Hairston v. Commissioner, T.C. Memo. Dec. 51,025(M) (1995)
Article summary. A number of unique tax rules apply to ministers. One of these rules is the eligibility of ministers for exemption from self—employment (social security) taxes if various conditions are met. A recent Tax Court ruling addresses the requirements for this exemption, and the possible consequences to ministers who apply for the exemption without meeting the eligibility requirements. The Court also addressed a number of other tax issues of interest to ministers, including home offices and telephone expenses. The Court's ruling is addressed fully in this feature article.
It is common for younger ministers to file for exemption from self—employment (social security) taxes without fully understanding the eligibility requirements. Many of these ministers later realize that they were not eligible for the exemption, and they wonder what they should do about it. This is a very difficult question, for which there is no satisfactory answer. A recent Tax Court decision sheds some light on this dilemma. This feature article will address the Court's decision, and assess its significance to ministers. The article also considers other tax issues addressed in the Court's decision.
A minister received his bachelor's degree in psychology and a graduate degree in Christian counseling from a church—affiliated university. He also completed undergraduate religion courses and graduate theology courses. The minister was ordained by a religious organization (the Body of Christ) in 1987, and was later "licensed" as a minister by the Assemblies of God. The minister is qualified to perform sacraments, to baptize, and to officiate at marriage ceremonies and burials. The minister opened a pastoral counseling practice in a rented office, and also established a new church. He purchased a home in the name of the church, but made the mortgage payments on the residence and deducted the mortgage interest on Schedule C of his individual income tax returns.
Sometime in 1987 the minister rented an office (the "downtown office") for the counseling business. The downtown office consists of a counseling office, waiting room, reception area, and a bathroom for the clients. The minister believes that any item that makes a counseling setting look like a business office is detrimental to the counseling session. As a result, the minister uses the downtown office to meet with and counsel clients, but does not research or attend to office work at the downtown location. Instead, he uses two rooms in his personal residence to store his books and office equipment and to prepare for counseling sessions. He claimed that approximately 20 percent of his home was used as a home office.
The minister started operating the Christian counseling center sometime in 1988. In addition to counseling, the minister occasionally preaches on Sundays, teaches in church settings, and administers sacraments. However, the only service for which he accepts remuneration is counseling. His federal income tax returns for taxable years 1988, 1989 and 1990 were audited by the Internal Revenue Service. The IRS focused on the minister's exemption from self—employment (social security) taxes and insisted that the exemption was invalid since he was not eligible for it. As a result, the IRS assessed self—employment taxes (at the full 15.3 percent rate) against the minister's net self—employment income for the three years under examination. The IRS also ruled that the minister had improperly deducted home office expenses. The minister appealed to the Tax Court.
The Court's ruling
exemption from social security
All ministers are self—employed for purposes of social security with respect to services they perform in the exercise of their ministry. This means they pay the "self—employment" tax (currently 15.3 percent of net earnings) rather than FICA taxes. However, federal law permits ministers to exempt themselves from self—employment taxes with respect to their ministerial income if they meet several conditions. These include the following two:
1. The minister must file an exemption application (Form 4361) in triplicate with the IRS. A minister certifies on Form 4361 that I am conscientiously opposed to, or because of my religious principles I am opposed to, the acceptance (for services I performed as a minister … ) of any public insurance that makes payments in the event of death, disability, old age, or retirement, or that makes payments toward the cost of, or provides services for, medical care. The form states that public insurance includes insurance systems established by the Social Security Act. There are three important factors to note.
a. Conscientious opposition based on religious belief. The income tax regulations clarify that ministers … requesting exemption from social security coverage must meet either of two alternative tests: (1) A religious principles test which refers to the institutional principles and discipline of the particular religious denomination to which he belongs, or (2) a conscientious opposition test which refers to the opposition because of religious considerations of individual ministers … (rather than opposition based upon the general conscience of any such individual or individuals). Under both the religious principles and conscientious opposition tests, a minister must have religion—based opposition to accepting social security benefits. The income tax regulations clearly reject the view that ministers can be eligible for exemption from social security coverage on the basis of conscientious opposition alone. The conscientious opposition must be rooted in religious belief. Further, economic or any other non—religious considerations are not a valid basis for the exemption. Regrettably, many ministers have been induced to exempt themselves from social security participation because of the recommendation of a financial counselor that they would be better off financially.
b. Opposition to the acceptance of public insurance benefits. The exemption is available only if a minister is opposed on the basis of religious considerations to the acceptance of social security benefitsrather than to payment of the tax. A minister may have religious opposition to payment of the tax, but this alone will not suffice. The individual must have religious opposition to accepting social security benefits upon his or her retirement or disability. This is an extraordinary claim that few ministers in good faith will be able to make.
c. Participation in private insurance programs permitted. The applicant's opposition must be to accepting benefits under the social security program (or any other public insurance system that provides retirement and other specified benefits). As a result, a minister who files the exemption application may still purchase life insurance or participate in retirement programs administered by non—governmental institutions (such as a life insurance company). The income tax regulations specify that the term public insurance refers to governmental, as distinguished from private, insurance and does not include insurance carried with a commercial insurance carrier. The regulation goes on to clarify that to qualify for the exemption a minister need not be opposed to the acceptance of all public insurance but he must be opposed on religious grounds to the acceptance of any such payment which, in whole or in part, is based on, or measured by earnings from, services performed by him in his capacity as a minister.
2. The exemption application (Form 4361) must be filed on time. The deadline is the due date of the federal tax return for the second year in which a minister has net earnings from self—employment of $400 or more, any part of which derives from the performance of services in the exercise of ministry.
The Tax Court addressed two important issues—whether or not the minister filed his exemption application on time, and whether he was eligible for exemption. These issues are addressed below:
was the exemption application filed on time?
The minister filed a Form 4361 ("Application for Exemption from Self Employment Tax"), which was received by the IRS on April 17, 1989. Box 3 and line 4 of the Form 4361 identified the minister as having been ordained by the Assemblies of God on August 31, 1984. Further, line 5 states that 1985 and 1986 were the first 2 years in which the minister had self—employment earnings of at least $400 from services as a minister. The application deadline, based on the information provided, would be April 15, 1987, 2 years prior to the date that the minister actually filed the application. The IRS marked the application "Disapproved for exemption" on May 2, 1989.
The Tax Court disagreed that the Form 4361 was filed too late. It observed:
In fact, [the minister] was ordained by the Body of Christ Church … on May 17, 1987. Based upon [his] testimony at trial and on returns [he] filed … it appears that 1988 was the first year in which [he] had self—employment income of $400 or more earned from services as a minister. Accordingly, the filing deadline for the exemption application would have been on April 15, 1990, one year after [he] filed the application.
The Court was wrong in reaching this conclusion. It focused on the date the minister was ordained (1987), ignoring the significance of the fact that he had been licensed as a minister in 1984. It is true that the minister's Form 4361 incorrectly stated that he had been ordained rather than licensed in 1984. But this error has absolutely no significance, since the time limit for filing the form ordinarily begins to run when a minister is either "ordained, licensed, or commissioned."
was the minister eligible for exemption?
The minister had not yet been informed by the IRS that his exemption application had been denied when he filed his 1988 tax return. Assuming that the application would be granted, he did not pay self—employment taxes and wrote "Exempt Form 4361" on the line relating to self—employment tax. He followed this same practice on his 1989 tax return, even though he had by then been informed by the IRS that his exemption application had been rejected. He again paid no self—employment tax on his 1990 tax return, but provided no explanation. The IRS determined that the minister had to pay self—employment taxes for all three years, since his exemption application had been rejected. The Tax Court agreed. In explaining why the minister was not eligible for exemption the Court observed:
[The minister] cannot prove that he is opposed to public insurance as a conscientious or religious principle, as is required by [the tax code] in order to qualify for exemption from self—employment tax. [His] testimony at trial reveals that he is not opposed to public insurance as a "religious issue." The following exchange illustrates [his] beliefs regarding public insurance:
The Court: Okay. And just to go back a couple questions, are you, as an ordained minister, opposed to public insurance?
[The minister]: Public—I am sorry?
The Court: Public insurance? Was that the reason that you had filed your application for exemption from the self—employment tax?
[The minister]: No. I am not opposed to the—to that, as a religious issue, no. We were advised to—by our accountant, to file for an exemption with the state, providing the state would allow it. And we asked the state to allow it, which they did.
Although [the minister] signed an exemption application stating that he is opposed to public insurance because of his religious principles, the Court finds [his] trial testimony to be more compelling. The application for exemption contained numerous significant mistakes, including the date that [he] was ordained and the religious body that ordained [him]. It is obvious that [he] did not carefully review the application. In view of the significant mistakes made on the application, it is possible that [he] did not even read the application, including the statement certifying that the applicant is opposed to public insurance, prior to signing the Form 4361.
We hold that [the minister] has failed to prove that he is opposed to public insurance as is required by [law] in order to qualify for exemption from the self—employment tax. [He] is therefore liable for self—employment taxes for the taxable years 1988, 1989, and 1990.
Notice what happened here. After conceding (incorrectly) that the minister's exemption application was filed on time, the Court concluded that the minister was not eligible for exemption because of comments he made during his trial. This is an extraordinary ruling that is of the utmost importance to younger ministers who are trying to decide whether or not to file a Form 4361. The ruling indicates that filing a timely Form 4361—which contains a certification by the applicant that he or she meets all of the eligibility requirements—may not be enough. The IRS or the courts may later question whether or not the minister in fact was eligible for the exemption when the Form 4361 was filed. The Court struggled with this conclusion. It acknowledged that the minister signed an exemption application stating that he was opposed to public insurance because of his religious principles. However, it found the minister's trial testimony to be more compelling. This conclusion was reinforced by the mistakes that appeared on the Form 4361, which suggested to the Court that the minister had not read the form and was not aware that he was ineligible for exemption.
Key point. Many ministers have filed a Form 4361 without being eligible for the exemption from self—employment taxes. These ministers must recognize that the validity of their exemption may be questioned in an audit.
other tax issues
The Court addressed a few other tax issues that will be of interest to ministers. They are summarized below:
The minister claimed that he used 20 percent of his home as a "home office" associated with his counseling ministry. Recall that the minister did all of his counseling in his downtown office, and used the office in his home (consisting of two rooms) to store his books and office equipment and to prepare for counseling sessions. He did not meet with or counsel clients at his home office but rather used the downtown office for that purpose. He claimed that he maintained his counseling books and accounting materials at the home office because the presence of these items in the downtown office would have "intimidated the clients."
The Tax Court concluded that the minister could not claim a business expense deduction for any portion of the expenses associated with his home office. It should be noted that a minister must meet the following requirements before qualifying for a business expense deduction for a home office:
(1) Exclusive use. The home office must be exclusively used in the minister's "trade or business." This means that the home office must not be used by other family members (for example, to watch television or do homework). The use of a part of your home for both personal and business purposes does not meet the exclusive use test.
(2) Regular basis. The home office must be used on a regular basis in the minister's "trade or business." This means that the home office must be used on a continuous basis by the minister for professional purposes (e.g., preparing sermons, conducting counseling, doing research, contacting members, writing correspondence, preparing for board meetings). Occasional or incidental use of the office for such purposes is not enough, even if the office is used for no other purposes.
(3) Convenience of the employer. If the minister is an employee, the home office must be for the convenience of the employer. This means that the home office must do more than make the employee's job more easy or efficient—it must be essential to the performance of the employee's job. The Court did not address this requirement, but assumed that it did not apply since the minister reported his income taxes as a self—employed individual.
(4) Principal place of business. The home office must be the minister's principal place of business. In 1993 the United States Supreme Court ruled (in the Soliman case) that "there are two primary considerations in deciding whether a home office is a taxpayer's principal place of business: the relative importance of the activities performed at each business location and the time spent at each place." The Supreme Court stated that "the point where goods and services are delivered must be given great weight in determining the place where the most important functions are performed." It continued:
Though not conclusive, the point where services are rendered or goods delivered is a principal consideration in most cases. If the nature of the business requires that its services are rendered or its goods are delivered at a facility with unique or special characteristics, this is a further and weighty consideration in finding that it is the delivery point or facility, not the taxpayer's residence, where the most important functions of the business are undertaken.
In addition to measuring the relative importance of the activities undertaken at each business location, the Supreme Court suggested that one should also compare the amount of time spent at home with the time spent at other places where business activities occur. Further, "this factor assumes particular significance when comparison of the importance of the functions performed at various places yields no definitive answer to the principal place of business inquiry."
The Tax Court applied the Supreme Court's Soliman decision in concluding that the minister did not qualify for a home office deduction. It observed:
In analyzing the first factor set forth in Soliman, the relative importance of the activities undertaken at each business location, we should consider whether the functions performed in the home office are necessary to the business. [The minister] maintained all of his records and books in his home office. Further [he] prepared for and reviewed his counseling sessions in his home office. Although [his] activities in his home office were important to his business [he] did not introduce any testimony showing that the functions which he performed at his home office were more important than the functions which he performed at his downtown office. On the contrary [he] actually met with and counseled his clients at the downtown office. Like the taxpayer in Soliman, the actual treatment (counseling) was the essence of [his] professional service and was the most significant event in the professional transaction. Because we find that the services performed in the downtown office were more significant than the activities undertaken in [the minister's] home office, this factor weighs heavily in favor of [the IRS].
We now turn to the second factor set forth in Soliman, the amount of time spent at each location. [The minister] testified that he spent almost as much time in the home office as the downtown office and that sometimes he spent more time in the home office than in the downtown office. As approximately equal time was spent at each location, this factor is not helpful in identifying [his] principal place of business.
Based upon the evidence presented, we find that [the minister's] home office is not his principal place of business for the counseling ministry.
Key point. The new IRS audit guidelines for ministers instruct agents to "question closely" the necessity of a home office. This is a business expense that invites scrutiny. It should not be claimed unless there is a reasonable basis for it.
The minister deducted telephone expenses which included expenses for the office phone in the downtown office, Yellow Pages advertising, charges for call forwarding from the business location to the personal residence, and business related long distance calls made from his home. The IRS disallowed the portion of the telephone expenses attributable to the minister's home office. It also insisted that the minister had failed to prove the expenses he incurred in the business use of his telephone. The Tax Court disagreed with this conclusion, noting that the minister clearly incurred some telephone expenses at home in the course of conducting his trade or business as a counselor, and that the deductibility of telephone expenses is not governed by the home office rules. It also observed that as a general rule, if the record provides sufficient evidence that the taxpayer has incurred a deductible expense, but the taxpayer is unable to adequately substantiate the amount of the deduction to which he or she is otherwise entitled, the Court may estimate the amount of such expense and allow the deduction to that extent. The Court estimated a modest amount of deductible telephone expenses for the years under examination. Note that the estimation of business expenses is not permitted for many business expenses, including automobile expenses, travel expenses, and entertainment expenses.
The Court further noted that section 262(b) of the Internal Revenue Code, effective for 1989 and later years, disallows a deduction for basic local telephone service with respect to the first telephone line to any residence of the taxpayer, regardless of any business use of the telephone. The Court added that this section, however, does not apply in this case since [the minister has] not claimed local telephone service expenses.
Significance of the court's decision
The most important aspect of the Court's decision was its treatment of the minister's application for exemption from self—employment taxes (Form 4361). Consider the following points:
1. Be familiar with the requirements for exemption. Ministers who are trying to decide whether or not to file a Form 4361 should review the form carefully to determine whether or not they meet all of the eligibility requirements. Two of those requirements are summarized earlier in this article. Unfortunately, most ministers who file Form 4361 do not qualify for exemption because they are not opposed on the basis of religious convictions to the acceptanceof public insurance benefits (including social security). Many of these ministers assume that they qualify for the exemption because they are opposed to the social security system as a whole, or do not believe it is financially viable. Many others have no understanding whatever of the basis for the exemption, and are persuaded by a financial adviser to file Form 4361.
Key point. Before submitting a Form 4361 to the IRS, be sure you read the form carefully and that you meet all of the requirements for exemption.
Key point. Before submitting a Form 4361 to the IRS, ask yourself the following question: If I am audited, and the validity of my exemption is questioned, will I be able to defend my position?
Key point. All of the eligibility requirements for exemption from self—employment taxes are discussed fully in chapter 9 of the 1996 edition of Richard Hammar's Church and Clergy Tax Guide.
2. If you already are exempt. Perhaps you already are exempt from self—employment taxes. You submitted a Form 4361 a number of years ago that was approved by the IRS. This case illustrates that the validity of an exemption may be questioned in an audit. As noted above, are you familiar enough with the requirements for exemption that you can defend your exemption?
Key point. Surveys conducted by Church Law & Tax Report reveal that a substantial number of ministers have applied for (and received) recognition of exemption from self—employment taxes. These ministers should review their Form 4361 to be sure that they are familiar with the basis for exemption and that they are able to defend their exemption in the event of an audit.
3. Can ministers revoke an exemption? Many ministers who are exempt from self—employment taxes will recognize that they are not eligible for the exemption if they take the time to review the eligibility requirements explained on their Form 4361. What should these ministers do? Many of them want to get back into the social security program. Can they? Does this case provide an "open door"? Unfortunately, the Tax Court's ruling does not respond directly to most of these questions. Federal law specifies that the exemption from self—employment taxes is irrevocable, and there have been no reported cases allowing a minister to voluntarily rejoin the program after filing a timely Form 4361.
Key point. There were two brief "windows" in the past when ministers were allowed by law to rejoin the social security system (the most recent expired in 1988). But Congress has not reopened these windows, and there is no indication that it will in the future.
This case does indicate that an exemption may be challenged by the IRS (or the courts) and may be revoked if it determined that the minister did not qualify. In other words, a minister may not affirmatively revoke an exemption, but the IRS or the courts may.
4. How far back can taxes be assessed? What if the IRS successfully revokes a minister's exemption on the ground the minister did not qualify? Can the IRS assess back taxes all the way to the year the Form 4361 was filed? In 1982 the IRS ruled that a taxpayer who fails to pay self—employment tax cannot be liable for more than three years of back taxes so long as he or she filed a Form 1040 for each year reporting federal income taxes. The IRS noted that federal tax law specifies that taxes must be assessed within three years after a return is filed, though taxes may be assessed at any time in the case of failure to file a return. In other words, the IRS generally can assess back taxes only for the three years preceding a return, but there is no limit on how far back the IRS can assess taxes if no return is filed.