Eligibility of Lay Church Employees for the Housing Allowance

The Tax Court issues an important decision.

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The Tax Court issues an important decision—Haimowitz v. Commissioner, T.C. Memo. 1997-40 (1997)

Article summary. The Tax Court recently addressed the issue of whether an administrator of a Jewish synagogue qualified for a housing allowance. The Court ruled that the administrator did not qualify since he was not ordained, commissioned, or licensed, and there was no evidence that a housing allowance had been properly designated. This feature article reviews the Court’s decision and addresses its relevance to other religious workers.

The tax code contains a number of special provisions that apply to “ordained, commissioned, or licensed ministers.” One of those special provisions is the housing allowance. Stated simply, a portion of a minister’s compensation that is designated in advance by an employing church as a housing allowance is excluded from taxable income for income tax reporting purposes, to the extent it is used for housing expenses and does not exceed the fair rental value of the home (furnished, including utilities). This is one of the most significant tax benefits available to ministers.

There are three requirements that must be met in order for a church worker to be eligible for a housing allowance: (1) the recipient must be a minister, (2) the housing allowance must represent compensation for services performed in the exercise of ministry, and (3) the allowance must be properly designated. In many cases, it is obvious whether or not these requirements are met. But in some cases it is not. In a recent decision the United States Tax Court addressed this question. The case involved the question of whether or not a “synagogue administrator who was neither a rabbi nor a cantor qualified for a housing allowance.” The court’s decision provides helpful guidance to all religious organizations. This feature article will review the facts of the case, summarize the court’s ruling, and evaluate the relevance of the ruling to other religious organizations and workers.

facts

A temple administrator of a Jewish synagogue participated for many years in a retirement plan maintained by the synagogue. After his retirement he did not report distributions from the retirement plan as taxable income since they were designated by the plan as a housing allowance. The IRS audited the administrator and determined that the retirement distributions were fully taxable since the administrator did not qualify for a housing allowance. The administrator appealed to the tax court.

The administrator had worked for the same synagogue for thirty years until his retirement. He was a college graduate, with a degree in social studies, but he never attended a religious seminary. Following his retirement he was recognized as a “fellow in synagogue administration” by the Synagogue Administrators Association.

The administrator’s responsibilities with the temple varied over time. He was hired initially as an executive director, performing mostly administrative functions such as hiring and recruitment tasks. The temple had a rabbi and a cantor working for it, both of whom performed the temple’s religious functions. The administrator never fulfilled the role of either. However, he eventually performed more religious duties for the temple as a “religious functionary”. These “religious” duties included the following:

• Over the course of his thirty years with the temple, he assisted about 500 students with their bar mitzvah preparations, though most of the training was conducted by the cantor and rabbi. The cantor would teach the students how to chant their Torah portions, and the rabbi would rehearse with them on the pulpit. The administrator would then attempt to “enhance” the students’ performance for a week or two before the ceremony. This included such duties as helping students with memorization of blessings, Torah readings, and elocution.

• He performed as the temple’s marriage ceremony director. He would meet with engaged couples to discuss wedding preparations. His advice was mostly organizational in nature and related to the specific details of planning a wedding. While he frequently participated in the wedding ceremony as a witness to the contract he never officiated.

• He assisted the rabbi with various tasks during the religious services. This included the duty of assigning certain responsibilities to congregants who performed these tasks during services. He also performed the following other activities for the temple: He managed cemetery lots that the temple made available to its congregants; he visited and conducted services for mourners; and he provided weekly speakers for senior citizens.

The retired administrator did not claim that he was a rabbi or cantor. Rather, he asserted that he qualified as a “minister of the gospel” because he performed duties as a “religious functionary” for the temple.

the court’s ruling

The Tax Court began its opinion by noting that

a “minister of the gospel” may exclude from gross income “the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.” In order for a minister to exclude a parsonage allowance, three criteria must be met: (1) the minister must provide services which are ordinarily the duties of a “minister of the gospel”; (2) the excluded amounts must actually be used to rent or otherwise provide a home; and (3) the rental allowance must be properly designated.

IRS conceded that the administrator used the retirement distributions for housing expenses, but it insisted that he did not qualify for a housing allowance with respect to these distributions since (1) at the time he contributed toward the retirement plan he was not a “minister of the gospel,” and (2) the retirement distributions were not properly designated by the temple as a housing allowance. The court addressed these two claims separately.

minister of the gospel

The court noted that the tax law does not define the phrase “minister of the gospel”, and there is no clear meaning of the term in the legislative history. Further, the income tax regulations “define only what a minister does, but not what a minister is”:

[T]he regulations list the following services which are considered those of a minister: (1) the performance of sacerdotal functions; (2) the conduct of religious worship; and (3) the performance of services in control, conduct, and maintenance of religious organizations. We also consider important whether the taxpayer was duly ordained, commissioned, or licensed, and whether the particular church or denomination recognized that person as a minister or religious leader.

Did the retired administrator’s duties as a “religious functionary” fall within the three types of services of a minister as described in the regulations? The court concluded that they did not:

As the temple’s employee, most of [the administrator’s] responsibilities related to some aspect of the Jewish religion. We note, however, these duties were more organizational than religious in nature and did not require performance from one who held ministerial authority.

Equally revealing, however, were the religious rites and ceremonies [he] did not perform. [He] admitted that he never fulfilled the role of either rabbi or cantor. The record displays his lack of such responsibility. [He] assumed responsibility over the bar and bat mitzvah students only in the last week or two of their training and only to enhance the efforts of the rabbi and cantor. The rabbi and cantor, however, held the main parochial responsibilities for the students’ training.

Further, [the administrator] acted as the marriage ceremony director and participated in wedding ceremonies as a witness. His responsibilities as director, however, were mostly secular in nature. While [he] participated in wedding ceremonies, he never officiated. Further, [he] assisted the rabbi with various functions during religious services. It was the rabbi, however … who actually led those services for which [the administrator] assisted. Finally, although [the administrator] visited and conducted services for mourners, he, presumably, did not officiate at the funerals.

[W]ith the sole exception of conducting services for mourners [the administrator] did not regularly perform those duties that ministers of the Jewish faith customarily perform.

The court also concluded that the administrator was never “ordained, commissioned, or licensed” as required by the regulations. He had admitted that he was not an ordained rabbi or commissioned cantor. Further, the fact that he was recognized as a Fellow in Synagogue Administration was not relevant, for two reasons. First, he “did not hold this title while he performed his duties with the temple. Rather, he received this honor … about 7 years after he left the temple.” Second, even if he had received this honor while performing services for the temple, it would not have established that he was ordained, commissioned, or licensed as a recognized religious official of the Jewish religion. Rather, as the title Fellow in Synagogue Administration suggests, the designation “reflects that [he] merely performed duties as an administrator, a primarily secular function.”

Finally, the court concluded that there was no evidence that the temple considered the administrator to be a religious leader.

The court concluded:

[W]e find that [the administrator] failed to demonstrate that he was a “minister of the gospel” as specified in the regulations and case law. As a judicial body we are loath to evaluate ecclesiastical authority in the various religious disciplines. We emphasize that our opinion is based on the record before us, and our finding should not diminish the importance of [the administrator’s] contributions to his community.

designation of rental allowance

The court also ruled that the administrator failed to qualify for a housing allowance since he did not establish that a housing allowance had ever been properly designated. The court noted that to qualify for a housing allowance “the amount paid to a minister, to rent or otherwise provide a home, must be designated as a [housing] allowance pursuant to official action taken in advance of such payment.” The income tax regulations specify that a designation “may be evidenced in an employment contract, in minutes of or in a resolution by a qualified organization, or in any appropriate instrument evidencing such official action. Without official designation, no exclusion is allowable.”

The court concluded that the administrator failed to demonstrate that the temple properly designated any portion of his retirement income as a housing allowance: “Completely missing from the record were details of the employment arrangement in which he and the temple were engaged. In fact, [he] presented no evidence which even [remotely] relates to the notion of official designation.”

relevance to other religious organizations and workers

What is the relevance of this ruling to other religious organizations and workers? Consider the following points:

1. Qualifying for a housing allowance. The court correctly noted that eligibility for a housing allowance requires that two conditions be met:

• the person is a minister of the gospel

• the housing allowance is provided as compensation for services performed in the exercise of ministry

2. Minister of the gospel. The first condition that must be met in order to qualify for a housing allowance is ministerial status. The recipient must be a minister of the gospel. The court concluded that the administrator did not qualify for a housing allowance since he was not a minister of the gospel. In reaching this decision, the court made a number of important observations that will be useful to other religious organizations in evaluating whether an employee is a minister of the gospel for tax purposes:

• While the tax code limits housing allowances to ministers of the gospel, neither the code nor the income tax regulations define this term.

• The income tax regulations do define “what a minister does.” They list the following functions: (1) the performance of sacerdotal functions; (2) the conduct of religious worship; and (3) the performance of services in control, conduct, and maintenance of religious organizations.

Key point. In deciding whether or not an individual performs the functions of a minister, consideration must be given not only to the religious duties the individual performs, but also to the religious duties that are not performed.

Key point. The court stressed that the performance of some religious functions is not enough to make one a minister for federal tax purposes. The administrator in this case performed a number of religious functions, but these were largely administrative in nature. More importantly, he performed few of the duties of an ordained, commissioned, or licensed minister.

Key point. The court did not say whether all three of the functions mentioned in the regulations must be performed in order for an individual to qualify as a minister for federal tax purpose.

• The regulations also refer to a “duly ordained, commissioned, or licensed” minister, and so this is another “important consideration.”

Key point. The court observed that “[w]e also consider important whether the taxpayer was duly ordained, commissioned, or licensed.” Other decisions of the Tax Court have made clear that this is not merely an “important” consideration, it is absolutely essential. No one can be a “minister” for federal tax purposes who is not, at a minimum, “ordained, commissioned, or licensed.”

• The court added another important consideration in determining whether or not a person is a minister for federal tax purposes-“whether the particular church or denomination recognized that person as a minister or religious leader.”

• The court referred to the fact that the administrator had no seminary training.

• The court referred to two prior Tax Court rulings addressing the definition of the term minister for federal tax purposes—Knight v. Commissioner, 92 T.C. 199 (1989) and Wingo v. Commissioner, 89 T.C. 922 (1987). As noted in prior issues of this newsletter, the Knight decision modified the Wingo decision. As a result, it is unfortunate that the court referred to the Wingo decision, which contains a far more restrictive definition of the term minister.

• The court acknowledged the difficulties associated with any attempt by the civil courts to define ecclesiastical terms: “As a judicial body we are loath to evaluate ecclesiastical authority in the various religious disciplines. We emphasize that our opinion is based on the record before us, and our finding should not diminish the importance of [the administrator’s] contributions to his community.”

4. Designating a housing allowance. The court concluded that even if the administrator were a “minister” for federal tax purposes, he would still be ineligible for a housing allowance since there was no evidence that a housing allowance had ever been properly designated for him. The court noted that to qualify for a housing allowance “the amount paid to a minister, to rent or otherwise provide a home, must be designated as a [housing] allowance pursuant to official action taken in advance of such payment.” The income tax regulations specify that the designation of the allowance may be contained in “an employment contract, in minutes of or in a resolution by a church or other qualified organization or in its budget, or in any other appropriate instrument evidencing such official action.”

Key point. Under no circumstances can a minister exclude any portion of an allowance retroactively designated by a church. The designation need not be in advance of the calendar year, but it will only be effective from the date of its enactment.

5. Consistency. “Ministers” are eligible for the following four special tax rules with respect to services they perform in the exercise of their ministry:

• the housing allowance exclusion (and the exclusion of the fair rental value of a church-owned parsonage)

• exemption from self-employment taxes (if several conditions are met)

• self-employed status for social security purposes (if not exempt)

• wages exempt from federal income tax withholding (ministers use the quarterly estimated tax procedure to pay their income taxes and self-employment taxes, unless they elect voluntary withholding of these taxes)

Here is the important point—persons who qualify as “ministers” for federal tax purposes must be consistent with regard to these four special tax rules—if one applies, then they all apply. To illustrate, persons who qualify as a minister for federal tax purposes not only are eligible for a housing allowance, but in addition they (1) are self-employed for social security (they pay self-employment taxes rather than FICA taxes), and (2) are exempt from federal income tax withholding (they use the estimated tax procedure to prepay these taxes).

6. Clergy of other faiths. The court acknowledged that the tax code uses the term “minister of the gospel” and that this term refers to clergy of the Christian faith. However, it insisted that “Congress did not intend to exclude those persons who are equivalent of ministers in other religions” and that “rabbis and cantors of the Jewish faith are considered ministers who can also qualify for the parsonage exclusion.”

7. Value of a Tax Court “memorandum” decision. The court’s decision was a “memorandum” decision, meaning that it was a ruling by only one judge. “Regular” opinions of the Tax Court, such as the Knight case, are of much greater precedential value than memorandum opinions, since they are decisions by the full Tax Court.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Liability of Church Board Members for Seizing a “Corporate Opportunity”

Church boards have mandated fiduciary duties.

Richard R. Hammar, Attorney, CPA

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White Gates Skeet Club, Inc. v. Lightfine, 658 N.E.2d 864 (Ill. App. 1995)

Background. The law imposes special “fiduciary duties” upon the board members of churches and other charities. The idea is simple. Board members are chosen to represent the organization, and so they must abide by the highest principles of integrity and loyalty in their dealings with it. One of these fiduciary duties is the duty not to “usurp” or misappropriate a corporate opportunity. What this means is this—board members cannot buy property that they know the church would have an interest in, and then sell it to the church for a profit. Such behavior violates the fiduciary duty the board members owe to the church.

A recent case. This principle was illustrated in a recent case. Some of the officers of a charity knew that the charity needed adjacent land. When they learned that adjacent land was available for sale they bought it in their own names, planning to later sell it to the charity at a profit. The charity sued the officers, and a court ruled that the officers held the property “in trust” for the charity. It observed that the courts have been “uncompromising” in ruling that under these circumstances board members hold title “in trust” for their corporation. This rule is “based on a wise public policy that, for the purpose of removing all temptation, extinguishes all possibility of profit flowing from a breach of the confidence imposed by the fiduciary relation.”

Relevance to church treasurers. Many church board members are unaware of the fiduciary duties they owe to the church. As this case illustrates, unfamiliarity with these duties can result in embarrassment and personal liability. Church treasurers can help by having church board members review this article.

Example. Bill is a member of the board of his church. He knows that the church needs to purchase six adjacent homes to expand its parking lot. He learns that the owners of one of the homes are interested in selling their home. Bill privately meets with the homeowners, and offers to pay $60,000 for their home. His offer is accepted, and he becomes the owner of the home. Bill later offers to sell the home to the church for $75,000. Bill views himself as a shrewd investor trying to make an honest profit. He is wrong. He has violated a fiduciary duty by “usurping” a corporate opportunity.

This article originally appeared in Church Treasurer Alert, November 1996.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Recent Trends in Employment Discrimination Cases

Lawsuits are on the rise and are not often covered by insurance policies.

Richard R. Hammar, Attorney, CPA

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Background. Church treasurers should take seriously the threat of an employment discrimination lawsuit. Not only are these kinds of lawsuits a rapidly growing area of litigation, but they often are not covered by a church’s insurance policies. This means that in many cases a church will be forced to hire an attorney and pay all legal fees incurred in the defense of such a lawsuit, in addition to paying any settlement or judgment.

Discrimination laws exist at the federal, state, and sometimes local levels. These laws prohibit various kinds of discrimination by employers against employees and applicants for employment. For example, the most comprehensive federal non-discrimination law is Title VII of the Civil Rights Act of 1964, which prohibits employers that have at least 15 employees and that are involved in interstate commerce from discriminating against an employee in any employment decision (such as hiring, dismissal, fringe benefits, and discipline) on the basis of race, color, national origin, religion, or sex. Other federal laws ban discrimination in employment based on age and disability. There are very limited exemptions for religious organizations under some of these laws.

Key point. Most states have enacted similar laws, and it is much more likely that these will apply to churches since they generally apply to employers with fewer than 15 employees and there is no requirement that the church be engaged in interstate commerce.

Survey of discrimination cases. Recent government data contain information that will be helpful to church leaders in evaluating employment discrimination litigation. Consider the following:

• The number of complaints filed with the EEOC is staggering—more than 87,000 complaints were filed in 1995. This number represents a slight (4 percent) decline over the number of complaints filed in 1994.

• There were an estimated 20,000 employee discrimination lawsuits filed in federal courts in 1995 according to government estimates—up from 8,500 cases filed in 1990. This does not include lawsuits filed in state courts alleging violations of state anti-discrimination laws. But only 410 of the federal lawsuits filed in 1995 were brought by the EEOC (a federal agency that enforces federal civil rights laws). This is only 2 percent of all cases. The rest of the cases were brought by individual employees directly. The EEOC is filing fewer lawsuits than in the past. It brought over 7 percent of all federal discrimination lawsuits in 1990.

Tip. Here is a critical tactical point to consider. Employers win employment discrimination lawsuits far more often when a jury is not involved. For 1994 (the most recent year for which data is available) employee-plaintiffs won 43 percent of employment discrimination cases tried before a jury, but only 22 percent of cases tried before a judge without a jury! Church leaders should keep these results in mind in evaluating whether or not to demand a jury in a discrimination lawsuit.

• Juries are far more generous in awarding money damages than judges. The average jury award in 1990 was $371,000. When judges heard cases without a jury the average award was much less—only $161,000.

Key point. This data further supports the tactical advantage of not demanding a jury in a discrimination lawsuit. Not only is the probability of success much greater for a church or other employer when a jury is not involved, but the damages awarded when the employer loses are much lower.

• Few church leaders realize that the amount of money awarded by both juries and judges in discrimination lawsuits has been declining significantly over the past few years. The average award by a jury was $371,000 in 1990. But by 1994 the average had dropped 73 percent to $102,000! The average award by a judge (without a jury) dropped from $161,000 in 1990 to $36,000 in 1994—a 78 percent drop.

Tip. This information will be useful to church leaders in evaluating whether or not to settle discrimination lawsuits, and if so, for what amount.

This article originally appeared in Church Treasurer Alert, August 1996.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

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How to Address Suspicions of Embezzlement

Four strategies to guide uncomfortable conversations as you seek to uncover the truth.

Richard R. Hammar, Attorney, CPA

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Sometimes a person who has embezzled church funds will voluntarily confess—usually out of a fear that he or she is about to be “caught.” But in many cases the embezzler does not confess—at least initially. Discrepancies or irregularities may occur which cause church leaders to suspect this person. Consider the following examples.

The same person has counted church offerings for many years. The pastor inadvertently notices that offerings are always higher when this person is absent (due to illness, business, or vacation).
Church officials noticed that a church bookkeeper was living a higher standard of living than was realistic given her income. Among other things, she purchased an expensive home and a luxury car.
Church offerings have remained constant, or increased slightly, despite the fact that attendance has increased.
A church treasurer notices that a church official with sole signature authority on the church checking account has purchased a number of expensive items from unknown companies without any documentation to prove what was purchased and why.

Church leaders often are unsure how to address suspected cases of embezzlement. The suspected embezzler is almost always a trusted member or employee, and church leaders are reluctant to accuse such a person without irrefutable evidence that he or she is guilty.

Seldom does such evidence exist. The pastor may confront the person about the suspicion, but in many cases the individual will deny any wrongdoing—even if guilty. This compounds the frustration of church officials, who do not know how to proceed.

Here is a list of steps that church leaders can take to resolve such difficult cases:

Confront the suspected embezzler

The pastor and at least one other church leader should confront the suspected embezzler. Inform the person that the church has evidence indicating that he or she has embezzled church funds. Seek a confession. Inform the person that if no one confesses, the church will be forced to call in a CPA firm to confirm that embezzlement has occurred, and to identify the probable embezzler.

Tip. Embezzlement is a criminal offense. Depending on the amount of funds or property taken, it may be a felony that can result in a sentence in the state penitentiary. This obviously would have a devastating impact on the embezzler, and his or her family.

If the evidence clearly indicates that a particular member or employee has embezzled church funds, but this person denies any wrongdoing, inform him or her that the church may be forced to turn the matter over to the police for investigation and prosecution.

Tip. Embezzlers never report their illegally obtained “income” on their tax returns. Nor do they suspect that failure to do so may subject them to criminal tax evasion charges! In fact, in some cases it is actually more likely that the IRS will prosecute the embezzler for tax evasion than the local prosecutor will prosecute for the crime of embezzlement.

If the evidence clearly indicates that a particular member or employee has embezzled church funds, but this person denies any wrongdoing, inform him or her that the church may be forced to turn the matter over to the IRS for investigation and possible prosecution.

Conduct an audit

Have a local CPA conduct an audit to establish that embezzlement has occurred, and provide an estimate of how much was embezzled.

If the suspected embezzler denies any wrongdoing (or if embezzlement is suspected but it is not clear who is guilty), church leaders should consider hiring a local CPA firm to look for evidence of embezzlement. There is a good possibility that the embezzlement will be detected, and that the perpetrator will be identified.

Tip. CPAs can also help the church establish a strong system of internal control to reduce the risk of embezzlement in the future.

Many church leaders have found that turning the investigation over to a CPA firm is much more acceptable than conducting the investigation internally. The CPA firm is completely objective, and ordinarily will not know the suspected embezzler. Further, few church members will object to the church hiring a CPA firm to detect wrongdoing and help establish a sound system of internal control.

Contact the police or local prosecutor

If the suspected embezzler does not confess, or if embezzlement is suspected but it is not clear who is guilty, church leaders must consider turning the matter over to the police or local prosecutor. This is a very difficult decision, since it may result in the prosecution and incarceration of a member of the congregation.

Respond to a confession

In some cases the embezzler eventually confesses. Often, this is to prevent the church from turning the case over to the IRS or the police, or to a CPA firm. Embezzlers believe they will receive “better treatment” from their own church than from the government. In many cases they are correct.

It often is astonishing how quickly church members will rally in support of the embezzler once he or she confesses—no matter how much money was stolen from the church. This is especially true when the embezzler used the embezzled funds for a “noble” purpose, such as medical bills for a sick child. Many church members demand that the embezzler be forgiven.

They are shocked and repulsed by the suggestion that the embezzler—their friend and fellow church member—be turned over to the IRS or the police! But is it this simple? Should church leaders join in the outpouring of sympathy? Should the matter be dropped once the embezzler confesses?

These are questions that each church will have to answer for itself, depending on the circumstances of each case. Before forgiving the embezzler and dropping the matter, church leaders should consider the following points:

A serious crime has been committed, and the embezzler has breached a sacred trust. The church should insist, at a minimum, that the embezzler must:

disclose how much money was embezzled
make full restitution by paying back all embezzled funds within a specified period of time, and
immediately and permanently be removed from any position within the church involving access to church funds

Tip. Closely scrutinize and question the amount of funds the embezzler claims to have taken. Remember, you are relying on the word of an admitted thief. Is it a realistic amount? Is it consistent with the irregularities or discrepancies that caused church leaders to suspect embezzlement in the first place? If in doubt, consider hiring a local CPA to review the amount the embezzler claims to have stolen.

In many cases the embezzler will insist that he or she is not able to pay back the embezzled funds.

They have been spent. This presents church leaders with a difficult decision, since the embezzler has received unreported taxable income from the church. The embezzler should be informed that the embezzled funds must either be returned within a specified time, or a promissory note must be signed promising to pay back the embezzled funds within a specified period of time.

The embezzler should be informed that failure to agree to either alternative will force the church to issue him or her a 1099 (or a corrected W-2 if the embezzler is an employee) reporting the embezzled funds as taxable income. Failure to do so will subject the church to a potential penalty (up to $10,000) for aiding and abetting in the substantial understatement of taxable income under section 6701 of the tax code.

Tip. An embezzler’s biggest problem ordinarily will not be with the church or even with the local prosecutor. It will be with the IRS for failure to report taxable income. There are only two ways to avoid trouble with the IRS: (1) the embezzler pays back the embezzled funds, or (2) the church reports the embezzled funds as taxable income on a 1099 or corrected W-2.

Church leaders must also remember that they owe a fiduciary obligation to the church and that they are stewards of the church’s resources.

Viewing the offender with mercy does not necessarily mean that the debt must be forgiven and a criminal act ignored. Churches are public charities that exist to serve religious purposes, and they are funded entirely out of charitable contributions from persons who justifiably assume that their contributions will be used to further the church’s mission. These purposes may not be served when a church forgives and ignores cases of embezzlement.

Tip. The federal Employee Polygraph Protection Act prohibits most employers from requiring or even suggesting that an employee submit to a polygraph exam. Employers also are prevented from dismissing or disciplining an employee for refusing to take a polygraph exam.

There is an exception that may apply in some cases—an employer may require that an employee take a polygraph exam if the employee is suspected of a specific act of theft or other economic loss and the employer has reported the matter to the police. However, the employer must follow very strict requirements to avoid liability.

A church should never suggest or require that an employee submit to a polygraph exam, even in cases of suspected embezzlement, without first contacting a local attorney for legal advice.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Reducing the Risk of Embezzlement

Can the risk of embezzlement be reduced? If so, how? The good news is that

Richard R. Hammar, Attorney, CPA

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Can the risk of embezzlement be reduced? If so, how? The good news is that there are number of steps that church leaders can take to reduce this risk, and most of them are quite simple. Consider the following:

1. Implement an effective system of internal control. The first and most effective deterrent to embezzlement is a strong system of “internal control.” Internal control is an accounting term that refers to policies and procedures adopted by an organization to safeguard its assets and promote the accuracy of its financial records. What procedures has your church adopted to insure that cash receipts are properly recorded and deposited, and that only those cash disbursements that are properly authorized are made? These are the kinds of questions that are addressed by a church’s system of internal control. A table in this newsletter addresses a number of common weaknesses in church internal control that increase the risk of embezzlement. The table provides helpful suggestions for responding to these weaknesses.

Key point. The most important point to emphasize is “division of responsibilities.” The more that tasks and responsibilities are shared or divided, the less risk there will be of embezzlement.

Key point. Many churches refuse to implement basic principles of internal control out of a fear of “offending” persons who may feel that they are being suspected of misconduct. The issue here is not one of hurt feelings, but accountability. The church, more than any other institution in society, should set the standard for financial accountability. After all, its programs and activities are rooted in religion, and it is funded entirely with donations from persons who rightfully assume that their contributions are being used for religious purposes. The church has a high responsibility to promote financial accountability. This duty is simply not met when the practices described above are followed.

2. Screen persons with financial responsibility. Some churches screen bookkeepers, accountants, and other employees who will have access to funds or be involved in financial decisions. Screening can consist of obtaining references from employers, prior employers, and other churches or charities with which the person has been employed or associated.

3. Annual audits. A church can reduce the risk of embezzlement by having an annual audit of its financial records by a CPA firm. An audit accomplishes three important functions:

An audit promotes an environment of accountability in which opportunities for embezzlement (and therefore the risk of embezzlement) are reduced.
The CPA (or CPAs) who conducts the audit will provide the church leadership with a “management letter” that points out weaknesses and inefficiencies in the church’s accounting and financial procedures. This information is invaluable to church leaders.
An audit contributes to the integrity and reputation of church leaders and staff members who handle funds.

Key point. Don’t confuse an audit with a more limited engagement that CPAs will perform, such as a “compilation.”

Key point. Audits can be expensive, and this will be a very relevant consideration for smaller churches. Of course, the time involved in performing an audit for a smaller church will be limited, which will result in a lower fee. Churches can control the cost of an audit by obtaining bids. Also, by staying with the same CPA firm, most churches will realize a savings in the second and succeeding years since the CPA will not have to spend time becoming familiar with the church’s financial and accounting procedures.

Key point. Smaller churches that cannot afford a full audit may want to consider two other options: (1) Hire a CPA to conduct a review, which is a simpler and less expensive procedure. If the review detects irregularities, a full audit may be considered worth the price. (2) Create an internal audit committee if there are accountants or business leaders within the church who have the ability to review accounting procedures and practices and look for weaknesses. These people often are very familiar with sound internal control policies, and will quickly correct weaknesses in the church’s financial operations. An added bonus—such a committee will serve as a deterrent to those who might otherwise be tempted to embezzle church funds.

4. Bonding of persons who handle funds. Churches can address the risk of embezzlement by bonding the church treasurer and any bookkeeper or accountant that is on staff. You can also purchase a blanket policy to cover all employees and officers. It is important to note that insurance policies vary. Some require that the embezzler be convicted before it will pay a claim, while others do not. The period of time covered by the policy will also vary. These are important points to be discussed by your church board in consultation with your insurance agent.

Key point. Insurance is not a substitute for implementing a sound system of internal control.

Church leaders can reduce the risk of embezzlement by reviewing common examples of poor internal controls, such as one person counts church offerings.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Embezzlement Defined

The definition of embezzlement varies slightly from state to state, but in general it refers

Richard R. Hammar, Attorney, CPA

Bio

The definition of embezzlement varies slightly from state to state, but in general it refers to the wrongful conversion of property that is lawfully in your possession. The idea is that someone has legal control or custody of property or funds, and then decides to convert the property or funds to his or her own personal use.

Most people who embezzle funds insist that they intended to pay the money back and were simply “borrowing” the funds temporarily. An intent to pay back embezzled funds is not a defense to the crime of embezzlement. Most church employees who embezzle funds plan on repaying the church fully before anyone suspects what has happened. One can only imagine how many such schemes actually work without anyone knowing about it. The courts are not persuaded by the claims of embezzlers that they intended to fully pay back the funds they misappropriated. The crime is complete when the embezzler misappropriates the church’s funds to his or her own personal use. As one court has noted:

The act of embezzlement is complete the moment the official converts the money to his own use even though he then has the intent to restore it. Few embezzlements are committed except with the full belief upon the part of the guilty person that he can and will restore the property before the day of accounting occurs. There is where the danger lies and the statute prohibiting embezzlement is passed in order to protect the public against such venturesome enterprises by people who have money in their control.

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

What if the embezzled funds are returned? The crime of embezzlement has occurred even if the embezzled funds in fact are paid back. Of course, it may be less likely that a prosecutor will prosecute a case under these circumstances. And even if the embezzler is prosecuted, this evidence may lessen the punishment. But the courts have consistently ruled that an actual return of embezzled funds does not purge the offense of its criminal nature or absolve the embezzler from punishment.

Key point. Even if an embezzler is caught or confesses, and then agrees to “pay back” the embezzled funds, church officials seldom know if all embezzled funds are being returned. They are relying almost entirely on the word of the embezzler.

Why churches often are vulnerable to embezzlement. Many churches refuse to adopt measures to reduce the risk of embezzlement out of a fear of that such measures will reflect a lack of trust in those persons who handle church funds.

Example. Tom has counted the church offering at his church for 25 years. The church board has discussed this arrangement several times, but fails to stop it out of a fear of offending Tom.

Why should church leaders take this risk seriously? For several reasons, including the following:

Survey data. Our survey data (mentioned above) demonstrates that embezzlement is a risk that every church should take seriously.
Removing temptation. Churches that take steps to prevent embezzlement remove a source of possible temptation from church employees and volunteers who work with money.
Protecting reputations. By taking steps to prevent embezzlement a church protects the reputation of innocent employees and volunteers who otherwise might be suspected of financial wrongdoing when financial irregularities occur.
Avoiding confrontations. By taking steps to prevent embezzlement a church avoids the unpleasant task of confronting individuals who are suspected of embezzlement.
Avoiding church division. By taking steps to prevent embezzlement a church avoids the risk of congregational division that often is associated with cases of embezzlement—w ith some members wanting to show mercy to the offender and others demanding justice.
Avoiding the need to inform donors. By taking steps to prevent embezzlement a church reduces the risk of having to tell donors that some of their contributions have been misappropriated by a church employee or volunteer.
Protecting the reputation of church leaders. By taking steps to prevent embezzlement a church reduces the damage to the reputation and stature of its leaders who otherwise may be blamed for allowing embezzlement to occur.
Preserving accountability. Churches that take steps to prevent embezzlement help to create a “culture of accountability” with regard to church funds.

These are powerful motivations for addressing the issue of embezzlement.

How it happens. Let’s look at a few cases of actual embezzlement of church funds to see how it can occur.

Example. An usher collected offerings each week in the church balcony, and pocketed all loose bills while carrying the offering plates down a stairway to the main floor. Church officials later estimated that he embezzled several thousands of dollars over a number of years, before being caught.

Example. The same two persons counted church offerings for many years. Each week they removed all loose coins and currency (not in offering envelopes) and split it between them. This practice went on for several years, and church officials later estimated that the two had embezzled several tens of thousands of dollars.

Example. A church left its Sunday offering, along with the official count, in a safe in the church office until Monday. On Monday morning a church employee deposited the offering. The employee ignored the official counts, and deposited the offering less loose coins and currency (which she retained). The deposits were never checked against the offering counts.

Example. A church child care director embezzled church funds by issuing herself paychecks for the gross amount of her pay (before deductions for tax withholding). The church withheld taxes and paid them to the government, but her paychecks reflected the gross amount of her pay.

Example. A pastor had the sole authority to write checks on the church’s checking account. He used church funds to pay for several personal expenses, amounting to thousands of dollars each year, until his actions were discovered.

Example. A church bookkeeper embezzled several thousand dollars by issuing checks to a fictitious company. He opened an account in the name of a fictitious company, issued church checks to the company for services that were never performed, and then deposited the checks in the fictitious company’s account. He later withdrew the funds and purchased two automobiles which he gave to a friend. A court ruled that the friend had to give the cars back to the church, since they had been purchased with embezzled church funds. The point here, as noted by the court, is that one who acquires property that was purchased with embezzled church funds may be required to transfer the property to the church.

Example. A minister received an unauthorized kickback of 5% of all funds paid by a church to a contractor who had been hired to build a new church facility. The minister received over $80,000 from this arrangement, in exchange for which he persuaded the church to use the contractor. The minister’s claim that the $80,000 represented a legal and nontaxable “love offering” was rejected by a federal court that found the minister guilty of several felony counts. This arrangement was not disclosed to the church board, and obviously amounted to an unauthorized diversion of church funds back to the minister.

Example. A church accountant embezzled $212,000 in church funds. This person’s scheme was to divert to his own use several designated offerings, and to inflate the cost of equipment that he paid for with his own funds and that the church later reimbursed at the inflated amounts. The interesting aspect of this case was that the accountant was not only found guilty of embezzlement, but he was also convicted for tax evasion because he had failed to report any of the embezzled money as taxable income, and was sentenced to prison.

Example. A court ruled that an insurance company that paid out $26,000 to a charity because of an act of embezzlement could sue the embezzler for the full amount that it paid. This is an important case, for it demonstrates that a church employee who embezzles church funds may be sued by the church insurance company if it pays out a claim based on the embezzlement. In other words, the fact that the church decides not to sue the embezzler does not mean that the person will be free from any personal liability. If the church has insurance to cover the loss, the insurance company can go after the embezzler for a full recovery of the amount that it paid out on account of the embezzlement.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

For Whom the Bell Tolls

What to do when the sound of church bells is not music to a neighborhood’s ears.

Richard R. Hammar, Attorney, CPA

Bio

Background. Many churches broadcast chimes and carillon music to their neighborhoods through bells in a steeple or electronic equipment. These broadcasts are inspiring and uplifting to many. But some neighbors may find the noise disturbing or even offensive. Do these neighbors have a legal right to stop the music? That was the issue addressed by a New York court.

Facts. A Presbyterian church played hourly chimes and in addition played carillon music at noon and 6 o’clock in the evening. A neighbor asked a court to stop the church from broadcasting the chimes and carillon music on the ground that it was “a complete disruption of her family life, prevents a child from sleeping, invades the privacy of her residence, and creates unnecessary stress.” The neighbor claimed that the chimes and music were a “private nuisance.”

The court’s ruling. The court began its opinion by observing that “what may be music to the ears of some can, in certain circumstances, be a nuisance to the ears of others.” It noted that a “private nuisance” is a use of one’s property in a way that causes an unreasonable and “substantial interference” with a neighbor’s enjoyment of his or her property. Did the church’s daily performance of chimes and carillon music create an unreasonable and substantial interference with the neighbor’s property? No, said the court. It pointed to an affidavit (submitted by the church) from an expert in noise management showing that the sound levels caused by the chimes and carillon music were “no greater than the sound from a passing automobile, of which some 6,500 passed [the neighbor’s] property each day.” The court also pointed to affidavits from 15 other neighbors who found the bells and chimes to be pleasant and inspirational.

Importance to church treasurers. If your church broadcasts chimes or carillon music to your neighborhood, and neighbors complain about the noise and threaten to take legal action if it does not stop, follow the lead of the church in this case by: (1) obtaining the opinion of a noise engineer who can compare the noise levels of your chimes or carillon music to other commonly accepted noises; and (2) obtaining the affidavits of several neighbors who find the bells and chimes pleasant and inspiring. These actions will reduce the likelihood that the complaining neighbors will be able to prove that the bells and chimes create an unreasonable and substantial interference to neighbors’ use and enjoyment of their properties. Langan v. Bellinger, 611 N.Y.S.2d 59 (A.D. 3 Dept. 1994).

This article originally appeared in Church Treasurer Alert, February 1996.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Often Overlooked Sources of Taxable Income to Ministers

Clarifying what income is taxable and what is not.

Richard R. Hammar, Attorney, CPA

Bio

Background. It is important for church treasurers to know how much taxable income the church is paying a minister so that the correct amount can be reported on the W-2 or 1099 the church issues to the minister. Unfortunately, the concept of “taxable income” is complex and confusing. Church treasurers often issue W-2 or 1099 forms that do not fully reflect all income received by a minister.

Key point. This article focuses on items of taxable income received by ministers that often are overlooked by church treasurers when completing the minister’s W-2 or 1099 form. Many of the items summarized below apply equally to non-minister staff members as well.

Assignments of income. Sometimes a minister or other staff member will refuse to accept payment for services rendered. Consider two examples:

• Rev. G conducts services for two weeks at another church whose pastor is on vacation. The church wants to pay Rev. G income of $750 for these services, but Rev. G declines and requests that the money be applied to the church’s building fund.

• Rev. T declines to accept a Christmas gift or anniversary gift of $500 from the congregation. Instead, Rev. T asks the church treasurer to transfer the amount to the church’s benevolence fund.

Clearly, both ministers believe they have avoided the receipt of taxable income by assigning these amounts to the church. Are they correct? Should a church treasurer report these amounts as taxable income on each minister’s W-2 form? Unfortunately, the answer is yes. The United States Supreme Court addressed this issue in a landmark ruling in 1940, in which it ruled that “[t]he power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.” Helvering v. Horst, 311 U.S. 112 (1940).

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

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

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

Refusals to accept full salary. Occasionally a minister or other staff member will decline to accept the full amount of a church-approved salary. Should a church treasurer report the full amount of the church-approved salary as income on the individual’s W-2 form? Church treasurers need to be familiar with the so-called “constructive receipt doctrine,” which is defined by the income tax regulations as follows:

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

A number of courts have ruled that this principle requires employees to include in their taxable income any portion of their stated salary that they refuse to accept.

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

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

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

In summary, there is a reasonable basis for not treating as taxable income that portion of an employee’s stated salary that is refused, particularly where the employee does not assign the income to a specified use but rather is content to leave the unpaid salary with the employer. Church treasurers should seek the advice of a CPA or tax attorney before adopting this position in a particular case.

Forgiveness of debt. Churches often make loans to their ministers, often at no interest. Sadly, in some cases a minister never repays the debt. Church treasurers often are unsure of their obligations under these circumstances. Consider the following example:

First Church hires Rev. B as a youth pastor. Rev. B is young and was recently married, and is in need of housing. Rev. B would like to buy a home but lacks the $10,000 needed for a down payment. The church board votes to loan Rev. B $10,000. Rev. B signs a no-interest $10,000 promissory note agreeing to pay the church back the $10,000 in 60 monthly installments of $166.67. Rev. B pays all of the monthly installments for the first year, but in the second and third year he pays only half of the required installments. He accepts another position and leaves First Church at the end of the third year. The balance due on his note is now $6,000. Over the next several months the church treasurer at First Church writes Rev. B on 3 occasions and requests that the note be paid in full. Rev. B does not respond to any of these requests. The church board eventually decides to forgive the debt and makes no further contact with Rev. B.

What should a church treasurer do under these circumstances? Does the forgiven debt of $6,000 represent taxable income? The forgiveness of debt ordinarily represents taxable income to the debtor. As a result, if a church makes a loan to a minister or other staff member and the debt is later forgiven by the church, the church should report the forgiven debt as income. Here are the rules to follow, using the same facts as in the example:

• If the church has not yet issued a W-2 or 1099 to Rev. B for his last year of employment, then reflect the forgiven debt on the W-2 or 1099.

• If the church already has issued a W-2 or 1099 to Rev. B for the last year of employment, then issue a corrected W-2 or 1099. A corrected W-2 is prepared on Form W-2c. Be sure to note the year of the Form W-2 that is being corrected. There is no separate form for a corrected 1099—simply fill out a new 1099 and check the box at the top of the form indicating that it is a “corrected” version.

• In addition to the forgiven debt ($6,000) Rev. B received income because no interest was charged by the church on the loan. In essence, this additional “income” consists of the amount of interest Rev. B would have paid the church had the prevailing commercial interest rate been charged by the church on the loan. A below market term loan of less than $10,000 is not subject to these rules (assuming one of its principal purposes is not the avoidance of tax). Check with a CPA or tax attorney for assistance in making this calculation. Different rules apply for “demand loans.”

Example. An employer paid the moving expenses of newly hired employees to relocate them to the employer’s city. Employees were required to reimburse the employer for a portion of the moving expenses paid by the employer if they terminated their employment within 1 year after being hired. An employee voluntarily terminated her employment within 1 year of being hired, and the employer was unsuccessful in collecting $5,000 in moving expenses from the employee. The employer eventually wrote this amount off as uncollectible. The IRS ruled that the employer had to report the forgiven debt as taxable income to the former employee. It observed: “It is well settled that where an employee’s debt to his employer is satisfied by canceling such debt, income is realized by the employee. Therefore, the employee must include in gross income the total amount of the debt that was canceled by [the employer]. The income realized upon cancellation of indebtedness arose as a result of an employment relationship. Accordingly, Form W 2 should be used to report the amount of indebtedness canceled. This form should be used even if the debt is canceled in a year subsequent to the year of employment.” IRS Letter Ruling 8315021.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Additional Sources of Income to Ministers

Clarifying what income is taxable and what is not.

Richard R. Hammar, Attorney, CPA

Bio

Key point. This article focuses on items of taxable income received by ministers that often are overlooked by church treasurers when completing the minister’s W-2 or 1099 form. Many of the items summarized in this article apply equally to non-minister staff members as well.

Bonuses. Any “bonus” paid by a church to a minister represents taxable income, and must be reported on the minister’s W-2 or 1099.

“Love gifts.” Churches often pay ministers a “love gift” on special occasions such as Christmas, birthdays, or anniversaries. Many church treasurers are not sure how to report these “gifts.” Are they nontaxable gifts, or do the represent taxable compensation for services rendered? Here is the basic test: If the purpose of a “gift” is to more fully compensate a minister for faithful services rendered on behalf of the church, the amount represents taxable compensation for services rendered and is not a nontaxable gift. It must be included on a minister’s W-2 or 1099. This is so even though the amount is called a “love gift.”

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

Here’s another important point—since 1987 federal law has specified that the term gift does not include “any amount transferred by or for an employer to, or for the benefit of, an employee.” An exception is a traditional employer holiday gift of low fair market value (such as a turkey, fruitcake, etc.). These items are nontaxable.

Note the following general principles:

Special occasion gifts made to a minister by the church out of the general fund should be reported as taxable compensation and included on the minister’s W 2 or 1099.
Members are free to make personal gifts directly to their minister, such as a card at Christmas accompanied by a check or cash. Such payments normally are tax free gifts to the minister (though they are not deductible by the donor).
Special occasion “gifts” to a minister funded through members’ contributions to the church (i.e., the contributions are entered or recorded in the church’s books as cash received and the members are given charitable contribution credit), should be reported as taxable compensation and included on the minister’s W 2 or 1099.
Members who contribute to special occasion offerings may deduct their contributions if (1) the contributions are to the church and are entered or recorded in the church’s books as cash received, and (2) they are able to itemize deductions on Schedule A (Form 1040).
Some churches collect an all cash special occasion offering with the understanding that the entire proceeds will be paid directly to the minister and that no contributions will be tax deductible. Whether or not these amounts represent taxable income to the minister will depend on the following factors: (1) the intent of the donors who contribute to the offering (e.g., if they are simply wanting to provide additional compensation to their minister in recognition of services rendered, then the transfer will be taxable compensation rather than a tax free gift); (2) whether or not a church adjusts the minister’s compensation on the basis of the special occasion offerings collected on his or her behalf; and (3) whether the contributions were spontaneous and voluntary as opposed to fixed amounts established under a “highly structured program” for transferring money to the minister on a regular basis. One court ruled that such “gifts” represented taxable compensation to a minister in part because “[t]he transfers were initiated, sponsored, collected and distributed by the congregation.”

Key point. An aggressive argument can be made that in some cases a Christmas offering collected by a congregation for its minister represents a nontaxable gift rather than taxable compensation if the following factors are present: (1) The members are not receipted for their contributions. (2) Members are informed that they are giving directly to the pastor. (3) Members do not deduct their contributions. (4) The church acts merely as an intermediary. The gifts in reality are made by individual members directly to their pastor. (5) The church’s minimal involvement in the arrangement (collecting and turning over the offering) does not amount to sufficient church involvement to prevent the offering from being characterized as several individual gifts from members directly to their pastor. (6) Only 1 special occasion offering is collected each year. (7) Members are not pressured or coerced into making contributions. Participating in the offering is entirely voluntary. (8) The pastor is adequately compensated through salary and fringe benefits mutually agreed to between the pastor and church board. (9) Most members contribute to such an offering out of sincere affection, respect, and admiration, and not out of a desire to compensate the pastor more fully for services rendered. Pastors and churches should not select the “aggressive approach” without the advice of a tax professional.

Retirement gifts. Most churches present retiring ministers with some form of “gift.” Are these “gifts” nontaxable, or should church treasurers treat them as taxable compensation and add them to the minister’s W-2 or 1099? In the vast majority of cases, retirement gifts represent taxable compensation. This is because federal law (since 1987) has specified that the term gift does not include “any amount transferred by or for an employer to, or for the benefit of, an employee.”

Key point. Prior to 1987 a number of courts (and the IRS itself) ruled that retirement gifts to ministers in some cases could represent nontaxable income. These rulings were all overruled by the tax law change that took effect in 1987 prohibiting employers from making tax-free gifts to employees.

Key point. The 1987 tax law change only applies to employees. It does not apply to self-employed workers. As a result, ministers who in fact are self-employed for income tax reporting purposes are not absolutely barred from receiving tax-free retirement gifts. But note—(1) it will be very difficult for most ministers to demonstrate that they are self-employed for income tax reporting purposes, and (2) self-employed ministers still must demonstrate that (a) the retirement gift was not intended to more fully compensate a minister for faithful services rendered on behalf of the church, and (b) the gift satisfied the legal definition of a gift as a transfer that “proceeds from a detached and disinterested generosity … out of affection, respect, admiration, charity, or like impulses.”

Key point. Ministers who receive retirement gifts directly from members may be able to treat them as tax free gifts. Of course, the members receive no charitable contribution deduction since their contributions went directly to an individual. See the above discussion on special occasion gifts.

Property purchased from the church at a discount. Sometimes a church will sell property to a minister at less than fair market value. For example, a church sells its parsonage (with a fair market value of $100,000) to its minister for $25,000. In these cases the church treasurer ordinarily must include in the minister’s W-2 or 1099 the excess of the property’s fair market value over the bargain sale price.

Social Security paid by the church. Ministers are always treated as self-employed for social security purposes with respect to services they perform in the exercise of their ministry. This means that they pay the full “self-employment tax” (15.3 percent) rather than FICA taxes. Some churches agree to pay a portion (or all) of this tax liability. Any amount paid to a minister to help him or her pay the higher self employment tax must be reported as additional compensation on the minister’s W 2 or 1099 form. The amount paid by the church must be reported as compensation for social security purposes as well.

Moving expenses paid by the church. Since 1994, employer reimbursements of an employee’s moving expenses are treated as a tax-free fringe benefit if (1) the moving expenses would be deductible by the employee if paid directly by the employee; (2) the employee did not deduct the expenses in a prior year; and (3) the employer only reimburses those moving expenses that are properly substantiated by the employee (under rules similar to an accountable expense reimbursement arrangement). Employer reimbursements that satisfy these requirements are not reported in box 1 of the W-2 form, but must be reported in box 13. Code “P” is used to identify these nontaxable reimbursements in box 13. Any moving expense reimbursements that do not satisfy the three requirements summarized above represent a taxable fringe benefit and must be reported as taxable income on the minister’s W-2 or 1099.

Personal use of a church-provided car. The important point to note is this—if a church provides a car to its minister, the minister’s personal use of the car is a taxable noncash fringe benefit. The church must determine the actual value of this fringe benefit so that it can be included in the minister’s income and reported on his or her W 2 or 1099 form. There are four ways to compute the taxable value of the personal use of a church-provided car—a general valuation rule and three special valuation rules. These rules are explained fully in chapter 4 of Richard Hammar’s 1996 Church and Clergy Tax Guide.

Below market interest loans. It is common for churches to make below market interest loans to ministers, often to assist the minister in obtaining a home. Church treasurers often are unaware that these loans may generate taxable income that must be reported on the minister’s W-2 or 1099. Here are the basic rules:

Demand loans. A demand loan is a loan payable in full at any time upon the church’s demand. For example, a church loans $20,000 to Rev. B with no indication of when it is to be repaid. If the church charges less than the prevailing interest rate then Rev. B is treated as having received additional compensation from the church in an amount equal to the “foregone interest.” These additional transfers of compensation are deemed to occur annually, generally on December 31. The “lender” (church) must report this amount as interest income to the “borrower” (minister). Foregone interest for any period is the amount of interest that would be payable for that period if interest occurred at the applicable federal rate, over and above any interest actually payable on the loan for the same period. The applicable federal rate is established by the IRS each month in a revenue ruling. You can get this rate from any IRS office.

Term loans. A term loan is a loan that is not a demand loan. These loans are payable over a specified period of time. For example, a church loans Rev. C $15,000 over a 10-year term at no interest. Rev. C is treated as having received an additional payment of compensation on the date the loan was made. The amount of compensation is the excess of the amount of the loan over the present value of all payments due under the loan. You can easily compute this amount with a financial calculator.

Key point. A below market demand or term loan of less than $10,000 is not subject to these rules (assuming one of its primary purposes was not the avoidance of tax)

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Inflating the Value of Donated Property

Donors face significant risks if they claim too high a value on donations.

Richard R. Hammar, Attorney, CPA

Bio

Background. Persons who donate property to charity want to claim the highest possible value to increase their charitable contribution deduction. Sometimes they claim too high an amount, and this can result in problems. Taxpayers who understate their income taxes in any year by $5,000 or more because they overstated the value of donated property on their tax return are subject to a penalty. The penalty only applies if the overstated value is at least 200% of its actual value. The penalty is computed by multiplying 20% times the amount of the underpayment of income taxes (the penalty rate increases to 40% if the overstated value is at least 400% of its actual value).

A common example of valuation overstatements involves overvaluations of properties donated to charity. Such overvaluations result in inflated charitable contribution deductions and a corresponding understatement of income taxes.

A recent case. A property owner purchased 250 acres of inaccessible mountain property in Alaska for $30,000. Two years later, after an unsuccessful attempt to sell the property, he donated it to charity and claimed a charitable contribution deduction of $2.75 million. The IRS audited the taxpayer, and claimed that the property was worth only $28,000. This meant that the taxpayer overstated the value of the donated property by 98 times! The Tax Court agreed with the IRS, and denied the donor’s inflated charitable contribution deduction. It also upheld the following penalties:

• Overvaluation of donated property. The Court ruled that the taxpayer was subject to the penalty for overvaluation of donated property (summarized above). The Court noted: “Here, [the taxpayer] attempted to claim a charitable contribution deduction for approximately 98 times the amount paid for the property 2 years prior to donation. [He] grossly overstated the value of the donated property.”

• Additional interest. Federal law provides for an interest rate of 120 percent if there is a “substantial underpayment” (an underpayment in excess of $1,000) in a taxable year “attributable to one or more tax-motivated transactions.” Tax-motivated transactions include inflated valuations of donated property. The Court ruled that the taxpayer could be assessed additional interest since he made “blatant misuse of the charitable donation provisions” and “participated in a scheme to generate egregious charitable contribution deductions through the gross overvaluation of the items donated.”

• Negligence. The Court also concluded that the taxpayer could be assessed an additional penalty for negligence. The Court noted that negligence is “the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.” The Court acknowledged that the taxpayer relied on the opinion of an appraiser that the donated property was worth $2.75 million. However, it cautioned that

mere reliance on an appraiser or expert in a matter does not automatically shield a taxpayer from the negligence addition; a taxpayer must affirmatively establish that his reliance was reasonable, prudent, and in good faith …. We cannot agree that [the taxpayer’s] reliance was reasonable, prudent, and in good faith …. [He] should have known the [appraiser] grossly overstated the fair market value of the donated property. [He] should have been aware that nothing had occurred to substantially increase the value of the property between the time [he] purchased the property and the time it was donated …. Common sense should have come into play …. It was unreasonable for petitioners to expect that property purchased for $30,174 would increase to a value of $2,750,000 just 2 years later, generating such enormous charitable contribution deductions.

Effect of a qualified appraisal. Donors who contribute property valued at more than $5,000 must obtain a qualified appraisal of the property and attach a qualified appraisal summary (IRS Form 8283) to the tax return on which the charitable contribution is claimed. The taxpayer in this case obtained a qualified appraisal, but this did not affect the Court’s conclusion that he was subject to the penalties described above. The tax code specifies that taxpayers who comply with the qualified appraisal requirements are not subject to this penalty even if there is an overvaluation, but only if the taxpayer “in addition to obtaining such appraisal … made a good faith investigation of the value of the contributed property.” The taxpayer in this case did not satisfy this requirement, so the qualified appraisal did not protect him from penalties.

Relevance to church treasurers. Church treasurers who receive donated property that may be worth more than $5,000 should advise the donor of the qualified appraisal requirement. It would be a good practice to have sample copies of IRS Form 8283 (with instructions) to distribute to these donors. You can obtain them by calling the IRS forms hotline at 1-800-TAX-FORM. Be sure you have current copies. This case suggests that you also may want to advise these donors that they have an obligation under the tax code to make their own “good faith investigation of the value of the contributed property” in order to avoid penalties associated with an inflated valuation.

This article originally appeared in Church Treasurer Alert, November 1995.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Tax Implications of Severance Pay

How to determine when an employee’s severance pay is taxable.

Richard R. Hammar, Attorney, CPA

Bio

Background. Many churches have entered into severance pay arrangements with a pastor or other staff member. Such arrangements can occur when a pastor or staff member is dismissed, retires, or voluntarily resigns. Consider the following examples:

Example 1. Rev. G is hired for a 3-year term at an annual salary of $45,000. After 2 years, the church membership votes to dismiss Rev. G. The church agrees to pay Rev. G “severance pay” in the amount of $45,000 (the full amount of the third year’s salary).

Example 2. Rev. C is called by a church for an indefinite term. After 10 years, Rev. C resigns to accept another position. The church board agrees to pay Rev. C “severance pay” of $20,000.

Example 3. Rev. T accepts a call as a pastor of a local church. After 1 year, she is dismissed and is replaced by a male pastor. Rev. T believes that the church was guilty of sex discrimination. The church and Rev. T enter into a severance agreement in which Rev. T agrees to waive any claims she has against the church under state and federal law in exchange for its agreement to pay her “severance pay” of $40,000 (representing one year’s salary).

Example 4. K has served as bookkeeper of her church for 20 years. She is 68 years old. The church board decides that it is time for K to retire so that a younger person can take over her job. When the board learns that K has visited with an attorney, they offer her a severance pay of one year’s full salary ($25,000).

Is severance pay taxable income? Is severance pay paid by a church taxable income to the recipient? In most cases, the answer is yes. The tax code imposes the income tax on “all income from whatever source derived,” unless a specific exclusion applies. The severance pay described in examples 1 and 2 (above) would be taxable under this general rule. There is one “exclusion” that will apply in some cases. Section 104 of the tax code excludes from taxable income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.” What does this language mean? Simply this—severance pay that is intended to settle personal injury claims may be nontaxable. The words “personal injuries” are defined broadly by the IRS and the courts, and include potential or threatened lawsuits based on discrimination and harassment. The severance pay described in examples 3 and 4 (above) may be nontaxable based on this section of the tax code.

Key point. The Tax Court has noted that “payments for terminating and canceling employment contracts are not payments for personal injuries.” Matray v. Commissioner, 56 T.C.M. 1107 (1989).

The IRS and the courts have addressed the section 104 exclusion of severance pay based on personal injuries in several rulings. Here are a few examples.

Case 1. A company asked a female manager to resign because it was not satisfied with her management style. The employee retained an attorney who threatened to sue the company for sex discrimination. The employee’s attorney worked out a severance agreement with the company in which the employee agreed to resign and release the company from all legal claims in exchange for a full year’s salary plus other benefits. The employee assumed that the continuation of her salary for one year represented “damages received … on account of personal injuries” under section 104 of the code and accordingly was not taxable. The Tax Court disagreed, based on the following considerations: (1) the company paid the employee an additional year’s salary “to reward her for her past services and to make her severance as amicable as possible”; (2) the severance agreement “contained no express reference to a sex discrimination claim, stating instead that the payment arose from the company’s dissatisfaction with the employee’s managerial style; (3) the company withheld taxes from the severance payments and issued the employee a W-2 reporting these payments as taxable income; (4) the company continued a number of employee benefits, including health insurance, for an additional year; and (5) the severance agreement was similar to other severance agreements the company executed with other officers who were asked to resign. Based on these considerations the Tax Court concluded that the severance pay that was paid to the former employee did not represent damages payable on account of a sex discrimination or other personal injury claim. Britell v. Commissioner, T.C Memo. 1995-264.

Case 2. An employee was dismissed by a company, and later threatened to sue the company for the emotional distress he had suffered. To avoid a lawsuit, the company entered into a severance agreement with the employee in which the employee released all legal claims against the company in exchange for its promise to pay him a cash settlement. The agreement stated the company “intends to treat all payments made hereunder as wages for purposes of any withholding obligation the company may have in order to avoid any penalties and interest which might otherwise accrue.” The Tax Court ruled that the severance pay was taxable income to the employee and not nontaxable damages payable as a result of personal injuries. The court noted that an employee’s belief that he has “certain claims relating to personal injuries … does not establish that the [severance] payments were made on account of personal injuries.” Further, the court pointed out that the company withheld taxes on the payments, and that such withholding “is a significant factor” in classifying the payments as taxable income. Nagourney v. Commissioner, 57 T.C.M. 954 (1989).

Case 3. A company offered older workers an “early retirement” option. Under this option, older workers signed a severance agreement in which they agreed to resign and to release the company from any age discrimination claims in exchange for a continuation of their salary for one year and continued medical insurance. The IRS ruled that the amounts paid to workers who accepted the early retirement option were not excludable from taxable income as a settlement of a personal injury claim. The IRS based this decision on the following considerations: (1) Section 1.61-2(a)(1) of the income tax regulations specifies that severance pay “is income to the recipient unless excluded by law.” (2) “Provisions that exempt income from taxation are to be construed narrowly.” (3) “The burden of proof is on the taxpayer to show that the requirements imposed by the Code are met in order to be entitled to an exclusion from [taxable income].” (4) The existence of a severance agreement in which an employee waives any discrimination claims that he or she has against an employer does not by itself establish that amounts payable under the agreement represent nontaxable damages to settle a personal injury claim. The IRS pointed out that the employee “never filed a lawsuit or any other type of claim against [the employer] alleging age discrimination. A payment cannot be characterized as damages for personal injuries where there is no indication that personal injuries actually exist.” IRS Letter Ruling 9331007.

Key point. The Tax Court has ruled that “damages are not excludable under section 104 if … the damages were received upon the prosecution of economic rights arising out of a contract.” Guidry v. Commissioner, 67 T.C.M. 2507 (1994).

Tips for church treasurers. Here are some factors, based on the above cases, to assist in deciding whether a severance payment made to a former worker represents taxable compensation or nontaxable damages in settlement of a personal injury claim:

Purpose of the payment. An amount paid to a former employee “to reward her for her past services and to make her severance as amicable as possible” is taxable compensation.
Reference to a discrimination claim. An amount paid to a former employee under a severance agreement that contains no reference to a specific discrimination or other personal injury claim is taxable compensation.
Did the church issue a W-2? If an employer pays a former employee severance pay, and reports the severance pay on a W-2 (or 1099), this is strong evidence that the amount represents taxable compensation.
Continuation of employee benefits. If an employer continues one or more employee benefits (such as health insurance) as part of a severance agreement, this suggests that any amount payable under the agreement represents taxable compensation.
Similar to other agreements. If a severance agreement is similar to other severance agreements an employer entered into with other employees, this suggests that amounts payable under the agreements represent taxable income.
Were taxes withheld? If an employer withholds taxes from amounts paid under a severance agreement, this “is a significant factor” in classifying the payments as taxable income. Of course, this factor will not be relevant in the case of ministers whose wages are not subject to withholding (unless they elect voluntary withholding).
What is the payment called? Referring to a payment as “severance pay” indicates that it is taxable compensation rather than nontaxable damages in settlement of a personal injury claim. Remember, section 1.61-2(a)(1) of the income tax regulations specifies that severance pay “is income to the recipient unless excluded by law.”
Exclusions are narrowly interpreted. The Supreme Court has ruled that “provisions that exempt income from taxation are to be narrowly construed.” United States v. Centennial Savings Bank, 111 S. Ct/ 1510 (1001). Any reasonable doubts about the correct classification of a particular payment should be resolved in favor of taxation rather than exclusion. Also remember this—the “burden of proof” is on the one claiming an exclusion.
Was severance pay based on salary? Severance pay based on a former employee’s salary (such as one year’s salary) are more likely to be viewed as taxable compensation rather than nontaxable damages in settlement of a personal injury claim. As the IRS has noted, “where payments made by an employer to its employees are excludable from the employee’s taxable income as damages for personal injury under section 104 of the Code, those payments are not remuneration for services performed by an employee for an employer, and therefore are not considered wages for purposes of the Code.” IRS Letter Ruling 9331007.
An actual personal injury claim must exist. To be nontaxable, severance pay must represent “damages” received in settlement of a personal injury claim. The income tax regulations defines the term “damages received” as “an amount received (other than workmen’s compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1(c). The IRS has noted that this language requires more than a settlement agreement in which a former employee “waives” any discrimination or other personal injury claims he or she may have against an employer. If the employee “never filed a lawsuit or any other type of claim against [the employer] … the payment cannot be characterized as damages for personal injuries” since “there is no indication that personal injuries actually exist.” IRS Letter Ruling 9331007.

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

What about a housing allowance? A related question is whether a church can designate any portion of severance pay as a housing allowance. This question has never been addressed by either the IRS or any court. However, an argument can be made that a church can designate a portion of severance pay as a housing allowance if the severance pay is treated as taxable compensation rather than as damages in settlement of a personal injury claim. If the severance pay represents taxable income, as the IRS will almost certainly insist in most cases, it is because the amount paid represents compensation based on services rendered. Since a housing allowance must be designated out of compensation paid to a minister for services rendered in the exercise of ministry, a reasonable case can be made that a housing allowance can be designated with respect to taxable severance pay.

Of course, a housing allowance can only be designated for ministers. And, the designation of a housing allowance will be of little value if the minister transfers immediately to another church that designates a timely housing allowance. But a designation of a housing allowance will be useful in the case of a minister who is not immediately employed by another church or religious organization. Note that there is no guaranty that this position will be accepted by either the IRS or the courts. All that can be said is that in many cases this position will have a reasonable basis and therefore no penalties will be assessed in the event the position is not allowed in an audit.

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

Key point. The Older Workers Benefit Protection Act of 1991, which applies to any employer with 20 or more employees that is engaged in interstate commerce, prohibits employees at least 40 years of age from “waiving” their rights under federal age discrimination law unless the waiver meets several specific requirements, including the following: (1) the waiver is in simple language; (2) the waiver specifically refers to rights arising under the federal Age Discrimination in Employment Act; (3) the employee does not waive rights or claims that may arise after the date the waiver is executed; (4) the employee must receive some benefit for signing the waiver in addition to salary; (5) the individual is advised in writing to consult with an attorney prior to executing the agreement; (6) the individual is given a period of at least 21 days within which to consider the agreement; and (7) the agreement provides that for a period of at least 7 days following the execution of such agreement, the individual may revoke the agreement. This law will not apply to most local churches, since they have fewer than 20 employees. Even churches with 20 or more employees are not subject to these requirements unless they are engaged in interstate commerce.

This article originally appeared in Church Treasurer Alert, October 1995.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Checking Workers’ Withholding

Employees may be able to pay less tax throughout the year if forms are corrected.

Richard R. Hammar, Attorney, CPA

Bio

The average tax refund last year was $1,066. A person receiving this amount could have received an extra $20.50 each week throughout the year instead. How? By reducing withheld taxes to more closely match their actual tax.

Tip. Church employees who receive large tax refunds should be encouraged to provide the church treasurer with a new Form W-4 (withholding allowance certificate). Often, large refunds are caused by the use of old W-4 forms that fail to take into account new information (such as additional dependents). You can order new W-4 forms, along with IRS Publication 919 (“Is My Withholding Correct?”) by calling the IRS toll-free number, 1-800-829-3676.

Tip. Many church members end up receiving large tax refunds because the information reported on their W-4 form is no longer accurate. Church treasurers may want to print the following brief notice in the church bulletin or newsletter: “Did you receive a tax refund this year? If so, this may indicate that the information on the W-4 form you submitted to your employer is either inaccurate or obsolete. You may want to provide your employer with an updated W-4. This can result in less taxes being withheld from your pay throughout the year.”

This article originally appeared in Church Treasurer Alert, June 1995.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Must Churches Pay the Minimum Wage to Child Care Workers?

A federal court issues an important clarification.

Richard R. Hammar, Attorney, CPA

Bio

Reich v. Miss Paula’s Day Care Center, Inc., 37 F.3d 1191 (6th Cir. 1994)

Background. Many churches operate child care centers during the week, and nearly every church has some form of child care during worship services. Must churches pay the minimum wage to persons who work in either capacity? A related question is whether or not churches must pay “overtime” compensation (“time and a half”) to employees who work more than 40 hours per week. If churches must pay the minimum wage and overtime pay, are there any exceptions? What about volunteer workers and self-employed individuals? Is there a difference between preschool and child care? These are questions that church treasurers often ask. A recent federal appeals court ruling directly addresses many of these questions.

Facts of the case. A child care center in Ohio provides custodial care for very young children. It has 12 employees and has grown to care for more than 60 children. Children attending the center range in age from “infants and toddlers” to those between ages three and six. Many of the children’s parents are low-income, working mothers or college students who are hard-pressed to pay for child care. Unlike pure babysitting services, the center provides the children with daily activities designed to produce mental stimulation and enrichment. The center has been able to remain affordable by paying its staff less than the federal minimum wage.

The federal Department of Labor notified the center that it was a “preschool” subject to the federal minimum wage law, and ordered it to pay $18,000 in back wages to employees who had been receiving salaries below the minimum wage.

The federal minimum wage and overtime law (the “Fair Labor Standards Act”) applies to workers employed by “an enterprise engaged in commerce or in the production of goods for commerce.” Federal law defines this term to include a “preschool, elementary or secondary school … (regardless of whether or not such … institution or school is public or private or operated for profit or not for profit).” The child care center argued that it was not a “preschool” but rather was a child care institution, since its program was primarily custodial in nature rather than educational.

The court’s decision. The court ruled that workers at the child care center were covered by the minimum wage law. It referred to a publication of the Department of Labor that defined the term preschool as follows:

A preschool is any enterprise … which provides for the care and protection of infants or preschool children outside their own homes during any portion of a 24-hour day. The term “preschool” includes any establishment or institution which accepts for enrollment children of preschool age for purposes of providing custodial, educational, or developmental services designed to prepare the children for school in the years before they enter the elementary school grades. This includes day care centers, nursery schools, kindergartens, head start programs and any similar facility primarily engaged in the care and protection of preschool children. Publication 1364.

In other words, there is no distinction between a preschool and a child care center. Both are included within the definition of the term “preschool,” even child care centers that provide custodial services and little if any education. The court also noted that the child care center in this case provided far more than custodial services.

The court made the following additional observations:

Other court rulings. It referred to two other federal appeals court decisions addressing the same issue. One court found that child care centers came within the definition of a preschool and were subject to the minimum wage law, while the other court reached the opposite conclusion.

Key point. In fact, a number of other federal courts have addressed this issue, and most have concluded that child care centers are preschools and their workers are entitled to the minimum wage. For more details, see the Special Report entitled “Must Churches Pay the Minimum Wage?” which is available from Church Law & Tax Report.

Professional babysitting services. The court pointed out that even if it agreed that a purely “custodial” child care center is not a “preschool,” this would not relieve the center from the minimum wage requirements since it would then meet the definition of a “professional babysitting service” which is covered by the minimum wage law.
Professional worker exception. The court suggested that the center’s best defense against coverage under the minimum wage law might be to stress its educational mission and then argue that its workers are “professional” employees who are exempted from the minimum wage requirements. The court observed that “we have not been asked to decide whether the quality of preschool learning experiences that [the center’s] staff members provide rises to a level that could bring those employees under the [law’s] exemption for those who work in a professional capacity. We therefore leave that question for another day.”

Key point. Department of Labor Publication 1364 states: “Employees employed in a bona fide executive, administrative, or professional capacity (including any employee employed in the capacity of academic administrative personnel or teacher in elementary or secondary schools) … are exempt from the minimum wage and hours provisions of the Act. While preschools engage in some educational activities for the children, employees whose primary duty is to care for the physical needs of the children would not ordinarily meet the requirements for exemption as teachers. This is true even though the term “kindergarten” may be applied to the ordinary day care center. However, bona fide teachers in a kindergarten which is part of an elementary school system are still considered exempt under the same conditions as a teacher in an elementary school.”

999 points of light. The court conceded that the center was on a tight budget, and that forcing it to pay minimum wage (and $18,000 in back pay) would probably put it out of business. It dismissed this result by noting: “It frequently is the effect, and even the underlying purpose, of a statutory scheme like [the minimum wage] to destroy low-wage operations that are brought within its coverage. If that is the government’s intended social policy, this court is not authorized to stand in its way.”

Relevance to church treasurers. What is the relevance of this ruling to church treasurers? Consider the following points:

1. Preschools. The Act specifies that church-operated preschools are enterprises engaged in commerce. Accordingly, they are subject to the minimum wage and overtime compensation requirements.

Key point. The courts have rejected the claim that subjecting church-operated preschools to these requirements violates the constitutional guaranty or religious freedom. However, all of these cases occurred prior to passage of the Religious Freedom Restoration Act. For more details, see the Special Report entitled “The Religious Freedom Restoration Act,” which is available from Church Law & Tax Report.

While a few federal courts have concluded that the term preschool does not include child care facilities that are primarily custodial rather than educational in nature (and that are not regulated or licensed by state law), other courts have rejected this interpretation of the law. It is the position of the Department of Labor that the term preschool includes child care facilities that are primarily custodial in nature. Accordingly, churches that operate preschools or child care facilities should recognize that the federal government will consider the employees of such facilities to be covered by the minimum wage and overtime pay requirements of the Fair Labor Standards Act. Prudence would dictate that churches follow these requirements with respect to such employees.

2. Uncompensated nursery workers and Sunday School teachers. What about workers in a church nursery that is open during worship services, or workers in a church’s Sunday School? Many churches operate a nursery for a few hours one day each week or month as an accommodation to mothers (often called “mothers day out”). Must churches pay workers in these programs the minimum wage? Clearly, if the workers are volunteers who work a few hours each week or month with no expectation of compensation, they are volunteers who are not covered by the federal minimum wage law. The Supreme Court has noted that while the definition of an employee is broad, it does have limits. For example, “an individual who, without promise or expectation of compensation, but solely for his personal purpose or pleasure, works in activities carried on by other persons either for their pleasure or profit, is outside the sweep of the [minimum wage law].” Further, Department of Labor Publication 1364 specifies that “[i]ndividuals who volunteer their services, usually on a part-time basis, to a preschool not as employees or in contemplation of pay are not considered employees within the meaning of the Act.” A Department of Labor attorney confirmed this understanding in a telephone conversation with your editor. The same rule would apply to volunteer Sunday School teachers.

3. Compensated nursery workers. Many churches pay their nursery attendants a fee for their services. It would be difficult to argue that such persons are not employees, and accordingly they would be entitled to the minimum wage if they perform services for an enterprise that is engaged in commerce. Is a church such an enterprise? No court has addressed this question. Remember, however, that the definition of an enterprise engaged in commerce includes church-operated preschools. Further, the Department of Labor in its Publication 1364 sets forth a very broad definition of preschool. Whether this definition is broad enough to cover church nursery workers is not clear at this time. A Department of Labor attorney informed your editor that compensated church nursery workers are covered by the federal minimum wage law. Until the federal courts provide clarification, churches must recognize that nursery workers who are compensated for their services may be covered by the federal minimum wage and overtime pay requirements. This apparently is the position of the Department of Labor. Future clarification of this issue of course will be published in this newsletter.

4. Elementary and secondary schools. The law specifies that church-operated schools are enterprises engaged in commerce. Accordingly, they are subject to the minimum wage and overtime pay requirements. The courts have rejected the claim that subjecting church-operated schools to these requirements violates the constitutional guaranty or religious freedom.

5. Adjustments. Preschools and churches that are covered by the minimum wage and overtime pay requirements can adjust their liability in a variety of ways. For example, they can reduce the number of hours worked each week; prohibit all unauthorized overtime work (however, they must also ensure that workers in fact do not work overtime, since an employer who “prohibits” overtime will be required to pay overtime compensation to employees that it “allows” to work more than 40 hours each week); reduce hourly compensation (but not below the minimum wage); reduce fringe benefits; or take credit for all indirect and noncash payments made on behalf of employees.

6. Required records. All employers having employees covered by the federal minimum wage and overtime pay requirements must maintain records documenting covered employees’ wages, hours, and the other conditions and practices of employment. Included are payroll records, employment contracts, pension plans and other employee benefits, and worktime schedules. If an employer intends to claim credit for noncash payments, it must maintain records documenting the value of such payments.

7. State law. Church treasurers must recognize that many states have enacted their own versions of the Fair Labor Standards Act. It is imperative to review the potential application of state minimum wage and overtime compensation laws to church workers.

8. Penalties. Penalties may be imposed for violations of the federal minimum wage law. Employers who violate the minimum wage or overtime pay requirements are liable to their employees for the amount of the unpaid minimum wage or the unpaid overtime pay, and “an additional equal amount as liquidated damages.” In addition, employees who are not paid minimum wage or overtime compensation can collect the reasonable cost of their attorney’s fees in suing the employer. Employers who “willfully” violate the minimum wage or overtime pay requirements of the Act are subject to a fine of up to $10,000 for each violation. A 2-year statute of limitations applies to the recovery of back wages except in the case of willful violations, in which case a 3-year statute of limitations applies.

This article originally appeared in Church Treasurer Alert, March 1995.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Church Membership Directories and the Copyright Law

A federal appeals court ruling is instructive.

Richard R. Hammar, Attorney, CPA

Bio

Olan Mills, Inc. v. Linn Photo, Inc., 23 F.3d 1345 (8th Cir. 1994)

Background. Many churches prepare pictorial directories of church members. These directories are an excellent way for members to get to know other members, especially in larger congregations. Often, an outside company is used to make all the appointments and arrangements, take the photos, and prepare the directory—at no cost to the church. Individuals and families that show up for their photo session typically are given a free copy of the photo that the company selects for the church directory. The company is paid by additional orders it receives from individuals and families.

A potential problem. Some members attempt to save money by taking their free photo to a local film developer for additional copies. Other members purchase a package of photographs from the church directory company, but later (in some cases many years later) want additional copies. Not knowing how to contact the company, they take their photographs to a local film developer for additional copies. Do these common practices violate the copyright law? This question was addressed directly by a federal appeals court in a recent case.

The court’s ruling. Olan Mills operates more than 1,000 portrait studios throughout the United States. It took a number of family photographs of one client, and placed a copyright notice on each photograph. A local film developer was asked to make copies of some of these photos, and it agreed to do so despite the fact that the photos all contained a copyright notice showing Olan Mills as the owner of the copyright in the photos. However, the film developer had the customer sign the following statement:

This is to state that I am the owner of this photograph and have not given any one else permission to copyright this photograph. I am submitting it to [the film developer] for a copy at my request. This copy is for my personal use, and I agree to hold harmless [the film developer] or any of its agents from any liability arising from the copying of this photograph.

Olan Mills later sued the film developer for copyright infringement. A federal appeals court ruled that the film developer had violated the copyright law. It noted that Olan Mills retained the copyright in all of its photographs, and that one of the exclusive rights of a copyright owner is the right to make copies. The court further noted:

A purchaser may own a copy of a photograph, but absent specific arrangements to the contrary, the copyright remains vested in the author of the photograph, here Olan Mills. Because the photographs in this case were clearly marked with a copyright notice [the film developer] could not reasonably rely on its indemnification agreement.

Relevance of the case to church treasurers. Has your church ever used an outside company to prepare a church pictorial directory of your membership? Are you considering doing so in the near future? If so, here are some important points to keep in mind:

Copyright ownership. In many cases, the copyright in any photograph will belong to the photographer. Often, the photographs will contain a copyright notice—although this is not a legal requirement in order for the photographer to have copyright ownership of the photographs.
Notice to members. Members often do not understand that the copyright in their individual or family photograph belongs to the photographer. They fail to distinguish between ownership of the photograph and ownership of the copyright in the photograph. If the photographer retains copyright in the photographs, then members may not make copies without the photographer’s authorization. And this is true for the full duration of copyright protection—the life of the author plus 50 years! If the copyright is owned by a company, the copyright will last for 75 years from the date of publication.

Key point. If the photographer retains copyright ownership in the photographs, the church should consider informing church members of this fact at the time the directory is being produced. The photographer will also mention this fact, at least in the fine print of an “agreement” signed by members. But members often are not aware of this fact. The church can help to avoid misunderstandings, and potential copyright infringement, by informing members in clear language that they do not have the legal right to make copies of their photographs without the photographer’s permission.

Negotiation. Many church leaders, if they thought about it, would want members to retain greater control over their family pictures. The problem is that no one considers this issue when the church is contacted by a church directory company. The point to stress is this—the church is in the driver’s seat and need not enter into an agreement with anyone that is not desirable to itself or its members. Make this a point of negotiation. Tell the directory company that you do not want your members to be guilty of copyright infringement if they make duplicate copies of their photographs in the future. There are many church directory companies, and you have the right to use one that will work with you.

This article originally appeared in Church Treasurer Alert, February 1995.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Tax Court Addresses Clergy Housing Allowances

Court reaffirms IRS stance on home loans.

Richard R. Hammar, Attorney, CPA

Bio

Rasmussen v. Commissioner, T.C. Memo. 1994-311.

Background. Ministers are able to exclude from their income (for federal income tax reporting purposes) that portion of their compensation that is designated by the church as a housing allowance—to the extent they in fact use the allowance “to provide a home.” The biggest expense for most ministers who own their homes is their monthly mortgage payment. When ministers who own their homes pay off their mortgage loan they lose a big housing expense and reduce the value of the housing allowance. Many of these ministers have obtained home equity loans, or a conventional loan secured by mortgage on their otherwise debt-free home, in order to include their loan repayments as a housing expense. The argument is this—since these loans are secured by a mortgage on the minister’s home they are a legitimate housing expense since the minister will lose the home if the loan is not paid. The IRS issued a ruling in 1991 that disallowed this practice. The Tax Court recently addressed the same issue and agreed with the IRS position.

The IRS ruling. In 1991 the IRS ruled that ministers cannot take into account home equity loan payments or payments on a personal loan secured by a mortgage on a home that is otherwise owned debt-free as legitimate housing-related expenses in computing the housing allowance.

Example. Rev. C is paid salary of $30,000 for 1994 plus a housing allowance of $10,000. Rev. C has housing expenses of $10,000, consisting of mortgage payments on a conventional home loan of $6,000, utilities of $2,500, and property taxes and insurance of $1,500. Rev. C can claim the full church-designated housing allowance as an exclusion from taxable income for income tax reporting purposes since he has housing-related expenses of at least this amount.

Example. Same facts as the previous example, except that Rev. C pays off his home mortgage loan. Rev. C is still eligible for a housing allowance, but it is excludable only to the extent of his actual housing-related expenses of $4,000. As a result, $6,000 of the housing allowance represents taxable income.

Example. Same facts as the previous example, except that Rev. C obtains a loan, secured by mortgage on his home, to pay for various personal expenses (a car, a vacation, a child’s college education, and various medical bills). The loan payments amount to $6,000 in 1994. Rev. C cannot include any portion of the $6,000 in computing his housing allowance exclusion for the year, since these are not an expense of providing a home. Rev. C’s housing allowance exclusion (the amount by which he can reduce his taxable income) is $4,000 (utilities, property taxes and insurance). The “excess housing allowance” of $6,000 must be reported as taxable income.

Example. Same facts as the previous example, except that Rev. C obtains a loan, secured by a mortgage on his home, to pay for remodeling expenses and furnishings. The full amount of these loan payments can be considered in computing Rev. C’s housing allowance for the year.

The IRS ruling was predictable, but its reasoning was questionable. After all, if a minister defaults on a home equity loan, or on a personal loan secured by a mortgage on his or her home (that is otherwise debt-free), the lender has the legal authority to sell the home in a foreclosure sale. For this reason it has been difficult to understand the IRS position that the threat of foreclosure does not make such loan payments an expense of “providing a home” as required by federal tax law. More clarification was needed, and the Tax Court responded in a recent ruling.

The Tax Court’s decision. The facts in the recent Tax Court ruling are simple. A Baptist minister bought a home in 1970 for $50,000. He financed the purchase through a mortgage loan, and had annual loan payments of $3,000. Between 1982 and 1986 the minister received $108,000 in personal loans from his church to assist him in paying various personal expenses (including medical bills, education expenses, and taxes). The church loans provided for interest rates “equal to current Treasury Bill rates.” Each year the church loan committee prepared a written acknowledgement stating that the loans were “deemed by the parties to be secured by a non-recorded deed of trust on the [pastor’s home].” Other than these acknowledgments, there were no documents purporting to be a mortgage held by the church on the pastor’s property. The church did not receive an appraisal of the property nor did it make any inquiry regarding title to the property. The church board designated large housing allowances for the pastor each year. The allowances were large enough to cover not only the pastor’s annual home mortgage loan payments of $3,000, but also miscellaneous housing expenses and repayments of the personal loans from the church. The IRS audited the minister and refused to let him count the loan repayments to the church in computing his housing allowance exclusion. The minister appealed to the Tax Court.

The minister claimed that he was entitled to include the loan repayments to the church in computing his housing allowance. He pointed out that the church loans were secured by a mortgage on his home and accordingly the repayments were payments to provide a home. The IRS countered by insisting that there was insufficient proof that the church loans in fact were secured by a mortgage on the pastor’s home. And, even if there were, the payments on the church loans were not used to “provide a home” as required by federal law.

Key point. The IRS relied on a 1984 Tax Court ruling in which the Court observed: “Congress intended to exclude from the minister’s income only that portion of his compensation paid by the church which was actually used by the minister for the purposes of renting or otherwise providing a home for himself.”

The Tax Court, in rejecting the pastor’s position, concluded:

Exemptions from gross income are to be construed narrowly … and [federal law does not] provide for the exclusion of payments on loans secured by a home if they are not used to “provide a home.” The proceeds of the church loans were used to pay personal expenses of [the pastor and his wife] unrelated to their home. Thus, even assuming that the loans were secured by the [pastor’s home, he has] not shown that the portion of the parsonage allowance used to repay the church loans was used for the maintenance or purchase of the home. On the record before us, we hold that [the pastor and his wife] have not proven that the portion of the parsonage allowance used to repay the church loans was used to provide a home as required by [federal law].

Significance to church treasurers. What is the significance of this ruling to church treasurers? Consider the following:

• Housing allowance designations. Church treasurers should alert ministers that they should not include loan payments in computing their housing allowance exclusion for 1994, even if the loan is secured by a mortgage on the minister’s home, unless the loan is “to provide a home.” According to the Tax Court, this refers to housing-related expenses. Ministers also should be advised not to take into account these kinds of loan repayments when estimating their housing allowance for 1995. If your church has developed a form for ministers to use in estimating their housing expenses each year, be sure to modify the form to clarify that these kinds of payments are not to be considered.

Key point. Ministers who have paid off their home mortgage loan and who later obtain a loan secured by a mortgage on their otherwise debt-free home may include their loan repayments in computing their housing allowance so long as the loan is used for housing expenses. The Tax Court conceded as much. Any form used by ministers to estimate their housing allowance should make this important distinction.

• Amending a housing allowance. If your minister has been treating repayments of personal loans as “housing expenses” for purposes of computing the housing allowance exclusion, you may want to consider amending the church’s housing allowance designation for 1994. While this is not necessary, it may result in a much more realistic amount. This in turn may reduce the “excess housing allowance” (the amount by which the church designated housing allowance exceeds actual housing expenses) that the minister must report as additional income on Form 1040.

• Gardening expenses. There is one additional aspect of the court’s decision that is worth mentioning. The court noted that the IRS had conceded on appeal that the minister was able to include, in computing his housing allowance exclusion, “other payments for providing a home such as maintenance, utilities, and gardening services.” In the past it has been unclear whether or not ministers can consider gardening services as housing expenses for purposes of computing their housing allowance exclusion. While this reference by the court to the IRS position on appeal does not constitute an authoritative pronouncement on this issue, it provides some support for this position. Once again, churches that use forms for computing a minister’s estimated housing expenses may want to add this item to the list of expenses.

This article originally appeared in Church Treasurer Alert, October 1994.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Charitable Contribution Substantiation Rules

What church treasurers must know now.

Richard R. Hammar, Attorney, CPA

Bio

The rules for substantiating charitable contributions changed on January 1, 1994. For a donor to deduct a charitable contribution (of cash or property) of $250 or more, several new requirements apply. The important points are: (1) donors no longer will be able to substantiate individual cash contributions of $250 or more with canceled checks; (2) the current contribution receipts provided by your church probably do not satisfy the new requirements (summarized in the table); and (3) in order for a donor to deduct contributions of $250 or more made in 1994, the donor must receive a receipt from the church by the earlier of the following two dates: the date the donor files a tax return claiming a deduction for the contribution, or the due date (including extensions) for filing the return.

The substantiation requirements vary depending on the nature of the contribution. They are summarized in the following table. Because of the complexity of the substantiation requirements, they are presented in the form of 10 rules. Simply find the rules that apply to a particular contribution, and follow the substantiation requirements described. Keep this table handy so that you can refer to it as needed.

Key point. The substantiation requirements are complex, but they are very important. Your church could provide a significant benefit to its members by sharing the information contained in this article with donors—and especially those who make contributions of noncash property.

SUBSTANTIATION REQUIREMENTS FOR CHARITABLE CONTRIBUTIONS

Note: More than one rule may apply to a particular contribution. Apply each rule that applies.

rule	Form of contribution	substantiation requirement
1	individual cash contributions of less than $250	new rules do not apply; substantiate with any one of the following: (1) a canceled check; (2) a receipt or letter from the donee church showing the church’s name and the amounts and dates of the contributions, or (3) any other reliable written record showing the name of the church
2	individual cash contributions of $250 or more	new rules apply; donors will not be allowed a tax deduction for individual cash contributions of $250 or more unless they receive a written receipt from the church or charity that satisfies the following requirements: (1) The receipt must be in writing; (2) the receipt must identify the donor by name (a social security number is not required); (3) The receipt should list separately each individual contribution of $250 or more (do not lump all contributions together); (4) the receipt must state whether or not the church provided any goods or services to the donor in exchange for the contribution, and if so, the receipt must include a good faith estimate of the value of those goods or services; (5) if the church provides no goods or services to a donor in exchange for a contribution, or if the only goods or services the church provides are “intangible religious benefits,” then the receipt must contain a statement to that effect; (6) the written acknowledgment must be received by the donor on or before the earlier of the following two dates: the date the donor files a tax return claiming a deduction for the contribution, or the due date (including extensions) for filing the return
3	individual cash contributions of $75 or less that are part contribution and part payment for goods or services received in exchange (“quid pro quo” contributions)	the new quid pro quo rules (Rule 4) do not apply to contributions of $75 or less, these contributions are still only deductible to the extent they exceed the value of the goods or services provided in exchange
4	individual cash contributions of more than $75 that are part contribution and part payment for goods or services received in exchange (“quid pro quo” contributions)	new rules apply (these are in addition to Rule 2); the church must provide a written statement to the donor that: (1) informs the donor that the amount of the contribution that is tax-deductible is limited to the excess of the amount of cash contributed by the donor over the value of any goods or services provided by the church in return; and (2) provides the donor with a good faith estimate of the value of the goods or services furnished to the donor Note: a written statement need not be issued if only token goods or services are provided to the donor (generally, with a value of $62 or 2% of the amount of the contribution, whichever is less) or if the donor receives solely an intangible religious benefit that generally is not sold in a commercial context outside the donative context
5	individual contributions of noncash property valued at less than $250	new rules do not apply; substantiate with a receipt that lists the donor’s name, the church’s name, and date and location of the contribution, and description (but not value) of the property
6	individual contributions of noncash property valued at $250 or more	new rules apply; donors will not be allowed a tax deduction for individual contributions of property valued at $250 or more unless they receive a written receipt from the church or charity that satisfies the requirements of Rule 2 (above) and that describes the property (no value needs to be stated)
7	individual contributions of noncash property valued by the donor at $500 to $5,000	the income tax regulations require that all donors of noncash property valued at $5,000 or less maintain reliable written records with respect to each item of donated property; the reliable written records must include the following information: (1) the name and address of the church; (2) the date and location of the contribution; (3) a detailed description of the property; (4) the fair market value of the property at the time of the contribution, including a description of how the value was determined; (5) the cost or other basis of the property; (6) if less than the donor’s entire interest in property is donated during the current year, an explanation of the total amount claimed as a deduction in the current year; (7) the terms of any agreement between the donor and church relating to the use, sale, or other disposition of the property Note: in addition to complying with Rule 6 (above), a donor must complete the front side (Section A, Part I, and Part II if applicable) of IRS Form 8283 and enclose the completed form with the Form 1040 on which the charitable contribution deduction is claimed
8	individual contributions of noncash property valued at more than $500	if the donated property is valued by the donor in excess of $500, the following additional written records must be maintained by the donor: (1) an explanation of the manner of acquisition by the donor (such as by purchase, gift, inheritance, or exchange), and (2) the cost or other basis of the property immediately preceding the date on which the contribution was made; these records are in addition to the requirements discussed above in connection with individual contributions of property valued by the donor at $250 or more
9	individual contributions of noncash property valued at more than $5,000	in addition to complying with Rule 6 (above), a donor must obtain a qualified appraisal of the donated property from a qualified appraiser, and complete a qualified appraisal summary (the back side of Form 8283), and has the summary signed by the appraiser and a church representative; the completed Form 8283 is then enclosed with the Form 1040 on which the charitable contribution deduction is claimed
10	quid pro quo contributions of noncash property	new rules apply (these are in addition to Rule 2); see Rules 3 and 4 (above)

This article originally appeared in Church Treasurer Alert, December 1993.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Q&A: Will Our Tax-Exempt Status Be Jeopardized if We Encourage a Senate Confirmation of a Federal Judge?

The answer revolves around whether your church’s actions were substantial in nature and constituted an attempt to influence legislation.

Richard R. Hammar, Attorney, CPA

Bio

Will a church jeopardize its tax-exempt status by encouraging Senate confirmation of federal judicial candidates?

Possibly, concluded the IRS chief counsel’s office in a General Counsel Memorandum (GCM).

Churches jeopardize their tax-exempt status under section 501(c)(3) of the Internal Revenue Code by either (1) engaging in substantial efforts to influence legislation, or (2) intervening or participating in a political campaign on behalf of or in opposition to any candidate for public office.

But do efforts to encourage Senate confirmation of federal judicial candidates fall under either of these restrictions? The IRS concluded that such efforts cannot be characterized as intervention or participation in a political campaign on behalf of or in opposition to a candidate for public office, since the income tax regulations define a “candidate for public office” as a contestant for elective public office. Federal judges, by comparison, are not elected but rather are appointed for life by the President with the consent of the Senate.

However, the IRS concluded that efforts to encourage Senate confirmation of federal judicial candidates did constitute an attempt to influence legislation, since Senate confirmation of judicial candidates constituted “legislation” for purposes of section 501(c)(3) of the Code. The IRS reasoned that Senate confirmation is a “final action by Congress,” much like any other legislation that is enacted. Accordingly, efforts to encourage the Senate to confirm judicial candidates constitute legislative activity, and jeopardize an organization’s tax-exempt status if the efforts are substantial in nature (GCM 39694).

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Computing Your Housing Allowance Exclusion

How to estimate accurately.

Richard R. Hammar, Attorney, CPA

Bio

The housing allowance is one of the most valuable tax benefits available to ministers. Yet, many ministers either fail to claim it or do not claim enough. In some cases, this results from tax advisors who are unfamiliar with ministers’ taxes. In this article, I will summarize the requirements for obtaining the full benefit available to ministers who live in a church-owned parsonage. In the next issue, I will discuss the rules that apply to ministers who rent or own their homes. Section 107 of the Internal Revenue Code says simply that “in the case of a minister of the gospel, gross income does not include—(1) the rental value of a home furnished to him as part of his compensation, to the extent used by him to rent or provide a home.” There are four important considerations to note in this section, First, the housing allowance is available only to a minister of the gospel. The income tax regulations (drafted by the Treasury Department and interpreting the Code) define a minister of the gospel to include any minister who has been ordained, commissioned, or licensed by a church or church organization that qualifies as a tax-exempt religious organization. Ministers who have been licensed by a religious organization that both licenses and ordains clergy must perform substantially all the religious functions of an ordained minister in order to qualify for the exemption.

Second, the housing allowance is an exclusion from gross income, rather than a deduction in computing or reducing adjusted gross income. As a result, it is not reported anywhere on Form 1040. In effect, the housing allowance is “claimed by not reporting it as income.

Third, section 107 excludes the fair rental value of a parsonage provided rent-free to a minister as well as an allowance paid to a minister to the extent used by him or her to pay expenses incurred in maintaining the parsonage (e.g., utilities, repairs, furnishings). Ministers who live in a church-owned parsonage do not report the fair rental value of the parsonage as income (as they ordinarily would do if they were allowed to live rent-free in a home provided by any other employer). The church is not required to declare an allowance in the amount of the fair rental value of the parsonage. The exclusion is automatic. However, if the minister incurs any expenses in living in the parsonage, then he or she may exclude them only to the extent that they do not exceed a “parsonage allowance” declared in writing and in advance by the church board.

Example. Rev. White lives rent-free at a church owned parsonage having a fair rental value of $6000 in 1986k The church expects Rev. White to incur some expenses in living in the parson age, and accordingly provides him with an allowance of $100 each month. His salary (not including the monthly allowance,) is $20,000 in 1986. On his 1986 federal income tax return Rev. White would not report the fair rental value of the parsonage ($6000) as income, even though the church never designated that amount as a housing allowance. However, he would have to report the total monthly allowances ($1200) as income unless the church board declared a parsonage allowance” in writing and in advance of at least $1200.

Suggestion. Ministers living in parsonages should be sure to have the church board declare a “parsonage allowance” in advice of each calendar year to cover any miscellaneous expenses the minister may incur in living in the parsonage. The allowance should be declared in writing and be incorporated into the board’s minutes.. The allowance can be a portion of the minister’s salary. For example, in the previous example, the church could have declared $1200 of Rev. White’s annual salary of $20,000 to be a parsonage allowance. The effect of this would have been to exclude the $1200 from gross income (to the extent Rev. White incurred expenses of at least that amount).

Churches failing to declare a parsonage allowance before January 1 should not wait until the following year to act. The declaration is effective from the date of its enactment on. Therefore, a church failing to declare a parsonage allowance until Match can still provide its minister with an important tax benefit for the remainder of the year.

Finally, section 107 requires that the parsonage be furnished to the minister as part of his or her compensation for services performed in the exercise of ministry. The regulations define “services performed in the exercise of ministry” to include (1) the performance of sacerdotal functions, (2) the conduct of religious worship, (3) direction, managing or promoting the activities of a religious organization under the authority of a church or church denomination, or (4) teaching or administrative duties at a theological seminary under the authority of a church or church denomination. A parsonage must be provided to a minister as compensation for one or more of these categories of employment in order for the minister to exclude the parsonage’s rental value from gross income.

The housing allowance is an exclusion for federal income tax purposes only. It cannot under any circumstances be excluded in computing a minister’s social security (self-employment) tax liability. Therefore, in computing the social security tax on Schedule SE of Form 1040, a minister must include the fair rental value of his or her parsonage as income on line 2 of Part 1. A minister must also include any parsonage allowance paid by his or her church to cover miscellaneous expenses in maintaining the parsonage. The rental value of a parsonage is a question of fact to be determined in each case on the basis of its particular circumstances.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.