Minister Fined After Failing to Pay $25K in Income Tax

US Tax Court tosses minister’s ‘frivolous’ argument for underreporting tens of thousands of dollars in W-2 income, levies fine under section 6673 of Tax Code.

Richard R. Hammar, Attorney, CPA

Bio

State: Federal
Categories: Income Taxes - Clergy, Payroll Tax Reporting

A minister’s federal tax return (Form 1040) was selected for examination by the IRS. The IRS determined that the minister had underreported his taxes by $24,884. The case was appealed to the Tax Court, which affirmed the IRS determination.

A frivolous argument

The minister’s tax return failed to report any wage income despite his church issuing a Form W-2 reporting $63,652 in compensation for his ministerial services.

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The minister argued he was not an employee, meaning his compensation was not taxable. The court observed, “The courts uniformly have rejected as frivolous the argument that money received in compensation for labor is not taxable income.”

The court noted that the church paid the minister as part of his compensation what were deemed “offsets” of the Social Security and Medicare taxes for which the minister was responsible.

It observed:

Because the minister’s compensation was not subject to the withholding and payment of such taxes by the church, the payments made by the church to [the minister] as “offsets” of his taxable income remain includible in his gross income. “To the extent that the church pays any amount toward the minister’s obligation for income tax or self-employment tax other than from the minister’s salary, the minister is in receipt of additional income that is includible in his gross income and must be considered in determining his income tax and self-employment tax liability.” (Quoting Rev. Rul. 68-507, 1968-2 C.B. 485.)

Ministers’ wages subject to self-employment tax

The Tax Court agreed with the IRS’s conclusion that the minister owed additional self-employment taxes:

[The minister] has also failed to carry his burden of showing that [the IRS’s] determination of additional self-employment tax was erroneous. Individuals are subject to tax under section 1401 [of the tax code] on their net earnings from self-employment, which is defined as the net income from any trade or business carried on by the individual. Section 3401(a)(9) provides that compensation for services paid to a “duly ordained, commissioned or licensed minister of a church” (church minister) is not wages for purposes of employment taxes and thus not subject to withholding and payment by a church employer. See Section 3402(a); see also Section 3121(b)(8).

In another case out of Florida, the IRS flexed its lien power on a minister who owed more than $7 million in unpaid taxes. Read about what the case means for churches and pastors here.

Instead, the provision of services by a church minister generally constitutes a trade or business, and a church minister’s wages are subject to self-employment tax. Section 1402(c)(4); see also Knight v. Commissioner, 92 T.C. 199, 201-202 (1989). While a church minister is permitted to submit a certificate seeking exemption from self-employment tax on religious or conscientious grounds, see section 1402(e), [the minister] has not alleged — nor does the record indicate — that he timely did so . …

[The minister] performed the duties and functions of a minister in his role at the church, which included leading worship services and ministering to members. … [He] received wages as compensation for those services. Due to his status as a minister under section 1402, the church did not withhold employment taxes from his compensation, which was properly subject to self-employment tax. We hold that the minister has failed to demonstrate that the IRS’s determination of self-employment tax was erroneous.

Section 6673 of the tax code authorizes the Tax Court, on its own initiative, to impose a penalty not in excess of $25,000 when it appears that (1) the proceedings have been instituted or maintained primarily for delay or (2) the taxpayer’s position in such proceeding is frivolous or groundless. A position maintained by the taxpayer is “frivolous” where it is “contrary to established law and unsupported by a reasoned, colorable argument for change in the law.” (Quoting Coleman v. Commissioner, 791 F.2d 68 (7th Cir. 1986)).

Here, the court noted the minister “contended that he is a ‘worker of common right and a nontaxpayer’ and thus ‘not subject to the jurisdiction of revenue law because of his occupation.’” The court found the argument frivolous, and despite warnings from the court, the minister continued to advance them. The court fined the minister $2,500 under section 6673.

What this means for churches

First, wages paid to employees for services rendered constitute taxable income and must be so reported by both the employer and employee.

The argument that ministers are not employees of their church and so their church compensation is not taxable is regarded as frivolous and can result in substantial penalties for both the employer and employee.

Second, as this case illustrates, churches often assist ministers with payment of self-employment taxes. The reasoning typically is that the church pays half of the Federal Insurance Contributions Act (FICA) taxes of non-minister employees, and so, as a matter of simple equity, the church should pay some portion of its minister’s self-employment taxes (Self-Employed Contributions Act (SECA)) which otherwise would be paid entirely by the minister. But note that any portion so paid by the church represents taxable income to the minister in computing both income taxes and self-employment taxes.

Third, section 6673 of the tax code authorizes the Tax Court to impose a penalty not in excess of $25,000 when it appears that (1) the proceedings have been instituted or maintained primarily for delay or (2) the taxpayer’s position in such proceeding is frivolous or groundless.

Van Pelt v. Commissioner, 2021 U.S. Tax Ct. LEXIS 69 (2021).

Legal Developments

IRS Wins Ruling Against Church for Misclassifying Employees

Tax Court says the tax-collection agency acted properly in assessing penalties against a church.

Richard R. Hammar, Attorney, CPA

Bio

State: Federal
Categories: Payroll Tax Reporting

Key point. The tax code imposes penalties on employers, including churches, that fail to issue information returns (i.e., W-2, 1099) to employees and contractors, and these penalties are significantly increased if the failure is willful.

The United States Tax Court ruled that the Internal Revenue Service acted properly in assessing penalties against a church for intentionally refusing to issue W-2 forms to its employees.

Section 6721(a) of the tax code imposes a penalty on employers for failure to file correct W-2 and other information returns. This penalty applies when an employer required to file an information return neglects to file it on time or fails to include within all information required to be shown. For the tax years involved in this case the penalty was $100 for each return with respect to which such failure occurred. However, if an employer intentionally disregards the filing requirement for Form W-2 and other information returns, the penalty significantly increases.

The IRS determined that a church with several full- and part-time employees had failed, for 2010 and 2011, to provide the Social Security Administration (SSA) with Forms W-2 for these workers. The IRS sent the church a notice of penalty (a “CP215 Notice”) for each year, informing the church of this discrepancy, requesting further information, and notifying the church that it risked penalties under section 6721.

Having received no response, the IRS, on December 2, 2013, assessed $5,942 of section 6721 penalties against the church for 2010. On November 3, 2014, the IRS assessed $6,354 of section 6721 penalties against the church for 2011. In an effort to collect these unpaid liabilities, the IRS sent the church a “Final Notice of Intent to Levy and Notice of Your Right to a Hearing.” This notice informed the church that its unpaid liabilities, including accrued interest, then totaled $12,840. The notice stated: “If you wish to request an Appeals hearing, complete the enclosed Form 12153, Request for a Collection Due Process or Equivalent Hearing, and send it to us within 30 days from this letter’s date.”

An IRS agent hand delivered the notice to the church during a field visit on September 10, 2015. The church took no action in response to the levy notice and did not request an appeals office hearing. A few months later the IRS sent the church a notice of “Federal Tax Lien Filing and Your Right to a Hearing.” The church requested a hearing in response to this notice. The IRS Appeals Office acknowledged receipt of the church’s hearing request, explaining that if it wished to pursue a collection alternative, it would need to submit Form 433-B, Collection Information Statement, with supporting financial information. The scheduling of a CDP hearing was delayed while the church sought assistance from the IRS Taxpayer Advocate Service. An IRS settlement officer eventually held a telephone hearing with the church on December 1, 2016.

During the hearing, the settlement officer explained that the church could not challenge its underlying liability for the penalties because it had failed to take advantage of a prior opportunity to dispute the penalties in response to the levy notice. In any event, the settlement officer stated that the church had not supplied adequate documentation to justify abatement of the penalties. The settlement officer explained that the church did not qualify for a collection alternative because: (1) it had not proposed a collection alternative; (2) it had not submitted Form 433-B or the financial information required for consideration of a collection alternative; and (3) it was not in current compliance with its tax-filing obligations, having neglected to file Form 941, Employer’s Quarterly Federal Tax Return.

The settlement officer reviewed the administrative file and concluded that the penalties had been properly assessed and that all requirements of law and administrative procedure had been satisfied. He determined that the church had submitted no information that would entitle it to withdrawal of the levy notice or penalties. The settlement officer concluded that the penalties had been properly assessed and that all requirements of law and administrative procedure had been satisfied. It determined that the church had submitted no information that would entitle it to a reduction in the penalty. The church appealed to the Tax Court.

The Tax Court noted that the tax regulations stipulate that if a taxpayer had a prior opportunity to dispute the existence or amount of an underlying tax liability, it cannot challenge the underlying liability when it receives a second notice from the IRS. Therefore, the only remaining basis for the church’s appeal was the contention that the IRS settlement officer’s acts constituted an abuse of discretion. Abuse of discretion exists “when a determination is arbitrary, capricious, or without sound basis in fact or law.” The court reviewed the settlement officer’s actions, and determined that the church had failed to meet the high standard of proving that he had acted with an abuse of discretion.

What this means for churches

The penalties addressed in this case for failing to issue information returns (i.e., W-2 or 1099-NEC) to employees and contractors have increased. The current penalties are as follows:

A penalty of $270 for each information return not issued by the due date.

A penalty of $270 for each information return that fails to include all the information required to be reported.

In either case, the penalty is reduced to $50 per return if corrected within 30 days of the required filing date ($110 if corrected before August 1).

The penalty is increased to $550 per return in cases of intentional disregard of the filing requirement. In some cases, this penalty may be increased.

Baptist Church v. Commissioner of Internal Revenue, T.C. Summ.Op. 2018-3.

Legal Developments

Church Responsible for Payroll Taxes

Pastor deemed responsible for total amount of delinquent payroll taxes.

Richard R. Hammar, Attorney, CPA

Bio

State: North Carolina
Categories: Payroll Tax Reporting

Church Law & Tax Report

Church Responsible for Payroll Taxes

Pastor deemed responsible for total amount of delinquent payroll taxes.

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

Key point. Federal law requires churches to comply with several payroll tax reporting obligations. Almost every church will be subject to at least some of these rules. Many states have similar provisions. Church leaders must take these rules seriously, since penalties are assessed for noncompliance. For example, church officers may be personally liable for a penalty equal to the amount of payroll taxes that are not withheld or deposited. It is essential for church leaders to understand these rules.

A federal district court in North Carolina ruled that a pastor was responsible for 100 percent of payroll taxes that her employing church failed to withhold or pay over to the government. A pastor filed for bankruptcy protection from her creditors. The IRS filed a claim for $88,000 with the bankruptcy court based on its assertion that the pastor was liable for $88,000 in unpaid payroll tax obligations of her church since she was a “responsible person” liable for unpaid payroll tax obligations. The pastor asked the court to reject the IRS claim on the grounds that she was not a “responsible person,” and that any recognition of the IRS claim was barred by the First Amendment’s guaranty of religious freedom. The bankruptcy court rejected the pastor’s defenses, and the case was appealed to a federal district court.

The court began its opinion by noting that “federal law requires employers to withhold federal income taxes and Social Security taxes from employee wages and remit those taxes to the United States. The employer holds these taxes in trust for the United States.” And, although the employer “remains liable for the unpaid payroll taxes, its officers and agents may incur personal liability for the unpaid payroll taxes.” Section 6672 of the tax code states:

Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall … be liable to a penalty equal to the total amount of tax evaded, or not collected, or not accounted for and paid over.

In order for an individual to be held personally liable under this section: “(1) the party assessed must be a person required to collect, truthfully account for, and pay over the tax, referred to as a ‘responsible person’; and (2) the responsible person must have willfully failed to insure that the withholding taxes were paid.”

responsible person

The court noted that the question of who within an organization is a “responsible person” required to collect and pay the payroll taxes to the United States, is a “pragmatic, substance-over-form inquiry into whether an officer or employee so participated in decisions concerning payment of creditors and disbursement of funds that he effectively had the authority—and hence a duty—to ensure payment of the corporation’s payroll taxes.” In other words, the “crucial inquiry is whether the person had the effective power to pay the taxes—that is, whether he had the actual authority or ability, in view of his status within the corporation, to pay the taxes owed.”

When making the determination of who is a “responsible person,” courts have considered several factors which are indicative of this authority, including whether the employee:

(1) served as an officer of the company or as a member of its board of directors; (2) controlled the company’s payroll; (3) determined which creditors to pay and when to pay them; (4) participated in the day-to-day management of the corporation; (5) possessed the power to write checks; and (6) had the ability to hire and fire employees. No single factor is controlling or dispositive in the responsible person inquiry.

The bankruptcy court concluded, and the district court agreed, that the pastor was a responsible person. In support of this conclusion, both courts referenced the bylaws of the pastor’s church, which specify that the pastor shall act “as CEO over all spiritual and business matters.” Additionally, the bylaws provide that the pastor shall be the “Chief Executive Officer of the said organization and shall be a continuing member of all boards and committees.” The pastor “shall be an ex-officio member of all standing committees, and shall have the general powers and duties of supervision and management usually vested in the office of president of a corporation.”

freedom of religion

The pastor argued that the courts were barred by the First Amendment guaranty of religious freedom from making a determination regarding “responsible person” status on the basis of a church’s bylaws. The court acknowledged that “the civil courts are obliged to play a limited role at times in resolving church disputes, the limited role being premised on First Amendment principles that preclude a court from deciding issues of religious doctrine and practice, or from interfering with internal church government. First Amendment values are jeopardized when church litigation turns on the resolution by civil courts of controversies over religious doctrine and practice.” However, the court concluded that the pastor “has not shown how mere citation of the bylaws in the bankruptcy court’s order is a challenge to the ecclesiastical decisions or religious customs of the church in violation of the [First Amendment]. In its most favorable light, the pastor asks the court to make the logical leap to hold that the mere citation of the church bylaws as part of the responsible person analysis under section 6672 is prohibited by the First Amendment. The case law, while limited in this specific context, does not appear to support this argument.”

The court also stressed that the bankruptcy court’s analysis of the church bylaws

was limited to a few paragraphs …. The bankruptcy court noted that the bylaws provide that the pastor shall be the CEO and a member of all boards and committees and … shall execute in the name of the church all deeds, bonds, mortgages, contracts and other documents, and have the powers and duties of supervision and management usually vested in the office of president of a corporation ….

The bankruptcy court interpreted the bylaws as authorizing the pastor to have decision making authority and supervision over business matters. The pastor argues that this interpretation now forces her to concern herself with secular affairs. Putting aside the fact that the plain language of the bylaws suggests that the pastor does concern herself with such affairs, the bankruptcy court did not base its decision on the bylaws alone. Contrarily, close examination of the bankruptcy court’s order reveals that it placed great emphasis on what the pastor actually did as the church’s pastor, including co-signing a $178,000.00 construction loan, disbursing and withholding payments to vendors and staff, signing a corporate resolution authorizing a bank account which authorized her to sign checks on behalf of the church, and hiring and firing employees.

Appellants do not contest the bankruptcy court’s consideration of (the pastor’s) actions, nor do they contest the documentary evidence showing that she was a responsible person with authority, a person required to collect, truthfully account for, and pay over GTI’s taxes. While appellants argue that the bankruptcy court impermissibly interpreted the GTI bylaws in such a way as to infringe upon appellants’ First Amendment rights, the court finds no support in the case law that the bankruptcy court’s findings or analysis did anything of the kind. As set forth above, appellants’ First Amendment argument is not supported by the case law appellants cite, especially in light of the bankruptcy court’s consideration of several other significant factors in its analysis finding (the pastor) to be a responsible person.

What This Means For Churches:

Section 6672 contains no exemption for church officers or employees. As a result, any church officer or employee having the authority to pay withheld taxes to the government, is potentially liable for 100 percent of the taxes owed if the church for any reason fails to withhold or pay them. The court enumerated several functions of the pastor that made her a “responsible person” liable for the unpaid payroll taxes. In addition, the court ruled that the First Amendment guaranty of religious freedom is not violated if a court examines a church’s bylaws to determine if a pastor, or other church employee, is a “responsible person.” Vaughn v. Internal Revenue Service, 2012-2 U.S.T.C. ¶50,487, (E.D.N.C. 2012).

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

State: Federal
Categories: Compensation and Benefits, Income Taxes - Clergy, Payroll Tax Reporting

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

Tax Freedom Day

Administration

Richard R. Hammar, Attorney, CPA

Bio

State: Federal
Categories: Payroll Tax Reporting

Tax freedom day is the day on which taxpayers stop working to pay federal, state, and local taxes and begin working for themselves. Tax freedom day was May 4 in 1987, April 28 in 1970, and February 13 in 1930.

Legal Developments

The Omnibus Budget Reconciliation Bill of 1987

Provisions of interest to churches and clergy

Richard R. Hammar, Attorney, CPA

Bio

On October 29, 1987, the House of Representatives passed the Omnibus Budget Reconciliation Bill of 1987 (H.R. 3545).

Provisions of interest to churches and clergy include the following:

(1) repeal of the motor fuels and tires excise tax exemptions for buses owned and operated by churches and other nonprofit organizations;

(2) the IRS will begin charging fees for some of its services, including $320 for each exempt organization ruling and $200 for each exempt organization determination;

(3) delays until 1988 the provision in the Tax Reform Act of 1986 requiring taxpayers (including many clergy) who use the estimated tax procedure to pay at least 90% of their current year's taxes in their quarterly estimated tax payments;

(4) employers (including churches) must give effect to replacement withholding allowance certificates (W-4 or W-4A) no later than the start of the first payroll period ending on or after the 30th day after the day on which the employee furnishes the certificate to the employer;

(5) a tax-exempt organization that filed an application for exemption (Form 1023) with the IRS must make available for inspection a copy of the application (including all supporting documentation) at its principal office to any individual during regular office hours; further, if the exempt organization maintains one or more regional or district offices having three or more employees, the required material similarly must be made available for public inspection at each such regional or district office;

(6) the House Ways and Means Committee urged the IRS to monitor the extent to which taxpayers are being properly advised by charitable organizations that their contributions are deductible only to the extent that they exceed the fair market value of any benefits or premiums received in exchange (e.g., if a religious radio program promises to send donors a book in exchange for a suggested donation, the donation is deductible only to the extent that it exceeds the fair market value of the book);

(7) charitable organizations must make available for public inspection during regular business hours their three most recent annual information returns (Form 990); a copy of the annual information return must also be kept at any regional or district office employing three or more persons; however, if a national religious denomination files annual information returns, copies of the return are not required to be made available at local churches since churches would not constitute offices of the national denomination;

(8) various changes have been made in the application for tax exemption (Form 1023), which pertain to information regarding predecessor and affiliated organizations;

(9) a provision in the bill clarifies that tax-exempt organizations will lose their exempt status by participating or intervening in any political campaign in opposition to as well as in support of any candidate for public office;

(10) tax-exempt organizations' distributive share of income from any publicly traded limited partnership is treated as unrelated business taxable income;

(11) benefits payable under certain church self-insured death benefit plans would be excludable from income;

(12) the restrictive rules that now apply to "eligible deferred compensation plans" of tax-exempt organizations (under revised Code section 457) would not extend to "nonelective" deferred compensation plans.

Source: CLTR January/February 1988

Legal Developments

Coverage of Church Employees Under the Social Security (FICA) System

There are three important developments to report concerning the coverage of church employees under the

Richard R. Hammar, Attorney, CPA

Bio

State: Pennsylvania
Categories: Payroll Tax Reporting, Tax Exemption

There are three important developments to report concerning the coverage of church employees under the Social Security (FICA) system:

1. A federal appeals court recently rejected the contention of a local church that the current treatment of churches and church employees under the Social Security program amounts to a violation of the constitutional guaranty of religious freedom.

Here are the facts. In 1983, Congress amended the Internal Revenue Code to make church employees subject, for the first time, to mandatory Social Security (FICA) taxation effective January 1, 1984. Congress later partially restored the previous exemption (retroactive to January 1, 1984) for any church that (1) was opposed for religious reasons to the payment of the employer's share of FICA taxes, and (2) irrevocably elected to exempt itself from Social Security taxation by filing a Form 8274 with the IRS no later than the day prior to the due date of the first employer's quarterly tax report (IRS Form 941) that the church was required to file after July 17, 1984. For churches with nonminister employees as of July 17, 1984, Form 8274 was due not later than October 30, 1984.

A timely election relieves a church of the obligation to pay the employer's share of FICA taxes (7.15% of employee wages in 1987), and relieves each nonminister employee of the obligation to pay the employee's share of FICA taxes (an additional 7.15% of wages in 1987). However, the employee is not relieved of all Social Security tax liability. On the contrary, the nonminister employees of an electing church are required to report and pay their Social Security taxes as self-employed individuals (the "self-employment tax"). And, this tax is significantly greater than the employee's share of FICA taxes. In 1987, for example, the self-employment tax rate is 12.3% of earnings. Therefore, a church employee receiving a salary of $10,000 in 1987 would pay $715 in FICA taxes if his or her church did not file an election on Form 8274 (the church would pay an additional $715). However, if the church filed the election to exempt itself from FICA taxes, the following consequences occur: (1) the church pays no FICA tax; (2) the employee pays no FICA tax; and (3) the employee must report and pay a self-employment tax liability of $1,230.

Many churches and church employees consider this situation unfair. Churches are free to exempt themselves from Social Security taxes, but only at the cost of significantly increasing the tax liability of their employees. In response, many electing churches have increased the salary of their employees to compensate for the increase in taxes. Of course, this leaves the church in essentially the same position as if it had not elected to be exempt—it in effect is paying Social Security taxes "indirectly."

This dilemma, argued a Baptist church in Pennsylvania, unconstitutionally restricts the religious freedom of churches by forcing them (contrary to their religious convictions) to divert church resources away from religious and charitable functions in order to increase employee compensation (and thereby "indirectly" pay the Social Security tax).

A federal appeals court rejected this contention. The court based its ruling on a 1982 Supreme Court decision that upheld the imposition of the Social Security tax to employees of Amish farmers though this directly violated the farmers' religious beliefs. The Supreme Court had observed that "tax systems could not function if denominations were allowed to challenge the tax systems because tax payments were spent in a manner that violates their religious belief." It concluded that the broad public interest in the maintenance of the federal tax systems was of such a high order that religious belief in conflict with the payment of the taxes provides no constitutional basis for resisting them. The appeals court found this precedent controlling in resolving the challenge to Social Security coverage of church employees.

The appeals court also rejected the church's argument that the taxation of church employees violates the first amendment's nonestablishment of religion clause by creating an "excessive entanglement" between church and state. It also rejected the claim that the Internal Revenue Code was impermissibly discriminatory in granting clergy an exemption from Social Security coverage but not churches or church employees. Bethel Baptist Church v. United States, 822 F.2d 1334 (3rd Cir. 1987).

2. The Tax Reform Act of 1986 permits churches that have elected to exempt themselves from the employer's share of FICA taxes by filing a timely Form 8274 to revoke their exemption.

However, the Act did not specify how churches could revoke their exemption. Temporary regulations recently issued by the Treasury Department provide that churches can revoke their exemption (starting with any calendar quarter after December 31, 1986) by filing a Form 941 (employer's quarterly tax return) accompanied by full payment of Social Security taxes for that quarter. To illustrate, if a church with three employees elects in November of 1987 to revoke its previous election to be exempt from Social Security taxes, it should simply submit a Form 941 on or by January 31, 1988 (the deadline for filing a Form 941 for the fourth calendar quarter) along with the applicable FICA taxes for that quarter. Thereafter, the deposit rules described in the "Tax Calendar" feature of this newsletter will apply. Of course, if a church revokes its exemption, nonminister employees are no longer treated as self-employed for Social Security purposes, and accordingly should no longer file quarterly estimated tax payments (their FICA taxes will be withheld from their wages).

3. A number of churches having nonminister employees (e.g., an office secretary) apparently do not know whether or not they have elected to exempt themselves from the employer's share of Social Security (FICA) taxes by filing a timely Form 8274.

Churches having nonminister employees as of July of 1984 had until October 30, 1984 to file the election. Churches not having nonminister employees in July of 1984 have until the day before the due date of their first quarterly employer's tax report (Form 941) to file the election. Ordinarily, this form is not required until a church hires a nonminister employee. The due dates for Form 941 are the last day of the month following the end of each calendar quarter (i.e., April 30, July 31, September 30, and January 31). Churches that filed a timely election but that nevertheless paid all employment taxes due from the effective date of their election through December 31, 1986 (a fairly common practice by churches that could not remember if they ever filed the election) are treated as if they never filed the election. Internal Revenue News Release IR-87-94.

Source:Church Law & Tax Report, September-October 1987