Inc., 1999 WL 3973 (Ohio App. 1999).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Paying Taxes with a Credit Card
Using credit cards for payments might not be as advantageous as taxpayers hope.
In 1999, the IRS for the first time allowed taxpayers to pay their federal taxes with a credit card. Some taxpayers saw this as a way to accumulate frequent flier miles—by charging taxes to a credit card that offers frequent flier miles for dollars charged. Unfortunately, a recent IRS news release confirms that there are some features to this program that make it unlikely that taxpayers will be able to fly anywhere soon. Here are the details:
2 ways to pay taxes by credit card. There are 2 ways for you to pay your taxes by credit card:
(1) Phone option. The pay-by-phone option allows you to charge taxes to American Express, Discover, or MasterCard accounts by calling 1-888-2PAY-TAX. An automatic voice response system will guide you through the process. Visa cards are not accepted, even though they represent about one-half of all credit cards used in this country. It is possible that Visa cards will be accepted in the future.
Key point. Taxpayers charging an estimated tax payment will not have to file the paper Form 1040-ES. The phone system, operated by Official Payments Corporation of San Ramon, Calif., will open January 14, 2000. The estimated tax payment option will become available March 1, 2000.
(2) Computer option. Three tax software developers (Intuit, Nelco, and Orrtax) offer electronic filing (e-file) and pay combinations for individuals. In these programs, the credit card payment information is part of the electronic return filed. The Intuit program (TurboTax) currently allows tax payments with the Discover card, Visa, MasterCard, Optima, or American Express.
What taxes can I pay by credit card? The phone option will accept three types of payments: the balance owed on a 1999 return; a projected balance of 1999 taxes due on a request for an automatic extension of time to file; or an estimated tax payment for tax year 2000. The computer option will accept the actual tax liability paid with your electronically-filed tax return.
Is there a maximum amount that I can charge? The maximum charge accepted by phone will be $99,999.99. There is no limit on taxes paid using the computer option.
How much will it cost me? The IRS does not set or collect any fees for credit card payments, but two other fees may apply.
(1) Convenience fee. There is a “convenience fee” that is charged by the company that processes the credit card payments. This fee is based on the amount of taxes charged. For example, the fee for a $1,000 charge is $35; the fee for a $2,000 charge is $68; and the fee for a $5,000 charge is $133. If you file electronically using TurboTax or MacInTax software and charge your balance due, your credit card company will process your payment and charge you a convenience fee.
(2) Cash advance fees. Credit card companies may charge a “cash advance” fee when taxpayers charge taxes to their credit card—if the charge is treated as a cash advance rather than a payment. You should check with your credit card company to see if imposes a cash advance fee on such charges, and if so, the amount of the fee. To illustrate, “cash advances” charged to a Visa credit are assessed a 3% fee.
The bottom line. Is it worth charging taxes to a credit card in order to earn frequent flier miles? Here are the factors to consider:
(1) Amount of miles needed for free travel. How many miles are needed for a free round-trip coach class ticket on my preferred airline? In most cases, the answer is 25,000 miles. This means that you will need to charge $25,000 (at a rate of one mile per dollar charged) to earn a single round-trip domestic ticket. That’s a lot of taxes! But, if other expenses are charged to the same credit card, a free ticket eventually will be earned. Also note that more miles may be needed to claim a free ticket during certain times of the year.
(2) Amount of the convenience and cash advance fees. The biggest limitation in earning frequent flier miles by charging taxes to a credit card is the cost of doing so. At a minimum, you will need to be pay the “convenience fee.” If you pay by phone, the fee for charging $25,000 will be substantial (close to $1,000)—far more than the cost of a discounted round-trip domestic ticket. If you pay by computer and charge your taxes to a credit card, you will need to check with your credit card company to determine if it imposes a fee, and if so, in what amount.
(3) Credit card interest. The exorbitant interest rates charged by credit card companies is another “cost” that must be considered when deciding whether or not to pay taxes by credit card. If you do not pay your credit card balance immediately, you will begin to incur interest on your balance. Interest payments will skyrocket if you pay the minimum balance on your credit card each month. Some credit card companies charge even higher rates for “cash advances,” and eliminate any “grace period.”
Tip. The credit card payment options will help some taxpayers who don’t have the full balance due when they file their tax return. Such taxpayers have other options available to them, including a bank loan or setting up an installment agreement with the IRS. Taxpayers may use Form 9465 to request an installment agreement. The law gives taxpayers a right to an installment agreement when they are unable to pay if the balance due is not more than $10,000, the tax will be fully paid within three years, and, during the previous five years, the taxpayer has not failed to either file returns or pay taxes and has not had an installment agreement.
In summary, there are both advantages and disadvantages to paying taxes with a credit card. This option clearly appeals to some taxpayers, since more than 129,000 people paid their federal taxes by credit card during 1999.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
IRS Defines “Last Known Address”
Clarifications may still not result in all notices making it to the right taxpayer.
The IRS generally has three years from the date a federal tax return is filed (or the due date for the return if the return is filed early) to audit the return and assess additional taxes and penalties. However, the IRS may not assess additional taxes and penalties unless it mails a “notice of deficiency” to the taxpayer giving the taxpayer an opportunity to challenge the IRS position before the United States Tax Court. An IRS notice of deficiency must be mailed to the taxpayer’s “last known address,” even if it is not received by the taxpayer. In the past, the term “last known address” was not defined by the tax code or regulations.
The IRS has released regulations defining this important term. There are two key points to note. First, the regulations define “last known address” as the address that appears on a taxpayer’s most recently filed federal tax return, unless the IRS is given clear and concise notification of a different address. Second, while the tax code does not require the IRS to check with the United States Postal Service concerning a change in a taxpayer’s address, the new regulations provide that beginning in May 2000 (and every November thereafter) the IRS will refer to the Postal Service’s National Change of Address (NCOA) database to obtain a taxpayer’s address for purposes of determining the taxpayer’s last known address. Any citizen can update his or her residential address with the Postal Service by submitting a Form 3575 containing a new address, and the new address is thereafter maintained in the NCOA database.
Beginning in May, before sending correspondence to a taxpayer, the IRS will review the NCOA database to see if the taxpayer has submitted a Form 3575 to the Postal Service with a more recent address. If so, the following will occur: (1) the correspondence will be mailed to the address obtained from the NCOA database, and (2) the IRS will use the new address from the NCOA database to update the automated master file. This updated address will be the taxpayer’s last known address. A new NCOA address will be the taxpayer’s last known address, unless the IRS is given clear and concise notification of a different address.
Using the NCOA database will increase customer service by allowing faster delivery of IRS correspondence to a taxpayer. Rather than mailing correspondence to an address which is no longer a taxpayer’s address and relying on the Postal Service to forward mail to the taxpayer’s most recent address, the IRS will mail the correspondence directly to the taxpayer’s most recent address. In addition, by updating the automated master file with the most recent address, future IRS correspondence will be mailed to the taxpayer’s most recent address.
Key point.Since the IRS will review the NCOA database only once each year, it is still possible if not likely that many IRS notices of deficiency will be mailed to the wrong address. Taxpayers can avoid this possibility by completing and submitting to the IRS a Form 8822. This form is used to notify the IRS of a change in address.
Tip. Place a notice in your church newsletter reminding members who have moved recently to inform the IRS of their new address by submitting Form 8822. Here’s an example: “Notifying the IRS of a new address. If you recently changed addresses you may want to inform the IRS of your new address. Failure to do so could result in a delay in receiving refunds or important tax notices. You can use Form 8822 to let the IRS know your new address. You can obtain this form by calling 1-800-TAX-FORM.”
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
McBrayer v. Commissioner, T.C. Memo. 1999-360 (1999)
Ministers and lay church employees often travel on church-related business. What are the tax consequences associated with a loss of one’s luggage while traveling on a business trip? The Tax Court addressed this question in a case.
A teacher claimed a Schedule C expense deduction in the amount of $530 for luggage that she claimed had been stolen while she was using a restroom at Reagan National Airport. The only evidence she produced in support of the deduction were receipts for two pieces of replacement luggage she purchased shortly after the loss. The IRS denied the deduction, and the Tax Court agreed. The court concluded that no loss deduction was available, for the following three reasons:
(1) The teacher failed to establish that her luggage had been stolen. The court noted that “to be entitled to a [loss] deduction a taxpayer is required to substantiate the deduction through the maintenance of books and records or other sufficient evidence.” It acknowledged that the teacher had provided the court with receipts for two pieces of replacement luggage, but concluded that this did not constitute sufficient substantiation of the loss. It concluded: “It is well settled that we are not required to accept petitioner’s self-serving testimony in the absence of corroborating evidence. [The teacher] failed to submit corroborating evidence, such as a police report. Such evidence would have been helpful in establishing the items stolen and the date of the theft.”
(2) The teacher failed to prove the amount of the loss. The court pointed out that she failed to substantiate the amount of the loss by documenting the “adjusted basis” of the lost luggage. In general, the first step in determining amount of a theft loss is to compute the property’s adjusted basis. This amount is the original cost of the property, with certain adjustments. Since the teacher failed to produce any evidence as to the original cost of her luggage, she failed to adequately substantiate her loss.
(3) The teacher failed to prove that the loss was not compensated for by insurance. A taxpayer must demonstrate that a loss was not covered by insurance.
What can church treasurers do to help? If a minister or lay church employee experiences a theft of personal property, here are some suggestions you can make soon after the loss to increase the likelihood of a loss deduction:
Encourage the pastor or lay employee to immediately file a police report. As the Tax Court noted, this will help to substantiate that the property in fact was stolen, and the date of the loss.
Encourage the pastor or lay employee to locate records substantiating the cost of the stolen property. This evidence will be required in order to support a loss deduction.
Key point. Even if all the required records are maintained, a loss deduction is subject to additional limitations. To illustrate, the amount of each loss (adjusted basis) must be reduced by $100, and total theft losses must be reduced by 10% of adjusted gross income (this rule is applied after the $100 reduction for each loss).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Liability for Disclosing Confidential Information
A New York court issues an important ruling-Lightman v. Flaum, 687 N.Y.S.2d 562 (1999)
A New York court issues an important ruling- Lightman v. Flaum, 687 N.Y.S.2d 562 (1999) [The Clergy-Penitent Privilege ]
Article summary. In a landmark case that should be reviewed by every minister and seminary student, a New York court ruled that a woman could sue two rabbis for disclosing extremely confidential information that she had divulged to them separately in the course of confidential marital counseling. This case illustrates the importance of clergy maintaining the confidentiality of information shared with them in the course of conversations protected by the clergy-penitent privilege. A failure to do so may result in civil liability for breach of a fiduciary duty to preserve confidential information.
A recent New York court ruling makes it more likely that clergy who disclose information shared with them in confidence will be subject to civil liability. This feature article will review the facts of this important ruling, summarize the court’s opinion, and evaluate the significance of the case to clergy and lay church leaders.
Facts
In 1995, a married woman (the “plaintiff”) sought counseling from two different rabbis. She shared with each of them, in separate counseling sessions, information of an extremely personal and confidential nature. The rabbis were employed by congregations that the plaintiff and her husband attended. A few months later, the plaintiff sued her husband for divorce. She also asked the court to award her custody of the couple’s four minor children. In response, the husband submitted affidavits in support of his claim to the custody of his children. These affidavits were prepared by the two rabbis, and they disclosed some of the confidential information that the plaintiff had shared with them during the counseling sessions.
The affidavit of one of the rabbis stated:
[The plaintiff] admitted to me that she stopped engaging in our religious purification laws since September 1995 and hence, all sexual activity has stopped by her own decision. [She also] admitted to me that she was seeing a man in a social setting and admitted, “I am doing the wrong things.” I spoke to her and counseled her against this.
The affidavit of the second rabbi stated:
[The plaintiff] admitted to me that she freely stopped her religious bathing so that she did not have to engage in any sexual relations with [her husband]. She told me she was not getting fulfillment. When I inquired what that meant, she simply answered, he doesn’t relate to me. Nothing was stated that amounted to cruel conduct by [the husband]. Her religious behavior has changed. She does not want to adhere to Jewish law despite the fact that she is an Orthodox Jew and her children are being raised Orthodox as well. She has engaged in bizarre behavior. I have no loyalty to either party except to state what I observed and to issue an opinion based on those observations from a religious point of view.
Based on these affidavits, the plaintiff sued both rabbis, claiming that they violated the clergy-penitent privilege and committed intentional infliction of emotional distress. She also sued one of the rabbis who submitted the second affidavit for defamation. The plaintiff claimed that the rabbis should be found legally liable and pay money damages for disclosing privileged and sensitive communications they had received from her.
The rabbis insisted that they were compelled by Jewish law to reveal the confidences to plaintiff’s husband, his attorney, and the court for the protection of both the husband and the children. Additionally, one of the rabbis asserted that the plaintiff was not seeking spiritual counseling or advice when she met with him, and both rabbis insisted that a third person was present when they met with her. One of the rabbis alleged that the plaintiff described “the most intimate details of her marriage” when he met with her in the presence of her friend, which surprised him. The other rabbi alleged that the husband had informed him that he and his wife were having marital problems, that she was deviating from Orthodox tradition, and that she was in “adulterous relationships.” Weeks later, the plaintiff and her mother appeared at his office and berated him for speaking to the plaintiff’s husband. In the course of the heated exchange, plaintiff admitted “she had stopped engaging in religious purification laws” and was “seeing men in social settings even though she was still married to [her husband].”
Both rabbis admitted notifying the husband and claimed that, in doing so, they were acting in accordance with their obligation as rabbis and spiritual advisers and, further, that this was to protect the four “innocent” children of the marriage.
The rabbis claimed that the plaintiff’s request for damages because of the alleged violation of the clergy-penitent privilege must be dismissed since no private cause of action existed for violating the privilege. They claimed that breach of the privilege is merely a violation of a rule of evidence, and that the sole remedy is the exclusion of the communication from evidence.
The Court’s Ruling
the clergy-penitent privilege imposes a fiduciary duty of confidentiality
The plaintiff’s primary claim was that the clergy-penitent privilege imposes a “fiduciary duty of confidentiality” upon clergy, and that this duty is breached when clergy disclose, without authorization, information that is shared with them in the course of a privileged conversation.
The court began its opinion by acknowledging that New York courts have allowed physicians to be sued for breaching the physician-patient privilege, and attorneys for violating the attorney-client privilege. The plaintiff conceded that no court in New York, or in any other state, had ever ruled that a member of the clergy can be sued for violating the clergy-penitent privilege. She insisted, however, that if physicians and attorneys can be sued for disclosing privileged information, then clergy should be held to the same standard. She pointed to the “care and diligence by most responsible members of the clergy in safeguarding confidences” as the reason the issue had never arisen.
The rabbis insisted that holding clergy personally liable for disclosing information shared with them in a communication protected by the clergy-penitent privilege would “impinge upon the free exercise of their religious rights, preserved by the first amendment.” The court agreed that
the imposition of liability … for conduct or activities of a religious society or its members, in furtherance of religious beliefs, is barred where the imposition of liability would result in the abridgement of the free exercise of religion, in violation of the first amendment. The same holds true where the court would be required to become excessively entangled with religious doctrine and its standards. In such instances, it has been recognized that a court must refrain from determining ecclesiastical questions.
However, the court continued:
[W]hile the first amendment does prohibit the intrusion upon the exercise of religious beliefs, the conduct of a religious entity remains subject to regulation for the protection of society. This is especially so where the imposition of liability or sanctions for the conduct complained of is secular in nature, namely, where liability is imposed equally, for religious institutions and parties, as well as for others, and where the basis for such liability may be determined without examination into religious law or policies. Thus, the free exercise clause is not an absolute defense where, as here, liability for tortious conduct is sought to be imposed upon members of the clergy. It may only serve as a defense where the alleged tortious conduct was undertaken pursuant to religious principles or doctrine.
Even where the conduct is predicated upon religious beliefs, it may nevertheless form the basis for liability where significant societal interests are involved. Thus, it has been held that the intentional torts of the clergy may be actionable, notwithstanding the allegation that they are incidents of religious beliefs. Other courts have sustained causes of action against religious organizations for negligent supervision and retention, upon the ground that a liability determination would not require examination of any religious doctrine, nor would it inhibit any religious practice. In such instances, the first amendment will not serve as a defense because it is not implicated.
Based upon the foregoing legal principles, in determining whether the first amendment is a viable defense, the threshold inquiry must be whether the complained of conduct is actually motivated by or involves religious practices or beliefs. If it is not, liability may be imposed without raising any constitutional inhibition or restriction. In such case, plainly, there is no entanglement with religion.
The court concluded that both rabbis could be sued for breach of the fiduciary duty of confidentiality on the basis of disclosing confidential information that was communicated to them in the course of a conversation protected by the clergy-penitent privilege. The court noted that “absent any religious or first amendment implication, there is no compelling reason here to shield these Rabbis from liability in tort for revealing such sensitive, personal communications, when other similarly situated professionals are subject to potential liability under statutory provisions analogous in scope and purpose to that at issue here.”
The court concluded,
It is beyond peradventure that, when one seeks the solace and spiritual advice and guidance of a member of the clergy, whether it be a priest, rabbi or minister, on such sensitive, personal matters as those involved in our case, this is not done as a prelude to an announcement from the pulpit. On this record, it is equally clear that these protectors of the faith, under the guise of religious necessity, the protection of the children and the sanctity of the marital institution, have taken upon themselves the disclosure to others of what, from its very nature and subject, was imparted in confidence, unless the privilege was waived by the presence of some third party or, from the nature of the meeting, the disclosure and communication was not made to the rabbis in their spiritual capacity. And, not only were disclosures made to [the husband], both [rabbis] readily acceded to his request that they be repeated to counsel and to the court in the matrimonial action, so as to influence the issue of temporary custody and/or visitation.
In my view, this was not only improper, it was outrageous and most offensive, especially considering the stature of [the rabbis] within the community, a standard which they readily abdicated here. From what was done, it is palpably clear why this determination is one of apparent first impression-no member of the clergy … would dare breach the sanctity of his or her office to make public the type of confidential, private disclosures at issue in this case. And, while both profess that religious law “compelled” disclosure, to the contrary, both were bound by civil law, which mandated strict confidentiality. After all, the privilege belongs to the penitent, not the clergy, and must be honored.
Moreover, to violate such basic rights under the guise of religious necessity, conviction or the protection of the Torah is not only wrong, it is outrageous. Under the factual scenario admitted by these [two rabbis], disclosure was not required to prevent [the husband] from violating Jewish law or tradition. Both [rabbis] knew that the couple was experiencing marital difficulties when they were told that plaintiff was no longer going to the Mikvah, the ritual bathing to purify the woman during her menstrual period. Clearly, this is a peculiarly sensitive matter, not readily discussed with others, nor in open, public exchanges. Notwithstanding that future marital relations would cause [the husband] to violate Jewish law, neither [rabbi] had a “religious obligation as a rabbi” to make public what had been imparted to them. In lieu of such, all that they had to do was ask the husband whether, notwithstanding their marital difficulties, the parties were still having normal relations. If so or, in the alternative, without such an inquiry, [they] could have emphasized to the husband the importance of ensuring that his wife was still going to the Mikvah. This, however, was not done. Moreover, as is apparent from [one rabbi’s affidavit] the disclosure was palpably unrelated to any religious doctrine, since what had been told to [him] was that “plaintiff admitted that she had stopped engaging in religious purification laws (which resulted in the cessation of all sexual activity with her husband).” Thus, since he had been told there was no sexual relationship, there was no need for disclosure, especially under the pretext of preventing any violation of religious doctrine, unless this was to serve some other male, Orthodox, but equally irrelevant role.
Notwithstanding the foregoing, disclosure in this case hardly equates with the overwhelming public and societal interest in preserving the sanctity of such confidential communications. Plainly, there is no justification, religious or otherwise, for disclosing that plaintiff had been seeing men outside the marriage. The alleged negative impact upon the four children, in terms of “their level of religious observance as well as their general well being” is so general that, in terms of importance, it cannot possibly measure against the overriding state and public interest in preserving confidentiality. The same holds true with respect to the alleged “religious obligation” to prevent the husband from having relations with a woman “who admittedly socialized with other men” or, in terms of the children, “to shield them from their mother’s improper conduct.” To acknowledge such would improperly and unwisely create a standard for these defendants, as Orthodox rabbis, different from that followed by the rest of society.
Did the clergy-penitent privilege apply in this case?
The court then addressed the rabbis’ defense that their conversations with the plaintiff were not subject to the clergy-penitent privilege, and so no fiduciary duty of confidentiality arose. In particular, they asserted that a third person was present during their conversations with the plaintiff, and one rabbi insisted that he had not been sought out by the plaintiff in his capacity as a spiritual adviser.
The court conceded that the fiduciary duty of confidentiality only arises in the course of communications that are subject to the clergy-penitent privilege, and therefore such a duty would not exist if the plaintiff’s statements to the rabbis were made in the presence of a third person or if the plaintiff did not consult with the rabbis as spiritual advisers. However, the court concluded that it lacked sufficient information to resolve these issues, and decided to let a jury decide whether or not the privilege applied to the plaintiff’s conversations with each rabbi.
infliction of emotional distress
The plaintiff claimed that the rabbis’ unauthorized disclosure of information she had shared with them in confidence amounted to an intentional infliction of emotional distress for which she was entitled to money damages. The court noted that
to state a cause of action for intentional infliction of emotional distress, the conduct complained of must be so outrageous in character, and so extreme in degree, as to go beyond all possible bounds of decency, and to be regarded as atrocious, and utterly intolerable in a civilized community. The conduct must be of such a nature that it so transcends the bounds of decency as to be regarded as atrocious and intolerable in a civilized society. More must be involved than hurt feelings; mere insults, indignities, threats or annoyances are insufficient. Intent or recklessness is an essential element of the cause of action.
The plaintiff insisted that the disclosure of privileged communications made to a rabbi by a penitent, done with malicious intent, meets this standard. The court agreed:
Bearing in mind the sanctity to be accorded such communications between clergy and penitent, and the necessity for confidentiality in conjunction with such spiritual counseling, without the fear of any reprisal or disclosure, it is both outrageous and intolerable that such communications would be revealed, even where, as here, this occurs in part in the context of a judicial proceeding. In my view, the conduct so transcends the bounds of decency as to be regarded as both intolerable and atrocious … .
The court cautioned that the plaintiff would have to persuade a jury that the rabbis’ acts were intentional or reckless.
Defamation
The plaintiff claimed that some of the statements contained in one of the rabbi’s affidavits were defamatory. The court rejected this claim, noting that “a written statement in the course of a judicial proceeding is absolutely privileged if, by any view or under any circumstances, it may be considered pertinent to the litigation.” The court concluded,
Clearly, the statements were pertinent to the litigation in that they were intended to reflect upon plaintiff’s fitness to be a good mother. Plaintiff claims that the statements fall without the scope of the privilege, since they must have been discussed and, therefore, published to her husband and his attorney prior to their having been reduced to writing for submission on the motion. She contends that this publication is not subject to any privilege. However, it is patently clear from the complaint that the statements, whenever published, were made in connection with the above action for divorce. The absolute privilege is not limited to statements made or documents used in open court. Thus, the statements are absolutely privileged since made for the purpose of litigation and may not be the subject of a claim for defamation.
Significance of the case to clergy
What is the significance of this case to clergy? A decision by a New York court has limited effect. It is not binding in any other state, and it is subject to reversal by the New York Court of Appeals (the highest state court in New York). Nevertheless, the case represents one of the few extended discussions of clergy liability for divulging confidences. As a result, it may be given special consideration by other courts. For these reasons the case merits serious study by clergy in every state. With these factors in mind, consider the following:
1. The fiduciary duty of confidentiality. By far the most significant aspect of the court’s decision was its conclusion that a “fiduciary duty of confidentiality” arises whenever confidential information is shared with a minister in a conversation that is protected by the clergy-penitent privilege. Ministers can be sued if they breach this duty by disclosing confidential information without authorization.
2. The fiduciary duty arises only in the context of privileged communications. The court ruled that the fiduciary duty of confidentiality arises only in the context of a communication that is protected by the clergy-penitent privilege. Every state recognizes this privilege, although the definition varies slightly from state to state. The clergy-penitent privilege in New York simply states that “unless the person confessing or confiding waives the privilege, a clergyman, or other minister of any religion or duly accredited Christian Science practitioner, shall not be allowed to disclose a confession or confidence made to him in his professional character as spiritual adviser.” As in most other states, the clergy-penitent privilege in New York only applies to (1) communications; (2) made in confidence; (3) to a minister; (4) acting in a professional capacity as a spiritual adviser. Communications meeting these requirements are protected by the clergy-penitent privilege, and they give rise to a fiduciary duty of confidentiality.
Example. G, a married man, seeks out his pastor for counseling and confesses to adultery. The conversation between G and the minister was protected by the clergy-penitent privilege. The minister later discloses this information to the church board. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. The minister also may be liable for intentional infliction of emotional distress.
Example. Same facts as the previous example, except that G was accompanied by a friend while meeting with the minister. In some states, the presence of a third person during a conversation with a minister will prevent the conversation from being privileged since it is not “confidential.” In such a state (assuming that it follows the decision of the New York court addressed in this article) the minister would not liable for breaching a fiduciary duty of confidentiality, since this duty only arises in the context of a conversation protected by the clergy-penitent privilege.
Example. A church adopts a policy prohibiting its minister from engaging in opposite sex counseling without a third person being present. During an opposite sex counseling session in which a third person is present, a counselee discloses highly confidential information which the minister later shares with the church board. In many states, the clergy-penitent privilege is not destroyed by the presence of a third person so long as that person is present “in furtherance of the communication.” A strong case can be made that the third person in this example is present “in furtherance of the communication.” As a result, if the state clergy-penitent privilege applies even if such a third person is present during the conversation between the minister and counselee, then the minister may be liable for breaching the duty of confidentiality in New York or in any other state that follows the decision of the New York court addressed in this article.
Example. A church member sees her minister at a high school soccer game. The two engage in a conversation at the end of the game while waiting to see some of the players. There are several people nearby. It is likely that a court would conclude that this conversation was not privileged since it was not “confidential” and the context of the conversation suggests that the member was not seeking out her minister in his professional capacity as a spiritual adviser. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister would not be personally liable for breaching a duty of confidentiality by disclosing confidential information shared with him by the member during their brief conversation, assuming that a court would conclude that the conversation was not privileged.
Example. A minister counsels with J, a church member. J informs the minister that he committed an unsolved crime. The minister shares this information with the police. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. The minister also may be liable for intentional infliction of emotional distress.
Example. A minister counsels with K, a church member. K informs the minister that her husband sexually molested their 6-year-old daughter. The minister is a mandatory child abuse reporter under state law, and so he promptly shares this information with the police. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. However, the New York court did not address the question raised by this example-whether or not a mandatory duty to report child abuse prevents liability based on a breach of a duty of confidentiality.
Example. Same facts as the previous example, except that the minister is a “permissive” rather than a mandatory child abuse reporter under state law. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. However, the New York court did not address the question raised by this example-whether or not a non-mandatory duty to report child abuse prevents liability based on a breach of a duty of confidentiality. It is less likely that a non-mandatory duty to report child abuse would prevent a minister from being found personally liable for breaching the fiduciary duty of confidentiality.
Example. A minister counsels with C, a church member. C informs the minister that he molested a child during a youth activity sponsored by the church. The minister promptly shares this information with the police. A state law makes ministers mandatory reporters of child abuse, except when they learn of abuse in the course of a conversation protected by the clergy-penitent privilege. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. However, the New York court did not address the question raised by this example-whether ministers who are mandatory reporters of child abuse, except when they learn of abuse in the course of a privileged communication, may be personally liable for breaching a fiduciary duty of confidentiality when they elect to share with the police or civil authorities information concerning child abuse that they learned in the course of a privileged conversation. It is possible that the New York court would find the minister liable for breaching the fiduciary duty of confidentiality under these circumstances, since the disclosure is not required by law.
3. The importance of being familiar with the clergy-penitent privilege in your state. The examples presented above demonstrate the importance of ministers being familiar with their own state’s clergy-penitent privilege.
4. Other precedent. The court concluded that this was only the second case in any state to address directly the liability of a minister for disclosing confidential information communicated in the course of a privileged conversation. The other case was a 1989 decision by a California appeals court. This decision, along with one other case cited by the New York court, are summarized below.
A bishop confessed to two denominational leaders that he was involved in an extramarital affair with a church member. The bishop asked the denominational leaders to keep his confession in confidence, and they promised to do so. A short time later, the female church member who was the other party to the affair confessed to a denominational leader, who promised to keep her confession in confidence. The denominational leaders allegedly disclosed these confidences to the local church’s board of elders, and to numerous other persons. One of the denominational leaders allegedly disclosed the confidences to the assembled congregation in a Sunday worship service, and then proceeded to “excommunicate” the bishop and “cast his spirit” from the church. The bishop also alleged that one of the denominational leaders disclosed his confession to a “gathering of local priests, ministers, pastors, and guests.”
As a result of these disclosures, the bishop and the female church member were shunned by friends, family, and members of their local church and denomination. The two sued the denomination and various officials, alleging invasion of privacy, breach of fiduciary duty, false imprisonment, emotional distress, and malpractice. The denomination countered by arguing that the civil courts lacked jurisdiction over the controversy since “the conduct complained of is ecclesiastical in nature.”
A trial court agreed with the church’s position, and dismissed most of the claims. On appeal, a state appeals court ruled that the church could be sued for emotional distress and related claims, and it ordered the case to proceed to trial. The court began its opinion by noting that “religious disputes can take a number of forms … and do not always result in immunity from liability.” The court acknowledged that the civil courts may not intervene in disputes over church doctrine, but it was not willing to accept the trial court’s summary conclusion that this dispute involved church doctrine. It observed,
The trial court was not told, and we do not know, whether it is a canon of [the church’s] belief that confessions (penitential or not) are revealed to the congregation … whether it is church practice for the substance of a confession to be shared among church officials; or whether it is consistent with church doctrine to reveal the substance of a confession to anyone outside the church, and if so, under what circumstances.
The court recognized that any government action that burdens a religious practice, such as allowing a minister to be sued for disclosing confidential information, involves substantial constitutional considerations. It cautioned that various factors must be taken into account, including whether the religious practice is rooted in church doctrine, and whether a government interest outweighs any burden on religion.
The court applied a four-part balancing test to determine whether the government can interfere with religious practices: (1) the government action limiting a religious practice must be in furtherance of some compelling government interest; (2) the burden on religious practice must be essential to further the government’s interest; (3) the type and level of the burden must be the minimum necessary to achieve the government interest; and (4) the burden must apply to everyone, not merely to those who have a religious belief.
In applying this four-part test, the court concluded that even if church doctrine required the disclosure of confidences, this would not end the analysis, since certain types of behavior may be regulated or subjected to legal liability by state law even if rooted in religious doctrine-so long as the state has a compelling interest that justifies the burden on religious conduct, the burden on religious practice is essential to the government interest, and the burden is the least restrictive means of achieving the government interest. The court noted that “under the banner of the first amendment provisions on religion, a clergyman may not with impunity defame a person, intentionally inflict serious emotional harm on a parishioner, or commit other torts.” In other words, the first amendment guaranty of religious freedom does not necessarily insulate clergy from liability for their actions.
The court acknowledged that “apparently there are no generally reported opinions where a counselee or communicant has sought to hold a religious officer liable in tort for [an unauthorized disclosure of confidential communications].” However, it saw no reason why clergy and church leaders should not be held legally accountable for injuries they inflict when they disclose confidential information to others without consent.
Alexander v. Culp, 705 N.E.2d 378 (Ohio App. 1993)
A church member (the “plaintiff”) met with his pastor for marital counseling. He confessed to having been involved in several affairs during his marriage, and that he was currently having an affair. The minister later disclosed these confessions to plaintiff’s wife and, after noting that the plaintiff was a liar and not to be trusted, suggested that the wife obtain a restraining order, change the locks on the doors, and retain counsel to secure a divorce. Since the plaintiff also stated he intended to take the children to another state, the minister suggested that she keep them away from their father. The court allowed the plaintiff to sue his pastor for negligence. It observed:
Public policy supports an action for breach of confidentiality by a minister. There is a public policy in favor of encouraging a person to seek religious counseling. People expect their disclosures to clergy members to be kept confidential… . Whether a particular case interferes with first amendment freedoms can be determined on a case by case basis.
Although Ohio had a statute which prohibited clergy from testifying as to confidences communicated during religious counseling, the provision had no application to any disclosure outside any legal proceeding. In holding that the facts set forth a claim for ordinary negligence, not malpractice, the Ohio court observed, “Although the duty not to disclose arose from the clergy/parishioner relationship, the breach of the duty to preserve [the plaintiff’s] confidences neither involved nor compromised any religious tenets.”
5. How clergy can respond. There are a number of steps that ministers can take to reduce the risk of liability based on unauthorized disclosures of confidential information. Consider the following:
Familiarity with your state’s clergy-penitent privilege. Be familiar with the provisions of the clergy-penitent privilege in your state. Remember, according to the New York court, liability based on a breach of the fiduciary duty of confidentiality is based on the clergy-penitent privilege. In most states, the clergy-penitent privilege will apply to any communication made to a minister, in confidence, while acting in a professional capacity as a spiritual adviser. Unfortunately, it is not always easy to determine if a particular conversation is privileged. Consider the following circumstances:
It is not always easy to determine if a person sought out a minister in his or her professional capacity as a spiritual adviser. The location of a conversation will be relevant, though not determinative, in resolving this question.
Sometimes a counselee will share confidential information with a minister, and later disclose the same information to other persons. What effect do these subsequent disclosures by the counselee have on the privileged nature of the previous conversation with the minister? Does the previous conversation cease to be privileged, because it is no longer “confidential”?
Does the clergy-penitent privilege apply to child abuse reporting? To illustrate, if a church member confesses to a minister that he has molested his minor child, is this communication privileged? What if the applicable state child abuse reporting law makes clergy mandatory child abuse reporters? What if clergy are not mandatory child abuse reporters? What if the child abuse reporting law specifies that ministers are not required to report child abuse that they learn of in the course of a privileged conversation?
The New York court’s decision addressed in this article presents clergy who are “mandatory” child abuse reporters under state law with a difficult dilemma: they may be criminally liable for not reporting known or reasonably suspected incidents of child abuse, and yet they may be liable for breaching a fiduciary duty of confidentiality if they do not report it. The New York court did not address this dilemma. It is possible, though not certain, that it would have concluded that ministers who are mandatory child abuse reporters under state law cannot be liable for breaching a fiduciary duty of confidentiality by complying with their legal duty to report child abuse, even if they learn of the abuse in the course of a privileged conversation. On the other hand, this conclusion is less certain in the case of ministers (1) who are permissive as opposed to mandatory child abuse reporters under state law, or (2) who are mandatory reporters in a state that excuses them from reporting child abuse they discover in the course of a conversation that is protected by the clergy-penitent privilege.
Does the clergy-penitent privilege apply when third persons are present? In some states, communications made to a minister in the presence of one or more “third persons” are not “confidential” and as a result are not privileged. In other states, the presence of a third person will not prevent a communication from being privileged, so long as the third person’s presence is “in furtherance of the communication.” Again, it is essential for ministers to be familiar with their state’s clergy-penitent privilege.
Tip. If the presence of a third person prevents a conversation with a minister from being privileged in your state, then you may want to consider having a third person present in some situations to reduce the risk of liability based on a breach of the fiduciary duty of confidentiality.
Resist the urge to disclose confidential information. In some cases, a minister’s disclosure of confidences is inadvertent, such as a spontaneous sermon illustration. In others, it is deliberate, such as a disclosure of confidential information to the church board. Ministers must realize that disclosing confidences may expose them to personal liability.
Obtain authorization in writing. In some cases, ministers may believe that they have a legitimate reason to disclose confidences. Consider the following examples: (1) A minister feels compelled to report child abuse; (2) a minister feels obligated to share a counselee’s personal failings with the church board because they disqualify the counselee from membership according to the church’s bylaws; or (3) a counselee informs a minister that he intends to kill or injure another person. Ministers can reduce the risk of liability in such cases by obtaining written consent from the counselee prior to disclosing the confidential information. One way to do this would be develop a written “counseling policy” that counselees must read and sign as a condition to any counseling relationship with a minister. The policy could state that counseling is provided subject to a number of conditions, including the consent of the counselee to the minister making disclosures under specified circumstances (in the case of child abuse, departures from the church’s standard of membership, threats to injure or kill others, etc.). Any such policy should be prepared or reviewed by an attorney.
6. Education. The case discussed in this article addresses a question of fundamental importance to ministers. Denominational offices and seminaries should be educating ministers and students preparing for ministry about the clergy-penitent privilege and the potential personal liability of ministers for disclosing confidences without consent.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
On October 1, 1999, the Social Security Administration (SSA) launched the largest customized mailing ever undertaken by a federal agency when it began mailing an annual Social Security statement to 125 million workers. The 4-page statement is designed to help workers with financial planning by providing estimates of their retirement, disability and survivors’ benefits. The statement will also provide workers an easy way to determine whether their earnings are accurately posted on their Social Security records. This is an important feature because Social Security benefits are based on an individual’s career wage record—not on taxes actually paid.
Here are some points for church treasurers to note:
The SSA will send the annual statements to workers who are ages 25 and older and not receiving Social Security benefits. SSA will stagger the mailing of the statements throughout the year, with approximately 500,000 statements delivered each day. Workers will automatically receive their statements about three months before their birth month.
An annual statement will contain the following information: (1) an estimate of the monthly retirement benefit that the worker would receive at age 62, full retirement age, and age 70; (2) an estimate of the amount of monthly disability benefits the worker would be entitled to receive if he or she became disabled; (3) an estimate of the monthly benefits the worker’s family would receive in the event of the worker’s death; (4) an annual breakdown of the worker’s earnings to date; and (4) a total of the Social Security taxes paid by the worker and his or her employer over the individual’s working career.
The SSA recently redesigned the statement to make it more user-friendly. For example, the language was simplified, the number of pages was reduced from six to four, and the redesigned statement was tested with focus groups and through a mail survey of 16,000 workers.
Church treasurers should inform compensated staff members that they will receive their annual statement within three months prior to their birthday, and encourage them to check the accuracy of the “earnings” and “taxes paid” sections of the statement.
Key point. Each annual statement will report a worker’s lifetime earnings on an annual basis, along with total Social Security taxes paid each year by the worker and his or her employer. It is important for church workers to check the accuracy of the earnings reported on their statement, since this will determine the amount of Social Security benefits they will receive in the future. Workers who can prove that the earnings information reported on their statement is incorrect should contact their local Social Security office for assistance in correcting the record.
Key point. It is especially important for ministers to check their statements carefully, because their earnings history is vulnerable to error for two reasons. First, many ministers who report their income taxes as employees erroneously report their social security taxes as employees (the church withholds FICA taxes from their wages like any nonminister church employee). In fact, ministers always are self-employed for social security with regard to the exercise of their ministry. Some ministers who report their social security taxes as employees have discovered errors in their earnings history, presumably because of their incorrect reporting status. Second, ministers who continue to work after beginning to receive social security retirement benefits are assumed by the SSA to be receiving twice their reported income. This is because such ministers will report income as wages on Form 1040 (line 7) and also as self-employment earnings on Schedule SE (Form 1040). SSA computers assume that amounts reported in these two places reflect different sources of income. While this is true for most workers, it is not true for ministers. Again, the reason is that their income must be reported as self-employment earnings on Schedule SE even though the same income is reported as employee wages on Form 1040. What appears to be “two” different sources of income in fact is only one. The result is that the minister appears to be earning more than the “annual earning test” (the amount that a retired person can earn between ages 62 and 70 without triggering a reduction in Social Security benefits). The bottom line is this—ministers should carefully review their yearly earnings history as reflected on their annual Social Security statement so they can correct errors.
Church treasurers should consider including a notice to church members in the weekly bulletin or church newsletter. Here is a sample notice: “SOCIAL SECURITY ANNUAL EARNINGS STATEMENT. Beginning on October 1, 1999, the Social Security Administration began mailing annual statements to workers 25 years of age and older. The 4-page statement will contain several items of information, including an estimate of the monthly benefit the worker will receive at retirement, and an annual breakdown of the worker’s earnings to date. Since your social security benefits will be based on your prior earnings, it is important to check your statement for accuracy. Any errors should be reported to the nearest Social Security office. You also can use the statement to determine if you need to increase annual contributions to your retirement plan.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Reimbursing Medical Expenses Without a Formal Plan
Background. It is common for churches to pay some or all of the medical expenses of their ministers or lay employees. This can include direct payment of expenses, reimbursing employees for expenses they have incurred, and paying a “deductible” amount on an employee’s medical insurance. The tax consequences of such payments and reimbursements are not well understood.
Section 105 of the tax code permits employees to exclude from gross income amounts received under an employer financed “accident and health plan” as payments for permanent injury or loss of bodily function, or as reimbursements of medical expenses. The payments can be made on behalf of a spouse or dependent of the employee. This exclusion assumes that the employer has established an “accident or health plan.” Unfortunately, the requirements for such a plan are not specified in the tax code. The regulations simply state that “an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness.” The regulations further specify that “an accident or health plan may be either insured or uninsured, and it is not necessary that the plan be in writing or that the employee’s rights to benefits under the plan be enforceable.” Of course, a written plan is preferable, since it generally will eliminate any doubt regarding the existence or date of a plan. The regulations do require that notice of a plan be “reasonably available” to employees (if employees’ rights under the plan are not enforceable).
Employers may reimburse employee medical expenses under either a self insured plan (e.g., reimbursements are paid out of the employer’s own funds rather than through an insurance policy), or an insured plan. However, if reimbursements are made under a self insured plan, then nondiscrimination rules apply. Generally, these rules require that the plan not discriminate in favor of highly compensated individuals with regard to either amount of benefits or eligibility to participate. If a self-insured plan is discriminatory, then highly compensated individuals ordinarily must report some or all of the amount of the employer’s reimbursements as taxable income. If a reimbursement arrangement discriminates in favor of highly compensated individuals on the basis of the amount of benefits (e.g., highly compensated individuals receive a greater benefit than other participants in the plan), then such individuals must report the entire amount of the reimbursements as income. More complicated rules determine how to compute the taxable portion of an employer’s reimbursements if the plan discriminates on the basis of participation (rather than the amount of benefits). In general, a plan discriminates in favor of highly compensated individuals on the basis of eligibility to participate unless the plan benefits 70 percent or more of all employees. Some employees can be disregarded in applying this test, including those who have not completed 3 years of service, or who have not attained age 25, or part time or seasonal employees, if they are not participants in the employer’s plan.
Key point. Who are highly compensated individuals? For churches, they include (1) one of the 5 highest paid officers, or (2) those employees among the highest paid 25 percent of all employees (some employees are not considered, including those who have not completed 3 years of service, or who have not attained age 25, or part time or seasonal employees—and who are not participants in the employer’s plan).
The regulations specify that “benefits paid to participants who are not highly compensated individuals may be excluded from gross income … even if the plan is discriminatory.” The fact that highly compensated employees must report some or all of their reimbursements as income does not affect the ability of non highly compensated employees to fully exclude employer reimbursements.
A recently published internal IRS policy provides church treasurers with some helpful guidance on these rules.
The IRS ruling. The IRS policy addresses this question: “Are employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan excludable from gross income by the employee under section 105(b) of the Internal Revenue Code?” The IRS policy concludes that “employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan are not excludable from gross income by the employee.”
The IRS noted that employers often adopt self-insured accident and health plans to cover medical expenses incurred prior to the date of the adoption of the plan but within the same taxable year. This is done in an attempt to allow employees to exclude these medical expense reimbursements from income.
Example 1. A church employee experiences a severe illness. The church board agrees to pay the $2,500 “deductible” on the employee’s health insurance policy. The board assumes that this amount is nontaxable because it was motivated by charity. Several weeks later, the board learns that the payment is nontaxable only if the church had a formal accident and health “plan” in place. The board hastily drafts a few paragraphs describing its “plan,” and inserts the text in the minutes of a board meeting.
The IRS noted that
The basic tenet of income taxation is that unless wages, benefits or other income fall within an explicit exclusion to the Internal Revenue Code’s definition of gross income, they are included within that term. Exclusions and exemptions from income are matters of legislative grace and are construed narrowly …. [Code section] 105(b) states that gross income does not include amounts paid, directly or indirectly, to the employee to reimburse the employee for expenses incurred by him, his spouse or dependents for medical care …. However, section 105(b) does not apply unless the medical expense reimbursements are received under an accident or health plan.
The IRS pointed out that the income tax regulations define a “plan” as “an arrangement for the payment of amounts to employees in the event of personal injuries or sickness.” The IRS conceded that a plan “need not be enforceable and need not be in writing.” However, in order for there to be a plan, the employer “must be committed to certain rules and regulations governing payment. These rules must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.”
The IRS concluded that “payments for reimbursement of medical expenses incurred prior to the adoption of a plan are not paid or received under an accident or health plan for employees. Thus, these amounts are includible in the employee’s gross income … and are not excludable under section 105(b) of the Code.”
Relevance to church treasurers. The relevance of the IRS policy to church treasurers is clear. church leaders often distribute funds to ministers and lay employees to cover medical expenses without any serious consideration of the tax consequences. In most cases, they simply assume that these payments are nontaxable. The IRS policy addressed in this article suggests that such an assumption may be erroneous and lead to needless tax complications. In many cases a church not only is required to report the payments or reimbursements as taxable income and add them to the employee’s W-2, but the employee will need to report them on his or her tax return and pay taxes on them. All of this can be avoided, the IRS concluded, if the church simply adopted an adequate “plan” in advance of making the medical payments.
Key point. The tax code and regulations do not define a “plan.” The IRS policy simply states that an employer “must be committed to certain rules and regulations governing payment,” and that these rules “must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.” While a plan need not be in writing, it certainly will be desirable for a church to set forth a plan in writing to eliminate any question regarding when it when it was adopted.
Key point. A plan may not operate retroactively. A church cannot reimburse an employee’s medical expenses, and later attempt to insulate these payments from tax by belatedly adopting a medical payment plan.
Let’s illustrate these important rules with some practical examples.
Example 2. Rev. M is a minister at First Church. He undergoes major surgery and incurs $10,000 of expenses that are not covered under any insurance policy. The church board decides to reimburse Rev. M for the full amount of $10,000. The church has no formal plan of reimbursing any employee’s medical expenses. Several weeks after making the $10,000 reimbursement, the church treasurer learns that the reimbursement will represent taxable income to Rev. M unless it was made pursuant to an “accident and health plan.” The church board quickly adopts a written plan. The board’s action is too late to avoid reporting the $10,000 reimbursement as taxable income to Rev. M under section 105 of the tax code.
Example 3. Same facts as example 2, except that the church board decides that their previous decision to reimburse the pastor’s medical expenses constituted an accident and health “plan.” They rely on the fact that such a plan need not be in writing. It is likely that the board’s argument will fail. According to the IRS internal policy, an employer “must be committed to certain rules and regulations governing payment,” and these rules “must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.” It is very unlikely that the IRS would consider the mere act of reimbursing the pastor’s medical expenses to constitute a “plan.” If the church’s argument were accepted, it would render the plan requirement meaningless, since any employer’s payment or reimbursement of medical expenses would automatically constitute a plan.
Example 4. Same facts as example 2, except that the church treasurer learned of the “plan” requirement a few weeks before the reimbursement was made. Prior to making the reimbursement, the church board adopted a “plan” that stated: “Resolved, that the church will pay the unreimbursed medical expenses of the pastor.” It is possible that this action will not constitute a valid plan. According to the IRS internal policy, an employer “must be committed to certain rules and regulations governing payment,” and these rules “must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.” Does the one-sentence resolution by the church board satisfy this test? Unfortunately, the answer is not clear. The church could have eliminated any doubt by providing more detail in the resolution.
Example 5. Same facts as example 2. The church treasurer realizes by now that the $10,000 reimbursement cannot be excluded from the pastor’s income as a payment under an accident and health plan under section 105 of the tax code. The church treasurer is wondering if the amount can be excluded from the pastor’s income as a charitable or benevolent distribution from the church. This is a possibility, depending on the circumstances. Churches certainly are free to make distributions to the poor and needy, since such distributions further a church’s religious and charitable purposes. However, when churches make distributions to one of their own employees (such as the pastor in this example), it is less likely that the distribution will be viewed by the IRS or the courts as serving the church’s religious and charitable purposes. This is so for the following two reasons: (1) Whenever an employee is the recipient of a church distribution, the immediate assumption is that the distribution represents additional taxable compensation for services rendered. (2) The income tax regulations define “charitable” quite narrowly. The term includes the “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).” It is unlikely, though not impossible, that the church’s reimbursement of the pastor’s medical bills would be deemed a “charitable” distribution under this definition.
Example 6. Same facts as example 2, except that the church board adopted a plan several months before reimbursing the pastor’s medical bills that spelled out the church’s commitment to paying the senior pastor’s medical bills not covered under any available insurance coverage. The plan did not provide for the payment of any other employee’s medical bills. Assuming that the board’s action qualifies as an accident and health “plan,” it will not prevent the $10,000 reimbursement from being treated as taxable income to Rev. M. Why? Since the church’s plan is self-insured (the pastor’s medical expenses will be paid out of the church’s general fund), the $10,000 is excludable from Rev. M’s income only to the extent that the church’s plan is not discriminatory. If Rev. M is one of the 5 highest paid officers, or is among the highest paid 25 percent of all employees, he may not exclude any of the $10,000 from his income for tax purposes if the same benefit is not available to non highly compensated individuals.
Example 7. First Church provides health insurance for Rev. G, who reports his income taxes as an employee. In order to reduce the cost of the insurance, the church elects a $1,000 deductible (e.g., the insurance pays for any expense only to the extent that it exceeds $1,000). The church established a “medical fund” for Rev. G in order to reimburse all of his medical expenses that are less than $1,000 (and not covered by insurance). The church does not provide health insurance, or a “medical fund,” for any other employee. The church’s “medical plan” is self insured and discriminatory (in favor of Rev. G, a highly compensated individual), and accordingly all of Rev. G’s medical expenses reimbursed by the church represent taxable income and must be included on his W 2 and Form 1040 (as wages). However, the health insurance premiums paid by the church are not taxable to Rev. G.
Payment of Employee Medical Expenses
Here are some important points to consider before paying some or all of an employee’s medical expenses:
Do you want the payments to be nontaxable? There are only two ways for this to occur: (1) The payments satisfy the IRS definition of “charitable.” This definition is quoted in the article. Note that this is a narrow definition, especially in the context of employees. (2) The payments are made pursuant to an accident and health plan.
If you are considering the adoption of an accident and health plan, note the payments made under the plan will be nontaxable only if they meet the following conditions: (1) an adequate plan is established prior to the payment or reimbursement of medical expenses, and (2) the plan does not discriminate in favor of “highly compensated individuals” as defined in this article.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. A church wants to help its pastor purchase a new home, and so it agrees to pay $50,000 of the purchase price. The pastor signs a promissory note agreeing to pay back the $50,000 in ten annual installments. The church board assures the pastor that the church will “forgive” each annual installment on the date it is due, and so the pastor will not have to pay back anything. Is this transaction legitimate? What are the tax consequences? Church treasurers need to understand the answer to these questions, since this kind of arrangement is common and often misunderstood.
An IRS memorandum. The IRS recently released an internal memorandum (a “field service advisory”) that addresses the tax consequences of debt forgiveness. Here are the facts of the arrangement the IRS was addressing. A widow and mother of three adult children owned a partial interest in farm land. She suffered a stroke and was later determined by a court to be incompetent. A guardian was appointed to handle her financial affairs. The guardian sold the farm land to the children in exchange for non-interest bearing promissory notes signed by each child. The sales agreement called upon each child to pay the guardian $10,000 annually. However, the agreement contained a “cancellation” provision specifying that the payments owed by the children each year would be “forgiven” by the guardian. The children and guardian recognized that these annual cancellations of debt constituted gifts, but they had no tax impact since they were not more than the annual gift tax exclusion of $10,000 for each child.
An IRS auditor determined that a completed gift had been made in the year the original sales agreement was signed, and not each year that the annual payments under the promissory notes were forgiven. As a result, the full amount of the notes represented a gift to the children in the year of the sale. Since these amounts were far more than $10,000, the children’s attempt to purchase their mother’s farm land without exceeding the annual gift tax exclusion failed.
The IRS national office was asked to evaluate this arrangement. Specifically, it was asked whether a gift to the children occurred when the property was transferred in exchange for the non-interest bearing notes. It also was asked to clarify its position “concerning taxpayers’ persistent use of the installment sale as an estate and gift tax avoidance technique.”
The IRS noted that the tax code imposes a “gift tax” on gifts, and that “the value of the property transferred, determined as of the date of the transfer, is the amount of the gift.” Further the code specifies that if property is transferred for less than full value “the amount by which the value of the property exceeds the value [received] shall be deemed a gift.”
The IRS observed:
If an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan. However, if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the donor will have made a gift only at the time of the forgiveness …. Transactions within a family group are subject to special scrutiny, and the presumption is that a transfer between family members is a gift.
Whether the transfer of property is a sale or a gift depends upon whether, as part of a prearranged or preconceived plan, the donor intended to forgive the notes that were received at the time of the transfer.
The IRS noted that the intent to forgive the notes was the determinative factor in this case, and that “a finding of a preconceived intent to forgive the notes relates to whether valuable consideration was received and thus to whether the transaction was in reality a bona fide sale or a disguised gift.”
The IRS pointed out that the children “did not execute separate notes” for each year, but rather “the indebtedness of each child … was represented by only one note.” The children insisted that their arrangement represented a valid installment sale. The IRS disagreed:
It is difficult to conceive of this exchange as an installment sale where the intent of the [children] to make a gift to themselves … is so clearly evident at the time of the [sale agreement]. The [children] have not come forward with evidence to show that the notes represented an obligation portions of which could be forgiven annually …. The [IRS auditor] in this case has appropriately treated this entire transaction as a sham …. It is axiomatic that questions of taxation are to be determined with regard to substance rather than form. An examination of the objective facts of this case, therefore, can only lead to the conclusion that the children are entitled to a gift tax exclusion for [one year] only.
The IRS national office conceded, in its internal memorandum, that “it is conceivable that a court would be inclined to treat this exchange as a bona fide transfer and strictly construe the relevant documents in accordance with their terms.” In other words, the children might persuade a court that the transaction was legitimate, and that they in fact made gifts each year in which the annual payments under the promissory notes were “forgiven.”
The IRS cautioned, however, that at a minimum the children had to prove “by some overt act” that the guardian had the “authority and discretion” to forgive the annual payments due under the promissory notes. It noted that an example of such an overt act “would be the cancellation by the [guardian] of a series of promissory notes on an annual basis.” The IRS concluded that such evidence was not present in this case. It acknowledged that the sales agreement contained a “cancellation” provision calling for the cancellation of the annual installment payments each year under the notes. However, the IRS concluded that “the conspicuous absence of any evidence of forgiveness in any of the subsequent years” effectively negated the legal effect of the cancellation provision. It observed:
The facts of this case clearly indicate that an intent to make a disguised gift for illusory consideration was formed at the time of the original transaction, and at no time subsequent …. In the absence of a showing that there was no prearranged or preconceived plan to forgive any indebtedness, a transfer of real property for non-interest bearing notes must be treated as a gift at the time of the original transfer. Further, the substance of a transaction must prevail over its form where an examination of the facts and circumstances of a transaction suggests that it lacks economic substance.
Relevance to church treasurers. There are important lessons for church treasurers to learn from the IRS memorandum. Consider the following:
No documentation
Many churches have advanced funds to a pastor to assist with the payment of a home. In some cases, there is no clear understanding as to the nature of the arrangement, and no documents are signed. It may not be until it is time for the church treasurer to issue the pastor a W-2 that the tax consequences of the transaction are addressed. If the amount advanced by the church is substantial, church leaders may attempt to characterize it as a “loan” to avoid reporting it as taxable compensation to the pastor. The IRS memorandum demonstrates that this may not be possible.
Example. A church wants to help its pastor buy a new home, and so it gives him $50,000 cash in September of 1999 to assist with the down payment. In January of year 2000, the church treasurer is preparing the pastor’s W-2 for 1999, and wonders whether to report the $50,000 as additional compensation. She presents this question to the church board, which is opposed to treating the full amount as taxable in 1999. They come up with the idea of treating the $50,000 as a tax-free gift. As a result, the treasurer reports no part of the $50,000 as additional compensation on the pastor’s W-2 for 1999 or any future year. This is incorrect. The $50,000 cannot be treated as a nontaxable “gift” to the pastor. See pages 111-114 in Richard Hammar’s 1999 church and Clergy Tax Guide for a full explanation.
Example. Same facts as the previous example, except that the pastor, treasurer, and board recognize that the $50,000 cannot be treated as a nontaxable gift. The board wants to minimize the tax impact to the pastor, and so it comes up with idea of treating the $50,000 as a non-interest bearing loan payable over ten years. They also agree informally to forgive each annual installment of $5,000. However, no documents are signed. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum addressed in this article suggests that the correct answer is (2). Why? The memorandum, which represents the thinking of the IRS national office, states that “if an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan.” Since such a “gift” must be treated as taxable compensation, the entire $50,000 represents taxable income in 1999.
Adequate documentation
The IRS memorandum makes it clear that the existence of adequate documentation may lead to a different result. Consider the following examples.
Example. A church wants to help its pastor buy a new home. The board agrees to loan $50,000 to the pastor in September of 1999 to assist with the down payment. It prepares a non-interest bearing ten-year promissory note in the amount of $50,000, which the pastor signs. The note is secured by a second mortgage on the pastor’s new home. The board minutes reflect the board’s intention that each annual payment ($5,000) will be forgiven when due. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum suggests that the correct answer is (2). The memorandum, which represents the thinking of the IRS national office, states that “if an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan.” The board minutes make it clear that there was a “prearranged” plan to forgive each year’s installment, and so the entire amount of the “loan” must be reported as income in the year of the transaction (1999).
Example. Same facts as the previous example, except there was no explicit understanding or agreement that the board would “forgive” each annual installment. Rather, the board left the question open. As a result, the board minutes contain no indication of any “prearranged” plan to forgive each annual installment. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum suggests that the correct answer is (1). The memorandum states that “if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the [church] will have made a gift only at the time of the forgiveness.” This means that income is realized by the pastor each year to the extent that the board decides to forgive the annual installment due under the promissory note. Of course, if the board forgives each annual installment in the year it is due, it becomes increasingly possible that the IRS might view the entire arrangement as “prearranged.” If so, the analysis of the previous example might apply.
Example. Same facts as the previous example, except that the church issues the pastor ten promissory notes for $5,000 each. The notes have “rolling” maturity dates, so that one note matures each year over the next ten years. The IRS memorandum suggests that this arrangement will have an even greater likelihood of avoiding the inclusion of the entire $50,000 amount as income on the pastor’s 1999 W-2. The IRS noted that to avoid treating the entire loan amount as a gift (or as income) in the year of the original transaction, the “borrower” must be able to prove “by some overt act” that the lender had the “authority and discretion” to forgive the annual payments due under the promissory note. It cited as an example of an “overt act” the cancellation by the lender of a series of promissory notes on an annual basis. Such acts, concluded the IRS, was evidence of “forgiveness in subsequent years.”
Key point. This article only addresses the tax consequences of a church’s “forgiveness” of a loan made to a pastor. It does not address the tax consequences of a church making a non-interest bearing loan to a pastor. That issue is addressed on page 122 of Richard Hammar’s 1999 church and Clergy Tax Guide.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Reimbursing Business Expenses Through Salary Reductions
Background. A securities firm employs investment consultants who incur travel and other employee business expenses in connection with the performance of services for their employer. The company adopted a plan to provide for the reimbursement of employee business expenses incurred by the investment consultants. It contains the following features:
The plan is mandatory for all investment consultants within the company.
Investment consultants are reimbursed for employee business expenses that would be deductible as business expenses on their personal tax returns.
Prior to the start of a calendar year, each investment consultant’s manager determines the amount, if any, to be excluded from the consultant’s commissions in the next year. If the manager reduces a consultant’s commissions, such amount is not less than $600 and not more than the reimbursement “cap.” The reimbursement cap equals the greater of $10,000 or 2.5% of the consultant’s commissions in the prior year. The amount of reimbursement that a consultant may receive under the plan in a calendar year may not exceed the lesser of the actual expenses or the reimbursement cap.
If a consultant’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the consultant and will not be carried over from one calendar year to the next.
If a consultant does not request reimbursement under the plan, he or she receives no additional compensation and remains subject to the base compensation reduction.
All consultants requesting reimbursement are required to prepare an expense report within 45 days after the expense is incurred. In preparing an expense report, a consultant must enter, in detail, the elements of each expense. For business travel expenses, a consultant must show the business purpose, the amount of each separate expense, when the expense was incurred, and the travel locations. For other employee business expenses, the consultant must show the business purpose, amount, and date of each expense item. Consultants must submit a receipt for any expense item exceeding $25 (this amount may be increased from time to time up to the applicable legal limit of $75). Business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense.
The employer examines all expense reports prior to payment to determine if the business purpose and amounts are reasonable. The employer approves, denies, or asks for additional information within 15 days of receiving the request for reimbursement. If additional information is requested, the consultant must provide it within 15 days, or the request will be denied.
The employer asked the IRS for a ruling that (1) the amounts reimbursed under the plan will be fully excludible from gross income of the consultants, and (2) that the amounts reimbursed are not wages subject to employment taxes and withholding, and need not be reported on Form W-2.
The IRS ruling. The IRS began its ruling by noting that if an employer’s reimbursements of an employee’s business expenses are “accountable,” they are not included in the employee’s income, they are not reported on the employee’s W-2, and they are not subject to tax withholding. To be accountable, three requirements must be met: (1) the reimbursed expenses are “business connected”; (2) the employee adequately substantiates the expenses within a reasonable time; and (3) the employee is required to return to the employer any portion of a reimbursement in excess of substantiated expenses.
The IRS cautioned that “if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan.” The result is that such reimbursements “are included in the employee’s gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to the withholding and payment of employment taxes.”
The IRS then briefly explained the three requirements of an accountable expense reimbursement arrangement:
#1—business connection
The IRS explained this requirement as follows:
An arrangement meets the business connection requirement … if it provides advances, allowances (including per diem allowances, allowances for meals and incidental expenses, and mileage allowances), or reimbursements for business expenses that are allowable as deductions under … the Code, and that are paid or incurred by the employee in connection with the performance of services as an employee. [The regulations] impose a reimbursement requirement, which will not be satisfied if the payor arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur allowable business expenses.
#2—substantiation
The IRS explained this requirement as follows:
[The] regulations provide that the substantiation requirement is met if the arrangement requires each business expense to be substantiated to the payor (the employer, its agent or a third party) within a reasonable period of time. An arrangement that reimburses business expenses governed by section 274(d) of the Code [pertaining to travel, transportation, entertainment, business gifts, cell phones, and personal computers] meets the substantiation requirement if the information submitted to the payor sufficiently substantiates the requisite elements of each expenditure or use. For example, when substantiating expenses for travel away from home [the regulations] require that information sufficiently substantiating the amount, time, place and business purpose of the expense must be submitted.
If an arrangement covers expenses not governed by section 274(d) of the Code [the regulations specify] that the substantiation requirement will be satisfied if information sufficient to enable the payor to identify the specific nature of each expense and to conclude that the expense is attributable to the payor’s business activities. Each element of an expenditure or use must be substantiated to the payor. It is not sufficient if an employee merely aggregates expenses into broad categories or reports individual expenses using vague, nondescriptive terms, such as miscellaneous business expenses.
#3—returning excess reimbursements
The IRS explained this requirement as follows:
With respect to the third requirement that amounts in excess of expenses must be returned to the payor, the … regulations provide that this requirement is met if the arrangement requires the employee to return to the payor within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated.
The IRS concluded that the company’s plan satisfied all three requirements for an accountable plan. With respect to the third requirement, the IRS noted that “because the plan is a reimbursement arrangement, the amount reimbursed should not exceed the amount substantiated; thus, there should not be an excess to return.” As a result, assuming that expenses “are properly deductible and substantiated,” the IRS reached the following conclusions:
(1) Reimbursements made to a consultant under the plan may be excluded from the consultant’s income as payments made under an accountable plan.
(2) Reimbursements made to a consultant under the plan are not wages subject to employment taxes, and are not reportable on the consultant’s Form W-2.
Significance of the case to church treasurers. Church treasurers should be aware of the following points:
1. Salary reduction agreements. The tax code prohibits employers from paying for accountable reimbursements out of salary reductions. Consider an example. A church pays Rev. J $1,000 each week, and also agrees to reimburse his substantiated business expenses for each month out of the first payroll check for the following month. Assume further that Rev. J substantiated $300 of business expenses for January. The church issued Rev. J his customary check of $1,000 for the first week of February, but only $700 of this check represents taxable salary while the remaining $300 represents a nontaxable reimbursement under an accountable plan. Only the $700 salary component of this check is included on Rev. J’s W 2 form at the end of the year. The code prohibits this practice for accountable reimbursement plans. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that use such an arrangement must recognize that all reimbursements paid through salary reduction are “nonaccountable,” and must be reported on the minister’s W-2.
2. Salary restructuring arrangements. What about salary restructuring arrangements? Does the ban on using salary reduction arrangements to fund accountable expense reimbursements apply to these arrangements as well? The IRS answered “yes” to this question in a 1993 private letter ruling. However, the private ruling addressed in this article signals a retreat from the 1993 position. The two rulings involve very similar facts, and in the 1999 ruling the IRS appears to be saying that employers may pay for reimbursements of employee business expenses under an accountable arrangement through salary “restructuring.” There are two important points to note:
The 1993 IRS ruling interpreting “salary reduction” arrangements to include salary “restructuring” arrangements was a private letter ruling that by law applied only to the taxpayers who requested it. The IRS has not reaffirmed the 1993 ruling in any official or binding precedent. The 1999 ruling discussed in this article is also a private letter ruling. What is the significance of this? To the extent that the 1993 ruling has been used in the past to prevent the use of salary restructuring arrangements to fund accountable expense reimbursements, the 1999 ruling can be interpreted as overruling the earlier ruling. While the 1999 ruling is of no more legal weight than the 1993 ruling, it is the same type of ruling and it entitled to the same weight.
The 1999 ruling, while binding only on the taxpayer who requested it, suggests that an accountable expense reimbursement arrangement can be funded out of a salary restructuring arrangement having most if not all of the following characteristics: (1) the plan is mandatory for all employees; (2) employees are reimbursed only for those business expenses that would be deductible as a business expense on their personal tax returns; (3) prior to the start of each year, the employer determines the amount, if any, to be excluded from the employee’s compensation in the next year; (4) reimbursements cannot exceed a “cap” specified by the employer; (5) if an employee’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the employee and will not be carried over from one calendar year to the next; (6) if an employee does not request reimbursement under the plan, he or she receives no additional compensation; (7) all employees requesting reimbursement are required to prepare an expense report within a reasonable time that substantiates the business purpose, amount, and date of each expense item (including a receipt for any expense item exceeding $75; (8) business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense; and (9) the employer examines all expense reports prior to payment to determine if the business purpose set forth on the report is reasonable and if the amounts claimed are reasonable.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Workers Compensation Benefits
No benefits for dancing-related injuries, court rules.
Karastamatis v. Industrial Commission, 1999 WL 391347 (Ill. App. 1999)
Background. Workers compensation laws have been enacted in all fifty states. These laws provide compensation to employees as a result job-related injuries and illnesses. The amount of compensation is determined by law and generally is based upon the nature and extent of the employee’s disability. In exchange for such benefits, employees give up the right to sue an employer directly. Fault is irrelevant under workers compensation laws. The only issues are (1) did an employment relationship exist; (2) did the injury occur during the course of employment; and (3) what were the nature and extent of the injuries?
church employees are protected by workers compensation laws in most states. However, there are exceptions. A few states exempt churches and nonprofit organizations from workers compensation coverage, and some states exempt employers having less than a specified number of employees.
Caution. If a church is not exempt from workers compensation law, what is the effect of its failure to obtain workers compensation insurance? Most workers compensation laws are compulsory. The employer cannot elect to remain outside the system. In a “compulsory” jurisdiction, a covered employer that fails to obtain workers compensation insurance will ordinarily be subject to a lawsuit by an injured employee, or may be treated as a “self-insurer” and be liable for the damages specified by the workers compensation law. A few states permit employers to elect coverage under workers compensation law. To coerce employers into electing coverage, these states impose various penalties upon employers that do not elect coverage.
A recent case. A recent case illustrates the application of workers compensation law to church workers. A church hired a man to work at its annual 3-day picnic which was held each year in the church’s parking lot. The worker set up tents, drove a van, cleaned, and stocked beverages and food. On the last day of the picnic, the worker served food and beverages. He took a break at 2 p.m. He resumed work and took his next break at 11:30 p.m. By this time the picnic was winding down and the worker asked a church officer if he could join other workers and guests who were dancing. He was told to “go ahead.” The worker then joined the other dancers and apparently became the leader in performing a “Greek dance”. After five or six minutes of dancing, he slipped and fell backwards to the ground, injuring his knee. He later claimed that the parking lot had oil spots on it which caused him to slip.
The worker filed an application for workers compensation benefits, claiming that he was a church employee and that his injury occurred during the course of his employment. A state workers compensation commission determined that the worker’s injury had not occurred in the course of his employment, and denied any benefits. The worker appealed.
The court began its opinion by noting that for the worker to qualify for workers compensation benefits he “must demonstrate that his injuries arose out of and in the course of his employment.” For an injury to arise out of the employment: “[T]he risk of injury must be a risk peculiar to the work or a risk to which the employee is exposed to a greater degree than the general public by reason of his employment.” An injury is not eligible for workers compensation benefits “if it resulted from a risk personal to the employee rather than incidental to the employment.” The court noted a “personal risk” is not necessarily converted into an employment risk simply because the employer allowed it. The court concluded:
[The worker’s] injuries did not result from some risk or hazard peculiar to his employment. [He] was hired to set up and stock the picnic and serve beer and food. He was not hired to dance. The risk of injury from dancing was not peculiar to [his] work or incidental to his employment because it did not belong to, nor was it in any way connected with, what [he] had to do in fulfilling his contract of service. [The worker] voluntarily exposed himself to an unnecessary danger entirely separate and apart from the activities and responsibilities of his job. His act of dancing was a personal act, solely for his own convenience; an act outside any employment risk. Further, [he] presented no evidence to show he was at an increased risk of injury from dancing because he was working at a picnic sponsored by a … church where his duties were to stock the picnic and serve food and beverages. Simply put, the risk of injury [the worker] was exposed to while dancing was neither peculiar to nor increased by the nature of his employment.
The worker insisted that his injuries arose out of his employment because he was injured while on a break and therefore the “personal comfort doctrine” applied. The court defined the personal comfort doctrine as follows: “Employees who, within the time and space limits of their employment, engage in acts which minister to personal comfort do not thereby leave the course of employment, unless the … method chosen is so unusual and unreasonable that the conduct cannot be considered an incident of the employment.”
The court noted that the personal comfort doctrine generally applies when an employee is on break and sustains an injury. It covers acts such as eating and drinking, obtaining fresh air, seeking relief from heat or cold, showering, resting, and restroom breaks. However, for the personal comfort doctrine to apply, an employee’s injury must “still be related to the employment environment and not a hazard to which [the employee] would have been equally exposed apart from his employment.” In this case, it was not the employment environment or premises that caused the worker’s injury, but rather the worker’s decision to engage in dancing while on break. Such conduct was simply too far removed from the employment environment to qualify for workers compensation benefits. The court observed that “there is no evidence that the conditions of the employment or the premises caused [the worker’s] injury nor is there any evidence that [he] was at an increased risk.” It concluded that “the risk of injury from dancing was personal to [the worker] and neither peculiar to his job nor a risk to which he was exposed to a greater degree than the general public.”
Significance to church treasurers. What is the significance of this case to church treasurers? Consider the following points:
Are we subject to workers compensation? Church treasurers should know whether their church is subject to state workers compensation law. If you are not sure if your church is covered, consider one or more of the following steps: (1) ask a local attorney; (2) ask your church insurance agent; or (3) call the agency in your state that administers the workers compensation program.
The risk of being uninsured. Employers that are covered by workers compensation law generally pay insurance premiums to cover the cost of benefits paid to injured workers. However, many churches have failed to obtain workers compensation insurance, often because of a false assumption that they are not covered by workers compensation law. This can expose a church to significant liability, for two reasons. First, an injured employee may be able to sue the church for damages in a civil lawsuit. Unlike workers compensation benefits, there is no limit on the amount a court can award in a civil lawsuit. Second, the damages a court awards in a civil lawsuit will not be covered under most church insurance policies. Often, general liability policies exclude employee injuries on the assumption that they are covered under a workers compensation policy. This can create a dangerous gap in coverage.
Do we have workers compensation insurance? If your church is subject to workers compensation law, then be sure you have obtained workers compensation insurance. If in doubt, ask your church insurance agent.
Employees. Workers compensation laws only cover injuries and illnesses suffered by employees on the job, but the term employee is defined very broadly to further the objectives of workers compensation law. As a result, persons whom a church may deem self-employed for income tax purposes may be deemed employees for purposes of the workers compensation law. This case is a good example. The employee status of the worker was not questioned, even though he was hired to work only for three days at a church picnic.
Injuries occurring in the course of employment. This case provides a useful clarification of workers compensation law. It demonstrates that church employees may qualify for workers compensation benefits for injuries they while on a job-related break. This no doubt will come as a surprise to many church leaders. However, not every injury occurring to an employee during a break will qualify for benefits. Such injuries must be related to the employment environment or premises. In this case, there were witnesses who directly contradicted the worker’s claim that he slipped on oil in the parking lot. As a result, the court concluded that the injury was not directly associated with the employer’s premises. Further, the act of dancing was so far removed from the employment environment that the injury did not qualify for benefits.
Key point. The court’s ruling exposes the church to a civil lawsuit by the injured employee. However, since the court determined that the injury did not occur in the course of the worker’s employment, the church ‘s general liability insurance policy should provide coverage in the event the worker sues the church.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Federal Court: Revocation of Church’s Tax-Exempt Status Was Proper
Ruling upholds rare instance when IRS took away exemption for political activities.
In order to maintain their tax-exempt status for federal income tax purposes, churches and other religious organizations must comply with several requirements specified in section 501(c)(3) of the tax code. One of these requirements is that the organization must not participate or intervene in any political campaign on behalf of (or in opposition to) any candidate for public office. Many churches have violated this requirement in the past with no adverse consequences. However, the landscape is changing.
In 1995 the IRS for the first time revoked the exempt status of a church for intervening in a political campaign. The church had published full-page ads in two national newspapers, warning Christians not to vote for candidate Bill Clinton in the 1992 presidential election. The IRS ruling was upheld recently by a federal court. The court rejected the church’s claim that the revocation of its tax-exempt status violated the first amendment and the Religious Freedom Restoration Act.
A federal court has upheld a ruling by the IRS revoking the tax-exempt status of a church on account of its intervention in the 1992 presidential campaign. This case makes it essential for church leaders to be familiar with the limitation on political involvement. This article reviews the court’s ruling, summarizes the limitation on political activities, and addresses the impact of the ruling on church practices.
Details of the case
On October 30, 1992, four days before a presidential election, Branch Ministries, Inc., doing business as the Church at Pierce Creek (the “church”), expressed its concern about the moral character of candidate Bill Clinton in a full page advertisement in the Washington Times and in USA Today. The advertisement proclaimed “Christian Beware. Do not put the economy ahead of the Ten Commandments.” It asserted that Bill Clinton supported abortion on demand, homosexuality and the distribution of condoms to teenagers in public schools.
The advertisement cited various Biblical passages and stated that “Bill Clinton is promoting policies that are in rebellion to God’s laws.” It concluded with the question, “How then can we vote for Bill Clinton?” At the bottom of the advertisement, in fine print, was the following notice: “This advertisement was co-sponsored by The Church at Pierce Creek, Daniel J. Little, Senior Pastor, and by churches and concerned Christians nationwide. Tax-deductible donations for this advertisement gladly accepted. Make donations to: The Church at Pierce Creek,” and provided a mailing address.
At the time the advertisement was published, the church was a tax-exempt organization. On October 31, 1992, the New York Times published an article entitled “Religious Right Intensifies Campaign for Bush.” The article discussed the role of the religious right in the 1992 presidential campaign and mentioned the advertisement described above, but it did not mention Branch Ministries or the Church at Pierce Creek by name. On December 1, 1992, the New York Times published an op-ed piece entitled “Tax-Exempt Politics?” The article discussed the “use of tax-exempt money for politics,” and, as a case in point, focused on the advertisement in USA Today by the Church at Pierce Creek. The article observed that “[t]he sponsors [of the advertisement] almost certainly violated the Internal Revenue Code.”
On November 20, 1992, the Regional Commissioner of the Internal Revenue Service sent the Church at Pierce Creek a letter stating that he was authorizing the District Director to begin “a church tax inquiry because a reasonable belief exists that you may not be tax-exempt or that you may be liable for tax. The general subject matter of the inquiry concerns political expenditures which you may have paid or incurred, as well as whether you are tax-exempt.” The letter also requested certain information “[i]n order to better understand your activities,” including information about the USA Today advertisement, any political campaigns for public office in which the church had sponsored advertisements, the political expenditures of the church, the total amount of contributions received in response to the USA Today advertisement, and the purpose of the church.
On December 23, 1992, the church sent a response to the request for information. The church took the position that it had not engaged in any political activity. Rather, the advertisement printed in USA Today and the Washington Times constituted a “warning to members of the Body of Christ,” and the warning “did not constitute participation in a political campaign.” The church refused to respond to most of the requests made by the IRS, including the request for the identities of persons who had contributed money in response to the USA Today and Washington Times advertisement.
By letters dated February 11, 1993 and August 11, 1993, the IRS informed the church that it was beginning a church tax examination, and it again requested certain documents from the church. At one point, the IRS drafted a summons to require the church to submit the requested information, but the summons was never issued. Finally, on January 19, 1995, the IRS issued a letter stating that the church’s status as a section 501(c)(3) tax-exempt organization was revoked, retroactive to January 1, 1992.
Three months after the revocation letter was issued, the church filed a lawsuit in federal court asserting that the revocation of its status as a Section 501(c)(3) organization was improper. The basic premise of the church’s claim was that once a church applies for and is deemed a section 501(c)(3) organization, the IRS lacks authority to revoke that status unless it concludes that the church is not a bona fide church. The church also contended that the IRS selectively prosecuted it on the basis of its conservative political or religious views in violation of the equal protection clause of the fifth amendment, and that the revocation of its exempt status violated the first amendment and the Religious Freedom Restoration Act.
The Court’s Ruling
Church Status
The church argued that the IRS has no authority to revoke the section 501(c)(3) status of a church unless it determines that the church is not a bona fide church. It insisted that the Church Audit Procedures Act (“CAPA”) provides a “zone of protection” that prevents the IRS from revoking the section 501(c)(3) status of a church on the basis of partisan political activity. The church also claimed that CAPA only permits the IRS to revoke the exempt status of “sham churches.” If the church is bona fide, the IRS can only impose a tax or seek an injunction to stop the activities of the church. It cannot revoke its exempt status.
The IRS conceded that the church in this case is a bona fide church. However, it asserted that it revoked the section 501(c)(3) status because the church engaged in partisan political activity in direct violation of section 501(c)(3). The IRS rejected the church’s claim that CAPA allows revocation only in the case of sham churches:
The clear statutory language of CAPA, however, provides that the [IRS] is authorized to revoke the tax-exempt status upon a determination that the organization “is not a church which (i) is exempt from taxation by reason of section 501(a) ….” Section 501(a) in turn provides that an “organization described in subsection [501](c) … shall be exempt from taxation under this subtitle ….” Subsection (c)(3) describes “corporations … organized and operated exclusively for religious … purposes … which do not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”
The court pointed out that the IRS determined, in compliance with the procedures set forth in CAPA, that the church, while it remained a bona fide church, was not an organization described in section 501(c)(3) because it had published or distributed a statement in opposition to a candidate for public office. Because the IRS determined that the church was not an organization described in section 501(c)(3), it had the legal authority to determine that it was no longer a church that was exempt from taxation.
Equal Protection of the Laws
The church claimed that the decision of the IRS to revoke its tax-exempt status was unconstitutionally motivated by the conservative political and religious beliefs of the church. The court noted that to win a selective prosecution claim, the church must clearly establish “(1) that the prosecutorial decision had a discriminatory effect, and (2) that it was motivated by a discriminatory purpose or intent.” The court continued:
A showing of discriminatory effect requires [the church] to demonstrate that similarly situated persons of other religions or political beliefs have not been prosecuted. Discriminatory purpose may be established either with direct evidence of intent or with “evidence concerning the unequal application of the law, statistical disparities and other indirect evidence of intent.” For obvious reasons, the selective prosecution standard is a “demanding one,” and [the church] must present “clear evidence” of both discriminatory effect and intent in order to establish their claim.
The court concluded that the church had failed to present “clear evidence” of either requirement, and the IRS therefore was entitled to summary judgment on this claim:
[The church has] presented little or no evidence of discriminatory effect. As the government has pointed out [the church has] not identified any “similarly situated” organization that retained its section 501(c)(3) status. [The church’s] evidence of similarly situated entities relates only to churches that have allowed political leaders to appear at religious services or churches that have used the pulpit to advocate a certain message. For purposes of deciding whether to begin an investigation, however, those entities are not similarly situated to the church. The IRS decided to revoke the tax-exempt … because the church had run a print advertisement in two national newspapers that was fully attributable to the church and that solicited donations. [The church has] pointed to no other instance in which a church so brazenly claimed responsibility for a political advertisement in a national newspaper and solicited tax-deductible donations for that political advertisement. In fact, [the church has] provided no evidence of an instance in which a political act could so easily be attributed to a tax-exempt church.
Virtually all of the 65 examples cited by [the church] are of candidates or other political figures speaking from the pulpits of churches or at synagogues-Reverend Jesse Jackson, Senators Al Gore, Charles Robb, Frank Lautenberg and Tom Harkin, Senate candidates Oliver North and Harvey Gantt, Governors Bill Clinton, Mario Cuomo and Douglas Wilder, gubernatorial candidates James Gilmore, III and Don Beyers, Jr., Mayors Marion Barry, Kurt Schmoke and Rudolph Giuliani, and numerous others. [The church maintains] that this conduct is similar to that of the church because, like the advertisement at issue here, those instances involve “public declarations” urging people to vote for or against particular candidates. As the court previously noted, however, “candidates giving speeches from pulpits or churches or churches sponsoring political debates or forums … are substantially dissimilar to the instant case.”
The court pointed out that in the only two instances with arguably similar circumstances, the IRS in fact did revoke the tax-exempt status of the two religious organizations. Each case is summarized below.
(1) Christian Echoes National Ministry, Inc. v. United States 470 F.2d 849 (10th Cir. 1964). In 1964, the IRS revoked the tax-exempt status of Christian Echoes National Ministry in part because “it had directly and indirectly intervened in political campaigns on behalf of candidates for public office.”
(2) The Way International. In 1985 the IRS revoked the section 501(c)(3) tax-exempt status of The Way International retroactively, in part because The Way had engaged in political activity. The Way International challenged the revocation of its exemption in federal court. While the case was pending, the parties entered into a settlement. The Way International was granted an exemption effective September 1, 1983, but the revocation for the prior years was allowed to stand.
The church argued that the fact that the IRS took actions against Christian Echoes and The Way does not undermine its selective prosecution claim because neither organization was a church. The court noted that this claim only bolstered the position of the IRS that there were no other “similar” cases in which the IRS treated politically active churches more leniently. The court concluded:
In the circumstances presented here-where a tax-exempt church bought an advertisement that stated its opposition to a particular candidate for public office, attributed the advertisement to the church and solicited tax-deductible contributions for the advertisement-the IRS was justified in revoking the tax-exempt status of the church, even if it might refrain from revoking the status of churches where attribution is less clear. In the absence of any showing that any other churches engaged in similar conduct and did not have their tax-exempt status revoked [the church has] failed to establish discriminatory effect.
The court then addressed the second requirement for a selective prosecution claim-clear evidence of discriminatory motivation by the IRS. As proof of this requirement, the church pointed to the fact that the IRS had not previously revoked the section 501(c)(3) status of a church for its involvement in a campaign for political office. The court rejected this argument, noting that “while statistical evidence may be used to establish discriminatory intent, it is not sufficient for [the church] to assert that the lack of any other revocations must mean that the IRS had a discriminatory intent where, as here, [the church has] failed to provide any evidence that there are any similarly situated churches that retained their section 501(c)(3) status.”
Free Exercise of Religion
The church also asserted that the revocation of its tax-exempt status violated the right to free exercise of religion guaranteed by the Religious Freedom Restoration Act (RFRA) and the first amendment. RFRA provides that the government “shall not substantially burden a person’s exercise of religion … [unless] it demonstrates that application of the burden to the person (1) is in furtherance of a compelling governmental interest; and (2) is the least restrictive means of furthering that compelling governmental interest.”
In order to invoke the protections of RFRA, the church first must demonstrate that the government has substantially interfered with its exercise of religion. If, and only if, the church can demonstrate a substantial burden, then the government has the burden under RFRA of establishing that the revocation serves a compelling governmental interest and that revocation is the least restrictive means of accomplishing that compelling interest. The court concluded that the church had failed to establish that the revocation of its tax-exempt status substantially burdened its right to freely exercise its religion:
A substantial burden exists where the government puts substantial pressure on an adherent to modify his behavior and to violate his beliefs, or where the government forces an individual to choose between following the precepts of her religion and forfeiting benefits, on the one hand, and abandoning one of the precepts of her religion.
The court stressed that the church had provided no evidence that the revocation of its exempt status by the IRS was in any way connected to its “refusal to violate its religious beliefs or abandon a precept of their religion.” Instead, the revocation was undertaken “because of the church’s involvement in partisan political activity.”
The church claimed that the decision of the IRS to revoke its section 501(c)(3) status had imposed a number of burdens, including exposure to federal income taxation, and the likelihood that contributions will decrease since donors will not be eligible to deduct their contributions to the church. The court acknowledged that the church was “probably correct” in claiming that the revocation had imposed these burdens, but it insisted that the church had “failed to establish that the revocation has imposed a burden on their free exercise of religion.” The court emphasized that the church had a choice-it “could engage in partisan political activity and forfeit its section 501(c)(3) status or it could refrain from partisan political activity and retain its section 501(c)(3) status.” The court insisted that this choice was unconnected to the church’s ability to freely exercise its religion.
The court noted that the only way in which the revocation of section 501(c)(3) status had any effect on the church’s exercise of religion was that the church had less operating money to spend on religious activities because it was now a taxable entity. But, the fact that the church had less money to spend on religious activities as a result of its participation in partisan political activity “is insufficient to establish a substantial burden on their free exercise of religion.”
Since the church had failed to demonstrate that the revocation of its tax-exempt status had “substantially interfered” with its exercise of religion, there was no violation of either RFRA or the first amendment guaranty of religious freedom, and there was no need for the IRS to demonstrate that the revocation served a compelling governmental interest. However, the court added that even if the church had demonstrated a substantial burden on the exercise of its religion, the IRS had met the compelling governmental interest standard and therefore the church’s rights were not violated. The court observed: “The government has a compelling interest in maintaining the integrity of the tax system and in not subsidizing partisan political activity, and section 501(c)(3) is the least restrictive means of accomplishing that purpose.”
Branch Ministries, Inc. v. Commissioner, 99-1 USTC ¶50,410 (D.D.C. 1999)
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. A few weeks ago the IRS released an internal memorandum (a “field service advisory”) addressing the question of whether parents can claim a charitable contribution deduction for tuition payments they make for their children who attend an Orthodox Jewish school. This memorandum will be instructive to any church or religious organization that operates a school.
Facts. The parents cited the following facts in supporting their claim that tuition payments they made on behalf of their children were deductible as charitable contributions:
The act of religious study for Orthodox Jews is an observance of their religion that begins at an early age and continues for life. As a result, tuition payments they make to Jewish religious schools are in furtherance of this religious function and are deductible as charitable contributions.
For the Orthodox Jew, the obligation to study the Torah and the Talmud is a matter of duty and adherence to Jewish law, a lifelong commitment ranking aside the obligation to pray. The observance of such duties primarily benefits the community, not the individual.
The primary purpose of Jewish schools is religious study. A significant portion of a student’s time at a Jewish school is devoted to religious study.
The United States Supreme Court ruled in 1990 that payments made directly to of two Mormon missionaries by their parents were not deductible since they were not made “to or for the use of” the Mormon Church. Davis v. Commissioner, 495 U.S. 472 (1990). The parents of the children attending the Jewish school argued that if the Mormon parents had made their payments to the Mormon Church with the understanding that such payments were for the support of the taxpayers’ sons, then such payments would have been deductible as charitable contributions. Similarly, since payments to Jewish religious schools are placed under the unfettered control of the school to help it carry out its religious function of providing religious study and worship, they should be deductible.
The payment of tuition to Jewish religious schools yields only an incidental benefit to the parent, and therefore avoids the Supreme Court’s holding in Hernandez v. Commissioner, 490 U.S. 680 (1989). In Hernandez, the Court held that payments to the Church of Scientology for auditing and training represent a “quid pro quo” exchange for direct benefits by the payor and as such were not deductible as charitable contributions. The parents insisted that this ruling did not apply to them, since the payment of tuition for religious study results in only an “incidental benefit” to themselves but a direct benefit to members of the Jewish religion. Tuition payments to Jewish religious schools, the parents argued, provide the students with the religious observance of their religion through religious study, but this benefit is only incidental to both students and their parents. The primary beneficiaries are the Jewish people who have had their religion preserved for thousands of years through careful adherence to the study of Judaism by members of the faith.
What the IRS concluded. The IRS rejected all of the parents’ arguments, and concluded that the tuition payments were not deductible as charitable contributions. The IRS based this conclusion on the following considerations:
The definition of a charitable contribution
The IRS noted that “a transfer of money or property to a charity is deductible … unless the taxpayer receives a valuable return benefit by reason of the transfer.” It quoted from the Supreme Court’s opinion in the Hernandez case: “The code makes no special preference for payments made in the expectation of gaining religious benefits or access to a religious service.” In other words, a charitable contribution is a transfer of cash or property to a charity without any equivalent return benefit to the donor. A charitable contribution exists only to the extent that the value of the cash or money exceeds the value of any goods or services received by the donor in exchange. The IRS memorandum concludes with the observation that the parents “clearly derive a substantial benefit on account of the payment of tuition and accordingly, such payments are not deductible.”
The implications of accepting the parents’ position
The IRS expressed concern that an acceptance of the parents’ position “would expand the charitable contribution deduction far beyond what Congress has provided.” It continued:
Numerous forms of payments to eligible donees plausibly could be categorized as providing a religious benefit or as securing access to a religious service. For example, some taxpayers might regard their tuition payments to parochial schools as generating a religious benefit or as securing access to a religious service; such payments, however, have long been held not to be charitable contributions ….
Other precedent
The IRS referred to a number of court decisions addressing the deductibility of tuition payments, including the following:
• Revenue Ruling 83-104. In 1983, the IRS issued a ruling addressing the deductibility of tuition payments. This ruling contained the following example:
A school requests parents to contribute a designated amount (e.g., $400) for each child enrolled in the school. Parents who do not make the $400 contribution are required to pay tuition of $400 for each child. Parents who neither make the contribution nor pay the tuition cannot enroll their children in the school. A parent who pays $400 to the school is not entitled to a charitable contribution deduction because the parent must either make the contribution or pay the tuition in order for his child to attend the school.
The IRS noted that no charitable contribution deduction is allowable in this example because the tuition payment “was not voluntary and was not made without the expectation of a commensurate benefit.”
DeJong v. Commissioner, 309 F.2d 373 (9th Cir. 1962). Parents made a “contribution” of $1,075 to the Society for Christian Instruction which operated full-time schools accredited by the state. The Society charged no tuition but raised funds from parents of enrolled students, churches and other entities. The stipulated annual cost of providing instruction for each child was $400. Although no tuition was charged, the parents who could so afford were expected to contribute to the Society at least to the extent of the cost of providing their children with an education. Though the cost of tuition covered both secular and religious education, the court concluded that the tuition payment ($400) was not deductible as a charitable contribution because it was not voluntary and was induced in substantial part by the benefits sought and anticipated from enrollment in the school.
Oppewal v. Commissioner, 468 F.2d 1000 (1st Cir. 1972). Parents deducted $900 as a charitable contribution to the Whitinsville Society for Christian Instruction. The court disallowed that part of the payment which represented the cost of educating the taxpayers’ children in the religiously-oriented school.
Winters v. Commissioner, 468 F.2d 778 (2d Cir. 1972). Parents claimed a charitable contribution deduction for payments made to a church fund established to support certain Christian schools, enrollment in which did not require payment of tuition. The court concluded that to the extent that the taxpayers received a benefit in return, the payment constituted nondeductible tuition.
Hernandez v. Commissioner, 490 U.S. 680 (1989). The Supreme Court ruled “contributions” made to the Church of Scientology for “auditing” were not deductible as charitable contributions. Auditing involves a counseling session between a Church official and a counselee during which the counselor utilizes an electronic device (an “E meter”) to identify areas of spiritual difficulty by measuring skin responses during a question and answer session. Counselees are encouraged to attain spiritual awareness through a series of auditing sessions. The Church also offers members doctrinal courses known as “training.” The Church charges fixed “donations” for auditing and training sessions (the charges are set forth in published schedules). The system of fixed charges was based on a tenet of Scientology (the doctrine of exchange) that requires persons to pay for any benefit received in order to avoid “spiritual decline.” The Court concluded that payments made to the Church of Scientology for auditing and training sessions were a non deductible reciprocal exchange—specific benefits in exchange for specific fees:
the Church established fixed price schedules for auditing and training sessions in each branch church; it calibrated particular prices to auditing or training sessions of particular lengths and levels of sophistication; it returned a refund if auditing and training services went unperformed; it distributed account cards on which person who had paid money to the Church could monitor what prepaid services they had not yet claimed; and it categorically barred provision of auditing or training services for free. Each of these practices reveals the inherently reciprocal nature of the exchange.
In other words, “contributions” to the Church (1) were mandatory, in the sense that no benefits or services were available without the prescribed payment, and (2) represented a specified fee for a specified service.
The IRS, in commenting on the Hernandez case, observed:
The Scientology ‘training’ at issue in Hernandez involved the intensive study of the writings and tenets of Scientology. This training did not involve secular education, and was a means of progressing up the Scientology ‘Bridge.’ There seems to be no relevant distinction between such training and the intensive study of Jewish writing and tenets. The parents stress the amount of time spent in study by students at Orthodox Jewish schools. Even if it is true that they devote more time to the activity than students of Scientology, this is simply a question of degree, and we see no reason why this distinction supports a result different from the result in Hernandez. Thus, whether the payment involved is in consideration for training to become a good Scientologist, Christian or Jew, we conclude that, under Hernandez, such payments do not qualify as charitable contributions ….
The IRS memorandum concludes by noting that the parents in this case “are required to make specific payments in return for which they receive a benefit—religious and secular education for their children. Under the rationale postulated in Hernandez, the parents are not entitled to a charitable contribution deduction for tuition payments made to Jewish religious schools.”
Relevance to church treasurers. Does your church operate a school or preschool? If so, are you allowing parents to deduct tuition payments as charitable contributions? Unfortunately, many church schools do so because of an unfamiliarity with the law. The IRS memorandum, and the cases it cites, demonstrate that tuition payments should not be treated or receipted as charitable contributions. There are three limited exceptions to this general rule:
1. Undesignated contributions to a scholarship fund. Church members are free to make undesignated payments to a school’s scholarship fund. Such payments can be treated as deductible charitable contributions. However, note that this assumes that the contribution in fact is undesignated, and is not accompanied by any “secret” understanding that the church or school will use the funds for a specific student. To illustrate, a parent cannot deduct an “undesignated” contribution that church or school officials apply to the tuition of the parent’s child. Further, the class of potential scholarship recipients must be substantial. A parent could not claim a charitable contribution deduction for “undesignated” contributions to a preschool’s scholarship fund if the preschool has only four students (one of whom is the donor’s daughter).
2. Payments in excess of tuition. The IRS and the courts have ruled that donors can claim a charitable contribution deduction to the extent that their donation exceeds the value of goods or services they receive in return. To illustrate, if a church school charges annual tuition of $3,000, and a parent makes a “contribution” of $4,000 to the school that is used to pay the tuition of the parent’s child, the parent qualifies for a charitable contribution deduction in the amount of $1,000.
3. A 1983 IRS ruling. In 1983, the IRS recognized the following limited exception to the general rule of the nondeductibility of tuition payments:
A church operates a school providing secular and religious education that is attended both by children of parents who are members of the church and by children of nonmembers. The church receives contributions from all of its members. These contributions are placed in the church’s general operating fund and are expended when needed to support church activities. A substantial portion of the other activities is unrelated to the school. Most church members do not have children in the school, and a major portion of the church’s expenses are attributable to its nonschool functions. The methods of soliciting contributions from church members with children in the school are the same as the methods of soliciting contributions from members without children in the school. The church has full control over the use of the contributions that it receives. Members who have children enrolled in the school are not required to pay tuition for their children, but tuition is charged for the children of nonmembers. A church member whose child attends the school contributes $200 to the church for its general purposes. The IRS ordinarily will conclude that the parent is allowed a charitable contribution deduction of $200 to the church. Because the facts indicate that the church school is supported by the church, that most contributors to the church are not parents of children enrolled in the school, and that contributions from parent members are solicited in the same manner as contributions from other members, a parent’s contributions will be considered charitable contributions, and not payments of tuition, unless there is a showing that the contributions by members with children in the school are significantly larger than those of other members. The absence of a tuition charge is not determinative in view of these facts.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. A used car dealer made payments in excess of $600 during the year to various independent contractors for personal services provided to his business. For example, the dealer paid auto repair shops, auto body shops, and auto detail services for work performed on his dealership’s cars. These independent contractors were paid by checks drawn on the dealer’s business account. At the time the dealer made payments to the independent contractors, no taxpayer identification numbers were obtained, and the dealer did not issue a Form 1099 to any of the contractors. The dealer asked the IRS if he was required to engage in “backup withholding” on payments he made to these contractors.
What the IRS said. The IRS ruled that the dealer was required to engage in backup withholding at the time it made payments to the contractors, since it failed to obtain their taxpayer identification numbers. Here are the points the IRS made:
(1) Form 1099 reporting requirement. Any employer engaged in a “trade or business” that makes payments of $600 or more in the course of that trade or business to an independent contractor, as compensation for services rendered, must issue the contractor a Form 1099 reporting the contractor’s name, address, taxpayer identification number, and amount of compensation.
(2) The $600 requirement. The Form 1099 reporting requirement is triggered “if the aggregate amount of the current payment and all previous payments to the payee during the calendar year equal $600 or more. The amount subject to withholding is the entire amount of the payment that causes the total amount paid to the payee to equal $600 or more and the amount of any subsequent payments made to the payee during the calendar year.”
(3) Backup withholding. An employer is required to withhold at a rate of 31 percent on any payment subject to the Form 1099 reporting requirement, at the time of the payment, if the employer has not received the contractor’s taxpayer identification number.
The IRS concluded that the dealer’s payments to the independent contractors were subject to the Form 1099 reporting requirement. And, since he failed to obtain the contractors’ taxpayer identification numbers, his “obligation to backup withhold commenced with the entire amount of the payment that caused the total amount paid to an independent contractors to equal $600 or more for the calendar year.”
Relevance to church treasurers. This ruling demonstrates that a church must issue a 1099 form to a person if the following five requirements are satisfied: (1) the church is “engaged in a trade or business”; (2) the church pays the person compensation of $600 or more during the calendar year; (3) the person is an independent contractor (not an employee of the church); (4) the payment is in the course of the church’s “trade or business”; and (5) no exception exists. The income tax regulations specify that the term “person engaged in a trade or business” includes not only “those so engaged for gain or profit, but also organizations the activities of which are not for the purpose of gain or profit” including organizations exempt from federal income tax under section 501(c)(3) of the Code. This includes churches and other religious organizations. There is no doubt that churches are required to issue 1099 forms if the other requirements are satisfied.
It is important for church treasurers to recognize that if an independent contractor performs services for the church (and earns at least $600 for the year), but fails to provide you with his or her taxpayer identification number, then the church is required by law to withhold 31 percent of the amount of compensation as “backup withholding.” And, this must be done at the time of payment. There is no way to do it retroactively, since the compensation has been paid.
Here are some tips for church treasurers to consider in complying with the backup withholding requirement:
• Know when a Form 1099 is required. Be familiar with the requirements summarized above. In particular, note that the Form 1099 reporting requirement only applies to payments made to independent contractors. Be aware of common examples of independent contractors, including guest speakers, and contract laborers. Examples of contract laborers include custodians and computer consultants who are hired for a specified fee, do not work full-time, advertise their services to other employers in the community, provide their own equipment and supplies, and perform their services without any direction or control from the church.
No Form 1099 is required for some kinds of payments, including (1) payments to a corporation; (2) travel expense reimbursements paid under an “accountable” reimbursement arrangement; and (3) payments of bills for merchandise, telegrams, telephone, freight, storage, and similar charges.
Example. A church hires a local landscaping company to maintain the church grounds. There is no need for the church to issue a Form 1099 if the company is a corporation. Note, however, that this exception only applies to corporations—and not to partnerships.
Tip. An independent contractor informs you that he is incorporated, and so the church is not required to issue him a Form 1099. Do you take the person’s word for it, or are you required to do more? Here are two options: (1) Have the person complete and sign Form W-9, checking the “corporation” box and writing “exempt” in Part II. Note that a taxpayer identification number should be provided, even though the church will not be issuing a Form 1099. This will be the corporation’s “employer identification number.” (2) Ask the independent contractor for proof of incorporation before relying on this exemption. This could include a copy of the certificate of incorporation issued by the state. Or, call the office of secretary of state (in the state of incorporation) and confirm the existence of the corporation.
• Obtaining taxpayer identification numbers. For many independent contractors, their taxpayer identification number will be their social security number. The income tax regulations state that you can obtain an independent contractor’s taxpayer identification number either orally or in writing.
Tip. Before making a payment to an independent contractor of $600 or more (or a lesser amount that increases annual compensation paid by the church to $600 or more), require the contractor to complete an IRS Form W-9. This form asks for the contractor’s taxpayer identification number. It is a good practice to have several of these forms on hand in the church office. Be sure you have the current version, since they are updated each year.
Key point. Churches can be penalized if the social security number they report on a Form 1099 is incorrect, unless they have exercised “due diligence.” A church will be deemed to have exercised due diligence if it has independent contractors provide their social security numbers using Form W-9.
The backup withholding requirements were designed to ensure that independent contractors fully report their income. Without backup reporting, such persons can often underreport their true income (without detection) by simply refusing to provide their social security numbers to employers. Of course, to avoid backup withholding, some independent contractors may consider providing you with a false social security number. The IRS will discover such a scheme when it receives the Form 1099 containing the false number. At such time, the IRS will notify the church to commence backup withholding on any future payments to the individual (until a correct social security number is provided).
• Form 941. Don’t forget to report backup withholdings on your quarterly Form 941 (employer’s quarterly tax return).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Revoking an Exemption from Social Security
Ministers may soon be allowed to revoke an exemption
Summary. Many ministers have exempted themselves from self-employment tax by filing a timely application form (Form 4361) with the IRS. Unfortunately, most of these ministers were not eligible for the exemption. In recognition of this fact, and because a growing number of exempt ministers were desperate to rejoin the Social Security program in order to qualify for Medicare benefits, Congress gave ministers a brief “window” of time in 1977, and again in 1987, to revoke an exemption from self-employment tax. Few did so. Ministers soon may be given another window to revoke an exemption from self-employment taxes. It is important for exempt ministers to be aware of these developments so they are ready to respond quickly if another window is provided. The lesson of the 1977 and 1987 legislation is that the longer ministers wait to revoke an exemption, the less likely it is that they will do so. This article reviews the status of current legislative efforts, assesses the likelihood of success, and provides ministers with recommendations to consider.
Ministers are allowed by federal law to exempt themselves from social security (self-employment) taxes by filing a timely exemption application (Form 4361) with the IRS. To qualify for exemption, ministers must meet the following six requirements:
1. The minister must be an ordained, commissioned, or licensed minister of a church.
2. The church or denomination that ordained, commissioned, or licensed the minister must be a tax-exempt religious organization.
3. The minister must file an exemption application (Form 4361) in triplicate with the IRS. A minister certifies on Form 4361 that “I am conscientiously opposed to, or because of my religious principles I am opposed to, the acceptance (for services I performed as a minister …) of any public insurance that makes payments in the event of death, disability, old age, or retirement, or that makes payments toward the cost of, or provides services for, medical care.” The form states that “public insurance includes insurance systems established by the Social Security Act.” There are three important factors to note. First, the regulations interpreting this language reject the view that ministers can be eligible for exemption from social security coverage on the basis of “conscientious opposition” alone. The conscientious opposition must be rooted in religious belief. Second, the exemption is available only if a minister is opposed on the basis of religious considerations to the acceptance of social security benefits rather than to payment of the tax. A minister may have religious opposition to payment of the tax, but this alone will not suffice. The individual must have religious opposition to accepting social security benefits upon his or her retirement or disability. This is an extraordinary claim that few ministers in good faith will be able to make. Third, the applicant’s opposition must be to accepting benefits under the social security program (or any other “public insurance” system that provides retirement and other specified benefits). As a result, a minister who files the exemption application may still purchase life insurance or participate in retirement programs administered by non-governmental institutions (such as a life insurance company).
4. The exemption application (Form 4361) must be filed on time. The deadline is the due date of the federal tax return for the second year in which a minister has net earnings from self-employment of $400 or more, any part of which derives from the performance of services in the exercise of ministry.
5. Notification of ordaining, commissioning, or licensing church or denomination. An applicant for exemption must inform “the ordaining, commissioning, or licensing body of the church or order that he is opposed” to social security coverage (Form 4361 contains a statement that the applicant has satisfied this requirement), and presumably, that he or she intends to apply for an exemption from social security coverage.
6. IRS verification. No application for exemption will be approved unless the IRS or the Secretary of the Department of Health and Human Services (or a designated representative) “has verified that the individual applying for the exemption is aware of the grounds on which the individual may receive an exemption … and that the individual seeks an exemption on such grounds.”
Key point. In this article, the term “self-employment tax” is used to describe the social security tax paid by self-employed persons, including ministers. Ministers always are deemed to be self-employed for social security purposes with respect to services performed in the exercise of their ministry (with the exception of some chaplains), and so they pay the self-employment tax rather than “FICA” taxes.
Revoking an exemption from social security
The tax code clearly states that ministers who exempt themselves from self-employment taxes cannot revoke their exemption. The decision to become exempt from self-employment taxes is “irrevocable.” IRC 1402(e)(4). Form 4361 itself warns that “once the application is approved, you cannot revoke it.”
On two occasions in the past, Congress has enacted special legislation giving ministers a brief “window” of time to revoke an exemption from self-employment taxes.
The 1977 Legislation
Congress allowed ministers who were exempt as of December 20, 1977, to revoke their exemption by the due date of their federal income tax return for 1977 (April 15, 1978) by filing a Form 4361-A.
The 1987 Legislation
The Tax Reform Act of 1986 gave exempt ministers another limited opportunity to revoke an exemption from self-employment taxes, by filing a Form 2031 with the IRS by the due date for their federal income tax return for 1987 (April 15, 1988). Congress provided this limited opportunity for ministers to revoke an exemption from self-employment taxes because of a recognition that many of these ministers did not qualify in the first place.
Ministers who revoked an exemption by April 15, 1988 did not become liable for self-employment taxes all the way back to the date of their original exemption. Rather, they were required to pay self-employment taxes effective January 1, 1986 or January 1, 1987. This meant, for example, that a minister who revoked an exemption by April 15, 1988 had to pay not only the first quarter’s estimated self-employment tax for 1988 by that date, but also (1) the entire social security tax liability for 1986 and 1987, or (2) the entire social security tax liability for 1987. The minister elected on the Form 2031 whether to pay taxes for both 1986 and 1987, or just for 1987.
The decision to revoke an exemption from self-employment tax was irrevocable.
Very few exempt ministers revoked their exemption. The reason is simple. Most ministers who were seriously considering revoking their exemption waited until the deadline, only to discover that pursing the revocation of their exemption would make them liable for at least five quarters of self-employment tax. Even on modest income, this was a crushing liability that few could afford. As a result, very few ministers revoked their exemption.
Recent Developments
A number of bills have been introduced in Congress over the past few years to provide ministers with another opportunity to revoke an exemption from self-employment coverage. Here are the key bills:
(1) House Bill H.R. 939
In 1997, Congressman English of Pennsylvania introduced House Bill 939, which provided, in part:
[A]ny exemption which has been received … by a duly ordained, commissioned, or licensed minister of a church … and which is effective for the taxable year in which this Act is enacted, may be revoked by filing an application therefor … if such application is filed no later than the due date of the federal income tax return (including any extension thereof) for the applicant’s second taxable year beginning after December 31, 1997. Any such revocation shall be effective … as specified in the application, either with respect to the applicant’s first taxable year beginning after December 31, 1997, or with respect to the applicant’s second taxable year beginning after such date, and for all succeeding taxable years; and the applicant for any such revocation may not thereafter again file application for an exemption …. If the application is filed after the due date of the applicant’s federal income tax return for a taxable year and is effective with respect to that taxable year, it shall include or be accompanied by payment in full of an amount equal to the total of the taxes that would have been imposed by … the Internal Revenue Code of 1986 with respect to all of the applicant’s income derived in that taxable year which would have constituted net earnings from self-employment … except for the exemption ….
This bill attracted only a few sponsors, and died in committee.
(2) the “ticket-to-work” bill
On June 4, 1998, the House of Representatives passed the “Ticket to Work and Self-Sufficiency Act of 1998” by an overwhelming vote of 410 to 1. This bill was designed to make it easier for disabled adults to receive vocational training without losing their social security disability (or SSI) payments. The bill was amended to include a provision allowing clergy to revoke an exemption from self-employment taxes. Section 8 of the bill provided, in part:
[A]ny exemption which has been received … by a duly ordained, commissioned, or licensed minister of a church, a member of a religious order, or a Christian Science practitioner, and which is effective for the taxable year in which this Act is enacted, may be revoked by filing an application therefor … if such application is filed no later than the due date of the federal income tax return (including any extension thereof) for the applicant’s second taxable year beginning after December 31, 1998. Any such revocation shall be effective … as specified in the application, either with respect to the applicant’s first taxable year beginning after December 31, 1998, or with respect to the applicant’s second taxable year beginning after such date, and for all succeeding taxable years; and the applicant for any such revocation may not thereafter again file application for an exemption …. If the application is filed after the due date of the applicant’s federal income tax return for a taxable year and is effective with respect to that taxable year, it shall include or be accompanied by payment in full of an amount equal to the total of the taxes that would have been imposed … with respect to all of the applicant’s income derived in that taxable year which would have constituted net earnings from self-employment … except for the exemption under section 1402(e)(1) of such Code.
Following the bill’s approval by the House of Representatives, it was sent to the Senate. The Senate failed to act on the bill by the end of the legislative session.
While this effort was unsuccessful, it is worth noting that the House of Representatives voted 410 to 1 to adopt a bill containing a provision allowing ministers a limited opportunity to revoke an exemption from self-employment tax.
(3) Senate Bill 331
On January 28, 1999, the “Work Incentive Improvement Act of 1999” (S. 331) was introduced in the United States Senate. The bill has the same purpose as the “Ticket to Work and Self-Sufficiency Act of 1998”-to assist disabled adults to participate in vocational training and employment programs. This bill currently has 73 cosponsors. Section 403 states, in part:
[A]ny exemption … by a duly ordained, commissioned, or licensed minister of a church, a member of a religious order, or a Christian Science practitioner, and which is effective for the taxable year in which this Act is enacted, may be revoked by filing an application therefore … if such application is filed no later than the due date of the federal income tax return (including any extension thereof) for the applicant’s second taxable year beginning after December 31, 1999. Any such revocation shall be effective … as specified in the application, either with respect to the applicant’s first taxable year beginning after December 31, 1999, or with respect to the applicant’s second taxable year beginning after such date, and for all succeeding taxable years; and the applicant for any such revocation may not thereafter again file application for an exemption …. If the application is filed after the due date of the applicant’s federal income tax return for a taxable year and is effective with respect to that taxable year, it shall include or be accompanied by payment in full of an amount equal to the total of the taxes that would have been imposed … with respect to all of the applicant’s income derived in that taxable year which would have constituted net earnings from self-employment …. except for the exemption ….
There are a number of important points to note:
(1) This provision is identical (except for the effective date) to the one contained in the Ticket to Work and Self-Sufficiency Act of 1998, which was approved by the House of Representatives in 1998 by a vote of 410 to 1.
(2) This bill was introduced on January 28, 1999 with 39 sponsors. By early May there were 72 sponsors.
(3) The provision allowing clergy to revoke an exemption from self-employment taxes is an amendment to a popular bill that is designed to assist disabled adults return to work.
(4) If enacted, this bill would allow exempt ministers to revoke their exemption by filing a form with the IRS by April 15, 2002. Ministers can choose to revoke their exemption beginning either with year 2000 or year 2001.
(5) Ministers who revoke their exemption will not be permitted to apply for exemption at a later time. The decision to revoke an exemption is irrevocable.
(6) Ministers who file for revocation of their exemption after the due date of the federal income tax return for a year in which they have elected to be covered by social security must include with their return payment of their entire self-employment tax liability for that year.
The following examples all assume that Senate Bill 331 will be enacted:
Example. Rev. D opted out of social security in 1980 because he did not want to pay the self-employment tax. He now recognizes that he was not eligible for the exemption, and would like to revoke it. If Senate Bill 331 is enacted, Rev. D will be able to file a form with the IRS revoking his exemption. On this form, Rev. D will designate whether he wants to revoke his exemption beginning with either the year 2000 or the year 2001.
Example. Same facts as the previous example. Rev. D waits until July 1, 2002, to file his revocation form. He has waited too long. The form must be filed no later than April 15, 2002.
Example. Same facts as the previous example, except that Rev. D obtained a four-month extension to file his year 2001 tax return (until August 15, 2002) by filing IRS Form 4868. It is not too late for Rev. D to file a revocation form, since the deadline is the due date for the federal tax return for the second year following December 31, 1999. The second year is 2001, and the due date for the federal tax return for that year is April 15, 2002. However, the proposed law specifies that the deadline for filing the revocation form for ministers who applied for a four-month extension to file their year 2001 tax return is August 15, 2002.
Example. Assume that Rev. D has net self-employment earnings of $50,000 in 2000 and 2001, including his church-designated housing allowance. Rev. D plans to file his year 2001 tax return by April 15, 2002 (he does not plan on filing for a four-month extension). He waits until April 15, 2002 to decide whether to revoke his exemption from self-employment tax. By delaying his decision, he how has two options: (1) Revoke his exemption beginning with the year 2000. He will be liable for “back taxes” to January 1, 2000-that is, for two years plus the first quarter of year 2002 self-employment taxes. This will amount to approximately $17,200 (multiply the 15.3% self-employment tax rate times two years of net self-employment earnings of $50,000, plus the first quarter of compensation for 2002). Obviously, this liability is so large that it is doubtful that Rev. D will be able to afford it. (2) Revoke his exemption beginning with the year 2001. He will be liable for “back taxes” to January 1, 2001, or one year plus the first quarter of year 2002 self-employment taxes. This will amount to approximately $9,600 (multiply the 15.3% self-employment tax rate times one year of net self-employment earnings of $50,000, plus the first quarter of compensation for 2002). Obviously, this liability is also substantial, making it unlikely that Rev. D will be able to afford revoking his exemption. The problem in this example is that Rev. D waited too long to decide whether or not to revoke the exemption. The key point is this-the longer ministers delay in making this decision, the less likely they will be able to afford revoking their exemption.
Example. Assume that Rev. D has net self-employment earnings of $50,000 in 2000 and 2001, including his church-designated housing allowance. Rev. D learns of the new law, and decides to revoke his exemption immediately by filing a revocation form with the IRS in January of 2000. He designates on the form that he wants to revoke his exemption beginning with the year 2000. Rev. D uses the quarterly estimated tax procedure to pay his taxes, and so he simply begins basing his quarterly estimates on both income taxes and self-employment taxes. This will increase his quarterly payments by approximately $1,900 (one-fourth of his annual self-employment tax, computed by multiplying net self-employment earnings of $50,000 times the self-employment tax rate of 15.3%). By making the decision to revoke the exemption early, Rev. D is avoiding the problem of having to make large payments of “back taxes”. It is more likely that Rev. D will be able to “afford” revoking his exemption in the event that he would like to do so.
Example. Rev. D revokes his exemption in January of 2000. After a few years, he regrets having done so, and wants to revert back to exempt status. He will not be permitted to do so. A decision to revoke an exemption is irrevocable.
Tip. Here is a very important point to note-if the new bill does become law, ministers who would like to revoke an exemption from social security should do so as soon as possible. Back in 1987, ministers were given an opportunity to revoke an exemption, and they could do so from January 1, 1987 through April 15, 1988. The problem was that ministers who revoked an exemption were liable for self-employment taxes back to January 1, 1987. Most ministers who were seriously considering revoking their exemption waited until the deadline, only to discover that the revocation of their exemption would make them liable for five quarters of self-employment tax. Even on modest income, this was a crushing tax liability that few could afford. As a result, very few ministers revoked their exemption.
(4) Senate Bill 170
On January 19, 1999, Senator Bob Smith (R-NH) introduced Senate Bill 170. The bill currently has 11 cosponsors (Senators Moynihan, Harkin, Lott, Dodd, Kerrey, Chafee, Mack, Murkowski, Santorum, Reid, Inouye). The text of this bill is identical to that of Senate Bill 331, quoted above.
In explaining the bill, Senator Smith observed:
Today I am introducing a bill to allow qualified members of the clergy of all faiths to participate in the Social Security program. This bill would provide a two-year open season during which certain ministers who previously had filed for an exemption from Social Security coverage could revoke their exemption. These members of the clergy would become subject to self-employment taxes, and their earnings would be credited for Social Security and Medicare purposes. Before 1968, a minister was exempt from Social Security coverage unless he or she chose to elect coverage. Since 1968, ministers have been covered by Social Security unless they file an irrevocable exemption with the Internal Revenue Service, usually within two years of beginning their ministry. On two other occasions, in 1977 and again in 1986, ministers were given a similar opportunity to revoke their exemption from Social Security coverage. Despite the existence of these brief open season periods, many exempt ministers did not take advantage of or have not had the opportunity to revoke their exemption from Social Security coverage. Because the exemption from Social Security is irrevocable, there is no way for them to gain access to the program under current law. Only an individual who is a duly ordained, commissioned, or licensed minister of a church, or a member of a religious order who has not taken a vow of poverty, would be able to revoke his or her exemption from Social Security, under my bill. Of course, this measure would not permit ministers who already have reached retirement age to gain access to the Social Security program.
This bill primarily would benefit modestly paid clergy, who are among the most likely to need Social Security benefits upon retirement. Many chose not to participate in the Social Security program early in their careers, before they fully understood the ramifications of filing for an exemption. If enacted, this measure would raise about $45 million over the next five years, according to the Congressional Budget Office. CBO has scored the bill as a revenue raiser and, as a result, it will require no budget offset. Over the long-term, the legislation would cost money, but I do not expect its costs to be that significant because CBO has estimated that only about 3,500 members of the clergy would exercise the option that this bill provides.
Similarly, Senator Moynihan observed:
Today I join my colleague, Senator Bob Smith of New Hampshire, in introducing a bill to allow certain members of the clergy who are currently exempt from Social Security an open season to opt in. Under section 1402 of the Internal Revenue Code, a member of the clergy who is conscientiously, or because of religious principles, opposed to participation in a public insurance program generally, may elect to be exempt from Social Security coverage and payroll taxes by filing an application of exemption with the Internal Revenue Service within two years of beginning the ministry. To be eligible for the exemption, the member of the clergy must be an individual who is a fully ordained, commissioned, or licensed minister of a church, or a member of a religious order who has not taken a vow of poverty. Once elected this exemption is irrevocable. This legislation would allow members of the clergy who are not eligible for Social Security a two-year open season in which they could revoke their exemption. At the time of exemption, many clergy did not fully understand the ramifications of their actions, and it is not until later in life, when they are blocked from coverage, that they realize their need for Social Security and Medicare. This decision to “opt in” would be irrevocable and all post-election earnings would be subject to the payroll tax and credited for the purposes of Social Security and Medicare. The Congressional Budget Office estimates that this legislation would affect approximately 3,500 members of the clergy and would increase revenues by about $45 million over the next five years. Similar legislation was passed both in the 1977 Social Security Amendments (Section 316) and in the Tax Reform Act of 1986 (Section 1704). This bill has been endorsed by the United States Catholic Conference and the National Conference of Catholic Bishops. It is a simple but much-needed measure, and I urge every member of the Senate to support it.
Conclusions
There are several important conclusions for ministers to note:
1. Nothing has been enacted, yet. No law giving ministers an opportunity to revoke an exemption from self-employment tax has been enacted yet. Ministers who would like to revoke an exemption should do nothing now-except to review their options and be prepared to act quickly if any of the pending bills becomes law.
Key point. As soon as any of the pending bills allowing ministers to revoke an exemption from self-employment tax is enacted, we will alert you immediately in this newsletter and in our weekly email newsletter for subscribers to our website library.
2. Enactment is likely. It is very likely that Congress will enact legislation giving ministers an opportunity to revoke an exemption from self-employment tax. Remember that 72 of 100 senators are sponsoring one of the pending bills (Senate Bill 331), and this bill is identical to the one contained in the Ticket to Work and Self-Sufficiency Act of 1998 which was approved by the House of Representatives by a vote of 410 to 1.
3. Be prepared to act. Since it is likely that Congress will enact legislation giving ministers an opportunity to revoke an exemption from self-employment tax, ministers should be reviewing their options at this time. Here are some questions to ask:
“Am I am exempt from self-employment tax? You are if you filed a timely Form 4361 in triplicate with the IRS, and received back one of the forms marked “approved.”
“Was I eligible for exemption at the time I filed Form 4361? Review the conditions for exemption that are summarized at the beginning of this article. Many ministers were not.
“Do I want to revoke my exemption? Some ministers will want to revoke an exemption because they now realize that they were not eligible. It is an ethical matter for them. For others, the inducement to revoke an exemption may be to qualify for Medicare coverage and the other benefits of social security.
“If I decide to revoke my exemption, when should I do so? Remember that the longer you wait to revoke your exemption, the more “back taxes” you will have to pay-up to a maximum of two years plus one quarter of self-employment taxes. Even on modest incomes, this can result in a crushing tax liability. If you decide to revoke your exemption, consider doing so as soon as the law allows. This will minimize the financial impact of your decision, and make it more “affordable” by avoiding a large “back taxes” liability.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
IRS Modifies Rules for Electronic Depositing of Payroll Taxes
What churches should know about the new requirements.
Congress enacted legislation a number of years ago requiring the IRS to develop a system for the electronic filing of payroll taxes. Congress wanted a simple, “paperless” way for employers to deposit their payroll taxes. In response, the IRS came up with the Electronic Federal Tax Payment System (or EFTPS). Traditionally, employers have used a paper coupon and a check to make federal tax deposits (FTDs). EFTPS eliminates most of the paperwork in the old FTD coupon system. With EFTPS, deposits may be made by telephone or personal computer, or through the financial institution of the employer.
The new electronic system is being phased in over a period of years by increasing the percentage of total taxes subject to the new EFTPS system each year. Congress mandated that 94 percent of employment taxes be collected electronically in 1999. The IRS previously assumed that this meant that employers with $50,000 or more in payroll tax deposits would have to deposit payroll taxes electronically. As a result, employers with $50,000 or more in payroll tax deposits for 1997 were required to begin depositing payroll taxes electronically by January 1, 1999.
Key point. The IRS announced in 1998 that it would not assess any penalty for failure to comply with the EFTPS system until July 1, 1999 for an employer with at least $50,000 in payroll tax deposits for 1997 that continues to deposit payroll taxes using paper forms. IRS Announcement IR-98-68.
Recent experience has demonstrated that the 94 percent requirement can be met by increasing the $50,000 threshold to $200,000. As a result, the IRS has issued important new regulations that contain the following provisions that will be of interest to church treasurers:
$200,000 threshold
Employers (including churches) do not need to deposit payroll taxes electronically unless they deposited payroll taxes of $200,000 or more in 1998. This is up from the $50,000 threshold that was scheduled to apply this year. Payroll taxes include withheld FICA and income taxes, as well as the employer’s share of FICA taxes. Employers that exceed the $200,000 threshold in a future year will be required to deposit payroll taxes electronically following a one-year grace period. If an employer’s deposits drop below $200,000 in a future year, it will not be allowed to revert back to making manual deposits at a local bank.
The higher threshold will apply to deposits made on or after January 1, 2000. The IRS has announced that it will waive penalties for employers with $50,000 or more in payroll tax deposits that continue to deposit manually through the end of 1999. However, the IRS is reminding employers eligible for the penalty relief that deposits must still be made on time even when using paper coupons or they risk a late deposit penalty.
A “Fresh Start”
Employers that have been making electronic deposits in anticipation of the $50,000 threshold will be allowed to revert to depositing payroll taxes manually at a bank if they do not meet the new $200,000 threshold for 1998. The IRS estimates that 65 percent of employers that would have met a $50,000 threshold will not meet the $200,000 threshold. The IRS estimates that 91 percent of all employers make less than $200,000 in payroll tax deposits. These are the employers that now can voluntarily deposit their payroll taxes electronically.
Voluntary Compliance Expected
The IRS is assuming that most employers who are not required to deposit electronically will realize the simplicity and convenience of doing so, and will voluntarily comply.
Conclusion
The IRS commissioner recently noted that the large number of employers who have voluntarily begun depositing payroll taxes electronically means that “most businesses can voluntarily participate.” However, he also expressed confidence that “most of the employers that are currently using the system will continue to do so because they find it easier to use.”
The President and CEO of the National Association for the Self-Employed recently observed: “The new $200,000 threshold shows that IRS has listened to small employers’ concerns on this issue, and we appreciate it. While electronic payment of taxes is increasingly popular due to its speed and convenience, the decision to raise the threshold requiring the use of EFTPS shows understanding and flexibility for the needs of smaller employers.”
Need more information? For information on EFTPS or to get an enrollment form, call EFTPS Customer Service at (800) 555-4477 or (800) 945-8400. Employers can begin using EFTPS as soon as they receive their payment instruction packet and personal identification number.
Examples
Here are some examples that will assist you in understanding the new rules:
Example. A church employs four persons—a minister, office secretary, bookkeeper, and custodian. In 1998, the church deposited payroll taxes of $15,000. The church is not required to deposit payroll taxes electronically.
Example. Same facts as the previous example. The church treasurer decides that depositing payroll taxes electronically would be easier, and she would like to do so. Can the church voluntarily deposit payroll taxes electronically using the EFTPS system, even though it deposited only $15,000 of payroll taxes in 1998? Yes, it may.
Example. A church has 20 employees. Over the past few years, it has been depositing payroll taxes of about $75,000 per year. Since deposits exceeded $50,000, the church treasurer began depositing payroll taxes electronically in 1998 in anticipation of being required to do so under the old rules. Under the new rules, the church has the following two options. First, it can continue to deposit payroll taxes electronically. Second, it can revert to depositing payroll taxes manually at a bank—assuming that it did not meet the new $200,000 threshold for 1998.
Example. A church has 15 employees. Over the past few years, it has been depositing payroll taxes of about $60,000 per year. The church decides not to voluntarily switch to electronic deposits in 1999, and continues making deposits manually at a local bank. The IRS has announced that a church with $50,000 or more of payroll tax deposits in 1998 will not be subject to any penalties for continuing to deposit payroll taxes manually. Under the old rules, this church would have been subject to penalties for not switching to electronic deposits by July 1, 1999.
Example. A church has 75 employees. In 1998 it deposited payroll taxes of $215,000. This church must begin depositing payroll taxes electronically no later than January 1, 2000. It will not be subject to penalties for continuing to deposit taxes manually up to that date.
Example. Same facts as the previous example. Assume that the church deposits payroll taxes of $220,000 in 2000, and $185,000 in 2001. Since its deposits dropped below $200,000 for 2001, can it revert to manual deposits in 2002? The new regulations clarify that once an employer has $200,000 in payroll tax deposits for 1998 or any future year, it must begin depositing payroll taxes electronically and cannot revert to manual deposits in a later year if its deposits drop below $200,000.
Example. A church manually deposits payroll taxes of $150,000 in 1998, and also in 1999 and 2000. In the year 2001 it deposits $210,000. The new regulations specify that the church has a one-year “grace period” to convert over to electronic deposits. This means that it can continue to deposit payroll taxes manually in 2002 if it chooses to do so.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. A donor claimed charitable contribution deductions totaling $26,000 on his 1993 tax return. The donor claimed that he had made contributions to two churches, and two church-affiliated colleges. The amount of the charitable contribution deduction was estimated by the donor and given to his tax return preparer who prepared his 1993 return. The donor did not maintain any documentation supporting the contributions claimed. The IRS audited the donor’s 1993 tax return, and allowed a charitable contribution deduction of only $1,300. The donor appealed to the Tax Court.
The Court’s decision. The Court began its opinion by noting that “deductions are a matter of legislative grace, and the taxpayer bears the burden of proving that he or she is entitled to the claimed deductions.”
The Court noted that in 1993 a donor could claim a charitable contribution deduction for cash contributions that were substantiated with any one or more of the following items:
(1) a canceled check
(2) a receipt, letter, or other communication from the charity acknowledging receipt of the contribution and showing its name, the date of the contribution, and the amount of the contribution, or
(3) in the absence of a canceled check or receipt from the charity, any other reliable written records showing the name of the charity and the date and amount of the contribution
Key point. These requirements still apply to individual cash contributions of less than $250. Since 1994, however, new substantiation requirements apply to cash contributions of $250 or more.
The Court noted that the taxpayer has the burden of proving entitlement to a charitable contribution deduction, and that the donor in this case did not meet this burden. It observed:
In this case, [the donor] did not substantiate the charitable contributions claimed on his 1993 return in excess of those allowed by [the IRS]. He kept no records regarding his 1993 contributions. In addition, his testimony regarding his charitable deductions was not credible. He testified at trial that he made a cash contribution of $5,000 to [his church] during a stewardship dinner in January 1993 and that the funds to make the contribution were withdrawn from his bank account at [a credit union] the day before the dinner. However, [the church] had no record of any charitable contribution, much less a substantial one, from the donor during 1993.
Similar claims were made concerning alleged contributions to [the other church and church-affiliated colleges]. The donor testified that he made a cash contribution of $5,000 to [one college] in November 1993 and a cash contribution of $5,000 to [another church] in December 1993. He also testified that, the day before each contribution was made, he withdrew the cash to make the contribution from his bank account at [the credit union]. However, [the college], one of the alleged donees, had no record of any charitable contribution, much less a substantial one, from the donor during 1993, and the record contains nothing to substantiate his testimony regarding the alleged $5,000 gift to [the second church]. We hold, therefore, that the donor has failed to prove that he is entitled to any charitable deduction for 1993 in excess of that allowed by the IRS.
Relevance to church treasurers. What is the relevance of this case to church treasurers? Consider the following:
1. The Court’s ruling applies to cash contributions of less than $250. It must be emphasized that this case was addressing contributions made in 1993—a year before the requirements for substantiating charitable contributions were overhauled by Congress. However, the pre-1994 substantiation rules applied by the Court still govern individual cash contributions of less than $250, and so the Court’s ruling provides helpful insights. The fact that the vast majority of individual contributions made to churches are for less than $250 underscores the relevance of the Court’s decision.
2. Substantiating individual cash contributions of less than $250. In order for donors to substantiate an individual cash contribution of less than $250 made to their church, they must maintain at least one of the three categories of documentation noted by the Court–a canceled check, a receipt or letter issued by the church, or “any other reliable written records” showing the name of the church and the date and amount of the contribution.
3. Evidence that is not sufficient. This case illustrates that some cash contributions of less than $250 to a church will be denied because of a lack of substantiation. The donor in this case maintained no canceled checks, and had no written receipt issued by any of the churches or colleges substantiating his alleged cash contributions of $26,000. In fact, two of the four charities that allegedly received contributions from the donor had no record of any contribution. In addition, the donor failed to produce bank records to substantiate his assertion that he withdrew funds the day before he made large contributions to the charities in question.
Tip. Most cash donations to churches are for less than $250. Such contributions must be substantiated with any of the three kinds of records mentioned by the Court in its decision. One of those methods of substantiation is with a receipt, letter, or other communication from the charity acknowledging receipt of the contribution and showing its name, the date of the contribution, and the amount of the contribution. Churches can help to ensure the deductibility of such contributions by issuing timely receipts or contribution summaries to donors.
4. Penalties. The Court upheld the assessment of penalties against the donor by the IRS. Code section 6662 authorizes the imposition of a 20-percent penalty on the portion of an underpayment of tax attributable to negligence or disregard of rules or regulations. For purposes of section 6662, the term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the tax code. Negligence also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. The term “disregard” includes any careless, reckless, or intentional disregard. The Court concluded that the donor in this case “did not make a reasonable effort to comply with the requirements of the code or the regulations” and “failed to maintain any records sufficient to support entitlement to the deductions claimed. Failure to maintain documentation in support of claimed deductions has been held to constitute negligence or disregard of rules or regulations for purposes of [the negligence penalty]. We conclude, therefore, that the donor is liable for the accuracy-related penalty under section 6662.”
Need more information? Chapter 7 of Richard Hammar’s 1999 Church and Clergy Tax Guide addresses all of the charitable contribution substantiation rules in detail, with many helpful examples, tables, and forms.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Changes in “Offer in Compromise” Program Will Benefit Taxpayers
IRS says it will accept more compromises in settling outstanding tax liabilities.
Changes in “Offer in Compromise” Program Will Benefit Taxpayers
IRS says it will accept more compromises in settling outstanding tax liabilities.
Richard R. Hammar
Sometimes taxpayers find themselves with a crushing tax liability, and no means to pay it. To illustrate, assume that Rev. G filed an application for exemption from self-employment tax (Form 4361) several years ago, and has assumed that he is exempt from the tax. In fact, he never received acknowledgement of his exemption from the IRS, and so he never was legally exempt. The IRS audits Rev. G, and assesses self-employment taxes for the previous three years, amounting to $25,000.
Or consider Rev. K. He has always assumed that the housing allowance is an exclusion in computing both income taxes and self-employment taxes. He is audited by the IRS, and is assessed several thousand dollars in additional taxes because he incorrectly applied the housing allowance exclusion in computing his self-employment taxes.
Both Rev. G and Rev. K have inadequate resources to pay their tax liability. Over the past several years, such taxpayers could apply for relief by making an “offer in compromise” to the IRS on Form 656. This form lists a taxpayer’s sources of income, and net worth, and lets taxpayers make an offer to the IRS to pay a reduced amount of tax. The IRS often makes counterproposals to these offers, and about one-fourth are eventually accepted. For example, in 1998 only 25,052 offers out of 105,255 (23.8 percent) were accepted, leading to the collection of $290 million out of $1.9 billion in outstanding tax bills.
The IRS announced recently that it is liberalizing its offer in compromise program, to ensure that more of these offers are accepted. This is good news for taxpayers with huge tax liabilities. Here are some steps the IRS has taken:
(1) In evaluating a taxpayer’s ability to pay, the IRS will consider the taxpayer’s own expenses, rather than using national “averages”.
(2) Instead of the old, stringent application guidelines that often led to immediate rejections, the IRS will now work with taxpayers to fine tune their compromise offers–a step that will lead to the acceptance of more offers.
(3) Taxpayers will be asked to provide fewer financial documents to qualify for smaller compromise offers.
(4) New deferred payment procedures provide more opportunities for compromise offers to be submitted by taxpayers who may have been excluded under the old guidelines.
(5)A short-term deferred payment option allows taxpayers up to two years to pay the compromise offer.
(6) Specially trained IRS experts will be devoted to handling compromise offers. These new offer specialists will bring more consistency to the offer in compromise program and centralize offer processing.
(7) There will be new independent reviews for each rejected compromise offer. These reviews assess whether rejection is in the best interest of the taxpayer and the government. Many of these changes are reflected in a new version of Form 656. IRS Information release, IR-1999-30.
This article originally appeared in Church Treasurer Alert, May 1999.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
What Church Treasurers Should Know about “New Hire” Reporting
Federal law requires employers to report certain information about new employees.
Background. Churches are subject to new hire reporting requirements, mandated by Congress as part of comprehensive welfare reform legislation enacted a few years ago. This article will explain the application of the new reporting requirements to churches.
What is new hire reporting? New hire reporting is a procedure used by employers to report information about all new hires to a designated state agency. The purpose of the reporting requirement is to lower welfare costs by increasing child support collections and reducing welfare and food stamp payments. Another purpose is to reduce fraudulent unemployment benefits payments to persons who are working.
Key point. Technically, states are not required to mandate new hire reporting. But, if they fail to do so, they will forfeit federal funding under certain programs. To date, all states have enacted legislation mandating new hire reporting.
Why is new hire reporting necessary? New hire reporting facilitates the collection of child support from parents who change jobs frequently to avoid paying child support. It also will be used to detect and prevent erroneous welfare and unemployment benefits payments.
How will the information be used? When employers (including churches) report new hire information to their designated state agency, the agency will match the information against its own child support records to locate parents and enforce existing child support orders. Once these matches are done, the information is sent to the “National Directory of New Hires,” so other states can compare the information with their own child support records. The information also will be shared with state welfare and unemployment agencies, to detect and prevent fraudulent or erroneous payments.
Are churches exempt from the new hire reporting requirements? No, they are not. The new hire reporting requirements apply to all “employers.” The new law defines the term “employer” as “the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person.” There is no exception for religious organizations. And, there is no exception for “small” employers having only one or two employees. But remember—reporting is only for new hires, as defined by state law. This generally will be any employee hired after a date specified by state law.
What are the penalties for not reporting? The federal welfare reform law prohibits states from assessing a penalty in excess of $25 for each failure to report a new hire. However, states may impose a penalty up to $500 if an employer and employee “conspire” to avoid the reporting requirements, or agree to submit a false report.
What information must be reported? The federal welfare reform legislation requires that employers include the following information in their new hire reports:
employee’s name
employee’s address
employee’s social security number
employer’s name
employer’s address
employer’s federal employer identification number (EIN)
Note that most of this information is contained on the W-4 form (“withholding allowance certificate”) completed by each new employee at the time of hire, and as a result most states allow employers to comply with the reporting requirements by sending a copy of each W-4 form completed by a newly hired employee.
Tip. The employer’s federal identification number is inserted on line 10 of Form W-4 only when the form is sent to the IRS. Since this happens infrequently, the employer’s identification number generally does not appear on the form. So, for an employer to use W-4 forms to comply with the new hire reporting requirements, it must manually insert its federal employer identification number (EIN) on line 10. The employer’s name and address also may need to be manually inserted on line 8.
Key point. Some states ask employers to voluntarily report additional information, such as date of hire, or medical insurance information.
What is the deadline for filing a new hire report? The deadline is specified by state law. However, it may not be later than 20 days after an employee is hired.
How do we make a new hire report? Most states allow employers to comply with the new hire reporting requirement in any one of three ways:
• Electronic or magnetic reporting. Some states permit employers to report by electronic file transfer (EFT); file transfer protocol (FTP); magnetic tape; or 3.5″ diskette.
• Fax or mail. Most states permit employers to fax or mail any one or more of the following:
(1) A copy of a new employee’s W-4. Be sure it is legible, and that the church’s federal employer identification number (EIN) is included on line 10. Also be sure that the church’s name and address are included on the form.
(2) A printed list.
(3) A new hire reporting form provided by your designated state agency.
Tip. If your church hires new employees infrequently, the easiest way to comply with the reporting obligation may be to use the state reporting form. Simply complete one form with your federal employer identification number, name, and address, and then make several copies. This way, you will only need to add an employee’s name, address, and social security number when a new employee is hired.
• Voice reporting. In some states, employers can report new hires by leaving a voice message on a special voice response system.
Tip. Be sure to check with your designated state agency to find out what reporting options are available in your state. Telephone numbers for all state agencies are included in a table in this newsletter. Use the option that is easiest for you.
Tip. Does your church use a payroll reporting service? If so, it may be automatically making the new hire reports for you. Check to be sure.
What about privacy concerns? Federal law requires each state to implement safeguards to protect the confidentiality of new hire reports. In addition, all data transmitted by states to the National Directory of new Hires is done over secure and dedicated lines.
Telephone Numbers of Designated State Agencies
StateTelephoneStateTelephoneStateTelephone
AL
334-353-8491
KY
800-817-2262
ND
800-755-8530
AK
907-269-6685
LA
888-223-1461
OH
800-208-8887
AZ
602-252-4045
ME
207-287-2886
OK
800-317-3785
AR
501-682-3087
MD
888-634-4737
OR
503-986-6053
CA
916-657-0529
MA
617-577-7200
PA
888-724-4737
CO
303-297-2849
MI
800-524-9846
RI
888-870-6461
CT
860-424-5044
MN
800-672-4473
SC
800-768-5858
DE
302-369-2160
MS
800-866-4461
SD
888-827-6078
DC
888-689-6088
MO
800-859-7999
TN
888-715-2289
FL
904-922-9590
MT
888-866-0327
TX
888-839-4473
GA
888-541-0469
NE
888-256-0293
UT
801-526-4361
HI
808-586-8984
NV
888-639-7241
VT
802-241-2194
ID
800-627-3880
NH
888-803-4485
VA
800-979-9014
IL
800-327-4473
NJ
609-588-2355
WA
800-562-0479
IN
800-437-9136
NM
888-878-1607
WV
800-835-4683
IA
515-281-5331
NY
800-972-1233
WI
888-300-4473
KS
888-219-7801
NC
888-514-4568
WY
800-970-9258
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Defamation of Pastors
A Louisiana court issues an important decision-Steed v. St. Paul’s United Methodist Church, 1999 WL 92626 (La. App. 1999)
A Louisiana court issues an important decision-Steed v. St. Paul’s United Methodist Church, 1999 WL 92626 (La. App. 1999) [Defamation, The Civil Rights Act of 1964]
Article summary. While the law allows pastors to sue parishioners or employees for defamation, it makes it difficult for them to do so. As “public figures,” they must be prepared to tolerate criticism and even false allegations. Only when those allegations are made maliciously can they sue for defamation. A Louisiana court ruled that a pastor could sue a former employee for defaming him by spreading false allegations of sexual misconduct. It concluded that she had acted with malice, and ordered her to pay him $90,000 in damages. The court also rejected the woman’s sexual harassment claims under state and federal law.
Imagine the pastor of your church being accused of sexual harassment of an employee. The pastor insists that he is innocent, and is cleared by a denominational board of inquiry. The congregation becomes aware of the allegations, and this results in a drastic decline in attendance and finances. The woman is interviewed by two local television stations, and a newspaper, and makes damaging allegations against the pastor. The pastor is forced to move to another city amidst the turmoil. What options does the pastor have in such a tragic scenario? Can he sue the former employee for defamation? That was the question addressed by a Louisiana state appeals court in a recent decision. This article will review the facts of the case, summarize the court’s ruling, and assess the significance of the case to other churches and clergy.
Facts
A woman (the “defendant”) was employed as choir director by a Methodist church. Shortly after she came to work, she claimed that the pastor started hugging her. At first the hugs seemed innocent, but they soon became lingering and made her uncomfortable. The hugs allegedly occurred in the pastor’s office and would often occur after staff meetings. She wanted to give him the benefit of the doubt and at first did not think anything was wrong. On one occasion the pastor came into the choir room and seemed visibly upset. She asked him what was wrong, and when he did not answer her, she put her hands on his shoulders and asked again. According to the defendant, the pastor then grabbed her around the waist, pulled her close to him, and tried to kiss her on her lips. She reportedly turned her head, at which time he kissed her hard on the cheek. She tried to pull away, and he let her go when he heard the organist coming into the room. Later, he asked the defendant if she thought the organist had seen them. The defendant replied no, and told him never to touch her again.
The defendant also testified that there were times when the pastor attempted to grab or touch her in the hall, in the sanctuary, and near the door of the lobby. She stated that on numerous occasions the pastor would tell her not to tell anyone about the incidents. He also frequently quizzed her about whom she had told. When asking these questions, the pastor would either grab her by the arm or block her exit from the office. The defendant reported that she told her husband, and then told the pastor that if he did not stop touching her and talking about the incidents, she would tell his wife and denominational officials (the district superintendent and bishop). She assured him that if he would quit talking about it, she would let the matter drop.
The defendant claimed that the pastor continued to badger her, so she told the organist, a church member, and the pastor-parish relations committee (which functioned as the church board). The defendant then met with the chairman of the pastor-parish relations committee to discuss the situation. According to her, the chairman acknowledged that the pastor had “a thing going on” with her, but that it was harmless. She claimed that she was never asked out on a date, never asked to have sex, and never propositioned in any way.
For his part, the pastor asserted that he first became aware of the accusations when the defendant was in his office and told him that she thought he was “making a play” for her. He closed the office door (after asking her permission) and asked if she was joking. When told she was not, the pastor informed her that she was obviously misinterpreting his actions, and that he was a happily married man and was not interested in her in that way. The pastor claimed that their next conversation occurred in the choir room. As he turned to leave he reached for her and she told him not to touch her. He later called her into his office, where she again accused him of making a play for her and informed him that she had told her husband. Later that week, the pastor called the defendant’s husband to tell him that nothing had happened. The husband later testified that the pastor had called to apologize for his actions. The pastor steadfastly denied all allegations of wrongful conduct.
The pastor-parish relations committee began discussing the defendant’s allegations. The only corroborating evidence she presented was the testimony of a person who had borrowed substantial amounts of money from the defendant and her husband on an interest-free basis, and who had purchased a car from them and instead of paying for it, worked it off through yard work. The pastor-parish relations committee proposed various solutions to the problem, all of which were rejected by both the defendant and pastor. The defendant would not accept any solution that did not involve counseling and a full acknowledgment by the pastor of his guilt before the pastor-parish relations committee, while the pastor refused to attend any counseling or admit to any wrongdoing. During this time the congregation began hearing about the accusations, and rumors started spreading. In an attempt to defuse the rumors, the pastor-parish relations committee read a statement to the congregation to the effect that the defendant had made allegations against the pastor, that the pastor-parish relations committee had conducted an investigation, and that there was no factual support for the allegations.
The defendant later filed a formal complaint with the district superintendent, who directed the complaint to be resolved by a “board of ordained ministers” pursuant to Methodist practice. She later withdrew her complaint since she was not allowed to have an attorney present or to call witnesses. The superintendent directed the board to resolve the complaint, and it later issued a statement after considering all the evidence that the pastor had been exonerated.
Church attendance, membership, and financial support to the church plummeted as a result of the defendant’s allegations. The bishop stepped in, transferred the pastor to a church in another part of the state, and appointed a new pastor for the church. The new pastor accepted the appointment on the condition that he could hire his own staff. As a result, the PPR terminated the entire staff, many of whom were later rehired by the new pastor. The defendant, however, was not rehired. Several pastor-parish relations committee members testified that the defendant’s allegations about the former pastor had nothing to do with her termination.
The defendant later sued the former pastor, her church, and state and national Methodist bodies alleging discrimination in employment in violation of Title VII of the Civil Rights Act of 1964, and sex discrimination and retaliatory discharge under state law. After filing her lawsuit, the defendant discussed her claims on two local television stations and a newspaper. A year later, the pastor sued the defendant for defamation of character.
The trial court dismissed the state and national church bodies because they were not the defendant’s employer as required by state and federal sexual discrimination statutes. The case went to a jury which dismissed the Title VII sex discrimination claim since the church had fewer than 15 employees (Title VII prohibits employers with 15 or more employees, and engaged in interstate commerce, from engaging in sex discrimination in employment decisions). The jury also dismissed the defendant’s sex discrimination claims against the pastor, since only employers can be sued under state and federal discrimination statutes. It dismissed the sex discrimination claims under state law against the church, and found the defendant liable for defaming the pastor. It ordered her to pay him $90,000 in damages. The defendant appealed.
The Court’s Ruling
Defamation
The appeals court only addressed the trial court’s defamation award in favor of the pastor. It began its opinion by noting that in order for ministers to win a defamation claim, they must prove the public and malicious disclosure of false allegations, resulting in an injury to reputation. The court defined “malice” as “the lack of reasonable belief in the truth of the words.” However, when words accuse a person of criminal conduct, they are presumed to be false and malicious, and defamation is assumed.
The court noted that
the record amply supports the finding that [the defendant’s] words were defamatory. [The pastor’s] reputation was diminished to the point that he was transferred from [his church] and in fact relocated in the southeast portion of the state, an extraordinary move necessary to distance him from the scandal. A rational juror could find, more probably than not, that his reputation, and his ability to serve as a minister in north Louisiana, were damaged by [the defendant’s] accusations. Moreover, [her] charges that [he] grabbed her, tried to kiss her, and physically blocked her from leaving his office, amount to accusations of at least simple battery. Additionally, by accusing him of sexual harassment, [the defendant] launched allegations which by their nature tended to injure his personal and professional reputation.
Even though malice was assumed because the defendant accused the pastor of criminal behavior, the court noted that the defendant’s own testimony provided additional proof of malice. Specifically, she admitted in court that when she told the television reporters that the pastor had grabbed her thigh, she was incorrect. Further, “the general absence of evidence to support her allegations could persuade a rational juror that [she] had no reasonable belief that her statements were true.”
Privilege
The defendant insisted that her statements could not be defamatory because they were privileged. The court acknowledged that “privilege is one of the defenses to a defamation suit.” In this case, the defendant claimed the “qualified privilege” that applies “when a statement is made in good faith, on a subject matter in which the person communicating it has an interest … to a person having a corresponding interest.” As an example of this privilege the court referred to “communications between appropriate persons within the employer’s walls, concerning allegations of conduct by an employee that bears on the employer’s interest.” This often is referred to as the “common interest” privilege. It is a “qualified” privilege rather than an absolute privilege, since it only applies if the person making the statements does so in good faith. The court noted that good faith exists “if the person making the statements had reasonable grounds for believing that the statements were true and he honestly believed them to be true.”
The defendant insisted that she made the statements in good faith, that she had an interest in reporting the pastor’s alleged sexual harassment, and that the people to whom she reported (members of the pastor-parish relations committee) had a duty to her as an employee and to the church to deal with ministers who engaged in sexual harassment. The court disagreed, noting that
with all the evidence in this record, the jury was not plainly wrong to conclude that [the defendant] was not in good faith. There was conflicting testimony regarding whether or not any sexual harassment had occurred; notably, [the defendant] admitted that her televised accusation was false. [The pastor] denied each and every accusation. The jury was entitled to find the evidence of [the pastor] more credible, and that of [the defendant] and her only corroborating witness … less so. In view of the conflicting evidence, this privilege does not apply.
Amount of Damages
The defendant asserted on appeal that the jury’s verdict of $90,000 was excessive. The pastor responded that the amount was inadequate. The court noted that in a defamation case a jury can award damages based on injury to reputation, personal humiliation, embarrassment, mental anguish, anxiety, and hurt feelings. In addition, a jury can award damages based on a loss of income. The court noted that several denominational officials testified that the pastor’s reputation had suffered because of the woman’s allegations. They pointed to the fact that he had to be transferred to a church in another part of the state. As a result,
it was reasonable for the jury to find that [the pastor’s] general reputation was injured by the allegations. [He] testified that due to the transfer his salary was reduced by $18,000 per year. The record clearly shows that [he] has suffered extreme embarrassment, humiliation, and loss of reputation from his fellow ministers and family, that he was transferred due in part to the accusations, and that he has suffered a loss of income due to the transfer. It was not manifestly erroneous for the jury to award [him] a lump sum of $90,000 in damages for his loss of reputation, his embarrassment and humiliation, and his loss of income.
Homeowner’s Insurance
The defendant’s homeowner’s insurance carrier refused to provide her with a legal defense, or pay any portion of the $90,000 verdict. It based its position on the policy’s exclusion of “bodily injury or property damage … intended by the insured.” The court noted that “insurance policies should be construed to effect, not deny, coverage,” and that “an exclusion from coverage should be narrowly construed.” The court concluded that the plain language of the exclusion restricted it to “injuries which were intended” rather than to “injuries from an intended act.” It concluded that the exclusion did apply, because the defendant clearly intended to injure the pastor:
[The defendant] made allegations that [the pastor], a married minister, was sexually harassing her. She repeated these allegations to various members of the congregation, reported them to [the pastor’s] supervisors, and instituted an interview which led to the airing of these allegations over two television stations … and a newspaper. Notably, when [the pastor-parish relations committee] attempted to resolve this situation, [the defendant] refused to accept any solution which did not include [the pastor’s] attending counseling and admitting … that he had sexually harassed her. Additionally, when asked about these statements [she] testified that she intended to accuse [him] of sexual harassment and that she was aware that his reputation would suffer. In sum, by making and repeating allegations of sexual harassment against a Methodist minister, [the defendant] either knew that [he] would suffer humiliation, loss of reputation, and a job transfer, or was substantially certain that these damages would follow. As such, she intended the accusations and the injuries; thus, the intentional act exclusion in her homeowner’s policy applies.
Relevance of the case to other churches and ministers
What is the relevance of this ruling to other churches? Obviously, a decision by a Louisiana appeals court is of limited significance since it has no direct or binding effect in any other state. Nevertheless, there are a number of aspects to the ruling that will be instructive to church leaders in every state. Consider the following:
1. Defamation-in general. The court noted that it is more difficult for “public figures,” including pastors, to establish defamation. There is a simple reason for this. Public figures, by assuming highly visible and prominent positions, must assume that they will be the subject of discussion, criticism, and even false allegations. As a result, they cannot be defamed, like ordinary citizens, by false statements that tend to injure their reputation. They also must prove that the person making the false statement did so maliciously. In this context, malice means that the person making the false statement either knew that the statement was false, or made it with a reckless disregard for its truth or falsity. This is a very difficult standard to meet. But this case illustrates that it is not impossible. The court concluded that the defendant acted maliciously when she made false statements about the pastor, and it based this conclusion on “the general absence of evidence to support her allegations” which “could persuade a rational juror that [she] had no reasonable belief that her statements were true.”
Note that persons who are not public figures do not have to prove malice in order to win a defamation claim. They need only prove that another person made a false statement about them, the false statement was “published,” and it injured their reputation.
Elements of Defamation
Non-public FigurePublic Figure
(1) Oral or written statement
(1) Oral or written statement
(2) Concerning another person
(2) Concerning another person
(3) The statement is false
(3) The statement is false
(4) The statement is publicized (made public through communication to other persons)
(4) The statement is publicized (made public through communication to other persons)
(5) Injury to the defamed person’s reputation
(5) Injury to the defamed person’s reputation
(6) The person making the defamatory statement did so with “malice,” meaning that he or she either knew the statement was false, or made it with a reckless disregard as to its truth or falsity
2. Defamation – statements concerning criminal activity. When words accuse a person of criminal conduct, they are presumed to be false and malicious, and defamation is assumed. In this case, the woman accused the pastor of various acts of hugging, touching, and fondling – all of which amount to the crime of “simple battery.” As a result, the defendant’s words were presumed to be false and malicious. This presumption can be overcome through opposing evidence, but the court concluded that the defendant failed to produce sufficient evidence to overcome the presumption.
• Key point. When persons make allegations of sexual misconduct against a pastor or other church worker, they often are alleging behavior that constitutes a crime under state law. Such accusations are so serious that the law creates a presumption that they are false and malicious, and defamation is assumed, unless the person making them “rebuts” the presumption of defamation by producing evidence to support the charges. As a result, persons should refrain from making charges of criminal misconduct against other church members or staff unless they have evidence that supports their allegations.
• Example. Two female church employees accuse their pastor or sexual harassment. The alleged harassment included numerous acts of inappropriate and unwelcome touching and hugging. The women submit their accusations to their church board. They support their charges with the testimony of two other church employees who witnessed the pastor engaging in some of the inappropriate acts. The women’s accusations, if true, would mean that the pastor committed the crime of simple battery. As a result, in many states their accusations are presumed to be false and malicious, and defamation is assumed. However, they can rebut this presumption through evidence that substantiates their charges. In this case, they will meet that burden. Not only are there two victims whose testimony is mutually corroborative, but there are two additional witnesses who observed the pastor engaging in some of the inappropriate behavior.
• Example. A mother informs her pastor and members of the church board that a volunteer youth worker sexually molested her son during an overnight church activity. The youth worker threatens to sue the mother for defamation. There were no witnesses to the alleged incident; however, the mother took her son to a physician who confirmed that sexual molestation had occurred. The women’s accusations, if true, would mean that the youth worker committed a crime (aggravated child molestation) under state law. As a result, in many states the mother’s accusations are presumed to be false and malicious, and defamation is assumed. However, she can rebut this presumption through evidence that substantiates her charges. In this case, she probably will meet that burden through her physician’s testimony.
3. Privileges to defamation. There are a number of privileges to defamation. A privileged statement is not defamatory. Some privileges are absolute, including statements that are truthful, or that are made before a court or legislature. Other privileges are qualified, meaning that they are subject to some exception or limitation. This case illustrates one example of a qualified privilege-statements concerning matters of common interest. Most courts have recognized that persons with a common interest in information about another person should be free to share information about that person without fear of being liable for defamation. But this privilege is not absolute. It only applies if the person making the allegedly defamatory statement does so in “good faith.” This means that the “the person making the statements had reasonable grounds for believing that the statements were true and he honestly believed them to be true.” Other courts simply say that the privilege can be lost if the person making a statement concerning a matter of common interest does so with malice. This is another way of saying that the person making the statement did not do so in good faith. Once again, malice in the context of defamation means that the person making the statement either knew that it was false, or made it with a reckless disregard as to its truth or falsity.
The defendant made a plausible claim that she disclosed information about the pastor’s alleged acts of sexual harassment to members of the pastor-parish relations committee because they had a legitimate interest in learning about such information. The court rejected this argument, and as a result concluded that the defendant’s remarks were not privileged. It based this conclusion in part on the false statement (“the pastor grabbed my thigh”) the defendant made in her television and newspaper interviews, and which she later admitted was false.
4. Proving a sexual harassment claim. Claims of sexual harassment often are difficult to resolve, because the evidence is conflicting. This case is illustrative. The evidence submitted by the parties is summarized in the following table:
Evidence Supporting the Defendant
Evidence Supporting the Pastor
Her own testimony
His own testimony
The testimony of an alleged witness
The defendant’s witness was not credible, since he had received preferential financial treatment from the defendant
The defendant made a statement (the pastor grabbed her thigh) in television and newspaper interviews that she later admitted was false
A denominational “board of ordained ministers” investigated the defendant’s charges, and exonerated the pastor
A jury did not accept the defendant’s accusations of sexual harassment
5. Title VII of the Civil Rights Act of 1964. Title VII prohibits employers with 15 or more employees, and that are engaged in interstate commerce, from discriminating in employment decisions on the basis of sex. Sexual harassment is a form of prohibited sex discrimination. The defendant claimed that the pastor’s behavior amounted to sexual harassment for which her employing church was liable under Title VII. The court dismissed this claim on the ground that the church employed fewer than 15 persons and so was not subject to Title VII.
6. Reducing the risk of similar claims. The effects of the defendant’s allegations were dramatic. Her allegations soon were spread throughout the congregation, resulting in a drastic decline in attendance and revenue. In addition, the church board had to call a meeting of the congregation to confront the matter, and the accused pastor was unceremoniously replaced and transferred to another part of the state. While it is impossible to eliminate the risk of such an ordeal, the good news is that church leaders can take steps to reduce the risk. Consider the following two suggestions:
#1 – Adopt a Sexual Harassment Policy
As we have pointed out in previous issues of this newsletter, it is very important for any church having employees to adopt a sexual harassment policy. Such a policy has a number of significant advantages. First, it will reduce the likelihood of such claims. Why is this so? Because a properly drafted policy will provide employees and employers with a definition of sexual harassment. Unfortunately, sexual harassment is more likely to flourish where employees and employers lack a clear understanding of what it means. By clearly defining the term in a policy, employees will be effectively warned against behaviors, however “innocent,” that cross the line. And, employers will be better informed about behavior that is inappropriate. In summary, a properly drafted sexual harassment policy can be an effective tool in reducing the risk of sexual harassment, and the turmoil that often is associated with such claims.
Second, a sexual harassment policy will provide a church with a potent legal defense in the event of a sexual harassment claim.
Here is a list of some of the terms that should be incorporated into a written sexual harassment policy:
Define sexual harassment (both quid pro quo and hostile environment) and state unequivocally that it will not be tolerated and that it will be the basis for immediate discipline (up to and including dismissal).
Contain a procedure for filing complaints of harassment with the employer.
Encourage victims to report incidents of harassment.
Assure employees that complaints will be investigated promptly.
Assure employees that they will not suffer retaliation for filing a complaint.
Discuss the discipline applicable to persons who violate the policy.
Assure the confidentiality of all complaints.
In addition to implementing a written sexual harassment policy, a church should also take the following steps:
Communicate the written policy to all workers.
Investigate all complaints immediately. Some courts have commented on the reluctance expressed by some male supervisors in investigating claims of sexual harassment. To illustrate, a federal appeals court observed: “Because women are disproportionately the victims of rape and sexual assault, women have a stronger incentive to be concerned with sexual behavior. Women who are victims of mild forms of sexual harassment may understandably worry whether a harasser’s conduct is merely a prelude to violent sexual assault. Men, who are rarely victims of sexual assault, may view sexual conduct in a vacuum without a full appreciation of the social setting or the underlying threat of violence that a woman may perceive.”
Discipline employees who are found guilty of harassment. However, be careful not to administer discipline without adequate proof of harassment. Discipline not involving dismissal should be accompanied by a warning that any future incidents of harassment will not be tolerated and may result in immediate dismissal.
Follow up by periodically asking the victim if there have been any further incidents of harassment.
• Key point. EEOC guidelines contain the following language: “Prevention is the best tool for the elimination of sexual harassment. An employer should take all steps necessary to prevent sexual harassment from occurring, such as affirmatively raising the subject, expressing strong disapproval, developing appropriate sanctions, informing employees of their right to raise and how to raise the issue of harassment under Title VII, and developing methods to sensitize all concerned.”
• Key point. The assistance of an attorney is vital in the drafting of a sexual harassment policy.
#2 – boundaries
Clergy and lay staff should understand the importance of establishing and honoring “boundaries” in their interactions with minors as well as members of the opposite sex. Boundaries not only reduce the risk of inappropriate behavior, but just as importantly they reduce the risk of false allegations which can be devastating to an innocent person. We have discussed appropriate boundaries on several occasions in this newsletter. Listed below are examples of boundaries that have been adopted by some churches. You may want to consider adopting some of them:
Only permit opposite sex counseling by clergy if a third person is present. The third person can be the pastor’s spouse, a staff member, board member, or some other person who is capable of maintaining confidences.
Only permit counseling of minors by clergy and lay employees and volunteers if a third person is present. The third person can be the counselor’s spouse, a staff member, board member, or some other person who is capable of maintaining confidences.
Require a third person to be present for any pastoral counseling occurring off of church premises. For example, if a woman calls the pastor at 3 AM and asks him to come to her apartment for counseling, the pastor can only go if a third person comes along.
Permit counseling to occur on church premises only during office hours when other staff are present and visible (through a window or doorway).
Require a third person to be present for any pastoral counseling occurring on church premises after hours and on weekends, or at any other time when there are not staff members who are present and visible during the counseling session.
Limit counseling sessions to a reasonable amount of time, such as 45 minutes.
Limit the number of counseling sessions with the same person to a reasonable number, such as 4 or 5 during the same calendar year.
Adopt a policy requiring women to be counseled by women.
Install a video camera in the pastor’s office, or wherever counseling occurs, that provides a video feed (not audio) to a terminal at another staff member’s desk. The staff member is instructed to remain at the desk throughout the counseling session, and to frequently monitor the screen. Alternatively, the counseling session can be recorded on video tape (without audio), and later played back in fast forward by a staff member who then prepares and signs a dated memorandum acknowledging that no inappropriate behavior was observed.
Churches that want to implement any one or more of these suggestions should do so by adopting an official policy through appropriate action of the board. This will remove any element of discretion. When a person calls the pastor and asks for counseling off of church premises, the pastor can simply respond that he or she is prohibited by church policy from accommodating the person without the presence of a third person.
The problem. According to our annual surveys of church financial practices, we know that most churches by now have adopted “accountable” expense reimbursement arrangements. This means that they reimburse business expenses incurred by their pastor, and perhaps lay employees, which are adequately substantiated (“accounted for”) in a timely manner. A question that often arises is who owns property purchased by a pastor or lay employee if the purchase price is reimbursed by the church under an accountable arrangement? The pastor (or lay employee)? The church? What difference does it make? Church treasurers should be able to answer these questions.
Let’s illustrate the practical significance of this subject with a few examples.
Example 1. First Church adopted an accountable expense reimbursement arrangement several years ago. It reimburses those expenses incurred by any of its employees that are adequately substantiated. To substantiate an expense, an employee must submit proof of its amount, date, location, and business purpose. Receipts are required for any expense of $75 or more. Substantiation of each expense must be completed within a month of the date the expense was incurred. Such an arrangement qualifies as an accountable expense reimbursement arrangement. Assume that Pastor D purchased a personal computer for $2,000 in 1998 that he uses entirely for work-related duties (sermon preparation, research, and communicating with church members and other ministers). In 1999, one year after purchasing the computer, Pastor D accepts a position at Second Church. A few days before moving, the treasurer at First Church asks Pastor D about the computer. Will he be leaving it, or taking it with him? Pastor D is unsure who should keep it, and so is the church treasurer.
Example 2. Pastor B has served as pastor of First Church for 20 years. Over that time, he has purchased several books and commentaries for a professional library that he maintains in his church office. Many of the books were purchased in the past few years. The church has reimbursed Pastor B for the purchase of all of these books. The reimbursements have amounted to $3,000. Pastor B accepts a position at Second Church. As his last day at First Church approaches, he begins to wonder about his library. Should he leave it for his successor at First Church? After all, the church paid for it. Or, should he pack it up and take it with him? He asks the church treasurer for her opinion, but she is unsure. They agree to let the pastor take the library with him. This decision is based on the fact that a pastor’s library is a matter of personal preference, and that Pastor B’s library may be of little if any use to his successor. Further, they assume that the next pastor probably will be bringing his own library with him from his previous church. An accountant who attends First Church learns that Pastor B will be taking the library with him. The accountant questions the legality of this arrangement. The church board addresses this issue, but does not know how to resolve it. They want to let Pastor B take the library with him, but they do not how to explain such a decision to the accountant.
Example 3. Same facts as example 2, except that Pastor B is retiring.
Example 4. Pastor T is the youth pastor and resident “computer expert” at his church. During the three years he is employed by the church, he purchases several CDs and software programs to assist in the performance of his duties. The church reimbursed him for all of these purchases, which amounted to nearly $1,500. Pastor T accepts a position at another church. A question arises as to the ownership of the CDs and computer programs.
How church treasurers should respond. Unfortunately, the tax code and regulations do not address the question of who owns property purchased by an employee if the purchase price is reimbursed by the employer under an accountable reimbursement arrangement. And no guidance has been provided by the IRS or the courts.
So what should church treasurers do? Here are our suggestions:
The general rule
In general, when an employer reimburses an employee for the cost of property purchased by the employee for business use, it is the employer rather than the employee that is the legal owner of the property. After all, property purchased by an employee cannot be reimbursed under an accountable arrangement unless the employee substantiates the cost and business purpose of the property. In other words, it must be clear that the property will be used solely for the business purposes of the employer. Under these circumstances, there is little doubt as a matter of law that the employer is the legal owner of the property. It paid for it, and the accountable nature of the reimbursement arrangement ensures that it will be used by the employee within the course of his or her employment on behalf of the employer.
Key point. In many states, a “resulting trust” arises by operation of law in favor of the person who purchases property in the name of another. The law presumes that it ordinarily is not the intention of a person paying for property to make a gift to the one receiving title.
Example 5. A court ruled that a home purchased by a church for its pastor was subject to a “purchase money resulting trust” in favor of the church and therefore the home could not be considered in a property settlement following the pastor’s divorce. The court ruled that when property is purchased by one person, but title is vested in another, the person holding title does so subject to a “purchase money resulting trust” in favor of the person who paid for the property. Cayten v. Cayten, 659 N.E.2d 805 (Ohio App. 1995).
A possible exception
In many cases, the value of property diminishes rapidly, and in a sense is “used up” within a period of months or a few years. As a result, the question of “ownership” of the property when the employee leaves his or her job has little relevance, since the value is so minimal.
Example 6. A pastor purchases a small dictation machine for $49 in 1995. The church treasurer reimburses her for the cost of the machine under the church’s accountable reimbursement arrangement. When she leaves the church in 1999, the value of the machine is negligible. The “value” of the machine has been “used up” over its useful life. The church in essence has received full value for the purchase, and it would be pointless to insist that the machine remain with the church.
Example 7. Pastor G purchases a “state of the art” computer in 1992 at a cost of $2,500. First Church reimbursed the full purchase price, since the pastor used the computer exclusively for church-related work. The computer is an IBM compatible 20 megahertz “286” model, with 1 RAM of memory and a hard disk storage space of 200 megabytes. It has no modem and no CD drive. Pastor G accepts a position at Second Church in 1999. He is still using the same computer, and a question arises as to the ownership of the machine. While the computer may have been “state of the art” in 1992, it is essentially worthless in 1999. Like the dictation equipment described in example 6, the church has received full value for its purchase of the computer, and it would be pointless to insist that the computer remain with First Church.
Inurement
Churches need to be concerned about the issue of inurement when they allow a minister or other employee to retain ownership and possession of property purchased by the church for church use. Churches are exempt from federal income taxes so long as they comply with a number of conditions set forth in section 501(c)(3) of the tax code. One of those conditions is that “no part of the net earnings [of the church or charity] inures to the benefit of any private shareholder or individual.” What does this language mean? The IRS has provided the following clarification:
An organization’s trustees, officers, members, founders, or contributors may not, by reason of their position, acquire any of its funds. They may, of course, receive reasonable compensation for goods or services or other expenditures in furtherance of exempt purposes. If funds are diverted from exempt purposes to private purposes, however, exemption is in jeopardy. The Code specifically forbids the inurement of earnings to the benefit of private shareholders or individuals …. The prohibition of inurement, in its simplest terms, means that a private shareholder or individual cannot pocket the organization’s funds except as reasonable payment for goods or services.” IRS Exempt Organizations Handbook section 381.1.
It is possible that prohibited inurement occurs when a church allows a minister or other employee to retain ownership and possession of property purchased with church funds for church use. However, in many cases the value of the property will be so minimal that inurement probably is not a problem. To avoid any question, especially if the property has some appreciable residual value, the church could “sell” the property to the employee, or it could determine the property’s market value and add this to the employee’s final W-2 or 1099 as additional compensation. In either case, the inurement problem would be avoided.
In deciding whether or not inurement has occurred, the relevant considerations will be as follows:
(1) the purchase price paid (or reimbursed) by the church
(2) the “useful life” of the property
(3) the date of purchase
(4) the residual value of the property at the time the pastor or lay employee is leaving his or her employment with the church
IRS regulations specify the useful life of several different kinds of property in order to allow taxpayers to compute depreciation deductions. These guidelines can be a helpful resource in deciding whether or not inurement has occurred.
Let’s apply the inurement principle to the above examples.
Example 1. Inurement is a possibility according to the above criteria, since (1) the purchase price paid by the church was substantial; (2) a one-year old computer still has a remaining “useful life” (according to IRS regulations, the useful life of computer equipment is 5 years); (3) the computer was purchased one year ago; and (4) the residual value of a one-year old computer is still significant. To avoid jeopardizing the church’s tax-exempt status as a result of prohibited inurement, the church has three options. First, it can ask Pastor D to return the computer. Second, it can let Pastor D keep the computer, but add the current value of the computer to Pastor D’s W-2. The computer’s current value can be obtained by calling local computer dealers, especially those dealing in used equipment. Third, the church can sell the computer to Pastor D for its current value.
Example 2. Inurement is a possibility according to the above criteria, since (1) the purchase price paid by the church was substantial; (2) some of the books still have a remaining “useful life” (according to IRS regulations, the useful life of books is 7 years); (3) while some of the books were purchased more than 7 years ago, many were purchased within the past 7 years; and (4) the residual value of books purchased within the past 7 years is still significant. To avoid jeopardizing the church’s tax-exempt status as a result of prohibited inurement, the church has three options. First, it can ask Pastor B to return books purchased within the past 7 years. Books purchased prior to that time are beyond their “useful life,” according to IRS regulations, and so their value is presumed to be insignificant. Second, it can let Pastor B keep the entire library, but add the current value of books purchased within the past 7 years to his W-2. The current value of these books can be obtained by calling a used book dealer. Third, the church can sell the books to Pastor B for their current value.
Example 3. See the analysis of example 2.
Example 4. Inurement is a possibility according to the above criteria, since (1) the purchase price paid by the church was substantial; (2) the CDs and software programs still have a remaining “useful life” (according to IRS regulations, the useful life of computer software is 36 months); (3) the CDs and software were purchased in the recent past (within the 36-month “useful life” specified by the IRS regulations); and (4) the residual value of the CDs and software is still significant. To avoid jeopardizing the church’s tax-exempt status as a result of prohibited inurement, the church has three options. First, it can ask Pastor T to return the CDs and software. Second, it can let Pastor T keep the CDs and software, but add the current value of these items to his W-2. The current value of CDs and software can be obtained from a local computer dealer, especially one that deals with used products. Third, the church can sell the CDs and software to Pastor T for their current value.
Example 5. Not applicable.
Example 6. Inurement is not a possibility according to the above criteria, since (1) the purchase price paid by the church was minimal; and (2) the current residual value of a dictation machine that cost $49 four years ago is negligible. IRS regulations specify that the useful life of such equipment is 7 years, and so the machine still has a remaining useful life. However, the age and minimal cost of the machine outweigh the significance of any remaining useful life.
Example 7. Inurement is not a possibility according to the above criteria, even though the original cost was substantial, since (1) the computer has outlived its useful life (according to IRS regulations, the useful life of computer equipment is 5 years); (2) the computer was purchased 7 years ago, and is essentially obsolete; and (3) the residual value of a 6-year-old computer is minimal.
Key point. This article has focused on the ownership of property purchased by a pastor or lay employee, when the purchase price is later reimbursed by the church under an accountable business expense reimbursement arrangement. The same analysis will apply, of course, if the church reimburses the purchase price under a nonaccountable arrangement. This article addresses accountable arrangements since the vast majority (93%, according to our surveys) of churches that reimburse business expenses claim to be doing so under an accountable arrangement.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
