Federal

Legal Developments

Payroll Service Employee Embezzles Funds

Employer held responsible for unpaid payroll taxes.

Richard R. Hammar, Attorney, CPA
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Pediatric Affiliates v. United States, 2007 WL 1113785 (3rd Cir. 2007)

The IRS notified an employer that it had underpaid its payroll taxes for two prior years. After some investigation, the employer discovered that an employee of its third party payroll service had misappropriated nearly $1 million it had transferred for the payment of taxes. The employee routinely underpaid the payroll taxes he forwarded to the IRS on behalf of the employer, and then pocketed the remaining funds. When the IRS informed the employer that it was responsible for the payroll taxes that remained outstanding, the employer filed suit in federal court. The employer insisted that it should not be held liable for unpaid payroll taxes and interest due to the embezzlement of funds it had transferred to the payroll service company for the payment of its tax obligations. A federal appeals court ruled against the employer based on "the well-established principle that a taxpayer's reliance on a third party to fulfill its tax obligations does not relieve the taxpayer of responsibility for those obligations …. The timely filing of returns and the payment of taxes are solely the duties of the taxpayer and are not delegable …. An employer is liable for payment of taxes that must be deducted and withheld from its employees' income. Misappropriation of funds by a third party does not relieve an employer of that obligation."


Tip. Does your church use a third party company to handle your payroll tax reporting obligations? If so, be aware that your church remains liable for the payment of all payroll taxes. The IRS offers employers the following advice: (1) If there are any issues with an account, the IRS will contact the employer. IRS correspondence is sent to the address of record so it is strongly suggested that the address not be changed to that of the payroll service provider as it may significantly limit the employer's ability to be timely informed of tax matters involving it. (2) For the employer's protection, the payroll service provider should be asked if it has a fiduciary bond in place. This could protect the employer in the event of default. (3) Employers should ask the service provider to enroll in and use EFTPS (Electronic Federal Tax Payment System), so the employer can confirm payments made on its behalf. EFTPS maintains a business's payment history for 16 months and can be viewed on-line after enrollment. The IRS recommends employers verify EFTPS payments as part of their bank account reconciliation process.

Legal Developments

Age Discrimination Claims

Age discrimination requires proof that age was the basis for an adverse employment decision.

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Age Discrimination Claims

Age discrimination requires proof that age was the basis for an adverse employment decision.

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

Key point 8-09. The federal Age Discrimination in Employment Act prohibits employers with 20 or more employees, and engaged in interstate commerce, from discriminating in any employment decision on the basis of the age of an employee or applicant for employment who is 40 years of age or older. The Act does not exempt religious organizations. Many states have similar laws that often apply to employers having fewer than 20 employees.

* A federal appeals court ruled that a church school had not violated a federal age discrimination law in its treatment of a custodian. The custodian complained that over a period of about five years he was subjected to several adverse employment actions as a result of his age. As examples, he asserted that he was harassed and criticized by his supervisor because of his age; he was unfairly sent home and docked pay on two occasions; he was denied overtime opportunities that went to younger employees; he was transferred to a less desirable shift; and was laid off with others on his new shift. The custodian claimed that these actions amounted to discrimination in violation of the federal Age Discrimination in Employment Act

The court noted that Under the ADEA, it is “unlawful for an employer to … discharge any individual or otherwise discriminate against any individual with respect to his compensation, terms, conditions, or privileges of employment, because of such individual’s age.” The court concluded that the school had “legitimate, non-discriminatory reasons” for each of its actions involving the custodian. First, he was not singled out when he was terminated, but rather was laid off as part of the school’s decision to “outsource” the entire custodial department to save money. Six out of the eight employees discharged were less than 40 years old. Second, the custodian had been sent home early from work as part of his supervisor’s efforts to discipline or motivate him after he performed unsatisfactorily on two occasions. Third, the custodian’s loss of overtime was attributable to the regular seasonal decrease in demand for custodial overtime work due to school being out of session during the summer months, and gym classes being held outside (leaving the gymnasium largely unused) during early Fall.

Application. This case illustrates that age discrimination requires proof that age was the basis for an adverse employment decision. An employer that dismisses an employee who is 40 years of age or older will not be guilty of age discrimination if it can prove a nondiscriminatory basis for its action. In this case, the court concluded that the school established that its actions involving the custodian were all based on legitimate, nondiscriminatory reasons dealing with the performance of his duties as well as cost-cutting decisions by the school. Abraham v. Abington Friends School, 2006 WL 3793380 (3rd Cir. 2006).

Legal Developments

Breach of Fiduciary Duty

Several courts have refused to hold churches and denominational agencies liable on the basis of a breach of a fiduciary duty for the sexual misconduct of a minister.

Richard R. Hammar, Attorney, CPA
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Church Law & Tax Report

Breach of Fiduciary Duty

Several courts have refused to hold churches and denominational agencies liable on the basis of a breach of a fiduciary duty for the sexual misconduct of a minister.

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

Key point 10-13.2. Several courts have refused to hold churches and denominational agencies liable on the basis of a breach of a fiduciary duty for the sexual misconduct of a minister. In some cases, this result is based on First Amendment considerations.

* A Connecticut court ruled that a priest and archdiocese were not liable on the basis of a breach of a fiduciary duty for the priest’s sexual relationship with an adult woman since no fiduciary duty arose under the circumstances. A 40-year-old woman (the “plaintiff”) with a long history of psychiatric and emotional problems sought out the “advice, counsel and friendship” of a priest. At the time, the priest was serving as an associate priest at a local church and was also an employee of the archdiocese. The plaintiff did not engage in formal counseling with the priest; rather, their relationship involved mainly recreational activities such as home visits, lunch and dinner dates, shopping trips, walks on the beach and trips to see movies. According to the plaintiff, the priest provided her emotional, spiritual and friendly support and that her “whole relationship” with him was one of counseling. At some point during their association, the priest became aware of her emotional problems and, nevertheless, engaged in a sexual relationship with her. The plaintiff alleged that she eventually ended the sexual aspect of their relationship after which the priest terminated all involvement with her.

The plaintiff sued the priest claiming that a fiduciary duty arose by virtue of the priest-parishioner relationship, and the priest breached this duty when, despite knowledge of her emotional problems, he engaged in “a close physical and intimate relationship” with her. The plaintiff also sued the archdiocese, claiming that it breached its duty to supervise the priest. Specifically, the plaintiff alleged that the archdiocese “knew or should have known that the priest had engaged in inappropriate behavior with the plaintiff” and, as a result, the archdiocese was liable for the priest’s breach of a fiduciary duty. A trial court dismissed the claims against the priest and archdiocese, and the plaintiff appealed.

Breach of a fiduciary duty

The appeals court defined a fiduciary or confidential relationship as “a relationship that is characterized by a unique degree of trust and confidence between the parties, one of whom has superior knowledge, skill or expertise and is under a duty to represent the interests of the other. The superior position of the fiduciary or dominant party affords him great opportunity for abuse of the confidence reposed in him.” The court acknowledged that “various state and federal courts” have concluded that a clergy-parishioner relationship may constitute a fiduciary relationship, but in each of those cases “something more than a general clergy-parishioner relationship was present.” For example, “the existence of a formal pastoral counseling relationship between a clergy member and a parishioner has been deemed significant in determining whether a fiduciary relationship was created. The court summarized the following precedent:

  • Colorado. (1) Court found that a fiduciary relationship existed between a clergyman and plaintiff, in part, because the clergyman had served as counselor to plaintiff. Moses v. Diocese of Colorado, 863 P.2d 310 (Colo. 1993). (2) A fiduciary duty was created when a priest undertook to counsel plaintiffs. Destefano v. Grabrian, 763 P.2d 275 (Colo. 1988).
  • Federal district court in Iowa. Court dismissed plaintiff’s breach of fiduciary duty claim because plaintiff simply alleged clergy-parishioner relationship, not counseling relationship. Doe v. Hartz, 52 F. Supp.2d 1027 (N.D. Iowa 1999).
  • New Jersey. The New Jersey Supreme Court concluded that a breach of fiduciary duty claim arising out of the sexual relationship between a clergyman and a parishioner who was seeking marital counseling was permissible under New Jersey law. In so doing, the court placed considerable weight on the fact that the plaintiff was engaged in a specific pastoral counseling relationship with the clergyman. According to that court, “trust and confidence are vital to the counseling relationship between parishioner and pastor. By accepting a parishioner for counseling, a pastor also accepts the responsibility of a fiduciary.” The court explained that “establishing a fiduciary duty essentially requires proof that a parishioner trusted and sought counseling from the pastor.” F.G. v. MacDonell, 696 A.2d 697 (1997).
  • Federal appeals court. A federal appeals court permitted a breach of fiduciary duty claim to proceed against a clergyman because the fiduciary duty allegedly arose out of a counseling relationship, not simply a clergy-parishioner relationship. Sanders v. Casa View Baptist Church, 134 F.3d 331 (5th Cir. 1998).

The court concluded that “something more” than the general clergy-parishioner relationship must be present to establish a fiduciary relationship, and it declined the plaintiff’s invitation to establish a fiduciary relationship “between all clergy and their congregants.” The court concluded that the plaintiff’s relationship with the priest in this case was not fiduciary in nature because it “was not characterized by the unique degree of trust and confidence required of a fiduciary relationship.” In particular, the court noted that the plaintiff had not alleged a formal pastoral counseling relationship between herself and the priest. Rather, she claimed that her “whole association” with the priest was one of “counseling.” The court disagreed:

The plaintiff’s interactions with the priest were largely social. She did not meet him for specific counseling appointments, but, rather, the two went on lunch and dinner dates, shopping trips, walks on the beach and trips to see movies. Also, the plaintiff has admitted that many of the conversations she considered counseling took place immediately after mass with other congregants present and that the counseling primarily involved discussions about their relationship …. While the priest may have counseled the plaintiff from time to time, as a priest may for any parishioner, he was not her counselor. Moreover … the plaintiff was well over the age of majority throughout the time of their consensual interactions. While we do not condone the defendant’s behavior, we conclude that no fiduciary relationship existed between him and the plaintiff; consequently, no fiduciary duty was breached.

Archdiocese

The court also dismissed the plaintiff’s negligent supervision claim against the archdiocese on the ground that there can be no negligent supervision if an employee does not engage in wrongful behavior. Since the priest had not breached a fiduciary duty, the archdiocese could not be liable on the basis of negligent supervision for his actions.

Application. This case is important because it is one of the most extensive discussions of the liability of ministers and churches for acts of sexual misconduct on the basis of a breach of a fiduciary duty. The court refused to find that a priest who was not involved in a counseling relationship with a church member has a fiduciary duty toward that person, and therefore the priest could not be liable on the basis of a breach of such a duty for any inappropriate sexual conduct. There may be other bases of liability, but not this one. Further, since the priest was not liable, the archdiocese could not be liable since its liability (whether on the basis of negligent hiring or supervision, or breach of a fiduciary duty) required that the priest’s acts be wrongful. Ahern v. Kappalumakkel, 903 A.2d 266 (Conn. App. 2006).

Legal Developments

Application of Laws to Specified Number of Employees

Some federal employment laws apply only to employers having a specified number of employees.

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Application of Laws to Specified Number of Employees

Some federal employment laws apply only to employers having a specified number of employees.

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

Key point 8-05.1. Many federal employment and civil rights laws apply only to those employers having a minimum number of employees. In determining whether or not an employer has the minimum number of employees, both full-time and part-time employees are counted. In addition, employees of unincorporated subsidiary ministries of a church are counted. The employees of incorporated subsidiary ministries may be counted if the church exercises sufficient control over the subsidiary.

* The United States Supreme Court ruled that the “15 employee” requirement for employer coverage under Title VII of the Civil Rights Act of 1964 is not “jurisdictional,” and so employers with fewer than 15 employees lose this defense if they fail to raise it before the end of a trial. Title VII of the Civil Rights Act of 1964 prohibits employers engaged in interstate commerce and having at least 15 employees from discriminating in any employment decisions on the basis of race, color, national origin, gender, or religion. Some courts have ruled that the 15 employee requirement is “jurisdictional,” meaning that a court does not have the legal authority to resolve a Title VII case involving an employer with fewer than 15 employees. As a result, an employer can raise the “less than 15 employees” defense at any time, even after a court renders a judgment. Other courts have ruled that the 15 employee requirement is not jurisdictional, but rather is simply a requirement for a Title VII claim. Under this interpretation, the “less than 15 employees” defense must be asserted in an employer’s response to a lawsuit or it will be waived.

In a recent case, the United States Supreme Court ruled that the 15 employee requirement under Title VII is not jurisdictional, but rather is a requirement of a Title VII claim. As a result, it is waived if not raised in response to a lawsuit. The case involved a woman who was employed by a restaurant as a server. She sued her employer for sexual harassment (a form of sex discrimination prohibited by Title VII). A jury awarded her $40,000 in damages. After the jury’s verdict, the employer asked the court to dismiss the lawsuit and verdict on the ground that it had fewer than 15 employees and so was not subject to Title VII. This was the first time the employer had raised this defense. The trial court granted the employer’s request on the ground that the 15 employee requirement was jurisdictional rather than simply a requirement of a Title VII claim, and therefore the court had no authority to resolve the case.

The United States Supreme Court reversed the trial court’s ruling, and held that the 15 employee requirement is simply a requirement of a Title VII case that must be raised in response to a lawsuit. It found no language in Title VII making this a jurisdictional requirement that can be raised at any time, and concluded that “when Congress does not rank a statutory limitation on coverage as jurisdictional, courts should treat the restriction as non-jurisdictional in character.”

Application. Some federal employment laws apply only to employers having a specified number of employees. To illustrate, employers must have 15 or more employees to be subject to Title VII of the Civil Rights Act of 1964 and the Americans with Disabilities Act. An employer must have at least 20 employees to be subject to the federal age discrimination law, and 50 employees to be subject to the Family Medical Leave Act. According to the Supreme Court’s recent decision, churches that are sued for violations of any of these laws must assert in their answer to the original lawsuit the “affirmative defense” that they have fewer than the required number of employees. A failure to do so will constitute a waiver of this defense. Arbaugh v. Y&H Corporation, 126 S.Ct. 1235 (2006).

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Legal Developments

Age Discrimination and Denomination Policy

A minister’s age discrimination lawsuit challenging a denominational policy requiring the retirement of ministers at 70 years of age was barred by the federal Religious Freedom Restoration Act.

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Age Discrimination and Denomination Policy

A minister’s age discrimination lawsuit challenging a denominational policy requiring the retirement of ministers at 70 years of age was barred by the federal Religious Freedom Restoration Act.

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

Key point 8-06. The civil courts have consistently ruled that the First Amendment prevents the civil courts from applying civil rights laws to the relationship between a church and a minister.

Key point 13-02.2. Congress enacted the Religious Freedom Restoration Act to prevent the government from enacting any law or adopting any practice that substantially burdens the free exercise of religion unless the law or practice is supported by a compelling government interest. The compelling government interest requirement applies to any law, including neutral laws of general applicability. The objective of the Act was to repudiate the Supreme Court’s decision in the Smith case (1990) in which the Court ruled that neutral laws of general applicability that burden the free exercise of religion do not need to be supported by a compelling government interest in order to satisfy the First Amendment. In 1997, the Supreme Court ruled that the Act was unconstitutional. However, other courts have limited this ruling to state and local legislation, and have concluded that the Act continues to apply to federal laws.

* A federal appeals court ruled that a minister’s age discrimination lawsuit challenging a denominational policy requiring the retirement of ministers at 70 years of age was barred by the federal Religious Freedom Restoration Act. A minister was forced into retirement at age 70 by a policy of his denomination. The minister sued his church and a denominational official for violating a federal age discrimination law making it unlawful for any employer with 20 or more employees that is engaged in commerce to discriminate in any employment decision on the basis of the age of any person who is at least 40 years of age. The minister asserted that the mandatory retirement policy was a “secular” matter that was not influenced by any religious considerations. He acknowledged that most courts refuse to intervene in employment disputes between churches and clergy as a result of the so-called “ministerial exception” to employment laws, but he insisted that the ministerial exception “should not insulate a church’s non-religious regulations that discriminate against ministers on the basis of age.” A federal district court dismissed the lawsuit on the basis of the ministerial exception.

A federal appeals court ignored the ministerial exception and ruled that the lawsuit was barred by the federal Religious Freedom Restoration Act (RFRA). It noted that the ministerial exception “has no basis in statutory text, whereas RFRA, if applicable, is explicit legislation that could not be more on point. Given the absence of other relevant statutory language, the RFRA must be deemed the full expression of Congress’s intent with regard to the religion-related issues before us and displace earlier judge-made doctrines that might have been used to ameliorate the age discrimination law’s impact on religious organizations and activities.”

RFRA provides: “Government shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability … [unless] it demonstrates that application of the burden to the person is in furtherance of a compelling governmental interest, and is the least restrictive means of furthering that compelling governmental interest.” The court reasoned that RFRA was broad enough to apply to a minister’s lawsuit against a church “since it applies to all federal law and the implementation of that law.” This language “easily covers the present action.”

The court rejected the minister’s claim that RFRA is unconstitutional. It concluded that RFRA represents a constitutional exercise of congressional power as it applies to the federal government.

One dissenting judge argued that RFRA has no application to disputes between private parties, such as the present case, and that the case should have been dismissed on the basis of the ministerial exception.

Application. This case suggests that the Religious Freedom Restoration Act can be used by churches to defend against discrimination claims under federal employment laws. This is the first court to reach such a conclusion. Other courts, and the dissenting judge in this case, apply the “ministerial exception” to such disputes. Hankins v. Lyght, 441 F.3d 96 (2nd Cir. 2006).

* See also (1) “Clergy—removal,” Fassl v. Our Lady of Perpetual Help Roman Catholic Church, 2005 WL 3135921 (E.D. Pa. 2006); (2) “Clergy—removal,” Celnik v. Congregation B’Nai Israel, 131 P.3d 102 (N.M. 2006), in the recent developments section of this newsletter.

Legal Developments

Failing to Report Compensation

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

Richard R. Hammar, Attorney, CPA
Bio

Church Law & Tax Report

Failing to Report Compensation

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

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

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

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

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

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

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

Abuse of a position of trust

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

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

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

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

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

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

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

Application. This case illustrates three important points.

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

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

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

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

Legal Developments

Employment Practices

A federal appeals court ruled that a minister’s age discrimination lawsuit was barred by the federal Religious Freedom Restoration Act.

Richard R. Hammar, Attorney, CPA
Bio

Key point 8-06. The civil courts have consistently ruled that the First Amendment prevents the civil courts from applying civil rights laws to the relationship between a church and a minister.
The Civil Rights Act of 1964

Key point 13-02.2. Congress enacted the Religious Freedom Restoration Act to prevent the government from enacting any law or adopting any practice that substantially burdens the free exercise of religion unless the law or practice is supported by a compelling government interest. The compelling government interest requirement applies to any law, including neutral laws of general applicability. The objective of the Act was to repudiate the Supreme Court's decision in the Smith case (1990) in which the Court ruled that neutral laws of general applicability that burden the free exercise of religion do not need to be supported by a compelling government interest in order to satisfy the First Amendment. In 1997, the Supreme Court ruled that the Act was unconstitutional. However, other courts have limited this ruling to state and local legislation, and have concluded that the Act continues to apply to federal laws.
The Free Exercise Clause

A federal appeals court ruled that a minister's age discrimination lawsuit challenging a denominational policy requiring the retirement of ministers at 70 years of age was barred by the federal Religious Freedom Restoration Act. A minister was forced into retirement at age 70 by a policy of his denomination. The minister sued his church and a denominational official for violating a federal age discrimination law making it unlawful for any employer with 20 or more employees that is engaged in commerce to discriminate in any employment decision on the basis of the age of any person who is at least 40 years of age. The minister asserted that the mandatory retirement policy was a 'secular' matter that was not influenced by any religious considerations. He acknowledged that most courts refuse to intervene in employment disputes between churches and clergy as a result of the so-called 'ministerial exception' to employment laws, but he insisted that the ministerial exception 'should not insulate a church's non-religious regulations that discriminate against ministers on the basis of age.' A federal district court dismissed the lawsuit on the basis of the ministerial exception.

A federal appeals court ignored the ministerial exception and ruled that the lawsuit was barred by the federal Religious Freedom Restoration Act (RFRA). It noted that the ministerial exception 'has no basis in statutory text, whereas RFRA, if applicable, is explicit legislation that could not be more on point. Given the absence of other relevant statutory language, the RFRA must be deemed the full expression of Congress's intent with regard to the religion-related issues before us and displace earlier judge-made doctrines that might have been used to ameliorate the age discrimination law's impact on religious organizations and activities.'

RFRA provides: 'Government shall not substantially burden a person's exercise of religion even if the burden results from a rule of general applicability … [unless] it demonstrates that application of the burden to the person is in furtherance of a compelling governmental interest, and is the least restrictive means of furthering that compelling governmental interest.' The court reasoned that RFRA was broad enough to apply to a minister's lawsuit against a church 'since it applies to all federal law and the implementation of that law.' This language 'easily covers the present action.'

The court rejected the minister's claim that RFRA is unconstitutional. It concluded that RFRA represents a constitutional exercise of congressional power as it applies to the federal government.

One dissenting judge argued that RFRA has no application to disputes between private parties, such as the present case, and that the case should have been dismissed on the basis of the ministerial exception.

Application. This case suggests that the Religious Freedom Restoration Act can be used by churches to defend against discrimination claims under federal employment laws. This is the first court to reach such a conclusion. Other courts, and the dissenting judge in this case, apply the 'ministerial exception' to such disputes. Hankins v. Lyght, 441 F.3d 96 (2nd Cir. 2006).

Legal Developments

Arbitration

A federal appeals court enforced the decision of an arbitrator in an employment dispute between a church-operated school and its principal.

Richard R. Hammar, Attorney, CPA
Bio

• Key point 10-16.8. Churches have various defenses available to them if they are sued as a result of a personal injury. One such defense is an arbitration policy. By adopting an arbitration policy, a church can compel members to arbitrate specified disputes with their church rather than pursue their claim in the civil courts.
Negligence as a Basis for Liability

* A federal appeals court enforced the decision of an arbitrator in an employment dispute between a church-operated school and its principal. The principal ('Julie') of a private Christian school was fired from her position, and she later sued the school for breach of contract and discrimination. The school asked the court to compel Julie to arbitrate her claims pursuant to an arbitration provision in her employment contract. Julie was reluctant at first to pursue arbitration because she was concerned that the ICC was biased in favor of the school. She ultimately agreed to the arbitration policy with modifications. One modification made the arbitration procedure subject to the Montana Arbitration Act. The court granted this request, and an arbitration was conducted in accordance with the Rules of Procedure for Christian Conciliation ('Rules') of the Institute for Christian Conciliation ('ICC'). In arbitration, Julie prevailed on her breach of contract claim and was awarded $150,000 in damages. In reaching his decision, the arbitrator determined that the school had wrongfully discharged Julie by failing to follow biblical precepts, as required in her employment contract; specifically, the conflict resolution process described in Matthew 18.

The school asked a federal district court to 'vacate' the arbitration on the basis of the Montana Arbitration Act, which empowers the civil courts to vacate arbitration awards under narrow conditions including arbitrator bias and an arbitrator acting outside the scope of his or her authority. A federal district court ruled that none of these exceptions applied, and the school appealed.

A federal appeals court agreed that none of the narrow grounds for vacating the arbitrator's award existed in this case. It concluded:

The parties freely and knowingly contracted to have their relationship governed by specified provisions of the Bible and the Rules of the ICC, and the arbitrator's determination that the school had not acted according to the dictates of Matthew 18 relates to that contract. Further, the Rules of the ICC indisputably contemplate that an arbitrator will have extremely broad discretion to fashion an appropriate remedy; and no language in the parties' contracts expresses their intent to depart from the Rules of the ICC. We hold that the arbitrator's award of damages is rationally derived from Julie's employment contract with the school and is not contrary to any express contractual provisions, either biblical or secular. Consequently, the school is not entitled to a vacating of the arbitrator's decision on this ground.

The court also rejected the school's claim that the arbitrator's award should be vacated on the basis of the arbitrator's lack of impartiality since the school failed to address or explain this argument in the brief it submitted to the court.


Application
. This case is important for the following reasons:

1. It illustrates the value of using arbitration policies to resolve disputes. Our research indicates that employment disputes are one of the most common forms of church litigation. One way that some churches are attempting to manage this risk is to implement arbitration policies. This is one of the few courts to address the validity of such policies. The court's conclusion that the school's arbitration policy was legally enforceable will be a helpful precedent in support of the validity of such policies.

2. Note that the arbitrator ruled in favor of the employee and against the school. Church leaders should recognize that an arbitration clause does not necessarily mean that the church will be 'better off' than if employment disputes were resolved in court.

3. The case also illustrates the fundamental principle that arbitration awards ordinarily are binding and not subject to civil court review except under very narrow conditions that were not met in this case. A party that 'loses' in an arbitration proceeding generally cannot run to the courts to have the award reversed.

4. Any arbitration policy should be drafted by an attorney, and submitted to the church's liability insurer for review. It is advisable that any church arbitration procedure be conditioned on its acceptance by the church's insurers.

5. The ability of employers to apply new policies to current employees has been a troubling legal question. In general, for a promise or commitment (such as an employee's "agreement" to be bound by a new employment policy) to be legally enforceable, the employee must receive some "consideration" or value in exchange for his or her agreement. Is continuing employment sufficient consideration to extend new policies to current employees? The courts have reached different answers to this question. To be certain, it is always advisable to offer additional consideration to current employees in return for their agreement to be bound by a new employment policy. This is another reason why it is important to have an attorney work with you in implementing an arbitration policy. Prescott v. Northlake Christian School, 141 Fed.Appx. 263 (5th Cir. 2005).

Copyright © 1994 – 2006 Christianity Today International.All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, A publication of Christianity Today International, 465 Gundersen Drive, Carol Stream, IL 60188.

Legal Developments

Clergy—Income Taxes

The United States Tax Court ruled that an itinerant evangelist was not able to deduct his travel expenses since he was never “away from home.”

Richard R. Hammar, Attorney, CPA
Bio

Key point. Travel expenses (transportation, meals, lodging) are deductible only if the taxpayer incurs these expenses while traveling "away from home" for business purposes.

Boyd v. Commissioner, T.C. Summary Opinion 2006-36.

The United States Tax Court ruled that an itinerant evangelist was not able to deduct his travel expenses since he was never "away from home."

A full-time evangelist did not have a church or a fixed base of operation for the conduct of his ministry. He and his spouse travel throughout the United States in a recreational vehicle and conduct religious services at churches for either a few days or a few weeks. The couple does not own or rent a residence. All of their mail is sent to their daughter. Whatever mail she receives, she mails it to her parents wherever they happen to be. Most of the mail is from churches inviting the couple to conduct religious services.

The couple's 1999 federal tax return was audited by the IRS. On Schedule C (Form 1040), the couple reported the income and expenses of their ministerial activity. Their income was $45,000, and their expenses (almost all of which were travel expenses) were $61,000, resulting in a net loss of $16,000. The IRS denied any deduction for the couple's travel expenses, and the couple appealed.

The Tax Court began its opinion by noting that section 162 of the tax code allows deductions for traveling expenses, including amounts expended for transportation, meals, and lodging, if the expenses are (1) ordinary and necessary, (2) incurred while "away from home", and (3) incurred in pursuit of a trade or business. The IRS insisted that the travel expenses were not incurred while the couple was "away from home," since they did not have a home, and therefore the expenses were not deductible.

The court agreed: "As a general rule, a taxpayer's principal place of employment is his tax home. Where the taxpayer has neither a principal place of business nor a permanent residence, he has no tax home from which he can be away. His home is wherever he happens to be." The court rejected the couple's claim that their "home" was in Mississippi. It concluded: "Whether the couple had a tax home is a question that is easily resolved in this case by the fact that they made only three visits to Mississippi during the year in question, and, on each visit, they stayed at the local church rectory and, perhaps, with their daughter. While the length of those visits was not established, the record indicates that the visits were not for prolonged periods. Most significantly, however, they bore no expenses in maintaining a home there in addition to their recreational vehicle.

Thus, they could not be away from home within the intent and meaning of section 162 because they had no home to be away from. Where the taxpayer does not have a permanent residence, he has no tax home from which he can be away. The home is wherever the taxpayer happens to be."

Legal Developments

The Consequences of Insurance Fraud

Don’t fill out an insurance application until you understand it.

Richard R. Hammar, Attorney, CPA
Bio

Zion Christian Church v. Brotherhood Mutual Insurance Company, 126 Fed.Appx. 235 (6th Cir. 2005)

Some church leaders view an insurance application as an annoyance to be completed as quickly, and with as little thought, as possible. Such an approach can be very risky, since a church's insurance policy can be nullified by the insurance company on the basis of fraud if the application contains any material misrepresentations. One church learned this lesson the hard way.

facts

An insurance company issued a policy to a Michigan church that provided coverage in the areas of general liability, personal injury liability, sexual acts liability, sexual harassment liability, directors and officers liability, employment practices liability, workers compensation, and excess liability. The church requested an additional "sexual acts liability coverage endorsement." To get the additional coverage, the church was required to complete a separate application disclosing, among other things, its knowledge of prior incidents involving sexual abuse or misconduct, or allegations of such behavior. This information was required in order to allow the insurance company to evaluate the risk of supplying the additional coverage. For example, the application asked:

  • Has your church ever had an allegation or lawsuit filed against it alleging any type of sexual abuse or misconduct?
  • Are you aware of any past or present situation in your ministry that could produce an allegation or lawsuit claiming any type of sexual abuse or misconduct?
  • Are you aware of any current employee or ministry volunteer who has previously been accused, charged, or convicted of any type of sexual abuse or sexual misconduct?
  • Please describe circumstances of any employee or ministry volunteer who has previously participated in, or been accused, charged, or convicted of, any type of sexual abuse or sexual misconduct. Please do not identify any individuals by name in this explanation.

The application for the additional sexual misconduct coverage was completed by the church's business administrator (Daniel) based on information that he received from the church's senior pastor (Pastor Steve). Daniel's answers indicated "no knowledge" of any prior sexual abuse or misconduct, based on information he had received from Pastor Steve.

Both the basic insurance policy, and the policy for additional sexual misconduct coverage, contained the following "fraud warning":

We do not provide coverage for an insured who has willfully concealed or misrepresented a material fact or circumstance with respect to this insurance … or engaged in fraudulent conduct or sworn falsely with respect to this insurance or the subject thereof.

The insurance company issued the church a policy for additional sexual misconduct coverage based on the information and representations contained in the church's application.

Pastor Steve's two sons were employed as associate pastors at the church. Daniel discovered that one of the sons was using church computers to view, download and transmit pornographic materials. He relayed this information to Pastor Steve who said he would "take care of it." Daniel also alleged that at least two female parishioners complained to him about inappropriate sexual advances by the other son. He promptly relayed this information to Pastor Steve who, again, said he would handle it. Daniel was eventually dismissed from his position, and he sued the church for defamation, breach of contract, and "retaliating" against him for "whistleblowing." Daniel and the church eventually reached an out-of-court settlement of his claim.

The church was sued in a second lawsuit by a former female employee who claimed that one of Pastor Steve's sons sexually harassed her when she was employed by the church. She alleged that the son made several inappropriate sexual advances over the course of two years, that she informed Pastor Steve, and that no corrective action was taken.

The church submitted this lawsuit to its insurance company, seeking a legal defense and the payment of any damages awarded by the court. In response, the insurance company sent the church a lengthy letter denying coverage and refusing to provide a legal defense of the claims brought by the former employee.

The church sought an opinion from the court regarding the availability of coverage under its insurance policies. The court agreed with the insurance company that no coverage was available to the church because of fraudulent responses in the application for insurance. The trial judge noted that the church had executed an application for sexual acts coverage in which it denied ever having had "an allegation or lawsuit filed against you alleging any type of sexual abuse or misconduct," denied being aware of any church employee "who has been previously accused … of any type of sexual abuse or sexual misconduct," and denied being "aware of any past or present situation in [the] ministry that could produce an allegation or lawsuit claiming any type of sexual abuse or misconduct."

But in fact, the church and Pastor Steve had been sued in 1992 by a former employee who alleged sexual misconduct by one of Pastor Steve's sons. In addition, Pastor Steve admitted in a deposition that this same son was accused of sexual molestation 16 years before and that the incident was "common knowledge" among his church members. Pastor Steve further testified that he was aware that his other son engaged in extramarital sexual acts over the course of at least five years.

In its defense, the church argued that its answer to the question about whether it had ever had an allegation or a lawsuit against it alleging any type of sexual abuse or sexual misconduct was truthful because the lawsuit brought by the former employee involved claims of wrongful discharge and emotional distress and not sexual misconduct. The court retorted: "You know, this is a Bill Clinton kind of construction of language that is so clear on its face that I find it offensive that you are actually arguing it."

The trial court concluded that the church's failure to disclose this history in its answers to the insurance application constituted fraud and negated any coverage. The church appealed.

the court's ruling

A Michigan appeals court began its opinion by noting:

The general rule is that where a policy of insurance is procured through the insured's intentional misrepresentation of a material fact in the application for insurance, and the person seeking to [obtain coverage under the policy] is the same person who procured the policy of insurance through fraud, an insurer may rescind an insurance policy and declare it void.

The court noted that a misrepresentation or concealment is "material" if the insurer "would not have issued the insurance coverage in the absence of the misrepresentation or concealment." It concluded that the church had engaged in material representations in completing the insurance application. It agreed with the trial judge's ruling, and then added:

The trial judge's references to Pastor Steve's knowledge are accurate. First, the church produced a copy of a complaint filed in 1992, prior to completion of the insurance application, wherein a former employee sued the church and Pastor Steve on behalf of herself and her deceased husband's estate. The complaint alleged wrongful discharge and intentional infliction of emotional distress based, in part, on allegations that the church and Pastor Steve engaged in a campaign to drive her from church employment and church membership solely because of her opposition to the nature in which the allegations of marital infidelity against Pastor Steve, and allegations of sexual misconduct with [female students at a church-run school] by Pastor Steve's son were addressed and handled.

In addition, affidavits were filed by two former associate pastors, a former member of the church's board of trustees, and former ministers and school teachers, each alleging that [one of Pastor Steve's sons] had engaged in sexual intercourse with various minor female students, yet remained an ordained minister gainfully employed by the church.

The court also referred to an excerpt from the minutes of the church board as evidence that Pastor Steve knew of his sons' sexual improprieties at the time the insurance application was completed. The minutes quote Pastor Steve making reference to incidents of sexual misconduct involving his sons prior to the time the insurance applications were submitted.

The court concluded:

There was an abundance of facts in the record before the district court to show that, in 1998 when the application for insurance was completed by Daniel using information supplied by Pastor Steve, it was well-known that there were many claims of sexual improprieties by church employees that should have been, but were not, disclosed. The insurer also filed an affidavit stating that it would never have granted coverage for sexual acts liability had it known this history …. From Pastor Steve's own deposition testimony it is clear that, at the time he applied for the insurance, he knew of information that should have been disclosed to the insurance company and he knew that he was required to disclose it. Instead, he chose to parse the language of the questions in an attempt to avoid disclosure in a way that was downright dishonest.

As a result, the court ruled that the insurance policy was null and void due to the church's material representations. This meant that the church had to obtain and compensate its own attorneys in the defense of the lawsuit, and to pay any adverse verdict or settlement.

The church insisted that even if its fraud nullified the sexual acts liability coverage, it did not invalidate the entire insurance contract and, under the general liability provisions of the contract, the insurance company owed not only coverage but also a duty to defend the underlying lawsuit. The court disagreed. It pointed out that the general liability policy "stated clearly that it did not apply to a loss of any kind arising directly or indirectly out of any actual or alleged sexual act." The policy defines "sexual act" to include:

a. any act which would be considered a criminal act under any applicable federal, state or local statute, ordinance or law relating to sexual offenses;

b. any act or attempted touching of a person by another person for the purpose of obtaining sexual arousal or sexual gratification;

c. any other act undertaken by a person for the purpose of obtaining sexual arousal or sexual gratification;

d. any conduct characterized or interpreted as sexual intimidation or sexual harassment, or as intimidation or harassment based on gender difference; or

e. any conduct characterized or interpreted as being sexual in nature.

The court noted that the sexual harassment lawsuit brought by the former employee against one of Pastor Steve's sons involved a "sexual act" as defined by the policy. Therefore, there was no coverage and, as a result, no duty to defend. The court concluded, "When an insurer has specifically and explicitly excluded coverage with unambiguous policy language, the express exclusions will free the insurer from any duty to defend."

The court also rejected the church's defense that the sexual acts recited in the sexual harassment lawsuit were consensual and involved no harm. It noted that "the exclusions of the policy are broad, making no mention of whether the excluded sexual acts are consensual or non-consensual. Loss resulting from sexual acts is simply not covered. For coverage of such loss, an insured must separately purchase the sexual acts liability coverage endorsement." The court continued:

Of course, the church did purchase that endorsement, albeit fraudulently, leading us to declare the endorsement void. However, even if we had not declared the sexual acts liability coverage endorsement void, that endorsement would not supply any relief for the church with respect to the lawsuit in this case because the endorsement itself also contained very specific exclusions which are applicable here. It stated "we do not pay for loss of any kind arising directly or indirectly out of any sexual act if you, your present leaders or your past leaders while in your service, had actual knowledge that an alleged perpetrator employed or appointed by you or representing you has admitted to anyone that he or she participated in any previous molestation act [or] admitted to anyone that he or she had participated in any previous extramarital sexual act."

What this means for churches

This case contains a number of important lessons for church leaders, including the following:

1. Insurance applications. An insurance application is an important legal document that should never be completed or signed without careful consideration. At a minimum, church leaders should:

  • Read the application.
  • If you don't fully understand a provision, call the insurance company. If it is your existing insurance company, call your agent. If you are applying for insurance from another company, then call that company. The application should have contact information (phone numbers and email addresses).
  • Do not make any representations (e.g., about knowledge of prior acts or claims) without discussing your response with other church leaders, including current and former board members and staff members. Be sure that some of the persons assisting with the responses have a long association with the church, and document the persons who were consulted and their responses so that you can refute any suggestion of fraud.
  • Be sure the application is signed by an authorized person or persons.

It is important to communicate these safeguards to church staff so that insurance applications are not signed by persons who fail to abide by them.

2. The legal effect of material misrepresentations. Most insurance policies contain a "fraud" provision that nullifies coverage in the event that an insured obtains coverage on the basis of material misrepresentations in the insurance application. As the church in this case discovered, such a result can have catastrophic consequences since a church may be solely responsible to find and compensate its own attorneys, and pay any adverse verdict or settlement.

3. Board minutes. Church board members should understand that in most cases the minutes of board meetings can be subpoenaed in the event of a lawsuit. This means that minutes may be used against a church in litigation if they contain material or admissions that support liability. This is exactly what happened in this case. The board minutes were subpoenaed by the plaintiff in the underlying sexual harassment lawsuit, and the trial court and appeals court both referred to statements contained in the minutes proving that the church had knowledge of prior incidents of sexual misconduct well before it completed the application of sexual misconduct coverage. As a result, the content of board minutes is very important. They should be worded with care so that they do not needlessly expose the church to an increased risk of liability.

4. Nepotism policies. This case dramatically illustrates why some churches have adopted "anti-nepotism" policies prohibiting the employment of persons who are related to current staff members. Such policies were once common, but in recent years have been used less frequently in part because of state laws that restrict or prohibit them. As a result, a church should not adopt such a policy without the advice of legal counsel.

Hiring employees who are related to current staff members is potentially dangerous, especially when the employees are related to the senior pastor, since accountability may be compromised. Pastor Steve's sons were guilty of numerous acts of sexual misconduct over the course of several years, but the church's response was limited at best. In some churches it is difficult if not impossible to hold the senior pastor's relatives to an acceptable level of accountability. And, as this case demonstrates, this can have tragic effects for a church.

Legal Developments

Freedom of Religion

A federal district court in Indiana ruled that the practice of opening each session of the state legislature with prayer violated the First Amendment’s nonestablishment of religion clause.

Richard R. Hammar, Attorney, CPA
Bio

Key point 14-02. The courts have ruled that the First Amendment allows chaplains and other ministers to pray before legislative assemblies.

A federal district court in Indiana ruled that the practice of opening each session of the state legislature with prayer violated the First Amendment's nonestablishment of religion clause because of the overt "sectarian" preference for Christianity.

Four Indiana residents sued the Speaker of the House of Representatives of the Indiana General Assembly claiming that most of the prayers the Speaker has permitted to open House sessions are sectarian Christian prayers, in violation of the nonestablishment of religion clause of the First Amendment to the United States Constitution. The evidence revealed that the official prayers repeatedly and consistently advanced the beliefs that define the Christian religion, and in particular the resurrection and divinity of Jesus. During the 2005 legislative session there were 52 prayers, 41 of them given by Christian pastors. Of these 41 prayers, 29 were offered in the name of Jesus. For example, one pastor's prayer concluded, "Father we are so grateful to you for your grace and mercy that you have allowed us to be able to have and Father I thank you for our Lord and Savior Jesus Christ, who died that we might have the right to come together in love." After this prayer the Speaker reintroduced the pastor, saying: "I understand he has a wonderful voice and he is going to bless us with a song." The pastor then proceeded to sing "Just a Little Talk with Jesus." A number of the legislators, staff, and visitors present in the chamber stood, clapped, and sang along at the invitation of the pastor. This event prompted some members of the House to walk out because they believed the sectarian religious display during the legislative session was inappropriate.

The court referred to the Supreme Court's 1983 ruling in Marsh v. Chambers, 463 U.S. 783 (1983), in which the Court permitted the practice of having a paid legislative chaplain offer invocations in a state legislature. After noting that the same Congress that approved the Bill of Rights (including the nonestablishment of religion clause) authorized the appointment of paid chaplains for the House and Senate, the Court concluded that "In light of the unambiguous and unbroken history of more than 200 years, there can be no doubt that the practice of opening legislative sessions with prayer has become part of the fabric of our society. To invoke Divine guidance on a public body entrusted with making the laws is not, in these circumstances, an establishment of religion or a step toward establishment; it is simply a tolerable acknowledgment of beliefs widely held among the people of this country." In addition, the Supreme Court concluded that "the content of the prayer is not of concern to judges where, as here, there is no indication that the prayer opportunity has been exploited to proselytize or advance any one, or to disparage any other, faith or belief. That being so, it is not for us to embark on a sensitive evaluation or to parse the content of a particular prayer."

The federal court in Indiana concluded, based on the Marsh decision, that "prayers offered to open legislative sessions do not, without more, violate the establishment clause. Second, the fact that prayers are offered in the Judeo-Christian tradition also does not violate the establishment clause, at least where the prayers are not explicitly Christian or explicitly Jewish. Third, however, there are constitutional limits to legislative prayer. The clear implication is that where the prayer opportunity has been exploited to proselytize or advance any one, or to disparage any other, faith or belief, official legislative prayers would violate the establishment clause." The court concluded that the practice of the Indiana legislature exceeded the constitutional limits because of the frequent use of Jesus' name. However, the court noted that the legislature could continue legislative prayers so long as persons offering the prayers were informed that their prayer "must be non-sectarian and must not be used to proselytize or advance any one faith or belief or to disparage any other faith or belief, and (b) that they should refrain from using Christ's name or title or any other denominational appeal."

It observed, "We cannot adopt a view of the tradition of legislative prayer that chops up American citizens on public occasions into representatives of one sect and one sect only, whether Christian, Jewish, or Wiccan. In private observances, the faithful surely choose to express the unique aspects of their creeds. But in their civic faith, Americans have reached more broadly. Our civic faith seeks guidance that is not the property of any sect. To ban all manifestations of this faith would needlessly transform and devitalize the very nature of our culture. When we gather as Americans, we do not abandon all expressions of religious faith. Instead, our expressions evoke common and inclusive themes and forswear the forbidding character of sectarian invocations."

The court concluded by quoting from a recent federal appeals court decision: "When the Founders of this Nation set the boundaries on the power of government, the first words they wrote in the Bill of Rights were 'Congress shall make no law respecting an establishment of religion ….' The Founders recognized that we are a people of many strong and vigorous faiths. They acted to protect the liberty to practice those faiths. The Founders also knew centuries of history in which religious conflicts had caused war and oppression. They recognized that even the best intentions of people of faith can lead to division, exclusion, and worse. And they recognized that a majority who sees its faith as true and benign can be tempted in a democratic republic to try to use the power and prestige of government to advance that faith in ways that would actually divide and exclude." Hinrichs v. Bosma, (S.D. Ind. 2005).

Legal Developments

Failing to Comply with Payroll Reporting Requirements Can Be Costly

Individuals can be ordered to personally pay for missing funds.

Richard R. Hammar, Attorney, CPA
Bio

Salzillo v. United States, 66 Fed. Cl. 23 (2005)

Background. Every employer is required by law to withhold federal income taxes and FICA taxes from employees' wages when they are paid (with certain exceptions). The tax code specifies that these withheld taxes are held in trust for the United States and so they are commonly referred to as "trust fund taxes."

In imposing the obligation to collect these taxes on employers, Congress recognized that some employers might fail to set aside and pay over the taxes to the government. When an employer fails to remit the withheld taxes, the United States must still credit each employee as if the withheld taxes were actually sent to the government. As a result, the United States obligates itself to pay benefits such as social security and income tax refunds, for which there is no corresponding revenue.

To protect against such losses, the persons responsible for ensuring that the trust fund taxes are paid, and who willfully fail to do so, may be held personally liable under section 6672 of the tax code. This section specifies that "any person required to collect and pay over any tax … who willfully fails to collect such tax and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over." This means that persons who are responsible for withholding taxes and paying withheld taxes to the government may be assessed a penalty of up to 100% of the taxes that are not withheld or paid.

Case study. When a company began experiencing severe financial problems, its president ordered the chief financial officer (CFO) to use withheld taxes to pay creditors. The CFO protested, but was told that he would be fired if he did not comply. The IRS later assessed a penalty of $554,000 against the CFO under section 6672 of the tax code. The CFO appealed to the federal Court of Claims.

The court noted that liability under section 6672 requires (1) a person, (2) who is required to collect and pay over withheld taxes, but who (3) willfully fails to do so. The first two requirements are combined into the single concept of "responsible person." Such a person generally must have some authority over the payment of taxes. The court acknowledged that the CFO in this case had check writing authority, and that such authority generally indicates the ability to pay taxes. However, the court concluded that the CFO in this case was not a responsible person:

Liability under section 6672 is not imposed because someone is an officer or has check writing authority, or even effectuates payments to third parties rather than the IRS. Rather, the existence of these features is important only in indicating whether such an individual had the effective power to make payments to the IRS.

A person having check writing authority will not be a responsible person under section 6672 if the "corporate president controlled which creditors would be paid, including the IRS." Such was the case here. The court pointed out that when the CFO attempted to pay the IRS $50,000 without obtaining the president's permission, the president quickly detected the unauthorized use of funds and shifted money from the account in question to prevent the check from being cashed by the IRS. The court concluded, "The root principle that emerges is that an individual is not responsible if a third party exercises so much control over corporate funds as affirmatively to prevent that individual from effectuating payments to the IRS. That is exactly what happened here [since] the president deprived the CFO of effective power to pay the IRS."

Key point. The court rejected the CFO's argument that he could not be a responsible person because he had been ordered by his superior to use the withheld taxes to pay creditors. It noted that "instructions from a superior not to pay taxes do not take a person otherwise responsible under section 6672 out of that category." This rule "applies even where it is found likely that had the employee disobeyed the instruction not to pay the IRS, he or she would have been fired."

Relevance to church treasurers. Section 6672 contains no exemption for church officers or employees. As a result, any church officer or employee having the authority to pay withheld taxes to the government is potentially liable for 100% of the taxes owed if the church for any reason fails to pay them. This case illustrates the following important points:

First, check writing authority is one fact to consider in deciding if someone is a responsible person under section 6672. However, in and of itself, it may not be determinative.

Second, a person having check writing authority will not be a responsible person under section 6672 if an officer exercises so much control over corporate funds "as affirmatively to prevent that person from effectuating payments to the IRS."

Third, the court rejected the CFO's argument that he could not be a responsible person because he had been ordered by his superior to use the withheld taxes to pay creditors. It stressed that "instructions from a superior not to pay taxes do not take a person otherwise responsible under section 6672 out of that category." And, this rule applies even where it is likely that the employee would have been fired if he or she had disobeyed the instruction not to pay the IRS.

Key point. Other courts have reached the same conclusion. To illustrate: (1) A federal appeals court, in a recent case, concluded that "it is not a defense that a taxpayer would lose his job if he signed a check to the IRS without the express authority of a superior." Lubetzky v. United States, 393 F.3d 76 (1st Cir. 2004). (2) Another federal appeals court concluded that "the fact that [an employer] might well have fired [an employee] had he disobeyed instructions and paid the taxes does not make him any less responsible for their payment." Howard v. United States, 711 F.2d 729 (5th Cir. 1983).

Legal Developments

Sexual Misconduct by Clergy, Lay Employees, and Volunteers

A federal appeals court ruled that various church agencies and officers could not be liable on the basis of negligence for the sexual molestation.

Richard R. Hammar, Attorney, CPA
Bio

Key point 10-07.2. Many courts have ruled that the first amendment prevents churches from being legally responsible on the basis of negligent retention for the misconduct of ministers.

Key point 10-18.2. Most courts have refused to hold denominational agencies liable for the acts of affiliated ministers and churches, either because of first amendment considerations or because the relationship between the denominational agency and affiliated church or minister is too remote to support liability.
Denominational Liability

A federal appeals court ruled that various church agencies and officers could not be liable on the basis of negligence for the sexual molestation of an adolescent boy by a pastor.

An adult male (the plaintiff) alleged that in 1994 and 1995 when he was a minor he was sexually molested on a number of occasions by a pastor (Pastor Fred) who was serving as a "pastor emeritus" in a church in Massachusetts affiliated with the Lutheran Church-Missouri Synod (LCMS). In 1997 Pastor Fred was prosecuted and convicted of various criminal charges relating to his molestation of the plaintiff.

The plaintiff sued various LCMS agencies and officers (the church defendants) on the ground that they employed or supervised or retained Pastor Fred in a position of trust with the knowledge that he had a history of sexually assaulting minors. Plaintiff alleged that in 1977, while serving as a pastor in New York, Pastor Fred was forced to leave his post because of "inappropriate behavior" towards female members including minors. The plaintiff further alleged that an LCMC officer having jurisdiction over churches in New York had personal knowledge of Pastor Fred's misconduct. However, in 1980 when Pastor Fred transferred to Massachusetts, this officer failed to inform church officials in Massachusetts of the prior misconduct knowing that during his ministry in that state he would have unsupervised access to children. The plaintiff claimed that this failure constituted negligent retention and negligent supervision, and was the cause of his injuries. A federal district court disagreed and dismissed the lawsuit.

A federal appeals court affirmed the lower court's ruling. It began its opinion by observing that "under New York law, which the parties agree applies in this case, a defendant generally has no duty to control the conduct of third persons so as to prevent them from harming others." The plaintiff sought to avoid this rule by basing liability on the theories of negligent retention and negligent supervision. The court noted that to state a claim for negligent supervision or retention under New York law, a plaintiff must show: (1) an employee-employer relationship, (2) that the employer "knew or should have known of the employee's propensity for the conduct which caused the injury" prior to the injury's occurrence, and (3) that the injury was committed on the employer's premises or with the employer's property.

The court concluded that the plaintiff failed to prove the second requirement: "Prior to 1997 [church officials] were unaware that Pastor Fred had ever engaged in, or been accused of engaging in, sexual misconduct. The plaintiff, for his part, failed to counter this assertion with admissible evidence from which a reasonable juror could infer that the church defendants, at any time prior to the relevant incident, knew or should have known of Pastor Fred's propensity to assault minors or otherwise to engage in inappropriate sexual conduct. The trial court therefore properly [dismissed the] negligence claims."

The court also concluded that the third requirement was not met since the incidents of sexual assault did not occur on church property but instead were perpetrated at the plaintiff's home and at Pastor Fred's home. Given these facts, "the plaintiff cannot satisfy the third element of a negligent supervision cause of action—the requirement that the injury must have been committed on the employer's premises or with the employer's property."

The court noted that to the extent that the plaintiff's complaint could be read to assert a claim against the defendants for breach of a fiduciary relationship, "the defendants' lack of actual or constructive knowledge of Pastor Fred's sexual proclivities would also be fatal to this claim."

Application. This case is important for the following reasons.

1. It is a precedent that can be used to defend against claims of negligence in the hiring, retention, or supervision of ministers by churches and denominational agencies. While not every court will agree with this court's conclusions, the case stands as a forceful and persuasive precedent, especially since it is an opinion of one of the most highly respected federal appeals courts.

2. The case underscores the significance of knowledge of prior misconduct. When church leaders learn of information suggesting that a minister (or lay employee or volunteer) poses a risk of harm to others, this may serve as the basis for liability based on negligent selection or retention if the person commits foreseeable harm to one or more persons. In such a case, the issue will be whether the church acted reasonably in response to the information that it received.

3. The court suggested that a 16-year-old incident of misconduct of "an unspecified sexual nature" does not necessarily constitute notice that the person will commit an act of child molestation. Other courts may disagree with this conclusion, but this case suggests that a person's unspecified acts of misconduct occurring many years ago may not make a church liable for that person's future acts of child molestation.

4. In order to prove negligent hiring, supervision, and retention, a plaintiff must show that "the employer knew or should have known of the employee's propensity for the conduct which caused the injury." The trial court noted that there is no "common-law duty to institute specific procedures for hiring employees unless the employer knows of facts that would lead a reasonably prudent person to investigate the prospective employee."

5. Denominational agencies that lack the authority to remove a pastor from a congregation cannot be liable for the pastor's misconduct based on negligent retention. Ehrens v. The Lutheran Church-Missouri Synod, 385 F.3d 232 (2nd Cir. 2004).

Legal Developments

Child Abuse Reporting

A federal appeals court ruled that a church was not liable for a minister’s acts of child molestation on the basis of a failure to comply with the state child abuse reporting law.

Richard R. Hammar, Attorney, CPA
Bio

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.
Failure to Report Child Abuse

A federal appeals court ruled that a church was not liable for a minister's acts of child molestation on the basis of a failure to comply with the state child abuse reporting law since ministers were not mandatory reporters at the time of the abuse and the church had no reason to suspect that the minister was engaging in such acts.

An adult male (Randy) sued a church and diocese claiming that he had been sexually molested by a priest when he was a 16-year-old student attending a church school. Randy claimed that the priest sexually abused him on multiple occasions, often after serving him alcohol, and that he repressed the shame associated with the abuse and discovered the link between the abuse and his psychological injuries only years later, when a psychologist explained that his emotional problems stemmed from the experiences with the priest. Randy asserted that the diocese had a legal duty to report child abuse, and that its failure to do so constituted negligence. A state appeals court disagreed. It acknowledged that "clergy" have been mandatory reporters under the Pennsylvania child abuse reporting law since 1995, but concluded that clergy were not mandatory reporters prior to 1995, and that the diocese had no reason to suspect that the priest had molested Randy and so there was nothing to report even if a duty did exist. As a result, the court dismissed Randy's claim. Hartz v. Diocese of Greensburg, 94 Fed.Appx. 52 (3rd Cir. 2004).

Legal Developments

Clergy—Income Taxes

The United States Tax Court ruled that the IRS can ignore a pastor’s “tithes” as a “living expense” in evaluating an offer in compromise.

Richard R. Hammar, Attorney, CPA
Bio

Key point. An offer in compromise is an offer a taxpayer submits to the IRS to settle a tax liability for less than the amount of the liability. The IRS can accept such offers in whole or in part under limited circumstances.

Pixley v. Commissioner, 123 T.C. 15 (2004).

The United States Tax Court ruled that the IRS can ignore a pastor's "tithes" as a "living expense" in evaluating an offer in compromise.

An ordained pastor (Brad) served as the pastor of a local church from 1995 through 2001. He then moved to another state and was employed as a medical technician in a hospital. The IRS sent Brad a letter notifying him that it was going to seize his assets in an attempt to satisfy unpaid tax liabilities of $60,000. Seeking to avoid IRS collection efforts, Brad submitted an "offer in compromise" to the IRS (on Form 656) in which he sought to have his tax liabilities compromised for a reduced amount. His offer listed his assets and liabilities, and included a monthly "tithe" of $520 to his church as a "necessary living expense."

The IRS asked Brad on numerous occasions to submit evidence that the tithe was a condition of his employment. Brad failed to respond to these requests, and the IRS rejected his offer in compromise. It concluded that Brad had the ability to fully pay his tax liabilities. Brad appealed to the Tax Court.

The court began its opinion by observing that "in this case we are called upon to address for the first time, in the context of an offer in compromise, the treatment of a minister's tithing expenses for purposes of determining ability to pay outstanding tax liabilities." On appeal, Brad claimed that tithing expenses were incurred as a condition of his employment as a minister and should be taken into account in determining his ability to pay taxes. He argued that the IRS's disallowance of the tithing expenses violated his first amendment right to the free exercise of religion.

The court noted that the IRS can reduce tax liabilities by accepting a taxpayer's offer in compromise, but only if there is doubt as to the tax liability, doubt as to collectibility of the tax, or to promote effective tax administration. In determining whether there is doubt as to collectibility, the IRS must determine the taxpayer's "ability to pay" the outstanding tax liabilities that are to be compromised. In making this determination, the IRS considers two kinds of expenses. "Necessary" expenses are used for a taxpayer's (and his family's) health and welfare or production of income. Expenses that do not qualify as necessary may nevertheless be allowable in certain limited circumstances as so-called "conditional" expenses. Charitable contributions are necessary expenses if they provide for a taxpayer's (or his family's) health and welfare or are a condition of the taxpayer's employment. The IRS Internal Revenue Manual specifically addresses tithes to religious organizations, as follows:

Question. If, as a condition of employment, a minister is to tithe, a business executive is required to contribute to a charity … will these expenses be allowed?

Answer. Yes. The only thing to consider is whether the amount being contributed equals the amount actually required and does not include a voluntary portion.

Brad insisted that tithing was a condition of his employment, and so should have been considered a necessary expense in evaluating his offer in compromise. The court disagreed, "There is no evidence that Brad was employed as a minister when the notice of determination was issued or that he has been employed as a minister at any time since. Consequently, even if we were to assume as Brad asserts that the Southern Baptist Convention has a doctrine that its members should tithe ten percent of their income to the church, we are unpersuaded that tithing was a requirement of his employment."

The court noted that Brad claimed that he had continued his ministry in an unpaid position while employed full-time as a medical technician, and that he continued to tithe to keep this position. It concluded, "Even if we were to assume that these allegations are true, they do not establish that tithes were paid as a condition of employment."

Brad also claimed that the IRS's disregard of tithing expense in evaluating offers in compromise violates the first amendment guaranty of religious freedom, since the effect of this policy was to reduce the funds that taxpayers have to support their religion and divert those funds to the U.S. Treasury. Once again, the court was not persuaded. It concluded:

It may well be true that paying their taxes will leave Brad with less funds to support his religion. But this is a burden, common to all taxpayers, on their pocketbooks, rather than a recognizable burden on the free exercise of their religious beliefs …. In any event, even if Brad could demonstrate a recognizable burden on the free exercise of religious beliefs, the burden would be justified by the government's compelling interest in collecting taxes and administering a uniform, mandatory, and sound tax system …. This compelling government interest underpins the IRS's authority to compromise tax liabilities and to prescribe guidelines for officers and employees of the Internal Revenue Service to determine whether an offer in compromise is adequate and should be accepted to resolve a tax dispute.


Application
. This case indicates that contributions to one's church will not be taken into account in evaluating offers in compromise except in those extraordinary instances in which the contributions are a condition of continued employment. In other words, had Brad been able to demonstrate that he was employed as a pastor, and that his church required him to tithe and that his job depended on doing so, then this expense could have been considered by the IRS in evaluating his offer in compromise.

Legal Developments

Social Security

A federal appeals court issued a ruling suggesting that ministers who opt out of Social Security will not be able to claim years later that they qualify for Social Security retirement benefits.

Richard R. Hammar, Attorney, CPA
Bio

Yoder v. Barnhardt, 2003 WL 137575 (7th Cir. 2003)

A federal appeals court issued a ruling suggesting that ministers who opt out of Social Security by filing a timely Form 4361 will not be able to claim years later that they qualify for Social Security retirement benefits on the ground that their exemption application was filed after the deadline expired and should never have been approved by the IRS.

Section 1402(g) of the tax code permits self employed members (whether ministers or laypersons) of certain religious faiths to exempt themselves from Social Security coverage if the meet several conditions, including the following: (1) the member belongs to a recognized religious sect that is opposed to the acceptance of Social Security benefits; (2) the member adheres to the sect's teachings relating to Social Security coverage; (3) the member files an exemption application (Form 4029); and (4) the member waives his right to all Social Security benefits.

A layman (Owen) applied for exemption from self-employment taxes by filing a Form 4029 with the IRS. His application was approved. Several years later, Owen sued the Social Security Administration (SSA), claiming that his application for exemption should never have been approved because it was not timely, and therefore he was entitled to Social Security retirement benefits. At the time Owen filed his application, the tax code mandated that such an application had to be submitted by the deadline for filing a tax return (Form 1040) for the first year that the individual had self-employment earnings.

Owen had worked in Social Security covered employment from 1950 to 1975, in 1977, and from 1986 to 1989. He also had income from self-employment beginning in 1973, when he became a member of the Conservative Mennonite Church. As a member of the Church, Owen was conscientiously opposed to Social Security benefits and so he filed with the IRS in 1981 an application for an exemption from paying self-employment tax. As part of this application, Owen agreed to waive all Social Security benefits. He stated on the application that he first became subject to self-employment tax in 1974. The IRS approved his application in 1981 and granted him the exemption to cover all years thereafter. Owen contends that the SSA was aware that the application was untimely because he did not apply for the exemption before the filing deadline for the first tax year in which he earned self-employment income.

After the IRS granted Owen the exemption he never again paid taxes on self-employment income. After he turned 65 in 1999, Owen applied for benefits with the SSA. The SSA denied his claim for benefits because he had been exempted from self-employment tax and had waived his right to Social Security benefits in his exemption application (Form 4029). Owen sued the SSA in an attempt to obtain his retirement benefits. He argued that his exemption (which included a waiver of all Social Security benefits) was invalid, and should not have been approved by the IRS, because he filed it after the deadline expired. A federal appeals court rejected Owen's claim. It noted that Owen "made a knowing waiver of his Social Security benefits in return for a tax exemption …. For over twenty years [he] did not pay self-employment tax and did not notify the IRS nor the SSA about the 'mistake' in granting his application. The government kept its part of the agreement, and Owen must keep his."


Application
. This case suggests that ministers who opt out of Social Security by filing a timely Form 4361 will not be able to claim years later that they qualify for Social Security retirement benefits on the ground that their exemption application was filed after the deadline expired and should never have been approved by the IRS.

Legal Developments

Reservations of Rights Letters

What do these letters mean?

Richard R. Hammar, Attorney, CPA
Bio

Background. Churches sometimes will receive a "reservation of rights" letter from their insurer when they are sued. A reservation of rights letter usually informs the insured that the insurer will provide a legal defense of a lawsuit, but under a "reservation of rights," meaning that it reserves the right not to "indemnify" (pay damages) on behalf of the insured if it later determines that the claims are not covered under the insurance policy. A recent federal appeals court ruling addressed a church's response to a reservation of rights letter.

A church was sued by a minor who alleged that he had been molested on six occasions by two ministers. The church notified its liability insurance company of the lawsuit. The insurer agreed to defend the church, subject to a "reservation of rights." In its reservation of rights letter, the insurer indicated that it was reserving the right not to indemnify the church on the ground that the ministers' acts may fall under a policy exclusion for "intentional acts." The church later entered into an out-of-court settlement with the victim, and submitted the settlement to its insurer for payment. The insurer declined on the ground that the theory of liability was not covered under the church's insurance policy.

The church asked a court to rule that the insurer had a duty to defend and indemnify it up to the policy limits for damages incurred in the underlying lawsuit. A trial court ruled that the insured did have a duty to indemnify the church based on its duty to defend the lawsuit. The insurer appealed, claiming that the duty to defend is broader than the duty to indemnify, and that an insurer's decision to provide a defense to a lawsuit does not necessarily mean that it has a duty to indemnify (pay damages) based on a settlement or judgment. It relied on an earlier case in which a court ruled that "the duty to defend is measured against the allegations in the lawsuit but the duty to pay is determined by the actual basis for the insured's liability to a third person."

The appeals court concluded that the trial court erred by incorrectly assuming that the insurer had a duty to indemnify the church based solely on its duty to defend. Instead, the trial court "should have determined whether the church had shown that the settled claim was a covered loss under the insurance policy." The court was unable to determine whether the church's claim was a covered loss under the policy because of the lack of evidence regarding the dates of the molestation of the minor. The church argued that there was no doubt that the minor was molested during the policy period based on the fact that the ministers both pleaded guilty to molesting the minor during the summer of 1997, which is within the policy period. The insurer disagreed. The appeals court sent the case back to the trial court to determine whether or not the claim was covered under the policy. If it was, then the insurer was obligated to pay the settlement amount on behalf of the church.

Relevance to church treasurers. If your church is sued, and you submit the lawsuit to your insurer, you should not be surprised to receive a reservation of rights letter in return. The insurer agrees to provide your church with a legal defense of the lawsuit, but reserves the right not to pay any damages based on a theory of liability that is not covered under the insurance policy.

In many cases, a lawsuit will recite several theories of liability (the "shotgun" approach), only some of which are covered under the church's insurance policy. If a court awards damages based on a theory of liability that is not covered under the policy, then the insurer is not obligated to pay the judgment even though it has paid for the defense of the case. This is not a common occurrence, but it does happen.

When it does, it comes as a surprise to church leaders who assume that the insurer's defense of the lawsuit meant that it would indemnify the church against any damages. This case illustrates that an insurer will not be required to indemnify a church against a judgment or settlement based solely on its decision to provide a legal defense of the case. Rather, the insurer's duty to indemnify is based solely on proof that the claim "was a covered loss under the insurance policy."

American States Insurance Company v. Synod of the Russian Orthodox Church, 335 F.3d 493 (5th Cir. 2003).

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Legal Developments

Clergy—Income Tax

The IRS ruled that teachers and administrative staff employed by a church school were not eligible for a housing allowance.

Richard R. Hammar, Attorney, CPA
Bio

Key point. To qualify for a housing allowance, one must be a minister of the gospel, and the allowance must represent compensation for the exercise of ministry.

IRS Letter Ruling 9126048.

The IRS ruled that teachers and administrative staff employed by a church school were not eligible for a housing allowance.

A church operates a private school for kindergarten through eighth grade. All of the teachers are certified by the state, and the school is accredited with the state department of education. The school's teachers and administrative staff are not required to attend a Bible college, seminary, or other theological program. Membership in the church is not required to be employed in either teaching or administrative positions, but employees are required to attend a church. The school's board adopted a resolution granting teachers and administrative staff a housing allowance. The school later asked the IRS for a private letter ruling confirming that the teachers and administrative staff were eligible for a housing allowance.

The IRS ruled that the teachers and administrative staff were not eligible for a housing allowance. It observed,

A review of the duties and responsibilities of the teachers and administrative staff reflect the typical duties and responsibilities found in secular schools. These duties do not include duties performed by ministers of the gospel which generally are: performing the Lord's supper, baptism, marriage, moderating of church sessions, sitting on church boards of government, conducting worship services, performing funeral services and ministering to the sick and needy. Ministers of the church are either ordained or licensed. The school states that the teachers and administrative staff are commissioned as ministers of the gospel and that the commissioning took place after the date each employee began his or her duties at school. The commissioning process consists of a job interview and hiring process which culminates in the signing of an employment contract and the first day of work. The school represents that when the board approves the candidate for the teaching or administrative position, they instruct the administrator to commission the candidate by calling him or her to be a teacher or administrative staff member and that the commissioning takes place on each employee's date of hire.

The IRS noted that a housing allowance is available only to a "minister of the gospel" and must represent compensation for service performed in the exercise of ministry.

minister of the gospel

The IRS acknowledged that "a balancing test of factors is used to determine whether a person is considered a minister of the gospel," citing the Tax Court's decision in Knight v. Commissioner, 92 T.C. 199 (1989). In the Knight case, the Tax Court concluded that in deciding if a person is a "minister" for tax purposes, there are five factors that must be considered, each of which comes from the income tax regulations: (1) does the individual administer the "sacraments"; (2) does the individual conduct worship services; (3) does the individual perform services in the "control, conduct, or maintenance of a religious organization" under the authority of a church or religious denomination; (4) is the individual "ordained, commissioned, or licensed"; and (5) is the individual considered to be a spiritual leader by his or her religious body? Only the fourth factor is required in all cases (the individual must be ordained, commissioned, or licensed). The remaining four factors need not all be present for a person to be considered a minister for tax purposes. The Tax Court in the Knight case did not say how many of the remaining four factors must be met. It merely observed that "failure to meet one or more of these factors must be weighed … in each case."

The IRS concluded that the teachers and administrative staff were not "ministers of the gospel" since they were not ordained, commissioned, or licensed. While it is true that the church "commissioned" them as ministers of the gospel, the IRS concluded that this was not sufficient to make them "ministers" for tax purposes. It explained it decision by referring to a 1970 Tax Court ruling:

In Kirk v. Commissioner, 51 T.C. 66 (1968) the Tax Court stated that the term "commission" means "the act of committing to the charge of another or an entrusting." The court held that [a nonordained church employee] was not commissioned because no congregation or other body of believers was committed to his charge. The duty of spreading the gospel, either by sermon or teaching, was not formally entrusted to his care. He was merely a nonordained church employee. Furthermore, all the services performed by him were of a secular nature.

The reference to the Knight case by the IRS is very significant. The Knight case contains perhaps the best analysis of the term "minister" since the Tax Court applied a "balancing test," noting that a minister need not actually perform every category of ministerial service described in the income tax regulations. In some rulings the IRS has omitted any reference to this important decision. The recent private letter ruling takes a different view. This is an important acknowledgment, for it will mean that more bona fide ministers will be considered "ministers" for tax purposes.

services performed in the exercise of ministry

The IRS noted that the income tax regulations provide the following examples of services performed in the exercise of ministry, "The performance of sacerdotal functions, the conduct of religious worship, the administration and maintenance of religious organizations and their integral agencies, and the performance of teaching and administrative functions at theological seminaries." It cited a 1968 case in which the Tax Court ruled that a "commissioned" Baptist minister of education was not a minister of the gospel because (1) his commissioning was only a "paperwork procedure" designed to qualify him for a housing allowance, without changing his authority or duties, and (2) "the evidence fell far short of showing that the prescribed duties of a minister of education are equivalent to the services performed by a Baptist minister. Lawrence v. Commissioner, 50 T.C. 494 (1968).

The IRS concluded that "the teachers and administrative staff of the school failed the minimum requirement of [being ordained, commissioned, or licensed]. The school hired the employees as teachers and administrative staff and not as ministers of the gospel. Furthermore, none of the prescribed duties of the teachers and administrative staff are equivalent to the services performed by a church minister. Accordingly, the teachers and administrative staff do not qualify for an exclusion under the parsonage allowance." IRS Letter Ruling 200318002 (2003).


Application
. There are five important points to note about this ruling:

1. Private letter rulings are binding only on the taxpayers involved in the ruling. They have no precedential effect in other cases. Nevertheless, attorneys and CPAs often view them as reflecting the likely view of the IRS on the issues involved.

2. The IRS applied the "balancing test" approach to defining a "minister of the gospel" that was first applied by the Tax Court in the Knight case in 1989. The balancing test is perhaps the best available definition of a "minister of the gospel."

3. Many churches operate primary or secondary schools, or colleges. This case suggests that not all teachers and administrative staff employed by such schools are eligible for a housing allowance, especially if (1) they are not required to attend a Bible college, seminary, or other theological training program; (2) membership in the church is not required to be employed in either teaching or administrative positions; (3) all of the services they perform are "of a secular nature"; and (4) "none of the prescribed duties of the teachers and administrative staff are equivalent to the services performed by a church minister."

4. Some teachers and administrative staff employed by church schools will qualify for a housing allowance. The income tax regulations themselves specify that "examples of specific services the performance of which will be considered duties of a minister … include … the performance of teaching and administrative duties at theological seminaries." Treas. Reg. § 1.107-1(a). To illustrate, the IRS has ruled that an ordained rabbi employed full-time as a religious instructor by a synagogue-controlled private school was eligible for a housing allowance. The rabbi taught Judaic studies, led daily worship services with the students in the school, trained students to conduct religious services, taught students to read the Torah, assisted with Bar Mitzvah training, and provided consultation to students, faculty and administrators of the school with respect to Jewish religious practices. He also taught students on the subjects of Jewish law, liturgy, holidays, customs, ethics and values. The IRS concluded that the rabbi was a minister who was engaged in the exercise of ministry, and therefore he was eligible for a housing allowance.

5. Persons who qualify as a minister must be consistent with respect to the four special tax rules that the tax code applies to ministers. For example, not only are they eligible for a housing allowance, but they are also self-employed for Social Security, they are exempt from income tax withholding, and they are eligible for exemption from self-employment taxes if they meet several conditions. Conversely, persons who do not qualify as a minister engaged in the exercise of ministry are not subject to any of these rules.

Resource. For a detailed discussion of the eligibility of school staff for a housing allowance, see chapter 3 of Richard Hammar's Church & Clergy Tax Guide.

Legal Developments

Trademarking a Church Name

A federal appeals court ruled that the registered trademark “Church of the Creator” was a descriptive rather than a “generic” mark that was entitled to legal protection.

Richard R. Hammar, Attorney, CPA
Bio

Key point 6-05. A church name is a valuable property right that is protected by the legal principle of unfair competition. Protection also is available under federal trademark law.

A federal appeals court ruled that the registered trademark "Church of the Creator" was a descriptive rather than a "generic" mark that was entitled to legal protection against infringing uses by other organizations using the same or a similar name.

A church obtained a trademark registration for its name ("Church of the Creator") in 1989. The trademark is for use on "religious instructional and teaching materials namely, newsletters, books, journals, pamphlets, and brochures; photographs, calendars, posters, writing paper and envelopes, note cards; printed adhesive decals." The church has made extensive use of its trademark in connection with seminars, ministerial services; religious consulting services; ministerial ordination, educational information, and various publications. The church operates a website (churchofthecreator.org).

In 1999 a white supremacist organization (the "defendant") began using the name World Church of the Creator. This organization's members adhere to the religion of "Creativity," a religion that espouses that the "White Race" is "the Creator" of all worthwhile culture and civilization. Defendant uses the name "World Church of the Creator" to communicate its messages through flyers, pamphlets, brochures, newsletters, television talk-show appearances and news interviews, and the Internet. Its messages are frequently white-supremacist, racist, and anti-Semitic.

The church filed a lawsuit alleging that the defendant's use of the name World Church of the Creator was causing public confusion, infringed upon its registered trademark, and was causing "dilution" of its registered trademark. Further, the church asserted that the defendant's message was incompatible with and antithetical to its own teachings. The defendant claimed that the term "Church of the Creator" is generic and not a protectable trademark, and that its use of the name World Church of the Creator was protected by the first amendment guaranty of religious freedom.

The court began its opinion by defining a trademark as "any word, name, symbol, or device or any combination thereof adopted and used by a manufacturer or merchant to identify his goods and distinguish them from those manufactured or sold by others."

The purpose of trademark law is to "aid consumers in identifying the source of goods by allowing producers the exclusive right to particular identifying words or symbols which they may attach to their products as a designator of source."

Trademarks are generally classified in increasing levels of distinctiveness: generic; descriptive; suggestive; arbitrary; and fanciful. The last three categories of marks, because their intrinsic nature serves to identify a particular source of a product, are deemed inherently distinctive and are entitled to protection.

In contrast, generic marks are not registrable as trademarks, and a term that is "merely descriptive" may be protectable as a trademark if it has acquired secondary meaning. A merely descriptive term is one that specifically describes a characteristic or an ingredient of a product.

The defendant insisted that the term "Church of the Creator" is generic and therefore is not protectable as a trademark. The church responded by noting that the mark became "incontestable" after five years of continuous use. A federal district court concluded that the mark was generic, and that it did not become incontestable after five years of use. The church appealed to a federal appeals court which reversed the district court's ruling and found that the church's trademark was descriptive rather than generic and was entitled to protection.

The appeals court conceded that "generic" marks are incapable of trademark protection even if the Patent and Trademark Office registers such a mark. It defined a generic mark as one that "has become the name of a product" such as "sandwich for meat between slices of bread." While the word "church" is generic, the court concluded that the term "Church of the Creator" was descriptive rather than generic:

Church of the Creator is descriptive, like "lite beer." It does not name the class of monotheistic religions. In the contemporary United States, variations on "Church of [Deity]" are used to differentiate individual denominations, not to denote the class of all religions. The list is considerable: Church of God; Church of God (Anderson, Indiana); First Church of God; Worldwide Church of God; Church of God in Christ; Assembly of God; Korean Assembly of God; Church of the Nazarene; Church of Christ; United Church of Christ; Disciples of Christ; Church of Christ, Scientist; Church of Jesus Christ of Latter Day Saints. There is room for extension with Church of Our Savior, Church of the Holy Spirit, Church of the Holy Trinity, Church of Jehovah, and so on. Yet all of these are recognizable as denominational names, not as the designation of the religion to which the denominations belong. No Jewish, Islamic, Baha'i, or Unitarian group would say that it belongs to a "Church of the Creator"; and a Christian congregation would classify itself first into its denomination (e.g., Baptist, Lutheran, Russian Orthodox, Society of Friends), then into one of the major groupings (Roman Catholic, Orthodox, and Protestant), and finally into Christianity, but never into a "Church of the Creator." No one called or emailed a Baptist church to complain about its complicity in the hate-mongering of the World Church of the Creator; people recognized the name as denominational, and that's why protests ended up in the Church of the Creator's in box. What is more, as these lists show, using "Church of the Creator" as a denominational name leaves ample options for other sects to distinguish themselves and achieve separate identities …. Because there are so many ways to describe religious denominations, there is no risk that exclusive use of "Church of the Creator" will appropriate a theology or exclude essential means of differentiating one set of beliefs from another.

The court rejected the defendant's argument that recognizing the trademark status of Church of the Creator violates the first amendment because it restricts the free exercise of religion. It noted that the Constitution itself authorizes Congress to create rights of this kind.

What this means for churches

This case is important because it recognizes that the names of local churches and religious denominations are entitled to trademark protection even if they include generic terms (such as "church" or "God"). Such names can be descriptive rather than generic, and descriptive names are entitled to protection so long as they have acquired a "secondary meaning." This means that through long and uninterrupted use a descriptive name has come to be associated by the public with a particular organization, as is common with the names of religious denominations. Te-Ta-Ma Truth Foundation v. The World Church of the Creator, 297 F.3d 662 (7th Cir. 2002).

Legal Developments

No Contribution Deduction for Church School Tuition

Court rejects argument that tuition resulted in an “intangible religious benefit.”

Richard R. Hammar, Attorney, CPA
Bio

A federal appeals court rejected a married couple's claim that they could deduct 55% of the cost of their son's tuition at a religious school since religious instruction comprised 55% of the curriculum and constituted an "intangible religious benefit" that did not reduce the value of their charitable contribution.

The court concluded, "Not only has the Supreme Court held that, generally, a payment for which one receives consideration does not constitute a contribution or gift … but it has explicitly rejected the contention … that there is an exception for payments for which one receives only religious benefits in return."

The parents also argued that they could claim a charitable contribution deduction for the amount by which their tuition payments exceeded the market value of their son's education. They claimed that the value of the education their son received was zero since the cost of an education at a public school was "free," and therefore they could fully deduct the cost of their son's tuition since the entire amount exceeded the "value" of the education received.

The court disagreed, noting that the value of their son's education was the cost of a comparable secular education offered by private schools. Further, the court noted that the parents presented no evidence of the tuition that private schools charge for a comparable secular education, and so there was no evidence showing that they made an "excess payment" that might qualify for a tax deduction.

Sklar v. Commissioner,2002-1 USTC 50,210 (9th Cir. 2002)

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