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There were several important tax developments in 2021 that affect tax reporting by ministers, church staff, and churches for the upcoming tax-filing season as well as reporting and records-keeping requirements in 2022 and beyond.
The top ten developments are explained in this article as well as the 2022 Church & Clergy Tax Guide, which also covers 53 other developments.
1. Status of the housing allowance
In March 2019, a federal appeals court rejected an atheist group’s challenge to the constitutionality of the ministers housing allowance. Gaylor v. Mnuchin, 919 F.3d 420 (7th Cir. 2019). The atheist group did not appeal this ruling, and there have been no further legal challenges. The housing allowance remains intact and is the most valuable tax benefit available to ministers.
2. Revoking an exemption from Social Security
Will Congress give ministers another opportunity to revoke an exemption from Social Security? It does not seem likely, at least for now. No bills were introduced in Congress in 2021 that would have authorized ministers to revoke an exemption from Social Security.
However, note that in 2020 the IRS amended its Internal Revenue Manual by adding section 220.127.116.11.11.3, which addresses the revocation of an exemption from self-employment taxes that was obtained for economic rather than religious reasons:
- Generally, once an exemption has been granted, it is irrevocable. However, if it becomes evident the application was made solely for economic considerations rather than religious opposition, then the taxpayer wasn’t qualified for the exemption from self-employment tax. Because the election for exemption is null, IRS Revenue Ruling 70–197 effectively allows for revocation.
- If the taxpayer requests a revocation of his/her exemption because the application was made solely for economic considerations, rather than religious opposition:
- Advise taxpayer the exemption has been revoked because it was originally based on economic considerations.
- Notify the Social Security Administration (SSA) and forward copies of all material related to the revocation.
- Associate all material related to revocation with a copy in the permanent file, noting the change.
- Update the “MIN-SE-TX-EXEMP-CD” with “9” to reverse the previous status. See IRM 18.104.22.168.10, MINISTER-SE-TX-EXEMP-CD Form 4361, for additional information.
- If application was not made solely for economic considerations, the taxpayer should be advised to process the revocation request as follows:
- If original copy is in the permanent file, then advise the taxpayer that it is irrevocable.
- If original copy is not in the permanent file, then (a) check open cases and (b) if found, return application to the taxpayer with no further action.
- If original copy is not in either the permanent file or open cases, then (a) send a request to the SSA for verification of the exemption and (b) once verified, advise taxpayer exemption is irrevocable.
- In all cases, attach a copy of the request and a copy of the IRS’s letter to the original copy in the permanent file.
A federal court case involving an attempt by a minister to revoke the exemption is handled below.
3. Charitable contribution deduction for non-itemizers
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (2020) encouraged Americans to contribute to churches and charitable organizations by permitting them to deduct up to $300 of cash contributions whether they itemize their deductions or not. Congress extended this deduction through 2021 and increased it to $600 for married couples filing a joint return.
4. California law demanding charities disclose large donors ruled unconstitutional
The United States Supreme Court ruled that a California law barring charities from soliciting contributions unless they disclose to the state Attorney General the identities of all donors contributing more than $5,000 violated the First Amendment’s right of association.
In the past, charitable organizations in California could not solicit contributions unless they disclosed to the state Attorney General’s Office the names and addresses of donors who contributed more than $5,000 in a particular tax year. This information was reported on IRS Form 990, Schedule B. The State claimed that having this information on hand made it easier to police misconduct by charities.
This law was challenged by the Americans for Prosperity Foundation and the Thomas More Law Center (the “petitioners”). Out of concern for their donors’ anonymity, the petitioners declined to file their Schedule Bs with the State.
For many years, the petitioners’ reluctance to turn over donor information presented no problem because the Attorney General was not particularly zealous about collecting Schedule Bs.
That changed in 2010 when the California Department of Justice ramped up its efforts to enforce charities’ Schedule B reporting obligations, sending thousands of deficiency letters to charities that had not complied with the Schedule B requirement. The petitioners each received a deficiency letter threatening them with penalties for continued noncompliance. They responded by filing suit in federal court.
In their complaints, the petitioners alleged that the Attorney General had violated their First Amendment rights and the rights of their donors. The petitioners alleged that disclosure of their Schedule Bs would make their donors less likely to contribute and would subject them to the risk of reprisals.
The court barred the Attorney General from collecting their Schedule B information. A federal appeals court reversed this ruling, noting that the disclosure of Schedule Bs would not meaningfully burden donors’ associational rights.
The United States Supreme Court agreed to review the dispute and ruled in favor of the petitioners. The Court concluded:
The upshot is that California casts a dragnet for sensitive donor information from tens of thousands of charities each year, even though that information will become relevant in only a small number of cases involving filed complaints. California does not rely on Schedule Bs to initiate investigations, and in all events, there are multiple alternative mechanisms through which the Attorney General can obtain Schedule B information after initiating an investigation. The need for up-front collection is particularly dubious given that California—one of only three States to impose such a requirement, did not rigorously enforce the disclosure obligation until 2010. . . .
The Attorney General may well prefer to have every charity’s information close at hand, just in case. But “the prime objective of the First Amendment is not efficiency.” . . . Mere administrative convenience does not remotely “reflect the seriousness of the actual burden” that the demand for Schedule Bs imposes on donors’ association rights.
This case is important because it limits the authority of government agencies to obtain confidential information about the amount and recipients of donors’ contributions. Americans For Prosperity Foundation v. Bonta, Attorney General of California, 594 U.S. ____ (2021).
5. A federal court in Illinois rejected a minister’s argument that he had revoked his exemption from Social Security
In 1981, a minister filed an application for exemption from self-employment taxes (Form 4361) with the IRS. His application was approved that same year. As a result, the minister stopped participating in Social Security and Medicare, and his earnings no longer were subject to self-employment taxes. The minister continued to be employed as a minister until retirement in 2012.
The minister had a limited opportunity to revoke his exemption. In 1999, Congress created a two-year window in 1999 and 2000 to revoke a minister’s exemption from paying self-employment taxes. A minister who wanted to revoke an exemption had to file a Form 2031 by April 15, 2002.
The minister did not file a Form 2031 on the advice of his accountant who told him not to revoke his exemption from self-employment taxes because his employing church could treat him as an administrative employee subject to FICA taxes. Beginning in 1999 or 2000, the church began deducting the employee portion of FICA taxes from his salary and paying the employee and employer portion of FICA taxes for him. The church continued deducting and paying FICA taxes for him through 2011.
The minister enclosed a “Miscellaneous Statement” with his 2000 tax return, which read:
TAXPAYER HAS BEEN EXEMPT FROM SELF-EMPLOYMENT TAXES AS A MINISTER THROUGH 1999. HOWEVER, SINCE FORM 2031 WAS TIMELY FILED TO REVOKE THE EXEMPTION, THE TAXPAYER IS BACK IN THE SOCIAL SECURITY PROGRAM FOR THE YEAR 2000 AND THEREAFTER.
Neither the minister nor his accountant had a copy of the Form 2031 referenced in the Miscellaneous Statement. Further, the IRS had no record of the minister filing a Form 2031.
In 2012, the minister filed for retirement and Medicare benefits with the Social Security Administration. On August 2014, his application was denied, whereupon he requested a hearing before an administrative law judge (ALJ).
Weighing all the evidence, including the minister’s testimony that he did not revoke the 1981 exemption and the conflicting Miscellaneous Statement with his 2000 tax return indicating that he filed the Form 2031, the ALJ found that the minister never revoked his 1981 exemption and therefore was not entitled to Social Security or Medicare benefits.
The ALJ found that the church’s payment of FICA taxes did not matter. The church’s payment of FICA taxes for the minister was improper because a minister is subject to self-employment taxes, not FICA taxes. While employers pay FICA taxes for employees, they do not pay FICA taxes for individuals such as ministers who are subject to self-employment taxes.
The ALJ further found that, to the extent that the minister performed nonministerial duties as a regular church employee, the church had not properly elected to treat him as an employee rather than a religious worker subject to self-employment taxes.
The ALJ stated the IRS did not allow voluntary Social Security payments if no taxes are due, referencing the following statement on the IRS website: “You cannot make voluntary Social Security payments if no taxes are due.” The ALJ concluded that the church’s FICA tax payments were not proper and did not cause the minister’s earnings to be counted as covered earnings for purposes of Social Security eligibility
The ALJ concluded that the minister did not qualify for retirement benefits. To qualify for retirement benefits, a person must work and earn 40 quarters of covered earnings, or roughly 10 years. The minister paid self-employment taxes for 19 quarters before his 1981 exemption, but he did not have any covered earnings thereafter.
The ALJ found that: (1) the minister was exempt from self-employment taxes after he secured his 1981 exemption, (2) he did not revoke the exemption during the two-year window in 1999-2000, and (3) he did not establish that the church properly paid FICA taxes on his behalf after 1999. The minister, therefore, did not have 40 quarters of covered earnings and accordingly did not qualify for retirement benefits.
In 2017, the Social Security Administration (SSA) Appeals Council denied the minister’s request for review. The decision of the ALJ then became the final decision of the SSA. The minister did not seek judicial review.
In 2018, the minister filed a second application for retirement benefits (2018 Application). On October 18, 2018, the 2018 Application was denied. On January 7, 2019, the minister requested an evidentiary hearing before an ALJ. On May 22, 2019, the ALJ dismissed the 2018 Application without a hearing.
The ALJ determined that the August 14, 2014, decision denying the 2012 Application was a final decision of the SSA and the minister did not seek judicial review of that decision. The ALJ determined that the August 14, 2014, decision was final and barred his second 2018 Application.
On September 9, 2019, the minister asked the Appeals Council to reopen the 2012 Application because he had new material evidence. The new material evidence was a letter from the minister to his counsel dated September 3, 2019. The letter stated that the minister had requested copies of his tax returns from 1999 and 2000. The minister stated in the letter:
WE JUST RECEIVED BACK A LETTER FROM IRS STATING THAT THESE FORMS ARE AVAILABLE FOR A LIMITED NUMBER OF YEARS.
WE NO LONGER HAVE THE RETURNS YOU REQUESTED FOR T[A]X YEAR 2000. THEY WERE DES[T]ROYED IN ACCORDANCE WITH THE US CONGRESS.
THIS SHOWS ME ONE THING. THEY HAVE ABSOLUTELY NO PROOF THAT THE FORM WE FILED WAS NOT SENT IN.
IT STATED BOLDLY ON MY 2000 TAX RETURN THAT WE HAD FILED FORM 2031 PROMPTLY TO THE IRS OFFICE.
THOSE IN IRS SHOULD HAVE TAKEN NOTE OF THAT FORM WHEN IT ARRIVED, ESPECIALLY WHEN THEY RE[C]EI[V]ED MY TAX RETURN AND SAW MY STATEMENT ON IT, BUT SOMEBODY LOST SOMETHING OR LAID IT ASIDE. THEY HAVE NO RECORD OF PROOF THAT THE FORM 2031 DID NOT COME TO THEIR OFFICE AS WE WERE TOLD TO DO. BUT WE HAVE IT BOLDLY PRINT[E]D ON OUR RETURN.
On December 13, 2019, the Appeals Council denied the minister’s request for review of the 2018 Application or to reopen the 2012 Application. The Appeals Council found no reason to change the May 22, 2019, dismissal of the 2018 Application. The Appeals Council also rejected the minister’s request to reopen the 2012 Application based upon new evidence. The minister sought review in a federal district court in Illinois, but the court affirmed the rulings of the ALJ and Appeals Council. Suey v. Saul, 2021 WL 3604510 (C.D. Ill. 2021).
6. A pastor did not satisfy the requirements for exemption from self-employment taxes because he failed to file a timely Form 4361
An ordained pastor and his wife (the “taxpayers”) filed joint tax returns for 2017 and 2018, reporting total income of $53,560 in 2017 and $64,090 in 2018. Each tax return contained a Schedule SE (IRS Form 1040, Self-Employment Tax) showing self-employment tax of $9,094 for 2017 and $9,056 for 2018.
It came to the pastor’s attention in early 2019 that portions of their returns had been prepared incorrectly. As a result, he employed a new tax firm to prepare and submit amended returns.
The new firm found that the couple was entitled to claim an exemption from self-employment (Social Security) taxes for services performed by a member of a religious order in the exercise of duties as required by such order. The tax firm prepared amended tax returns for 2017 and 2018, requesting refunds for self-employment taxes. The IRS denied the request for refund, and litigation followed.
On appeal, the IRS argued that the tax code exempts ministers from self-employment taxes with respect to compensation received in the exercise of ministry, but several conditions are required including the filing of a timely exemption application (Form 4361) that is approved by the IRS.
Since the pastor failed to file a timely Form 4361, he was not exempt. A federal appeals court agreed, noting that “to claim the exemption, the [pastor and his wife] must have submitted the application and the IRS must have accepted it. . . . The [pastor and his wife] failed to allege either requirement.”
The appeals court stated:
In most instances, employment wages are subject to withholdings pursuant to the Federal Insurance Contributions Act (“FICA”). There, “employment” specifically excludes “service performed by a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry.” Instead, income garnered from services performed by a duly ordained, commissioned, or licensed minister, in a capacity as a minister, is considered self-employment income and therefore subject to self-employment tax and the Self-Employment Contributions Act (“SECA”). SECA tax ultimately reaches “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business.” [SECA] excludes from the definition of “trade or business,” and thus exempts from SECA, “the performance of service by a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry.”
However, the court continued, SECA provides that
the exemption is not automatic; the taxpayer must apply and be approved. [SECA] further specifies that a “duly ordained, commissioned, or licensed minister” must file an application prescribed by regulation that includes statements indicating the taxpayer “is conscientiously opposed to, or because of religious principles he is opposed to, the acceptance (with respect to services performed by him as such minister, member, or practitioner) of any public insurance” and “has informed the ordaining, commissioning, or licensing body of the church or order that he is opposed to such insurance.”
The required application “is IRS Form 4361: a one-page form that includes the relevant statements.” But “[m]erely filing that form does not invoke the exemption; the Form must be approved by the IRS.”
The court concluded:
The [court] argues that the [pastor and his wife’s] Complaint does not allege they complied with the statutory provisions which would allow them to take advantage of [SECA’s] tax exemption. There is no mention of obtaining the required approval for such an exemption or an assertion that they submitted IRS Form 4361. . . . The Complaint summarily asserts that . . . [they] were not required to apply for, or obtain approval of, the exemption[.]
The court also rejected the pastor’s claim that he was exempt from self-employment taxes on his ministerial income since he was a member of a “religious order” (his Protestant denomination) and had taken a vow of poverty.
The court acknowledged that the tax code exempts from self-employment tax income received by a member of a religious order who has taken a vow of poverty, but it concluded that this exception did not apply to the pastor since there was no evidence that he had ever taken such a vow.
Note. The tax code treats the income of a minister in the exercise of ministry as self-employment income subject to the self-employment tax, unless the minister is a member of a religious order who has taken a vow of poverty, or the minister asks the IRS for an exemption from self-employment tax (using Form 4361) for his or her services and the IRS approves the request. Note that several conditions apply.
Arensmeyer v. United States, 2021 U.S. Claims LEXIS 1311 (Ct. Cl. 2021).
7. Court rejects ministry’s claim that it is exempt from all taxes and regulation
A federal court in California rejected as “frivolous” a religious ministry’s claim that it was exempt from all taxes and regulation because it was a “section 508(c)(1)(A)” church. Steeves v. IRS, 2020 WL 5943543 (S.D.C. 2020)
For my full analysis of this case and what it means for churches, see this Legal Development.
8. Charity founder’s wife heavily penalized for excess benefit
The United States Tax Court ruled that the wife of the founder of a medical missions charity had received an excess benefit from the charity subjecting her to a “first-tier” penalty of 25 percent of the amount of the excess benefit, and an additional “second-tier” tax of 200 percent of the excess since it had not been returned to the charity. Ononuju v. Commissioner, T.C. Memo 2021-94 (2021).
Note. It is important for church leaders to be familiar with this case since excess benefit transactions are common among churches and expose ministers and possibly others to significant penalties under section 4958 of the tax code. Note that these penalties are assessed against the minister, not the church.
For my full analysis of this case and what it means for churches, see this Legal Development.
9. The IRS revokes a church’s tax-exempt status for using its assets for the private benefit of its founder.
The Internal Revenue Service (IRS) issued a private letter ruling revoking a church’s tax-exempt status on the ground that the church’s assets were used for the private benefit of its founder.
One of the requirements for tax-exempt status under section 501(c)(3) of the Internal Revenue Code is that none of a church’s assets can inure to the benefit of a private individual other than as reasonable compensation for services rendered. IRS Publication 1828 addresses inurement as follows:
Churches, like all exempt organizations under section 501(c)(3) of the tax code, are prohibited from engaging in activities that result in inurement of the church’s income or assets to insiders (i.e., as persons having a personal and private interest in the activities of the organization). Insiders could include the minister, church board members, officers, and in certain circumstances, employees. Examples of prohibited inurement include the payment of dividends, the payment of unreasonable compensation to insiders, and transferring property to insiders for less than fair market value. The prohibition against inurement to insiders is absolute; therefore, any amount of inurement is, potentially, grounds for loss of tax-exempt status. In addition, the insider involved may be subject to excise tax [under section 4958 of the tax code]. . . . Note that prohibited inurement doesn’t include reasonable payments for services rendered, payments that further tax-exempt purposes or payments made for the fair market value of real or personal property.
In its private letter ruling, the IRS revoked the tax-exempt status of a church on the basis of inurement. The IRS concluded:
Section 501(c)(3) of the Code provides that a public charity cannot have any part of the net earnings inure to the benefit of any private shareholder or individual. Section 1.501(c)(3)-1(c)(2) of the Regulations clarifies that an organization is not operated exclusively for exempt purposes if its net earnings inure to the benefit of private individuals.
[The church’s] Founder was in control of the church’s assets, which included the bank account and financial records. She was in a position to exercise substantial influence over the church’s affairs. Under [her] direction, the church’s net earnings were allowed to inure for her and her husband’s personal benefit . . . . The church’s bank account was used to benefit the [Founder and his wife] by paying off their mortgage.
Where an exempt organization engages in a transaction with an insider and there is a purpose to benefit the insider rather than the organization, inurement occurs even though the transaction ultimately proves profitable for the exempt organization. The test is not ultimate profit or loss but whether, at every stage of the transaction, those controlling the organization guarded its interests and dealt with related parties at arm’s-length. . . .
The church’s bank statements showed many debit card transactions for personal clothing, grooming, fitness, sporting goods, etc. [The Founder] stated that since she was not receiving a paycheck, the church paid for her general grooming expense. . . . The church did not keep contemporaneous records such as a mileage log for the personal vehicle or an events log for the many purchases of food to substantiate business use.
Loans were made between the church and [its Founder] without any interest or contemporaneous contracts. . . .
The above transactions were completed because [the Founder] treated the church’s assets as if they were her personal bank account and personal assets. The church and its treasurer did not operate for the benefit of the church, but for personal benefit.
IRS Private Letter Ruling 201926014.
10. Tax Court denies deductions for multimillion-dollar charitable contribution for lack of adequate substantiation
A taxpayer reported three very large noncash charitable contributions to a church on his returns for 2008 and 2009, which he valued well in excess of $3,500,000. He received no appraisal for these contributions. The IRS audited his returns and disallowed any charitable contribution deduction due to a lack of substantiation. The United States Tax Court affirmed this ruling on appeal. The Court observed:
Section B of [Form 8283] has to be completed when a taxpayer donates property worth more than $5,000. The top of section B tells taxpayers that appraisals are generally required for properties that they list. For deductions of more than $500,000 “you must attach a qualified appraisal of the property” Question 5(c) asks for the “appraised fair market value.” Part III is a declaration of an appraiser—and requires the signature of the appraiser used for the listed properties in Part I.
We think that four mentions of “appraisal”, “appraiser”, or “appraised” on one page of one form is pretty good notice that substantial noncash donations need to be backed up by an appraisal. Yet despite all these warning signals, [the taxpayer] never had a professional appraisal performed or attached one to either his 2008 or 2009 return for any of the large noncash charitable donations that he claimed. . . .
One does not have to be a tax expert to be able to read Form 8283. Had [the taxpayer] reviewed that two-page form, he would have seen that it said “[a]n appraisal is generally required for property listed in Section B,” or “you must attach a qualified appraisal of the property,” or “[a]ppraised fair market value,” or “Declaration of Appraiser.” For a man as smart as [the taxpayer,] this would have suggested that there was a potential major error on the return, and should have prompted him (at the very least) to ask [his return preparer] whether an appraisal was needed. Instead, he just signed the return.
The taxpayer’s problem in this case was that he failed to obtain a qualified appraisal of the donated property. For most contributions of noncash property valued by the donor at more than $5,000, the tax code and regulations impose the following substantiation requirements:
- The donor must obtain a qualified appraisal of the donated property that: (a) is made not earlier than 60 days before the date of contribution of the appraised property nor later than the due date of the return on which a deduction is first claimed; (b) is prepared, signed, and dated by a qualified appraiser; (c) includes a statement that the appraisal was prepared for income tax purposes; and (d) includes the appraised fair market value of the property on the date (or expected date) of the contribution. The regulations contain a detailed definition of a qualified appraiser.
- The donor must attach a completed qualified appraisal summary (Part “B” of Form 8283) to the tax return on which the charitable contribution deduction is claimed. The appraisal summary must be signed and dated by both the qualified appraiser who prepared the qualified appraisal and a representative of the donee charity. It also must include several items of information, including a description of the donated property; the date the donor acquired the donated property and the manner of acquisition; the cost or basis of the donated property; a statement as to whether the contribution was made by means of a bargain sale and the amount of any consideration received from the donee for the contribution; the name, address, and taxpayer identification number of the qualified appraiser; and the appraised fair market value of the property on the date of contribution.
Pankratz v. Commissioner, T.C. Memo. 2021-26 (2021)