Pastor, Church & Law

§ 9.09

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Key point 9-09. Bankruptcy trustees are prohibited by the federal Religious Liberty and Charitable Donation Protection Act from recovering contributions made by bankrupt debtors to a church or other charity prior to declaring bankruptcy, unless the contributions were made with an intent to defraud creditors. This protection extends to any contribution amounting to less than 15 percent of a debtor's gross annual income, or more if the debtor can establish a regular pattern of giving more. In addition, the Act bars bankruptcy courts from rejecting a bankruptcy plan because it allows the debtor to continue making contributions to a church or charity. Again, this protection applies to debtors whose bankruptcy plan calls for making charitable contributions of less than 15 percent of their gross annual income, or more if they can prove a pattern of giving more.

In the past, churches were adversely affected by federal bankruptcy law in two ways. First, many courts ruled that bankruptcy trustees could recover contributions made to a church by a bankrupt donor within a year of filing a bankruptcy petition. Second, church members who declared bankruptcy were not allowed by some bankruptcy courts to continue making contributions to their church. These harmful restrictions were eliminated when Congress enacted the Religious Liberty and Charitable Donation Protection Act. The Act, which is actually an amendment to the bankruptcy code, provides significant protection to churches as well as to church members who file for bankruptcy. This section will review the background of the Act, explain its key provisions, and demonstrate its application with practical examples.

1. Authority of Bankruptcy Trustees to Recover Charitable Contributions

background

Section 548(a) of the bankruptcy code authorizes a bankruptcy trustee to "avoid" or recover two kinds of "fraudulent transfers" made by bankrupt debtors within a year of filing for bankruptcy:

(1) Intent to defraud. Section 548(a)(1) gives a bankruptcy trustee the legal authority to recover "any transfer of an interest of the debtor in property … that was made or incurred on or within one year before the date of the filing of the petition, if the debtor voluntarily or involuntarily made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted."

(2) Transfers of cash or property for less than "reasonably equivalent value." Section 548(a)(2) gives a bankruptcy trustee the legal authority to recover "any transfer of an interest of the debtor in property … that was made or incurred on or within one year before the date of the filing of the petition, if the debtor voluntarily or involuntarily … received less than a reasonably equivalent value in exchange for such transfer or obligation and was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation … or intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor's ability to pay as such debts matured."

In the past, many bankruptcy trustees contacted churches, demanding that they return donations made by bankrupt debtors within a year of filing for bankruptcy. They argued that charitable contributions made by bankrupt debtors to a church are for less than "reasonably equivalent value," and therefore can be recovered by bankruptcy trustees under the second type of "fraudulent transfer" mentioned above. Donors and churches protested such efforts. They insisted that donors do receive valuable benefits in exchange for their contributions, such as preaching, teaching, sacraments, and counseling. Not so, countered bankruptcy trustees. These benefits would be available whether or not a donor gives anything, and so it cannot be said that a donor is receiving "reasonably equivalent value" in exchange for a contribution. Many courts agreed with this logic, and ordered churches to turn over contributions made by bankrupt debtors. This created a hardship for many churches. After all, most churches had already spent the debtor's contributions before being contacted by the bankruptcy trustee, and so "returning" them (especially if they were substantial) was often difficult.

These arguments were conclusively resolved by Congress in 1998 with the enactment, by unanimous vote, of the Religious Freedom and Charitable Donation Protection Act. In introducing the House bill, Congressman Packard observed:

Mr. Speaker, how much of the work done by your church or favorite charity depends on the generous donations of parishioners and contributors like yourself? Did you know that creditors can take already donated money from them because current bankruptcy law allows them to do so? It's unbelievable, but it's true. In a recent case, a United States Federal Bankruptcy Trustee brought an action against the Crystal Evangelical Free Church of New Hope, Minnesota. In doing so, this unprecedented case reinterpreted the Bankruptcy Code to mean that if an individual gives money to a non-profit group within one year of declaring bankruptcy, creditors can come after the group to re-claim this money. Why? Because an individual must receive something of "reasonable equivalent value" in return for a monetary donation. Mr. Speaker, current law essentially says that if an individual has filed for bankruptcy, he cannot simply donate money to a charitable organization or to the church. However, because the Bankruptcy Code allows for certain "entertainment exemptions," taking a luxury vacation, purchasing liquor, buying a new car, or making 1-900 calls to psychics, are all reasonable expenditures. This case outraged me and I decided to do something about it. I introduced legislation in early October to protect certain charitable contributions. Known as the Religious Liberty and Charitable Donation Protection Act, this legislation will amend U.S. Code to protect our nation's churches and charities from the hands of creditors. Mr. Speaker, H.R. 2604, the Religious Liberty and Charitable Donation Protection Act, will allow your church or favorite charity to continue to thrive and prosper. Donations received in good faith from individuals will not be taken from their pockets by creditors. I encourage all of my colleagues to co-sponsor this important legislation. As the holidays quickly approach, we must work to address the needs of our churches, charities and the less fortunate who rely on their vital services. H.R. 2604 will do just that.

The key to the Act was the following provision, which is an amendment to section 548(a)(2) of the bankruptcy code:

A transfer of a charitable contribution to a qualified religious or charitable entity or organization shall not be considered to be a transfer [subject to recovery by a bankruptcy trustee] in any case in which—(A) the amount of that contribution does not exceed 15 percent of the gross annual income of the debtor for the year in which the transfer of the contribution is made; or (B) the contribution made by a debtor exceeded the percentage amount of gross annual income specified in subparagraph (A), if the transfer was consistent with the practices of the debtor in making charitable contributions.

Key point. Note that there are two separate protections here: (1) bankruptcy trustees cannot recover contributions made by a bankrupt debtor for less than reasonably equivalent value within a year prior to filing for bankruptcy if the contributions amount to 15 percent or less of the debtor's gross annual income; and, (2) bankruptcy trustees cannot recover contributions made by a bankrupt debtor for less than reasonably equivalent value within a year prior to filing for bankruptcy if the contributions exceed 15 percent of the debtor's gross annual income, and the amount of the contributions are consistent with the debtor's giving practices.

Key point. It is critical to note that this provision only amends the second type of "fraudulent transfer" described at the beginning of this section—transfers of cash or property made for less than "reasonably equivalent value" within a year of filing a bankruptcy petition. The Act does not amend the first kind of fraudulent transfer—those made with an actual intent to defraud.

The meaning of the above-quoted section was addressed in a committee report accompanying the Act. The report reads, in part:

[The Act] protects certain charitable contributions made by an individual debtor to qualified religious or charitable entities within one year preceding the filing date of the debtor's bankruptcy petition from being avoided by a bankruptcy trustee under section 548 of the Bankruptcy Code. The bill protects donations to qualified religious organizations as well as to charities … [The Act] is not intended to diminish any of the protections against prepetition fraudulent transfers available under section 548 of the Bankruptcy Code. If a debtor, on the eve of filing for bankruptcy relief, suddenly donates 15 percent of his or her gross income to a religious organization, the debtor's fraudulent intent, if any, would be subject to scrutiny under … the Bankruptcy Code. This fifteen percent "safe harbor" merely shifts the burden of proof and limits litigation to where there is evidence of a change in pattern large enough to establish fraudulent intent. As Professor Laycock explained during the subcommittee hearing on this bill: "If I have been going along for years putting $5 a week in the collection plate and all of a sudden, before I file for bankruptcy, I clean out my last account and give 15 percent of my last year's income to my church, the trustee and the bankruptcy judge will look at the timing, the amount, the circumstances, the change in pattern, and they will say those are all badges of fraud. They will say I had the actual intent to hinder or defraud my creditors, and that is recoverable under section 548(a)(1). The fraud scenario is not going to happen."

Likewise, Senator Grassley … stated: "[T]he bill does not amend section 548(a)(1) of the Bankruptcy Code. This section lets bankruptcy courts recover any transfer of assets on the eve of bankruptcy if the transfer was made to delay or hinder a creditor. Therefore, if the bill is enacted, we don't have to worry about a sudden rash of charitable giving in anticipation of bankruptcy. Such transfers would obviously be for the purpose of hindering creditors and would still be subject to the bankruptcy judge's powers. In other words, there really isn't much room for abuse as a result of [this] legislation."

In addition, [the Act] protects the rights of certain debtors to tithe or make charitable contributions after filing for bankruptcy relief. Some courts have dismissed a debtor's chapter 7 case (a form of bankruptcy relief that discharges an individual debtor of most of his or her personal liability without any requirement for repayment) for substantial abuse under section 707(b) of the Bankruptcy Code based on the debtor's charitable contributions ….

Let's illustrate the impact of this provision with some practical examples.

Examples

• Bob has attended his church for many years. For the past two years, his contributions to his church have averaged $50 per week, or about $2,500 per year. Bob's gross annual income for the current year is about $40,000. On May 15 Bob files for bankruptcy. A bankruptcy trustee contacts the church treasurer, and demands that the church turn over all contributions made by Bob during the year prior to the date he filed for bankruptcy. The Religious Freedom and Charitable Donation Protection Act applies directly to this scenario, and protects the church from the reach of the trustee, since: (1) the amount of Bob's annual contributions in the two previous years in which the contributions were made did not exceed 15 percent of his gross annual income (15 percent of $40,000 = $6,000); and (2) the timing, amount, and circumstances surrounding the contributions, as well as the lack of any change in the debtor's normal pattern or practice, suggest that Bob did not commit intentional fraud, and so the trustee cannot recover contributions on this basis.

• Same facts as the previous example, except that in addition to his weekly giving Bob made a one-time gift to the church building fund in the amount of $5,000. Bob's total giving for the year preceding the filing of his bankruptcy petition now totals $7,500, or nearly 19 percent of his gross annual income. As a result, he is not eligible for the 15 percent "safe harbor" rule. The trustee will be able to recover the $7,500 in contributions made by Bob to the church within a year of filing the bankruptcy petition, unless Bob can demonstrate that giving 19 percent of his gross annual income is consistent with his normal practices in making charitable contributions. It is unlikely that Bob or the church will be able to satisfy this condition, since the gift to the building fund was a "one time" extraordinary gift for Bob that was unlike his giving pattern in any prior year.

• Barb believes strongly in giving to her church, and for each of the past several years has given 20 percent of her income. On June 1 of the current year she files for bankruptcy. A bankruptcy trustee contacts the church treasurer, and demands that the church turn over all contributions made by Barb for the year prior to the date she filed for bankruptcy. The Religious Freedom and Charitable Donation Protection Act applies directly to this scenario, and protects the church from the reach of the trustee, since: (1) the amount of Barb's annual contributions for the years in which the contributions were made exceeded 15 percent of her gross annual income, but she had a consistent practice in prior years of giving this amount; and (2) the timing, amount, and circumstances surrounding the contributions, as well as the lack of any change in the debtor's normal pattern or practice, suggest that Barb did not commit intentional fraud, and so the trustee cannot recover contributions on this basis.

• Bill has attended his church sporadically for the past several years. For the past few years, his contributions to his church have averaged less than $1,000 per year. Bill's gross annual income for the current and previous year is about $80,000. Bill is facing a staggering debt load due to mismanagement and unrestrained credit card charges. He wants to declare bankruptcy, but he has a $15,000 bank account that he wants to protect. He decides to give the entire amount to his church in order to keep it from the bankruptcy court and his creditors. He gives the entire balance to his church on June 1. On July 1, Bill files for bankruptcy. A bankruptcy trustee contacts the church treasurer, demanding that the church turn over the $15,000 contribution. The Religious Freedom and Charitable Donation Protection Act does not protect Bill or the church. The timing, amount, and circumstances surrounding the contribution of $15,000 strongly indicate that Bill had an actual intent to hinder, delay, or defraud his creditors. This conclusion is reinforced by the fact that the gift was contrary to Bill's normal pattern or practice of giving. As a result, the trustee probably will be able to force the church to return the $15,000.

Case studies

• A federal court in New Jersey ordered a church to return a $20,000 contribution to a bankruptcy court that had been made by a church member within a year before he filed for bankruptcy. The contribution amounted to 74 percent of the member's total annual income. The court acknowledged that section 548(a)(2) of the Bankruptcy Code allows debtors to give up to 15 percent of their income to charity in the year prior to filing for bankruptcy, or a larger amount that is "consistent with the practices of the debtor in making charitable contributions." The court noted that the Bankruptcy Code provides no guidance as to interpretation of the phrase "consistent with the practices of the debtor in making charitable contributions." However, it concluded that "in this case it is beyond reasonable dispute that the debtor's $20,000 donation to the church was not consistent with his prior practices in making charitable contributions. The next largest donation made by the debtor during the prior two years was $2,000. The $20,000 donation also exceeds his total annual donations for each of [the previous three years]. It would be a gross distortion of the concept of consistency to hold that this donation was consistent with the debtor's prior practices in making charitable contributions." The court rejected the church's argument that an uncharacteristically large donation can be disregarded in an evaluation of "consistency" on the ground that it came from an unexpected "windfall," such as an inheritance.[167] Jackson v. The Church of Manalapan, 249 B.R. 373 (D.N.J. 2000).

• A federal court in California ruled that a bankruptcy trustee could not recover charitable contributions made by a church member to his church in the year preceding his filing of a bankruptcy petition, since the amount of his contributions were less than 15 percent of his gross annual income.[168] In re Lewis, 401 B.R. 431 (C.D. Cal. 2009).

Key point. Whenever a donor makes a large gift of cash or property to a church, church leaders should be alert to the fact that a bankruptcy trustee may be able to recover the contribution at a later date if the donor files for bankruptcy within a year after making the gift and none of the exceptions described in this section applies.

2. Making Charitable Contributions after Filing for Bankruptcy

The bankruptcy code states that a court may not approve a bankruptcy plan unless it provides that all of a debtor's "projected disposable income to be received in the three-year period beginning on the date that the first payment is due under the plan will be applied to make payments under the plan." In addition, a court can dismiss a bankruptcy case to avoid "substantial abuse" of the bankruptcy law. Many courts have dismissed bankruptcy cases on the ground that a debtor's plan called for a continuation of charitable contributions.

The Religious Freedom and Charitable Donation Protection Act of 1998 clarifies that bankruptcy courts no longer can dismiss bankruptcy cases on the ground that a debtor proposes to continue making charitable contributions. This assumes that the debtor's contributions will not exceed 15 percent of his or her gross annual income for the year in which the contributions are made (or a higher percentage if consistent with the debtor's regular practice in making charitable contributions).

The committee report accompanying the Act states:

In addition [the bill] protects the rights of certain debtors to tithe or make charitable contributions after filing for bankruptcy relief. Some courts have dismissed a debtor's chapter 7 case … for substantial abuse under section 707(b) of the bankruptcy code based on the debtor's charitable contributions. The bill also protects the rights of debtors who file for chapter 13 to tithe or make charitable contributions. Some courts have held that tithing is not a reasonably necessary expense or have attempted to fix a specific percentage as the maximum that the debtor may include in his or her budget.

Let's illustrate the impact of this provision with a few practical examples.

Examples

• A bankruptcy court in Arkansas ruled that a bankruptcy trustee could not object to a couple's bankruptcy plan on the ground that they proposed to continue making contributions of approximately ten percent to their church.[169] In re Petty, 338 B.R. 805 (E.D. Ark. 2006).

• Brad files a chapter 7 bankruptcy petition. Brad's plan states that he will use all available "disposable income" to pay his creditors during the three year period following the approval of his plan. But the plan permits Brad to continue making contributions to his church, which in the past have averaged 10 percent of his income. Some creditors object to the plan, and demand that the court reject it, since Brad will be making contributions to his church rather than using these funds to pay off his lawful debts. The Religious Liberty and Charitable Donation Protection Act of 1998 specifies that the court cannot reject Brad's bankruptcy plan because of the charitable contributions—since the contributions are less than 15 percent of his gross annual income.

• Same facts as the previous example, except that Brad's plan proposes to pay contributions to his church in the amount of 25 percent of his gross annual income. Brad would rather that his church receive all available income than his creditors. Several creditors object to this plan. The court probably will deny Brad's request for bankruptcy protection, since the substantial contributions proposed in his plan exceed 15 percent of his gross annual income, and are not consistent with his prior practice of making charitable contributions.

• A bankruptcy court in Montana ruled that a bankruptcy trustee could not object to a couple's bankruptcy plan on the ground that they proposed to continue making contributions to their church in the amount of seven percent of their gross income.[170] In re Cavanagh, 242 B.R. 707 (D. Mont. 2000).

The Religious Freedom and Charitable Donation Protection Act Checklist

Step #1: Did the bankruptcy debtor make one or more contributions of cash or property to a church within a year preceding the filing of a bankruptcy petition?

• If not, stop here. A bankruptcy trustee cannot recover the debtor's contributions from the church.
• If yes, go to step #2

Step #2: In making contributions to the church, did the debtor have an actual intent to hinder, delay, or defraud his or her creditors? In deciding if an intent to defraud exists, consider the timing, amount, and circumstances surrounding the contributions, as well as any change in the debtor's normal pattern or practice.

• If yes, a bankruptcy trustee can recover from the church contributions made by the debtor within a year prior to the filing of the bankruptcy petition.
• If not, go to step #3.

Step #3: Did the debtor receive "reasonably equivalent value" for the contributions made to the church? Note that reasonably equivalent value will not include such "intangible" religious services as preaching, teaching, sacraments, or counseling.

• If yes, stop here. A bankruptcy trustee cannot recover the debtor's contributions from the church.
• If no, go to step #5.

Step #4: Is the value of the debtor's contributions 15 percent or less of his or her gross annual income?

• If yes, stop here. A bankruptcy trustee cannot recover the debtor's contributions from the church.
• If no, go to step #5.

Step #5: Is the value of the debtor's contributions consistent with the practices of the debtor in making charitable contributions?

• If yes, stop here. A bankruptcy trustee cannot recover the debtor's contributions from the church.
• If no, a bankruptcy trustee can recover from the church contributions made by the debtor within a year prior to the filing of the bankruptcy petition.