IRS Letter Ruling 9821053
Background. Many churches operate schools and offer "tuition discounts" to some employees whose children attend the school. Consider the following example:
Example. A church operates a private school. The annual tuition is $2,500. However, the school allows the children of its two pastors to attend the school for free. Both pastors are full-time church employees, but they do have some involvement with the school. One of them serves as "president" of the school as part of his job description as senior pastor of the church, and the other teaches a course each semester at the school (and is paid $500 each semester). The school allows the children of its employees to attend at "half" tuition. The same rate applies to the children of church employees.
Are there tax consequences to the tuition discounts described in this example? Do the tuition "reductions" represent taxable income to the parents, or are they nontaxable? If they are nontaxable, what conditions apply? These are important questions, and church treasurers should have some familiarity with them.
"Qualified tuition reductions". Section 117(d) of the tax code specifies that the amount of any "qualified tuition reduction" is excluded from an employee's gross income for income tax purposes so long as the following conditions are satisfied:
(1) The tuition reduction is for the education of (a) an individual who currently is employed by the school; (b) an individual who quit working at the school on account of retirement or disability; (c) a widow or widower of an individual who died while employed at the school; or (d) a spouse or dependent child of any of the above named individuals.
(2) The school is an elementary, secondary, or undergraduate institution, and it normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.
(3) "Highly compensated employees" cannot exclude qualified tuition reductions from their gross income unless the same benefit "is available on substantially similar terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees."
The term highly compensated employee generally refers to an employee who had compensation in excess of $80,000 for the previous year. The fact that a highly compensated employee must report the value of a tuition reduction in his or her income for tax reporting purposes does not affect the right of employees who are not highly compensated to exclude the value of tuition reductions from their income.
What about church employees? Many churches that operate private schools offer tuition discounts to employees of both the church and school, and assume that the tax treatment is the same. But is it? Does the exclusion of qualified tuition reductions from a school employee's taxable income apply to church employees? Unfortunately, the answer to this question is far from clear. Let's begin by looking at the example at the beginning of this article. Which employees would qualify for the exclusion of qualified tuition reductions? There is no question about the school employees—assuming that none earned more than $80,000 in the previous year. As a result, the value of the tuition discount should not be reported on their W 2 forms. This should be true even if these employees are paid by the church, since they work full time for the school and therefore could be considered school employees.
But what about the two pastors? Are they eligible for the exclusion? Section 117(d) of the Code defines a qualified tuition reduction as "any reduction in tuition provided to an employee of an organization described in section 170(b)(1)(A)(ii) for the education (below the graduate level) at such organization." Section 170(b)(1)(A)(ii) refers to educational institutions that "normally maintain a regular faculty and curriculum and normally have a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on." In other words, tuition reductions granted to the employees of an educational institution are tax exempt.
But, it is unclear whether the IRS or the courts would consider an employee who works directly for a church to be an employee of an educational institution, even if the church operates a private school. The church still may be considered to be a religious rather than an educational institution. This conclusion is reinforced by the fact that Code section 170(b)(1)(A)(i) specifically lists "churches" as a separate category. The IRS may consider these persons to be employed by a church rather than by an educational institution. If so, they would not be eligible for the exclusion.
Could it not be argued that the pastor who teaches one course per semester at the school is a school employee for purposes of the qualified tuition reduction exclusion because he is performing services on behalf of the school for compensation? Does the fact that he is teaching only one course per semester matter? A recent IRS ruling suggests that it does not.
A recent IRS ruling. Here are the facts of the IRS ruling. A worker was hired to teach English as a second language by a public school. She worked three evenings per week and was paid an hourly wage. Either the school or the worker could terminate the agreement for services at any time. For a number of years, the school treated the teacher as an employee and reported her wages on a W-2 form. In 1994 the school began treating the teacher as self-employed and reported her earnings on a 1099 form. The teacher was given training by the school in the form of teacher workshops; she was given instructions by the school and was subject to its supervision; from time to time the assistant principal sat in the classroom and observed her teaching; a formal evaluation was prepared by the assistant principal at least once per semester; the teacher performed her services at the school using supplies and materials furnished by the school. Other than transportation costs, the teacher did not incur any expenses while performing her services. She did not have a financial investment in a business related to her teaching and could not incur a loss or realize a profit. Under these facts, the IRS ruled that the teacher was an employee rather than self-employed. It stressed that the key consideration in deciding whether or not a worker is an employee or self-employed is the degree of control that the employer exercises over the worker's performance of services. It concluded that the facts of this case demonstrated sufficient control to render the teacher an employee. It noted that less control is needed to find that a professional worker is an employee, since such workers generally work with very little control or supervision. IRS Private Letter Ruling 9821053.
Key point. The IRS ruling can be used to support the availability of the qualified tuition reduction exclusion to pastors and other church employees who teach one or more classes each semester at a church-operated school. After all, this ruling leaves little doubt that the IRS considers part-time teachers who work only a few hours each week to be employees. The same logic should apply to the definition of a "school employee" for purposes of determining eligibility for the qualified tuition reduction exclusion.
Key point. If you decide that a pastor who teaches a course at a church-operated school is a school employee and therefore eligible for the exclusion of qualified tuition reductions, be sure to be consistent. Any teaching compensation should be reported as employee wages. If the school issues its own paychecks, it should do so for the pastor.
What about the other pastor in our example—the one who serves as the school's president? Should he be considered a part-time school employee because his job description includes serving as the school's president? Does it matter whether or not he is paid for his services? Obviously, employees ordinarily must be paid something, although it does not necessarily have to be in the form of cash. But while the pastor is not compensated directly for his services as school president, the argument could be made that, since his job description includes these duties, a portion of his church salary should be considered compensation for these services.
A Tax Court decision. A few years ago the United States Tax Court addressed the eligibility of a pastor and his wife for the tuition discount exclusion. Rasmussen v. Commissioner, 68 T.C.M. 30 (1994). The pastor served as senior pastor of a Baptist church, and his wife served as principal of a private school operated by the same church. The couple received tuition discounts for their children who attended the school. The Court noted that "by reason of their employment with the church and the school, petitioners, as well as all other full-time employees of the school, received tuition reductions for their children's education at the school." In fact, the Court noted that the IRS had conceded that the couple's tuition discounts were not taxable. It is interesting that the Court observed that the couple received tuition discounts "by reason of their employment with the church and the school." However, this language should not be pushed too far. After all, the wife was a school employee, and the tuition discounts were nontaxable by reason of her employment. Nevertheless, this case will of some value in supporting the nontaxability of tuition discounts received by the children of pastors and other church employees who are not employees of a school operated by their church.
Conclusions. Consider the following conclusions:
* Employees of a church-operated school. They qualify for the exclusion of qualified tuition reductions, assuming that all of the conditions summarized above are satisfied.
* Church employees who perform compensated service for a church-operated school. For example, a church secretary performs some secretarial services for the school; a church custodian performs some custodial services for the school; a church bookkeeper performs some accounting functions for the school; or, a pastor teaches a course. In each of these examples it is likely that the church employee will qualify for the tuition reduction exclusion, assuming that all of the conditions summarized above are satisfied.
* Church employees who perform uncompensated service for a church-operated school. As noted in this next paragraph, it is not clear that these employees are eligible for the qualified tuition reduction exclusion. However, keep in mind that in some cases a church employee who performs "uncompensated" services for a church-operated school in fact may be compensated. The pastor in our example who served as president of the school is a good example. So long as the pastor's job description included serving as the school president, the argument can be made that he was a school employee and that a portion of his church compensation could be allocated to these duties.
Key point. Church employees who perform compensated or uncompensated services on behalf of a church-operated school should be sure that their job descriptions reflect their school services. This will increase the likelihood of their eligibility for the tuition reduction exclusion.
* Church employees who perform no services for a church-operated school. According to the literal language of the tax code, they do not qualify for the tuition reduction exclusion because they are not school employees. However, as a practical matter, there are thousands of pastors and other church employees who are claiming the exclusion under these same circumstances, and neither the IRS nor the courts have addressed their eligibility for the exclusion in any reported ruling or decision. The ultimate answer to this question depends upon how narrowly or broadly the IRS or a court will interpret the "school employee" requirement. In the final analysis, whether or not such employees should claim the exclusion will depend on how aggressive they want to be in reporting their taxes. Our recommendation—discuss your eligibility with a professional tax advisor.
Example. A federal appeals court rejected the claim of one church that its school employees were really church employees and therefore exempt from the Fair Labor Standards Act (minimum wage and overtime pay). The church pointed out that the school was "inextricably intertwined" with the church, that the church and school shared a common building and a common payroll account, and that school employees were required to subscribe to the church's statement of faith. The court rejected this reasoning without explanation. This case suggests that church employees should not assume that they can be treated as school employees in order to qualify for the exclusion of qualified tuition reductions. Dole v. Shenandoah Baptist Church, 899 F.2d 1389 (4th Cir. 1990).
This article originally appeared in Church Treasurer Alert, September 1998.