Compensation and Benefits

Legal Developments

Tax Court Rejects Pastor’s Attempt to Avoid Taxes Through Vow of Poverty, Salary Renunciation

The use of funds for personal purposes indicates dominion and control, even over an account titled in the name of a church or other religious organization.

Richard R. Hammar, Attorney, CPA
Bio

Key point. Ministers cannot avoid taxes by making a vow of poverty, renouncing a salary, and having their church pay for all of their expenses, if they maintain effective control over the payment of expenses.

The United States Tax Court rejected an attempt by a pastor to avoid income taxes by making a “vow of poverty,” renouncing a salary, having his church pay all of his expenses, but retaining effective control over the funds.

In 2001 a pastor recommended to his church’s board of advisers that the church be restructured to include a “corporation sole” as an office of the church. The board of advisers unanimously agreed with this recommendation, and a nonprofit corporation sole was created in the name of “the Office of Presiding Head Apostle” currently held by the pastor. The church was located in Florida, which does not recognize corporations sole, so the corporation sole was established under the laws of Nevada

Later that year, the pastor signed a document titled “Vow of Poverty” in which he agreed to divest his property and future income to the church and in turn the church would provide for his physical, financial, and personal needs. By resolution, the church resolved that “the church accepts … the pastor’s declaration and will provide all his needs as Apostle of this church ministry,” and affirmed that “the church shall pay his housing, all ministry expenses, and any other needs necessary for his care.” The church established an apostolic bank account, and the pastor had “signatory authority over this account for his use.”

The IRS audited the pastor for four years during which he did not file a Federal income tax return nor did he file a timely certificate of exemption from self-employment tax. The IRS assessed unreported income of $46,642, $18,430, $16,824, and $26,865 for the four years being examined. Most of these amounts represented payments made by the church on the pastor’s behalf. The pastor did not dispute that the church made those payments on his behalf for his personal expenditures. The only issue was whether the vow of poverty insulated him from paying Federal income tax and self-employment tax on those amounts.

Income taxes
The Tax Court agreed with the IRS that the amounts in question represented taxable income. The court began its opinion by rehearsing basic facts:

Section 61(a) [of the tax code] defines gross income as “all income from whatever source derived”, including compensation for services. This definition includes all accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. A taxpayer has dominion and control when the taxpayer is free to use the funds at will. The use of funds for personal purposes indicates dominion and control, even over an account titled in the name of a church or other religious organization.

The court noted that in previous decisions it held that a vow of poverty does not insulate a pastor from tax liability even when the pastor receives funds directly from his church in exchange for services rendered if the pastor “does not remit those funds to the church in accordance with his vow of poverty, has control over the funds, and uses the funds for personal expenditures.” The pastor insisted that such rulings did not apply to him since they dealt with clergy who earned money from a secular employer and thereafter “assigned” the funds to a church or religious order, whereas in the present case the pastor executed a vow of poverty to his church and received payments for his well-being from the church.

The court acknowledged that “income earned by a member of a religious order on account of services performed directly for the order or for the church with which the order is affiliated and remitted back to the order in conformity with the member’s vow of poverty is not includible in the member’s gross income.” But such was not the case here. The “critical difference in this case” was that the pastor did not remit income to his church pursuant to his vow of poverty, he had signatory authority over the “apostolic bank account,” and the payments the church made on his behalf served only to benefit him in meeting his living expenses.” Therefore, “the compensation he received from his church in the form of the church or its related entities made on his behalf must be included in his gross income.”

Self-employment taxes
The court also agreed with the IRS that the amounts in question were subject to self-employment tax:

Unless an exemption certificate is timely filed, the minister is liable for self-employment tax on income derived from the ministry. The time limitation [for filing for exemption] is mandatory and is to be complied with strictly. [The pastor] did not file a timely application for exemption from self-employment tax for any of the years at issue. He therefore does not qualify for an exemption from self-employment tax.

What this means for churches

The lesson of this case is that schemes to avoid income taxes by vows of poverty and “corporations sole” never work, at least if a minister retains effective control over the funds and their distribution. As the court noted, the tax code defines taxable income broadly to include “all income from whatever source derived,” and this includes “all accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” A taxpayer has dominion and control “when the taxpayer is free to use the funds at will. The use of funds for personal purposes indicates dominion and control, even over an account titled in the name of a church or other religious organization.” T.C. Memo. 2016-167.

Legal Developments

Religious Corporation’s Attempt to Block IRS Summons Rejected by Federal District Court

This case provides a helpful review of some of the protections of the Church Audit Procedures Act that were set forth in section 7611 of the tax code.

Richard R. Hammar, Attorney, CPA
Bio

Key point. The tax code provides several protections available to churches in the event the IRS serves notice of a “church tax inquiry” or “church tax examination.”

A federal district court in South Carolina rejected an attempt by a religious corporation to block an IRS summons seeking the production of the corporation’s bank records at eight banks.

A religious corporation (the “plaintiff”) was incorporated as a nonprofit entity in 1972. In its early years, the plaintiff’s primary function was to produce and broadcast a weekly radio program. At some point, the plaintiff began a weekly faith-based television program. In 2015, the plaintiff was informed by the IRS that it had been selected for audit and that the IRS would be seeking access to its bank records. The plaintiff’s accountant informed the IRS agent in charge of the audit that the plaintiff was claiming church status and all the protections of the Church Audit Procedures Act (section 7611 of the tax code). In response, the IRS sent the plaintiff a “notice of church tax inquiry” listing the following areas of concern:

  • Whether the plaintiff had engaged in excess benefit transactions with disqualified persons. The IRS noted that the plaintiff’s chief officer was paid $371,445 in “reportable compensation” plus an additional $48,000 in “other compensation,” described as a parsonage allowance. The next highest paid employee received compensation of $125,596, consisting of a base salary and “commission income based on a fixed percentage of broadcast placement revenue.”
  • Whether the plaintiff had received unrelated (and unreported) business income from the rental of various properties.
  • Whether all compensation was properly reported on W-2s.
  • Whether the plaintiff’s claim of church status was warranted.

The notice asked for several items of information regarding the plaintiff’s religious activities, revenue and expenses, and detailed information on compensation paid to the officers. The plaintiff did not respond to these inquiries on the ground that the IRS officer who signed the notice was “director, exempt organizations,” and not a “high level IRS official” required to sign any notice of church tax inquiry by section 7611 of the tax code.

The IRS informed the plaintiff that “because you did not provide the information we requested, we still think an examination of the organization’s books and records may be necessary.” This letter identified the same concerns previously noted (possible excess benefit transactions, receipt of unrelated business income, failure to report all compensation, and claim of church status).

Rather than further pursuing a church tax examination, the IRS issued summonses to the plaintiff’s banks in 2016. The plaintiff sought to quash the eight summonses on the following grounds:

(1) The purpose was improper because the summonses were issued in support of a church tax inquiry that was not properly authorized under section 7611.

The court noted that section 7611 of the tax code, which incorporates the Church Audit Procedures Act, defines a “church tax inquiry” as “any inquiry to a church to serve as a basis for determining” whether the church is exempt from tax due to its status as a church or is subject to taxation for some other reason (e.g., because it is carrying on an unrelated trade or business). IRC 7611(h)(2).

Section 7611 defines a “church tax examination” as any examination of (A) Church Records at the request of the IRS, or (B) the religious activities of any church. IRC 7611(h)(3). “Church Records” is defined to exclude records acquired “pursuant to a summons to which Section 7609 applies.” IRC 7611(h)(4). “Thus, church tax inquiries and church tax examinations are two distinct investigatory tools used for the same purpose and are directed to the church or to records in the church’s custody (as opposed to church-related records held by a third party).”

The court continued:

Presumably because church examinations are more intrusive, section 7611 provides that a church must be offered a conference before a church tax examination is conducted. Church records and activities may, moreover, only be examined “to the extent necessary to determine” liability for tax or whether the entity was, in fact, operating as a church during the relevant period ….

Third-party summonses are governed by section 7609, not section 7611, even when the summons is issued in connection with a church tax inquiry …. Legislative history confirms that section 7611 is inapplicable to third-party summonses …. The House Conference report [in connection with section 7609] stated the “church audit procedures” did not apply to examination of the types of third-party records sought here, explaining as follows: “Records held by third parties (e.g., cancelled checks or other records in the possession of a bank) are not considered church records for purposes of the conference agreement. Thus … the IRS is permitted access to such records without regard to the requirements of the church audit procedures.

(2) The IRS failed to provide the plaintiff with the required tax inquiry notice before issuing the summonses.

The plaintiff claimed that the IRS had failed to provide proper notice that it might seek information from third parties. The court disagreed, noting that the IRS has provided the plaintiff with this information by providing it with a copy of IRS Publication 1, which advises taxpayers that the IRS may “sometimes talk with other persons if we need information that you have been unable to provide.”

(3) The summonses violate section 7611’s prohibition on repetitive church inquiries.

The court noted that “if any church tax inquiry or examination with respect to any church is completed and does not result in [an adverse consequence] no other church tax inquiry or examination may begin with respect to such church during the applicable 5-year period unless such inquiry or examination is approved in writing by the Treasury Secretary or does not involve the same or similar issues involved in the preceding inquiry or examination.” IRC 7611(f)(1).

The court concluded that occasional correspondence from the IRS that did not constitute church tax inquiries did not count in applying this provision.

What this means for churches

This case provides a helpful review of some of the protections of the Church Audit Procedures Act that were set forth in section 7611 of the tax code. They may be summarized as follows:

Tax inquiries and examinations of churches

Congress has imposed special limitations, found in section 7611 of the tax code, on how and when the IRS may conduct civil tax inquiries and examinations of churches. The IRS may only initiate a church tax inquiry if an appropriate high-level Treasury Department official reasonably believes, based on a written statement of the facts and circumstances, that the organization: (a) may not qualify for the exemption or (b) may not be paying tax on an unrelated business or other taxable activity.

Restrictions on church inquiries and examinations

Restrictions on church inquiries and examinations apply only to churches and conventions or associations of churches. They don’t apply to related organizations. For example, the rules don’t apply to schools that, although operated by a church, are organized as separate legal entities. Similarly, the rules don’t apply to integrated auxiliaries of a church.

Restrictions on church inquiries and examinations do not apply to all church inquiries by the IRS. The most common exception relates to routine requests for information. For example, IRS requests for information from churches about filing of returns, compliance with income or Social Security and Medicare tax withholding requirements, supplemental information needed to process returns or applications, and other similar inquiries are not covered by the special church audit rules.

Restrictions on church inquiries and examinations don’t apply to criminal investigations or to investigations of the tax liability of any person connected with the church, such as a contributor or minister.

The procedures described in section 7611 are used in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and a pastor or other insider.

Audit process

The sequence of the audit process is:

  • If the reasonable belief requirement is met, the IRS must begin an inquiry by providing a church with written notice containing an explanation of its concerns.
  • The church is allowed a reasonable period in which to respond by furnishing a written explanation to alleviate IRS concerns.
  • If the church fails to respond within the required time, or if its response is not sufficient to alleviate IRS concerns, the IRS may, generally within 90 days, issue a second notice, informing the church of the need to examine its books and records.
  • After issuance of a second notice, but before commencement of an examination of its books and records, the church may request a conference with an IRS official to discuss IRS concerns. The second notice will contain a copy of all documents collected or prepared by the IRS for use in the examination and subject to disclosure under the Freedom of Information Act, as supplemented by code section 6103 relating to disclosure and confidentiality of tax return information.
  • Generally, examination of a church’s books and records must be completed within two years from the date of the second notice from the IRS.

If at any time during the inquiry process the church supplies information sufficient to alleviate the concerns of the IRS, the matter will be closed without examination of the church’s books and records. There are additional safeguards for the protection of churches under section 7611. For example, the IRS can’t begin a subsequent examination of a church for a five-year period unless the previous examination resulted in a revocation, notice of deficiency or assessment, or a request for a significant change in church operations, including a significant change in accounting practices. Bible Study Time v. United States, 2017 WL 897818 (D.S.C. 2017).

Legal Developments

Court Willing to Resolve Pastor’s Lawsuit Against Church for Compensation Dispute

Court ruled that it was not barred by the “ministerial exception” and “ecclesiastical abstention doctrine” from resolving a claim by a pastor that his church had failed to pay him the salary and benefits to which they had contractually agreed.

Richard R. Hammar, Attorney, CPA
Bio


Key point 2-04.2. Some courts are willing to resolve disputes over the termination of clergy if they can do so without any inquiry into religious doctrine.

A North Carolina court ruled that it was not barred by the "ministerial exception" and "ecclesiastical abstention doctrine" from resolving a claim by a pastor that his church had failed to pay him the salary and benefits to which they had contractually agreed.

A pastor (the "plaintiff") was employed by a church in 1975 on a part-time basis. He also worked for a secular employer. In order to be eligible for retirement at his secular employer, the plaintiff was required to continue working until 2013. However, in 2001, the plaintiff resigned his secular job and entered into a contract with the church titled "Agreement of Full Time Pastorship." This contract consisted of several provisions, including the following:

The Pastor shall serve the church for an indefinite period since there is no scriptural support of tenure.

If the Pastor should become disabled to carry on his work, he shall be paid his full salary until the disability insurance begins to be paid (which is provided by the church) and relieves the church of its responsibility to Pastor.

Whereas, at any time the church shall become dissatisfied with the services of Pastor and ask for his resignation, the congregation at that time shall take a vote and be governed by the majority of voting members eligible (members in good standing with church). At that time the church shall pay the Pastor the total package in advance or his services shall continue until such time the church shall meet this requirement.

The plaintiff claimed that he was guaranteed under the contract "salary continuation upon his disability" and "salary, housing, utilities, social security, and medical insurance through 2013" in consideration of resigning from his secular job and losing his retirement and other benefits to which he would have been entitled had he continued his employment.

After 10 years of serving as head pastor of the church, the plaintiff contracted kidney disease, was hospitalized, and underwent surgery. As a result, he was no longer able to serve as the pastor of the church. In addition, because the long-term disability insurance policy mentioned in the employment agreement lapsed prior to the plaintiff's disability, he was without any disability coverage. The plaintiff claimed that the church ceased all payment of his salary and benefits.

The plaintiff sued the church and its board of deacons (the "church defendants") in 2013. The church defendants filed a motion asking the court to dismiss the case on the ground that it lacked jurisdiction to resolve an internal church dispute. The trial court agreed with the defendants and dismissed the case. The plaintiff appealed.

The at-will employment doctrine

On appeal, the church defendants argued that, in the absence of an employment contract providing for a specified term of employment, the plaintiff was an "at will employee" and could not sue for breach of contract.

The state wage and hour law

The court agreed that employees hired for indefinite periods are deemed to be "at will employees" whose employment can be terminated by the employee or employer at any time, with or without cause. But it noted that the at-will employment doctrine "does not preclude an at-will employee from suing for breach of contract with respect to benefits or compensation to which the parties contractually agreed." Because the plaintiff "is not challenging the basis for his dismissal, but only seeks to recover money and benefits owed under the employment contract he alleges he entered into with defendants, the at-will doctrine is inapplicable."

The plaintiff also alleged a claim under the state Wage and Hour Act, which provides: "Every employer shall pay every employee all wages and tips accruing to the employee on the regular payday. Pay periods may be daily, weekly, bi-weekly, semi-monthly, or monthly." Further, "any employer who violates the Act … shall be liable to the employee … in the amount of their unpaid compensation."

The court noted that the plaintiff's allegations that the contractually promised "salary" constituted wages as defined in the Wage and Hour Act, along with his allegation that the church defendants wrongfully failed to pay that salary, "sufficiently alleged a claim under the North Carolina Wage and Hour Act." The court noted that "once the employee has earned the wages and benefits under [the Act] the employer may not rescind them."

The ministerial exception doctrine

The defendants' main argument in support of their motion to dismiss the plaintiff's lawsuit was that the civil courts are barred by the "ministerial exception" and "ecclesiastical abstention" doctrine from resolving internal church disputes. The court noted that the defendants, in citing the ministerial exception and ecclesiastical abstention doctrine, "address almost exclusively the doctrine's applicability to wrongful discharge claims." However, the court noted, the plaintiff's lawsuit was not challenging the termination of his employment, but "the non-payment of contractually agreed upon compensation and benefits." Therefore, the court concluded, neither doctrine applied to the plaintiff's claims.

In affirmatively recognizing the ministerial exception, a unanimous United States Supreme Court observed in a 2012 case:

[The courts] have uniformly recognized the existence of a "ministerial exception," grounded in the First Amendment, that precludes application of [employment discrimination] legislation to claims concerning the employment relationship between a religious institution and its ministers … . By imposing an unwanted minister, the state infringes the Free Exercise Clause, which protects a religious group's right to shape its own faith and mission through its appointments. According the state the power to determine which individuals will minister to the faithful also violates the Establishment Clause, which prohibits government involvement in such ecclesiastical decisions. Hosanna-Tabor Evangelical Lutheran Church & School v. E.E.O.C., 132 S.Ct. 694 (2012).

At the conclusion of the Hosanna-Tabor ruling, the Supreme Court limited its holding to the narrow circumstance of "employment discrimination suits brought on behalf of a minister, challenging her church's decision to fire her" and specifically "expressed no view on whether the exception bars … actions by employees alleging breach of contract."

Contractual transactions, and the resulting obligations, are assumed voluntarily. Underneath everything, churches are organizations. And, like any other organization, a church is always free to burden its activities voluntarily through contracts, and such contracts are fully enforceable in civil court. Surely, a church can contract with its own pastors just as it can with outside parties. Enforcement of a promise, willingly made and supported by consideration, in no way constitutes a state-imposed limit upon a church's free exercise rights.The church defendants vigorously argued that "it is the decision of a church to hire or fire its pastor that is protected from judicial scrutiny" by the ministerial exception. But the court retorted that "defendants cite no authority and provide no argument why the ministerial exception, as articulated in Hosanna-Tabor, should apply to claims based on nonpayment of compensation and benefits." The court quoted with approval from a 2014 ruling by the Kentucky Supreme Court:

We are not presented with a situation where the government is inappropriately meddling in the selection of who will minister to the congregation. Limits on a religious institution's ability to choose—or the criteria for choosing—who will minister to its faithful are not being foisted on the religious institution … . This is a situation in which a religious institution has voluntarily circumscribed its own conduct, arguably in the form of a contractual agreement, and now that agreement, if found to exist, may be enforced according to its own terms. That cannot breach church autonomy. Arguably, instead, this exemplifies religious autonomy because religious institutions are free to set forth policies that align with their respective mission. Kirby v. Lexington Theological Seminary, 426 S.W.3d 597 (Ky. 2014).

Accordingly, "because plaintiff's complaint does not challenge the church's decision to terminate his employment, but instead seeks to enforce a contractual obligation regarding his compensation and benefits, we hold that the ministerial exception does not apply and is not a basis for dismissal of plaintiff's claims."

The ecclesiastical abstention doctrine

The "ecclesiastical abstention doctrine," which has been recognized by state and federal courts, "is a jurisdictional bar to courts adjudicating ecclesiastical matters of a church." The courts "have no jurisdiction over and no concern with purely ecclesiastical questions and controversies." The Supreme Court "has interpreted [the First Amendment's prohibition of any establishment of religion] to mean that the civil courts cannot decide disputes involving religious organizations where the religious organizations would be deprived of interpreting and determining their own laws and doctrine."

However, the court again noted that "while the courts can under no circumstance referee ecclesiastical disputes," they "do have jurisdiction, as to civil, contract and property rights which are involved in, or arise from, a church controversy." It continued:

The question of liability for the salary of a minister or pastor is governed by the principles which prevail in the law of contracts, and it is generally held that a valid contract for the payment of such a salary will be enforced … . However, the controversy must be resolved pursuant to neutral principles of law … .

Defendants seem to argue, without citing any pertinent authority, that the First Amendment of the United States Constitution immunizes, without exception, a religious institution from liability arising out of a contract between the religious institution and its ministerial employees. This unsupported assertion cannot be reconciled with [prior cases] … . A holding that a religious body must be held free from any responsibility for wholly predictable and foreseeable injurious consequences of personnel decisions, although such decisions incorporate no theological or dogmatic tenets, would go beyond First Amendment protection and cloak such bodies with an exclusive immunity greater than that required for the preservation of the principles constitutionally safeguarded … .

Although defendants cite numerous decisions holding that civil courts cannot interject themselves into ecclesiastical disputes, they again focus their argument on the bar against courts determining the propriety of a church's decision to dismiss a plaintiff from his position as pastor—an issue not present in this case … .

Accordingly, because a court can decide plaintiff's contract-based claims applying "neutral principles of law," without entangling the court in an ecclesiastical dispute or interpretation, we hold that the ecclesiastical abstention doctrine does not require dismissal of plaintiff's complaint. We, therefore, hold plaintiff has sufficiently stated claims for relief and, therefore, reverse the trial court's order dismissing plaintiff's complaint.

What this means for churches

The court concluded that while the ministerial exception bars discrimination claims by current or dismissed ministers, it does not bar breach-of-contract claims that can be resolved without recourse to church doctrine. While some other courts have disagreed with the conclusion, there is sufficient support for it that it is imperative for church leaders to obtain legal review of employment agreements and handbooks and other contractual documents to ensure that they will not give rise to breach-of-contract claims that the civil courts may be able to adjudicate. Through careful drafting, this risk can be significantly reduced, if not eliminated. Bigelow v. Baptist Church, 786 S.E.2d 358 (N.C. App. 2016).

Legal Developments

Tax Court rules ‘Love Gifts’ to Pastor Represent Taxable Compensation

“Love gifts” made by churches and church members to clergy constitute taxable compensation

Richard R. Hammar, Attorney, CPA
Bio

Key point. "Love gifts" made by churches and church members to clergy constitute taxable compensation for services performed rather than nontaxable gifts.

The United States Tax Court ruled that "love gifts" made by a church to its pastor represented taxable compensation.

A church had 25 to 30 active members and as many as 7 ministers, and offered services three days each week. The lead pastor had informed the church's board of directors that he did not want to be paid a salary for his pastoral services but would not be opposed to receiving "love offerings," gifts, or loans from the church.

The pastor and his wife managed the church's checking account, and jointly signed all of the church's checks. They signed numerous checks in 2012, made payable to the pastor, with handwritten notations such as "Love Offering" or "Love Gift" on the memo line. The church transferred "love offerings" to other members of the church, including the pastor's wife.

In 2012, the church's bookkeeper prepared and sent to the pastor a Form 1099-MISC reporting that he had received nonemployee compensation of $4,815 from the church. When the bookkeeper left the church in late 2015, the pastor's daughter became the church's bookkeeper.

The pastor filed a joint federal income tax return for 2012, claiming a deduction for a charitable contribution of $6,478 to the church. He did not, however, include as an item of income the $4,815 of nonemployee compensation reported on Form 1099-MISC. Although the pastor did not dispute that he had received $4,815 from the church, he insisted that the amounts transferred to him were improperly reported as nonemployee compensation when in fact they were nontaxable "love offerings," gifts, or loans.

The IRS audited the pastor's 2012 tax return, and determined that the $4,815 represented taxable income, and not a nontaxable love gift. The IRS also ruled that none of this amount could be characterized as a tax-free loan since neither the church nor the pastor was able to produce objective evidence, such as bank records or a promissory note, showing that the church made any loans to the pastor.

The pastor appealed to the Tax Court, which affirmed the decision of the IRS. The court concluded:

In Commissioner v. Duberstein, 363 U.S. at 284-285, the United States Supreme Court stated that the problem of distinguishing gifts from taxable income "does not lend itself to any more definitive statement that would produce a talisman for the solution of concrete cases." The Supreme Court concluded that, in cases such as this one, the transferor's intention is the most critical consideration, and there must be an objective inquiry into the transferor's intent. In other words, rather than relying on a taxpayer's subjective characterization of the transfers, a court must focus on the objective facts and circumstances.

The record shows that the transfers were made to compensate [the pastor] for his services as pastor. As the pastor candidly explained at trial, he had informed the board of directors that he would accept "love offerings" and gifts as substitutes for a salary. The church's bookkeeper at the time considered the payments to be compensation as is reflected in the Form 1099-MISC that she issued to him. In the light of these facts, the pastor's subjective characterization of the transfers as nontaxable "love offerings" and "love gifts" is misguided.

The pastor did not offer the testimony of any members of the congregation (including the other directors) or [the former bookkeeper] that would allow the court to conclude that the transfers were anything other than compensation for services. The frequency of the transfers and the fact that they purport to have been made on behalf of the entire congregation is further objective evidence that the transfers represented a form of compensation.

In conclusion, we hold that the amounts that the pastor received from the church in 2012 represented compensation for services and, thus, constituted taxable income to him.

What this means for churches

This case addresses the recurring question of the distinction between nontaxable gifts and taxable compensation for the performance of services. Note the following points:

1. Ministers often receive "love gifts" from their employing church or directly from individuals. Love gifts from a church typically are funded by a "love offering" collected by the church from members. Whether collected in an offering, or paid directly by members to their minister, the question is whether such payments represent taxable compensation or tax-free gifts. The tax code excludes "gifts" from taxable income. IRC 102. But it also broadly defines taxable income as "all income from whatever source derived, including (but not limited to) the following items … compensation for services, including fees, commissions, fringe benefits, and similar items." IRC 61. This means that any "love gift" provided to a minister, whether from individuals or a church, constitutes taxable income if the transferor's intent was to more fully compensate the pastor for services rendered.

2. The Tax Court stressed that a donor's intent must be assessed in light of objective facts and circumstances. The court concluded that in this case the facts unequivocally demonstrated that the intent of donors and the church itself was to compensate the pastor for services he performed. The court pointed to the following facts:
The pastor informed the board of directors that he would accept "love offerings" and gifts as substitutes for a salary. The church's bookkeeper at the time considered the payments to be compensation as is reflected in the Form 1099-MISC that she issued to him. The pastor did not offer the testimony of any members of the congregation (including those on the board) that would allow the court to conclude that the transfers were anything other than compensation for services. The frequency of the transfers and the fact that they purported to have been made on behalf of the entire congregation is further objective evidence that the transfers represented a form of compensation.

3. The court referenced section 102(c) of the tax code, which specifies that the definition of the term gift does not include "any amount transferred by or for an employer to, or for the benefit of, an employee." However, it noted that the IRS did not raise this issue or contend that the pastor was an employee of the church.

4. Love gifts almost always will constitute taxable income rather than tax-free gifts because the donor's intent is to more fully compensate the pastor for services performed. There is a significant risk of getting this wrong. If a love gift is not reported as taxable income by the church or the recipient in the year it is provided, the IRS may be able to assess intermediate sanctions in the form of substantial excise taxes against the recipient, and possibly members of the church board, regardless of the amount of the benefit, under section 4958 of the tax code.

Jackson v. Commissioner of Internal Revenue, T.C. Summ. 2016-69 (2016).

Legal Developments

Churches and Revoking Pension

Church Law and Tax Report Churches and Revoking Pension Key point 2-04.1. Most courts have

Church Law and Tax Report

Churches and Revoking Pension

Key point 2-04.1. Most courts have concluded that they are barred by the First Amendment guarantees of religious freedom and nonestablishment of religion from resolving challenges by dismissed clergy to the legal validity of their dismissals.

A federal bankruptcy court in Delaware ruled that it was barred by the “ministerial exception” from resolving a dismissed priest’s claim that his diocese acted unlawfully in revoking his pension benefits based on his sexual abuse of minors. A Catholic diocese filed for bankruptcy protection under Chapter 11 of the bankruptcy code. The diocese had been named as a defendant in 131 child molestation claims involving several priests. The diocese entered into a settlement with the abuse victims in the bankruptcy proceedings. The settlement contained a provision stating that eight priests who had been dismissed by the diocese for abusing minors would be ineligible for benefits of any kind arising on or after the date of the bankruptcy petition, including benefits under the diocese “clergy pension plan.” One of the priests objected to the revocation of his benefits, claiming that this amounted to a breach of contract that could be adjudicated by the court without delving into religious doctrine.

In rejecting the priest’s claim, the court relied on the so-called “ministerial exemption” which generally bars the civil courts from resolving employment disputes between churches and clergy. The court quoted from a 2012 United States Supreme Court ruling that recognized and affirmed the ministerial exemption:

The members of a religious group put their faith in the hands of their ministers. Requiring a church to accept or retain an unwanted minister, or punishing a church for failing to do so, intrudes upon more than a mere employment decision. Such action interferes with the internal governance of the church, depriving the church of control over the selection of those who will personify its beliefs. By imposing an unwanted minister, the state infringes the Free Exercise Clause, which protects a religious group’s right to shape its own faith and mission through its appointments. According the state the power to determine which individuals will minister to the faithful also violates the Establishment Clause, which prohibits government involvement in such ecclesiastical decisions. Hosanna-Tabor Evangelical Lutheran Church and School v. E.E.O.C., 132 S.Ct. 694 (2012).

The Supreme Court concluded that an award of any relief, such as frontpay, backpay, compensatory and punitive damages, or attorney’s fees, would “operate as a penalty on the church for terminating an unwanted minister,” and was prohibited by the First Amendment.

The diocese argued that under the Hosanna-Tabor ruling, the bankruptcy court was barred from granting the priest any relief on account of his removal from ministry. The court agreed.

Hosanna-Tabor has made it clear that the Establishment Clause and the Free Exercise Clause bar the government from interfering with the decision of a religious group to fire one of its ministers. In the same vein, the Court is unable to require a church to “accept or retain an unwanted minister, or punish … a church for failing to do so.” Awarding any relief that would “operate as a penalty on the church for terminating an unwanted minister” is equally prohibited by the First Amendment, seeing as the award of such relief would depend on a determination that the church was wrong to have relieved the minister in question … .

Much like how awarding [the plaintiff] in Hosanna-Tabor with any relief (of frontpay, backpay, compensatory and punitive damages, or attorney’s fees) would operate as a penalty on the church for terminating an unwanted minister, awarding [the priest in this case] with relief for his claim of pension and sustenance would likewise effectively create a penalty or punishment upon the diocese for the removal of the priest from ministerial duties … . The court is barred, by the ministerial exception, from forcing the dismissed priest’s reinstatement into ministry, or awarding any form of relief that would come at the diocese’s expense on account of his removal … .

The ministerial exception exists in order to ensure that “the authority to select and control who will minister to the faithful … is the church’s alone.” The diocese (through the Bishop) chose to remove eight priests from ministry, and that decision remains the diocese’s alone. The granting of any claims for pensions, sustenance, or other forms of relief against the diocese would create a determination that the diocese was wrong to have relieved the ministers of their positions—a decision that the Supreme Court has already declared “strictly ecclesiastical,” and off-limits for the courts.

What This Means For Churches:

This case illustrates how some courts have construed the ministerial exception broadly to apply not only to cases involving termination of clergy, but also to collateral issues. As the Supreme Court noted in the Hosanna-Tabor case, the ministerial exception bars civil courts from awarding damages to dismissed clergy if doing so would have the effect of punishing a church for its decision to terminate a minister. In re Catholic Diocese, 513 B.R. 639 (D. Del. 2014).

Legal Developments

Exemption of Unemployment Services in the Employ of a Church Doesn’t Violate First Amendment

Terminated employee unable to sue church for lack of unemployment benefits.

Richard R. Hammar, Attorney, CPA
Bio

Key point. The exemption of church employees from state unemployment compensation laws does not violate the First Amendment's Establishment or Free Exercise of Religion Clauses.

A Texas court ruled that the exemption of services in the employ of a church from the unemployment compensation system did not violate the First Amendment's prohibition of the establishment of religion.

A church terminated the employment of its pianist and organist (the "plaintiff"). The plaintiff filed a claim for unemployment benefits. His claim was denied because he had not earned sufficient covered wages to establish a claim for unemployment benefits. The plaintiff filed a lawsuit arguing that exemption of church employment in establishing a claim of unemployment benefits violated the First Amendment's guarantees of the nonestablishment and free exercise of religion.

Background

Under the Texas unemployment compensation system, employers make contributions in the form of excise taxes to the compensation fund. Eligible individuals who are unemployed through no fault of their own may receive unemployment benefits from the compensation fund. An individual is eligible for unemployment benefits if he or she is totally unemployed in a "benefit period." Employment covered by the unemployment compensation system generally includes service performed by an individual for wages. There are, however, a number of exemptions, including "service in the employ of a church." The Federal Unemployment Tax Act (FUTA) contains an identical exemption from the definition of "employment." Service in the employ of a church or a religious organization has been exempted from the Texas unemployment compensation system since it was established in 1936.

First Amendment's "Establishment Clause"

The plaintiff claimed that the exemption of services performed for a church from the definition of covered employment violated the Establishment Clause of the First Amendment. The Establishment Clause provides that "Congress shall make no law respecting an establishment of religion."

When, as in this case, a law "affords a uniform benefit to all religions," rather than "drawing distinctions on religious grounds," a court should evaluate whether the law violates the Establishment Clause under the three-part test in Lemon v. Kurtzman, 403 U.S. 602 (1971). Under this test, a law (1) must have a secular legislative purpose, (2) must have a principal or primary effect that neither advances nor inhibits religion, and (3) must not foster "an excessive government entanglement with religion."

The plaintiff claimed that the tax exemption for churches under the unemployment statute did not meet the first prong of the Lemon test because it did not have a secular purpose. The court noted that "a statute need not have exclusively secular objectives to meet the secular purpose standard; the touchstone is neutrality, and it is only when the government acts with the ostensible and predominant purpose of advancing religion that it violates the first prong of the Lemon test."

In this case, the Texas legislature stated the purpose of establishing the unemployment compensation system was to provide for the support of individuals who were unemployed through no fault of their own. The purpose for the exemption of service in the employ of a church from the definition of employment in the FUTA (which is identical to the exemption in the Texas statute) was "to address a concern that coverage of workers whose employment patterns are irregular or whose wages are not easily accountable would adversely affect administration of the program. These purposes are secular in nature."

The court also noted that the exemption of church employment was not the only variety of employment that was exempt under the unemployment statute. Rather, "a number of types of work are excluded from employment … reflecting the legislature's decision that the entities for whom that work is performed should not be subject to the burden of paying the tax required by the unemployment compensation system." The breadth of the exemptions "demonstrates the exemption [of church employment] was not aimed at establishing, sponsoring, or supporting religion."

The court concluded that the exemption of church employment from unemployment coverage did not violate the second or third prongs of the Lemon test (a principal effect that neither advances nor inhibits religion, and no excessive entanglement between church and state).

First Amendment's "Free Exercise of Religion" Clause

The plaintiff claimed that the exemption of church employment from unemployment coverage under the Texas statute violated his constitutional right to the free exercise of his religion, specifically his right to play music during worship services. The Free Exercise Clause provides that "Congress shall make no law … prohibiting the free exercise [of religion]."

The court noted that a free exercise claim will be sustained only if the government "has placed a substantial burden on the observation of a central religious belief" without "a compelling governmental interest justifying the burden." The government imposes a substantial burden on the free exercise of religion by forcing an individual to choose between "following the precepts of his religion and forfeiting benefits," or by "putting substantial pressure on an adherent to modify his behavior and to violate his beliefs." However, an individual's right to freely exercise his religion "is not necessarily violated simply because his religious practice is burdened by a governmental program."

The court concluded that the plaintiff provided no explanation of how the exemption in the unemployment statute put substantial pressure on him "either to modify his behavior or to violate his religious beliefs. Further, we can discern nothing about the exemption that affected his ability to play music during church services, violated his religious beliefs, or required him to work under conditions forbidden by his religion … . We conclude that exempting service performed in the employ of a church from the definition of employment placed, at most, an inconsequential burden on the plaintiff's ability to play music during church services and does not violate his right to freely exercise his religion."

What this means for churches

This is one of the few cases to directly address the constitutionality of the exemption of church employees from coverage under state unemployment compensation laws. The court's conclusion that this exemption is constitutional will be a useful precedent in future challenges in other states. Spicer v. Texas Workforce Commission, 430 S.W.3d 526 (Tex. App. 2014).

Legal Developments

First Amendment Leaves Room for Employee Lawsuits

D.C. court of appeal rules religious freedom doesn’t bar a pastor from suing for unpaid compensation.

Richard R. Hammar, Attorney, CPA
Bio

Key point 9-07. The First Amendment allows civil courts to resolve internal church disputes so long as they can do so without interpreting doctrine or polity.

A District of Columbia court of appeals ruled that the First Amendment guaranty of religious freedom did not bar a pastor from suing her church for payment of the compensation the church had agreed to pay.

In 2004, a minister (the "plaintiff") was employed by a church through the first in a series of one-year contracts. When she became pastor, the church had low enrollment, it had defaulted on its second mortgage, and it had been in default for two years. The plaintiff managed to refinance the mortgage and obtained $79,000 from the refinancing.

The church paid the plaintiff in yearly contracts during her first three years as pastor. However, because of the church's financial difficulties, in her fourth year, she agreed to receive her salary and housing allowance on a payment plan, rather than in the amounts and on the schedule previously agreed upon. She received payments in accordance with the payment plan until April 2008. She did not receive any payment for her services in 2009.

The plaintiff sued the church, claiming that it owed her $39,200 under terms of the contract covering her final year of services at the church. After hearing all the evidence, the trial court concluded that the pastor had "established by a preponderance of the evidence that this is a straightforward contract case, uncomplicated by ecclesiastical considerations." The church appealed, claiming that the dispute was an ecclesiastical matter over which the civil courts have no jurisdiction.

The appeals court began its opinion by acknowledging that the First Amendment guaranty of religious freedom "requires civil courts to defer to the decisions of the highest tribunals of hierarchical religious organizations on matters of religious doctrine, discipline, faith, and ecclesiastical rule, custom, or law." Further, the First Amendment "precludes civil courts from interfering with a religious organization's right to choose its ministers."

However, "civil court review of church action is not entirely prohibited." It continued: "The touchstone for determining whether civil courts have jurisdiction is whether the courts may employ neutral principles of law and ensure that their decisions are not premised on the consideration of doctrinal matters, whether the ritual and liturgy of worship or the tenets of faith." The court concluded that the First Amendment did not bar the civil courts from resolving the plaintiff's breach of contract claim:

In this case, we are satisfied that the First Amendment does not bar [the plaintiff] from pursuing her contract claim against the church. The record does not suggest that resolving her contract claim will require the court to entangle itself in church doctrine. Rather, the record shows that she entered into a year-long contract to serve as pastor of the church, that she completed her obligations under the contract, and that the church did not honor its promise to pay her. Consequently, the trial court should be able to resolve the claim by employing neutral principles of law.

The plaintiff does not challenge the church's authority to hire, to fire, or to assign her duties, and she does not seek reinstatement. In other words, she does not seek to "limit the church's choice of its religious representatives," and we decline to extend the "ministerial exception" to categorically bar any claim whatsoever by a ministerial employee … . [Her] contract claim stands alone … . She does not claim she was wrongfully terminated or otherwise tether her contract claim to matters of church doctrine or governance; she claims only that the church failed to pay her salary after acknowledging its obligation to do so … . She has demonstrated that the trial court can resolve her claim without delving into matters reserved for ecclesiastical judgment.

The court cautioned that "if it becomes apparent to the trial court that this dispute does in fact turn on matters of doctrinal interpretation or church governance, the trial court may grant summary judgment to avoid excessive entanglement with religion."

What this means for churches

This case demonstrates that not all employment disputes between churches and clergy are barred by the so-called "ministerial exception." Some courts, like this one, are willing to resolve such disputes if they can do so without delving into "matters of doctrinal interpretation or church governance." Second Episcopal Dist. African Methodist Episcopal Church v. Prioleau, 49 A.3d 812 (D.C. 2012).

Legal Developments

Pennsylvania Teacher Granted Unemployment

Court rules that teacher terminated from church-affiliated school is eligible for unemployment benefits.

Richard R. Hammar, Attorney, CPA
Bio

Key point. Employees of churches and church-affiliated schools are ineligible for unemployment benefits in most states.

A Pennsylvania court ruled that a terminated employee of a church-affiliated school was eligible for unemployment benefits since her employment was not exempt from coverage.

A common question for any church that operates a school or preschool is the application of state unemployment laws to its employees. Are employees entitled to unemployment benefits if they resign or are terminated? This question was addressed by a Pennsylvania court. An assistant (the "plaintiff") to the principal of a religious school was terminated, and she applied for unemployment compensation benefits under state law. A state agency determined that she was ineligible for benefits because she did not have sufficient wages entitling her to benefits. In reaching this conclusion, the agency excluded wages from her employment with the school since it considered such employment to be excluded from the definition of "employment" under the unemployment compensation law on the basis of the following exemption:

Service performed in the employ of (i) a church or convention or association of churches or (ii) an organization which is operated primarily for religious purposes and which is operated, supervised, controlled or principally supported by a church or convention or association of churches.

The plaintiff appealed this ruling to a state unemployment compensation board of review, which reversed the agency's determination that the plaintiff's services were exempt from the definition of covered employment under the unemployment compensation law. The board cited the following facts that had been established in this dispute:

  • The school was a Christian school that "operates for educational purposes with strong religious influence" from its founding church.
  • The school is a nonprofit organization separate and apart from the church.
  • Many of the church's elders serve on the school's board of directors and many of the school's employees are both members of the church and elders of the church.
  • While the school and church at one time shared a building in which there was a rental agreement, the school currently operates in a separate space.
  • The school pays its own bills and receives zero funding from the church.

The board determined that the school is a nonprofit organization legally separate from its founder (the church), and operated primarily for educational purposes. The board also found that the school received no funding from the church, and, even though it rented a facility from the church when the plaintiff began employment, the school later purchased its own facility. The board concluded that, based on these circumstances, the school did not constitute a church or convention or association of churches or an organization that is operated primarily for religious purposes and that is operated, supervised, controlled or primarily supported by a church, or convention or association of churches. As a result, services performed by the plaintiff constituted covered employment, and wages earned for the school were to be considered in determining financial eligibility for unemployment benefits. The school appealed to the civil courts. The Commonwealth Court of Pennsylvania affirmed the board's determination that the plaintiff's employment with the school was covered employment under the unemployment compensation law.

The court quoted the above-cited exemption of services performed for religious organizations from the definition of "employment" in determining eligibility for unemployment benefits, and concluded that it did apply to the school in this case:

Here, the record … includes little evidence of the extent to which the religious underpinnings pervade the curriculum. Instead, it appears that the board's factual finding that the school is "operated primarily for educational purposes with a strong religious influence" is almost a verbatim quote from school's witness. Unfortunately, the employer's witness provided nothing further of substance. Accordingly, this case comes down to the board's fact finding …. We give primacy to the board's finding that the school "operated primarily for educational purposes." Therefore, we conclude that the board did not err in determining that the plaintiff's employment is not exempt from coverage under the Law because the school does not operate primarily for religious purposes based on the Board's findings. Imani Christian Academy v. Unemployment Compensation Board of Review, 42 A.3d 1171 (Pa. Common. 2012).

Legal Developments

Overtime Pay for Work-Related Smartphone Use

Follow these steps to reduce your risk of overtime liability.

Richard R. Hammar, Attorney, CPA
Bio

Key point 8-08.6. The Fair Labor Standards Act exempts employees employed in an executive, administrative, or professional capacity from the minimum wage and overtime pay provisions. To be covered by one of these exemptions, an employee must perform specified duties, and be paid a salary in excess of a specified amount.

A federal court in Illinois refused to dismiss a lawsuit claiming that the City of Chicago violated the Fair Labor Standards Act by failing to pay police officers overtime pay for the use of smartphones for work-related business during nonworking hours.

A Chicago police sergeant (the "plaintiff") sued the City of Chicago on behalf of himself and all other employees of the Chicago Police Department against the City of Chicago, alleging that the City violated the Fair Labor Standards Act ("FLSA") by failing to pay plaintiffs all the compensation they were due.

The plaintiff claimed that, at various points in the last three years, he and other employees of the police department were issued personal data assistants ("PDAs") or other electronic communication devices. He further alleged that:

  • he and other employees were "required to use" those devices to perform work outside of normal working hours without receiving compensation—including overtime compensation;
  • police work was "routinely and regularly accomplished through the use of these PDAs";
  • without these PDAs and the work routinely performed while off-duty, the police department would be far less successful in accomplishing its law enforcement objectives;
  • he received numerous telephone calls, e-mails, voice mails, and text message work orders on his PDA while off the clock, and was expected to respond to these communications throughout the night and into the early morning hours while off duty without being compensated for the time he spent doing so;
  • he and other employees were not paid overtime for the excess hours they worked during off-duty hours using their PDAs; and
  • the city did not keep appropriate records as required by the FLSA to determine wages, hours, and other conditions and practices of employment.

The plaintiff sought monetary damages in the form of overtime compensation equal to the unpaid compensation and overtime compensation due all police department employees, plus interest, and reasonable attorney's fees, costs, and expenses.

The city asked the court to dismiss the lawsuit for failure to state a claim upon which relief could be granted. The court declined to do so, noting that the plaintiff's claim had sufficient merit to proceed to trial. The court acknowledged that "de minimis" (i.e., minimal) compensable time is "not recoverable under the FLSA." It referred to a federal regulation that states: "In recording working time under the Act, insubstantial or insignificant periods of time beyond the scheduled working hours, which cannot as a practical administrative matter be precisely recorded for payroll purposes, may be disregarded." 29 C.F.R. § 785.47.

This rule applies to "uncertain and indefinite periods of time involving a few seconds or minutes duration."

The city also argued that plaintiff failed to allege the amount of time he spent off duty, beyond a de minimis amount, responding to PDA communications that required his immediate response. The court responded: "Whether the amount of time plaintiff worked off the clock is greater than a de minimis amount, however, is a matter of the proof of his claim, not a matter of the sufficiency and plausibility of his complaint. We are mindful that some courts have required more detailed allegations as to the type and amount of work that allegedly earned FLSA overtime compensation …. [But] the elements that must be shown are simply a failure to pay overtime compensation … and failure to keep payroll records in accordance with the Act."

The court concluded:

The plaintiff pleaded that he was entitled to overtime pay because he "routinely and regularly" responded to phone calls, e-mails and work orders off the clock, as expected by the police department. He further has alleged that he was not paid for the excess hours worked, and that the city failed to keep appropriate records. These allegations of FLSA violations are plausible, and they give the city adequate notice of the claim. Whether plaintiff can prove what he has plead remains to be seen after discovery.

What This Means For Churches

This is the first case that we have seen to address employer liability for overtime based on employees' use of cell phones during non-working hours for business purposes. This court suggested that liability may arise, so long as the cell phone use is documentable and not "de minimis." The case now proceeds to trial, unless it is settled. Future developments regarding this and similar cases will be addressed in future editions of Church Law & Tax Report. For now, church leaders should consider some obvious steps to reduce this potential risk of an overtime pay liability:

  1. Only issue cell phones to employees who clearly satisfy the definition of "exempt employees" under the FLSA. Exempt employees include administrative, executive, and professional employees. Ministers generally are considered professional employees. See sections 8-08.5 and 8-08.6 in Richard Hammar's Pastor, Church & Law (4th ed. 2008) for a full explanation of these exemptions.
  2. If you currently issue cell phones to non-exempt employees, review each case to determine if there is a legitimate business need to do so.
  3. If you determine that a legitimate business need exists for issuing cell phones to one or more non-exempt employees, then require these employees to keep accurate records of their business use of the device that should be cross-checked against the church's monthly cell phone bills for confirmation. The employer has a duty under the FLSA to maintain these records. Obviously, this is going to be an administrative burden for the church that may prompt a reconsideration of which employees really need a church-provided cell phone.
  4. If you determine that a legitimate business need exists for issuing cell phones to one or more non-exempt employees, then consider a policy that requires these employees to leave their church-provided cell phones in their church office during non-working hours. Allen v. City of Chicago, 2011 WL 941383 (N.D. Ill. 2011).

    5. Employment Practices

    See (1) "Compensation," Allen v. City of Chicago, 2011 WL 941383 (N.D. Ill. 2011), and (2) "Minimum wage and overtime pay," Alcazar v. Corporation of the Catholic Archbishop, 627 F.3d 1288 (9th Cir. 2010), and (3) "Privacy," Duncan v. Peterson, 947 N.E.2d 305 (Ill. App. 2010), in the Legal Developments section of this website.

    Fair Labor Standards Act

    See "Minimum wage and overtime pay," Alcazar v. Corporation of the Catholic Archbishop, 627 F.3d 1288 (9th Cir. 2010), in the Legal Developments section of this website.

Legal Developments

Application of the FLSA Minimum Wage and Overtime Requirements to a Church Employee

New York court rules Episcopal church custodian not entitled to overtime or minimum wage under FLSA.

Richard R. Hammar, Attorney, CPA
Bio


Key point 8-08.2. The Fair Labor Standards Act mandates that employers pay the minimum wage, and overtime compensation, to employees who work for an enterprise engaged in commerce. There is no exception for religious organizations, but there are exceptions for certain classifications of employees.

Key point 8-08.3. The Fair Labor Standards Act mandates that employers pay the minimum wage, and overtime compensation, to employees who are engaged in commerce or in the production of goods for commerce. There is no exception for religious organizations, but there are exceptions for certain classifications of employees.

A federal district court in New York ruled that a custodian who worked for an Episcopal church was not entitled to minimum wage or overtime pay under the Fair Labor Standards Act since the church was not an "enterprise" and the custodian did not qualify for individual coverage.

In 1982, a church hired a new custodian (the "plaintiff") to clean the church. The plaintiff worked seven days a week. On Sundays, he worked from 7 a.m. until services ended. On all other days he worked from 8 a.m. to 5 p.m., though he often cleaned the church after evening services. His custodial duties included sweeping, mopping, and vacuuming the buildings and bathrooms, removing garbage, flushing the air conditioner, maintaining the boiler, and clearing the sidewalks of trash, leaves, and snow. The plaintiff was on-call at all hours if a problem arose with the electricity, plumbing, air conditioner, or boiler. When a new pastor was hired by the church in 1999, he increased the hours the plaintiff worked by requiring him to turn off the building's alarm at 7 a.m. and turn on the alarm after church functions concluded every evening.

The plaintiff paid the electrical, plumbing, and oil vendors on behalf of the church, purchased cleaning supplies, picked-up church vestments and the pastor's personal clothing from the dry-cleaners located across the street, delivered mail to the post office, and folded 800 church bulletins each week or took the bulletins to a local printing shop. The church reimbursed the plaintiff by check for these church-related purchases.

From 1982 until 2007 the plaintiff lived in the two-bedroom apartment located in a church building. Beginning in 1982, he earned $70 per week in wages and lived in the apartment rent-free. In 1986, the church's finance committee began requiring the plaintiff to pay $250 per month in rent for the apartment. In 2000, the church increased the plaintiff's bi-weekly wage to $519.76. In 2002, the church increased his bi-weekly wage to $625, an amount the pastor believed to be adequate compensation for forty hours of work per week. In addition to his wages, the plaintiff received $50 per event for helping during each event and cleaning afterward. He also received Christmas bonuses, though not every year. No one at the church recorded the hours the plaintiff worked. In 2004, the church paid two additional people to clean the buildings.

In September 2005, the plaintiff requested medical leave to undergo surgery and receive treatment. Throughout his convalescence, he continued to turn the alarm off and on every day and perform some of his custodial duties, such as shoveling snow and vacuuming the church, and the church continued to pay him. In February 2006, he provided the church with a letter from his doctor stating that he could return to work full-time in March 2006. On February 10, 2006, the pastor and an associate pastor met with the plaintiff and terminated his employment because the church "could no longer afford to wait for him and decided instead to let him go." The church offered the plaintiff several severance packages, but he rejected them all.

In 2007, the plaintiff sued the church to recover unpaid minimum wages and overtime compensation pursuant to the federal Fair Labor Standards Act (FLSA) and the New York Labor Law (NYLL). The plaintiff also complained that the church failed to maintain adequate written records for hours worked and wages earned in violation of the FLSA and NYLL. The church asked the court to dismiss the case on the ground that the FLSA does not cover the church as an "enterprise" or the plaintiff as an individual employee.

The Fair Labor Standards Act

The FLSA requires that an employer pay minimum wages and an overtime wage of not less than one-and-a-half times the regular rate for hours worked in excess of 40 hours in a single work week if an employee is either (1) employed by an enterprise engaged in commerce or in the production of goods for commerce, or (2) engaged in commerce or in the production of goods for commerce. The two categories are commonly referred to as "enterprise" and "individual" coverage, respectively.

The employee bears the burden of establishing either enterprise or individual coverage. The burden then shifts to the employer to establish a specific exemption.

enterprise coverage: combining the church and diocese

The FLSA covers an enterprise engaged in commerce or in the production of goods for commerce if:

  1. employees engaged in commerce or in the production of goods for commerce, or employees handled, sold, or otherwise worked on goods or materials that have been moved in or produced for commerce by any person, and
  2. the enterprise has no less than $500,000 in annual gross volume of sales made or business done.

    3. The plaintiff conceded that the church did not meet this definition of an enterprise, but he claimed that the combination of the church and local diocese did meet the definition. The court conceded that two entities can be combined in applying the definition of an enterprise if (1) the entities engage in related activities performed through unified operation or common control, (2) for a common business purpose. To support the claim of unified operation or common control, the plaintiff described the hierarchical structure of the Episcopal Church where parishes financially support the dioceses and in return receive administrative and financial support and the right to perform religious activities.

    (1) related activities performed through unified operation or common control

    However, the court stressed that the diocese was not a party to this lawsuit, and that if the plaintiff claims that separate entities perform related activities through unified operation or common control, then he must "name each entity as a defendant in the action." Since he did not do so, the court "cannot consider the diocese in determining whether the church constitutes an enterprise because the diocese is not a party to this action. Even if the plaintiff had named both the church diocese as defendants, the court concluded that they could not be combined in determining enterprise coverage:

    Even if the plaintiff had sued the diocese, the court would not reach the merits of whether the diocese constitutes an enterprise because summary judgment would be granted in favor of the diocese on the threshold question of FLSA coverage. The FLSA applies only to an "employer" who "suffers or permits" an "employee" to work. If the plaintiff sued the diocese and church, then he would have the burden of proving that he constitutes an employee of the diocese or an employee of both the diocese and church as joint employers. [A federal appeals court] has identified nonexclusive factors to aid the courts in determining the "economic reality" of the relationship between an individual and an alleged employer, such as whether the alleged employer (1) had the power to hire and fire the individual, (2) supervised and controlled employee work schedules or conditions of employment, (3) determined the rate and method of payment, and (4) maintained employment records. Where an individual alleges that two entities constitute joint employers, courts must also consider whether both entities have "functional control over workers even in the absence of the formal control measured by the [preceding] factors."

    Considering all factors and facts to ascertain the economic reality here, the plaintiff constituted an employee of the church alone. Employees of the church had the power to hire and fire the plaintiff; the pastor hired the plaintiff in 1982 and his successor fired him in 2006. [The pastors] supervised and controlled the plaintiff's work schedule and conditions of employment; [one of the pastors] required the plaintiff to work seven days a week from eight in the morning until at least five in the evening and his successor increased the hours the plaintiff worked to include turning off the building's alarm at seven every morning and turning on the alarm after church functions concluded every evening. The pastors determined the rate and method of payment …. Checks used to pay the plaintiff for all wages and reimbursements were printed with the account name and address of the church and signed by church employees. Neither the diocese nor the church maintained employment records. There is no evidence that the diocese had any control over the plaintiff's work as a custodian for the church. He could not prove that the diocese and church constitute joint employers. The diocese is not relevant in this action or in theory.

    (2) common business purpose

    The second factor that must exist for two entities to be combined in determining enterprise coverage is a common business purpose. The court noted that a Department of Labor ("DOL") regulation provides nonprofit organizations with an exemption from the definition of an "enterprise." 29 C.F.R. § 779.214. An organization that performs religious, educational, or charitable activities "does not perform these activities for a business purpose, and thus does not constitute an enterprise, unless the activities compete in the marketplace with ordinary commercial enterprises."

    The court noted that in only two cases had a religious organization been found to have a business purpose:

    Tony & Susan Alamo Foundation v. Secretary of Labor, 471 U.S. 290 (1985). A church operated 33 businesses, including service stations, retail clothing and grocery outlets, hog farms, roofing and electrical construction companies, a recordkeeping company, a motel, and companies engaged in the production and distribution of candy, in three states. The United States Supreme Court found that the church constituted an enterprise because the businesses engaged in ordinary commercial activities that competed with other commercial enterprises, even though employees were "spreading the gospel."

    Boekemeier v. Fourth Universalist Society, 86 F.Supp.2d 280 (S.D.N.Y. 2000). A New York church employed a staff to solicit, through monthly mass mailings, press releases, and advertisements, intrastate and interstate renters for events. The court found that the church constituted an enterprise because the extent and result of the church's efforts to secure rental activity competed directly with other commercial landlords and rental facilities. The court also highlighted the fact that income from the rental activity supplemented church operations, as rental fees constituted 80 percent of the church's income.

    The plaintiff insisted that the church was engaged in a business purpose because of the rental of its facilities for weddings and other social events, and that it was competing with commercial enterprises. The court concluded that the church's rental activities did not constitute a business purpose that competed with commercial enterprises, since (1) the church rented its facilities for weddings and social events only 10 times per year; (2) the church did not advertise or market its properties for events; (3) the church did not employ a staff to solicit renters; (4) rental fees constituted only 4 percent of the income raised by the church. The court concluded that "no reasonable inference can be drawn in favor of the claim that this activity competes with ordinary rental facilities to serve the general public or that the church relied on rental income to support church operations."

    enterprise coverage: employees engaged in commerce

    The FLSA covers an enterprise where "employees engaged in commerce or in the production of goods for commerce, or employees handled, sold, or otherwise worked on goods or materials that have been moved in or produced for commerce by any person." The court concluded that the plaintiff's handling of janitorial goods that had moved in commerce was more than sufficient to invoke enterprise coverage.

    enterprise coverage: the $500,000 annual sales requirement

    The court noted that the FLSA will not cover an entity that has less than $500,000 in annual gross volume of sales made or business done. Charitable contributions donated to a nonprofit "are not included in this calculation unless the organization solicited or used the contributions for the purpose of furthering commercial activities." The court concluded that the plaintiff had failed to prove that the church received business income of $500,000 or more.

    In conclusion, the plaintiff "failed to prove two of the three essential elements of enterprise coverage with respect to which he has the burden of proof," and therefore the FLSA "does not cover the church as an enterprise engaged in commerce or in the production of goods for commerce."

    individual coverage

    The FLSA requires that an employer pay minimum wages and an overtime wage of not less than one-and-a-half times the regular rate for hours worked in excess of 40 hours in a single work week if an employee is engaged in commerce or in the production of goods for commerce. This is commonly referred to as "individual" coverage. The court noted that the FLSA can cover an employee "engaged in commerce or in the production of goods for commerce" regardless of whether the employer constitutes an enterprise.

    The DOL provides custodial employees with a specific ground for individual coverage where the employee "performs maintenance and custodial work on the machinery, equipment, or premises where goods regularly are produced for commerce or from which goods are regularly shipped in interstate commerce." 29 C.F.R. § 779.116.

    The plaintiff compared himself to the plaintiff in the Boekemeier case (summarized above) where the court found that the employee-custodian engaged in commerce by ordering cleaning supplies and equipment one to six times a year from out-of-state vendors by telephone and fax on behalf of the employer-church. The court reasoned that the employee purchased goods "important" to the employer in a "recurrent and frequent" manner.

    The court conceded that the plaintiff purchased cleaning supplies in a recurrent and frequent manner, and regularly contacted (by telephone) electrical, plumbing, and oil vendors, paid for their services, and received reimbursement from the church. However, unlike the church custodian in the Boekemeier case, he did so exclusively from in-state vendors. The Boekemeier case "is distinguishable from this case because the employee was closely related to the movement of commerce by purchasing goods directly from out-of-state vendors, while [the plaintiff in this case] simply affected commerce by purchasing goods from local vendors."

    The court conceded that the plaintiff delivered mail to the post office on a regular and recurrent basis. But, it noted that DOL regulations "make clear that this activity must be of an interstate nature to establish individual coverage." 29 C.F.R. § 779.102. There was no evidence in this case "that mail delivered by the plaintiff to the post office was of an interstate nature."

    What this means for churches

    This case is important because it is one of the most extended discussions of the application of the FLSA minimum wage and overtime requirements to a church employee. Few churches will meet the FLSA's definition of enterprise coverage. But of greater relevance is the court's interpretation of "individual" coverage. The court's conclusion that church custodians who order janitorial supplies from in-state vendors by phone or the mail are not "engaged in commerce" will make it more difficult for church employees to pursue a claim for minimum wage or overtime pay under the FLSA. Note, however, that such claims may be more likely to succeed under state employment laws. Locke v. St. Augustine's Church, 690 F.Supp.2d 77 (E.D.N.Y, 2010). See also "Compensation," Tarasi v. Jugis, 692 S.E.2d 194 (N.C. App. 2010), in the Legal Developments section of this website.

Legal Developments

Compensation Dispute

Court rules that it’s against the First Amendment to resolve a priest’s compensation dispute with his diocese.

Richard R. Hammar, Attorney, CPA
Bio

Key point 8-08.7. Ministers who are employed to perform ministerial services, and who are paid a salary that meets or exceeds the "salary test," are professional employees exempt from the provisions of the Fair Labor Standards Act. Ministers not compensated on a salary basis, or who earn a salary below the salary test, may not be covered by the Act. Department of Labor regulations suggest that the Act does not apply to any ministers, and a few federal courts have ruled that the so-called ministerial exception prevents the application of the Act to ministers.

A North Carolina court ruled that it was barred by the First Amendment guaranty of religious freedom from resolving a priest's compensation dispute with his diocese.

A Catholic priest claimed that his diocese had failed to assign him to a suitable position and failed to properly compensate him for his services. He submitted his grievance to the Vatican's "Congregation for Clergy." The Congregation later instructed the diocese to "provide some priestly ministry for this priest and ensure that he is henceforth to be provided with an adequate means of livelihood."

The priest alleged that the diocese never followed this mandate, and has continued to refuse to give him either an assignment or a salary. As a result, he sued the diocese, claiming that it had violated the North Carolina Wage and Hour Act. The Act provides that employers must "pay every employee all wages and tips accruing to the employee on the regular payday," and that "employees whose employment is discontinued for any reason shall be paid all wages due on or before the next regular payday either through the regular pay channels." The priest alleged that the diocese had violated these provisions by refusing to comply with the decision and instruction of the Congregation." A trial court dismissed the lawsuit, and the priest appealed.

In affirming the trial court's dismissal of the lawsuit, the appeals court observed:

The First Amendment to the United States Constitution prohibits any law "respecting an establishment of religion, or prohibiting the free exercise thereof." The United States Supreme Court has interpreted this clause to mean that the civil courts cannot decide disputes involving religious organizations where the religious organizations would be deprived of interpreting and determining their own laws and doctrine. Thus, the dispositive question is whether resolution of the legal claim brought against a religious organization requires the court to interpret or weigh church doctrine.

The court concluded that any resolution of the priest's claims would require the court "to determine, under ecclesiastical law, the compensation to which the priest is entitled as an adequate means of livelihood and the appropriate necessities as envisioned in the Code of Canon Law." Such a determination "is beyond the jurisdiction of the North Carolina courts and we must affirm the order of the trial court to dismiss his claim."

What this means for churches

This case illustrates a principle that has been recognized by many courts: The First Amendment guaranty of religious freedom bars the civil courts from resolving compensation disputes between clergy and churches, especially when such disputes implicate religious doctrine. Tarasi v. Jugis, 692 S.E.2d 194 (N.C. App. 2010).

Legal Developments

Breach of Contract and the Ministerial Exception

Court agrees to hear church organist’s breach of contract lawsuit.

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Breach of Contract and the Ministerial Exception

Court agrees to hear church organist’s breach of contract lawsuit.

Richard R. Hammar, J.D., LL.M., CPA

Key point. The civil courts have consistently ruled that the First Amendment prevents the civil courts from applying employment laws to the relationship between a church and a minister.

A Pennsylvania court ruled that a trial court erred in dismissing a church organist’s breach of contract lawsuit against her employing church on the basis of the “ministerial exception” without any analysis of the functions that she performed or their importance to the church’s mission. A woman (the “plaintiff”) was employed by a church as its organist. She and the church entered into a six-year contract, renewable annually, obligating her to play the organ for worship services in exchange for a weekly fee of $275. This arrangement continued for several years until the church unilaterally reduced her pay to $50 per week. The plaintiff sued the church for breach of contract. The trial court dismissed the plaintiff’s complaint with the following observation:

We accept the argument of [the church] that [the plaintiff’s] contract claim is barred by the Free Exercise Clause of the First Amendment to the United States Constitution which prohibits judicial encroachment upon decisions made by a religious institution concerning the employment of its ministers. Because the Roman Catholic Church views music as an integral part of Catholic worship, the Organist/Musical Director is considered a minister of the church. Therefore, this court has no jurisdiction.

A state appeals court reversed the trial court’s dismissal of the case. It acknowledged that the “ministerial exception” precludes civil courts “from considering claims involving the employment relationship between a religious institution and its ministerial employees, based on the institution’s constitutional right to be free from judicial interference in the selection of those employees.” The court noted that the ministerial exception “applies only to ministers, and whether a person is or is not a minister requires an evaluation of the person’s actual functions within the church.” The courts generally have applied a “ministerial-function” test under which the exception applies “if primary duties include teaching, spreading the faith, church governance, supervision of a religious order, or supervision of participation in religious ritual and worship.”

The court concluded that the trial court erred by ruling that because “the Roman Catholic Church views music as an integral part of its Catholic worship,” anyone who holds the position of “Organist/Musical Director” is a minister for purposes of the ministerial exception. The court found “no basis in either state or federal cases applying the ministerial exception for such a per se classification based merely upon the person’s title.”

The court was unable to say, based on the evidence presented, whether the plaintiff’s primary duties involved teaching, spreading the faith, church governance, supervision of a religious order, or supervision of participation in religious ritual and worship, as required by the “ministerial function” test. Indeed, the evidence presented by the church “did not even establish that the Roman Catholic Church views music as an integral part of its Catholic worship,” a point central to the trial court’s decision.

Alternatively, the church asked that the appeals court affirm the trial court’s decision based on Pennsylvania’s presumption that all employment is “at-will.” The church pointed out that the plaintiff signed a written contract with the church acknowledging her at-will status. The court rejected this argument, noting that the at-will doctrine only applies to employees hired for an indefinite term, and that the plaintiff had been hired for a six-year term, renewable annually.

Application. Many courts have ruled that the ministerial exception applies to church music directors. This court did not reject those rulings, but rather refused to adopt a rule that church organists and music directors are always deemed “ministers” for purposes of the ministerial exception. Instead, the court insisted that a “ministerial function” test must be applied to ensure that an employee in fact is functioning as a minister. It remanded the case back to the trial court with the instruction to decide, on the basis of the ministerial function test, whether the ministerial exception should bar judicial resolution of the plaintiff’s claims. Cooper v. Church of St. Benedict, 954 A.2d 1216 (Pa. Super. 2008).

This Recent Development first appeared in Church Law & Tax Report, March/April 2009.

Legal Developments

Clergy Compensation Disputes

Court rules that it cannot resolve a pastor’s lawsuit for breach of contract.

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Clergy Compensation Disputes

Court rules that it cannot resolve a pastor’s lawsuit for breach of contract.

Richard R. Hammar, J.D., LL.M., CPA

Key point The First Amendment allows civil courts to resolve internal church disputes so long as they can do so without interpreting doctrine or polity.

A Colorado court ruled that it was barred by the First Amendment from resolving a pastor’s lawsuit seeking additional compensation from his church on the basis of breach of contract. An ordained pastor (the “plaintiff”) served as the senior pastor of a church for nearly 20 years. He sued his church for breach of contract as a result of the church’s alleged failure to compensate him fully for his services as pastor since 1991. He relied on representations and assurances by the church that it would compensate him whenever it was financially able to do so. According to the lawsuit, the church had obtained substantial proceeds from the sale of church property, and as a result was obligated to perform on its assurance of compensation.

The church denied any liability on several grounds, including the fact that the pastor had not adequately performed his duties as pastor. It also argued that the pastor’s breach of contract claim “arose directly out of the ministerial relationship … and therefore, under the First Amendment to the United States Constitution, the court was precluded from exercising jurisdiction.”

The trial court dismissed the case, concluding that it could not exercise jurisdiction because resolution of the claims would involve excessive government entanglement with religion. The plaintiff appealed.

A state appeals court noted that churches have autonomy in making decisions regarding their own internal affairs and that the “church autonomy doctrine prohibits civil court review of internal church disputes involving matters of faith, doctrine, church governance, and polity.” Bryce v. Episcopal Church, 289 F.3d 648 (10th Cir.2002).

A state appeals court began its opinion by noting that “the threshold inquiry here is whether the underlying dispute is a secular one, capable of review by a civil court, or an ecclesiastical one about discipline, faith, internal organization, or ecclesiastical rule, custom or law. While civil courts have jurisdiction to render decisions in religious controversies involving rights outside the doctrinal realm, such disputes must be resolved by application of secular or neutral principles of law, thereby avoiding any impermissible inquiry into ecclesiastical questions.”

The court noted that one of the issues to be resolved was whether the pastor properly performed his duties as a pastor. Analysis of that issue “would require inquiry into the church’s bylaws and the nature of the pastor’s responsibilities as defined in his job description.” The court continued:

The bylaws provide, among other requirements, “The Pastor is responsible for leading the church to function as a New Testament church. The Pastor will lead the congregation, the organization, and the church staff to perform their tasks in accordance with 1 Peter 5.” Similarly, the job description states, among other duties, that the pastor shall “carry out other responsibilities put upon the pastor by scripture, as the under shepherd” and “fulfill personal responsibility to witness and encourage people to become part of the church fellowship.”

The determination whether [the plaintiff] has performed such duties adequately would necessarily entangle the court or a jury in matters that are purely ecclesiastical. Accordingly, the trial court properly ruled that the First Amendment precluded it from exercising jurisdiction.

The court based its conclusion, in part, on a previous federal appeals court case holding that matters such as a minister’s salary, place of assignment, and duties are matters of church administration and governance and are thus beyond the purview of civil authorities. McClure v. Salvation Army, 460 F.2d 553 (5th Cir.1972).

Application. This case indicates that the reluctance of the civil courts to resolve internal church disputes extends to disputes over clergy compensation, so long as a resolution of such claims would require a civil court to delve into matters of church doctrine and internal governance. Since most clergy compensation disputes involve matters of professional competence and internal church governance, they generally are beyond the authority of the civil courts to resolve. Jones v. Crestview Southern Baptist Church, 192 P.3d 571 (Colo. App. 2008).

This Recent Development first appeared in Church Law & Tax Report, March/April 2009.

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Legal Developments

Church Employee Fired After Raising Objections to Financial Policies

Court rules that woman can sue church for violation of public policy and emotional distress.

Richard R. Hammar, Attorney, CPA
Bio

Key Point 8-22. In most states, employees who are hired for an indefinite period are considered "at will" employees. This means that the employment relationship may be terminated at will by either the employer or employee, with or without cause, and with or without notice. The courts and state legislatures have created a number of exceptions to the at will employment rule. These exceptions limit the right of an employer to terminate an at will employee. Employees who are hired for a specific term are not at will employees, and they may be terminated only if the employer has "good cause."

Key Point 8-25. Employers often evaluate some or all of their employees on a periodic basis. Such evaluations can help employees be more productive, but they also can be used as evidence of discrimination if an employee who is a member of a protected class under a state or federal employment law is terminated despite average or above-average evaluations.

A Connecticut court ruled that a church employee who was dismissed from employment could sue the church for violation of public policy and emotional distress, but not negligence or blacklisting.

A church hired a woman (the "plaintiff") as the director of its school. She was employed in this position for six years. In her last annual performance evaluation the church rated her as satisfactory and did not provide any indication that it was unhappy with her job performance.

Shortly after this performance evaluation was prepared, the plaintiff expressed an objection to the church's use of a tuition increase to make improvements to the church. She informed church leaders that it was improper for the church to tell the children's parents that the tuition increase would be utilized by the school when actually it was being used for the general use of the church. The church dismissed the plaintiff as an employee a few days after she raised her objection. The plaintiff sued the church on the following four grounds:

Negligence per se

The plaintiff claimed that the church was liable on the basis of the legal principle of "negligence per se" for violating a state law providing that "no individually identifiable information contained in the personnel file … of any employee shall be disclosed by an employer to any person or entity not employed by or affiliated with the employer without the written authorization of such employee."

Under the doctrine of negligence per se, a person who violates a statute can be sued for monetary damages if (1) the purpose of the statute is to protect the interest of the plaintiff, individually, as opposed to the public; (2) the statute must clearly apply to the conduct of the defendant; (3) the defendant must violate the statute; and (4) the violation of the statute must cause the plaintiff's injury.

The plaintiff claimed that the church violated the statute by failing to implement proper policies to prevent its employees from disclosing confidential information contained in her personnel file, and that this violation amounted to negligence per se since she was within the class of persons protected by the statute. The court disagreed, noting that the statute did specifically authorize private lawsuits as a remedy for its violation.

Blacklisting

The plaintiff also sued the church for "blacklisting" her. Specifically, she claimed that the church "propagated to potential employers her name and false information concerning her with the intent and for the purpose of preventing her from securing employment with potential employers." Once again, the court concluded that no statute authorized private lawsuits by victims of blacklisting, and it declined to create such a remedy.

Violation of public policy

The plaintiff claimed that her termination violated public policy since it was based on her objection to what she believed to be an unethical practice of her employer. In particular, she alleged that it was a violation of public policy for a church (1) to mislead persons concerning the intended use of the funds it solicits, and (2) to solicit payment with a promise that the payment will result in one receiving a better product, knowing that it is not the case.

The church insisted that neither of these public policies was violated by the plaintiff's dismissal, or even related to her dismissal. The court refused the church's request to dismiss this claim.

Emotional distress

The plaintiff claimed that the church negligently inflicted emotional distress upon her in its termination process when it falsely accused her, in writing, of misconduct, including falsely accusing her of conduct constituting theft, embezzlement, and falsification of records and repeated dishonesty.

She claimed to have been further emotionally distressed "as there was a reasonable chance that she will be compelled to confront the false reasons given by the church for her termination to future employers, when they ask her concerning the reasons for her separation from employment."

She also claimed that she was emotionally distressed because the church negligently waited until after the start of the school year to terminate her employment knowing that it would be more difficult for her to obtain subsequent employment. The church asked the court to dismiss the plaintiff's emotional distress claim because its conduct in the termination process was not unreasonable. The court denied this request.

In summary, the court permitted the plaintiff to pursue her third and fourth claims against the church. 2007 WL 2570443 (Conn. Super. 2007).

See also "Compensation," Trinity Baptist Church v. Howard, 869 N.E.2d 1225 (Ind. App. 2007), in the Legal Developments section of this website.

Legal Developments

Former Pastor Sues Church for Breach of Compensation Agreement

Have all important documents reviewed by legal counsel.

Richard R. Hammar, Attorney, CPA
Bio

Key Point 2-03. Clergy compensation consists of a number of items that often are not well understood. Clergy compensation that is unreasonable in amount may jeopardize a church's tax-exempt status or trigger "intermediate sanctions" in the form of excise taxes that can be assessed against a recipient of unreasonable compensation.

Key Point 8-22. In most states, employees who are hired for an indefinite period are considered "at will" employees. This means that the employment relationship may be terminated at will by either the employer or employee, with or without cause, and with or without notice. The courts and state legislatures have created a number of exceptions to the at will employment rule. These exceptions limit the right of an employer to terminate an at will employee. Employees who are hired for a specific term are not at will employees, and they may be terminated only if the employer has "good cause."

An Indiana court ruled that a "compensation agreement" between a church and its new senior pastor was in effect a contract of employment that was violated by the church board.

In 1994, a church hired a new pastor (the "plaintiff") to succeed a former pastor who died after 54 years of service. The plaintiff served as the pastor from 1994 through the end of 1996 without a written contract of compensation. At the end of 1996, the church board adopted an agreement governing "the full and complete terms and agreement for the employment compensation of [the plaintiff]."

In 2001, the church board terminated the plaintiff's employment after a no confidence vote by the church's membership. The plaintiff sued the church, claiming that the termination of his employment constituted a breach of the compensation agreement. A jury ruled in favor of the plaintiff and awarded him $205,000 in damages.

On appeal, the church made two arguments. First, the agreement between the board and plaintiff was a compensation agreement, not an agreement for employment, and therefore the church could not be liable for wrongful termination of employment. Second, the church argued that even if the compensation agreement was an employment agreement, it specified an indefinite term of employment and therefore should be interpreted as establishing an employment at will relationship. The church noted that an employee at will may be terminated for any reason or no reason at all.

Was the compensation agreement an employment contract?

In responding to the church's first argument the court noted that "the words or labels of a contract are not conclusive but should be considered in connection with the provisions of the contract." In this case, the agreement was entitled "Compensation for Pastoral Services" between the church and plaintiff. The agreement provided in Article I ("Introduction") that it contained the "full and complete terms and agreement for [the plaintiff's] employment compensation" and that his compensation could be "terminated … with a 60 day notice." The agreement also specified that "employment shall be in accordance with the bylaws of the church." The court concluded that "it is apparent from the language of the agreement that although it is primarily a compensation agreement, it also covers terms of employment by incorporation of the church's bylaws. Thus, we cannot agree with the church's initial contention."

Employment at will?

In responding to the church's second contention, the court noted that the church bylaws stated that "the pastor is called for life and removable only by death." The church asserted that this provision was so indefinite that the relationship between the parties should be characterized as at will employment. The court disagreed: "Here, the church's bylaws, which were drafted by the church and were incorporated into the agreement … clearly state that a pastor is removable only by death. This provision is unequivocal and it negates the presumption that the plaintiff was an at will employee who could be terminated without cause."

What this means for churches

This case is important for two reasons. First, it demonstrates that agreements may have legal significance that transcends the intention of church leaders. This is one reason why it is imperative for important documents to be reviewed by legal counsel. Second, the court concluded that a church bylaw provision defining the term of employment of a senior pastor as lasting until death made the relationship definite in length, which negated the employment at will doctrine. As a result, the church could not terminate the plaintiff's employment without cause.

Note that the church board based its decision to terminate the pastor's employment on the congregation's vote of confidence which revealed a lack of support for the pastor. Presumably, under the church's bylaws, such votes did not negate the "employment until death" provision. Such inconsistencies are common in church bylaws and are one reason why such documents should periodically be reviewed by an attorney with experience working with religious organizations. Trinity Baptist Church v. Howard, 869 N.E.2d 1225 (Ind. App. 2007).

Legal Developments

Denominational Agency Employee Sues for National Origin Discrimination

Employers generally cannot be sued for discrimination based on isolated comments.

Richard R. Hammar, Attorney, CPA
Bio

Key Point 8-11. Employees and applicants for employment who believe that an employer has violated a federal civil rights law must pursue their claim according to a specific procedure. Failure to do so will result in the dismissal of their claim.

A federal court in Pennsylvania ruled that a denominational agency did not engage in unlawful "national origin" discrimination against a Romanian-born employee as a result of (1) a single comment that the employee heard another employee make about immigrant workers, and (2) a requirement that the employee have a doctor's note authorizing all future sick days.

An American citizen of Romanian birth (the "plaintiff") was employed by a denominational agency for five years in the accounting department. From the beginning of her employment, the plaintiff's superiors complained about the quality and slowness of her work.

At a meeting to address these complaints, the plaintiff alleged that two fellow employees engaged in an inappropriate conversation about immigrants after the presidential election in 2004. Specifically, she claimed that they pointed at her and said that the reason Americans do not have enough jobs is because President Bush brings immigrants to the United States.

She filed a complaint with the human resources director, who investigated the matter and assured the plaintiff that any similar comments would not be tolerated.

After four years of employment, the plaintiff was informed that she must obtain a doctor's authorization for any future sick days. This requirement was due to concerns the plaintiff's superiors had concerning the number of sick days she was taking as well as discrepancies involving the number of sick days she took and the employer's payroll records.

The plaintiff's supervisor was asked by an assistant treasurer to submit to him a draft of her annual performance evaluation for her fourth year of employment. The treasurer instructed the supervisor to include in her evaluation a summary of work-related problems. The supervisor refused to do so, and submitted an evaluation that rated the plaintiff's overall performance as "exceeds expectations."

The supervisor was cited for insubordination and removed as the plaintiff's immediate supervisor. The treasurer proceeded to complete the plaintiff's annual performance evaluation himself. He referred to her work-related problems, and downgraded her overall rating from "exceeds expectations" to "meets expectations." The treasurer continued to receive complaints about the plaintiff's performance.

In her fifth and final year of employment, the plaintiff submitted a doctor's note to her employer stating that she would be out indefinitely because of depression. She never returned to work, but remained employed until the expiration of her 12 weeks of unpaid leave under the federal Family and Medical Leave Act.

She had been warned by letter that her failure to return to work during this 12-week period would result in the termination of her employment. This letter informed the plaintiff that the employer was not required to hold her job open, and provided her with the names and telephone numbers of contact persons with whom she could discuss her options. She did not contact anyone.

She later sued her former employer for discriminating against her on account of her national origin in violation of Title VII of the Civil Rights Act of 1964 which prohibits employers with 15 or more employees and engaged in interstate commerce from discriminating in any employment decision on the basis of a person's race, color, national origin, gender, or religion.

Hostile work environment

The court noted that "employers violate Title VII when they harass their employees so severely or pervasively that they alter the conditions of the employee's employment and create an abusive working environment." The plaintiff insisted that this occurred when she overheard the two other employees make the comment about immigrant workers taking jobs from American citizens. The court disagreed: "[The plaintiff] has failed to produce any evidence showing that the discrimination she was subjected to was severe or pervasive. The evidence only shows that one comment was ever made … which referenced Immigrants in any manner. She needs to show more than this one incident. While she has presented evidence showing that these women made other disparaging comments, such as calling her stupid, she has not shown that these comments, which are offensive and unprofessional, were motivated by her national origin. Verbal harassment, no matter how unpleasant and ill-willed, is simply not prohibited by Title VII if not motivated by the plaintiff's [national origin.] The evidence does not establish that the discrimination [the plaintiff] suffered on account of her national origin was severe or pervasive."

Doctor's authorization

The plaintiff claimed that the requirement that she obtain a doctor's authorization for any future sick leave was intended to discriminate against her because of her national origin. The court noted that to establish a case of national origin discrimination, the plaintiff had to show are that she (1) was a member of a protected class, (2) was qualified for the position in question, (3) suffered an adverse employment action, and (4) the circumstances support an inference of discrimination.

The court noted that the plaintiff proved the fi rst two elements, but failed to prove the third since there was no evidence of an adverse employment action against her based on her national origin. It noted that an adverse employment action "is an action by an employer that alters the employee's compensation, terms, conditions, or privileges of employment, deprives her of employment opportunities, or adversely affects her status as an employee."

The employer's "employee handbook" contained the following provision: "A doctor's release to return to work may be required after any illness of 3 days or more in duration. A doctor's release to return to work may be required after any illness resulting in any time missed from work. Your supervisor will notify you when a doctor's release is required for an illness less than three days in duration."

The court noted, based on this provision, that "one of the terms of [the plaintiff's] employment was that she could be required at anytime to present a doctor's note following an absence for illness. The fact that the provision was not enforced until [the employer] deemed it necessary did not effect a change in the terms of [the plaintiff's] employment. She has not shown that she suffered an adverse employment action. Other courts … have also held that the imposition of a doctor's note requirement is not an adverse employment action."

The court also concluded that the plaintiff failed to prove the fourth element (the circumstances surrounding the imposition of the requirement of a doctor's note did not give rise to an inference of discrimination). Quite the contrary, the plaintiff "was treated similarly to other employees with regard to the doctor's note requirement."

What this means for churches

This case illustrates the importance of objective employee evaluations. The plaintiff's immediate superior wanted to give the plaintiff an overall evaluation of "exceeds expectations," without any reference to her chronic absenteeism and performance problems.

This is a typical response by supervisors, since inflated evaluations are deemed preferable to the confrontation that often accompanies more candid and objective evaluations. In this case, the assistant treasurer acted properly by amending the evaluation to recount the absenteeism and performance problems, and by reducing the overall evaluation to "meets expectations."

Annual performance evaluations generally are not legally required for church employees. In fact, churches often are better off not using them at all as opposed to having evaluations that are inflated. inflated evaluations will significantly limit a church's ability to dismiss an employee who is protected by a state or federal employment discrimination law, since a strong inference arises that the "real" reason an employee with inflated evaluations is terminated is not job related, but rather due to discriminatory intent.

Second, this case demonstrates that employment discrimination claims based on a hostile working environment require proof of a level of discrimination that is both severe and pervasive, and this generally is not possible with isolated, off-hand comments. 2007 WL 2461822 (E.D. Pa. 2007).

Legal Developments

Failing to Report Compensation

Pastors who take money from their church without authorization, and fail to report it on their tax return, may be subject to criminal liability.

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Failing to Report Compensation

Pastors who take money from their church without authorization, and fail to report it on their tax return, may be subject to criminal liability.

Richard R. Hammar, J.D., LL.M., CPA

Key point. Pastors who take money from their church without authorization, and fail to report it on their tax return, may be subject to criminal liability for willfully making a false tax return. Their punishment can be “enhanced” under federal sentencing guidelines if their acts amounted to an abuse of a position of trust, or a taking of over $10,000 from an illegal source without reporting it.

* A federal appeals court affirmed the enhanced prison sentence of a pastor who failed to report on his income tax return more than $500,000 in compensation and benefits received from his church. A church hired a new pastor (Pastor James) under whose leadership the church membership grew from 500 to 2,000 people. Weekly church income grew from $7,000 to $40,000. The church provided Pastor James with compensation of $110,000. However, Pastor James chose to supplement his salary by taking money directly from the Sunday collection without reporting it on his tax returns. According to church board members, shortly after Pastor James began his employment he demanded $1,000 from the Sunday collection, a practice that he followed on most Sundays. Pastor James explained that he wanted the money as cash rather than as part of his salary in order to “avoid taxes.”

Although the congregation was not aware of Pastor James’ actions, some officials apparently knew and raised questions about the practice. The chairman of the board, for instance, questioned Pastor James about it, telling him it amounted to “stealing” and “deceiving God’s people.” Pastor James rationalized his actions by saying “I bring it in, and I take it out.” He also warned the chairman of the board not to “muzzle the ox.” When a deacon told him that his actions were wrong, Pastor James responded, “You have a lot to learn about how to take care of your pastor.” In order to cover themselves, several church officials who were aware of Pastor James’s practice made notes about the payments to him in the records of the weekly offering sheets. Pastor James instructed them to stop making the records. Despite assurances that the church would raise his salary if it was not enough, Pastor James refused such an arrangement.

In addition to the money taken from the Sunday collections, Pastor James also failed to include on his tax returns various fringe benefits, such as a Mercedes that he used for both personal and church business, making personal credit card and life insurance payments with church funds, and using the church credit card for personal expenditures. From these benefits and the weekly draws on the collection plate, the government calculated that Pastor James had additional gross income in the amount of $520,602 in the years of 1996 through 2001, resulting in a large tax deficit.

The government indicted Pastor James on five counts of willfully making and subscribing a false income tax return, and one count of failure to file an income tax return. Pastor James pleaded guilty to one count of making a false tax return for the year 1997. At the sentencing hearing, the court heard testimony and arguments regarding potential “enhancements” of the prison sentence based on abuse of a position of trust and obtaining over $10,000 in income from illegal sources without reporting it. The court imposed both enhancements. Pastor James appealed, challenging the enhancements of his sentence imposed by the trial court.

Abuse of a position of trust

Federal sentencing guidelines specify that if a defendant “abused a position of public or private trust, or used a special skill, in a manner that significantly facilitated the commission or concealment of the offense,” his or her sentence can be enhanced. The appeals court noted that for the enhancement to apply, Pastor James must have: (1) occupied a position of trust and (2) abused that position in a manner that significantly facilitated the commission or concealment of his offense. The court concluded that both requirements were met:

Here, there can be no doubt that Pastor James held a position of trust in the church and used his position to facilitate this crime. Specifically, Pastor James, who was in complete control of the church, demanded cash payments directly from the Sunday offering. The church did not authorize this; the few people who knew about the practice challenged him, but were cowed by haughty rebukes about the proper treatment of a pastor. Pastor James also attempted to thwart the members of the church who were keeping track of these payments in order to better conceal his crime. Pastor James’s tax fraud was only possible because of his [position].

The court rejected Pastor James’ argument that the enhancement of his sentence was improper because the church, whose trust he abused, was not a victim of his tax fraud because it was financially prospering under his pastoral care. The court concluded:

It is clear that the church was a victim. Pastor James claims that the offers to improve his salary by the head of the church board (while trying to talk Pastor James out of stealing from the collection plate) and the healthiness of church finances prove his point that he deserved (and thus took) more. They do not. While the church might have been willing to increase his salary, that was a decision for the church, not for him. What Pastor James committed was theft; he did not tell the church that he wanted an increased salary and had not received permission for the additional money. Nor can the overall healthiness of church finances salvage his actions. Pastor James’ argument, essentially a slightly more sophisticated version of “I bring it in, and I can take it out,” betrays a fundamental misapprehension. The funds were not his. While no doubt his skillful ministry explains to a large extent the uptick in contributions, they were contributions to the church, not to him. The church was not entitled to just a healthy cut of the increased revenues; it was entitled to all of it. Clearly, the church was a victim of Pastor James’s scheme to extract tax-free income.

Failure to report more than $10,000 in income from an illegal source

Federal sentencing guidelines also permit an enhancement in a prison sentence for a crime involving a failure to report more than $10,000 in income from an illegal source. The appeals court upheld the trial court’s enhancement of Pastor James’ sentence on this ground. It concluded: “Pastor James stole from the Sunday offerings, taking thousands of dollars without permission from the church. Moreover, he used church funds to pay his personal credit cards and life insurance, and racked up thousands more on church credit cards for personal expenditures. Pastor James contends that the government failed to show his intent to commit theft by deception, but such intent can be shown from circumstantial evidence and has been shown by the evidence here. The more than $500,000 that Pastor James took from the church during the course of his episcopacy was derived from his illegal activities, making the enhancement completely appropriate.”

The court concluded its opinion by observing that “Pastor James committed a serious crime. He abused his position while pursuing his scheme to cheat the IRS. The district court thoughtfully weighed the various considerations bearing on Pastor James’s sentence and selected a reasonable one. Therefore, we affirm the decision of the district court.”

Application. This case illustrates three important points.

First, a church employee’s failure to report compensation and taxable fringe benefits as taxable income on his or her income tax return may result in criminal liability for making a false income tax return. Section 7206(1) of the tax code specifies that “any person who willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter … shall be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 or imprisoned not more than 3 years, or both, together with the costs of prosecution.”

Second, the sentence prescribed by section 7206(1) can be “enhanced” due to several factors, including abuse of a position of trust, and obtaining over $10,000 in income from illegal sources without reporting it.

Third, Pastor James failed to report several fringe benefits as taxable income, including personal use of a church-owned Mercedes automobile, making personal credit card and life insurance payments with church funds, and using the church credit card for personal expenditures. These kinds of activities are not uncommon, and it is important for church leaders to understand the tax implications of failing to report them as taxable compensation. Chapter 4 of Richard Hammar’s 2007 Church & Clergy Tax Guide lists 22 different kinds of taxable income that are common in churches, and being familiar with this material can help to ensure that taxable benefits are being reported as taxable income.

Fourth, while the court did not address the issue, Pastor James could be assessed substantial excise taxes called “intermediate sanctions” as a result of excess benefits. Such benefits include (1) taxable benefits not reported as taxable compensation, regardless of amount, and (2) compensation and benefits reported as taxable income, if they exceed “reasonable” compensation. In either case, the recipient (if an officer or director, or relative of an officer or director) can be assessed excise taxes of up to 225% of the amount of the “excess benefit.” This significant issue is addressed fully in chapter 4 of Richard Hammar’s 2007 Church & Clergy Tax Guide. United States v. Ellis, 440 F.3d 434 (7th Cir. 2006).

Legal Developments

Performance-Based Employee Bonuses

Can this type of bonus jeopardize an organization’s tax-exempt status?

Richard R. Hammar, Attorney, CPA
Bio

Private Letter Ruling 9112006

Does a tax-exempt organization jeopardize its exempt status by paying employees a "bonus" that is based on performance?

That was the issue addressed by the IRS in a recent ruling. Churches and other organizations exempt from federal income taxes under section 501(c)(3) of the Internal Revenue Code may not pay "unreasonable compensation" to their workers. If they do, they risk losing their tax-exempt status.

The "PTL" organization lost its tax-exempt status retroactively to 1984 on the basis of unreasonable compensation paid to three of its top employees. What about employer bonuses that reward employees for outstanding achievement? Do they jeopardize an exempt organization's tax-exempt status?

The case before the IRS involved a nonprofit hospital that proposed to pay bonuses to its employees. The hospital created a "funding pool" out of which the bonuses were paid. This pool did not ordinarily exceed 2-3% of the hospital's payroll. Half of the pool was distributed to all employees based on the hospital's overall performance, and the other half was distributed to the employees of individual departments that exceeded specific goals. These limitations ensured that the bonus available to any one employee ordinarily was modest.

Further, the hospital had its independent auditors (a CPA firm) review compensation of the higher-paid employees (physicians and executives) to ensure that no one received more than reasonable compensation. The independent auditors surveyed 18 of the largest hospitals in the country to determine the reasonableness of compensation paid to physicians and executives. The auditors also used their own experience as a national accounting firm to make this decision.

In evaluating the reasonableness of compensation, the auditors took into account the performance bonuses, as well as all other forms of compensation. If a bonus would increase a particular employee's total compensation to a level that the auditors deem to be unreasonable, then the bonus is not paid.

In concluding that this arrangement did not jeopardize the hospital's tax-exempt status, the IRS observed:

The information submitted indicates the participation of all employees, the development of multi-level standards for increased productivity and cost efficiency, as well as for the quality of health care provided, the various levels of independent review, the operation of a quality assurance program, the relatedness of the plan's employee distribution to the services performed, the review of the total compensation paid by independent auditors of incentive payments, and the limitations established to safeguard against possible abuses, all as described above and in the case file, should not produce distributions to your employees that are in excess of reasonable compensation for the services performed …. Accordingly, based on the information submitted, we conclude that your proposed incentive compensation plan will not adversely affect your tax-exempt status under section 501(c)(3) of the Code. However, this ruling is based on the understanding that all payments under your incentive pay plan remain within the range of reasonable compensation for employees covered.

This ruling is of interest to churches and religious organizations that pay above-average compensation to clergy and church executives. It is our position that any church or religious organization paying total annual compensation of $100,000 or more to any individual should obtain a written opinion from a tax attorney or CPA that the amount of compensation is not unreasonable. Compensation includes not only salary, but also housing allowances, business expense reimbursements under a nonaccountable plan, taxable fringe benefits, personal use of an employer-owned vehicle, and various other items.

The recent IRS ruling indicates that a charity can reduce the risk of jeopardizing its tax-exempt status by having an annual review of compensation by a tax attorney or CPA firm. An evaluation of the reasonableness of compensation will involve several considerations, including a comparison of what other similarly situated clergy and executives are earning in related organizations.

Churches and religious organizations should bear in mind that an IRS finding of unreasonable compensation may result in loss of tax-exempt status. This would have a variety of negative consequences, including the following: (1) the church's net income would be subject to federal (and possibly state) income taxation; (2) donors no longer could deduct contributions to the church; (3) ineligibility to establish "403(b)" tax-sheltered annuities; (4) possible loss of property and sales tax exemptions; (5) loss of preferential mailing rates; (6) possible loss of a housing allowance exclusion for ministers serving the church; (7) possible inapplicability of a minister's exemption from social security taxes to compensation received from the church; and (8) clergy compensation might not be exempt from federal income tax withholding.

Clearly, any activity that jeopardizes a church's exemption from federal income taxation, and correspondingly the benefits summarized above, is a matter that must be taken very seriously.

Legal Developments

Medical Insurance Premiums as Taxable Compensation

The IRS recently ruled on this issue.

Richard R. Hammar, Attorney, CPA
Bio

The IRS ruled that workers receive taxable compensation if they can choose to have their employer pay their medical insurance premiums or receive an equivalent amount in cash.

An employer adopted a group health program for its employees and paid employee medical insurance premiums directly to the insurance company. Employees who chose not to participate in the program were given cash in the amount of the premiums that the employer would have paid.

The IRS noted that section 106 of the Internal Revenue Code permits employees to exclude from their income taxes the amount of health insurance premiums paid by their employer. The IRS further acknowledged that it ruled in 1961 that employees who pay their own health insurance premiums directly to an insurance company and are reimbursed by their employer for the amount of the premiums do not have to report this amount as income for tax purposes so long as the employer requires proof that the insurance coverage exists and that the employee in fact paid the premium.

However, the IRS ruled in 1975 that monies paid by an employer to an employee to purchase health insurance were includable in the employee's taxable income since the employer did not verify that the employee in fact used the monies to pay health insurance premiums.

The 1975 ruling was based on the "constructive receipt" doctrine, under which a taxpayer will be taxed on income that is "constructively" received. The income tax regulations specify that "income, although not actually reduced to the taxpayer's possession, is constructively received in the taxable year during which it is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time, or so that the taxpayer could have drawn upon it during the taxable year if notice of intention to withdraw had been given."

The IRS concluded that the constructive receipt principle requires an employee to report as taxable income amounts paid by an employer that the employee can receive as a cash benefit or as a medical insurance premium reimbursement, at the employee's option.

It does not matter that employees in fact use the money to pay health insurance premiums, since they have the right to treat it as a cash benefit. This is all that is required to create taxable income under the constructive receipt rule.

The IRS further noted that "if health insurance is purchased [with the employer payments], the premium amount is considered an employee contribution out of salary rather than a contribution by the employer within the scope of section 106." Private Letter Ruling 9022060.

Legal Developments

Pension Funds and Bankruptcy

Can a bankrupt minister protect his pension funds?

Richard R. Hammar, Attorney, CPA
Bio

Can a minister who files for bankruptcy protect his pension funds from bankruptcy creditors?

That was the issue before a federal bankruptcy court in an important ruling. A 56-year-old minister declared bankruptcy, and both he and his denominational pension board sought to protect his pension funds from the reach of creditors in the bankruptcy proceeding.

The pension plan is funded by a combination of member and congregation contributions. The plan provides that the minister shall contribute 3% of his salary and the congregation which employs him shall contribute 8% of the member's salary.

Both the member and the congregation may make additional optional contributions, which are to be allocated as member or congregation contributions, respectively. When a member attains the age of 60 years or completes 40 years of service, the combined accumulation of the member and congregation contributions is applied to purchase a retirement annuity for the member.

The plan provides that if a member becomes ineligible under the plan before the age of retirement or 40 years of service, he may elect to withdraw part or all of the accumulated member contributions. The amount remaining in the member's account will be fully vested in the member and will continue to draw interest until it can be applied toward an annuity or death benefit as provided in the plan.

The member accumulation that may be withdrawn consists solely of member contributions and does not include interest on those amounts. The pension board conceded that the debtor could become eligible to withdraw the accumulated member contributions under the plan by the act of resigning his ordination as a minister.

The current balance in the pension fund is $51,273.35, and the total member contribution, which is the amount the debtor actually contributed to the plan, is $6,848.10. The pension board argued that the entire pension was beyond the reach of the bankruptcy court, or, if this argument lost, that only those funds contributed by the minister himself (and not the congregations) could be reached by the court.

The pension board noted that, under a clause prohibiting alienation or assignment of an interest in the plan, the plan assets could neither be levied upon by creditors nor transferred by the debtor. The board did not dispute the court's characterization of the minister's personal contributions as "voluntary," but asserted that since the minister has no present right to withdraw the member accumulation portion of the plan, neither should the court be able to reach the minister's interest for the benefit of creditors.

The court concluded that the minister's own contributions to the plan were reachable by the bankruptcy creditors, but not the contributions made by congregations to the plan. It emphasized that "the scope of the bankruptcy estate under the Bankruptcy Code is quite broad and consists of 'all legal or equitable interests of the debtor in property as of the commencement of the case.'

In general, property becomes part of the debtor's estate regardless of any restrictions which may have been placed on its transfer." However, there is an important exception to this rule—a minister's pension account is not reachable by bankruptcy creditors if the plan prohibits transfers to creditors (or anyone else) in a way that satisfies the definition of a "spendthrift trust" under state law. A spendthrift trust is a trust that is created for the benefit of a particular beneficiary by a person who does not want the beneficiary to have any control or access to the trust funds. It ordinarily is designed to protect a beneficiary "from his own improvidence or incapacity."

The court noted that "traditionally, there are three requirements for a spendthrift trust: (1) the settlor [i.e., the person who creates the trust] may not be a beneficiary of the trust plan, (2) the trust must contain a clause barring any beneficiary from voluntarily or involuntarily transferring his interest in the trust, and (3) the debtor-beneficiary must have no present dominion or control over the trust corpus." The court emphasized that "the beneficiary's inability to gain access to or demand distribution from the trust corpus is the primary element of a spendthrift trust."

The court concluded that the minister, at the time of filing bankruptcy,

"had the ability to withdraw the member accumulation portion of his pension assets by the act of resigning his ordination as a minister …. In a true spendthrift trust, a beneficiary can take no action to initiate an early termination of the trust or invasion of the trust corpus. A right to control distribution from trust funds is inimical to the purpose of a spendthrift trust, which is to provide for the maintenance of another while protecting the beneficiary from his own improvidence or incapacity. Because the [minister] could access the entire amount of his member contributions by the voluntary act of resigning his ordination as a minister, he has effective dominion and control over these assets sufficient to disqualify this portion of the plan as a spendthrift trust."

The court concluded that "the plan fails as a spendthrift trust to the extent that the [minister] can compel a premature distribution of plan assets, as this is contrary to the purpose and requirements of a spendthrift trust."

However, the court concluded that the congregational contributions to the minister's pension fund were not accessible to the bankruptcy creditors, since this aspect of the plan satisfied the requirements of a spendthrift trust.

The court observed:

"Under the terms of the plan, the [minister] could withdraw only the member contribution portion resigning his ordination at this time. The amount remaining the pension plan is shielded from his dominion and control thus retains its character as a spendthrift trust. Disqualification of a portion of a plan as a spendthrift does not bring the [minister's] entire interest, including funds to which he has no rights of withdrawal, into property the estate. The funds to which the [minister] has no right of withdrawal satisfy traditional spendthrift requirements [and are excluded from the reach of bankruptcy creditors]."

The court stressed that as to the congregational contributions to the pension fund, the plan "contains an absolute restriction on alienation or assignment of plan benefits, and there is no question … regarding the sufficiency of the plan's anti-alienation clause." This case provides important insight into the ability of creditors to access clergy pension funds. It should be reviewed carefully by both ministers and denominational pension boards. Tomer v. Board of Pensions of the Church of God, 117 B.R. 391 (S.D. Ill. 1990).

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