Lost Receipts Cost Pastor, Wife Almost $37,000 in Unreimbursed Business Expenses

Although a pastor and his wife sought large deductions for unreimbursed business expenses, the IRS denied them after a through examination.

 

Key point. The Tax Cuts and Jobs Act of 2017 suspended from 2018 through 2025 a tax deduction for unreimbursed employee business expenses. It also suspended all other miscellaneous itemized deductions that were subject to the two-percent floor under prior law. 

While no itemized deduction is allowed from 2018 through 2025 for unreimbursed employee business expenses, this case remains relevant for the following reasons: (1) calculating business expenses that are reimbursable under an accountable reimbursement arrangement (and the effectiveness and conveniences offered by one); (2) calculating  the business expenses reported by self-employed persons on Schedule C (Form 1040); and (3) computing unreimbursed and nonaccountable reimbursed expenses incurred after 2025. 

The Internal Revenue Service (IRS) disallowed a couple’s tax deduction of $36,510 for unreimbursed employee expenses for lack of receipts supporting those expenses, instead allowing a deduction of only $877.86. 

Hop down for details on the couple’s tax returns and IRS examination.

Skip ahead to learn about “heightened substantiation requirements.”

Jump to the end to read what this case means for churches.

A new job causes financial strain

A husband and wife lived in Oklahoma from the beginning of 2014 until August 2014. The husband was pastor of a church. His wife sold furniture at a store.

The husband’s role as pastor was not just religious and ministerial. He performed maintenance, tech work, and graphic design for the church. 

He also traveled, whether for conferences and retreats, meetings with ministers at other churches, or to pick up large equipment the church needed, such as a soundboard or lighting rigs.

In July 2014, the husband began discussions with a Florida church about an executive youth pastor position. On July 15 he traveled to Florida for an interview. His wife joined him to interview for a teaching position with the church’s school. The couple were offered the positions, and they moved to Florida the next month. 

But the move to Florida proved to be a financial strain. 

 

Out-of-pocket costs, lower pay

Because the Florida church is in a rural area, everything is spread far apart.

Therefore, the pastor logged tens of thousands of miles for meetings, hospital visits, and other pastoral duties. He paid for this out of pocket and was not reimbursed (i.e., the expenses were unreimbursed employee business expenses).

In addition, the wife took a significant pay decrease to accept the teaching position at the church’s school. 

She paid for her own chalk, pencils, paper, notebooks, markers, classroom decorations, and other common supplies. 

She also bought basic classroom supplies for many low-income students, and rewards for good behavior. 

None of these purchases were reimbursed by the school.

The wife’s mother moved to Florida when the couple did, but struggled to find employment. In August 2015 she moved into the couple’s extra bedroom. To make room, they moved records, documents and office supplies from the bedroom to the garage.

The financial stress and family issues persisted. The couple’s first child had been born in early 2016, and they expended much of their savings. 

Return to Florida

By early 2016, the couple decided to leave Florida. They requested a few months to transition, but the Florida church granted only three weeks. 

The husband reached out to his former church in Oklahoma, and was offered a position there. In the ensuing weeks, the couple rushed to find a new place to live, sold their home in Florida, and returned to Oklahoma.

At the time, the couple had the funds available to rent only one moving truck. They took what they could carry back with them to Oklahoma, but the wife’s mother had to put some items from the garage into storage in Florida with the intent of returning in a few months to retrieve them. In doing so, the couple inadvertently moved the boxes containing their business and tax records into the storage unit. 

By August 2017 the wife’s mother had stopped paying for the storage unit, and the unit had been repossessed.

Tax return and examination

The couple timely filed their 2014 joint income tax return. They reported total income of $68,899 and claimed above-the-line deductions of $250 for educator expenses and $4,950 for moving expenses, resulting in adjusted gross income of $63,699. They claimed itemized deductions totaling $50,116 and exemptions totaling $7,900 for taxable income of $5,683.

On Schedule A, the couple reported (before application of the two-percent floor) unreimbursed employee expenses totaling $37,460 and tax preparation fees of $75. The couple’s unreimbursed employee expenses consisted of $950 of excess educator expenses related to the wife’s employment at the Florida church school, and $36,510 related to the husband’s employment as a minister. 

The husband’s expenses were calculated on Form 2106, Employee Business Expenses, as follows:

Unreimbursed employee business expenses Amount
Vehicle expenses $31,360
Travel expenses while away from home overnight $2,800
50% of meals and entertainment $750
Other business expenses $1,600
Total $36,510

The couple reported business use of two vehicles. For vehicle 1, a 2003 Dodge truck, they reported 34,000 business miles. For vehicle 2, a 2009 Nissan Altima, they reported 22,000 business miles. They multiplied the claimed 56,000 total business miles driven by the then-standard mileage rate of 56 cents to arrive at the vehicle expense of $31,360.

The IRS selected their return for examination in 2017, and it was during the examination that the husband discovered that his records were lost. He was unable to provide the IRS with the requested documentation but attempted to reconstruct his mileage log from memory. 

The IRS determined that the couple was not entitled to the deductions for unreimbursed employee expenses or tax preparation fees and issued a notice of deficiency. The couple appealed to the United States Tax Court.

Heightened substantiation requirements 

The Court noted that section 274 of the tax code prescribes stricter substantiation requirements for travel expenses, meals, and lodging away from home, and expenses with respect to the business use of a car. 

So, “even if such an expense would be otherwise deductible, section 274 may still preclude a deduction if the taxpayer does not present sufficient substantiation.”

To meet the heightened substantiation requirements, taxpayers must substantiate by adequate records “(1) the amount of the expense, (2) the time and place of the expense, (3) the business purpose of the expense or use, and (4) the business relationship.”

To substantiate car expenses through adequate records, taxpayers must maintain a contemporaneous log, trip sheet, or similar record, as well as corroborating documentary evidence, that together establish each required element of the expense.

In the absence of adequate records, taxpayers must establish each required element by their own statement, whether written or oral, containing specific information in detail as to such element and by other corroborative evidence sufficient to establish such element. 

The Court then addressed the deductibility of several unreimbursed employee business expenses:

Vehicle expenses.

The Court concluded that the couple had not satisfied the heightened substantiation requirements with respect to the claimed $31,360 deduction for vehicle expenses. The husband testified that his mileage log and other records from 2014 were lost, likely left in his mother-in-law’s storage unit in Florida and abandoned after she neglected to pay the rent on the unit following the family’s move back to Oklahoma in 2016. 

The husband attempted to reconstruct his mileage from memory, including on his list only those trips for which he could recall the specific dates and other details. While the Court found the husband to be 

forthright and believes he attempted to reconstruct his mileage in good faith, the reconstructed mileage log does not satisfy the requirements of section 274. It lacks sufficient specificity with respect to many of the trips …

Accordingly, the Court sustained the government’s disallowance of a vehicle expense deduction.

Travel expenses.

With respect to the claimed $2,800 travel expense deduction, the couple introduced into evidence copies of email receipts and itineraries from Priceline.com for a July 15 flight from Dallas to [Florida] for their job interviews for $748; a July 14 hotel stay in Dallas for $96.19; an August 1 hotel reservation for two rooms for the husband and a colleague in Columbus, Mississippi, for $156.26; a September 4 flight from Fort Lauderdale to Atlanta for $324.18; and a car rental in Atlanta from September 4 through September 7, for $83.49.

The Court was satisfied that: 

the taxpayers have met the strict substantiation requirements with respect to the Dallas hotel stay, the husband’s flight from Dallas to [Florida], the flight from [Florida] to Atlanta, and the car rental. The information in the email receipts, along with the other evidence in the record, meets the requirements of section 274. The [wife’s] flight is not a deductible business expense, however, because expenses incurred in seeking or investigating a new trade or business are not deductible under [tax code] section 162(a) and there is insufficient information in the record to substantiate the business purpose of the Columbus trip or the portion, if any, that was paid by the husband himself. Accordingly, the Court holds that [the taxpayers]  are entitled to a travel expense deduction of $877.86. 

Meals and entertainment expenses.

The couple claimed a deduction of $750 (50 percent of $1,500) for meals and entertainment expenses, but provided no receipts or other evidence beyond general testimony in support of the claimed meals and entertainment expenses. The Court disallowed a deduction.

Other business expenses.

The couple claimed a deduction for other expenses of $1,600. These expenses included $1,000 for a used MacBook laptop, $200 for a used Nexus 7 tablet, and a used HTC One smartphone. The husband could not recall at trial whether the $1,600 figure included any other purchases. 

The Court noted that section 280F(d)(4) of the tax code defines “listed property” to include any computer or peripheral equipment, including laptops and tablets. The laptop and the tablet “are thus subject to the heightened substantiation requirements of section 274.” But because the couple did not provide any evidence beyond their own testimony to back up the reported expenses, the Court denied a deduction for them.

Tax preparation fees.

Finally, the couple claimed, and the IRS disallowed, a deduction of $75 for tax preparation fees. The Tax Court agreed with the IRS that the couple “did not introduce any evidence or other substantiation in support of this amount beyond testimony that they generally used TurboTax to prepare their tax returns.” 

What this means for churches 

This case occurred before the Tax Cuts and Jobs Act of 2017, when unreimbursed employee business expenses were tax deductible as an itemized deduction on Schedule A (Form 2106) if a taxpayer had sufficient documentation to substantiate the deduction. In this case, a deduction was disallowed, because the taxpayers produced insufficient substantiation to qualify for a deduction of their unreimbursed employee business expenses.

As noted, the Tax Cuts and Jobs Act of 2017 suspended, from 2018 through 2025, a tax deduction for unreimbursed employee business expenses and all other miscellaneous itemized deductions that were subject to the two-percent floor under prior law.

However, this case is helpful in assisting self-employed church staff in computing the business expenses reported on Schedule C (Form 1040).

And, should the Tax Cuts and Jobs Act expire, this case will be helpful in assisting in assisting self-employed church staff in computing unreimbursed and nonaccountable reimbursed expenses after 2025.

The importance of accountable reimbursement plans

While no itemized deduction is allowed from 2018 through 2025 for unreimbursed employee business expenses, the suspension of an itemized deduction for unreimbursed employee business expenses (through 2025) does not affect the deductibility of business expenses reimbursed by an employer under an accountable reimbursement plan.

The Tax Cuts and Jobs Act of 2017 left intact a tax deduction for these expenses. The deductibility of business expenses reimbursed under an accountable plan is a primary reason for employers to maintain such a plan for the reimbursement of employee business expenses.

An accountable plan is one with the following four characteristics:

  • only ordinary and necessary employee business expenses are reimbursed; 
  • no reimbursement is allowed without an adequate accounting of expenses within a reasonable period of time (not more than 60 days after an expense is incurred); 
  • any excess reimbursement or allowance must be returned to the employer within a reasonable period of time (not more than 120 days after an excess reimbursement is paid); and 
  • an employer’s reimbursements must come out of the employer’s funds and not by reducing the employee’s salary. 

Under an accountable plan, an employee reports to the church rather than to the IRS. The reimbursements are not reported as income to the employee, and the employee does not claim any deductions. In general, this is the best way for churches to handle employee business expenses. But it is especially needed now with the disallowance of itemized deductions for unreimbursed employee business expenses mandated by the Tax Cuts and Jobs Act of 2017.

 

Philips v. Commissioner, T.C. Sum. Op. (2023).

Federal Court Bars Guidance Counselor’s Title VII Claims

Case shows the importance of having all faculty-related handbooks, job descriptions, and contracts reviewed by legal counsel.

Key Point 8-10.1 The civil courts have consistently ruled that the First Amendment prevents them from applying employment laws to the relationship between a church and a minister.

Update: A federal appeals court has ruled that a guidance counselor at a Catholic high school was a “minister” and that the First Amendment’s “ministerial exception” barred her claims under Title VII of the Civil Rights Act of 1964 for discrimination, retaliation, and hostile work environment.


In recent legal development out of Florida, Richard Hammar explains the ins and outs of a case in which the court finally said no to hearing a property dispute between a church and its governing body.


‘Morals Clause’

A Catholic school (“School”) in the Archdiocese of Indianapolis had, as its mission, “to provide, in concert with parents, parish, and community, an educational opportunity which seeks to form Christian leaders in body, mind, and spirit.”

A woman (“Plaintiff”) began working at the School as a guidance counselor.

She was not a practicing Catholic. As part of her job, Plaintiff served on the School’s main leadership body, the Administrative Council.

The Council meets weekly to address the School’s “day-to-day operations and spiritual life.”

The Administrative Council also makes decisions related to the school’s religious mission. This includes arranging logistics for an all-school liturgy and qualifications for a student to serve as a eucharistic minister.

The School used a one-year employment contract for teachers and guidance counselors.

For more than 30 years, the School included a “morals clause” in those contracts.

From 2007 to 2017, the school used a contract titled, “School Teacher Contract.” It required employees to refrain from “any personal conduct or lifestyle at variance with the policies of the Archdiocese or the moral or religious teachings of the Roman Catholic Church.”

Failure to do so would result in “default under the contract.”

An employee was also in default if she engaged in “cohabitation (living together) without being legally married.”

The school principal and the pastor could “suspend or terminate the employment” of a defaulted employee at his or her discretion.

‘Teaching Ministry Contract’

For the 2017-2018 school year, the School instituted a new employment agreement entitled “Teaching Ministry Contract.”

It contained the same morals clause and attached a Ministry Description detailing the responsibilities of the position.

In May 2018, Plaintiff signed a contract titled, “School Guidance Counselor Ministry Contract,” which came with the “Archdiocese of Indianapolis Ministry Description.”

The updated contract included a similar morals clause, but now stated that an employee was in default if the employee were to engage in a relationship “contrary to a valid marriage as seen through the eyes of the Catholic Church,” which defines marriage as between a man and a woman.

The accompanying Ministry Description defined the primary functions of a school guidance counselor in part as:

Adhering to mission and within the school’s supervisory structure, including the school principal and pastor or high school principal and president, the school guidance counselor will collaborate with parents and fellow professional educators to foster the spiritual, academic, social, and emotional growth of the children entrusted in his/her care.

The Ministry Description also labeled guidance counselors as “ministers of the faith,” and stated that their position included “facilitating faith formation.”

A guidance counselor’s responsibilities included:

1. Communicating the Catholic faith to students and families through implementation of the school’s guidance curriculum, academic course planning, college and career planning, administration of the school’s academic programs, and by offering direct support to individual students and families in efforts to foster the integration of faith, culture, and life.

2. Praying with and for students, families, and colleagues. Participating in and celebrating liturgies and prayer services as appropriate.

3. Teaching and celebrating Catholic traditions and all observances in the Liturgical Year.

4. Modeling the example of Jesus, the Master Teacher, in what He taught, how He lived, and how He treated others.

5. Conveying the Church’s message and carrying out its mission by modeling a Christ-centered life.

6. Participating in religious instruction and Catholic formation, including Christian services, offered at the school. Non-Catholic school guidance counselors are expected to participate to the fullest extent possible (e.g., non-Catholics would come forward to receive a blessing instead of Holy Communion in the Catholic Mass).

By signing the contract, Plaintiff acknowledged that she received the Ministry Description and agreed to fulfill “the duties and responsibilities” of the agreement.

But she insisted that these documents did not describe either her or the school’s actual conduct.

The School did not renew the Plaintiff’s employment contract based on her civil union with another woman in violation of the Catholic Church’s moral teachings.

The Plaintiff filed a Title VII claim.

A federal court in Indiana initially said the Title VII case did not violate the church autonomy doctrine (also known as the ecclesiastical abstention doctrine) and could proceed to a trial.

Before it could, the School filed a “motion for summary judgment,” reiterating its belief the ministerial exception applied to the case.

The federal court agreed and granted the School’s motion.

The Plaintiff appealed.

‘Expected to carry out the school’s religious mission’

The federal appeals court affirmed that the ministerial exception barred all of the Plaintiff’s claims:

As the Co-Director of Guidance and a member of the Administrative Council, Plaintiff was one of the school leaders responsible for the vast majority of the school’s daily ministry, education, and operations. She was expected to take part in the school’s day-to-day operations, which included responsibilities that conveyed the Catholic faith to students, such as leading prayer over the public address system more than once. Her employment agreements and faculty handbooks recognized these job duties and responsibilities by stating that she was expected to carry out the school’s religious mission. . . . Her job included facilitating faith formation by communicating the Catholic religion to students, “modeling a Christ-centered life,” and “praying with and for students.” According to the Archdiocese’s Ministry Description, guidance counselors were “to foster the spiritual, academic, social and emotional growth of the children entrusted in his/her care.”

What this Title VII case means for church schools and church school leaders

This Title VII case supports the application of the ministerial exception to guidance counselors in church schools.

But, as the courts here noted, such a conclusion is dependent on the text of faculty handbooks, faculty contracts, and other pertinent documents. The federal court and the federal appellate court both determined the Plaintiff was a minister because she was entrusted with communicating the Catholic faith to the school’s students and guiding the school’s religious mission. The ministerial exception thus barred all of her claims at the federal and state levels.

To ensure the application of the ministerial exception to school staff, these important documents should be reviewed by legal counsel, and modified as appropriate.

Starkey v. Roman Catholic Archdiocese, 41 F.4th 931 (7th Cir. 2022).

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.

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.

Tip: The 2023 Church and Clergy Tax Guide is out. If you’re an Advantage Member, there’s nothing to do – it’ll come to you. If you’re not, visit Church Law & Tax’s store to pick up your guide (available in hard copy or .pdf) today.

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).

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).

Member Sickened from Food at Church Banquet Not Allowed to Sue Caterer

While the church wasn’t named in lawsuit, churches should note the potential liability they could face if accused of negligence.

Key point 10-01. Negligence is conduct that creates an unreasonable risk of foreseeable harm to the person or property of another, and which results in the foreseeable harm. The important point is that negligence need not be intentional. It includes conduct that is simply careless, heedless, or inadvertent. A person who kills a pedestrian while texting on a cellphone did not intend to kill the victim, but nonetheless may be liable for monetary damages in a civil lawsuit based on negligence.

A federal appeals court ruled that a woman who became violently ill after consuming shellfish prepared by a hotel caterer for a church banquet could not sue for her injuries.

Background

A female church member (the “plaintiff”) suffered an allergic reaction after eating a meal prepared by a hotel caterer for a church’s annual banquet hosted at the hotel’s conference center.

Representatives for the hotel communicated extensively with the pastor organizing the event about the entrée selections for the banquet. The menu was scheduled to include a blue-crab-stuffed chicken. The pastor asked the hotel about a chicken option with no seafood in case anyone had an allergy, and the hotel agreed to make one available. But no one from the church ever told the hotel to expect someone with food allergies and the church placed no orders for a seafood-free chicken dish.

The signed banquet event order forms reflected orders for 30 blue-crab-stuffed chicken breasts and 20 honey-glazed salmon entrees, with dietary restrictions marked “N/A.” When a hotel employee asked the pastor on the day of the banquet whether any attendees had “changes to this menu because of restrictions,” the pastor responded “no.”

The plaintiff did not inform the church or the hotel about her shellfish allergy. She claimed that she never saw the menu options that the church posted; instead, the pastor told her only that the options were “salmon, chicken or veggies.” The plaintiff told the pastor that she wanted the chicken.

On the day of the banquet, the plaintiff sat at a seat marked by a place card stating her name and “chicken.” The pastor had prepared these place cards in accordance with the event order form she received from the hotel. The hotel instructed the church to provide place cards to identify which entrée each attendee should be served.

The plaintiff didn’t communicate with the server, who delivered her blue-crab-stuffed chicken. She ate a few bites and almost immediately became seriously ill.

The plaintiff: Hotel was guilty of negligence

The plaintiff sued the hotel, claiming that it was guilty of negligence and “owed a duty to all patrons to provide an adequate warning of the latent dangers arising from the consumption of seafood products.”

She also asserted that the hotel knew or should have known the chicken dish contained seafood, which would be life-threatening to people with seafood allergies; that the presence of the crabmeat wasn’t obvious to her; and that the “food label” didn’t disclose the presence of crab meat. A federal district court in Georgia rejected the plaintiff’s claims, and the case was appealed to a federal appeals court.

Appeals court: Hotel had not “misled or misinformed consumers”

The appeals court concluded that the district court did not err in dismissing the case because the plaintiff failed to show that the hotel breached any duty of care that it owed her and therefore “no genuine issue as to any material fact” remained to be adjudicated.

The court noted that the plaintiff’s theory of liability was based on an alleged duty to warn all patrons of the latent dangers of seafood consumption. But “she has failed to identify any . . . statute or caselaw that might possibly stand for the proposition that a food-serving establishment has such a duty—particularly where, as here, the patrons preselected entrees to be served and told the establishment that no one had any dietary restrictions.”

The plaintiff noted that Georgia law prescribes that “[f]ood shall be offered for human consumption in a way that does not mislead or misinform the consumer.” According to the plaintiff, the hotel violated this provision by “disguising blue crab stuffed chicken as a regular chicken breast entrée.” The court disagreed:

This argument fails based on the undisputed facts in the record. [The hotel’s] agents communicated to the Church’s [pastor] repeatedly and in writing that the entrée being offered was a blue-crab-stuffed chicken breast and asked several times whether any guests had dietary restrictions. [The hotel] also offered a different seafood-free chicken entrée for anyone with a seafood allergy. [The pastor] nevertheless executed the banquet event orders on behalf of her church for “thirty blue crab stuffed chicken breasts.” . . . There is no plausible argument that [the hotel] “disguise[ed]” its dish or misled or misinformed consumers when it provided the exact entrée that the Church ordered for its members. Therefore, [the plaintiff] has failed to establish that [the hotel] breached any duty that it may have had under this [law].

What this means for churches

Churches conduct meal functions for a number of reasons, including retirements, celebrations, special anniversaries, weddings, and funerals. Such meals may be prepared onsite by church employees or volunteers, catered onsite by an outside food service, or catered by an outside food service at a location other than the church.

Whether an event occurs on or off church property, church staff must take steps to ensure that persons with food allergies are identified and accommodated. While the plaintiff in this case chose not to name her church as a defendant, others in similar circumstances may not be so restrained.

Crawford v. Marriott International, Inc. 2021 WL 5054442 (11th Cir. 2021)

Donor Denied Deduction for His Gift of a Conference Center

Make sure donors of large, noncash gifts understand substantiation rules so that they don’t miss out on deductions.

Key point. Charitable contributions are subject to several substantiation requirements. A failure to comply with these requirements may lead to a denial of a charitable contribution deduction.

The United States Tax Court ruled that a taxpayer was not entitled to a charitable contribution deduction for the donation of property to a religious charity since he failed to comply with the strict substantiation requirements set forth in the tax code.

Background

A taxpayer made several donations to a religious charity, including a conference center. To determine the center’s value, he contracted with a certified general appraiser for his help.

After viewing the property, however, the appraiser felt uncomfortable providing an appraised value. He believed the property was a very elaborate complex, and he had never seen a similar building in his appraisal career. He felt he couldn’t complete the appraisal according to the Uniform Standards of Professional Appraisal Practice (USPAP).

However, the appraiser did describe the three traditional valuation methods—comparable sales, income, and replacement cost—that appraisers use, and then explained why he felt uncomfortable using any of them. He told the taxpayer that of the three methods, the replacement cost approach had “the most solid evidence.”

The taxpayer did not try to get another appraisal, but instead totaled up the cost of the conference center and claimed that amount as a deduction. The IRS denied a charitable contribution deduction for the conference center, and the taxpayer appealed to the United States Tax Court.

Tax Court: Taxpayer failed to provide a Form 8283

The Court affirmed the IRS denial of any contribution deduction. It noted that for any noncash contribution exceeding $5,000 (with some exceptions) the income tax regulations require the donor to: (1) obtain a qualified appraisal for the contributed property, (2) attach a fully completed appraisal summary (Form 8283) to the tax return on which the deduction is claimed, and (3) maintain records pertaining to the claimed deduction.

A qualified appraisal must include, among other things:

  • a description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property appraised is the property that was contributed;
  • a description of the property’s physical condition;
  • the valuation method used to determine the fair market value; and
  • the specific basis for the valuation.

A qualified appraisal must be made no earlier than 60 days before the date of the contribution and no later than the due date of the return, including extensions. Additionally, it must be prepared by a qualified appraiser.

The definition of a qualified appraiser includes the following:

  • It is a person with verifiable education and experience in valuing the type of property for which the appraisal is performed. In addition, the individual: (a) has earned an appraisal designation from a generally recognized professional appraiser organization, or (b) has met certain minimum education requirements and has two or more years of experience.
    To meet the minimum education requirement, a qualified appraiser must have successfully completed professional or college-level coursework obtained from: (i) a professional or college-level educational organization, (ii) a professional trade or appraiser organization that regularly offers educational programs in valuing the type of property, or (iii) an employer as part of an employee apprenticeship or education program similar to professional or college-level courses.
  • The person regularly prepares appraisals for compensation.
  • The person is not an “excluded individual” (i.e., the donor or donee, a relative of the donor, and so on).

In addition, the taxpayer must obtain a contemporaneous written acknowledgment from the donee organization for any contribution of $250 or more. The contemporaneous written acknowledgment must include a description of any property contributed, a statement as to whether the donee provided any goods or services in exchange, and a description and good faith estimate of the value of such goods or services.

The Tax Court concluded that no deduction was allowable because the taxpayer failed to attach a copy of Form 8283 to his tax return, and the donated property was never appraised by a qualified appraiser.

The taxpayer conceded that he did not attach a qualified appraisal of the donated property to his returns.

The Court concluded:

The complete denial of a deduction can be harsh, but this failure alone might be enough for us to deny the contested deductions. There is but one hope for the taxpayer—section 170(f)(11)(A)(ii)(II). Congress … added an escape hatch from nondeductibility for well-intentioned taxpayers. Section 170(f)(11)(A)(ii)(II) tells us not to deny a deduction for failure to comply with [the substantiation requirements pertaining to gifts of noncash property exceeding $5,000] “if it is shown that the failure to meet such requirements is due to reasonable cause and not to willful neglect.”

The Court determined that this exception did not apply since the taxpayer had considerable business experience and should have understood the substantiation requirements from a cursory review of Form 8283 and its instructions.

What this means for churches

Churches should note the following guidelines for certain noncash donations.

1. Don’t assume donors understand rules for noncash gifts

Do not assume that donors are familiar with the substantiation rules that apply to gifts of noncash property. Church treasurers should obtain copies of Form 8283 each year to give to persons who donate noncash property to the church during the year. You can download copies of Form 8283 on the IRS website. Be sure to get the form and the instructions (two separate, downloadable documents).

2. Ask for a qualified appraisal for large gifts

Ask donors of noncash property to be sure that they obtain a qualified appraisal if you believe they may claim a charitable contribution deduction of more than $5,000.

3. Know that donations of stock are handled differently

No qualified appraisal is required for donations of publicly traded stock. However, a qualified appraisal is required for donations of privately held stock when the claimed value exceeds $10,000.

Pankratz v. Commissioner, T.C. Memo. 2021-26 (2021).

Charity Founder’s Wife Heavily Penalized for Excess Benefit

Tax Court upholds more than in penalties and taxes for unreported compensation left uncorrected.

The United States Tax Court ruled that the wife of the founder of a medical missions charity had received an excess benefit from the charity subjecting her to a “first-tier” penalty of 25 percent of the amount of the excess benefit, and an additional “second-tier” tax of 200 percent of the excess since it had not been returned to the charity.

Note. It is important for church leaders to be familiar with this case since excess benefit transactions are common among churches and expose ministers and possibly others to significant penalties under section 4958 of the tax code. These penalties are assessed against the minister, not the church.

Background

In 2000, a medical missions charity (the “charity”) applied to the Internal Revenue Service (IRS) for recognition of tax-exempt status. In its application, it described its exempt purpose as the operation of a clinic to provide medical examination and treatment services for individuals unable to afford such services. The IRS granted the exemption.

The founder of the charity served as its president from its inception through 2014. His wife (the “petitioner”) held various positions with the charity. In 2000, she was listed as a member of its board of directors. In an annual report filed in October 2012 with the state of Michigan, she was listed as its secretary and treasurer. She was listed as its secretary and as a director on its Form 990 for 2013, and as its secretary on its Form 990 for 2014.

She regularly attended the charity’s board meetings during 2013 and 2014. Neither she nor her husband had an employment contract with the charity in either year.

On its Form 990 (the annual federal information return for tax-exempt charities) for 2013, the charity reported providing the petitioner, in her capacity as “Secretary/Director,” compensation of $21,000. The charity also reported providing compensation of $21,000 to her husband in his capacity as “President/Director.” The charity issued Forms W-2 for 2013, reporting that it had paid the petitioner and her husband $26,000 each. They reported these amounts as wages on a jointly filed Form 1040, U.S. Individual Income Tax Return.

On its Form 990 for 2014, the charity reported that the petitioner and her husband each received “reportable compensation from the organization” of zero. The charity issued neither of them a Form W-2 for 2014. The charity recorded no officer or director salaries in its general ledger for 2014. There is no indication in the minutes of its board meetings that the charity intended to provide compensation to the wife during 2014.

However, during 2014, the charity issued the wife biweekly checks in the amount of $1,000. At trial, she testified that this “was my paycheck because [my husband] put me on [the charity’s] payroll.” These checks totaled $27,000 during 2014.

Also during 2014, the charity issued the wife monthly checks in amounts ranging from $6,000 to $10,000. They totaled $88,000 for the year.

In October 2015, the IRS commenced an examination of the charity’s records. The agency determined the wife received excess benefits from the charity in the amount of $115,000, all consisting of the checks she had received. The IRS determined that the checks were used to defray the personal living expenses of the wife’s family (husband, wife, and eight children).

In 2018 the IRS issued the wife a notice of deficiency for 2014. This notice determined a first-tier excise tax of $28,750 and a second-tier excise tax of $230,000 under section 4958(b) of the federal tax code. The second-tier tax, computed as 200 percent of the excess benefit, is imposed by law when a disqualified person fails to correct the excess benefit transaction in a timely fashion.

The wife sought relief in the Tax Court. Later that year, the IRS issued the charity a determination letter revoking its tax-exempt status retroactively to January 1, 2014. The IRS determined that the charity had failed to establish that “no part of [its] earnings inures to the benefit of any private shareholders or individuals” or that it was “operating exclusively for an exempt purpose.”

The wife and charity appealed the IRS determinations to the Tax Court. However, the charity declined to pursue its challenge to the revocation of its tax-exempt status and so the Court dismissed its appeal for a “failure to prosecute.”

The Tax Court applies Section 4958

Section 4958 imposes an excise tax on a “disqualified person” who engages in an “excess benefit transaction” with a tax-exempt charity. Section 4958(c)(1)(A) defines an “excess benefit transaction” to mean

any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.

An “applicable tax-exempt organization” is an organization described in tax code section 501(c)(3), including churches and other religious organizations.

Section 4958(a)(1) imposes on each excess benefit transaction an excise tax “equal to 25 percent of the excess benefit” and provides that this tax “shall be paid by any disqualified person . . . with respect to such transaction.” If the excess benefit transaction is not corrected in timely fashion, the disqualified person is liable for a second-tier tax equal to 200 percent of the excess benefit.

The Court stressed that Congress enacted section 4958 not to collect revenue but to deter insiders from influencing their organizations in order to receive unreasonable compensation.

Disqualified persons

Intermediate sanctions only apply to “disqualified persons,” which include:

  1. Voting members of the governing body, presidents, chief executive officers, chief operating officers, treasurers, and chief financial officers. The category of “treasurers and chief financial officers” includes “any person who, regardless of title, has ultimate responsibility for managing the finances of the organization.” A person who serves as treasurer “has this ultimate responsibility unless the person demonstrates otherwise.”
  2. Family members of disqualified persons, down to the level of great-grandchildren, are disqualified persons with respect to a charity.
  3. The Tax Court concluded that the wife was a disqualified person because she served as a director and executive officer of the charity, and she was the spouse of a disqualified person (the president).

    Excess benefit transactions

    The term “excess benefit transaction” is defined by section 4958 as any transaction in which an economic benefit is provided by a tax-exempt organization to a “disqualified person” if the value of the economic benefit provided exceeds the value of the services received for providing the benefit.

    Section 4958 further provides that an economic benefit is not treated as consideration for the performance of services unless the charity clearly indicates its intent to so treat it. And, a charity

    is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit at issue. If an organization fails to provide this contemporaneous substantiation, any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit.

    The “contemporaneous substantiation” requirement can be satisfied in two ways: by timely reporting or by “other written contemporaneous evidence.”

    Timely reporting occurs if the organization reports a payment to the disqualified person as compensation on a Form W-2 or a Form 990 filed before the IRS commences its examination. Timely reporting also occurs if the disqualified person reports the payment as income on an original or amended Form 1040 filed before the earlier of the date on which the IRS commences its examination or supplies written documentation of a potential excess benefit transaction.

    The “contemporaneous substantiation” requirement can also be satisfied by “other written contemporaneous evidence” showing that “the appropriate decision-making body or an officer authorized to approve compensation approved a transfer as compensation for services in accordance with established procedures.”

    Such evidence includes “an approved written employment contract executed on or before the date of the transfer,” other documentation showing that “an authorized body contemporaneously approved the transfer as compensation for services,” and contemporaneous written evidence establishing “a reasonable belief by the . . . organization that a benefit was a nontaxable benefit.”

    The Tax Court’s conclusion

    During 2014, the wife received biweekly checks totaling $27,000, and monthly certified checks totaling $88,000, for a total of $115,000. If these checks constituted compensation for services provided by the wife to the charity, and were contemporaneously substantiated as noted above, then there would be no excess benefit transaction, since section 4958 provides that an economic benefit is not treated as consideration for the performance of services unless the charity clearly indicates its intent to so treat it.

    Reviewing the facts surrounding the wife’s case, the Tax Court concluded:

    [The petitioner] supplied no contemporaneous substantiation to show that [the charity] “clearly indicated its intent” to treat the $27,000, much less the $88,000, as compensation for her services. The charity did not report any of those payments as compensation to petitioner on a Form W-2, and petitioner did not report any of those payments as income on her Form 1040. . . . Nor did petitioner supply any other type of contemporaneous substantiation. Specifically, she offered no evidence (such as an employment contract or minutes of board meetings) showing that “the appropriate decision-making body or an officer authorized to approve compensation approved . . . her payments as compensation for services in accordance with established procedures.” In the absence of contemporaneous substantiation, “any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit.” Petitioner is thus foreclosed from contending that the $115,000 she received was not an “excess benefit” because paid in consideration of her performance of services (emphasis added).

    Substantial penalties

    Based on the Tax Court’s conclusion that the wife was a disqualified person, it then calculated penalties for her.

    First-tier tax of 25 percent

    Under Section 4958(a), a disqualified person who receives an excess benefit is penalized through a first-tier tax equal to 25 percent of the excess benefit. Based on $115,000 of excess benefits for the wife, the first-tier tax equaled $28,750.

    Second-tier tax of 200 percent

    Under Section 4958(b), if a first-tier tax is imposed on the excess benefit received by a disqualified person “and the excess benefit involved in such transaction is not corrected within the taxable period,” then, by law, a second-tier tax equal to 200 percent of the excess benefit must be imposed on the disqualified person.

    A failure to correct

    The Tax Court concluded the wife never corrected the excess benefit transaction. “Correction” means “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards,” according to Section 4958.

    The Tax Court then said:

    [The] “taxable period” during which correction must occur (assuming the tax has not yet been assessed) is the period beginning with the date of the transaction and ending on “the date of mailing a notice of deficiency with respect to the tax imposed by section (a)(1)” [i.e., the 25-percent tax]. . . . The “taxable period” during which petitioner was obligated to make correction “thus closed on August 13, 2018, when the notice of deficiency was mailed” [to her by the IRS].

    The Tax Court stated:

    Petitioner did not correct the excess benefit transactions within the “taxable period.” There is no evidence that she returned to the charity, at any time, any portion of the $115,000 at issue. Nor did she show that she made any effort to place the charity “in a financial position not worse than that in which it would be if . . . she were dealing [with it] under the highest fiduciary standards.” We accordingly hold that she is liable for a second-tier tax of $230,000 (200% × $115,000).

    The availability of abatement

    The Tax Court also noted the ability for a disqualified person to abate both the first- and second-tier taxes.

    To abate the second-tier tax, which helps further explain the abatement process for the first-tier tax (see below), the Tax Court said:

    Section 4961(a) affords a disqualified person an opportunity to avoid the second-tier tax. It provides that, if the taxable event is corrected “during the correction period,” the second-tier tax “shall not be assessed, and if assessed the assessment shall be abated, and if collected shall be credited or refunded as an overpayment.” For this purpose, the “correction period” means, with respect to any taxable event:

    the period beginning on the date on which such event occurs and ending 90 days after the date of mailing under section 6212(a) of a notice of deficiency with respect to the second tier tax imposed on such taxable event, extended by—

    (A) any period in which a deficiency cannot be assessed under section 6213(a), and

    (B) any other period which the Secretary [of the Treasury] determines is reasonable and necessary to bring about correction of the taxable event.

    It then added:

    Under these rules, the “correction period” will remain open at least until this Court’s decision has become final following any appeal. Section 4961(b) grants us jurisdiction “to conduct any necessary supplemental proceeding to determine whether the taxable event was corrected during the correction period.” Any such proceeding must begin within 90 days “after the last day of the correction period.” Petitioner thus retains the opportunity to avoid assessment and collection of the second-tier tax.

    The Tax Court noted that section 4962 provides for non-assessment or abatement of the first-tier tax (25 percent) in certain circumstances, too. The court explained:

    To qualify for this treatment, the disqualified person must establish two facts “to the satisfaction of the [IRS].” . . . Specifically, she must show (1) that the taxable event “was due to reasonable cause and not to willful neglect” and (2) that the event “was corrected within the correction period for such event.” . . . The “correction period” for the first-tier tax is the same as for the second-tier tax.

    Additional penalty for failing to file Form 4720

    The failure of the wife and charity to also timely file Form 4720 with the IRS resulted in an “addition to tax” penalty of $7,313 for the wife, which the Tax Court also upheld.

    “Tax-exempt organizations are required to file a Form 4720 to report liability for various excise taxes, including taxes imposed for [excess benefit transactions],” the Tax Court said. But the charity did not file for 2014, leading the IRS to conclude the wife “was therefore required to file a separate return on Form 4720 by May 15, 2015,” which she did not, the Tax Court said.

    “To avoid liability petitioner must demonstrate that her failure to file was ‘due to reasonable cause and not due to willful neglect’ [Tax Code section] 6651(a)(1)),” the Tax Court said.

    In upholding the additional penalty for the wife, it noted:

    Reasonable cause exists “if the taxpayer exercised ordinary business care and prudence but, nevertheless, was unable to file the return within the time prescribed by law. . . . A taxpayer’s belief that no return is required in itself is not sufficient to show that the failure to file was due to reasonable cause.”

    The Court concluded that the petitioner failed to demonstrate reasonable cause to justify her failure to file Form 4720. As examples of reasonable cause, the Court cited “postal delays, timely filing of a return with the wrong office, death or serious illness of the taxpayer or a member of his family, [or] the taxpayer’s unavoidable absence from the United States.”

    It added:

    The Form 4720 is admittedly an exotic species: The obligation to file this return—unlike the obligation to file (say) Form 1040—is far from common knowledge, especially for someone not actually involved in a charity’s operations. Petitioner had received monthly checks from [her charity] for prior years, and we do not believe that she understood that such transactions needed to be reported on an excise tax return. “[I]gnorance of the law, however, does not amount to reasonable cause.”

    What this means for churches

    This case has many important lessons for church leaders, including the following.

    Penalties for excess benefit transaction

    If a church or other charity provides compensation or benefits to a disqualified person in excess of the value of services provided in return, and the excess is not “contemporaneously reported” as taxable income on a Form W-2 or the recipient’s Form 1040, then this constitutes an excess benefit transaction subjecting the recipient to the following penalties (known as “intermediate sanctions”):

    • A “first-tier” penalty of 25 percent of the amount of the excess benefit.
    • A “second-tier” penalty of 200 percent of the amount of the excess benefit. The second-tier penalty is not discretionary with the IRS.

    In this case, the Tax Court concluded that the $115,000 the charity paid the wife was not contemporaneously reported on a Form W-2 or the wife’s Form 1040, and therefore it constituted an excess benefit to her. This triggered the first- and second-tier penalties of 25 percent and 200 percent of the amount of the excess ($28,750 and $230,000, respectively).

    Correcting the excess benefit transaction

    If the first-tier 25-percent excise tax is assessed against a disqualified person and he or she fails to correct the excess benefit within the taxable period (defined below), then by law, the second-tier 200 percent tax must be assessed.

    Section 4958 specifies that the disqualified person can correct the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.”

    The correction must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25-percent tax, or the date the 25-percent tax is actually assessed.

    The definition of “disqualified person”

    Since intermediate sanctions apply only to disqualified persons (and in some cases managers), it is important for church leaders to be familiar with the definition of “disqualified person.”

    The regulations define it as any person who at any time during the five-year period ending on the date of an excess benefit transaction was in a position to exercise substantial influence over the affairs of the tax-exempt organization, or any family member of such a person.

    Sanctions assessed against recipient

    Intermediate sanctions are assessed against the recipient, not the church or charity.

    Imposing an excise tax

    An excise tax equal to 10 percent of the excess benefit may be imposed on the participation of an organization manager in an excess benefit transaction between a tax-exempt organization and a disqualified person.

    This tax, which may not exceed $20,000 with respect to any single transaction, is only imposed if the 25-percent tax is imposed on the disqualified person, the organization manager knowingly participated in the transaction, and the manager’s participation was willful and not due to reasonable cause.

    There is also joint and several liability for this tax, meaning a person may be liable for both the tax paid by the disqualified person and this organization manager’s tax in appropriate circumstances. This tax is explained more fully below.

    Treating excess benefit as compensation

    An excess benefit is treated as compensation when paid if the exempt organization reports the benefit as taxable income on a Form W-2 or Form 1099-NEC issued to the recipient or if the recipient reported the benefit as taxable income on his or her Form 1040.

    Other written evidence may be used to demonstrate that the organization approved a transfer as compensation in accordance with established procedures, which include, but are not limited to, (a) an approved written employment contract executed on or before the date of transfer, (b) appropriate documentation indicating that an authorized body approved the transfer as compensation for services on or before the date of the transfer, and (c) written evidence that existed on or before the due date of the appropriate federal tax return (Form W-2, Form 1099-NEC, or Form 1040), including extensions, of a reasonable belief by the exempt organization that under the tax code the benefit was excludable from the disqualified person’s gross income.

    Failing to report excess benefit as compensation

    If an excess benefit is not reported as taxable compensation when paid, the IRS will assume that the entire amount of the benefit exceeds the value of any services provided by the recipient, and therefore the entire benefit constitutes an excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit.

    Automatic excess benefit transactions for personal use of church property

    In four private rulings issued in 2004, the IRS assessed intermediate sanctions against a pastor because of the personal use of church property by himself and members of his family, and the reimbursement of expenses by the church under a nonaccountable plan without any substantiation of business purpose.

    Most importantly, the IRS concluded that these benefits were automatic excess benefit transactions resulting in intermediate sanctions, regardless of amount, since they were not reported as taxable income on the pastor’s Form W-2 or Form 1040 for the year in which the benefits were paid.

    Churches that allow staff members to use a church-owned vehicle or other church property for personal use or that reimburse business or personal expenses of a staff member (or relative of a staff member) under a nonaccountable arrangement may be engaged in an automatic excess benefit transaction that will subject the staff member to intermediate sanctions under section 4958 regardless of the amount of the benefits.

    This result can be avoided if the church or the pastor reports the benefits as taxable income during the year the benefits are received, and they may be partly or completely abated if the pastor corrects the excess benefit within the tax period defined by section 4958.

    This generally means returning the excess benefit to the church by the earlier of (a) the date the IRS mailed the taxpayer a notice of deficiency with respect to the 25-percent excise tax, or (b) the date on which the 25-percent excise tax is assessed.

    If a disqualified person corrects an excess benefit transaction during the taxable period, the 200-percent excise tax is automatically abated. If the disqualified person corrects the excess benefit transaction during the correction period, the 25-percent excise tax is abated only if the disqualified person can establish that (a) the excess benefit transaction was due to reasonable cause and (b) was not due to willful neglect.

    Jeopardizing a church’s tax-exempt status

    Section 501(c)(3) of the Internal Revenue Code prohibits tax-exempt organizations (including churches) from paying unreasonable compensation to any employee or other person. A violation of this requirement will jeopardize an exempt organization’s tax-exempt status.

    The IRS can revoke an exempt organization’s tax-exempt status if it pays an excess benefit to a disqualified person. However, in most cases, the IRS will pursue intermediate sanctions rather than revocation of exempt status.

    One of the requirements for tax-exempt status under section 501(c)(3) is that none of a church’s assets can inure to the benefit of a private individual other than as reasonable compensation for services rendered. The fact that the IRS assesses intermediate sanctions does not preclude a finding of “inurement” that may jeopardize a church’s tax-exempt status. In any excess benefit transaction, both outcomes are possible. The tax regulations specify:

    In determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organization . . . that engages in one or more excess benefit transactions . . . that violate the prohibition on inurement under section 501(c)(3) the [IRS] will consider all relevant facts and circumstances, including, but not limited to, the following—

    (A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

    (B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

    (C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

    (D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

    (E) Whether the excess benefit transaction has been corrected . . . or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction. Treas. Reg. 1.501(c)(3)-1(f)(2).

    The factors listed in paragraphs (D) and (E) of this section will weigh more heavily in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction or transactions and takes action before the IRS discovers the excess benefit transaction or transactions.

    Case studies to illustrate rules

    The following case studies will further illustrate these rules. Assume that each senior pastor in these case studies meets the definition of a disqualified person.

    Case study 1. A church uses an accountable reimbursement arrangement for the reimbursement of its senior pastor’s business-related transportation, travel, entertainment, and cellphone expenses. The church only reimburses those expenses for which the pastor produces documentary evidence of the date, amount, location, and business purpose of each expense within 30 days. By the end of the year, the church has reimbursed $4,000 of expenses.

    Since the church’s reimbursement arrangement is accountable, neither the church nor the senior pastor is required to report the reimbursements as taxable income and the reimbursements are not taken into account in deciding if the church has provided an excess benefit to the pastor.

    Case study 2. A church sends its pastor and his wife on an all-expense-paid trip to Hawaii in honor of their 25th wedding anniversary. The total cost of the trip is $8,000. The church treasurer assumes that this amount is a nontaxable fringe benefit and so does not report any of the $8,000 on the pastor’s Form W-2. The pastor likewise assumes that the cost of the trip is a nontaxable benefit.

    The church’s payment of these travel expenses constitutes an automatic excess benefit resulting in intermediate sanctions, since it was not reported as taxable income by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount.

    This will result in (1) an excise tax of $2,000 (25 percent of $8,000), (2) an excise tax of $16,000 (200 percent of $8,000), and (3) a penalty for failing to file Form 4720 (assuming the church and pastor failed to do so).

    If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect

    For this purpose, reasonable cause means exercising “ordinary business care and prudence.” Not due to willful neglect means that the receipt of the excess benefit was not due to the disqualified person’s conscious, intentional, or voluntary failure to comply with section 4958 and that the noncompliance was not due to conscious indifference.

    If the pastor cannot establish both of these requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $8,000 plus interest to the church and paid federal income tax on the $8,000 as additional compensation. Also, note that the senior pastor and his wife are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person.

    Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively.

    Case study 3. A church collected a $4,000 “love offering” from the congregation during the Christmas season last year. The congregation was informed that donations would be tax-deductible, and donations were reported on the annual contribution summary provided to each member. Both the pastor and church treasurer assumed the total amount was a nontaxable gift, so neither reported it as taxable income (on Form W-2 or Form 1040).

    The love offering constitutes an automatic excess benefit resulting in intermediate sanctions, since it was not reported as taxable compensation by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount. This will result in (1) an excise tax of $1,000 (25 percent of $4,000), (2) an excise tax of $8,000 (200 percent of $4,000), and (3) a penalty for failing to file Form 4720 (assuming the church and the pastor failed to do so).

    If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect.

    If the pastor cannot establish both of these requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $4,000 plus interest to the church and paid federal income tax on the $4,000 as additional compensation.

    Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively.

    Case study 4. In Private Letter Ruling 201517014 (2015), the IRS revoked an organization’s tax-exempt status because of its compensation practices. The organization was run by its founder and his wife, who served as its CEO and CFO, and their daughter (collectively, the “officers”). The IRS audited the organization and found the following:

    • The organization made auto loan payments on vehicles used solely by the officers.
    • The organization did not maintain any documentation to show the business use of the vehicles used by the officers. No mileage logs were provided with specific dates, miles driven, and locations of travel, and no receipts or business purpose for the use of the vehicles were provided.
    • The officers used the organization’s corporate credit cards for personal purchases. The amounts were not repaid by the officers and were not reported as compensation.
    • The organization made no-interest loans to the CEO that were not reported as compensation. There was no contemporaneous documentation of the loan, nor were there any security or repayment provisions.

    The IRS noted that “fact patterns suggesting inurement frequently suggest excess benefit transactions between an exempt organization and a disqualified person under section 4958” of the tax code. The IRS noted that the income tax regulations instruct the IRS to consider a variety of factors to determine whether revocation is appropriate when section 4958 excise taxes also apply:

    (A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

    (B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

    (C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

    (D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

    (E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6)), or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction.

    Note. For additional case studies, see the “Compensation” section in the Legal Library.

    Ononuju v. Commissioner, T.C. Memo 2021-94 (2021).

Why Churches Should Report Criminal Activities

Air Force’s liability for church shootings has broader implications—including the reporting of sexual abuse.

Key point. Negligence is a common basis for liability. Negligence is conduct that creates an unreasonable and foreseeable risk of harm to another person that results in injury. Negligent conduct need not be intentional. It may consist either of a specific act or failure to act.

A federal district court in Texas ruled that the United States Air Force was 60 percent at fault for the shooting rampage at the First Baptist Church in Sutherland, Texas, in 2017 that left 26 persons dead and 22 more wounded. The failure of Air Force leaders to report the perpetrator’s prior criminal conduct demonstrates the potential liability that organizations—including churches—can face as a result of failing to act.

A former service member attacks Texas church

Devin Patrick Kelley (Kelley) entered the First Baptist Church in Sutherland Springs, Texas, on November 5, 2017, and opened fire, killing 26 people and wounding 22 more. After fleeing the scene, Kelley later died from a self-inflicted gunshot wound.

Several survivors and relatives of those injured or killed (the plaintiffs) sued the United States government, claiming that Kelley should not have cleared the background check mandated for firearms purchases because he had been convicted of a disqualifying offense in November 2012 while he was serving in the Air Force at Holloman Air Force Base in New Mexico. Specifically, Kelley had been convicted by general court-martial of assaulting his then-wife and infant stepson on numerous occasions.

Court: The Air Force failed to meet an obligation

The court noted that the Air Force had an obligation—and multiple opportunities—to ensure that Kelley’s fingerprints and criminal history were submitted to the Criminal Justice Information Services Division (CJIS) of the Federal Bureau of Investigation (FBI) for inclusion in its databases as required by law, but it failed to do so.

In early 2019, the Air Force issued letters of admonishment to three Air Force employees involved in the investigation of Kelley between June 2011 and October 2012.

The letters concluded that the failure to ensure the reporting of criminal history data to the CJIS constituted a dereliction of duty that “fell below the minimum standards” and “contributed to Devin Kelley not being properly identified as an individual prohibited by law from purchasing a firearm.”

The court observed:

There is no question that the [Air Force] agents at [Holloman Air Force Base] who were responsible for collecting and submitting Kelley’s information to the FBI failed to meet this standard of care. [Department of Defense] and [Air Force] instructions imposed mandatory obligations on investigative agents and corrections officers to submit Kelley’s fingerprints and final dispositions. Yet the government stipulated that at no time before the Sutherland Springs Church shooting did the government submit Kelley’s fingerprints or final dispositions. . . . When the [Air Force] received notice of Kelley’s conviction for a reportable offense on November 7, 2012—based in part on conduct discovered during its own investigation—it had an obligation to submit the final disposition report to the FBI within 15 days. It failed to do so. . . . The court concludes that the government failed to exercise reasonable care in performing its undertaking to collect and submit Kelley’s fingerprints and conviction information to the FBI. . . .

The clerk at the Academy Sporting Goods store where Kelley purchased his weapons testified, “We did a [National Instant Criminal Background Check System (NICS)] background check, which goes to the FBI. After the FBI received their document, they sent us a document with a proceed to transfer the firearm to Mr. Devin Kelley.” As a result, “the only reason Kelley was able to acquire the firearms used in the shooting was the Air Force’s failure to submit his criminal history.”

The court concluded:

[T]he government failed to exercise reasonable care in its undertaking to submit criminal history to the FBI. The government’s failure to exercise reasonable care increased the risk of physical harm to the general public, including plaintiffs. And its failure proximately caused the deaths and injuries of plaintiffs at the Sutherland Springs First Baptist Church on November 5, 2017.

What this means for churches

This case is relevant to churches since it suggests that a church can be sued for negligence if it fails to report an incident of child abuse and thereby keeps the offender’s wrongful conduct out of searchable criminal databases.

To illustrate, assume that a pastor learns that a male youth worker has molested a minor female. The pastor decides to handle the matter internally and does not report it to the child abuse hotline.

The offender begins attending another church, where he applies for a youth ministry position. The second church conducts a background check and finds no evidence of wrongdoing. Accordingly, it selects the individual for a youth ministry position.

If the offender molests a minor in the second church, the argument could be made that the failure of the first church to report the offender’s abusive conduct to the state enabled the offender to molest the victim in the second church. This possibility demonstrates the importance of reporting child abuse . Holcombe v. United States, 2021 WL 2821125 (W.D. Tex. 2021).

A Church’s Tax-Exempt Status Does Not Extend to Its Minister

Tax court confirms imposition of substantial penalties on taxpayer who claimed he functioned as a church.

A taxpayer did not pay federal income taxes or self-employment taxes for six years. He was audited by the Internal Revenue Service (IRS) and was assessed back taxes and penalties. The IRS rejected his defense that he was “functioning as a church.”

On appeal, the US Tax Court agreed with the IRS. The Court observed:

No provision in [the tax code] exempts an individual functioning as a church from the obligation to pay tax on his taxable income. Ministers may be entitled to exclude the rental value of a parsonage from gross income . . . but they are taxable on the income they earn from ministering . . . and section 501(c)(3) exempts religious organizations from income tax. But, again, there is no exemption from the . . . income tax for income earned by individuals from religious activities.

Imposition of penalties

The Court concurred with the imposition by the IRS of the following penalties for the six years under review (references are to the tax code):

  • Unpaid back taxes of $400,297.
  • Section 6651(a)(1) imposes an addition to tax for failure to file a timely tax return. The addition equals 5 percent of the amount required to be shown as tax on the delinquent return for each month or fraction thereof during which the return remains delinquent, up to a maximum addition of 25 percent for returns more than four months delinquent. The IRS concluded that this penalty amounted to $90,061.
  • The IRS determined that the taxpayer was liable for an addition to tax for each year under either section 6651(a)(1) (for failure to file a timely return) or section 6651(f) (which imposes an increased addition to tax when a taxpayer’s failure to file is fraudulent). The IRS conceded that the section 6651(f) addition to tax does not apply in this case.
  • Section 6654 provides for an addition to tax in case of any underpayment of estimated tax. The IRS assessed section 6654(a) additions to tax of $14,387 for all of the years at issue.
  • Section 6673(a)(1) imposes a penalty of up to $25,000 if the taxpayer has instituted or maintained proceedings before the Tax Court primarily for delay or the taxpayer’s position in the proceeding is frivolous or groundless. A taxpayer’s position is frivolous if it is contrary to established law and unsupported by a reasoned, colorable argument for change in the law. The purpose of section 6673 is to compel taxpayers to conform their conduct to settled principles before they file returns and litigate. The Court noted that it could, on its own initiative, require a taxpayer to pay a section 6673(a)(1) penalty. It noted that the taxpayer “failed to report substantial amounts of income for six years and his argument that the Code is null and void is frivolous. . . . We need not decide whether his other argument, that he is functioning as a church (which, in the context of this case, we reject), is also frivolous. A taxpayer who makes frivolous arguments is not immune from penalty just because some of his arguments may not be frivolous. . . . He was warned by the IRS . . . that he was making frivolous arguments in challenging the constitutionality of the federal income tax system. He ignored those warnings at his peril.” The Court imposed a penalty of $2,500.

What this means for churches

This case affirms that a church’s tax-exempt status does not extend to its ministers. Additionally, it contains a good summary of the substantial tax penalties the IRS can impose on taxpayers who fail to file a tax return or pursue frivolous tax positions. Lloyd v. Commissioner, T.C. Memo 2020-92 (2020).

A Nearly $22 Million Verdict for Sexual Abuse Not Excessive, Affirms Federal Appeals Court

Churches should understand that a single incident of child abuse can expose a church to damages far in excess of its insurance coverage.

Key point 10-04 . A church may be liable on the basis of negligent selection for a worker’s molestation of a minor if the church was negligent in the selection of the worker. Negligence means a failure to exercise reasonable care, and so negligent selection refers to a failure to exercise reasonable care in the selection of the worker. Liability based on negligent selection may be imposed upon a church for the acts of employees and volunteers.

Key point 10-04.3 . Churches can reduce the risk of liability based on negligent selection for the sexual molestation of minors by adopting risk management policies and procedures.

A federal appeals court ruled that a $21.7 million verdict against a teacher and private Jewish school for the teacher’s sexual molestation of a student was not excessive and would not be overturned.

Psychologist: the victim suffered from PTSD due to abuse

An adult male (the “victim”) sued the teacher and school alleging that the teacher sexually abused him for several years while he was a minor student at the school. The teacher had been, at various times, the dean, director, treasurer, and president of the board of directors of the school.

The victim was a student at the school from Fall 2001 until Spring 2005. During that time, when the victim was 14 to 17 years old, the teacher sexually abused him on a frequent, sometimes weekly, basis, sometimes for hours at a time. The teacher provided the victim with alcohol and engaged in a variety of sexual activities with him at several locations including the school, motels, and the teacher’s home.

The victim suffered physical, emotional, and psychological injuries as a result of the abuse. The lasting effect of that abuse was corroborated by his wife and his clinical psychologist.

The victim’s psychologist, a specialist in post-traumatic stress disorder (PTSD) and childhood trauma related to physical, emotional, and sexual abuse, conducted a forensic interview of the victim, and concluded that the victim was shut off emotionally, had lost his sense of trust, had difficulty with intimacy and vulnerability, continued to suffer from PTSD, and would continue to struggle with PTSD throughout his life.

Trial judge ruling: the defendant “repeatedly sexually abused” the victim

The teacher was convicted of felony child abuse, and sentenced to 20 years in prison. At a sentencing hearing, the trial judge denounced the teacher for his actions, noting that the evidence showed that he “repeatedly sexually abused” the victim over several years, and was guilty of a “colossal violation of trust. . . . He committed the worst possible crime in the worst possible way.”

The victim sued the teacher and school (the “defendants”) in a civil lawsuit, alleging that the teacher had sexually abused him and that the school’s administrators had knowledge of the abuse but failed to report the teacher to law enforcement as required by Connecticut law.

At the conclusion of trial, the jury awarded the victim $15 million in compensatory damages, and $5 million in punitive damages plus interest of $1,749,041 for a total award of $21,749,041.

The defendants appealed this verdict to a federal appeals court, arguing that it was excessive and had to be substantially reduced. The defendants asserted that the

evidence presented at trial simply did not support the jury’s exorbitant verdict in this case, which is dramatically out of step with non-economic damage awards by juries in cases involving similar claims of sexual abuse, both in Connecticut and throughout the country.

Past rulings guide appeals court’s decision against teacher

The appeals court affirmed the trial court’s verdict. It observed:

In considering a damages award, a trial court must evaluate whether the jury’s award falls somewhere within the necessarily uncertain limits of just damages or whether the size of the verdict so shocks the sense of justice as to compel the conclusion that the jury [was] influenced by partiality, prejudice, mistake or corruption. A jury award may not be set aside merely because it exceeds what the court would have awarded. There are only a few decisions in Connecticut addressing the size of a jury award in cases concerning sexual abuse of a minor, but they are instructive. For example, in [one case] the court denied a motion to set aside a $15 million jury verdict against a defendant based on claims that he sexually abused the plaintiff from the time she was six years old until she was seventeen. [In another case] the Connecticut Supreme Court upheld an award of $7 million for three incidents of sexual assault against a minor victim. And in [a third case] the court awarded $75,200 for economic damages; $500,000 for noneconomic damages; and $167,800 in punitive damages based on claims that the defendant sexually molested the plaintiff several times before the plaintiff’s sixteenth birthday. . . .

The district court did not abuse its discretion in [refusing to reduce the amount of the verdict] because the verdict is not excessive as a matter of Connecticut law. While the teacher argues that the victim lacked evidence to support the award of noneconomic damages, there was ample evidence in the record of his physical, emotional, and psychological injuries. In addition to his own testimony, his wife and psychologist both testified that he had issues with intimacy, forming emotional attachments, and vulnerability with others. His wife explained that the teacher’s abuse had a significant, negative impact on their married life. . . . The victim’s psychologist, an expert in PTSD and childhood trauma, indicated that even with treatment, the sexual abuse the victim suffered as a minor would have lifelong consequences for him. The jury clearly credited the witnesses’ testimony in finding the defendants liable and awarding compensatory damages of $15 million.

The amount of compensatory damages is undoubtedly high, but we are not persuaded that a [reduction in the size of the verdict] is warranted under Connecticut law. The award here is not excessive when compared to the awards in the cases cited above. Here, the record indicates that the victim suffered repeated abuse for approximately three years, from the time he was fourteen until he was seventeen years old. At certain points, he was abused for hours at a time, on a weekly basis. . . .

The court noted that on a “per incident basis,” the $15 million verdict for compensatory damages “falls within the range of noneconomic damages that have been upheld by Connecticut courts in cases of sexual abuse.” It cited three additional rulings by the Connecticut Supreme Court:

  • Doe v. BSA Corp., 147 A.3d 104 (Conn. 2016). The Connecticut Supreme Court permitted a $7 million award for three incidents of sexual assault involving a ten-year-old boy by a Boy Scouts leader.
  • Doe v. Thames Valley Council for Community Action, Inc., 797 A.2d 1146 (Conn. 2002). The Connecticut Supreme Court upheld a total award of noneconomic damages of $220,000 to minors who were sexually assaulted by their school bus driver.
  • Sciola v. Shernow, 577 A.2d 1081 (Conn. 1990). The Connecticut Supreme Court ruled that a trial court erred in ordering a reduction of a jury verdict from $400,000 to $323,833 in favor of a plaintiff who claimed that her dentist sexually assaulted her while she was sedated.

The court concluded:

[The victim] testified that [the teacher] sexually abused him weekly during his sophomore year (when he was fourteen years old) and somewhat less often during his junior and senior years (but still at least every three or four weeks), and therefore he was sexually assaulted dozens of times. Based on the evidence presented at trial, we are not persuaded that the jury’s award ‘shocks the sense of justice.’ Consequently, we conclude that the district court did not abuse its discretion in denying the motion for a new trial. . . . The teacher’s challenge to the amount of the verdict fails.

What this means for churches

The sexual molestation of minors remains one of the most serious legal risks facing churches today for a number of reasons, including:

  • In many churches, the number of minors attending youth services and activities is substantial.
  • A single incident of child molestation can cause negative publicity in the community.
  • In many cases, victims of child sexual abuse will sue the church for monetary damages.
  • Many churches have inadequate insurance for child molestation claims, resulting in a potentially significant uninsured risk.
  • A church is exposed to a civil lawsuit by victims of child sexual abuse, usually on the basis of negligent hiring, supervision, or retention.
  • Most states have extended the statute of limitations for cases of child sexual abuse, exposing a church to lawsuits for decades.

The case addressed in this article adds an additional reason why incidents of child molestation represent a significant risk for churches: the possibility of a jury awarding substantial damages to a victim far in excess of a church’s insurance coverage.

How many churches could survive an adverse verdict of $20 million for a case of child molestation? Admittedly, this case involved numerous acts of severe molestation over several years. But the court referenced a verdict of $7 million in a case involving the molestation of a Boy Scout on three occasions. The court cited two other cases involving much lower verdicts, but these were older cases involving very different facts.

The lesson of this case is clear: A single incident of child abuse can expose a church to damages far in excess of its insurance coverage. As a result, this risk constitutes an existential threat to a church that must be taken seriously. Mirlis v. Greer, 952 F.3d 36 (2nd Cir. 2020).

Church School Could be Liable for Failure to Comply with State Child Abuse Reporting Law

A church can be liable on the basis of negligence for an employee’s acts of child molestation if it was aware of prior acts of molestation but failed to report them to the agency designated by state law.

Key point 4-08. Every state has a child abuse reporting law that requires persons designated as mandatory reporters to report known or reasonably suspected incidents of child abuse. Ministers are mandatory reporters in many states. Some states exempt ministers from reporting child abuse if they learned of the abuse in the course of a conversation protected by the clergy-penitent privilege. Ministers may face criminal and civil liability for failing to report child abuse.

A federal appeals court ruled that a church school could be liable on the basis of negligence for a coach’s sexual relationship with a minor student as a result of its failure to comply with a state child abuse reporting law if it had reasonable cause to suspect that child sexual abuse was occurring.

An adult male (the “coach”) was employed as the girls’ basketball coach at a Christian secondary school from 2008 until 2010. While he was the school’s basketball coach, he sent over 3,200 text messages over a three-month period to a 17-year-old student (the “victim”) who was a member of the girls’ basketball team. The victim informed the school principal later in 2009 that she had received inappropriate texts from the coach. By that point, she had deleted all of the text messages from her phone, but she provided the principal with descriptions of some of the text messages, some of which were sexually explicit. In some, the coach stated that he loved her, did not want her to be with her boyfriend, and wanted to marry her. In addition, the victim suggested to the principal that he speak with another student about similar conduct.

The coach denied that the texts contained any sexual content. Nevertheless, the principal asked him to step aside from his coaching duties while he conducted an investigation, in which he relayed at least some information about the accusations to the school’s athletic director, a friend who was a local police chief, the assistant coach of the girls’ basketball team, the school’s attorneys, and the victim’s parents. The parents were unable to obtain the content of the text messages, but provided phone logs showing that the coach and victim had exchanged thousands of texts in the last few months of 2009.

The principal also contacted the other student the victim identified to investigate whether the coach had an inappropriate relationship with her. This student denied having a physical relationship with the coach, but she suggested that the principal speak with a third student. This student informed the principal that the coach had sent her inappropriate texts before and after her graduation asking about her sexual relations with her boyfriend. She denied having an inappropriate physical relationship with the coach and testified that he never suggested that he wanted to be intimate with her.

Based on the investigation and on the advice of school counsel, the school asked the coach to resign due to the large volume of texts with the victim. The coach resigned a few days later, citing health reasons. No one at the school reported the coach’s texting conduct to law enforcement or the Pennsylvania child protective services agencies.

Following his resignation, the coach applied for a position as a softball coach at a public high school. His application did not mention his position at the Christian school but listed that school’s athletic director as one of several personal references. The athletic director at the public school did not call any of the listed personal references, but obtained all required background and criminal history checks, and all background checks cleared. After being hired as the girls’ softball coach, the coach also applied for an open position as girls’ basketball coach at the same school. He submitted a résumé listing as his reason for leaving his former coaching position a “difference of philosophy” and “heart problems.”

The public school did not hire the coach, but its athletic director did inquire of the athletic director at the Christian school about the coach. The former athletic director stated that the coach had left his coaching position at the Christian school due to an “issue with . . . texting.”

The athletic director informed the principal about the texting issue, and the principal instructed the director to “keep an eye on it” and “watch, see if you see anything.”

During the 2011–2012 school year, there were no complaints from any students or parents about the coach, and he received a positive performance evaluation and returned the following season.

An adolescent female (the “plaintiff”) was on the coach’s softball team during the 2011–2012 and 2012–2013 school years. She did not report any problems with him during her freshman season. Starting in April 2013, during her sophomore season, the coach began sending the plaintiff text messages in which he commented on her looks, and by June 2013, the texts became sexual. During the summer of 2013, the pair engaged in sexual relations. The plaintiff took steps to hide the relationship, but in late September 2013, her parents discovered her sexual relationship with the coach and contacted the police. The coach was arrested and was charged with and pleaded guilty to child pornography and sexual abuse of a minor for his actions with the plaintiff.

The victim later sued the Christian school and school officials for negligence, alleging that these defendants failed to report the coach’s misconduct with the first victim to the civil authorities, and that this failure caused her injury because the coach was not apprehended for his crimes and therefore was free to groom and molest her. A federal district court dismissed all claims against the Christian school, and the case was appealed.

The federal appeals court’s ruling

The plaintiff’s main argument on appeal was that the defendants were liable for her injuries on the basis of their failure to report the abuse as required by the state child abuse reporting law (the Pennsylvania’s Child Protective Services Law), which requires school employees and school administrators to report suspected sexual abuse and exploitation of students. The reporting law specifies:

An administrator and a school employee . . . shall report immediately to law enforcement officials and the appropriate district attorney any report of serious bodily injury or sexual abuse or sexual exploitation alleged to have been committed by a school employee against a student.

The court noted that the reporting law “therefore requires schools to report to law enforcement where there is reasonable cause to suspect sexual abuse or sexual exploitation of a student.” The question in this case was whether the Christian school and its officials had reasonable cause to suspect sexual abuse or exploitation by the coach with the first victim thereby triggering a legal duty to report. The court concluded that such cause existed, and therefore the district court should not have dismissed the case. The court acknowledged the following facts:

When the Christian school principal learned of the first victim’s sexting allegations he investigated them by speaking to the victim, the victim’s parents, the assistant basketball coach who worked with the coach, two other female students rumored to have experienced inappropriate behavior by the coach, the school’s attorneys, and a friend who was a police chief in another jurisdiction. The principal confirmed that the coach had sent the first victim over 3,000 texts between September and December 2009, but the texts had since been deleted. The only remaining evidence of their content was a written record, made by the first victim at her parents’ direction, of what the most suggestive messages had said. The coach denied that the texts contained inappropriate content, and the victim did not assert that the coach had any inappropriate physical sexual contact with her. The principal also followed up on the first victim’s statement that the coach had inappropriate relationships with other students, but these students also denied any physical sexual involvement with the coach. Thus, the principal was able to confirm that coach sent the victim a large number of texts but, on the evidence before him, could not substantiate the “actual proven physical abuse” that he thought the [child abuse reporting law] required.

But, the court insisted that

even if there was no actual proof of physical abuse, a jury could find the victim’s account of the coach’s texts, which allegedly expressed his love and sexual desire for her, combined with the large volume of texts sent by the coach to the victim and the rumors concerning the coach and other female students, sufficient to provide “reasonable cause to suspect . . . sexual abuse or sexual exploitation.” Because a genuine dispute exists as to whether the school defendants were required to report the coach’s conduct to authorities . . . we will vacate the District Court’s order granting summary judgment to the school defendants.

What this means for churches

This case illustrates an important point: A church can be liable on the basis of negligence for an employee’s acts of child molestation if it was aware of prior acts of molestation but failed to report them to the agency designated by state law. The key finding of the court was that even if the school and school officials had no actual proof of sexual abuse, a jury could find that a duty to report arose because the following facts could constitute “reasonable cause to suspect sexual abuse or sexual exploitation of a student”: (1) thousands of emails and text messages were shared between the coach and the first victim; and (2) though the victim claimed that all the texts had been deleted, she did recall that the coach’s texts expressed his love and sexual desire for her.

The bottom line is that to safeguard minors from future abuse, and manage legal risk, the best practice for churches and pastors to follow is to report to the designated state reporting agency all known or reasonably suspected incidents of sexual abuse of a minor. This is so regardless of whether a pastor is a mandatory or permissive reporter, and whether the clergy-penitent privilege excuses a duty to report. Nace v. Pennridge School District, 2018 WL 3737960 (3rd Cir. 2018).

Court Barred from Settling Sexual Harassment Claim

First Amendment prevents the civil courts from applying employment laws to the relationship between a church and a minister.

Update. The decision made in this case from 2019 was affirmed by Seventh Circuit in 2021, ending the plaintiff’s legal challenge.

Key point 8-10.01. 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.

Key point 8-12.05. Sexual harassment is a form of sex discrimination prohibited by Title VII of the Civil Rights Act of 1964. It consists of both “quid pro quo” harassment and “hostile environment” harassment. Religious organizations that are subject to Title VII are covered by this prohibition. An employer is automatically liable for supervisory employees’ acts of harassment, but a defense is available to claims of hostile environment harassment if the employer adopted a written harassment policy and an alleged victim fails to pursue remedies available under the policy. In some cases, an employer may be liable for acts of sexual harassment committed by nonsupervisory employees, and even nonemployees.

A federal appeals court ruled that the ministerial exception barred a church organist’s sexual harassment claim against his employing church for its creation of an offensive working environment through unwelcome verbal conduct of a sexual nature.

An adult male (the “plaintiff”) served for two years as “Music Director, Choir Director and Organist” for the Archdiocese of Chicago and a local parish (the “church defendants”). His immediate supervisor was the parish priest. The priest knew that the plaintiff was gay and that he was engaged to another man. During the plaintiff’s two years of employment, the priest allegedly made remarks critical of the plaintiff’s sexual orientation.

In 2013, the priest asked the plaintiff when he planned to marry his partner, and the plaintiff responded that the wedding would be sometime in 2014. The plaintiff claimed that the abusive and harassing behavior became increasingly hostile as the wedding date approached. The marriage took place in September 2014. Four days after the wedding, the priest asked the plaintiff to resign because of the marriage. When the plaintiff refused to resign, the priest fired him and said, “Your union is against the teachings of the Catholic church.”

The plaintiff sued the priest, church, and the Archdiocese of Chicago, alleging employment discrimination based on sexual orientation and marital status in violation of Title VII of the Civil Rights Act of 1964, and disability discrimination in violation of the Americans with Disabilities Act. On the disability discrimination claim, the plaintiff alleged that he was frequently harassed because of his diabetes and a metabolic syndrome. For example, the plaintiff alleged that the priest repeatedly complained about the cost of keeping the plaintiff on the parish’s health and dental insurance plans because of his weight and diabetes.

The trial court dismissed the lawsuit on the grounds that the discrimination and wrongful-termination claims were barred by the First Amendment’s “ministerial exception” which generally bars the civil courts from resolving employment disputes between churches and clergy. The plaintiff appealed, modifying his claims to challenge the “hostile work environment” rather than the firing itself.

The appeals court’s ruling

Title VII of the Civil Rights Act of 1964 prohibits employers with at least 15 employees from discriminating against any employee or applicant “with respect to compensation, terms, conditions or privileges of employment, because of such individual’s sex.” Sexual harassment is a form of sex discrimination prohibited by Title VII. The courts have identified two types of sexual harassment—”quid pro quo” and hostile environment. “Quid pro quo” harassment refers to conditioning employment opportunities on submission to a sexual or social relationship, while “hostile environment” harassment refers to the creation of an intimidating, hostile, or offensive working environment through unwelcome verbal or physical conduct of a sexual nature. In general, an employer is liable for a supervisory employee’s hostile environment sexual harassment.

In this case, the court noted, the plaintiff conceded that he was a “minister” for purposes of the ministerial exception, but claimed that the church defendants had nonetheless violated Title VII by creating a “hostile environment.” The question before the court was whether the ministerial exception applied to sexual harassment claims based on a hostile environment. The court noted that only a few courts have addressed whether hostile work environment claims brought by a minister are barred by the ministerial exception, and the courts have reached opposite conclusions. The court concluded:

[The plaintiff’s] hostile-environment claims based on his sex, sexual orientation, and marital status pose [a risk] of impermissible entanglement with religion. First, his status as a minister weighs in favor of more protection of the church defendants under the First Amendment. Remember that the church defendants have absolute say in who will be its ministers. The Archdiocese might very well assert that it has a heightened interest in opposing same-sex marriage amongst those who fulfill ministerial roles. Either the Court would have to accept that proposition as true (thus intensifying the intrusion in regulating how the opposition is conveyed to the Church’s ministers) or the parties would have to engage in intrusive discovery on the sincerity of that belief. Indeed, even if the proposition would be accepted as true, the Church itself would have a litigation interest in proving to the jury why there is a heightened interest in opposing same-sex marriage amongst its ministers. That would put the Church in a position of having to affirmatively introduce evidence of its religious justification, so the litigation’s intrusion would not be just a matter of responding to the plaintiff’s discovery requests. The Church might even wish to offer the views of its congregants on this issue, especially if the plaintiff offered evidence from congregants that they would not be offended by a gay music director.

But the appeals court allowed the disability discrimination claim to proceed:

Here, the Archdiocese offers no religious explanation for the alleged disability discrimination. The Archdiocese justifies the comments as “reflecting the pastor’s subjective views and evaluation of plaintiff’s fitness for his position as a minister. But this is not a religious justification based on any Church doctrine or belief, . . . at least as proffered so far by the defense. So the disability claim does not pose the same dangers to religious entanglement as the sexual orientation and marital-status claims. Nothing in discovery should impose on religious doctrine on this claim. Rather, the inquiry will make secular judgments on the nature and severity of the harassment (and whether it even happened), as well as what, if anything, the Archdiocese did to prevent or correct it. The [First Amendment] does not bar the plaintiff from pursuing the hostile-environment claims based on disability.

What this means for churches

This case is helpful because it provides a broad interpretation of the ministerial exception, extending it not only to discrimination claims by dismissed ministers claiming discrimination based on sexual orientation, but also to “hostile environment” sexual harassment claims, whether or not a minister is dismissed. Demkovich v. St. Andrew the Apostle Parish, 2018 U.S. Dist. LEXIS 168584 (N.D. Ill. 2018).

IRS Wins Ruling Against Church for Misclassifying Employees

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

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.

Court Barred by First Amendment from Resolving a Dismissed Minister’s Terminated Retirement Benefits

The court concluded that the plaintiff “sought review of the procedures that resulted in ecclesiastical decisions and necessitated a review of religious law and practice, which is exactly the inquiry that the First Amendment prohibits civil courts from undertaking.”

Key point. Breach of contract claims by dismissed ministers, no matter how meritorious, cannot be resolved by the civil courts if doing so would require an interpretation of religious doctrine, or involves a claim that a decision by the highest ecclesiastical tribunal of a hierarchical denomination did not comply with the church’s laws and regulations.

A federal appeals court ruled that it was barred by the First Amendment religion clauses from resolving a dismissed minister’s claim that a denominational pension board acted improperly in terminating his retirement benefits pursuant to denominational rules when he was “defrocked” and ceased to be a minister in good standing.

An ordained minister (the “plaintiff”) began collecting benefits in 2009 after fulfilling the three conditions identified in his human resource manual for eligibility: (1) he had remained as a member in good standing of the denomination, (2) completed 10 years of full-time paid service for the denomination, and (3) had reached or exceeded retirement age.

The plaintiff’s retirement benefits were terminated for not “remaining as a member of good standing of the denomination” after being defrocked and dismissed from the denomination. The plaintiff sued the denomination, claiming that the termination of his retirement benefits constituted a breach of contract and a violation of the denomination’s covenant of good faith and fair dealing. A federal district court ruled that the lawsuit turned on an “interpretation of what constitutes a ‘member in good standing’ under denominational rules of governance, custom, and faith” and any ruling by the court would violate the religious freedom guaranteed by the First Amendment.

A federal appeals court affirmed the trial court’s dismissal of the case. The court observed:

The [trial] court correctly dismissed the lawsuit. A dispute involving the application of church doctrine and procedure to discipline one of its members is not appropriate for secular adjudication. The plaintiff’s claims, which were predicated on his defrocking, his excommunication, and the termination of his retirement benefits due to a “theological disagreement” would have required encroachment into matters of church dogma and governance. Based on “the separation of church and state principles required by the … First Amendment … the [trial] court could not interfere with the purely ecclesiastical decisions of the [denomination] regarding the plaintiff’s fitness to serve in the clergy or to remain a member of the denomination.

Civil courts may apply neutral principles of law to decide church disputes that involve no consideration of doctrinal matters, but the plaintiff’s lawsuit required examination of church doctrine and polity. His claims … turned on whether he was entitled to retirement benefits. And his entitlement to retirement benefits was conditioned on, among other things, that he remain as a member in good standing of the church. As the trial court stated, it could not “define ‘member’ for a specific church or denomination … because that would require defining the very core of what the religious body as a whole believes.” Likewise, to determine if the plaintiff had remained in good standing, the trial court explained, it would have had to “scrutinize documents related to church rules and discipline and … apply its interpretation of those rules to the plaintiff’s conduct. In other words, the court would have had to determine whether [the denomination] exercised its religion in accordance with the doctrine, faith, custom, and rules of governance” of the church. Because the plaintiff’s claims required an examination of doctrinal beliefs and internal church procedures, the trial court had no power to entertain his controversy with the denomination.

The court noted that the plaintiff’s claim that the denomination breached its implied covenants of good faith and fair dealing also would require review of a decision about internal church governance. The plaintiff alleged that he had been defrocked, excommunicated, and had his retirement benefits cancelled in violation of church procedural rules and the process afforded other ministers. But, the court noted, the United States Supreme Court issued a ruling in 1976 “prohibiting civil courts from undertaking an inquiry into whether the decisions of the highest ecclesiastical tribunal of a hierarchical church complied with church laws and regulations.” Serbian E. Orthodox Diocese v. Milivojevich, 426 U.S. 696 (1976). Such an inquiry by a civil court “would undermine the general rule that religious controversies are not the proper subject of civil court inquiry, and that a civil court must accept the ecclesiastical decisions of church tribunals as it finds them.”

In conclusion, the plaintiff “sought review of the procedures that resulted in ecclesiastical decisions and necessitated a review of religious law and practice, which is exactly the inquiry that the First Amendment prohibits civil courts from undertaking.”

What this means for churches

This case illustrates the view of many courts that breach of contract claims by dismissed ministers, no matter how meritorious, cannot be resolved by the civil courts if doing so would require an interpretation of religious doctrine, or, as in this case, involves a claim that a decision by the highest ecclesiastical tribunal of a hierarchical denomination did not comply with the church’s laws and regulations. 719 Fed.Appx. 926 (2018).

School Not Responsible for Student’s Suicide

Court ruled that a parochial school was not responsible for the suicide of a freshman student who was a victim of relentless bullying.


Key point 10-11.
A church may be legally responsible on the basis of negligent supervision for injuries resulting from a failure to exercise adequate supervision of its programs and activities.

Key point 10-17.1. Punitive damages are monetary damages awarded by a jury “in addition to compensation for a loss sustained, in order to punish, and make an example of, the wrongdoer.” They are awarded when a person’s conduct is reprehensible and outrageous. Most church insurance policies exclude punitive damages. This means that a jury award of punitive damages represents an uninsured risk.

Editor’s note: The following Recent Development contains offensive slurs regarding sexual orientation. These details are facts from the case and are included here to help church leaders understand both the nature and severity of the situation, and the types of factors that can contribute to potential litigation.

The federal Court of Claims ruled that a parochial school was not responsible for the suicide of a freshman student who was a victim of relentless bullying.

In his freshman year as a student at a Catholic high school, a freshman student (the “victim”) was allegedly abused and harassed while on campus. He was called “faggot,” “fag,” “gay,” and suffered other sexually oriented and derogatory verbal abuse. The victim’s mother identified three male students as primarily responsible for the abusive behavior, which included advice for the victim to “go home and kill himself.” Students also hit the victim with belts. Tragically, the victim later committed suicide.

The victim’s mother (the “plaintiff”) sued the school, claiming that it was responsible for her son’s death because of its failure to enforce its own anti-bullying policy. The trial court granted the school’s motion to dismiss all claims, concluding that the plaintiff had failed to demonstrate that the school was negligent, and failed to show that she was entitled to punitive damages. The plaintiff appealed.

The appeals court agreed with the trial court’s dismissal of the lawsuit. It noted that a claim of negligence requires proof of the following elements: (1) a duty of care owed by the defendant to the plaintiff; (2) conduct by the defendant falling below the standard of care amounting to a breach of that duty; (3) an injury or loss; and (4) the injury or loss was reasonably foreseeable “by a person of ordinary intelligence and prudence.” The court concluded that the victim’s suicide was not reasonably foreseeable and so the school was not responsible for it:

If a school is aware of a student being bullied but does nothing to prevent the bullying, it is reasonably foreseeable that the victim of the bullying might resort to self-harm, even suicide… . Thus, to allege successfully that the victim’s suicide was foreseeable [the plaintiff’s] complaint should have included facts alleging that the school was aware of the abuse and harassment the victim experienced. The complaint fails to make such allegations. The fact that the students responsible for bullying him had a history of this behavior does not establish the school’s knowledge that they continued to be bullies or that the victim was their new victim. The plaintiff provides no facts that any teacher saw or heard the bullying, that [she or her son] told anyone at the school what was happening, or any other fact to support an inference that the school had any knowledge of the situation.

A school with no knowledge of bullying has no reason to believe the anti-bullying policy needs enforcement, let alone that failure to enforce the policy may result in a student’s death. Therefore, we cannot conclude that the harm giving rise to the lawsuit could have reasonably been foreseen or anticipated by a person of ordinary intelligence and prudence.

The appeals court also agreed with the trial court’s rejection of punitive damages:

Under state law [the plaintiff] would be eligible for punitive damages only if the district court found that the school acted recklessly. A person acts recklessly when the person is aware of, but consciously disregards, a substantial and unjustifiable risk of such a nature that its disregard constitutes a gross deviation from the standard of care that an ordinary person would exercise under all the circumstances. The trial court found that the plaintiff failed to allege facts showing that the school was aware the victim might try to hurt himself, or that it was aware but consciously disregarded the risk, and therefore decided punitive damages were not appropriate. The plaintiff points to no facts explaining why the decision to deny punitive damages was an abuse of the trial court’s discretion, beyond claiming that the court’s determination on the question of recklessness was incorrect. This claim was properly dismissed.

What this means for churches

This case is instructive for the following reasons. First, it is one of the few cases to address the liability of a religious organization for bullying activities. The court concluded that a religious organization is not responsible for deaths or injuries caused by bullying unless it was aware of the bullying activities that led to the injury or death and failed to intervene. Second, the court concluded that punitive damages were not appropriate in this case, even if the school had been negligent, since its conduct did not meet the high threshold of punitive damages—reckless behavior or gross negligence.

The implication is clear. Church leaders that know about bullying activities have a duty to intervene, and failure to do so may lead to liability based on negligence, and, possibly, punitive damages. It should be noted that punitive damages are monetary damages awarded by a jury “in addition to compensation for a loss sustained, in order to punish, and make an example of, the wrongdoer.” They are awarded when a person’s conduct is reprehensible and outrageous. Most church insurance policies exclude punitive damages. This means that a jury award of punitive damages represents an uninsured risk. Tumminello v. High School, 678 Fed.Appx. 281 (6th Cir. 2017).

Related Topics:

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.

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.

Coffee Shop Founded by a Pastor Fails to Qualify for Tax-Exempt Status

A predominantly commercial enterprise will not qualify for tax-exempt status if its principal activities are indistinguishable from competing for-profit entities, even if it engages in occasional or insignificant activities in furtherance of its religious mission.

Key point. The operation of a coffee shop as a church outreach to the community will not constitute a basis for tax-exempt status if the operation of the coffee shop is overly commercialized to the extent that the religious purpose is minimal.

The IRS ruled that a “coffee shop” founded by the pastor of a church for personal evangelism in an urban area did not qualify for tax-exempt status since it was indistinguishable in operation from secular, for-profit coffee shops.

A nonprofit corporation (the “Corporation”) was formed for the following four purposes:

  1. Proclaim earnestly the gospel message and to urge its personal acceptance.
  2. Promote prayer, Bible study, missions, Christian fellowship, evangelism, Christian service and encouraging, in every possible way, a lifetime commitment to Christ.
  3. Provide a forum in which the Gospel of Jesus Christ can be discussed with non-believers outside of a formal church setting.
  4. Generously extend the grace of God by giving away 100% of all profits (except those retained for capital expenditures) to community ministries, other local, national or international nonprofits or organizations, or those in financial need.
  5. The founder of the Corporation came up with the vision to form a coffee shop where believers could interact with nonbelievers in a safe and friendly environment to convey the gospel in a nonconfrontational manner in word and deed. The founder served as pastor of a local church, but he elected to form the Corporation as a separate entity from his church in order to encourage other Christian churches and organizations to participate in his vision. The founder’s church granted funding for the Corporation’s start up, and the Corporation’s bylaws specified that a majority of its board members had to be members of the church.

    The Corporation applied to the IRS for recognition of tax-exempt status as a ministry organized and operated exclusively for religious purposes. Its application for exemption described it purposes and activities as follows:

    • Once formed, the Corporation opened a coffee shop and obtained trade name protection for its name.
    • It sold coffee locally and planned to eventually sell it online as well.
    • The Corporation’s coffee shop was open Monday through Friday from 6 a.m. to 8 p.m. and Saturday from 7 a.m. to 8 p.m.
    • It had free WiFi and power outlets for customer use. It used coffee that was sourced directly from coffee farmers. The Corporation believed that its coffee benefited coffee farmers 50 percent to 100 percent over the price paid for “”Fair Trade” coffee. Its drink selection included coffee, tea, smoothies, frappes, soft drinks, and juices. Food items included baked goods, soups, sandwiches, salads, and desserts.
    • The coffee shop provided a location for both formal and informal Bible study, church group meetings, and meetings for other organizations. The coffee shop was used for a Women’s Bible Study, a Men’s Bible Ministry, meetings of the church’s elders, book signings, birthday parties, baby and bridal showers, community business meetings, game nights, live music, and similar events.
    • The Corporation stated that its promotion of the gospel of Jesus Christ was subtle and indirect. Several times a year the gospel was promoted through a program consisting of a donor paying for a certain amount of coffee in advance. Then, when a customer came in they were told by the staff that the coffee had already been paid for and, “that the coffee is not free but that the price has already been paid, just like Jesus already paid the price for all of our sins by dying on the cross for us.”
    • The Corporation had a “Monthly Mission” in which it partnered with other ministries, missionaries, and nonprofit organizations by highlighting their activities to help raise funds, supplies, and recognition for them. The Corporation selected a “partner” and provided information about the person or organization to customers. It also collected donations for the partner.
    • The Corporation gave away meals and drinks to the homeless and helped connect them with local ministries for lodging and jobs.
    • The Corporation took part in a training program that helped train underserved youth by placing them in a local business for a six-week internship so they could gain firsthand experience.
    • The coffee shop’s activities are run by compensated staff as well as volunteers.
    • Almost all of the coffee shop’s revenue was from the sale of food items. Its largest expense was for salaries and wages. It also had occupancy expenses and expenses for cost of goods sold, advertising, licenses and permits, insurance, supplies, payroll, and repairs and maintenance.
    • The coffee shop had not earned profits that would have allowed it to give away any substantial amount of money, but it hoped to be able to do so in the future.

    In rejecting the Corporation’s application for tax-exempt status, the IRS noted that one of the requirements for exemption enumerated in section 501(c)(3) of the tax code is that the organization seeking exempt status must be “organized and operated exclusively for charitable, religious or educational purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.” This essential requirement was not met in this case, the IRS concluded:

    You are not described in Section 501(c)(3) of the Code … because you fail the operational test. Specifically, the facts show you are not operated exclusively for Section 501(c)(3) purposes because a substantial portion of your activities consists of the operation of a coffee shop in a commercial manner.

    While donating funds to other nonprofit community organizations is charitable … your main focus is the operation of a coffee shop. Additionally, while some of the activities that take place in the coffee shop … advance religion, more than an insubstantial portion of your activities serve a commercial purpose… . You are not regarded as “operated exclusively” for one or more exempt purposes because you do not engage primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3) of the Code. Your primary activity is the operation of a coffee shop in a commercial manner. You are open to the public Monday through Friday from 6 a.m. to 8 p.m. and Saturday from 7 a.m. to 8 p.m. You have free Wi-Fi and power outlets throughout for customer use. You have space that can be used for gatherings such as meetings and parties. You have a selection of food and beverage items that can be purchased at the coffee shop… . You believe the location of the coffee house is ideal because there are no other similar businesses downtown. Therefore, the operation of your coffee shop to raise funds is a commercial activity, not a charitable activity ….

    The operation of the coffee shop and your programs to further the Gospel of Jesus Christ, partner with other organizations, and participate in community activities are separate and distinct activities. Since the operation of the coffee shop is a substantial part of your activities and is not a recognized charitable purpose, you are not organized and operated exclusively for 501(c)(3) purposes ….

    You are operating a coffee shop that is open to the public six days a week in competition with other commercial markets. This is indicative of a business. Your primary sources of revenues are from coffee shop sales. Your expenses are mainly for salaries, cost of goods sold, and occupancy expenses to support the operation of the coffee shop. Taking in totality, the operation of your coffee shop constitutes a significant non-exempt commercial activity.

    The IRS concluded: “You do not qualify for recognition of exemption from federal income tax as an organization described in Section 501(c)(3) of the Code. Your coffee shop activities are indistinguishable from similar activities of an ordinary commercial enterprise.”

    What this means for churches

    This case is instructive for any church that is considering the creation of a commercial venture in furtherance of its religious mission. A predominantly commercial enterprise will not qualify for tax-exempt status if its principal activities are indistinguishable from competing for-profit entities, even if it engages in occasional or insignificant activities in furtherance of its religious mission.

    Churches that operate coffee shops on or off of church premises should be aware of the following legal and tax considerations:

    • Income tax exemption for separate facilities. A church cannot assume that a coffee shop will be exempt from federal income taxes, even if it has a religious purpose, if its commercial functions and purposes are significant. In such cases, the facility may fail the “operational test” of tax-exempt status described in section 501(c)(3) of the Internal Revenue Code.
    • The federal unrelated business income tax, which subjects tax-exempt entities to the corporate income tax. There are exceptions, including facilities that are operated by volunteer labor.
    • The potential impact on a church’s property tax exemption.
    • The potential impact of an applicable state sales tax law.
    • Compliance with local zoning laws.
    • Compliance with health department regulations.
    • Liability issues for injuries occurring at the facility.

    The least regulatory burden will apply to church-operated coffee facilities that:

    • Are located on church property.
    • Are operated solely for the convenience of members.
    • Are operated by volunteers.
    • Are not advertised to the general public by exterior signage, newspaper ads, etc.
    • Are open only during (or immediately before and after) church services.
    • Do not charge a fee for coffee or snacks.

    IRS Private Letter Ruling 201645017 (2017).

$65 Million Charitable Contribution Deduction Denied by IRS

Donor not entitled to a charitable contribution deduction because it was unable to meet the strict substantiation requirements

Key point. Charitable contribution deductions for contributions of noncash property are subject to various substantiation requirements. Failure to comply with these requirements can result in a loss of any deduction, even if there is no doubt that a contribution was made.

The United States Tax Court upheld the IRS's denial of a $65 million charitable contribution deduction because the written acknowledgment issued by the donee charity was not "contemporaneous" as required by the tax code.

On its 2007 tax return, a partnership claimed a charitable contribution deduction of $65 million. In order to substantiate a charitable contribution deduction of $250 or more, a taxpayer must secure and maintain in its files a "contemporaneous written acknowledgment" (CWA) from the donee organization. IRC 170(f)(8)(A). The CWA must state (among other things) whether the donee provided the donor with any goods or services in exchange for the gift. IRC 170(f)(8)(B)(ii).

The IRS audited the partnership's tax return and disallowed the charitable contribution deduction in its entirety. The donee organization thereafter submitted an amended return that included the information specified in subparagraph (B), including whether the donee provided the donor with any goods or services in exchange for the gift. The partnership appealed to the United States Tax Court. The partnership asked the court to dismiss the case on the ground that the substantiation requirements had been met. The court declined to do so.

The court began its opinion by stressing that "the requirement that a CWA be obtained for charitable contributions of $250 or more is a strict one. In the absence of a CWA meeting the statute's demands, no deduction shall be allowed." If a taxpayer fails to meet the strict substantiation requirements of section 170(f)(8), "the entire deduction is disallowed."

Further, the doctrine of "substantial compliance" does not apply to the failure to obtain a CWA meeting the statutory requirements. In other words, a taxpayer's substantial compliance with the tax code's substantiation requirements is no defense to noncompliance. The court explained:

Section 170(f)(8)(B) [of the tax code] provides that a CWA must include the following information:

(i) The amount of cash and a description (but not value) of any property other than cash contributed.
(ii) Whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i).
(iii) A description and good faith estimate of the value of any goods or services referred to in clause (ii)… .

An acknowledgment qualifies as "contemporaneous" only if the donee provides it to the taxpayer on or before the earlier of "the date on which the taxpayer files a return for the taxable year in which the contribution was made" or "the due date (including extensions) for filing such return."

The court concluded that the partnership failed to comply with the tax code's requirement of a CWA, despite its attempt to rectify the mistake by filing an updated form after the deadline had expired.

What this means for churches

This case illustrates the consequences that can result from a church's failure to comply with the substantiation requirements for charitable contributions. Those requirements are stricter for contributions of $250 or more, and, as this case demonstrates, require the written acknowledgment (receipt) provided by a charity to donors to be contemporaneous and include a statement indicating whether the charity provided goods or services to the donor in consideration of the contribution. If goods or services were provided, the church's written acknowledgment must provide a description and good faith estimate of the value of those goods or services, or, if only intangible religious benefits were provided, a statement to that effect.

Churches failing to provide donors with a proper acknowledgment jeopardize the deductibility of donors' contributions. In this case, that meant the loss of a $65 million contribution deduction.

Both the IRS and the Tax Court stressed that whether or not the donor actually made the donation was irrelevant. Even assuming that the donor made the $65 million contribution, it was not entitled to a charitable contribution deduction because it was unable to meet the strict substantiation requirements that apply to contributions of $250 or more. When it comes to the substantiation of charitable contributions, it is form over substance. And, "substantial compliance" with the law is no excuse or defense. 15 West 17th Street LLC v. Commissioner, 147 T.C. 19 (2016).

Tip. To avoid jeopardizing the tax deductibility of charitable contributions, churches should advise donors at the end of 2017 not to file their 2017 income tax returns until they have received a written acknowledgment of their contributions. This communication should be in writing. To illustrate, the following statement could be placed in the church bulletin or newsletter for the last few weeks of 2017 or included in a letter to members: "IMPORTANT NOTICE: To ensure the deductibility of your church contributions made this year, please do not file your 2017 income tax return until you have received a written acknowledgment of your contributions from the church. You may lose a deduction for some contributions if you file your tax return before receiving a written acknowledgment of your contributions from the church."

Tip. Be alert to any donation of noncash property that may be valued by the donor at more than $500. Be sure the donor is aware of the need to complete Section A of Form 8283 for donations of property valued at more than $500 but not more than $5,000, and Section B of Form 8283 for donations of property (other than publicly traded stock) valued at more than $5,000. The instructions to Form 8283 contain a helpful summary of the substantiation requirements that apply to these kinds of gifts. Different rules apply to donations of vehicles. Failure to comply with these rules may lead to a loss of a deduction. Churches should have these forms on hand to give to donors who make contributions of noncash property.

Orthodox Jewish Family Not Eligible for Religious Exemption from State Mandatory Vaccinations

Plaintiffs had not sustained their burden of establishing that they hold genuine and sincere religious beliefs against the practice of vaccinating.

A federal court in New York ruled that Orthodox Jewish parents failed to prove that they qualified for a religious exemption from a state mandatory vaccination law for public and private school students.

Section 2164 of the New York Public Health Law (PHL) imposes a baseline requirement that school-aged children be immunized against certain enumerated diseases. In relevant part, the statute provides as follows:

No principal, teacher, owner or person in charge of a school shall permit any child to be admitted to such school, or to attend such school, in excess of fourteen days, without the [appropriate certificate by an administering physician] or some other acceptable evidence of the child's immunization against poliomyelitis, mumps, measles, diphtheria, rubella, varicella, hepatitis B, pertussis, tetanus, and, where applicable, Haemophilus influenza, meningococcal disease, and pneumococcal disease.

However, the PHL carves out two exemptions from this general requirement, namely: (i) a medical exemption for children whose pediatrician certifies that the required immunizations may be detrimental to their health, and (ii) a religious exemption. The religious exemption removes from the statute's purview "children whose parent, parents, or guardian hold genuine and sincere religious beliefs which are contrary to" the practice of vaccinating, and, as to them, requires no certificate of immunization as a prerequisite to their attendance at school.

A married couple (the "plaintiffs") enrolled their three daughters in a private Jewish school. The mother is a devout Orthodox Jew and has raised her three daughters in the Orthodox Jewish tradition. For reasons that she alleges are inexorably linked to her faith, she has not vaccinated her children and does not intend to do so. From 2010 to 2015, none of the daughters was vaccinated as required by the terms of the PHL because the mother applied for, and received, a religious exemption under the law.

In 2015, the school reevaluated its handling of religious exemptions, and made the process of exemption more intensive, as a result of a measles outbreak in another state. This outbreak caused many parents to question the school's preparedness for a similar event. The school determined that its enforcement of the PHL to be below the legal standard. In particular, school officials concluded that the school had not previously conducted any meaningful review of students' applications for religious exemptions, and that the school had simply "rubber stamped" such requests without conducting due diligence.

Accordingly, in 2015, the school began "strict enforcement" of the state immunization law by, for example, closely scrutinizing the reasons given by parents seeking religious exemptions for their children. School officials met with the plaintiffs, but concluded that they did not qualify for a religious exemption since the primary basis of their objection to vaccination was for health reasons.

The parents asked a court to issue an injunction compelling the school to admit their unvaccinated children. The court declined to do so, concluding that the parents had not demonstrated sincere religious objection to vaccinations. The court observed:

The mother reiterated her belief that the Torah commands her "to keep the body completely whole and pure without defilement." In this regard, she referred to Jewish beliefs against making cuttings in the flesh, but did not supply any specific quotations. She also reiterated her belief in prioritizing natural remedies over invasive medical treatments, stating that "any disease which can be treated naturally should be treated in a natural way … ."

The court did not doubt that the plaintiffs "held a genuine and sincere belief that they should not vaccinate their children." However, "careful consideration of the current record suggests that these beliefs were formed with a primary view toward the children's health, and not their religion. In this regard, the record clearly does not support a finding that Orthodox Judaism, even as interpreted by these plaintiffs, forbids the practice."

The court concluded:

The evidence shows that the plaintiffs are devoutly religious. However, the evidence connecting this faith to their objection to vaccinating their children is tenuous. Initially, as noted, the plaintiffs concede that there is no tenet of the Orthodox Jewish religion that prohibits the practice of vaccinating. In fact, the evidence shows that, of the approximately 1,700 Orthodox Jewish students at [the school] only a small minority of families interpret Judaic law as prohibiting the practice.

Further … there is evidence in this case to indicate that the plaintiffs hold a selective personal belief against the practice of vaccinating, as opposed to a religious belief. In this regard, the mother relies primarily on the Torah's commandment to guard the body against disease. However, the mother testified that she applies this rule flexibly; that it is her prerogative to determine the best method of guarding her children's bodies against disease; and that the full force of Jewish law should attach to her decisions … .

The selectivity with which the mother applies the Torah's commandments is also apparent in other parts of her testimony. For example, she has pierced ears, contradicting her purported belief against making cuttings in the skin. She ingests prenatal vitamins because they are doctor recommended, apparently without regard for whether vaccinations are similarly recommended. She permits Novocaine to be injected into her body by a dentist, undermining her objection to foreign impure substances being inoculated into the body. And, despite testifying that Jewish law forbids prophylactic remedies for healthy individuals, she applies sunblock to her daughters' skin to prevent adverse health effects of sun exposure.

In conclusion, the court found that the Plaintiffs had not sustained their burden of establishing that they hold genuine and sincere religious beliefs against the practice of vaccinating. As a result, an injunction was unwarranted.

What this means for churches

An increasing number of public elementary and secondary public schools have adopted policies requiring the vaccination of students. Many of these policies are based on state law. While religious exemptions are recognized in some states, many exemptions are conditional and, as this case demonstrates, will not always apply.

The parents' eligibility for a religious exemption in this case was denied for the following reasons: (1) Their opposition to medical interventions was selective. They considered some consistent with their religious faith, and some inconsistent with it. (2) They had difficulty pointing to specific passages in the Torah that prohibited vaccination. (3) Of the 1,700 students at the Jewish school their children attended, only three families expressed religious objection to vaccination. NM v. Hebrew Academy, 155 F.Supp.3d 247 (E.D.N.Y. 2016).

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

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

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).

Taxpayers Must Meet Strict Requirements for Continuing Education Expense Deductions

Key point. Continuing education expenses that are part of a program of study that will


Key point. Continuing education expenses that are part of a program of study that will lead to qualifying a taxpayer in a new trade or business are not deductible as a business expense even if the taxpayer did not intend to enter that trade or business.

The Tax Court denied a taxpayer's deduction for continuing education expenses because he failed to meet the strict requirements of the tax code. A physician claimed a business expense deduction on his tax return for flight lessons that would enable him to provide medical services to persons in remote areas. The IRS denied the deduction, and the taxpayer appealed. The Tax Court observed:

Section 162 [of the tax code] allows a deduction for all ordinary and necessary expenses paid in carrying on a trade or business. Section 162 does not explicitly provide for a deduction for continuing education expenses, but such expenses may be deductible under section 162 if they fall within its regulations. The regulations under section 162 allow a taxpayer to deduct expenditures for education if that education either (1) maintains or improves skills that are required by an individual in his employment, trade, or business or (2) meets express requirements set by the individual's employer or by a law or regulation as a condition of continued employment, status, or compensation. Education undertaken by an individual to meet minimum education requirements for qualification in his own or any other trade or business are not deductible.

The court noted that "in deciding whether the taxpayer's flying lessons are deductible education expenses under section 162, we need to determine whether the education expenses were incurred to maintain or improve his skills for use in his business or whether the education would qualify him to meet the minimum education requirements of some other trade or business."

The court cited previous decisions in which it held that if the education for which deductions are claimed qualify a taxpayer "to perform tasks and activities that are significantly different from those that he could perform before receiving the education, then the education qualifies the taxpayer for a new trade or business … . It is irrelevant whether this education actually leads to qualification in a new trade or business." The court concluded:

The taxpayer paid educational expenses for flight instruction. He testified that he intended to use these skills in his business. However, he failed to demonstrate that his flying lessons improved or maintained his skills as a doctor. The skills petitioner learned during the flying lessons were significantly different from the skills he already possessed. Consequently, the cost of his flying lessons are not deductible continuing education expenses under section 162. It is irrelevant that these lessons may have helped him reach patients in rural areas.

What This Means For Churches:

It is common for pastors to enroll in continuing education courses at local universities and seminaries, or through online courses. Can the costs of these educational opportunities be deducted as a business expense on a pastor's tax return? As the Tax Court noted, you may deduct expenses you incur for education, such as tuition, books, supplies, correspondence courses, and certain travel and transportation expenses, even though the education may lead to a degree, if the education (1) is required by your employer, or by law or regulation, to keep your salary, status, or job or (2) maintains or improves skills required in your present work.

However, you may not deduct expenses incurred for education, even if one or both of the above-mentioned requirements are met, if the education (1) is required in order to meet the minimum educational requirements to qualify you in your trade or business or (2) is part of a program of study that will lead to qualifying you in a new trade or business, even if you did not intend to enter that trade or business. You can deduct the costs of qualifying, work-related education as a business expense even if the education could lead to a degree.

Once you have met the minimum educational requirements for your job, your employer may require you to get more education. This additional education is qualifying work-related education if all three of the following requirements are met:

• it is required for you to keep your present salary, status, or job;

• the requirement serves a bona fide business purpose of your employer; and

• the education is not part of a program that will qualify you for a new trade or business.

If you get more education than your employer requires, the additional education can be qualifying work-related education only if it maintains or improves skills required in present work.

In a previous case, the Tax Court ruled that a minister could not deduct the cost of courses he took at a local university to complete his undergraduate degree, even though he took the courses to enhance his ministerial skills. The minister enrolled in various courses at a local university (including Introduction to Counseling, Internship in Ministry Practice, Death and Dying as a Life Cycle, Modern Social Problems, The Family, Community, Ethics in Human Services, Symphonic Choir, Basic Writing, and Writing Strategies). These courses were not required for him to continue as a local pastor. He later earned a bachelor's degree in human services. On his tax return he claimed a deduction of $9,698 for "continuing education." The amount claimed represented tuition, books, and course-related fees incurred for the courses taken at the university.

The IRS disallowed the deduction, and the minister appealed. The Tax Court agreed that the educational expenses were not deductible. It acknowledged that education expenses are deductible as business expenses if the education "maintains or improves skills required by the taxpayer in his employment or meets the express requirements of an employer imposed as a condition for the taxpayer's continued employment." However, education expenses are not deductible if they are "made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business." This is so even if the courses meet the express requirements of the employer.

Whether the education qualifies a taxpayer for a new trade or business depends upon the "tasks and activities which he was qualified to perform before the education and those which he is qualified to perform afterwards." The court noted that it had "repeatedly disallowed education expenses where the education qualified the taxpayer to perform significantly different tasks and activities. Further, the taxpayer's subjective purpose in pursuing the education is irrelevant, and the question of deductibility is not satisfied by a showing that the taxpayer did not in fact carry on or did not intend to carry on a new trade or business." The court agreed that the courses the minister took qualified him for a new trade or business and that the expenses of a college education are almost always nondeductible personal expenses.

The court concluded, "We conclude that the courses, which ultimately led to his bachelor's degree, qualified him in a new trade or business. The courses provided him with a background in a variety of social issues that could have prepared him for employment with several public agencies and private nonprofit organizations outside of the ministry. Whether or not he remains in the ministry is irrelevant; what is important under the regulations is that the degree 'will lead' him to qualify for a new trade or business." The court noted that it is "all but impossible" for taxpayers to establish that a bachelor's degree program does not qualify them for a new trade or business. Warren v. Commissioner, T.C. Memo. 2003-175 (2003). Holden v. Commissioner, T.C. Memo. 2015-83 (2015).

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