Key point 7-21. Embezzlement refers to the wrongful conversion of funds that are lawfully in one’s possession.
A Texas pastor was charged with theft of U.S. currency valued between $2,500 and $30,000 from his church, a third-degree felony.
The pastor pleaded “not guilty,” and the case proceeded to a jury trial.
At trial, the evidence showed that the pastor represented to his church members that he had a “calling” to support a South African church and orphanage in need of financial assistance.
The church and its members directed “love offerings” to the pastor to support the South African church and orphanage.
Tip: “Love offerings” from a church to its pastor almost always constitute taxable income to the pastor.
The church’s elders began questioning the legitimacy of the pastor’s representations, which were later revealed to be false.
The “love offerings” occurred from August 2017 until October 2017.
Pastor sentenced with theft
The jury found the pastor guilty. Following the jury’s guilty verdict, the trial court gave the pastor a three-year prison sentence. The pastor appealed.
A state appeals court found no basis for an appeal and affirmed the trial court’s verdict.
Why this case matters to church leaders
There are aspects to this case that merit consideration by church leaders. Consider the following:
1. Control over funds
The court concluded that the church members’ “love gifts” to the pastor were not tax-free, even though he claimed that he would use them exclusively to help a church and orphanage in South Africa. The reason: the donated funds were not sufficiently subject to the church’s control. It was entirely up to the pastor to decide how the funds were spent. The fact that the pastor failed to use the funds for the church and orphanage in South Africa underscores the problem.
2. Discretionary funds and the ‘constructive receipt’ tax rule
It is a common practice for a congregation to set aside a sum of money in a discretionary fund and give a minister the sole authority to distribute the money in the fund. In some cases, the minister has no instructions regarding permissible distributions. In other cases, the congregation establishes some guidelines, but these often are oral, ambiguous, and nonaccountable. Many ministers and churches are unaware of the potential tax consequences of these arrangements.
The IRS could assert that the full value of the discretionary fund constitutes taxable income to the minister, even if the minister does not benefit from the fund. The mere fact that the minister could benefit from the fund may be enough for the fund to constitute taxable income.
The basis for this result is the “constructive receipt” rule, which is explained in income tax regulation 1.451-2(a):
Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
For a discretionary fund to constitute taxable income to a minister, it is essential that the minister have the authority to “draw upon it at any time” for his or her personal use. This means the fund was established without any express prohibition against personal distributions.
EXAMPLE: The Tax Court ruled that a pastor was required to report as taxable income $182,000 in deposits to a church bank account over which he exercised complete dominion and control. This case supports the view that church contributions to discretionary funds over which a pastor has complete control represent taxable income to the pastor. The court concluded:
[The minister] had unfettered access to the funds in the church accounts, and there is no evidence that the church congregation had any say over how those funds were used. Indeed, the only member of the church congregation who testified at trial had no knowledge of the church’s finances, suggesting that [the pastor] did not share any information about church finances with the congregation. The facts show that [he] fully controlled the church accounts, used money in those accounts at will, including to pay personal expenses, and were not accountable to anyone in their congregation for their use of the church funds. Accordingly, we conclude that [the pastor] exercised dominion and control over the church bank accounts. Consequently, all deposits into those accounts, except those from nontaxable sources, are properly includable in petitioners’ gross income. 101 T.C.M. 1550 (2011).
3. Love gifts
This case demonstrates once again that “love gifts” to a pastor represent taxable income and should be so reported by the pastor and the church.
4. Charitable contributions
Contributions by church members to a pastor’s discretionary fund will not be tax deductible by donors, assuming that the pastor has sole discretion on distributions from the fund. This is because charitable contributions must be made to, or for the use of, a “qualified charitable organization.” Section 170(c) of the tax code defines qualified organizations to include, among others, any organization that satisfies all the following requirements:
- created or organized in the United States (or a United States possession);
- organized and operated exclusively for religious, educational, or other charitable purposes;
- no part of the net earnings of which inures to the benefit of any private individual; and
- not disqualified for tax exempt status under section 501(c)(3) by reason of attempting to influence legislation, and which does not participate or intervene in any political campaign on behalf of any candidate for public office.
Donations to a pastor earmarked for a discretionary fund over which he or she exercises sole dominion does not satisfy this definition.
The IRS can impose an excise tax against a “disqualified person,” and in some cases against church board members individually, if excessive compensation is paid to the disqualified person. Most senior pastors will meet the definition of a disqualified person. These taxes, known as intermediate sanctions, are substantial (up to 225 percent of the amount of compensation the IRS determines to exceed reasonable compensation).
As a result, governing boards or other bodies that determine clergy compensation should be prepared to document any amount that may be viewed by the IRS as excessive. This includes salary, fringe benefits, and special-occasion gifts. If in doubt, the opinion of a tax attorney should be obtained.
The IRS deems any taxable fringe benefit provided to an officer or director of a tax-exempt charity (including a church), or a relative of such a person, to be an automatic excess benefit that may trigger intermediate sanctions, regardless of the amount of the benefit, unless the benefit was timely reported as taxable income by either the recipient or the employer.
As a result, the failure of the pastor, or his employing church, to report the offerings as taxable income made them an automatic excess benefit subjecting the pastor, and possibly members of the church board, to substantial excise taxes as noted above.
6. Donations to foreign charities
The pastor’s assertion that he was raising funds for a church and orphanage in South Africa raises the question of the deductibility of contributions made to churches and charities in other countries. The IRS summarizes the rules as follows:
You can’t deduct contributions to . . . foreign organizations other than certain Canadian, Israeli, or Mexican charitable organizations. . . . Also, you can’t deduct a contribution you made to any qualifying organization if the contribution is earmarked to go to a foreign organization. However, certain contributions to a qualified organization for use in a program conducted by a foreign charity may be deductible as long as they aren’t earmarked to go to the foreign charity. For the contribution to be deductible, the qualified organization must approve the program as furthering its own exempt purposes and must keep control over the use of the contributed funds. The contribution is also deductible if the foreign charity is only an administrative arm of the qualified organization. . . .
You may be able to deduct contributions to certain Canadian charitable organizations covered under an income tax treaty with Canada. To deduct your contribution to a Canadian charity, you generally must have income from sources in Canada. See IRS Publication 597 (Information on the United States–Canada Income Tax Treaty) for information on how to figure your deduction.
You may be able to deduct contributions to certain Mexican charitable organizations under an income tax treaty with Mexico. The organization must meet tests that are essentially the same as the tests that qualify U.S. organizations to receive deductible contributions. The organization may be able to tell you if it meets these tests. (IRS Publication 526)
7. Internal controls
This case provides a useful lesson in the importance of maintaining good “internal controls” over a church’s financial resources, and the problems that can occur when internal controls are neglected.
Learn best practices for establishing internal controls with our online course, “Safeguarding Your Church’s Finances.”
8. Criminal consequences
The case illustrates that church leaders like this pastor who mishandle church funds may be subject to both tax penalties and criminal liability.
Zitha v. State, 2023 WL 3526080 (Tex. App. 2023).
