Clergy Status-Employee or Self-employed—Retirement Plans, Clergy Compensation, Computation of Social Security Tax, Tax Withholding and Estimated Tax Reporting, Unemployment Taxes and Churches

Article summary. In August the President signed into law two major tax bills-the Taxpayer Relief Act and the Balanced Budget Act. These new laws contain a number of provisions that will be of interest to ministers and churches. The more important provisions are summarized in this feature article, with several examples and a review of all effective dates.

Once again Congress has enacted sweeping tax changes that will impact every taxpayer. This article will review those provisions of greatest relevance to ministers and churches.

1. Child tax credit. One of the key provisions of the Taxpayer Relief Act is the creation of a new child tax credit. Here is how it works. If you have one or more children under 17 years of age, and you earn less than a specified amount of income, then you will be able to claim a $400 credit on your 1998 tax return for each child. The credit increases to $500 in 1999. Here are some key considerations to note:

! Qualifying child. To qualify for the credit, you must have a child who (1) is under 17 years of age; (2) is your child, descendent, stepson or stepdaughter, or foster child; and (3) is claimed by you as a dependent on your tax return.

! Phaseout for high—income taxpayers. The child care credit is reduced by $50 for each $1,000 of adjusted gross income in excess of $110,000 for married couples filing jointly. For single persons, the credit is reduced by $50 for each $1,000 of adjusted gross income in excess of $75,000. These amounts are not adjusted for inflation.

! Refundable child care credit. Some lower income families will be eligible to receive a supplemental credit. To qualify, a family must be eligible to receive the earned income tax credit. Unfortunately, the amount of this credit is so difficult to compute that few eligible families will be able to claim it. Congress anticipated this problem, and has instructed the IRS to determine “whether a simplified method of calculating the credit can be achieved.” We will report any progress in future issues of this newsletter. For now, here is a “ballpark test” that can be used-the supplemental credit will not be available unless you (1) qualify for the earned income credit, and (2) your earned income credit exceeds your share of FICA or self—employment taxes.

2. Home office expenses. Many ministers and church staff members maintain an office in their home and perform some of their duties in their home office. Are expenses associated with the home office deductible as a business expense? Unfortunately, it has become much more difficult in recent years to claim a home office deduction. The Taxpayer Relief Act makes it a little easier. Consider the following:

! Background. Prior to 1976, home office expenses were deductible whenever they were “appropriate and helpful” to the taxpayer’s business. In 1976 Congress narrowed the home office deduction by making it available only when the office is used regularly and exclusively as a principal place of business, or as a place of business used to meet clients in the normal course of business. In 1993, the United States Supreme Court announced a very narrow interpretation of a taxpayer’s “principal place of business.” Commissioner v. Soliman, 113 S. Ct. 701 (1993). The Court concluded that a physician did not qualify for a home office deduction even though he used his home office regularly and exclusively for business, because the “essence of his professional service” was performed in hospitals. It focused on the place where the primary income—generating functions are performed, and the amount of time spent at each location. Under this analysis, the only possible conclusion was that the physician’s principal place of business was at the hospitals where he worked, and not his home office where he performed largely administrative tasks.

! The new law. The Taxpayer Relief Act repeals the Soliman decision and recognizes that some taxpayers will be eligible for a home office deduction if they use their home office for largely administrative tasks-even if their income—generating activities occur at another location. This is a major break for taxpayers with home offices. The new law provides that a home office qualifies as a principal place of business if:

(1) the office is used by the taxpayer to conduct administrative or management activities related to a trade or business, and

(2) there is no other fixed location where the taxpayer conducts substantial administrative and management activities of the trade or business

As before, the home office must be used regularly and exclusively for business purposes.

Taxpayers who meet these new requirements are eligible for a home office deduction even if they conduct some administrative and management activities at a fixed location of their business outside their home-so long as those activities are not substantial. For example, a taxpayer occasionally does minimal paperwork at another fixed location of the business. Further, taxpayers can claim a home office deduction even though they conduct substantial non—administrative or non—management business activities at a fixed location of their business outside their home. For example, a taxpayer meets with or provides services to customers or clients at a fixed location that is away from home. It is this rule that overturns the Soliman decision, and makes the home office deduction available to many more persons.

! Effect of an office in the church. What if a minister has a home office, but an office is also available at the church? Is a home office deduction ever available under these circumstances? In the past, the answer has been “no,” at least for ministers who are employees for federal income tax reporting purposes. For an employee to qualify for a home office deduction, the use of a home office must not only be regular and exclusive, but it also must be for the “convenience of the employer.” This has meant that the home office must be essential for the employee to perform his or her work. This is simply not the case when an office is available in the church. The courts and the IRS have ruled that if an employer provides employees access to an office on its premises for the performance of their duties, and an employee elects to conduct these duties at home as matter of personal preference, then the employee’s use of the home office is not for the “convenience of the employer” and there is no deduction allowed.

In summary, if a self—employed taxpayer in fact does not perform substantial administrative or management activities at any fixed location of the business away from home, then the second part of the new test is met whether or not the taxpayer elected not to use an office away from home that was available. However, for employees, the fact that they elect not to use an office on their employer’s premises that is available to them for administrative activities will still be relevant in deciding whether or not they meet the “convenience of the employer” requirement.

3. Health insurance deduction for the self—employed. Under current law, self—employed persons can deduct health insurance costs for themselves (and their spouse and children) as follows: 40 percent in 1997; 45 percent in 1998 through 2002; 50 percent in 2003; 60 percent in 2004; 70 percent in 2005; and 80 percent in 2006 and thereafter. This deduction is not allowed in any year in which the self—employed person is eligible to participate in a subsidized health plan maintained by an employer of either the self—employed person or his or her spouse.

The Taxpayer Relief Act accelerates the health insurance deduction for self—employed workers as follows: 40 percent in 1997; 45 percent in 1998 and 1999; 50 percent in 2000 and 2001; 60 percent in 2002; 80 percent in 2003 through 2005; 90 percent in 2006; and 100 percent in 2007 and thereafter.

4. Real estate reporting requirements. Under current law, persons who close real estate transactions are required to file an information return (Form 1099S) with the IRS. This return reports the details of the transaction, and is designed to disclose persons who may owe capital gains tax. The Taxpayer Relief Act exempts sales of personal residences with a gross sales price of $500,000 or less ($250,000 or less for single taxpayers) from this reporting requirement, beginning after May 6, 1997. The purpose of this change is to relieve taxpayers of the reporting requirement on transactions that will be exempt from the capital gains tax under new rules (explained below) that took effect after May 6, 1997.

5. “Continuous levy” authority of the IRS extends to social security payments. Under current law, taxpayers who do not pay a tax within 10 days of notice and demand by the IRS are subject to “levy.” A levy is a procedure the IRS uses to collect the tax deficiency. It permits the IRS to seize property owned by the taxpayer. Generally, a levy does not apply to property acquired after the date of the levy-with one exception. A levy on wages is “continuous” from the date it is first made until the debt is paid in full.

The Taxpayer Relief Act permits the IRS to impose a continuous levy on federal payments for which eligibility is not based on the income or assets of the taxpayer. To illustrate, the IRS will now be able to treat social security checks like wages. This means that a levy against such payments will “continue” until the tax deficiency is paid. The new law specifies that such levies can attach up to 15 percent of any payment due the taxpayer.

This provision took effect on August 6, 1997.

6. Earned income credit modifications. Certain low—income workers are entitled to claim a refundable earned income credit (EIC) on their tax return. A refundable credit is a credit that not only reduces income taxes, but allows a refund to taxpayers whose credit exceeds their tax liability. The amount of the credit depends on the number of children the taxpayer has, and it is phased out for taxpayers with adjusted gross income above certain limits. The Taxpayer Relief Act makes certain changes to the earned income credit, including the following:

! Fraud or recklessness. A taxpayer who fraudulently claims an EIC is ineligible to claim the EIC for the next 10 years. A taxpayer who erroneously claims the EIC due to reckless or intentional disregard of the law is ineligible to claim the credit for the next 2 years. This provision took effect January 1, 1997.

! Definition of adjusted gross income. The EIC is phased out for taxpayers with adjusted gross income above specified levels. The new law provides that tax—exempt interest and nontaxable distributions from pensions, annuities, and IRAs (if not rolled over into similar tax—favored products) are not counted in computing adjusted gross income for purposes of determining eligibility for the EIC. This provision takes effect in 1998.

7. Foreign earned income credit. United States citizens generally are subject to federal income tax on all their income, whether derived in the United States or in a foreign country. However, citizens working in foreign countries may be eligible to exclude from their income for federal income tax purposes certain foreign earned income and housing costs. To qualify for these exclusions, the individual must either (1) be a resident of the foreign country for an uninterrupted period that includes the entire tax year, or (2) be present overseas for 330 days out of any 12 consecutive month period. The maximum exclusion for foreign earned income under current law is $70,000 per year.

The Taxpayer Relief Act increases the $70,000 annual foreign earned income exclusion by $2,000 per year beginning in 1998, until it reaches a maximum of $80,000 in the year 2002. In addition, the credit will be indexed for inflation beginning in 2008. This credit is claimed by many American missionaries serving in foreign countries.

8. Increase in standard deduction of dependents. Under current law, the standard deduction of a taxpayer who is claimed as a dependent on another’s tax return cannot exceed the lesser of (1) the standard deduction for an individual (projected to be $4,250 for 1998), or (2) the greater of $500 (indexed for inflation) or the dependent’s earned income. In other words, a minor child who works outside the home, and who is claimed as a dependent on his parents’ tax return, is eligible for a reduced standard deduction based on this formula.

The Taxpayer Relief Act increases the standard deduction for a taxpayer who is claimed as a dependent on another’s tax return to the lesser of (1) the standard deduction for individuals, or (2) the greater of (a) $500 (indexed for inflation), or (b) the individual’s earned income plus $250. The $250 amount will be indexed for inflation after 1998. The new standard deduction rules take effect in 1998.

9. Estimated tax penalties. Taxpayers are subject to an “addition to tax” for any underpayment of estimated taxes. This penalty is not assessed if the total tax liability for the year (reduced by any withheld tax and estimated tax payments) is less than $500. The Taxpayer Relief Act increases this amount to $1,000, beginning in 1998.

10. Estimated tax requirements. Under current law, a taxpayer is subject to a penalty for underpayments of estimated taxes. The penalty is avoided if a taxpayer makes timely estimated tax payments at least equal to (1) 100 percent of the previous year’s tax liability, or (2) 90 percent of the current year’s tax liability. The 100 percent of last year’s tax liability exception is increased to 110 percent for individuals with adjusted gross income of more than $150,000 for the previous year.

The Taxpayer Relief Act changes the 110 percent of last year’s tax liability rule to 100 percent of the previous year’s tax liability in 1998; 105 percent of the previous year’s tax liability in 1999, 2000, and 2001; and 112 percent of the previous year’s tax liability in 2002.

1. HOPE scholarship tax credit. The Taxpayer Relief Act provides welcome relief to families with children in college or vocational training. Beginning in 1998, taxpayers can claim a “HOPE” credit against federal income taxes of up to $1,500 per student per year for 50 percent of qualified tuition and related expenses (not including room, board, and books) paid during the first two years of the student’s postsecondary, undergraduate education in a degree or certificate program. Here are some of the key provisions:

! Effective date. HOPE scholarship credits are available for tuition expenses and academic fees paid after December 31, 1997, for education furnished in academic periods beginning after such date.

! Eligible taxpayers. Who qualifies for the HOPE scholarship credit? The law provides that the credit is available for tuition expenses incurred by a taxpayer, or the taxpayer’s spouse or dependent child.

! First two years of college. The HOPE credit applies only to tuition incurred during the first two years of a college or vocational program leading to a degree or certificate.

! Amount of credit. The credit is 100 percent of the first $1,000 of tuition and fees, and 50 percent on the next $1,000 of tuition and fees-for a total available credit of $1,500. Remember that a credit is a direct dollar—for—dollar reduction in income taxes. It is far more beneficial than a tax deduction which merely reduces taxable income.

! Eligible students. To be eligible for a HOPE credit, a student must be enrolled at least half—time in a degree or certificate program leading to a recognized educational credential at an eligible educational institution.

! What expenses are eligible for the credit? The credit is available with respect to amounts paid for tuition and academic fees. It is not available with respect to amounts paid for books, meals, lodging, student activities, athletics, insurance, transportation, and similar personal expenses.

! Phaseout for high—income taxpayers. The HOPE credit is phased out for single taxpayers with adjusted gross income between $40,000 and $50,000. The credit is phased out for married taxpayers who file jointly with adjusted gross income between $80,000 and $100,000. These amounts will be indexed for inflation after 1999, although the first year when an adjustment can be made is 2001.

! Which year is the credit claimed? The HOPE credit is available in the year the tuition expenses are paid-so long as the education begins or continues during that year or during the first three months of the next year.

! What about loans? Qualified tuition expenses paid with the proceeds of a loan are eligible for a HOPE credit. The credit is not applied to the repayment of the loan itself.

! Reporting requirements. The new law specifies that parents cannot claim the HOPE credit unless their tax return reports the name and social security number of the eligible student. Tax returns for 1998 and future years will allow parents to provide this information.

2. Lifetime learning credit. Here’s another break for parents with children in college-taxpayers are allowed a “lifetime learning credit” against federal income taxes equal to 20 percent of tuition and academic fees incurred during a year on behalf of the taxpayer, or the taxpayer’s spouse or dependent child. Here are some of the details:

! Effective date. This credit applies to tuition expenses incurred after June 30, 1998, for education furnished in academic periods beginning after such date.

! Eligible taxpayers. The credit is available for tuition expenses incurred by a taxpayer, or the taxpayer’s spouse or dependent child.

! Amount of credit. The credit is 20 percent of the first $5,000 of tuition and academic fees. This means that the maximum credit will be $1,000 per year. However, for expenses paid after December 31, 2002, up to $10,000 of tuition and academic fees will be eligible for the 20 percent lifetime learning credit. This means that the maximum credit will increase to $2,000 per year.

! No two—year limitation. Unlike HOPE credits, the lifetime learning credit is not limited to the first two years of postsecondary, undergraduate education. It can be claimed for an unlimited number of years.

! Multiple children. The lifetime learning credit can be claimed in any one year on behalf of any number of eligible students.

! Eligible students. The lifetime learning credit is available to students at both undergraduate and graduate educational institutions (and postsecondary vocational schools). In addition, students need not be enrolled half—time or full—time.

What expenses are eligible for the credit? Same as for HOPE credits (see above).

! Phaseout for high—income taxpayers. Same as for HOPE credits (see above).

! Which year is the credit claimed? Same as for HOPE credits (see above).

! What about loans? Same as for HOPE credits (see above).

! Choice of credit. If a taxpayer claims a HOPE credit with respect to a student then the lifetime learning credit will not be available with respect to that same student for the year, although the lifetime learning credit may be available with respect to that student for other years. Also, taxpayers who claim an exclusion for distributions from an “education IRA” (explained later in this article) with respect to a student will not be able to claim a lifetime learning credit for that student during the same year.

3. Education IRAs. Taxpayers are given yet another break for education expenses under the new law-they can contribute up to $500 each year to an “education IRA.” Here is how it works. A taxpayer establishes an education IRA and designates a “beneficiary” (usually, the taxpayer’s child). The taxpayer contributes up to $500 each year into the account, up until the beneficiary’s 18th birthday. Earnings on an education IRA generally accumulate tax—free-provided they are distributed for the post—secondary educational expenses of the beneficiary. Here are some more specifics:

! Effective date. Parents can begin contributing to education IRAs on or after January 1, 1998.

! Annual contribution limit. Parents can contribute a maximum of $500 each year to an education IRA. This amount is phased out for higher income taxpayers. The phaseout begins at $95,000 of adjusted gross income for single parents, and is phased out completely at $110,000. The phaseout begins at $150,000 of adjusted gross income for married couples filing jointly, and is phased out completely at $160,000.

! Qualified expenses. Earnings must be distributed for “qualified expenses” in order to accumulate tax—free. Such expenses include post—secondary tuition, fees, books, supplies, equipment, and certain room and board expenses. Room and board expenses qualify only if the beneficiary is enrolled on at least a half—time basis. Further, “room and board expenses” are defined to mean the minimum room and board allowance as determined by the college or other academic institution in computing costs of attendance for federal financial aid programs.

! Termination of education IRAs. Any balance remaining in an education IRA when a beneficiary attains 30 years of age must be distributed, and the earnings portion of such a distribution will be included in the beneficiary’s taxable income and subject to an additional ten percent penalty tax because the distribution was not for educational purposes.

! Interaction with HOPE credits and lifetime learning credits. In any year in which an exclusion is claimed for a distribution from an education IRA, neither a HOPE credit nor a lifetime learning credit may be claimed with respect to educational expenses incurred during that year on behalf of the same student. The HOPE credit and lifetime learning credit may be available in other years with respect to that beneficiary.

! Qualified educational institutions. Education IRAs can be distributed for the qualified educational expenses incurred by beneficiaries attending post—secondary undergraduate or graduate educational institutions. Some vocational institutions also qualify.

! Tax treatment of distributions. An education IRA will consist of two components-all annual contributions made to the account plus accumulated earnings. Distributions from the account likewise will consist of both contributions and earnings. The portion of an annual distribution that comes from annual contributions is always tax—free to the beneficiary, but the portion that comes from earnings may not be. Here are two rules to keep in mind:

(1) Qualified education expenses equal or exceed the annual distribution from an education IRA. The full amount of the distribution is tax—free to the beneficiary.

(2) Qualified education expenses are less than the annual distribution from an education IRA. This scenario will be far less common, especially for the next several years. However, it may apply to students who are taking only a few courses. The earnings component of a distribution (see the previous example) will be partially tax—free and partially taxable. You compute these amounts by multiplying the earnings component of the distribution times the ratio of educational expenses to the total amount of the distribution.

! Technical requirements. Parents cannot treat an existing IRA as an education IRA. You must establish a separate IRA that you specifically designate as an education IRA.

4. Penalty—free withdrawals from an existing IRA to pay for educational expenses. Beginning in 1998, the 10 percent penalty that applies to early distributions from an IRA will not apply to amounts used for qualified higher education expenses (including graduate courses) of the taxpayer or the taxpayer’s spouse, child, or grandchild. The penalty—free withdrawal is available for “qualified higher education expenses,” meaning tuition, fees, books, supplies, equipment required for enrollment, and room and board. All expenses must be incurred at a post—secondary educational institution, including a graduate program.

5. Extension of employer—provided educational assistance exclusion. In the past, an employee’s taxable income did not include amounts paid by an employer for educational assistance if such amounts were paid pursuant to an educational assistance program that met certain requirements. This exclusion was limited to $5,250 of educational assistance per employee during a calendar year, and applied whether or not the education was job related. The exclusion expired for graduate education beginning after June 30, 1996, and for undergraduate education beginning after June 30, 1997. The Taxpayer Relief Act extends this exclusion for undergraduate education for courses beginning before June 1, 2000. The exclusion does not apply to graduate—level courses.

1. Increase IRA phaseout limits. Under current law, if an individual (or his or her spouse) is an active participant in an employer—sponsored retirement plan, the $2,000 IRA deduction limit is phased out over the following levels of adjusted gross income: (1) $25,000 to $35,000 for single persons; and (2) $40,000 to $50,000 for married persons filing jointly. The Taxpayer Relief Act contains two important modifications in these rules, effective in 1998:

(1) Spouse’s participation not considered. An individual will not be considered to be an active participant in an employer—sponsored retirement plan merely because his or her spouse is an active participant in such a plan. However, the maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, is phased out for taxpayers with adjusted gross income between $150,000 and $160,000.

(2) Phaseout limits increased. The deductible IRA phaseout ranges are increased as follows:

Joint Returns

tax year phaseout range (adjusted gross income)

1998 $50,000—$60,000

1999 $51,000—$61,000

2000 $52,000—$62,000

2001 $53,000—$63,000

2002 $54,000—$64,000

2003 $60,000—$70,000

2004 $65,000—$75,000

2005 $70,000—$80,000

2006 $75,000—$85,000

2007 and thereafter $80,000—$100,000

Single Taxpayers

tax year phase out range (adjusted gross income)

1998 $30,000—$40,000

1999 $31,000—$41,000

2000 $32,000—$42,000

2001 $33,000—$43,000

2002 $34,000—$44,000

2003 $40,000—$50,000

2004 $45,000—$55,000

2005 and thereafter $50,000—$60,000

2. “Roth” (“backloaded”) IRAs. Another new IRA that debuts in 1998 is the so—called “Roth” or “backloaded” IRA. It is named in honor of Senator William Roth (R—Del.), its chief advocate. Here is how it works. Taxpayers can make annual nondeductible contributions of up to $2,000 to a Roth IRA, and distributions from such an IRA are not taxed if they are made after a five year holding period, and are made as a result of the account holder’s: (1) attaining age 59 and 1/2 or older, (2) death, (3) disability, or (4) purchase of a first home. Further, earnings on Roth IRAs accumulate tax—free. Here are some more details:

! Phaseout for higher income taxpayers. Roth IRAs are phased out for single taxpayers with adjusted gross income of $95,000 to $110,000, and for married taxpayers filing jointly with adjusted gross income of $150,000 to $160,000.

! Rollovers. A regular IRA may be rolled over to a Roth IRA. Only taxpayers with adjusted gross income of less than $100,000 are eligible for this provision.

! Maximum IRA contribution. Persons who cannot (or do not) make contributions to a deductible IRA or a Roth IRA can continue to make contributions to a nondeductible IRA, as under prior law. However, the new law clarifies that in no case may contributions to all of a taxpayer’s IRAs for the same year exceed $2,000.

! No age limit on contributions. Unlike a regular IRA, taxpayers can make contributions to a Roth IRA after they reach age 70 and 1/2.

! Technical requirements. A Roth IRA must be separately established, and it must be designated as a Roth IRA when it is created.

 Regular IRARoth IRA

3. No penalty for early IRA withdrawals by first—time homebuyers. Under current law, a 10 percent “additional tax” applies to distributions from an IRA prior to age 59 and 1/2. Beginning in 1998, the Taxpayer Relief Act permits taxpayers to withdraw funds from their IRA prior to age 59 and 1/2 for “first—time homebuyer expenses” without triggering the 10 percent penalty (up to $10,000). The expenses must be incurred to buy or build a principal residence for yourself, or a child or grandchild.

4. Repeal of 15 percent tax on excess distributions from a retirement plan. Under current law, a 15 percent tax is imposed on excess distributions from most types of retirement plans (including IRAs and tax—sheltered annuities). Excess distributions generally are those in excess of $160,000 for 1997, or $800,000 in the case of a lump—sum distribution. Congress suspended this tax for the years 1997 through 1999. The Taxpayer Relief Act repeals it permanently. The new law also repeals the assessment of the 15 percent penalty to “excess accumulations” of funds within a retirement account.

5. Modification of section 403(b) exclusion allowance. Under current law, annual contributions to a 403(b) annuity cannot exceed the “exclusion allowance.” In general, the exclusion allowance is the excess (if any) of (1) 20 percent of the employee’s “includible compensation” multiplied times his or her years of service, over (2) the total employer contributions for an annuity excluded for prior years. The Taxpayer Relief Act provides that the term “includible compensation” shall not include elective deferrals (by salary reduction agreement) into a 403(b) annuity or a cafeteria plan. The effect of this change, which took effect on January 1, 1998, will be to increase the amount that some employees can contribute to their 403(b) annuity.

1. Capital gains tax rate reduction. Under current law, gain or loss in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of a “capital asset,” the “capital gain” is taxed at ordinary income tax rates, except that individuals are subject to a maximum rate of 28 percent on the net capital gain. A capital asset generally means any property, with some exceptions (including depreciable real estate used in a taxpayer’s trade or business, and property held for sale to customers). Common examples include real personal residences and investments.

The Taxpayer Relief Act contains the following modifications:

! Reduction in rate of tax. The maximum rate of tax on net capital gain of individuals is reduced from 28 percent to 20 percent. This means that taxpayers who are in the 28 percent (or higher) income tax bracket will pay a capital gains tax of 20 percent. Lower—income taxpayers whose ordinary income is taxed at the 15 percent rate will pay a capital gains tax of 10 percent.

! Additional tax rate reduction in 2001. Beginning in the year 2001, the maximum capital gains rates for assets which are held for more than 5 years are 18 percent (for persons in the 28 percent or higher ordinary income tax bracket) and 8 percent (for persons in the 15 percent ordinary income tax bracket). The 18 percent rate applies only to assets that are acquired on or after January 1, 2001.

2. Sales of personal residences. Under current law, no gain is recognized on the sale of a principal residence if (1) a new residence is purchased that is at least equal in cost to the sales price of the old residence, and (2) the new residence is used as a principal residence of the taxpayer at some point within a “replacement period” that begins two years prior to the sale of the old residence and ends two years after the sale. Also, under present law an individual can exclude on a one—time basis up to $125,000 of gains from the sale of a principal residence if the taxpayer (1) has attained age 55 before the sale, and (2) has owned the property and used it as a principal residence for 3 or more of the 5 years preceding the sale.

The Taxpayer Relief Act eliminates these rules for sales of principal residences occurring after May 6, 1997. The new rules are much more liberal, and will greatly benefit many taxpayers. Here is breakdown of the new rules:

! Higher nontaxable amounts. Most importantly, after May 6, 1997 a married couple (who file a joint return) can exclude up to $500,000 of gain from the sale or exchange of a principal residence. Single taxpayers can exclude up to $250,000.

! Holding period. To qualify for the full exclusion, a taxpayer must have owned and occupied the residence as a principal residence for at least 2 of the 5 years prior to the date of sale or exchange. But, unlike the former law, the tax benefit may not be lost completely if this “holding period” is not satisfied. Taxpayers who sell a home without meeting this requirement get a partial benefit if they had to sell their home on account of a change of place of employment, health, or other unforeseen circumstances. The partial benefit is the fraction of $500,000 (or $250,000 for single taxpayers) equal to the fraction of 2 years that the home was owned and occupied as a principal residence.

A special rule applies to persons who become physically or mentally incapable of self—care and who move into a licensed facility (including a nursing home). If they owned and occupied a residence for at least 1 year before moving into such a facility, the 2—year “holding period” rule will not apply to them.

! Multiple sales allowed. The old rule that permitted only one exclusion of up to $125,000 for taxpayers at least 55 years of age is out the window. Taxpayers can claim the $500,000 exclusion every two years, and there is no minimum age requirement!

! Remarriages. Assume that John is a single taxpayer who has never excluded gain from the sale of a home under the new rules. He marries Jane, who has used the exclusion within 2 years prior to their marriage. John can still claim up to a $250,000 exclusion of gain from the sale of residence. Once two years have passed since the last exclusion was allowed to either of them, they can exclude up to $500,000 of gain on a joint return.

1. Estate tax relief. Some people unexpectedly find themselves subject to federal estate taxes because of insurance proceeds, successful investments, and inheritances. The estate tax is substantial-it begins at a 37 percent rate. Fortunately, there are ways to reduce it. Under current law, estates of less than $600,000 are exempt from tax (unchanged since 1987). This amount is increased under the new law as follows:

year   ;&nbs p;effective exemption

1997 $600,000

1998 $625,000

1999 $650,000

2000 $675,000

2001 $675,000

2002 $700,000

2003 $700,000

2004 $850,000

2005 $950,000

2006 and thereafter $1 million

These rates are not indexed for inflation.

2. Annual gift exclusion. Under current law, a taxpayer can exclude up to $10,000 in gifts made to each donee during a calendar year without affecting the $600,000 lifetime exemption from estate taxes described above. Gifts of more than this amount reduce the $600,000 estate exemption. For married couples, the exclusion is available to each spouse. To illustrate, a couple with three children can give up to $60,000 each year ($20,000 to each child), without affecting their exemption from estate taxes. Many couples have used this technique to reduce estate taxes by reducing the size of their estate that will be distributed at death. The $10,000 annual gift exclusion has remained unchanged for several years, meaning that its real value has been steadily eroded by inflation. The Taxpayer Relief Act provides that the $10,000 annual gift exclusion will be indexed for inflation beginning in 1999 (rounded to the next lowest multiple of $1,000).

1. Delay in penalty for failure to deposit payroll taxes electronically. Current law requires a “phase in” of the electronic deposit of payroll taxes under the Electronic Federal Tax Payment System (EFTPS). Employers that deposited payroll taxes of more than $50,000 in 1995 were required to begin depositing such taxes electronically not later than January 1, 1997. The Small Business Jobs Protection Act of 1996 postponed this deadline until July 1, 1997. The IRS announced in June of 1997 that it would not impose penalties for failure to comply through the end of 1997-for employers that make timely deposits using paper forms while converting over to the EFTPS system. The Taxpayer Relief Act provides that no penalties will be assessed for failure to use the EFTPS system to deposit payroll taxes prior to July 1, 1998.

1. Increase in charitable mileage rate. Under current law, taxpayers can deduct out—of—pocket expenses incurred in performing services on behalf of a church or other charity. Since 1984, taxpayers have been permitted to value the use of a car while performing charitable services at a “standard charitable mileage rate” of 12 cents per mile. The Taxpayer Relief Act increases this rate to 14 cents per mile for miles driven on or after January 1, 1998. The new rate is not indexed for inflation.

2. Corporate sponsorship payments. While this provision will not be directly relevant to most churches, it will be relevant to a number of other religious organizations (including parachurch ministries, broadcasters, denominational agencies, and schools). The Taxpayer Relief Act specifies that “qualified sponsorship payments” received by a tax—exempt organization will not be subject to the unrelated business income tax (UBIT). A qualified sponsorship payment is defined as a payment made by a business to a charity in exchange for the use of the business’s name or logo by the charity.

The new law cautions that this exception will not apply to:

(1) Advertising of a company’s products or services “including messages containing qualitative or comparative language, price information, or other indications of savings or value, an endorsement, or an inducement to purchase, sell, or use such products or services.”

(2) Any payment which entitles a company to advertise its name or logo “in regularly scheduled and printed material” published by the charity-unless “related to and primarily distributed in connection with a specific event conducted by” the charity.

(3) Any payment made in connection with any qualified convention or trade show activity.

3. Eliminate gift tax filing requirements for gifts to charity. Persons who donate more than $10,000 to any one person or organization in the same year are required to file a federal gift tax return with the IRS. Gifts to churches and other charities are exempted from this requirement. The Taxpayer Relief Act clarifies that this exemption applies only to gifts of a donor’s entire interest in property to the church or charity. It does not apply to a gift of a partial interest in property. This provision applies to gifts made after August 5, 1997.

1. Contributions on behalf of self—employed ministers to church retirement plans. The Taxpayer Relief Act provides that in the case of contributions made on behalf of a minister who is self—employed to a church plan, the contribution is nontaxable to the extent that it would be if the minister were an employee of a church and the contribution were made to the plan. This provision takes effect in 1998.

2. Church plan exception to group health coverage. Under the Health Insurance Portability and Accountability Act (enacted in 1996), group health plans may not condition participation on an employee’s health or medical condition. The Taxpayer Relief Act provides that certain church plans do not violate this nondiscrimination requirement merely because the plan requires evidence of good health in order for an individual to enroll in the plan, for individuals (1) who are employees of an employer with 10 or fewer employees, or self—employed, or (2) who enroll after the first 90 days of eligibility under the plan. This provision applies to a church for a particular year if the plan required evidence of good health as of July 15, 1997, and at all times thereafter.

3. Religious schools exempt from federal unemployment tax. The Balanced Budget Act contained a provision exempting from federal unemployment tax any work performed in an elementary or secondary school that is operated primarily for religious purposes. The exemption is available even though a religious school is not operated, supervised, controlled, or principally supported by a church or a convention or association of churches. This provision took effect as of August 7, 1997.

© Copyright 1997, 1998 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m69 m71 c0697