Dismissing Church Employees for Violating Moral Standards

A federal appeals court issues an important ruling.

Richard R. Hammar, Attorney, CPA
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Church Law and Tax2000-11-01

Dismissing Church Employees for Violating Moral Standards

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

A federal appeals court issues an important ruling- Kathy v. Catholic Diocese, 206 F.3d 651 (6th Cir. 2000)

Article summary. Federal laws, as well as the laws of many states, permit churches and religious schools to discriminate in employment decisions on the basis of religion. As a result, religious employers are free to employ only persons of a certain religious faith. They also are permitted to impose their religious standards upon their employees, and they may discipline or dismiss employees who violate those standards. However, religious employers may not apply religious standards in a way that discriminates against a protected class of employees, such as women, minorities, the aged, or disabled. A federal appeals court ruled that a church school may have violated a federal ban on employment discrimination based on pregnancy when it dismissed a female employee who was four months pregnant on the day she was married. The court conceded that religious schools can impose religious standards upon their employees, but it concluded that there was substantial evidence refuting the school’s claim that “religious standards” were the basis for its decision to terminate the employee.

• Key point 8-07. Employees and applicants for employment who believe that an employer has violated a federal civil rights law must pursue their claim according to a specific procedure. Failure to do so will result in the dismissal of their claim. The Civil Rights Act of 1964

• Key point 8-08.1. Title VII of the Civil Rights Act of 1964 prohibits employers engaged in commerce and having at least 15 employees from discriminating in any employment decision on the basis of race, color, national origin, gender, or religion. Religious organizations are exempt from the ban on religious discrimination, but not from the other prohibited forms of discrimination. The Civil Rights Act of 1964

Many churches have dismissed employees for failure to comply with church moral teachings. While federal and state laws ordinarily protect the right of churches to impose their moral standards on their employees, there are exceptions. For example, a church may be legally liable for applying its moral standards in a way that discriminates against an employee who is a member of a protected class under a federal or state civil rights law. This was the issue in a recent federal appeals court case. The court ruled that a church school may have violated a federal ban on pregnancy discrimination by terminating a female teacher who was pregnant on the day she was married. While the school insisted that its decision was based solely on its moral teachings, the court was not persuaded. Church leaders who expect church employees to abide by church moral teachings should carefully review this article in order to minimize the risk of a discrimination lawsuit.

Facts

A female teacher (“Kathy”) was hired to teach at a church-operated parochial school in 1994. During her first year she taught eighth grade math and religion, high school math, and she coached a girls’ basketball team. After her first year, the school renewed Kathy’s teaching contract for the next school term and granted her request to teach the second grade. Kathy’s position as a second-grade teacher involved significant training and ministry in the Catholic faith. She provided daily religious instruction to students, took students to religious services on a regular basis, and prepared her second-grade students for the sacraments. Kathy acknowledged that her position required her to “build a Christian community,” “integrate learning and faith,” and “instill a sense of mission” in her students.

For each of her two years at the school, Kathy’s employment was governed by a one-year employment contract (the “Contract”) as well as the “Affirmations for Employment” (“the Affirmation”), both of which she signed for each year. In addition to laying out basic terms of salary, duration and other routine aspects of the position, the Contract incorporates the provisions of the Affirmation document as part of its terms and conditions.

The Affirmation outlines the ministerial responsibilities of the “teacher/minister,” including the following provisions:

(1) A statement that the signer “believes that the work of the Catholic Church, [its agencies] and institutions has characteristics that make it different from the work of other agencies and institutions”

(2) A statement that the signer will “work diligently to maintain and strengthen the Catholic Church and its members,” and that “by word and example, the [employee] will reflect the values of the Catholic Church”

(3) Statements that the signer believes in “mutual trust” and “open communication,” and

(4) A statement by the signer that she “is more than a professional”

The Contract also incorporates the Teacher Handbook, which states that the mission of the school is to “instill in our children the Gospel message of Jesus Christ.” The Handbook describes the mission statement and broad philosophy of the school, and lays out more specific matters of school policy and administration, including describing teachers’ “religious responsibilities” (e.g., teachers are “expected to uphold, by word and example, all truths, values, and teachings of the Roman Catholic church”).

Neither the Teacher’s Handbook nor the Affirmation explicitly states, nor was Kathy ever expressly informed (in writing, orally or otherwise), that premarital sex comprised a violation of the terms of either the Contract or the Affirmation.

In the fall of 1995, Kathy and her boyfriend met with the associate pastor of the church that operated the school to discuss their intention to marry. Kathy and her husband were married in the church in February 1996. In early March, Kathy informed the assistant principal and other teachers that she was pregnant. Around late March or early April, Kathy became visibly pregnant and began to wear maternity clothing to school. Based on his observation of Kathy’s pregnancy, the associate pastor correctly concluded that she had engaged in premarital sex. Kathy later admitted that her pregnancy resulted from sex before her marriage.

On learning that Kathy had engaged in premarital sex, school officials did not immediately terminate Kathy. Instead, they considered “all options,” including immediate termination. Ultimately, school officials decided that the most appropriate course of action was to permit Kathy to continue teaching for the remainder of the school year, without renewing her contract after the year had finished. On May 3, 1996, the associate pastor advised Kathy in a conference that “under the circumstances,” the school “would not renew her contract or hire her for the next school year.” In a formal letter explaining the decision not to renew her contract, sent on May 4, the associate pastor wrote:

We expect our teachers to be good, strong role models for our children …. It is stated in your contract, working agreement that “by word and example you will reflect the values of the Catholic Church.” Parents in the community have serious concerns about a teacher who marries and is expecting a child 5 months after the wedding date. We expect teachers and staff members to observe the 6 month preparation time for marriage. The church does not uphold sexual intercourse outside of marriage. We consider this a breach of contract/working agreement.

Kathy continued teaching through the end of the school year. Her child was born on July 10, 1996.

Kathy claimed that when the associate pastor informed her of the decision not to renew her teaching contract, he only stated that it was due to her pregnancy so soon after marriage and did not mention premarital sex. She also questioned the associate pastor’s assertion that, after discovering her pregnancy, the school decided to retain her only through the remainder of the 1995-1996 school year. In particular, Kathy received a glowing Teacher Performance Evaluation on April 19, 1996, nearly two months after the school concluded that she had premarital sex. In addition to noting her “successful” performance in almost all of fifteen objective criteria, the school’s principal praised her for “adjusting very well” to the “busy and changing year in regard to her classroom reassignment and personal life.” Finally, the evaluation implied that a contract renewal would be forthcoming for the following year, concluding, “Your class of 2nd grade students is well managed and respectful. I would expect continued growth for the 1996-97 school year.”

On October 11, 1996, Kathy filed a charge of discrimination with the Equal Employment Opportunity Commission (EEOC), a federal agency that enforces several federal civil rights laws. The EEOC investigated Kathy’s claim, and issued her a “notice of right to sue” letter. Such a letter indicates that the EEOC believes there is a reasonable basis for the discrimination claim, and it gives the employee the option of suing in federal court. Kathy later sued the school and church officials in federal court claiming illegal sex and pregnancy discrimination under Title VII of the federal Civil Rights Act of 1964, and an Ohio civil rights law. Title VII prohibits discrimination in employment on the basis of several factors, including gender and pregnancy.

Proving Discrimination

The courts have developed a “three stage” process for evaluating discrimination claims.

Stage 1-the employee must prove a “prima facie case”

A claim of discrimination based on pregnancy, like any other discrimination claim under Title VII, requires that the plaintiff establish a “prima facie case” of unlawful discrimination by showing that

(1) She was pregnant

(2) She was qualified for her job

(3) She was subjected to an adverse employment decision, and

(4) There was a connection between her pregnancy and the adverse employment decision

The school and church officials conceded that the first, third, and fourth requirements of a prima facie were met, but they insisted that Kathy failed to prove the second requirement and therefore her case had to be dismissed because she failed to prove all four elements of a prima facie case. The school and church officials claimed that by engaging in premarital sex, Kathy had violated both the Contract and Affirmation, and her promise “to live according to the principles of the Catholic Church.” Her own actions therefore rendered her unqualified for the teaching position. The trial court agreed, and dismissed the case on the ground that Kathy failed to prove her prima facie case.

The trial court noted that even if Kathy had made out a prima facie case, she had still failed to show that the school’s “nondiscriminatory” reason for the non-renewal was a mere pretext for pregnancy discrimination. In reaching this conclusion, the court pointed to the statement of the associate pastor that “it was not pregnancy that motivated the termination,” but the fact of premarital sex.

Stage 2-the employer must prove a nondiscriminatory basis for its actions

If the plaintiff successfully establishes a prima facie case, the burden shifts to the employer to demonstrate a “legitimate, nondiscriminatory reason” for its actions. If the employer fails to satisfy this burden, the plaintiff wins.

Stage 3-the employee must prove discrimination

If the employer proves a nondiscriminatory basis for its actions, the presumption of intentional discrimination is negated, and the employee must then prove by a preponderance of the evidence that the employer intentionally discriminated against her. She may do this by showing that the “nondiscriminatory” reasons the employer offered were not credible, but were merely a “pretext” for intentional discrimination.

The appeals court’s ruling

Kathy appealed the case to a federal appeals court. The court’s decision is summarized in the following sections.

The religious employer exception

Title VII, Section 703(e)(2) of the Civil Rights Act of 1964 specifies:

[I]t shall not be an unlawful employment practice for a school, college, university, or other educational institution or institution of learning to hire and employ employees of a particular religion if such school, college, university, or other educational institution or institution of learning is, in whole or in substantial part, owned, supported, controlled, or managed by a particular religion or by a particular religious corporation, association, or society, or if the curriculum of such school, college, university, or other educational institution or institution of learning is directed toward the propagation of a particular religion.

This provision exempts religious educational institutions, whether at the primary, secondary, or college level, from the prohibition of religious discrimination contained in Title VII. However, religious educational institutions remain subject to Title VII’s ban on pregnancy discrimination.

It is not always easy to determine whether a decision by a church or religious school to terminate a pregnant employee is permitted “religious” discrimination or prohibited “pregnancy” discrimination. The court observed:

In suits like Kathy’s, courts have made clear that if the school’s purported discrimination is based on a policy of preventing nonmarital sexual activity which emanates from the religious and moral precepts of the school, and if that policy is applied equally to its male and female employees, then the school has not discriminated based on pregnancy in violation of Title VII. The central question in this case, therefore, is whether [the school’s] nonrenewal of Kathy’s contract constituted discrimination based on her pregnancy as opposed to a gender-neutral enforcement of the school’s premarital sex policy. While the former violates Title VII, the latter does not.

The court concluded that it was inappropriate for the trial court to dismiss the case since Kathy had presented sufficient evidence to create a genuine dispute as to the school’s motivation in dismissing her.

The prima facie case

The appeals court disagreed with the trial court’s decision that Kathy had failed to prove a “prima facie case.” It noted that the prima facie requirement for proving a Title VII claim is “a burden easily met,” and that it is “only the first stage of proof in a Title VII case, and its purpose is simply to force an employer to proceed with its case.” The appeals court concluded that the trial court had confused the three stages involved in proving a discrimination claim (summarized above):

The court found Kathy “unqualified” under prong two of the prima facie case because she had not lived up to the promises she made to “exemplify the moral values taught by the church.” Because her pregnancy due to premarital sex meant that “she no longer met all the qualifications of her position,” even strong evidence as to her satisfactory performance (i.e., her evaluations and teaching record) could not overcome these moral failings. This analysis improperly imported the later stages of the inquiry into the initial prima facie stage. [The school] alleges that it did not renew Kathy’s contract because she violated its premarital sex policy, which constituted part of the broader ministerial requirements of being a teacher; conversely, Kathy argues that this rebuttal is a pretext for discrimination. Rather than resolve this debate at the prima facie stage [the trial court should have addressed this dispute] at the inquiry’s third stage, when its role is to decide the “ultimate question” of discrimination. In other words, when assessing whether a plaintiff has met her employer’s legitimate expectations at the prima facie stage of a termination case, a court must examine plaintiff’s evidence independent of the nondiscriminatory reason “produced” by the defense as its reason for terminating plaintiff. The district court clearly failed to do this ….

Without considering the “ultimate question” of whether the school’s premarital sex policy was applied in a discriminatory way, or whether it was the true reason the school terminated Kathy, there is little doubt that Kathy made a prima facie case showing that she was meeting the school’s legitimate expectations. In order to show that she was qualified, the plaintiff must prove that she was performing at a level which met her employer’s legitimate expectations. The evidence Kathy presented of her two-year record of success, and in particular her positive April 1996 evaluation, is more than enough to meet this standard. The fact that the school allowed her to keep teaching for the remainder of the year further bolsters this showing. She thus successfully made out a prima facie case.

The employer’s proof of a nondiscriminatory basis for its actions

Since the court concluded that Kathy met the prima facie case requirement, the burden then shifted to the employer to demonstrate a nondiscriminatory basis for its decision to terminate Kathy. This is “stage 2” in the three-stage discrimination analysis summarized above.

The court concluded that the school “successfully articulated a nondiscriminatory reason for its actions.” It noted that stage 2 of the discrimination analysis required the school to rebut the presumption of discrimination (that arose when Kathy proved her prima facie case) by producing evidence that Kathy was dismissed for a legitimate, nondiscriminatory reason. The court concluded that the school satisfied this burden “by asserting that it did not renew Kathy’s contract because she violated her clear duties as a teacher by engaging in premarital sex.”

Kathy’s proof of discrimination

Since the school rebutted the prima facie case of discrimination by providing evidence of a legitimate, nondiscriminatory basis for its decision to terminate Kathy, “stage 3” of the discrimination analysis shifted the burden of proof back to Kathy to demonstrate that the alleged nondiscriminatory basis for the school’s decision “was not the true reason for the employment decision.” In other words, Kathy had to “answer the ultimate question: did [the school] discriminate against her becauseshe was pregnant, or for engaging in sex outside of marriage in violation of the school’s moral code?”

The court noted that there were a number of ways for Kathy to prove that the school discriminated against her on the basis of pregnancy rather than on the basis of its moral and religious tenets:

(1) First, she can show intentional discrimination directly by showing that a discriminatory reason more likely motivated the employer than the reason the employer offered.

(2) Second, she can indirectly show pretext by showing that the employer’s explanation is “unworthy of credence.” The court noted Kathy had made a persuasive case that the school’s “religious” reason for terminating her was a mere “pretext.” This is important, because if Kathy could prove that the school’s alleged “religious” basis for terminating her was a mere pretext (i.e., a false basis), then this exposed the school to a pregnancy discrimination claim. With regard to pretext, the court observed,

Kathy presented a variety of concrete evidence casting into doubt the “reason” [the school] proffered-that it decided not to renew her contract because she had violated its blanket policy against premarital sex-and raising an issue of fact as to whether the treatment was due to her pregnancy. Most importantly, she presented evidence that the school continued to view her as sufficiently qualified to teach: the complimentary evaluation (mentioning both her “personal” and “professional” life), its consideration of other “options” for some time before opting to terminate her, and [the associate pastor’s] suggestion that “things might have worked out differently” had Kathy notified him of her pregnancy sooner. She also produced some evidence showing that the school may have focused more on the fact of her pregnancy than her sexual activity. For instance, she testified to conversations and produced statements in which school officials explicitly discussed her “pregnancy” rather than her sexual actions.

(3) “In the pregnancy discrimination context in particular, Kathy also may show that [the school] enforced its premarital sex policy in a discriminatory manner-against only pregnant women, or against only women. This is because a school violates Title VII if, due purely to the fact that women can become pregnant and men cannot, it punishes only women for sexual relations because those relations are revealed through pregnancy. In other words, a school cannot use the mere observation or knowledge of pregnancy as its sole method of detecting violations of its premarital sex policy.” The court concluded that Kathy might be able to prove discrimination on this basis as well:

Finally, Kathy adduced evidence that the policy was not applied equally among men and women. School officials acknowledged in their depositions that Kathy’s pregnancy alone had signaled them that she engaged in premarital sex, and that the school does not otherwise inquire as to whether male teachers engage in premarital sex. At oral argument, counsel for [the school] conceded that it was only Kathy’s pregnancy that made it evident that she had engaged in premarital sex. These admissions raise an issue of material fact as to whether [the school] enforces its policy solely by observing the pregnancy of its female teachers, which would constitute a form of pregnancy discrimination.

The court cautioned that the school may have “sharp retorts to many of Kathy’s factual claims. Indeed, many of its responses could well convince a jury of its case.” But it was inappropriate for the trial court to have dismissed the case. The court remanded the case back to the trial court for further proceedings, noting that “Kathy has introduced sufficient evidence to make out a prima facie case, and sufficient evidence to call into question the school’s proffered reason for her non-renewal. The law entitles her to make her case before a [jury].”

Breach of contract claim

The appeals court dismissed Kathy’s breach of contract claim. It noted that “the contract itself was for a one-year term, to end on June 30, 1996, with no express or implied right to renewal. Its terms were fulfilled.”

Relevance of the case to church leaders

A decision by the federal appeals court for the sixth circuit has limited effect. It is binding only on federal courts in the states of Kentucky, Michigan, Ohio, and Tennessee. Nevertheless, opinions by federal appeals courts often are given considerable weight by state and federal courts in other circuits, and in addition the case represents one of the most extended discussions of church employment practices. As a result, it may be given special consideration by other courts. For these reasons the case merits serious study by church leaders in every state. With these factors in mind, consider the following:

1. Application of civil rights laws to churches and other religious employers. Do state and federal civil rights laws apply to churches? Federal laws banning discrimination in employment are summarized in the table on the next page. This table defines “covered employers” under each federal law so church leaders can determine whether or not their church is covered. Note that churches will be covered under most federal employment and civil rights laws only to the extent that they are engaged in interstate commerce. This important requirement is addressed in section 8-05 of the third edition of Richard Hammar’s book, Pastor, Church & Law.

The church school in this case was sued for violating the ban on pregnancy discrimination in employment under Title VII of the Civil Rights Act of 1964. The court apparently assumed that the school was engaged in commerce, and had the required number of employees (15), since neither issue was addressed in the court’s opinion.

Most states have their own civil rights laws, and it is much more likely that these will apply to churches since there is no “commerce” requirement and the required number of employees is generally lower.

• Resource. For a full explanation of the application of civil rights and employment laws to churches, see chapter 8 in the third edition of Richard Hammar’s book, Pastor, Church & Law (3rd ed. 2000), available from the publisher of this newsletter by calling 1-800-222-1840.

2. Employment decisions based on morals. Can a church lawfully discriminate against an employee or applicant for employment on the basis of moral teachings? In some cases, religious organizations will be able to demonstrate that their moral teachings are integral to their religious beliefs, and therefore employment discrimination based on moral teachings is a form of religious discrimination that is permitted by Title VII.

• Tip. To avoid any confusion, religious organizations that take an adverse employment action against an employee or applicant for employment as a result of the organization’s moral teachings should word their determination with references to relevant passages from scripture. This will make it more likely that a court will view the decision as a protected form of religious discrimination.

The court observed in this case that neither the Teacher’s Handbook nor the Affirmation explicitly stated, nor was Kathy ever informed, that premarital sex was a violation of the church’s moral standards and therefore was a basis for discipline or dismissal.

• Tip. It is common for church employment handbooks or employment contracts to state that employees will be expected to conform to the church’s moral teachings. Some churches spell out with a high degree of specificity the moral teachings employees will be expected to follow. Other churches use vague references to moral or religious teachings. In the latter case, it is a good practice for the handbook or contract to specify that the church board, or some other officer or body, has the sole and final authority to determine the church’s moral tenets. This will reduce any chance of confusion as to the meaning of these terms.

3. Factors indicating wrongful discrimination. The most important aspect of this case was the court’s conclusion that while religious employers may discriminate on the basis of religion in their employment decisions, they may not use “religious standards” as a “pretext” for discriminating against an employee who a member of a protected class under state or federal law. While the school insisted that it terminated Kathy solely on account of her violation of the church’s moral teachings regarding premarital sex, the court concluded that Kathy had presented sufficient evidence of unlawful discrimination to allow the case to go to a jury.

The court pointed to the following two ways in which Kathy had undermined the school’s claim that “religious standards” were the sole basis for its decision to terminate Kathy:

(1) Pretext. A religious employer can dismiss an employee for violating the employer’s moral standards. This is a permitted form of religious discrimination by a religious employer. However, employees who are dismissed for violating such standards, and who are members of a protected class under a federal or state civil rights law, may be able to sue the employer for discrimination if they can prove that the “religious” reason for the termination is pretextual or untrue. This is a very important point. In this case, if Kathy could prove that the school’s alleged “religious” basis for terminating her was a mere pretext, then this exposed the school to a pregnancy discrimination claim. As evidence that the school’s “religious” basis for terminating Kathy was pretextual, the court pointed to evidence that the school

continued to view her as sufficiently qualified to teach: the complimentary evaluation (mentioning both her “personal” and “professional” life), its consideration of other “options” for some time before opting to terminate her, and [the associate pastor’s] suggestion that “things might have worked out differently” had Kathy notified him of her pregnancy sooner. She also produced some evidence showing that the school may have focused more on the fact of her pregnancy than her sexual activity. For instance, she testified to conversations and produced statements in which school officials explicitly discussed her “pregnancy” rather than her sexual actions.

(2) Inconsistent application of moral standards. Another way in which Kathy undermined the school’s “religious” basis for its decision to terminate her was the application of its premarital sex policy in a discriminatory manner. In particular, the court noted that if the policy only was enforced against pregnant women, or women in general, then this would be an example of prohibited sex discrimination under Title VII. Kathy insisted that the school’s policy only identified pregnancy as proof of premarital sex. If this were true, then the policy would discriminate against employees on the basis of pregnancy, and would be unlawful under Title VII. The court observed,

Kathy adduced evidence that the policy was not applied equally among men and women. School officials acknowledged in their depositions that Kathy’s pregnancy alone had signaled them that she engaged in premarital sex, and that the school does not otherwise inquire as to whether male teachers engage in premarital sex. At oral argument, counsel for [the school] conceded that it was only Kathy’s pregnancy that made it evident that she had engaged in premarital sex. These admissions raise an issue of material fact as to whether [the school] enforces its policy solely by observing the pregnancy of its female teachers, which would constitute a form of pregnancy discrimination.

• Caution. Churches that dismiss female employees who are single and pregnant, but do not dismiss male employees who engage in extramarital sexual relations, are exposing themselves to a possible wrongful discrimination claim.

4. Procedure for proving discrimination. The court provided an excellent summary of the analysis the federal courts apply in evaluating employment discrimination cases. When a church is charged with discrimination by a former or current employee, this case will provide church leaders with a good summary of the analysis a court will follow in deciding if discrimination occurred.

5. The relevance of performance evaluations. The court concluded that the very positive employee evaluation Kathy had received prior to her termination was evidence that the school in fact had not terminated her on the basis of her violation of its moral teachings. After all, if the school had such standards, and they were as important as church officials insisted, then how could someone who so blatantly violated them receive an exemplary performance evaluation?

• Tip. Does your church evaluate employees? If so, be sure the evaluations are objective. In addition, be aware that positive evaluations may be used against you if you dismiss an employee for violating the church’s moral teachings, and one or more positive evaluations were issued after church leaders became aware of the employee’s violation of the church’s moral teachings.

6. Communicating employment standards to employees. The school communicated to Kathy in her contract of employment, as well as her “Affirmations of Employment,” that she was expected to conform to the church’s moral standards. Kathy signed both documents. This is an excellent practice to follow by any church that seeks to impose its moral standards on its employees. This eliminates any claim by employees that they “didn’t know” they were expected to abide by such standards.

7. Insurance. It comes as a surprise to many church leaders that they do not have insurance to cover employment discrimination claims. This means that a church is responsible for retaining and paying its own attorney, and paying the full amount of any judgment or settlement.

• Tip. Church insurance policies generally do not cover employment-related claims, including discrimination. If your church is sued for wrongful employment discrimination, you probably will need to retain and pay for your own attorney, and pay any judgment or settlement amount. You should immediately review your liability policy with your insurance agent to see if you have any coverage for such claims. If you do not, ask how it can be obtained. You may be able to obtain an endorsement for “employment practices.” Also, a “directors and officers” policy may cover these claims.

8. Breach of contract. The court rejected Kathy’s claim that the school was guilty of breach of contract when it failed to renew her contract for another school term. The court drew a distinction between breach of contract and a refusal to renew a one-year contract: “[T]he contract itself was for a one-year term, to end on June 30, 1996, with no express or implied right to renewal. Its terms were fulfilled.”

Dismissing an Employee for Violation of a Church’s Moral Teachings

Before dismissing an employee for violating the church’s moral teachings, church leaders should ask the following questions:

(1) Is there sufficient evidence to support our decision?

(2) Did we inform the employee, in an employee handbook or other document, that he or she would be subject to dismissal for engaging in behavior in violation of our moral teachings?

(3) How will we describe the basis for our decision? The best description will refer to the church’s doctrinal tenets, and scriptural citations. Stay away from words such as “pregnancy” that can have a “secular” meaning, and that diminish the “religious exemption” available to churches under most federal and state civil rights and employment laws.

(4) How have we treated other employees in the past who were guilty of the same kind of misconduct? Have we treated all employees equally, or have we treated some employees less favorably than others? For example, have we dismissed female employees who were guilt of extramarital sexual relations, but only warned or reprimanded male employees guilty of the same behavior? Before dismissing an employee for misconduct, church leaders should review all other known cases involving similar misconduct by other employees. Be sure that the church’s actions are consistent with its previous practice, and that an employee who is protected against discrimination by state or federal law not be treated less favorably than other employees.

(5) Have we contacted an attorney before taking final action?

Application of Selected Federal Employment and Civil Rights Laws to Religious Organizations
StatuteMain ProvisionsCovered Employers
Title VII of 1964 Civil Rights Actbars discrimination in employment decisions on the basis of race, color, national origin, sex, or religion15 or more employees + interstate commerce

religious employers can discriminate on the basis of religion

Age Discrimination in Employment Actbars discrimination in employment decisions on the basis of age (if 40 or over)20 or more employees + interstate commerce
Americans with Disabilities Actbars discrimination against a qualified individual with a disability who can perform essential job functions with or without reasonable employer accommodation (that does not impose undue hardship)15 or more employees + interstate commerce
religious employers can discriminate on the basis of religion
Employee Polygraph Protection Actemployers cannot require, request, suggest, or cause any employee or applicant to take a polygraph examinterstate commerce (no minimum number of employees)
Immigration Reform and Control ActI-9 form must be completed by all new employees demonstrating identity and eligibility to workall employers
Fair Labor Standards Actrequires minimum wage and overtime pay to be paid to employeesemployers who employ employees who are engaged in commerce or in the production of goods for commerce, as well as any employee “employed in an enterprise engaged in commerce or in the production of goods for commerce”
Family and Medical Leave Act of 1993eligible employees qualify for up to 12 weeks unpaid leave per year because of (1) birth or adoption of child, including care for such child, or (2) caring for spouse, child, or parent with a serious health condition, or (3) the employee’s serious health condition50 or more employees + interstate commerce
Occupational Safety and Health Actmandates a safe and healthy workplace for covered employeesan organization “engaged in a business affecting commerce who has employees”
Older Workers Benefit Protection Act of 1991bars employees at least 40 years old from “waiving” their rights under age discrimination law unless the waiver meets strict legal standards20 or more employees + interstate commerce

Copyright 2000 by Church Law & Tax Report. 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, PO Box 1098, Matthews, NC 28106. Reference Code: m86 m43 m65 c0600
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

What Church Treasurers Should Know about Subrogation

A Wisconsin court issues an important decision.

Richard R. Hammar, Attorney, CPA
Bio

Tower Insurance Company, Inc. v. Chang, 601 N.W.2d 848 (Wisc. App. 1999)

Background. Few church treasurers could define the term “subrogation.” Yet, an understanding of this term can be very important, as a recent case demonstrates. This article will summarize this case, explain its importance, and review what church treasurers should know about subrogation.

Two young girls were at their church on a Wednesday night to help serve a pancake supper and attend an evening service. After helping serve the pancake supper, the girls participated in the worship service. Following the service they were directed to go to the educational wing of the building for a religious training class. Instead of going straight to the class, the girls stopped at the ladies restroom lounge in the church basement. While there, they lit a candle and failed to extinguish it when they went to their class. The candle ignited some silk flowers and the fire spread and caused severe damage to the church.

The church’s insurance company paid for the loss. It then filed suit against the two girls and their family’s insurers for subrogation. Under the principle of subrogation an insurance company that pays a loss is entitled to maintain any claims the insured may have had against a third person whose negligence caused the loss. In this case, the church’s insurance company, after paying the extensive fire loss, attempted to assert on behalf of the insured church a negligence claim against the girls.

The girls argued that there could be no subrogation against them since they were “additional insureds” under the church’s insurance policy and an insurance company cannot subrogate against its own insureds. The church insurance policy contained an endorsement extending coverage to church members. It included the following as insureds: “Any of your church members, but only with respect to their liability for your activities or activities they perform on your behalf.”

The insurance company conceded that the girls were church members, but it insisted that they were not insureds under this provision because their negligent acts of lighting a candle in the church restroom, and leaving it unattended, were not done “on behalf” of the church. In addition, the insurance company argued that even if the girls were insureds under the church’s policy, it could still subrogate against them because their actions were criminal.

The girls responded by claiming that the policy language was ambiguous and could be construed to include them as insureds, and therefore the church insurance company could not pursue its subrogation claim against them. Alternatively, they argued that the subrogation claim against them must fail because they were immunized as “volunteers” under a state charitable immunity law that states:

a volunteer is not liable to any person for damages, settlements, fees, fines, penalties or other monetary liabilities arising from any act or omission as a volunteer, unless the person asserting liability proves that the act or omission constitutes any of the following: (a) A violation of criminal law, unless the volunteer had reasonable cause to believe his or her conduct was lawful or no reasonable cause to believe his or her conduct was unlawful. (b) Willful misconduct… . (e) An act or omission for which the volunteer received compensation or anything of substantial value in lieu of compensation. Wisc. Stats. 187.33.

The trial court concluded that the insurance policy was ambiguous. The court reasoned, however, that a reasonable person in the position of the insured “would understand the endorsement language to cover the activity of lighting the candle during the course of the girls’ activities at the church.” Because the trial court dismissed the insurance company’s claim against the girls on the coverage issue, it did not reach their immunity argument. The insurance company appealed.

The court’s ruling. The appeals court began its opinion by observing that “when scrutinizing the policy language, the test is not what the insurer intended the words to mean, but what a reasonable person in the position of the insured would have understood them to mean.” Further, if a term in an insurance policy “is susceptible to more than one reasonable interpretation, it is ambiguous. In that case, we construe the term in favor of coverage. If the policy’s terms are unambiguous, we merely apply them to the facts of the case.”

The court noted that there was no dispute about what the girls did. Rather, “the question is whether their actions were for a church activity or activity performed on behalf of the church, within the meaning of the policy.”

Volunteer coverage

The court clarified that the girls were not insureds under a provision in the church insurance policy that includes volunteers as insureds when they are “acting at the direction of, and within the scope of their duties for you [the church].” The court noted that the girls “lit the candle between service and class, not during their stint as workers at the pancake supper. Thus, cases addressing the scope of duties as a volunteer are inapposite.”

Church member coverage

The court then addressed the question of whether or not the girls were covered under the endorsement in the insurance policy extending coverage to “[a]ny of your church members, but only with respect to their liability for your activities or activities they perform on your behalf.” The court agreed that this language was ambiguous:

What counts as a church activity? Does the phrase only cover those tasks done at the explicit direction of church officials, as when the girls draped a sash over the cross during the evening’s services? Or does the phrase extend coverage to anything done in conjunction with a church function, such as the child of one church member injuring the child of another while playing between events at a church picnic? Because both interpretations are reasonable, the endorsement language is ambiguous and must be construed to afford coverage. Furthermore, the broader interpretation makes more sense. The girls were only at the church because of their participation in the church dinner, the church service and the confirmation class. A reasonable person in the girls’ position taking a short break in the church building between one church event and another would expect to be covered. [The insurance company] is correct that it is what the girls were doing and not where they were doing it that is important. But what they were doing was spending the evening participating in church events. The girls are additional insureds under the policy endorsement bringing in church members.

“Scope of employment” test rejected

The court rejected the insurance company’s argument that whether or not the girls were performing acts on behalf of the church when they lit the candle should be decided on the basis of the “scope of employment” test in employment law. Generally, an employer is responsible under the principle of “respondeat superior” for the negligent acts of its employees that are committed within the scope of their employment. The court refused to apply this test in deciding whether or not the girls’ acts were done on behalf of the church:

The rule that the master is liable for the servant’s torts is based upon two main considerations. First, the master is benefiting from the servant’s performance of employment duties. Second, within the time of service, the master may exert some control over the servant’s activities. These factors justify the master’s liability for the servant’s wrongs that occur incidental to his or her employment. These same considerations do not, however, justify liability for actions taking place outside the scope of employment. Here, however, we do not have an agency relationship. The girls are members of the church, not its employees. The church has insured its members to protect them while they are participating in church activities. This decision to insure all members reflects the church’s communal status; it is not one authority figure profiting from and able to control the actions of underlings. In the context of this case we do not find the scope of employment cases helpful.

Criminal acts

The insurance company argued that even if the girls were insureds it should be allowed to pursue a subrogation claim against them because the lighting of the candle was a criminal act. It insisted that an insurer may seek subrogation from an insured when it is the insured’s own intentional acts that cause the loss. The court concluded that this principle did not apply in this case, since the girls pled guilty only to the misdemeanor of “negligent handling of burning materials.” This was not an intentional or “criminal” act, the court concluded. “Negligence is all the girls admitted … and negligence is what insurance coverage is all about.”

Relevance to church treasurers. Church treasurers should be familiar with the principle of subrogation since it may expose church members to unexpected liability. Church members whose negligence causes a loss (injury or property damage) that the church insurer pays under the church insurance policy may be sued by the insurer to recover the full amount of the loss that it paid. This case clarifies some important points about subrogation:

(1) Volunteers. Insurance companies cannot subrogate against persons who are “insureds” under the church insurance policy. Volunteers are specifically listed as insureds under many church insurance policies with respect to their volunteer activities. Church treasurers should review their church insurance policy to see if such a provision exists. If not, contact your insurance agent and request an appropriate endorsement.

(2) Church members. Insurance companies cannot subrogate against persons who are “insureds” under the church insurance policy. Church members are specifically listed as insureds under many church insurance policies with respect to actions they perform on behalf of the church. Church treasurers should review their church insurance policy to see if such a provision exists. If not, contact your insurance agent and request an appropriate endorsement.

(3) Interpreting provisions in the church insurance policy. As this case illustrates, the courts generally interpret ambiguous terms and provisions in church insurance policies in favor of the church. In this case, this principle meant that the volunteer and church member coverage provisions in the church’s insurance policy were construed broadly in favor of the church.

(4) Insurance companies generally can subrogate against volunteers or church members who perform criminal acts, even if the perpetrator is otherwise an “insured” under the church insurance policy. Church staff members of volunteers who engage in criminal acts for which the church insurance company pays a loss should understand that they may be sued personally by the insurance company for the full amount of the loss. For example, church members and volunteers who engage in sexual misconduct, embezzlement, or reckless driving of a vehicle may be sued personally by the church insurer to recover any amounts paid out under the church insurance policy as a result of such acts.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

The Use of Cell Phones by Church Staff (Part 3)

What church treasurers need to know.

Richard R. Hammar, Attorney, CPA
Bio

Background. This is the third in a series of three articles addressing the use of cell phones by church staff. The first article in this series appeared in the July 2000 issue of Church Treasurer Alert. It addressed two important limitations that are imposed by the tax code on the business use of cell phones by employees: (1) the phone must be for the “convenience of the employer,” and (2) the phone must be a “condition of employment.” The second article appeared in the September 2000 issue of this newsletter, and addressed substantiation requirements and the use of cell phones by self-employed workers. This article addresses a few additional issues.

Which employees get cell phones? Which church employees should be provided with a cell phone by the church? Every pastoral staff member? Secretaries? Custodians? Bookkeepers? The best approach from a tax perspective would be to provide cell phones only to employees who meet the “convenience of the employer” and “condition of employment” requirements discussed in the first article in this series (see the July 2000 newsletter). After all, if these tests are not met, then an employee will not be able to treat the use of the phone as a business expense and the church cannot reimburse any use of the phone under an accountable expense reimbursement arrangement.

Cell phone “sharing.” Some churches provide one cell phone for use by more than one staff member. Such an arrangement creates significant complexity. Consider the following: (1) If the church has an accountable business expense reimbursement arrangement, then it will need to have staff members who use the phone substantiate the business nature of every “business” call on each monthly phone bill. (2) The church then can determine the “business use percentage” (the percentage of total phone time that consists of business calls). (3) The business use percentage, multiplied times the monthly phone bill, represents the amount deemed substantiated under an accountable arrangement, meaning that this amount does not represent taxable income. (4) The remaining or “personal” component of each monthly bill represents taxable income that must be allocated to the users of the phone. This is not an easy task. Church treasurers can simply apply the taxable personal use equally to each user, or try and allocate the personal use on the basis of actual personal use.

Pagers. Consider providing pagers instead of cell phones to some church staffers. Pagers are much cheaper to purchase and operate, and nonbusiness use is minimized because they can only receive communications, messages last only for a few seconds, and rarely does one receive more than a few pages each day. After all, how many persons repeatedly try to communicate with others through pages? It should be expected that church staff who are provided with pagers will occasionally receive “personal” pages, but in most cases these will be so infrequent and of such short duration that they will constitute a nontaxable “de minimis” fringe benefit and so will not represent taxable income. A “de minimis” fringe benefit is a fringe benefit that is so minimal in value that it would be unreasonable or administratively impractical to account for it. The income tax regulations give several examples of de minimis fringe benefits, including occasional personal use of the church duplicating machine. There is no doubt that occasional receipt of personal pages would be meet this test. Note that this is much different than personal use of cell phones which can occupy several hours each month. There is one additional advantage of providing pagers to church staff. In many cases personal use will be so limited that exclusive business use can be assumed. This means that the church’s payment of the purchase price of the pager, and its payment of monthly user fees, can be treated as “accountable” reimbursements that will be reportable as taxable income to the staff member who uses the pager. This is especially true if a very limited number of persons outside the church office know the pager number (the employee’s spouse and children). Further, unlike cell phones, the relatively low cost of using pagers (a few dollars each month) all but eliminates any audit risk, especially since infrequent personal use in most cases would be treated as a nontaxable “de minimis” fringe benefit.

What cell phone plan is best? Church leaders should carefully evaluate available cell phone plans before making phones available to church staff members. The selection of an appropriate plan should take into account several factors, including the following:

(1) Does the employee need long distance service? If an employee rarely travels out of state on church business, why would the church want to provide him or her with a “national” plan at a much higher cost than purely local coverage?

(2) Minutes of use. How many minutes of use should be provided? Consider the employee’s activities. Does the employee’s position require him or her to be away from the church office frequently? Does the employee’s position require that he or she be accessible at all times? Does the employee’s position require frequent telephone calls?

(3) Frequent evaluation. Monitor cell phone bills regularly. Employees who rarely use up their monthly “total minutes,” or who use a significant portion of their total minutes in the last few days of the month, probably have the wrong usage plan. Move to a plan with a lower number of minutes.


Tip. Some cell phone companies are allowing users to have two lines on the same phone. One line can be used exclusively for business calls, and the second line can be used for personal calls. Such an arrangement can make the substantiation of the business use of a cell phone much simpler. The church staff member pays the bills associated with the second (or “personal”) line.

Handling excess “talk time.” Churches should consider how to handle charges incurred because of “talk time” in excess of the minutes available under the cell phone usage plan paid for by the church. For example, if the senior pastor is provided with a cell phone that has 500 minutes of monthly “talk time” available, and the pastor incurs an additional $300 in charges for a month because of “talk time” in excess of 500 minutes, will the church reimburse this additional cost so long as the pastor can substantiate business use? That is a question that church leaders must resolve. There are two options:

(1) Cap the church’s reimbursements. If the monthly talk time limit is adequate, then church leaders may want to “cap” the church’s reimbursements at the monthly rate, and inform the staff member that all charges incurred because of talk time in excess of the monthly usage limit will be reported as taxable income.

(2) Reimburse business use. Church leaders can agree to reimburse all business calls that are properly substantiated, including those in excess of the monthly usage limit available under the cell phone plan purchased by the church.

A cell phone policy. Consider the adoption of a cell phone policy incorporating many of the points made in the three articles in this series. For example, the policy could address the following points:

(1) the criteria for determining who gets a cell phone

(2) the substantiation that will be required if the church maintains an accountable expense reimbursement arrangement, and the tax consequences associated with a failure by an employee to adequately substantiate business use

(3) an explanation of how many minutes of monthly cell phone “talk time” each employee will have, and a description of how excess charges will be handled

(4) a reminder that cell phones are provided for and paid by the church, and therefore cell phones should not be used for any personal use except emergencies

(5) a prohibition of any use of cell phones while driving a vehicle on church business (an exception may be made in the case of emergencies if the phone is used in the “hands free” mode, but such an exception will increase the risk of accidents and liability)

(6) a prohibition of any use of a cell phone by anyone while driving minors or adults to or from a church function or activity in either their own vehicle or a church-owned vehicle (would parents want their youth pastor talking to his girl friend on a cell phone while driving children to a church activity in a church van?)

(7) a warning of the potential adverse health consequences of prolonged use of cell phones

(8) a requirement that cell phones be turned off while refueling a car (operating a cell phone while refueling is a safety hazard)

(9) a requirement that employees report lost cell phones to the church treasurer immediately so that the cell phone company can be contacted and service to the lost phone disconnected

Traffic risks. A vast and growing number of Americans have cell phones, and frequently use them when they drive. It is now common to see drivers driving recklessly while talking on a cell phone. But is driving while talking on a cell phone really more dangerous? Yes it is, according to a number of recent studies. Consider the following:
  • A National Highway Traffic Safety Administration study estimates that 85% of cell phone owners use their phones while driving their car.
  • Several countries have banned the use of cell phones while driving.
  • Laws prohibiting the use of cell phones while driving have been introduced in nearly 40 states, but so far none has been enacted.
  • The National Highway Traffic Safety Administration says that “driver inattention” is the cause of half of all traffic accidents.
  • A car traveling at 50 miles per hour will cover 73 feet in one second—far less time than is normally involved in answering or dialing a cell phone.
  • One recent study concluded that drivers who use their cell phones only one hour each month have a 5 times greater risk of being involved in an traffic accident than drivers who don’t use their cell phones.
  • A survey analyzing more than 200,000 car accidents in Oklahoma concluded that drivers with cell phones were much more likely to have been cited by police for inattention, unsafe speed, driving on the wrong side of the road, striking a fixed object, overturning a vehicle, swerving prior to the accident, and running off the road. In addition, drivers with cell phones were more likely to have been involved in fatal accidents.
  • A study published in the February 1998 New England Journal of Medicine concluded that persons who drive while using a cell phone are 4 times more likely to be involved in an accident.

This evidence suggests a number of reasonable precautions, including the following:

(1) Drivers of children. It is certainly a good practice to have a cell phone available on any vehicle that is being used to transport minors to or from a church activity. A cell phone can be invaluable in the event of an emergency. However, the driver of the vehicle should be barred from using the cell phone while driving the vehicle. Calls can be answered or placed by another adult on the vehicle. This policy should apply to the use of any vehicle to transport minors, whether or not owned by the church.

(2) Drivers of adults. The same policy that applies to the use of cell phones while transporting minors should apply to the transportation of one or more adult passengers.

(3) Driving alone. The use of a cell phone by a church staff member while driving a car on church business should be discouraged, if not prohibited. If the phone has a “voice mail” feature, a missed call that must be returned a few minutes later when the driver reaches his or her destination ordinarily will not create a problem. Some churches may want to make this rule less restrictive by allowing use of cell phones while driving in the event of an emergency, and other churches will want to eliminate any restrictions on the use of cell phones by church staff members while driving. In such cases, churches at a minimum should require that the phone be used in “hands free” mode, and appropriate devices to permit such use should be provided. Any “less restrictive” policy should be applied only to church staff members while driving alone, and not to drivers of children or adults.

Health risks. The verdict is still out on the health effects of prolonged cell phone use. If future studies establish a conclusive link, then it is possible that employees who suffer health problems that are linked to cell phone use may be able to obtain workers compensation benefits from their employer. This is a relevant issue for churches, since many have not obtained workers compensation insurance. These churches would have to pay the full amount of the workers compensation benefits since they failed to obtain insurance and their general liability insurance policy provides no coverage for employment-related injuries.

The clergy privilege. Cell phone conversations are not confidential. It is easy for others to eavesdrop. This raises an important question concerning the application of the “clergy-penitent privilege” to conversations conducted over a cell phone. In all 50 states, the clergy privilege applies only to communications that are “confidential.” Does this mean that conversations over a cell phone can never be privileged? No court has addressed this question. However, to eliminate any doubt, ministers may want to refrain from engaging in confidential spiritual counseling over a cell phone. Ministers who receive a call on a cell phone from a person seeking spiritual counsel should ask the caller to call back on a land line.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Tax Court Denies Deduction for a Gift of Property

Substantiation requirements not followed.

Richard R. Hammar, Attorney, CPA
Bio

Jorgenson v. Commissioner, 79 T.C.M. 1444 (2000).

Background. In 1993 a married couple (the “taxpayers”) donated property having a fair market value of $10,000 to their local Boys and Girls Club. In 1994, they donated a truck having a fair market value of $14,850 to their church. The taxpayers failed to obtain qualified appraisals for both charitable contributions prior to the due date of their 1993 and 1994 tax returns. They were audited by the IRS, and only then did they produce letters from two appraisers (dated after the taxpayers filed their tax returns). The IRS disallowed any deduction for either of these contributions, and the taxpayers appealed.

The Tax Court ruling. The Tax Court noted that the tax code specifies that a taxpayer must obtain a “qualified appraisal” for donated property (except money and certain publicly traded securities) in excess of $5,000. In addition, the income tax regulations require that the taxpayer attach an “appraisal summary” to the tax return, and the IRS has prescribed Form 8283 to be used as the appraisal summary.

The Tax Court concluded: “Although we have not demanded that the taxpayer strictly comply with the reporting requirements of [the regulations] we have required that the taxpayer substantially comply with the regulations in order to take the deduction for a charitable contribution. Based on the record, we find that [the taxpayers] did not timely obtain qualified appraisals and failed to include complete appraisal summaries with their 1993 and 1994 tax returns. Because [they] failed to comply substantially with [the regulations] we hold that [they] are not entitled to deduct the noncash charitable contributions.”

The Tax Court further ruled that the IRS could assess an “accuracy-related penalty” against the taxpayers. Section 6662 of the tax code permits the IRS to assess a penalty of 20 percent on the amount of underpayment of tax attributable to a “substantial understatement” of tax. A substantial understatement of tax is defined as an understatement of tax that exceeds the greater of 10 percent of the tax required to be shown on the tax return or $5,000. The understatement is reduced to the extent that the taxpayer has (1) adequately disclosed his or her position or (2) has substantial authority for the tax treatment of the item. The court concluded that neither the taxpayers nor their accountant “provided an explanation why timely qualified appraisals were not conducted for the noncash charitable contributions and why the appraisal summaries on Form 8283 were not fully completed. We, therefore, sustain [the] imposition of the accuracy-related penalty with regard to the underpayment associated with the … the noncash charitable contributions.”


Tip. Do not assume that donors are familiar with the substantiation rules that apply to gifts of noncash property. Church treasurers should obtain several copies of Form 8283 each January to give to persons who donate noncash property (other than publicly traded securities) to the church during the year. You can order multiple copies of Form 8283 by calling the IRS forms hotline at 1-800-TAX-FORM.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

United States Supreme Court Issues Three Important Rulings

What church leaders need to know.

Richard R. Hammar, Attorney, CPA
Bio

What church leaders need to know

Article summary. This was an historic term for the United States Supreme Court. It rendered a number of sweeping rulings that will have a significant impact on American life. Three of those rulings are of special interest to church leaders. In one case, the Court ruled that a New Jersey law prohibiting the Boy Scouts from dismissing a gay activist scoutmaster violated the Boy Scouts’ first amendment right of association. In a second case, the Court upheld the constitutionality of a government program providing funds to both public and private schools (including church-affiliated schools) for teaching materials. In a third case, the Court ruled that the student-led prayers at the start of public high school football games violates the first amendment “nonestablishment of religion” clause.

The United States Supreme Court has issued three rulings that will be of interest to church leaders. These rulings are summarized below.

Case #1 – Gay Scout Leaders

The Supreme Court ruled that a New Jersey civil rights law requiring the Boy Scouts to use a gay activist as a scout leader violated the Boy Scouts’ first amendment right of association. When scouting officials learned from a newspaper article that one of their scoutmasters was a homosexual activist, they terminated his services, explaining that the Boy Scouts “specifically forbid membership to homosexuals.” The former scoutmaster sued the Boy Scouts claiming that it had violated a New Jersey “public accommodations” law by dismissing him. The New Jersey law prohibits, among other things, discrimination on the basis of sexual orientation in places of public accommodation. The Supreme Court began its opinion by observing that “implicit in the right to engage in activities protected by the first amendment” is “a corresponding right to associate with others in pursuit of a wide variety of political, social, economic, educational, religious, and cultural ends.” This right “is crucial in preventing the majority from imposing its views on groups that would rather express other, perhaps unpopular, ideas.” The court continued:

Government actions that may unconstitutionally burden this freedom may take many forms, one of which is “intrusion into the internal structure or affairs of an association” like a “regulation that forces the group to accept members it does not desire.” Forcing a group to accept certain members may impair the ability of the group to express those views, and only those views, that it intends to express. Thus, “[f]reedom of association … plainly presupposes a freedom not to associate.” The forced inclusion of an unwanted person in a group infringes the group’s freedom of expressive association if the presence of that person affects in a significant way the group’s ability to advocate public or private viewpoints.

The Court noted that the general mission of the Boy Scouts is clear: “[T]o instill values in young people.” The Boy Scouts asserted that homosexual conduct is inconsistent with its values. To illustrate, a position statement promulgated by the Boy Scouts in 1991 states, “We believe that homosexual conduct is inconsistent with the requirement in the Scout Oath that a Scout be morally straight and in the Scout Law that a Scout be clean in word and deed, and that homosexuals do not provide a desirable role model for Scouts.”

The Court acknowledged that the right of association is not absolute, and may be “overridden” by regulations adopted to serve “compelling state interests, unrelated to the suppression of ideas, that cannot be achieved through means significantly less restrictive of associational freedoms.” The Court rejected the argument that New Jersey had a compelling interest in so severely intruding on the Boy Scouts’ rights to freedom of association. As a result, the Court concluded that the first amendment “prohibits the state from imposing such a requirement through the application of its public accommodations law.”

The Court conceded that the public perception of homosexuality in this country has changed, and that homosexuality “has gained greater societal acceptance.” However, “this is scarcely an argument for denying first amendment protection to those who refuse to accept these views. The first amendment protects expression, be it of the popular variety or not …. [T]he fact that an idea may be embraced and advocated by increasing numbers of people is all the more reason to protect the first amendment rights of those who wish to voice a different view.”

The Court concluded:

We are not, as we must not be, guided by our views of whether the Boy Scouts’ teachings with respect to homosexual conduct are right or wrong; public or judicial disapproval of a tenet of an organization’s expression does not justify the state’s effort to compel the organization to accept members where such acceptance would derogate from the organization’s expressive message. “While the law is free to promote all sorts of conduct in place of harmful behavior, it is not free to interfere with speech for no better reason than promoting an approved message or discouraging a disfavored one, however enlightened either purpose may strike the government.”

Application. This case has limited relevance to churches. The New Jersey public accommodation law exempted religious organizations from the ban on discrimination on the basis of sexual orientation in public places and programs. This case probably makes it even less likely that a church could be successfully sued for discriminating on the basis of sexual orientation in employment, membership, or in its programs or facilities. Boy Scouts of America v. Dale, __ U.S. __ (2000).

Case #2 – Government Aid to Church Schools

The Supreme Court ruled that the use of federal funds to provide secular and nonideological educational materials (including library materials, computer equipment and software, and textbooks) to both public and church-affiliated schools did not violate the first amendment’s nonestablishment of religion clause. As part of a longstanding school aid program known as “Chapter 2,” the federal government distributes funds to state and local governmental agencies, which in turn lend educational materials and equipment to public and private schools. The question addressed by the Court was whether Chapter 2 violates the first amendment’s “nonestablishment of religion” clause if some of the funds are used to provide educational materials to church-affiliated private schools.

Chapter 2 provides funding for a wide variety of educational materials, including library services and materials, reference materials, computer software and hardware for instructional use, and other curricular materials. Several restrictions apply to aid to private schools. For example, the “services, materials, and equipment” provided to private schools must be “secular, neutral, and nonideological.” In addition, private schools may not acquire control of Chapter 2 funds or ownership of Chapter 2 materials, equipment, or property. A private school receives the materials and equipment by submitting an application to a local educational agency detailing which items the school seeks and how it will use them. The agency, if it approves the application, purchases those items and then lends them to the school.

The Court noted that the first amendment prevents Congress from making a law “respecting an establishment of religion,” and that over the past 50 years it has “consistently struggled to apply these simple words in the context of governmental aid to religious schools.” However, the Court noted that in a 1997 case it provided some clarification by holding that government aid to religious schools generally will not violate the first amendment so long as it (1) has a secular purpose; (2) does not result in governmental indoctrination; (3) does not define its recipients by reference to religion; and (4) does not create an excessive entanglement. Since the parties to the lawsuit never questioned the first or fourth factors, the Court focused on the second and third.

Governmental Indoctrination

The Court noted that the question “whether governmental aid to religious schools results in governmental indoctrination is ultimately a question whether any religious indoctrination that occurs in those schools could reasonably be attributed to governmental action.” It continued:

In distinguishing between indoctrination that is attributable to the state and indoctrination that is not, we have consistently turned to the principle of neutrality, upholding aid that is offered to a broad range of groups or persons without regard to their religion. If the religious, irreligious, and areligious are all alike eligible for governmental aid, no one would conclude that any indoctrination that any particular recipient conducts has been done at the behest of the government …. If the government is offering assistance to recipients who provide, so to speak, a broad range of indoctrination, the government itself is not thought responsible for any particular indoctrination. To put the point differently, if the government, seeking to further some legitimate secular purpose, offers aid on the same terms, without regard to religion, to all who adequately further that purpose, then it is fair to say that any aid going to a religious recipient only has the effect of furthering that secular purpose.

The Court also emphasized the importance of determining whether government aid that goes to religious schools does so “only as a result of the genuinely independent and private choices of individuals” as opposed to an act of government: “For if numerous private choices, rather than the single choice of a government, determine the distribution of aid pursuant to neutral eligibility criteria, then a government cannot, or at least cannot easily, grant special favors that might lead to a religious establishment.”

The court concluded that the principles of neutrality and private choice prevented the government aid in this case from being reasonably “attributed” to the government.

Defining Recipients with Reference to Religion

Does Chapter 2 define the recipients of government aid by reference to religion? The Court ruled that it did not, since the aid was allocated on the basis of “neutral, secular criteria that neither favor nor disfavor religion, and is made available to both religious and secular beneficiaries on a nondiscriminatory basis.”

Application. This case represents an unequivocal recognition of the fact that some forms of government aid to religious schools are constitutionally permissible. Churches that operate primary or secondary schools should be familiar with the provisions of Chapter 2, which is now technically Subchapter VI of Chapter 70 of Title 20 of the United States Code, where it was codified by the Improving America’s Schools Act of 1994, Pub. L. 103-382. Mitchell v. Helms, __ U.S. __ (2000).

Case #3 – Prayer before Public High School Football Games

The Supreme Court ruled that student-led prayers at the start of public high school football games violated the first amendment’s nonestablishment of religion clause. A public high school adopted a policy permitting, but not requiring, the school’s “student council chaplain” to recite a nonsectarian, nonproselytizing prayer at the start of football games. This policy was challenged by two students, and their parents, as a violation of the first amendment. The school argued that the prayers were permissible since they were “private student speech” that was beyond the reach of the first amendment, which is a limitation on government action. The court agreed that private speech is beyond the reach of the first amendment, but it concluded that the prayers addressed in this case were not “private speech” but rather had to be attributed to the state (school). It based this conclusion on the following factors: (1) the prayers are authorized by a government policy and take place on government property at government-sponsored school-related events, and are broadcast over the school’s public address system which is under the control of school officials; (2) the pregame ceremony, during which the prayer is recited, is “clothed in the traditional indicia of school sporting events, which generally include not just the team, but also cheerleaders and band members dressed in uniforms sporting the school name and mascot; (3) the school’s name “is likely written in large print across the field and on banners and flags”; (4) the crowd “will certainly include many who display the school colors and insignia on their school T-shirts, jackets, or hats and who may also be waving signs displaying the school name.”

The Court noted that “it is in a setting such as this that the board has chosen to permit the elected student to rise and give the invocation.” In this context the members of the listening audience “must perceive the pregame message as a public expression of the views of the majority of the student body delivered with the approval of the school administration.” Regardless of the listener’s support for, or objection to, the message, an objective student “will unquestionably perceive the inevitable pregame prayer as stamped with the school’s seal of approval.”

The Court listed other factors in support of its conclusion that the prayers were public rather than private speech: (1) the school allows only one student, the same student for the entire season, to give the invocation; (2) the invocation is subject to school regulations that confine the content and topic of the student’s message; and (3) the election by the student body of the student council chaplain ensured that “minority” religious views would be “effectively silenced.”

The Court concluded:

School sponsorship of a religious message is impermissible because it sends the ancillary message to members of the audience who are nonadherents “that they are outsiders, not full members of the political community, and an accompanying message to adherents that they are insiders, favored members of the political community.” The delivery of such a message-over the school’s public address system, by a speaker representing the student body, under the supervision of school faculty, and pursuant to a school policy that explicitly and implicitly encourages public prayer-is not properly characterized as “private” speech ….

High school home football games are traditional gatherings of a school community; they bring together students and faculty as well as friends and family from years present and past to root for a common cause. Undoubtedly, the games are not important to some students, and they voluntarily choose not to attend. For many others, however, the choice between whether to attend these games or to risk facing a personally offensive religious ritual is in no practical sense an easy one. The Constitution, moreover, demands that the school may not force this difficult choice upon these students for “it is a tenet of the first amendment that the state cannot require one of its citizens to forfeit his or her rights and benefits as the price of resisting conformance to state-sponsored religious practice.”

Application. “Private speech” cannot violate the nonestablishment of religion clause. The problem in this case, the Court concluded, was that the prayers at football games were not private speech. The school’s substantial involvement made the prayers “public” or governmental speech. The Court conceded, at the end of its opinion, that the first amendment does not prohibit “all religious activity in our public schools.” As examples, it cited cases that have allowed (1) religious student groups to meet on public high school property during noninstructional hours if the same privilege is granted to other student groups, and (2) religious organizations to meet on public school property if the property is made available to other community groups. It also acknowledged that “nothing in the Constitution as interpreted by this Court prohibits any public school student from voluntarily praying at any time before, during, or after the schoolday.” However, it insisted that “the religious liberty protected by the Constitution is abridged when the state affirmatively sponsors the particular religious practice of prayer.” Santa Fe Independent School District v. Doe, __ U.S. __ (2000).

© Copyright 2000 by Church Law & Tax Report. 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, PO Box 1098, Matthews, NC 28106. Reference Code: m47 m42 m88 m43 c0500
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Failure to Read a Contract

Unexpected financial obligations can arise if contracts aren’t thoroughly understood.

Richard R. Hammar, Attorney, CPA
Bio

Background. A church purchased property for $40,000. It made a down payment of $11,000 and then, pursuant to a promissory note, agreed to pay the balance of $29,000 at 10% interest. An amortization schedule accompanying the note showed 93 monthly payments of $311.64 each. The church made each of these payments.

After the church had made all of the payments called for in the amortization schedule, the seller discovered that the amortization schedule was wrong, and that the church still owed a balance of $19,229 under the terms of the promissory note. The church claimed that it had paid its obligation in full since it had complied fully with the amortization schedule.

The seller sued the church, and a trial court ruled that the church had to pay the balance. A state appeals court affirmed the trial court’s decision. It concluded:

[The seller] understood that he was executing a sale with vendor’s lien and received $11,000.00 as a down payment toward the $40,000.00 sale price. Further, [the seller] understood that … he was [executing] a promissory note in his favor from [the church] in the amount of $29,000.00 with ten percent (10%) interest …. [The seller] failed to discover that 93 payments at $311.64 covered only half of the principal and interest owed. However, the source of error in this matter is not [the seller’s] failure to read the entire document, for even if [he] had read every word of it, there is nothing to support that he would have caught the error in computation. Indeed, the stated price and interest rate were as was intended and the inconsistencies between those numbers and the number of payments was not noticed …. It is not likely that any person who is not a “number cruncher” would have caught this incongruity. Failure to read and failure to compute are two different things. [A party to a contract is required] to read the contract but … any ambiguity or inconsistency therein [is not] interpreted against him for failure to do so. He is treated no better than a person who read the contract; he is also treated no worse.

Relevance to church treasurers. The church was legally bound by the terms of the promissory note rather than the erroneous amortization schedule, and so it ended up having to pay an additional $19,229. While this was the amount the church agreed to pay in the promissory note that it executed, this liability was an unexpected hardship for the church because of its reliance on the erroneous amortization schedule that it had faithfully followed for nearly 8 years. The lesson of this case to church treasurers is clear—never assume amortization schedules are accurate! Whenever the church purchases land, buildings, vehicles, or any other form of property by means of a promissory note, be sure to double-check the accuracy of the payment schedule. Capdeville v. White’s Temple of Church of God in Christ, Inc., 1999 WL 1259258 (La. App. 1999).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

The Use of Cell Phones by Church Staff (Part 2)

What church treasurers need to know.

Richard R. Hammar, Attorney, CPA
Bio

Background. This is the second in a series of three articles addressing the use of cell phones by church staff. The first article in this series appeared in the July 2000 issue of Church Treasurer Alert. It addressed two important limitations that are imposed by the tax code on the business use of cell phones by employees: (1) the phone must be for the “convenience of the employer,” and (2) the phone must be a “condition of employment.” As a table in this newsletter demonstrates, these requirements apply to employee-owned cell phones, and must be met in order for an employee to deduct the entire cost of a cell phone in the year of purchase and to claim a tax deduction for the business use of the phone. In addition, these requirements must be met in order for a church to reimburse an employee’s business use of his or her own cell phone under an accountable arrangement.


Key point. The tax treatment of cell phones is complex. A table in this newsletter summarizes all of the rules. Use this handy resource to quickly answer most of the important tax questions.

Use of Cell Phones by Church Employees: The Tax Consequences Who owns the phone?Tax consequences?Recommendation
Church Depends on whether the arrangement is accountable or nonaccountable:

• Nonaccountable plan. The church requires no substantiation of the “business use percentage” (the percentage of total phone time that is devoted to business). The church must report the full amount of all monthly usage bills that it pays as taxable income to the employee on Forms W-2 and 941. If the user is not a minister (or a minister who has elected voluntary tax withholding) then the church also must withhold taxes on the reported amounts.

• Accountable plan. The church requires the user to keep a diary, log, or other record documenting the duration and business or personal nature of each call. From this data the church can determine the “business use percentage” (the percentage of total phone time that is devoted to business). This percentage is multiplied times each monthly bill, and the resulting amount is not reported as taxable income to the employee since business use has been properly “accounted for.” The church can reimburse only the business use percentage of each bill, or it can pay the entire amount. If it pays the entire amount, then the reimbursements in excess of substantiated business use represent taxable income. The church must report these excess payments as taxable income to the employee on Forms W-2 and 941. If the user is not a minister (or a minister who has elected voluntary tax withholding) then the church also must withhold taxes on the reported amounts. Be sure the church pays cell phone charges under an accountable arrangement that requires employees to substantiate the business use percentage.

Be sure the church pays cell phone charges under an accountable arrangement that requires employees to substantiate the business use percentage.
Employee Cell phone depreciation

An employee can claim a “section 179” deduction (on Form 2106) for the cost of the phone in the year of purchase if 3 requirements are met:

• Business use. The employee uses the phone more than 50% of the time for business. The “section 179” deduction is for the cost of the phone multiplied times the business use percentage. If business use does not exceed 50%, the employee can depreciate the cost of the phone over 5 years.)

• Condition of employment. The use of the phone must be required for the employee to perform duties properly. The employer does not have to explicitly require the employee to use the phone. A mere statement by the employer that the use of the phone is a condition of employment is not sufficient.

• Convenience of the employer. The use of a cell phone by an employee is for the convenience of the employer if it is for a substantial business reason of the employer. The use of the phone during the employee’s regular working hours to carry on the employer’s business is generally for the employer’s convenience. Employees should be urged to keep adequate records to prove that the business use percentage exceeds 50%. This will allow a deduction for the cost of the phone (multiplied times the phone’s business use percentage) in the year of purchase.

Employees should be urged to keep adequate records to prove that the business use percentage exceeds 50%. This will allow a deduction for the cost of the phone (multiplied times the phone’s business use percentage) in the year of purchase.
Monthly cell phone user fees:

• Church pays (reimburses) the monthly fees. Tax treatment depends on whether the reimbursement arrangement is accountable or nonaccountable (defined above).

(1) If accountable, and the “condition of employment” and “convenience of employer” tests (defined above) are met, the church’s reimbursements of expenses associated with substantiated business use of the phone are not reported as taxable income to the employee.

(2) If nonaccountable, or if the “condition of employment” and “convenience of the employer” tests are not met, the church’s reimbursements must be reported as taxable income to the employee and the church may need to withhold taxes on the amount reported. This same rule applies to any reimbursement of personal cell phone use in excess of substantiated business use.

• Employee pays all monthly fees (no church reimbursement). The employee can claim a business expense deduction (computed on Form 2106) for the business use of the phone, if: (1) the employee has adequate records to prove the business use percentage of the phone; (2) the deduction is limited to the business use percentage multiplied times all monthly charges; (3) the “condition of employment” test (defined above) is met; and (4) the “convenience of the employer” test (defined above) is met. The church requires an accounting of the business use of the phone, and reimburses charges allocable to that use only.

The church requires an accounting of the business use of the phone, and reimburses charges allocable to that use only.

Substantiation requirements. An additional requirement applies to the business use of cell phones whether they are owned by the church or an employee—the business use of the cell phone must be substantiated in accordance with strict requirements spelled out in the tax code. This section explains and illustrates this important requirement.

Employees cannot deduct the purchase cost of their cell phones, or any portion of monthly user charges they pay, unless they maintain adequate records. In addition, adequate records proving the business use of a cell phone are required in order for the church to reimburse these expenses under an accountable arrangement.

Adequate records must show the time, place, business purpose, and amounts of these expenses. Generally, you must also have receipts for any expense of $75 or more. To meet the adequate records requirement, an employee must maintain an account book, diary, log, statement of expense, trip sheet, or similar record or other documentary evidence that, together with a receipt, is sufficient to establish each element of an expenditure or use. Information need not be recorded in an account book, diary, or similar record if the information is already shown on a receipt. For example, a monthly invoice from a telephone company ordinarily will show the amount of the expense and the “time” (month) during which the calls were made. However, the invoice will not show the business purpose of the calls, and so this information must be provided by the user.

An employee’s records must support all of the following:

(1) The amount of each separate expense, such as the cost of acquiring the phone, maintenance and repair costs, and any other expenses.

(2) The amount of each business use (based on an appropriate measure, such as time), and the total use of the property for the tax year.

(3) The date of the expenditure or use.

(4) The business purpose for the expenditure or use.

Employees must record the elements of an expenditure or use at the time they have full knowledge of those elements. An expense account statement made from an account book, diary, or similar record prepared or maintained at or near the time of the expenditure or use is generally considered a timely record if in the regular course of business it is given by an employee to the employer.

An adequate record of business purpose must generally be in the form of a written statement. However, the amount of backup necessary to establish a business purpose depends on the facts and circumstances of each case. A written explanation of the business purpose will not be required if the purpose can be determined from the surrounding facts and circumstances. This ordinarily is not possible with cell phones.

If any of the information on the elements of an expenditure or use is confidential, the employee does not need to include it in the account book or similar record if it is recorded at or near the time of the expenditure or use. However, it must be retained by the employee and made available to the IRS district director upon request. This rule may apply to some calls made by ministers.

Employees can maintain adequate records for portions of a tax year and use that record to support business use for the entire tax year if it can be shown by other evidence that the periods for which adequate records were maintained are representative of use throughout the year.


Key point. The substantiation requirements must be met not only by employees wanting to claim a tax deduction for the business use of their phone that is not reimbursed by the church, but also by the church in reimbursing expenses under an accountable arrangement. The requirements are identical.

Self-employed workers. Some ministers and lay church workers are self-employed for income tax reporting purposes. Note the following rules that apply to these workers:
  • The table reproduced in this article addresses the use of cell phones by employees, not self-employed workers.
  • If the church owns a cell phone used by a self-employed worker, this can be used by the IRS as evidence that the worker in fact is an employee for income tax reporting purposes.
  • If the church owns a cell phone used by a self-employed worker, and pays the monthly user fees, then the church must report these payments as taxable income to the worker (on Form 1099) if the arrangement is nonaccountable. If the arrangement is accountable, then the payments are not reported as taxable income to the worker. See the table for definitions of nonaccountable and accountable reimbursement arrangements.
  • If the worker owns the phone, he or she may deduct the cost of the phone in the year of purchase if the phone is used more than 50% for business. This is referred to as the “section 179 deduction.” The “condition of employment” and “convenience of the employer” requirements do not apply. Only the percentage of cost that corresponds to the “business use percentage” of the phone may be deducted in the year of purchase. For example, if the worker’s records show that the phone is used 75% of the time for business, then 75% of the cost of the phone can be deducted in the year of purchase.
  • If the worker owns the cell phone, then the monthly user fees can be claimed as a tax deduction if the worker pays them and maintains adequate records. The deduction is reported on Schedule C (Form 1040). The “condition of employment” and “convenience of the employer” requirements do not apply.
  • If the worker owns the cell phone, and monthly user fees are paid or reimbursed by the church, the reimbursements are not reported as taxable income to the worker so long as the church’s reimbursement arrangement is accountable. See the table for details. Note that the reimbursement of business expenses by an employer under an accountable arrangement can be used by the IRS as evidence that the worker in fact is an employee for income tax reporting purposes.
  • If the worker owns the cell phone and does not maintain adequate records of business use, then no tax deduction is available.


Key point. The concluding article in this 3-part series on cell phones will appear in the October 2000 issue of Church Treasurer Alert.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Is it Time to Reconsider your Pastor’s Housing Allowance?

What church treasurers need to know about a recent Tax Court case.

Richard R. Hammar, Attorney, CPA
Bio

Warren v. Commissioner, 114 T.C. 23 (2000)

Background. In one of the most significant clergy tax cases in recent years, the United States Tax Court ruled that a housing allowance is nontaxable for income tax reporting purposes so long as it is used to pay for housing-related expenses. The court threw out the annual “rental value” test that the IRS adopted in 1971, which limited nontaxable housing allowances for ministers who own their homes to the “annual rental value” of their home. The court’s decision will have a direct and immediate impact on many ministers. Church treasurers should be familiar with the application of this ruling to their pastor or pastors. This article will tell you what you need to know.

The housing allowance. Section 107 of the Internal Revenue Code provides that “in the case of a minister of the gospel, gross income does not include … the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.” This language requires very little explanation. The portion of a minister’s church-designated housing allowance that is used to pay for housing-related expenses is nontaxable for federal income tax reporting purposes. Stated differently, ministers may exclude from taxable income the lesser of (1) the church-designated housing allowance, or (2) the actual amount of housing-related expenses paid during the year.


Key point. There are certain technical requirements that must be met in order for a minister to qualify for a housing allowance exclusion. The allowance must be designated by official church action, and it must be designated in advance. Housing allowances cannot be declared retroactively. These and other requirements are reviewed fully in chapter 6 of Richard Hammar’s year 2000 Church and Clergy Tax Guide.

Unfortunately, in 1971 the IRS imposed an additional limitation on ministers who own their homes: the housing allowance exclusion may not exceed the annual rental value of the minister’s home (furnished) plus the cost of utilities. Revenue Ruling 71 280. Therefore, ministers who own their homes may only exclude actual housing expenses to the extent such expenses do not exceed either the church designated allowance or the fair rental value of the home plus the cost of utilities.


Key point. In Publication 517, the IRS explains how to compute the nontaxable portion of a housing allowance as follows: “If you are a minister who owns your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the lowest of the following amounts: (1) the amount actually used to provide a home, (2) the amount officially designated as a rental allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.”

The Tax Court case. A pastor of a large church wrote several best-selling books and operated a tape and book ministry. Since the pastor received substantial income from the tape and book ministry, his church designated all of his church compensation (between $75,000 and $100,000 per year) as a housing allowance. The pastor used all of these allowances to pay for housing expenses, and so both he and the church treated the allowances as fully nontaxable for income tax reporting purposes. However, the “annual rental value” of the pastor’s home was substantially less than his housing allowance or his actual housing expenses. He chose to ignore the IRS-imposed rental value test in computing the nontaxable portion of his housing allowance. As a result, he reported little or no taxable compensation for several years.

The IRS audited the pastor’s tax returns for three years and determined that he owed a significant amount of additional taxes because he failed to limit the nontaxable portion of his housing allowance to the annual rental value of his home (furnished, including utilities). The pastor appealed the IRS decision to the United States Tax Court.

The Tax Court (by an overwhelming vote of 14-3) threw out the annual rental value test, noting that the tax code does not limit the nontaxable amount of a minister’s housing allowance to the fair market rental value of the minister’s home. The language of the code is clear, and it imposes no “rental value” limitation.

The vast majority of pastors who will be helped by the court’s decision are not those with exorbitant incomes from outside sources (as some fear), but rather lower and middle income pastors who pay a down payment in the year they acquire a home, who have to make emergency repairs to their home, or who decide to remodel. Consider the following examples.


Example. Pastor C is paid a salary of $40,000 for year 2000. The church board designated $25,000 of this amount as a housing allowance. In February, Pastor C purchases a new home and makes a down payment of $15,000. Assume that he has additional housing expenses of $7,000 for the year, and that the annual rental value of the home (furnished, including utilities) is $10,000. Prior to the Tax Court’s recent decision, Pastor C’s nontaxable housing allowance would have been the least of the following three amounts: (1) the church-designated housing allowance ($25,000); (2) actual housing expenses ($22,000); or (3) the annual rental value of the home ($10,000). Since the annual rental value is the lowest amount, this would have been the nontaxable amount of Pastor C’s housing allowance. But why should this be so? The IRS insisted that the rental value limitation avoids “unfairness” by preventing ministers with other sources of income from having their employing church designate all of their church compensation as a housing allowance. But does this argument make sense in this example? Pastor C receives no substantial income from another vocation that allows his church to “unfairly” designate all of his church compensation as a housing allowance. In reality, it is “unfair” to apply the annual rental value test to Pastor C under these circumstances. Fortunately, 14 of the Tax Court’s 17 judges agreed.

Relevance to church treasurers. What is the relevance of the Tax Court’s ruling to church treasurers? Consider the following:

1. The status of the annual rental value test. Ministers should be informed that they can ignore the annual rental value test in computing the nontaxable amount of their housing allowance. The IRS is free to challenge ministers who ignore the annual rental value test, but ministers can rely on the Tax Court’s decision, which not only provides strong judicial support for their position but also protects them from penalties. If the IRS appeals the case and the federal appeals court for the ninth circuit affirms the Tax Court’s decision, then the IRS would not challenge ministers who ignore the annual rental value test in the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. Such a ruling would add even greater weight to the Tax Court’s decision, making it more likely that appeals courts in other federal circuits would reach the same conclusion. The IRS could appeal such a decision to the Supreme Court, but it is highly unlikely that the Supreme Court would review the case.

2. How much of a minister’s compensation can be designated as a housing allowance? The church in this case designated all of the pastor’s compensation as a housing allowance. The IRS insisted that the tax code prohibits the designation of all of a minister’s compensation as a housing allowance, but the Tax Court rejected this position.

There are many ministers who have most or all of their compensation designated as a housing allowance. Common examples would be bivocational pastors, pastors of small congregations or “missions” churches, and part-time associate pastors. Contrary to the IRS position, it is not “abusive” for churches to designate most or all of the income paid to these pastors as a housing allowance. The Tax Court’s decision will serve as strong legal support for the legitimacy of such housing allowances.

3. Impact on church boards. In most churches, the church board designates housing allowances. In some churches, a “compensation committee” or the congregation itself designates housing allowances. In any case, church leaders should recognize the impact of the Tax Court’s ruling on the process of designating housing allowances. Most importantly, the case will permit churches to designate larger housing allowances than were permissible in the past.


Example. A church board is considering the year 2001 compensation package for Pastor B. It decides on total compensation of $30,000. Pastor B informs the board that he will have ordinary housing expenses of $10,000, but that he also will be incurring remodeling expenses of an additional $10,000. The board is uncomfortable designating two-thirds of Pastor B’s total compensation as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate two-thirds of the pastor’s compensation as a housing allowance.


Example. Pastor H is a part-time associate pastor at his church. The church board plans to pay him $10,000 for 2001. Pastor H asks the board to designate 100 percent of this amount as a housing allowance. The church treasurer is uncomfortable designating the entire amount as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor H’s compensation as a housing allowance.


Example. A church board is considering the year 2001 compensation package for Pastor N. It decides on total compensation of $60,000. Pastor N asks the board to designate this entire amount as a housing allowance. He informs the board that he will have ordinary housing expenses of $15,000, but that he also will be purchasing a new home in 2001 and plans on making a large down payment (with the sale proceeds from his prior residence) of $45,000. Pastor N’s spouse is employed as a college professor, and the couple plans on using her salary for living expenses in 2001. The church board is uncomfortable designating the entire salary as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor N’s compensation as a housing allowance.

4. Amending an existing housing allowance. The Tax Court’s decision suggests that church treasurers review the housing allowances designated for any pastor or pastors on staff. Churches are free to “amend” a housing allowance during the year if it proves to be inadequate to cover actual housing expenses. Of course, any amendment only operates prospectively and not retroactively. Here are some situations in which a church may want to amend a pastor’s year 2000 housing allowance as a result of the Tax Court’s decision.
  • Percentage designations. Some churches designate a fixed percentage (e.g., 40%) of the compensation of pastors who own their home as a housing allowance, assuming that such an approach prevents the housing allowance from exceeding the annual rental value of the pastor’s home. The Tax Court’s decision makes percentage designations harder to justify, since they often will prevent pastors from having all of their housing expenses covered by their housing allowance.
  • Basing housing allowances on annual rental value. Some churches are uncomfortable in designating a housing allowance in an amount significantly higher than the apparent annual rental value of a pastor’s home, since they assume that the nontaxable portion of the housing allowance cannot exceed this amount. There no longer is any justification for this approach. If your pastor’s housing allowance was based in part on the annual rental value of his or her home, then you should consider amending the allowance for the remainder of the year.
  • “Accountable” arrangements. Some churches have adopted an “accountable” approach to handling housing allowances. Under such an approach, churches do not issue W-2 forms to pastors until the pastors provide the church treasurer with their actual housing expenses for the previous year. This allows the church treasurer to reduce a pastor’s W-2 income by the actual amount of the church-designated housing allowance that is nontaxable. In the past, such churches reduced W-2 income for pastors who own their homes by the lowest of the following three amounts: (1) the church-designated housing allowance; (2) the pastor’s substantiated housing expenses for the previous year; or (3) the annual rental value of the pastor’s home (furnished, including utilities). Such churches should now eliminate the annual rental value test in computing the nontaxable amount of the housing allowance.
  • Change in circumstances. A number of circumstances may occur during the year that make an amendment to a pastor’s housing allowance appropriate. The Tax Court’s recent ruling allows churches to increase the portion of a pastor’s salary allocated to housing allowance no matter how significant those expenses may be. Here are some examples of circumstances that warrant a review of a pastor’s housing allowance: (1) a pastor purchases a new home; (2) a pastor incurs unexpected home repairs; (3) a pastor incurs remodeling expenses; (4) the purchase of new furnishings or appliances; (5) the mortgage interest rate under an adjustable rate mortgage on the pastor’s home is increased; (6) a pastor makes a large down payment on the purchase of a new home; or (7) a pastor makes a large prepayment of a mortgage loan.

5. Amended tax returns. Church treasurers should remind pastors that may file an amended tax return with the IRS (Form 1040X) if their nontaxable housing allowance was reduced in any one or more the previous three years because of the annual rental value test.

6. Get ready for 2001. In designating housing allowances for 2001, church leaders should take the Tax Court’s recent ruling into account. This means that you will not want to apply the “annual rental value test” in designating a housing allowance. For pastors who own their homes, the housing allowance may be any portion of their church compensation that is necessary to cover anticipated housing expenses.

7. Social security. Note that a housing allowance is nontaxable only in computing federal income taxes. Housing allowances are included in a pastor’s income in computing the self-employment (social security) tax. The same is true for the annual rental value of a church-provided parsonage. Be sure your pastor is aware of this important limitation.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Revoking an Exemption from Social Security

We have noted in previous issues of this newsletter that ministers who opted out of

Richard R. Hammar, Attorney, CPA
Bio

We have noted in previous issues of this newsletter that ministers who opted out of social security have been given a limited opportunity to revoke their exemption. The IRS has released the Form 2031 that ministers may use to revoke an exemption. Ministers wanting to revoke an exemption from social security can obtain a copy of Form 2031 by calling the IRS toll-free forms hotline at 1-800-TAX-FORM, or by downloading a copy from the IRS website (www.irs.gov).

Remember that ministers who have opted out of social security will have until April 15, 2002 to revoke their exemption. Ministers who revoke their exemption will have to elect, on Form 2031, to begin coverage as of either January 1, 2000 or January 1, 2001. In order to minimize or avoid paying “back taxes,” ministers wanting to revoke an exemption should file the revocation form as follows:

Complete and return the Form 2031 immediately, and elect to begin coverage as of January 1, 2000. The form must be accompanied by a check in the amount of estimated self-employment taxes for the first two quarters of year 2000.

• Key point. If you wait until on or after September 15, 2000 (but before January 15, 2001) to file the form, and elect to begin coverage on January 1, 2000, you will need to enclose a check in the amount of estimated self-employment taxes for the first three quarters of 2000. If you wait until on or after January 15, 2001 to file the form, and elect to begin coverage on January 1, 2000, you will need to enclose a check in the amount of estimated self-employment taxes for all four quarters of 2000.

• Key point. Some ministers who are nearing retirement will want to elect to begin coverage on January 1, 2000 in order to accumulate four quarters of coverage for the year. In general, it takes forty quarters of coverage to be “permanently insured” for social security and Medicare benefits.

At anytime in the year 2000, and elect to begin coverage on January 1, 2001. This will avoid any liability for back taxes. Ministers will pay self-employment taxes along with their quarterly installments of estimated income taxes on April 15, June 15, and September 15 of year 2001, and January 15 of 2002.

For more information, see the feature article entitled “Revoking an Exemption from Social Security” in the July-August 1999 issue of this newsletter.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Negligence as a Basis for Liability

A Missouri court ruled that a church was not responsible for an associate pastor’s sexual relationship with a church secretary while she was hospitalized.

Richard R. Hammar, Attorney, CPA
Bio

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

• Key point 10-12. Churches face a number of legal risks when they offer counseling services by ministers or laypersons. These include negligent selection, retention, or supervision of a counselor who engages in sexual misconduct or negligent counseling. A church also may be vicariously liable for a counselor’s failure to report child abuse, breach of confidentiality, and breach of a fiduciary relationship.

• Key point 10-12.1. Churches can reduce the risk of liability associated with pastoral or lay counseling by adopting risk management policies and procedures.

A Missouri court ruled that a church was not responsible for an associate pastor’s sexual relationship with a church secretary while she was hospitalized. In 1995 a woman (Linda) was hired as a secretary by a nondenominational church. Several months later, Linda was admitted to a hospital following a drug overdose. Although she was diagnosed as suffering from depression, she was released from the hospital a short time later. Because the church’s pastor believed that Linda was still in need of professional counseling and treatment, he suggested that she consult with a psychologist at a Christian counseling center. Following her visit to the center, Linda was admitted to a psychiatric center. While at the center, Linda was visited by her pastor. During one visit, Linda repeatedly asked him to touch and hold her, and to lay in bed with her. The pastor believed that she was attempting to seduce him and considered this behavior to be out of the ordinary for her. She was released from the center shortly after this visit but was readmitted later that month. During her second admission to the center, the pastor visited her again, this time accompanied by an associate pastor at the church. The pastor brought the associate pastor as a result of Linda’s strange behavior during his previous visit. Another associate pastor (Pastor Bob) from the church also visited Linda during her second stay at the center. During this visit, he and Linda went into a public room and talked. After talking for approximately an hour, they had a sexual encounter. Over the next several weeks, after her release from the center, she and Pastor Bob had three other consensual sexual encounters.

Linda later sued Pastor Bob and her church. She claimed that the sexual encounters that had taken place between Linda and Pastor Bob were sexual assaults, and that the church was responsible for them on the basis of an “intentional failure to supervise clergy.” She noted that the church failed to follow its own policies in allowing Pastor Bob to meet alone with her and because it failed to warn him of Linda’s attempt to seduce the senior pastor when he first visited her at the hospital.

The church asked the court to dismiss it from the lawsuit on the ground that Linda could not show that it knew Pastor Bob presented a risk of harm to Linda or that it disregarded any such risk since he had no history of sexual misconduct or a known propensity for sexual misconduct of which it was aware. A trial court dismissed all claims against the church and Pastor Bob, and Linda appealed.

The appeals court affirmed the trial court’s dismissal of the lawsuit. It began its opinion by observing that

to state a claim against the [church] for intentional failure to supervise clergy based on [Pastor Bob’s] alleged sexual assault . . . [Linda] was required to allege that: (1) [Pastor Bob] was under the supervision of the [church]; (2) the [church] knew that he was certain or substantially certain to harm Linda; (3) the [church] disregarded this known risk by failing to take any action to protect Linda; (4) the [church’s] inaction caused damage to Linda; and (5) the harm occurred on premises owned by the [church] or while [Pastor Bob] was using property owned by the [church].

The court noted that the Pastor Bob had “no history of sexual misconduct or a known propensity for sexual misconduct that was certain or substantially certain to harm Linda of which it could have been aware and disregarded.” As a result, the case had to be dismissed unless Linda offered evidence rebutting the church’s claim. Linda referred to the statements of the senior pastor that (1) Linda, while a patient at the center, was displaying unusual behavior and was inclined to engage in aberrant sexual contact with a church pastor; and (2) he believed Linda would be harmed if she engaged in extramarital sexual contact. From this, she claimed that the church was aware that she was likely to engage in sexual contact with any pastor who went to visit her alone and that such sexual contact would be harmful to her. She claimed that this evidence was sufficient to rebut the church’s claim that it was not aware that Pastor Bob presented a substantial risk of harm to Linda if he visited her at the center without a chaperone. The court disagreed:

Nowhere in her petition did [Linda] allege that the [church] knew that [Pastor Bob] was certain or substantially certain to harm Linda due to his dangerous proclivities or any propensity on his part to engage in sexual misconduct. Instead, she alleged that the church knew that Linda had displayed aberrant sexual behavior during a visit with [the senior pastor] and was likely to engage in illicit sexual behavior if left alone with a pastor. This is insufficient to establish that the [church] knew that [Pastor Bob] presented a substantial risk of harm to Linda, which was disregarded by the church. This establishes simply that the danger of which the church allegedly should have been aware was caused by Linda, not [Pastor Bob]. Hence, [Linda] failed to establish that . . . (1) [the church] was aware that the member of its clergy [Pastor Bob] presented a substantial risk of harm to Linda; and (2) if such risk existed, it disregarded it.

Application. This case illustrates the risks involved in unsupervised opposite sex counseling off of church premises. While the court dismissed the lawsuit against the church, the result might well have been different had the church had any prior indication of inappropriate sexual conduct by Pastor Bob. It also should be noted that Linda claimed the church had a policy prohibiting opposite sex counseling off of church premises, and that this policy had been violated when Pastor Bob counseled with her at the hospital. The court did not address this contention. However, if the church had such a policy, and Pastor Bob violated it when he engaged in counseling with Linda in the hospital, this could have made the church liable for Pastor Bob’s acts. The lesson is clear-there are risks of both inappropriate physical contact and false allegations of such contact when pastors engage in opposite sex counseling. These risks increase when the counseling occurs off of church premises, since there is no supervision or accountability. These same risks exist when a pastor simply pays a visit to a person in the hospital even if no “counseling” occurs. Pastors should be aware of these risks and take steps to reduce or eliminate them. The most effective “risk management” technique would be to take another person along when engaging in opposite sex counseling, or when visiting persons in the hospital (especially when they are in private rooms). This is exactly what the senior pastor did on his second visit with Linda.

Rhodelander v. Liberty Christian Fellowship, 1999 WL 587291 (Mo. App. 1999).

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

The Civil Rights Act of 1964

A federal court in North Carolina ruled that the first amendment did not prevent it from resolving a sexual harassment claim brought by two nonminister church employees against their church.

Richard R. Hammar, Attorney, CPA
Bio

The Civil Rights Act of 1964

• Key point 8-08. Title VII of the CivilRights Act of 1964 prohibits employers engaged in commerce and having at least 15 employees fromdiscriminating in any employment decision on the basis of race, color, nationalorigin, gender, or religion.

• Key point 8-08.1. Title VII of the CivilRights Act of 1964 prohibits employers engaged in commerce and having at least 15 employees fromdiscriminating in any employment decision on the basis of race, color, nationalorigin, gender, or religion. Religious organizations are exempt from theban on religious discrimination, but not from the other prohibited formsof discrimination.

• Key point 8-08.2. Sexual harassment is aform of sex discrimination prohibited by Title VII of the Civil Rights Act of 1964. It consists of both”quid pro quo” harassment and “hostile environment” harassment. Religiousorganizations that are subject to Title VII are covered by this prohibition. Anemployer is automatically liable for supervisory employees’ acts ofharassment, but a defense is available to claims of hostile environmentharassment if they have adopted a written harassment policy and an allegedvictim fails to pursue remedies available under the policy. In some cases,an employer may be liable for acts of sexual harassment committed bynonsupervisory employees, and even nonemployees.

A federal court in North Carolina ruled that the firstamendment did not prevent it from resolving a sexual harassment claim brought by twononminister church employees against their church. A church’s receptionistand the pastor’s secretary (both of whom were female) claimed that thepastor had sexually harassed them, and they sued the church and adenominational agency for damages. The women made a number of allegations in theirlawsuit, including the following: (1) The pastor’s harassment of the receptionistbegan immediately after she started work, although she did not complain at that timebecause she did not want “it to seem like [she] was causing waves,” and shewas afraid she might lose her job. (2) The receptionist later did speakwith the church’s business manager about the harassment, and thebusiness manager confronted the pastor about it. The pastor issued the receptionistan apology and the harassment stopped for about a week. (3) The receptionistalso reported the pastor’s harassment to a denominational officer. (4)The receptionist resigned her employment and submitted a written grievance to herchurch and denominational office. (5) The pastor’s secretary reported thepastor’s harassment to an associate pastor at the church who assured herthat he would “take care of it.” The harassment continued. (6) The pastor’ssecretary spoke with a member of the church’s staff-parish relationscommittee about the harassment, but the harassment continued. (7) The pastor’ssecretary, along with several other female employees in the church office, metwith the church business manager regarding the pastor’s harassingbehavior. Unsatisfied with the business manager’s response to her concerns,the pastor’s secretary submitted her formal grievance to a denominationalofficial. (8) The pastor and church retaliated against the pastor’s secretaryfor reporting the sexual harassment by demoting her to church secretarytwo months after she filed her grievance. (9) The denominationinvestigated the women’s charges, and eighteen months later the pastorvoluntarily resigned his credentials as a minister.

The women’s sexual harassment claim

Title VII of the Civil Rights Act of 1964 prohibits coveredemployers from discriminating against any employee or applicant “with respect tocompensation, terms, conditions or privileges of employment, because of suchindividual’s sex.” Sexual harassment is a form of sex discrimination prohibitedby Title VII. The courts have identified two types of sexualharassment-“quid pro quo” and hostile environment. “Quid pro quo” harassment refers toconditioning employment opportunities on submission to a sexual or socialrelationship, while “hostile environment” harassment refers to the creation of anintimidating, hostile, or offensive working environment through unwelcome verbalor physical conduct of a sexual nature. In general, an employer is liable fora supervisory employee’s hostile environment sexual harassment.

The former receptionist and pastor’s secretary sued the church anddenominational agency claiming that they were responsible for the pastor’srepeated acts of hostile environment sexual harassment since he was a supervisoryemployee. In particular, the women alleged that the church and denomination(1) “failed to take timely and appropriate action to correct the problem and,hence, permitted [the pastor] to continue sexual harassment of theplaintiffs,” and (2) that their failure “to act upon notice of sexual harassmentby one of [their] employees unreasonably interfered with theplaintiffs’ work performance and created an intimidating, hostile, offensive andabusive work environment.” The women asked the court for a permanentinjunction, back pay, compensatory damages for past and future losses, punitivedamages, attorneys’ fees, and costs.

The church’s first amendment defense

The church and denomination argued that any attempt by the civilcourts to review the decisions of religious organizations regarding thesupervision and management of pastors would unconstitutionally interfere withmatters of internal church governance in violation of the first amendmentguaranty of religious freedom. The court acknowledged that “suits in whichministers or those individuals performing ministerial functions challenge theselection, failure to hire, assignment, or discharge decisions of religiousinstitutions are barred by the first amendment.” It further noted that thecourts have applied the church-minister exception “to bar claims brought by layemployees of religious institutions whose primary duties consist of teaching,spreading the faith, church governance, supervision of a religious order, orsupervision or participation in religious ritual and worship.”

On the other hand, the court referred to several cases in which thecivil courts have held that “secular or lay employees who do not performessentially religious functions are protected by Title VII and that religiousinstitutions are not insulated from liability under Title VII or otherantidiscrimination statutes for various forms of discriminatory conduct with respectto such employees.”

Turning to the facts of this case, the court noted that the womenwere “secular, lay employees who performed non-religious, administrativetasks for a religious institution,” and that a resolution of their sexualharassment claim would not violate the first amendment. The court noted that

to establish a claim for hostile environmentsexual harassment under Title VII, a plaintiff employee must prove that (1) the conduct wasunwelcome; (2) it was based on the sex of the plaintiff; (3) it wassufficiently severe or pervasive to alter the plaintiffs’ conditions of employment andto create an abusive working environment; and (4) it was imputable to theemployer. The fourth element requires a plaintiff to demonstrate a factualbasis upon which a harasser’s conduct may be imputed to an employer. Anemployer’s liability for its employee’s sexual harassment of anotherindividual may be premised on the employer’s own negligence. An employer isnegligent with respect to sexual harassment if it knew or should have knownabout the conduct but failed to stop it.

The court concluded that it could decide whether or not the churchand denomination “took some action that was reasonably calculated toput an end to the abusive environment” without any inquiry into religiousdoctrine.

Application. This case is important because it illustratesthe potential liability of churches and denominational agencies for ministers'”hostile environment” sexual harassment. “Hostile environment” harassmentrefers to the creation of an intimidating, hostile, or offensive workingenvironment through unwelcome verbal or physical conduct of a sexual nature.Churches and denominational agencies that are aware (or should be aware)that a pastor is engaging in such behavior will be responsible for it ifthey fail to take appropriate steps to protect employees. It is criticalfor church leaders to comprehend the legal significance of suchknowledge. Finally, the court rejected the claim of the church anddenomination that the first amendment guaranty of religious freedom prevented thecivil courts from resolving the women’s claims. So long as such claims involvenonminister employees and can be resolved without reference to doctrine orpolity, the first amendment does not bar the civil courts from resolvingthem. Smith v. Raleigh District of the North Carolina Conference ofthe United Methodist Church, 63 F.Supp.2d 694 (E.D.N.C. 1999).

© Copyright2000 by Church Law & Tax Report.All rights reserved. This publication is designed toprovide accurate and authoritative information in regard to thesubject matter covered. It is provided with the understanding thatthe publisher is not engaged in rendering legal, accounting, orother professional service. If legal advice or other expertassistance is required, the services of a competent professionalperson should be sought. Church Law & Tax Report, PO Box 1098,Matthews, NC 28106. Reference Code: m43 c0400
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Tax Court Liberalizes the Housing Allowance

Annual “rental value” limit abolished by the Tax Court–but Congress later intervened to make the decision obsolete.

Richard R. Hammar, Attorney, CPA
Bio

Annual “rental value” limit abolished – Warren v, Commissioner, 114 T.C. 23 (2000).

Editor’s Note: This case’s outcome became obsolete in 2002 when the US Congress passed the Clergy Housing Clarification Act of 2002.

Article summary. The housing allowance is the most significant benefit available to ministers. A recent Tax Court ruling makes it even more beneficial. The court abolished the annual “rental value” test which for nearly 30 years has limited the nontaxable portion of a housing allowance for ministers who own their homes to the annual rental value of their home. This test has prevented countless ministers from claiming a nontaxable housing allowance up to the full amount of their housing expenses. Ministers who have been hurt the most by the rental value test include those who have made a large down payment on a home, prepaid a significant amount of their mortgage loan, or incurred substantial repair or remodeling expenses. With the demise of the rental value test, ministers will be able to treat their church-designated housing allowance as nontaxable for federal income tax reporting purposes to the extent it is used to pay for housing-related expenses.

In one of the most significant clergy tax cases in recent years, the United States Tax Court ruled that a housing allowance is nontaxable for income tax reporting purposes so long as it is used to pay for housing-related expenses. The court threw out the annual “rental value” test that the IRS adopted in 1971, which limited nontaxable housing allowances for ministers who own their homes to the annual rental value of their home. The court’s decision will have a direct and immediate impact on many ministers. This article will summarize the facts of this important case, review the court’s decision, and assess the significance of the case to ministers and other church leaders.

Background

Section 107 of the Internal Revenue Code provides that “in the case of a minister of the gospel, gross income does not include … the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.” This language requires very little explanation. The portion of a minister’s church-designated housing allowance that is used to pay for housing-related expenses is nontaxable for federal income tax reporting purposes. Stated differently, ministers may exclude from taxable income the lesser of (1) the church-designated housing allowance, or (2) the actual amount of housing-related expenses paid during the year.

• Key point. There are certain technical requirements that must be met in order for a minister to qualify for a housing allowance exclusion. The allowance must be designated by official church action, and it must be designated in advance. Housing allowances cannot be declared retroactively. These and other requirements are reviewed fully in chapter 6 of Richard Hammar’s year 2000 Church and Clergy Tax Guide.

Unfortunately, in 1971 the IRS imposed an additional limitation on ministers who own their homes: the housing allowance exclusion may not exceed the annual rental value of the minister’s home (furnished) plus the cost of utilities. Revenue Ruling 71-280. Therefore, ministers who own their homes may only exclude actual housing expenses to the extent such expenses do not exceed either the church-designated allowance or the fair rental value of the home plus the cost of utilities.

In Publication 517, the IRS explains how to compute the nontaxable portion of a housing allowance as follows: “If you are a minister who owns your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the lowest of the following amounts: (1) the amount actually used to provide a home, (2) the amount officially designated as a rental allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.”

What has been the impact of the IRS-imposed “fair rental value” test? There are two points to note. First, the test has had little if any impact on ministers who have not incurred substantial housing expenses. Second, the test has had a substantial impact on ministers who have incurred extraordinary expenses. Consider the following examples.

• Example. Pastor B purchased a home in 1999. Pastor B’s housing expenses in 1999 were $12,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor B paid a $15,000 down payment on the home. The church board designated $30,000 of Pastor B’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor B’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor B could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $30,000, or that Pastor B incurred $27,000 in housing expenses (including the down payment), was irrelevant. This result had a direct and negative tax impact on Pastor B. Assuming that Pastor B is in the 15% tax bracket, the tax effect amounts to approximately $2,550 in additional taxes (15% multiplied times the excess of Pastor B’s actual housing expenses over the home’s annual rental value).

• Example. Pastor G owns his home. Pastor G’s housing expenses in 1999 were $12,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor G had to replace the roof on his home, at a cost of $5,000. The church board designated $20,000 of Pastor G’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor G’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor G could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $20,000, or that Pastor G incurred $17,000 in housing expenses (including the new roof), was irrelevant. This result had a direct and negative tax impact on Pastor G. Assuming that Pastor G is in the 15% tax bracket, the tax effect amounts to approximately $1,050 in additional taxes (15% multiplied times the excess of Pastor G’s actual housing expenses over the home’s annual rental value).

• Example. Pastor K owns his home. Pastor K’s housing expenses in 1999 were $15,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor K incurred $8,000 of expenses in remodeling the basement of his home. The church board designated $25,000 of Pastor K’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor K’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor K could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $25,000, or that Pastor K incurred $23,000 in housing expenses (including the remodeling job), was irrelevant. This result had a direct and negative tax impact on Pastor K. Assuming that Pastor K is in the 15% tax bracket, the tax effect amounts to approximately $1,950 in additional taxes (15% multiplied times the excess of Pastor K’s actual housing expenses over the home’s annual rental value).

• Example. Pastor M owns his home. Pastor M’s housing expenses in 1999 were $12,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor M prepaid $10,000 of his remaining mortgage debt in order to “get out of debt” as soon as possible. The church board designated $25,000 of Pastor M’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor M’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor M could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $25,000, or that Pastor M incurred $22,000 in housing expenses (including the mortgage prepayment), was irrelevant. This result had a direct and negative tax impact on Pastor M. Assuming that Pastor M is in the 15% tax bracket, the tax effect amounts to approximately $1,800 in additional taxes (15% multiplied times the excess of Pastor M’s actual housing expenses over the home’s annual rental value).

Facts

Let’s turn now to the facts of the recent Tax Court case. Rick Warren (the “pastor”) is an ordained Baptist minister with a master of divinity degree from Southwestern Theological Seminary and a doctor of ministry degree from Fuller Theological Seminary. In 1980, the pastor founded the Saddleback Valley Community Church (the “church”) in his home. Over the years the church used many different facilities to house the congregation, and the congregation has grown to more than 18,000 persons. The pastor also has authored best-selling books including The Purpose Driven Church, The Power to Change Your Life, and Answers to Life’s Difficult Questions, and he owns and operates a tape and book ministry called “The Encouraging Word.”

In 1992 the pastor bought a residence for $360,000. The annual fair market rental value of the residence was $58,061 in 1993, $58,004 in 1994, and $59,479 in 1995.

Each year the church’s trustees met to designate the amount of compensation to be paid to each of its ministers. The trustees also allocated these amounts between salary and housing allowances. The church paid the pastor compensation of $77,663 in 1993, $86,175 in 1994, and $100,000 in 1995. For 1993 and 1994 the trustees designated 100% of the pastor’s compensation as a housing allowance. In 1995, the trustees allocated $20,000 for salary and $80,000 for a housing allowance.

The pastor incurred housing expenses of $77,663 in 1993, $76,309 in 1994, and $84,278 in 1995 to provide a home for himself and his family. These amounts were used to pay for such housing-related expenses as mortgage payments, utilities, furnishings, landscaping, repairs, maintenance, real property taxes, and homeowner’s insurance premiums.

The pastor reported the following amounts as taxable income on his federal tax returns: 1993-none; 1994-$9,866; and 1995-$20,000. These amounts represented the amount of housing expenses in excess of compensation for the year. In other words, the pastor treated as nontaxable the lower of the following two amounts: his church-designated housing allowance for the year, or his actual housing expenses (columns C or D). He did not consider the annual rental value of his home in calculating the nontaxable amount. The following table summarizes this data:

ABCDEF
yearcompensation paid by the churchhousing allowance designated by the churchhousing expensesannual rental value of the homeamount excluded from taxable income
1993$77,663$77,663 (100% of income)$77,663$58,061$77,663
1994$86,175$86,175 (100% of income)$76,309$58,004$76,309
1995$100,000$80,000$84,278$59,479$80,000

The pastor also reported the following amounts of net income from his tape and book ministry during the years in question: 1993 – $183,635; 1994 – $217,770; and 1995 – $221,401.

The IRS audited the pastor’s tax returns for 1993-1995, and assessed $55,287 in “deficiencies” and penalties, as follows:

YearDeficiencyPenalty
1993$11,932$2,386
1994$18,061$3,612
1995$16,080$3,216

The IRS Position

The sole basis for the IRS position was that the nontaxable portion of the pastor’s housing allowance was limited to the least of the following three amounts: (1) the church-designated housing allowance, (2) actual housing expense, and (3) the annual rental value of the pastor’s home (furnished, including utilities). For each of the three years under examination, the IRS noted that the annual rental value was the lowest of the three limits, and therefore the pastor’s disregard of this limit resulted in an overstatement of the nontaxable amount of his housing allowances each year.

• Key point. The pastor claimed that the nontaxable portion of his housing allowance was the lesser of the amounts in columns C or D. The IRS insisted that the nontaxable amount was the least of the amounts in columns C, D, or E.

The IRS offered the following arguments to defend the annual rental value test: (1) the “rental value” language in section 106 supports the test; (2) the “part of compensation” language in section 107 supports the test; (3) the rental value test prevents ministers who own their homes from receiving a greater tax benefit than those who live in a church-provided parsonage; (4) the rental value test prevents ministers from acquiring expensive homes; and (5) the rental value test prevents ministers with other sources of income from acquiring more expensive homes by allocating a larger amount of their church compensation to a nontaxable housing allowance.

The pastor appealed the IRS decision to the United States Tax Court.

The court’s ruling

The Tax Court rejected each of the IRS’s arguments and invalidated the annual rental value test. The court’s response to each of the IRS’s arguments is summarized below.

#1 – The wording of section 107

The IRS claimed that the wording of section 107 of the Internal Revenue Code supported the rental value test. Here is the full text of section 107:

Section 107. Rental Value of Parsonages

In the case of a minister of the gospel, gross income does not include-

(1) the rental value of a home furnished to him as part of his compensation; or (2) the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.

The IRS insisted that allowing ministers to claim a nontaxable housing allowance in an amount exceeding the annual rental value of their home would be contrary to the “rental” language in section 107 and “to the concern for equality among ministers.” Specifically, the IRS pointed out that the title of section 107 (“Rental Value of Parsonages”) and the use of the word “rental” in both subsections 107(1) and 107(2) require use of the annual rental value limitation. The Tax Court disagreed. With regard to the significance of the title to section 107, the court noted that “it is well settled that the heading of a section does not limit the plain meaning of the text.” The court then addressed the significance of the word “rental” in the text of section 107:

Contrary to [the IRS’s] position, neither section 107(2), the regulations promulgated thereunder, nor the related legislative history, limits the amount that may be excluded from income as a parsonage allowance under section 107(2) to the fair market rental value of the residence occupied. A rental allowance excludable under section 107(2) may be used (1) to rent a home, (2) to purchase a home, and (3) to pay expenses directly related to providing a home. Section 107(1) limits the exclusion to the rental value of a home furnished as part of a minister’s compensation. In contrast, no fair rental value limit is stated in section 107(2) or the regulations issued thereunder ….

The trouble with [the IRS’s] analysis is that the Congress, faced with the “rental value” language of section 107(1), did not choose to use such language in section 107(2). Instead, the Congress provided that the exclusion applies to “the rental allowance paid … to the extent used by [the minister] to rent or provide a home.” Thus, the Congress clearly provided a different measure for the exclusion under section 107(2) than the measure provided under section 107(1). [The IRS] has failed to show us a policy problem so overwhelming as to force us to conclude that the Congress could not have meant what it said [quoting Reed v. Commissioner, 82 T.C. 208 (1984)] ….

[The IRS] contends that to not impose a fair rental value limit requires that we disregard the word “rental” in section 107(2). We disagree. Section 107(2) clearly is not limited to payment of rent; on the contrary, it expressly applies to a rental allowance “to the extent used … to rent or provide a home.” This includes home purchases ….

[We] believe our reading gives full effect to all of the words in section 107(2). First, section 107(2) specifically excludes not only the cost of renting a home, but also the cost of providing a home. Second, section 107(2) does not include language used in section 107(1) that limits the amount of the section 107(2) exclusion to the rental value of the residence; instead, section 107(2) requires that the amount excluded be a rental allowance paid as compensation to the minister and used by him or her to rent or provide a home.

#2 – “Part of compensation”

The IRS pointed out that section 107(2) refers to a rental allowance paid to a minister “as part of his compensation.” It insisted that this language demonstrated that Congress did not intend for churches to be able to designate all of a minister’s compensation as a housing allowance, as the church in this case had done for two of the three years under consideration. Once again, the court disagreed:

[The IRS’s] reading suggests that the “part of his compensation” language in section 107(2) requires that, to be excludable under section 107(2), any “part” of a minister’s compensation may be designated as a rental allowance so long as less than “all” is so designated. Under that interpretation, a taxpayer could qualify under section 107(2) if, for example, the amount designated as a rental allowance were $1.00 less than the minister’s total compensation. This reading is not specifically indicated by the legislative history or required by the regulations. It seems unlikely that such a tiny difference in amounts should control whether section 107(2) applies.

The “part of his compensation” language also appears in section 107(1). Thus, under [the IRS’s] reading, no exclusion would be available to a minister to whom a church provided a home but no other compensation because the home would be all of that minister’s compensation. We do not think Congress intended to require ministers living under those circumstances to pay tax on the value of their church-provided housing, and we do not believe the phrase “part of his compensation” in section 107(1) and section 107(2) has that effect. Instead, we give full meaning to the words of the statute when we read section 107(1) and section 107(2) to require simply that the source of the funds be the minister’s compensation.

The court concluded by noting that “where a statute plainly authorizes an exclusion from income, as here, we require unequivocal evidence of legislative purpose before construing the statute so as to override the plain meaning of the words used therein. Congress chose not to include the rental value limit in section 107(2). We do not read section 107(2) to provide otherwise.”

#3 – Unequal treatment

The IRS asserted that the annual rental value test prevents “unequal treatment” between ministers who live in a church-provided parsonage and those who receive a housing allowance with which they provide their own housing. Specifically, the IRS claimed that if ministers who own a home and receive a housing allowance could use the allowance to pay for housing expenses in excess of the annual rental value of their home, they would be in a “better” tax position than ministers who live in church-provided parsonages. The court rejected this argument on the basis of three considerations.

(1) No prior rulings. The court noted that it had never before ruled that ministers who provide their own home must never be treated more favorably than ministers living in a parsonage.

(2) The annual rental value test does not ensure equality. The court noted that the annual rental value test does not eliminate unequal treatment between ministers who live in a parsonage and those who provide their own home. In fact, in some cases, ministers who provide their own home will be treated less favorably than ministers who live in a church-provided parsonage. To illustrate, if the rental value of a minister’s home is more than his actual housing expenses, the nontaxable portion of his housing allowance is limited to actual expenses. Such a minister cannot treat the annual rental value as nontaxable. This minister is treated less favorably than ministers who live in a church-provided parsonage and who can exclude from taxable income the full annual rental value of the parsonage.

(3) Compliance burden. Finally, the court noted that if it retained the annual rental value test, then ministers who provide their own housing would face a “compliance burden” not imposed on ministers who live in a parsonage. Ministers who provide their own housing

could be required to obtain an estimate of the rental value of their home every year in order to know how much to exclude under section 107(2). This burden is not imposed on ministers for whom homes are provided, the rental value of which is excludable under section 107(1), because they may simply exclude the value of the home without any need to estimate the rental value. In the instant case, the parties stipulated the rental value for each year. However, the burden of obtaining valuation estimates could become onerous where rental value is in dispute. We decline to endorse this disparate treatment here by imposing potentially burdensome valuation obligations where neither the statute nor the legislative history so requires.

#4 – “Expensive” homes

The IRS suggested that without a rental value test, ministers would be free to acquire expensive homes and finance them through inflated housing allowances. In rejecting this argument, the court noted that “a more expensive home presumably would have a greater rental value which presumably would be excludable under [the IRS’s] approach.”

#5 – Other sources of income

The court acknowledged the IRS concern that a minister with additional income from another source could spend more for housing, and have a larger housing allowance exclusion. For example, assume that Pastor T is employed full-time as a public school teacher in addition to his duties as a part-time associate pastor at his church. For the year 2000, the church board agrees to pay him $10,000, all of which is designated as a housing allowance. Does this scenario discriminate against ministers who are employed full-time by their church and have no outside sources of income, and who are less able to apply their total church income to housing expenses? Perhaps. But the court concluded that “we are aware of no authority to justify our consideration of this point in construing section 107(2).”

The court acknowledged that the pastor’s substantial earnings from his tape and book ministry enabled him to spend more for housing. However, “the same financial flexibility would be available to a minister who has investment income or who is married to a spouse that earns a separate income …. Concern over those issues does not … justify our adding a fair rental value limit to sec. 107(2).”

The dissenting opinion

The court’s decision was endorsed by 14 Tax Court judges. Three judges dissented. Their reasoning is summarized below:

Extravagance

The dissenters began their opinion by noting that

the facts of this case present an archetypical example of the potential for abuse …. For the first 3 of its 4 fiscal periods here involved, the [church] designated 100 percent of [the pastor’s[ compensation as a housing allowance. Yet [the pastor], with other income (largely Schedule C income) near or in excess of $200,000 for each of the taxable years at issue, is nevertheless awarded an exclusion from tax of substantially all of [his] salary …. Moreover, with funds available from the above-mentioned alternative sources to cover living expenses otherwise necessary but unrelated to providing a home, [the pastor was] at liberty to, and did, spend nearly all compensation for the betterment of [his] residence …. I am satisfied that the rental allowance of section 107(2) was not intended to operate in this manner.

Of course, the simple answer to this concern is that it completely disregards the fact that the vast majority of pastors who will be helped by the court’s decision are not those with exorbitant incomes from outside sources, but rather lower to middle income pastors who pay a down payment in the year they acquire a home, who have to make emergency repairs to their home, or who decide to remodel. Consider the following examples.

• Example. Pastor C is paid a salary of $40,000 for year 2000. The church board designated $25,000 of this amount as a housing allowance. In February, Pastor C purchases a new home, and makes a down payment of $15,000. Assume that he has additional housing expenses of $7,000 for the year, and that the annual rental value of the home (furnished, including utilities) is $10,000. According to the dissenting opinion, Pastor C’s nontaxable housing allowance would be the least of the following three amounts: (1) the church-designated housing allowance ($25,000); (2) actual housing expenses ($22,000); or (3) the annual rental value of the home ($10,000). Since the annual rental value is the lowest amount, this is the amount of Pastor C’s housing allowance that is nontaxable. But why should this be so? Pastor C receives no substantial income from another vocation. Clearly, this scenario is far more common than the facts in the Tax Court’s case which the dissenting judges found to be so unfair. In their zeal to protect against rare cases of abuse, they defended a rule that would cause financial hardship and real “unfairness” to countless lower and middle income pastors. Fortunately, 14 of the Tax Court’s 17 judges rejected this result.

• Example. Pastor L’s roof collapses during a snowstorm during the Christmas season in 1999. Knowing that it would cost $5,000 to repair, and that he incurs about $10,000 of additional housing expenses per year, Pastor L has the church board designate $15,000 of his year 2000 salary of $40,000 as a housing allowance. Assume that the annual rental value of the home (furnished, including utilities) is $10,000. According to the dissenting opinion, Pastor L’s nontaxable housing allowance would be the least of the following three amounts: (1) the church-designated housing allowance ($15,000); (2) actual housing expenses ($15,000); or (3) the annual rental value of the home ($10,000). Since the annual rental value is the lowest amount, this is the amount of Pastor L’s housing allowance that is nontaxable. But why should this be so? Pastor L receives no substantial income from another vocation. Clearly, this scenario is far more common than the facts in the Tax Court’s case which the dissenting judges found to be so unfair. In their zeal to protect against rare cases of abuse, they defended a rule that would cause financial hardship and real “unfairness” to countless lower and middle income pastors. Fortunately, 14 of the Tax Court’s 17 judges rejected this result.

The dissenting judges’ reference to the court’s “open-handed generosity to the favored few” is clearly unjustified. A more apt description would be the dissenting judges’ attempt to salvage a rule that penalizes the vast majority of lower and middle income ministers.

The wording of section 107

The dissenting judges agreed with the IRS that the language of section 107, and its very title, supported the annual rental value test. The matter of the title (“Rental Value of Parsonages”) can be quickly addressed. The simple fact is that section 107(1) predated section 107(2) by several decades. Section 107(1), which provides that the rental value of a church-provided parsonage is nontaxable to a minister in computing federal income taxes, was appropriately entitled “Rental Value of Parsonages.” Unfortunately, this title was not changed when Congress added section 107(2), but this omission is of no consequence. It certainly does not provide support for the IRS’s annual rental value test.

The dissenting judges also noted that “the statute does not simply say that an allowance, or even a housing allowance or a residence allowance, used to provide a home may be excluded. Rather, the law states that gross income does not include a rental allowance so used. The majority’s interpretation effectively writes this term out of section 107(2).” Once again, the dissenting judges are misguided. Applying section 107(2) literally, as they apparently want to do, would not require recognition of the IRS-invented annual rental value limitation. Instead, it would limit the section 107(2) exclusion to ministers who use a church-designated housing allowance to rent a home. Ministers who own their home would receive no benefit. This result is so absurd that the dissenting judges did not embrace it. They opted instead for the view that the “rental” language in section 107 requires the nontaxable portion of a minister’s housing allowance to be limited to the annual rental value of the minister’s home. But as the court pointed out, there is no basis whatever in the text of section 107 to support such a view.

• Key point. Here’s a point that the dissenting judges completely ignored. Section 107(2) was enacted in 1954, and it was not until 1971 that the IRS “discovered” the annual rental value test. If the language (and title) of section 107 so clearly supports the annual rental value test, then why did it take the IRS 17 years to discover it?

Significance of the Case to Ministers and other Church Leaders

What is the relevance of the Tax Court’s ruling to other ministers and lay church leaders? Consider the following:

1. Significance of a “regular” Tax Court decision. The Tax Court’s opinion was a “regular” decision of the court. This means that it was a decision of the entire court. Such decisions serve as national precedents and may be relied on by taxpayers in all 50 states, unless reversed on appeal by either a federal appeals court or the United States Supreme Court. The IRS can appeal the Tax Court decision to the federal court of appeals for the ninth circuit, which has jurisdiction in the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. There are risks in doing so, however. The appeals court could reverse the Tax Court decision, which would eliminate the decision as a national precedent. On the other hand, the appeals court could affirm the decision, which would be a strong endorsement of the case and would leave the IRS with the option of appealing to the Supreme Court. It is very unlikely that the Supreme Court would hear such an appeal, which would make the appeals court’s decision final. The IRS could challenge the Tax Court decision in other states, and provoke appeals to other federal appeals courts.

• Key point. In our opinion, the federal appeals court would affirm the Tax Court’s decision if the IRS chooses to appeal. After all, it was a decision by 14 of the court’s 17 judges, which indicates overwhelming support for the pastor’s position. It is unusual for cases with such strong judicial support to be reversed by a federal appeals court. In the next issue of this newsletter we will let you know whether or not the IRS has appealed the case. If it does, we will be reporting all developments.

2. The status of the annual rental value test. For now, ministers can ignore the annual rental value test in computing the nontaxable amount of their housing allowance. The IRS is free to challenge ministers who ignore the annual rental value test, but ministers can rely on the Tax Court’s decision, which not only provides strong judicial support for their position but also protects them from penalties. If the IRS appeals the case, and the federal appeals court for the ninth circuit affirms the Tax Court’s decision, then the IRS cannot challenge ministers who ignore the annual rental value test in the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. Such a ruling would add even greater weight to the Tax Court’s decision, making it more likely that appeals courts in other federal circuits would reach the same conclusion.

3. The IRS audit guide for ministers. The IRS issued audit guidelines in 1995 for its agents to follow when auditing ministers. The audit guidelines assist IRS agents in the examination of ministers’ tax returns. They alert agents to the key questions to ask, and provide background information along with the IRS position on a number of issues. The guidelines provide agents with the following information regarding housing allowances:

Code section 107 provides an exclusion from gross income for a “parsonage allowance,” housing specifically provided to a minister of the gospel. This includes the rental value of a home furnished to him or her as part of compensation or a rental allowance, to the extent that the payment is used to rent or provide a home. The term “parsonage allowance” includes church provided parsonages, rental allowance with which the minister may rent a home and housing allowances with which the minister may purchase a home. A minister can receive a parsonage allowance for only one home ….

The amount of the parsonage allowance excludible from gross income is the least of (1) The amount actually used to provide a home, (2) the amount officially designated as a housing allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.

The IRS audit guidelines contain the following example:

• Example. B, an ordained minister, is vice president of academic affairs at Holy Bible Seminary. His compensation package includes a salary of $80,000 per year and a $30,000 housing allowance. His housing costs for the year included mortgage payments of $15,000, utilities of $3,000, and $3,600 for home maintenance and new furniture. The fair rental value of the home, as furnished, is $18,000 per year. The three amounts for comparison are: (a) Actual expenses of $21,600 ($15,000 mortgage payments + $3,000 utilities + $3,600 other costs); (b) designated housing allowance of $30,000; (c) fair rental value plus utilities of $21,000 ($18,000 + $3,000 utilities). B may exclude $21,000 from gross income but must include in income the other $9,000 of the housing allowance. The entire $30,000 will be considered in arriving at net self-employment income.

The IRS audit guidelines for ministers apply the annual rental value limit that was invalidated by the Tax Court in its recent decision. The IRS may choose to retain the rental value limit in the audit guidelines, which will mean that IRS agents will continue to apply it when auditing ministers. But, as noted above:

(1) Ministers who ignore the annual rental value test can rely on the Tax Court’s decision in support of their position if audited. Such ministers can immediately appeal the IRS position to the Tax Court, which of course will rule in favor of the minister on the basis of its recent decision. This will force the IRS to appeal to a federal appeals court.

(2) If a federal appeals court agrees with the Tax Court, then this eliminates any further IRS application of the annual rental value test in the states comprising that “circuit.” This assumes that the Supreme Court declines to accept an appeal of the case.

4. The “other” rental value test not affected. Section 107(1) of the tax code specifies that “in the case of a minister of the gospel, gross income does not include … the rental value of a home furnished to him as part of his compensation.” However, since this exclusion only applies to the computation of income taxes, ministers who live in a church-provided parsonage must include the annual rental value of the parsonage when computing their self-employment taxes (unless they have exempted themselves from such taxes).

• Example. Pastor E lives in a church-provided parsonage. For the year 2000, she receives a salary of $40,000. The annual rental value of the parsonage is $10,000. In computing her income taxes, Pastor E reports only $40,000 as church compensation. She does not include the annual rental value of the parsonage. However, in computing her self-employment taxes, Pastor E must include both her salary ($40,000) and the annual rental value of the parsonage ($10,000). This rule is not affected by the Tax Court’s decision.

5. How much of a minister’s compensation can be designated as housing allowance? The church in this case designated all of the pastor’s compensation as a housing allowance for two of the three years under consideration. The IRS insisted that section 107 prohibited designation of all of a minister’s compensation as a housing allowance. It relied on the language of section 107, which refers to a rental allowance paid to a minister “as part of his compensation.” It insisted that this language demonstrated that Congress did not intend for churches to be able to designate all of a minister’s compensation as a housing allowance, as the church in this case had done for two of the three years under consideration. The Tax Court rejected this argument:

[The IRS’s] reading suggests that the “part of his compensation” language in section 107(2) requires that, to be excludable under section 107(2), any “part” of a minister’s compensation may be designated as a rental allowance so long as less than “all” is so designated. Under that interpretation, a taxpayer could qualify under section 107(2) if, for example, the amount designated as a rental allowance were $1.00 less than the minister’s total compensation. This reading is not specifically indicated by the legislative history or required by the regulations. It seems unlikely that such a tiny difference in amounts should control whether section 107(2) applies.

There are many ministers who have most or all of their compensation designated as a housing allowance. Common examples would be bivocational pastors, pastors of small congregations or “missions” churches, and part-time associate pastors. Contrary to the position of the IRS and the dissenting judges, it is not “abusive” for churches to designate most or all of the income paid to these pastors as a housing allowance. The Tax Court’s decision will serve as strong legal support for the legitimacy of such housing allowances.

6. Retired ministers. Many denominational pension plans designate all of the pension distributions of retired pastors as a housing allowance. It should be noted that the Tax Court’s decision is strong legal support for such a practice. Had the Tax Court embraced the IRS position, denominational pension boards would have had to reassess the continuation of this practice.

7. Impact on church boards. In most churches, the church board designates housing allowances. In some churches, a “compensation committee” or the congregation itself designates housing allowances. In any case, church leaders should recognize the impact of the Tax Court’s ruling on the process of designating housing allowances. Most importantly, the case will permit churches to designate larger housing allowances than were permissible in the past.

• Example. A church board is considering the year 2001 compensation package for Pastor B. It decides on total compensation of $30,000. Pastor B informs the board that he will have ordinary housing expenses of $10,000, but that he also will be incurring remodeling expenses of an additional $10,000. The board is uncomfortable designating two-thirds of Pastor B’s total compensation as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate two-thirds of the pastor’s compensation as a housing allowance.

• Example. Pastor H is a part-time associate pastor at his church. The church board plans to pay him $10,000 for 2001. Pastor H asks the board to designate 100 percent of this amount as a housing allowance. The church treasurer is uncomfortable designating the entire amount as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor H’s compensation as a housing allowance.

• Example. A church board is considering the year 2001 compensation package for Pastor N. It decides on total compensation of $60,000. Pastor N asks the board to designate this entire amount as a housing allowance. He informs the board that he will have ordinary housing expenses of $15,000, but that he also will be purchasing a new home in 2001 and plans on making a large down payment (with the sale proceeds from his prior residence) of $45,000. Pastor N’s spouse is employed as a college professor, and the couple plans on using her salary for living expenses in 2001. The church board is uncomfortable designating the entire salary as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor N’s compensation as a housing allowance.

8. Social security. Ministers should recognize that a housing allowance is nontaxable only in computing federal income taxes. Housing allowances are included in a pastor’s income in computing the self-employment (social security) tax. The same is true for the annual rental value of a church-provided parsonage.

9. Examples. The tax effect of the Tax Court’s decision is summarized in the following table.

ABCDEFG
casesalarychurch designated housing allowanceactual housing expensesannual rental value of home (furnished, including utilities)non-
taxable housing allowance
the IRS position (lowest of columns C,D, and E)		non-
taxable housing allowance
applying the Tax Court’s decision (lower of columns C or D)
1$25,000$10,000$12,000$15,000$10,000$10,000
2$50,000$25,000$25,000$15,000$15,000$25,000
3$40,000$10,000$25,000$15,000$10,000$10,000
4$60,000$60,000$60,000$20,000$20,000$60,000
5$10,000$10,000$10,000$12,000$10,000$10,000
6$30,000$0$12,000$15,000$0$0
7$40,000$20,000$10,000$12,000$10,000$10,000
8$40,000$20,000$12,000$10,000$10,000$12,000
9$75,000$40,000$35,000$20,000$20,000$35,000
10$40,000$15,000$5,000$10,000$5,000$5,000

© Copyright 2000 by Church Law & Tax Report. 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, PO Box 1098, Matthews, NC 28106. Reference Code: m96 m27 c0400
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Hang Up and Drive!

The use of cell phones by church staff (Part 1).

Richard R. Hammar, Attorney, CPA
Bio

Background. Over the past few years several churches have provided their senior pastor with a cell phone. Many of these churches provide cell phones to other staff members as well. There is no doubt that such phones are a tremendous convenience, and make a pastor accessible in the event of emergencies. But few pastors, or church treasurers, have a clear understanding of the tax implications associated with the use of these phones. Consider the following:
  • The tax code treats cell phones as “listed property,” meaning that expenses associated with the use of such phones cannot be deducted by an employee or reimbursed by an employer under an accountable arrangement unless they are provided for the “convenience of the employer,” they are a “condition of employment,” and strict substantiation requirements are met.
  • Who keeps the cell phone when the employee no longer works for the church?
  • What is the effect of church-provided cell phones on the reporting status (employee or self-employed) of church staff?
  • What safety concerns are associated with the use of cell phones?
  • What, if any, impact do cell phones have on the clergy-penitent privilege?
  • What rules apply to the use of cell phones by self-employed church workers?

This article will address the first issue—the implications of cell phones being “listed property” under the tax code. The next issue of Church Treasurer Alert will complete the analysis of the first issue, and then address the other issues.

“Listed property”

Section 280F of the tax code imposes stricter substantiation requirements on the business use of certain kinds of property. The code refers to these kinds of property as “listed property,” and for many years the list has included automobiles and personal computers. In 1989, Congress added cell phones to the list. A committee report to the 1989 law states:

The bill expands the definition of listed property to include cellular telephones and other similar telecommunications equipment. Thus, if … an individual buys or leases a cellular telephone or other similar telecommunications equipment that is used by the individual in connection with the performance of services as an employee, no deduction for any business use is allowed unless the business use of the equipment is for the convenience of the employer and required as a condition of employment. Finally, no deduction is allowed with respect to such equipment unless the taxpayer either maintains adequate records or provides other sufficient evidence that establishes the amount of business use, investment use, and personal use of the equipment.

This language identifies three important conditions that must be met in order to treat an employee’s use of a cell phone as a business expense:

(1) the employee’s use of the phone is for the convenience of the employer

(2) the employee’s use of the phone is required as a condition of employment, and

(3) the employee adequately substantiates the business use of the phone

These conditions apply not only to the deductibility of an employee’s use of a cell phone in the course of his or her business, but also to the reimbursement of the cost of such phones by employers under an accountable business expense reimbursement arrangement. As a result, it is very important for church treasurers to be familiar with these rules.


Key point. Church treasurers should be familiar with the following tax consequences of failing any one or more of the three conditions that apply to the use of a cell phone by an employee: (1) the employee cannot claim an employee business expense for any portion of the cost of using the cell phone that he or she pays (i.e., the cost of the cell phone is an unreimbursed expense); (2) the church cannot reimburse any portion of the cost of the cell phone under an accountable business expense reimbursement arrangement; (3) any expenses associated with the cost and use of the cell phone paid by the church must be treated as “nonaccountable” reimbursements, meaning that they must be reported as taxable compensation to the employee (and included on his or her W-2 form); and (4) in the case of nonminister employees the church must withhold income taxes and FICA taxes from the amount of its reimbursements of cell phone expenses.

Let’s look at each of the three conditions that must be met in order to treat cell phone expenses as a business expense.

#1—Convenience of the employer

When is a cell phone used for the convenience of one’s employer? The income tax regulations note:

In order to satisfy the “condition of employment” requirement, the use of the property must be required in order for the employee to perform the duties of his or her employment properly. Whether the use of the property is so required depends on all the facts and circumstances. Thus, the employer need not explicitly require the employee to use the property. Similarly, a mere statement by the employer that the use of the property is a condition of employment is not sufficient.

The regulations also clarify that the term “convenience of the employer” generally has the same meaning as it does under section 119 of the code, which excludes from taxable income meals or lodging “furnished for the convenience of an employer.” Section 119 provides that meals furnished by an employer without charge to the employee will be regarded as furnished for the convenience of the employer if the meals are furnished for a substantial “noncompensatory business reason” of the employer. If an employer furnishes meals as a means of providing additional compensation to an employee, the meals so furnished will not be regarded as furnished for the convenience of the employer. On the other hand, if the employer furnishes meals to an employee for a substantial noncompensatory business reason, the meals will be regarded as furnished for the convenience of the employer. The income tax regulations list a number of examples of meals that are provided to employees for “substantial noncompensatory business reasons,” including the following two:

(1) The “emergency” rule. Meals furnished to employees during working hours in order to have them available for emergency calls during their meal period are one example of a substantial noncompensatory business reason. To satisfy this test, the regulations caution that “it must be shown that emergencies have actually occurred, or can reasonably be expected to occur, in the employer’s business which have resulted, or will result, in the employer calling on the employee to perform his job during his meal period.”

(2) The “no adequate facilities available” rule. Another example of a substantial noncompensatory business reason are meals furnished to employees during working hours because they could not otherwise secure meals within a reasonable meal period. For example, meals may qualify under this rule when there are insufficient eating facilities in the vicinity of the employer’s premises.


Key point. In summary, for a cell phone to satisfy the “convenience of the employer” requirement, it must meet two requirements: (1) It must be required in order to the employee to properly perform his or her job; and (2) it must be provided for a substantial noncompensatory business reason, such as the immediate accessibility of the employee in the event of an emergency, or the inadequacy of the employee’s office telephone.

Let’s apply the “convenience of the employer” rule to the use of cell phones by church employees.


Example 1. Pastor B is the senior pastor of his church. His church provides Pastor B with a telephone in his church office, and it also provides him with a cell phone. There is little doubt that the cell phone is for the convenience of Pastor B’s employer since it is needed for him to properly perform his job and it is provided to him for substantial noncompensatory business reasons. In particular, it meets the “emergency rule” since the cell phone makes Pastor B accessible in the event of an emergency (such as the sudden death or hospitalization of a church member) during those frequent times when he is not in his church office, and, it meets the “no adequate facilities available” rule since the telephone provided by the church in Pastor B’s office is not an adequate means of reaching him when he is not in his office.


Example 2. A church provides its bookkeeper with a cell phone. The bookkeeper rarely leaves her office for business purposes and the church provides her with a telephone in her church office. The cell phone is not for the convenience of the employer since it is not necessary in order for her to properly perform her job and there is no substantial noncompensatory business reason for her to have it. The “emergency rule” probably cannot be met, since it is unlikely that emergencies will occur that would require the bookkeeper to be contacted immediately on a cell phone. This is so for two reasons. First, it is rare for emergencies to occur that will require the immediate assistance of a bookkeeper, and second, since she rarely leaves her office during business hours, the telephone the church provides in her office is sufficient. As a result, providing the cell phone to the bookkeeper does not have a substantial noncompensatory business purpose and so it is not for the convenience of the employer. Church treasurers should be familiar with the following tax consequences of failing the “convenience of the employer” test: (1) the employee cannot claim an employee business expense for any portion of the cost of using the cell phone that she pays (i.e., the cost of the cell phone is an unreimbursed expense); (2) the church cannot reimburse any portion of the cost of the cell phone under an accountable business expense reimbursement arrangement; (3) any expenses associated with the cost and use of the cell phone paid by the church must be treated as “nonaccountable” reimbursements, meaning that they must be reported as taxable compensation to the employee (and included on her W-2 form); and (4) in the case of nonminister employees the church must withhold income taxes and FICA taxes from the amount of its reimbursements of cell phone expenses.


Example 3. A church provides its office secretary with a cell phone. The secretary rarely leaves her office for business purposes and the church provides her with a telephone in her church office. The analysis in example 2 would apply to this example.


Example 4. A church provides its custodian with a cell phone so that he can be reached wherever he is on church premises. The cell phone may or may not be for the convenience of the employer, depending on the circumstances. In particular, consider the following: (1) How easy is it for the church to locate the custodian while he is on church premises? This task generally is much easier in smaller churches. On the other hand, many larger churches have an intercom system or other communications device that makes it easy to locate a custodian. The easier it is to locate the custodian, the less likely the cell phone will be for the convenience of the employer. (2) How often does the custodian have to be away from church property in the performance of his duties? The less often he is away from church premises in the performance of his job, the less likely a cell phone will be for the convenience of the employer. (3) If the custodian occasionally has to be away from church premises to perform his job, how often and for how long is he away? If he is away from church property infrequently in the performance of his duties, it is unlikely a cell phone will be for the convenience of the employer. (4) Have there ever been any emergencies at the church requiring immediate communication with the custodian? Can such emergencies reasonably be foreseen? If not, it will be difficult to prove that the cell phone was provided for a substantial noncompensatory business purpose, or that it is required in order for the custodian to reasonably perform his duties. (5) Why aren’t the telephones available at church adequate for the custodian to perform his job? If the cell phone does not meet the “convenience of the employer” test, the tax consequences summarized in example 2 will apply.


Example 5. A church provides its music director with a cell phone. She is not a credentialed minister. The cell phone may or may not be for the convenience of the employer, depending on the circumstances. In reaching a decision, it will be helpful to apply the five questions noted in example 4. If the cell phone does not meet the “convenience of the employer” test, the tax consequences summarized in example 2 will apply.


Example 6. A church provides its business administrator with a cell phone. He is not a credentialed minister. The cell phones may or may not be for the convenience of the employer, depending on the circumstances. In reaching a decision, it will be helpful to apply the five questions noted in example 4. If the cell phone does not meet the “convenience of the employer” test, the tax consequences summarized in example 2 will apply.

#2—Condition of employment

The second condition that must be met in order to treat an employee’s use of a cell phone as a business expense is that use of the cell phone is required as a “condition of employment.” This condition is very similar to the “convenience of the employer” requirement. In fact, the Tax Court has ruled that they are basically the same test. U.S. Junior Chamber of Commerce v. Commissioner, 334 F.2d 660 (Ct. Cl. 1964). At a minimum, the “condition of employment” requirement means that a cell phone is necessary in order for a church employee to perform his or her job. Once again, it is not necessary that a church explicitly requires an employee to use a cell phone. On the other hand, it is not enough that a church merely states that an employee’s use of a cell phone is a condition of employment.

If a cell phone does not meet the “condition of employment” test, the tax consequences summarized in example 2 will apply.


Tip. The income tax regulations state that an employer need not “explicitly require” the employee to use a cell phone in order to meet the “convenience of the employer” test, and that “a mere statement by the employer that the use of the property is a condition of employment is not sufficient.” However, a resolution of the church board to the effect that a cell phone is being provided to certain employees in order to enable them to properly perform the requirements of their job would increase the likelihood that the IRS would consider a cell phone to be for the employer’s convenience. We recommend this practice.

This article will be continued in the next issue of Church Treasurer Alert.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Hiring Workers Without Social Security Numbers

Helpful guidance for church treasurers.

Richard R. Hammar, Attorney, CPA
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Church Finance Today

Hiring Workers Without Social Security Numbers

Helpful guidance for church treasurers.

Richard R. Hammar

Background. Occasionally, persons applying for a position at a church will disclose that they do not have a social security number. They insist that this is perfectly legal, and may even insinuate that it would be “unlawful” not to hire them on this basis. Is this true? Not according to a recent federal appeals court ruling. An applicant for employment was not hired by a secular employer because he did not have a social security number. The applicant sued the employer, claiming that his decision not to have a social security number was based on his religious belief that such numbers represent the “mark of the beast” in the Book of Revelation, and therefore the employer’s decision not to hire him amounted to unlawful religious discrimination.

The court’s ruling. The court concluded that an employer that hires an employee without a social security number is in “violation of federal law,” since section 6109 of the tax code requires that employers list employees’ social security numbers on W-2 forms. An employer’s duty to accommodate an employee’s religious beliefs does not require that it violate the law, the court concluded.

The court acknowledged that the tax code specifies that no penalty is imposed on an employer for failing to report an employee’s social security number on a W-2 form if it is able to demonstrate that “such failure is due to reasonable cause and not to willful neglect.” However, the court concluded that “even if a waiver could be obtained, we think that the expense and trouble incident to applying for it imposes a hardship” and that the waiver provision “does not exist to benefit employees who caused the penalties to be imposed.”

The court also rejected the applicant’s argument that the employer could have accommodated his religious beliefs by hiring him as an independent contractor.

Relevance to church treasurers. According to this case, churches are free to deny employment to persons who do not have a social security number. This is so for 2 reasons: First, churches are free to discriminate on the basis of religion in their employment decisions under federal law and the laws of most states. As a result, they generally cannot be sued for “religious discrimination” in their employment decisions. Second, as this case demonstrates, employers are legally required to report employees’ social security numbers on W-2 forms, and they need not ignore this mandate (or seek a waiver of it) because of the religious beliefs of an employee or an applicant for employment. This case is binding in the eighth federal circuit, which includes the states of Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota. It amounts to a persuasive, but nonbinding, precedent in other states. Seaworth v. Pearson, 2000-1 USTC ¶ 50,244 (8th Cir. 2000).

This article originally appeared in Church Treasurer Alert, July 2000.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Tax Court Denies Deduction for Gifts to a Church

Substantiation requirements not followed.

Richard R. Hammar, Attorney, CPA
Bio

Jacobson v. Commissioner, T.C. Memo. 1999-401 (1999)

A taxpayer claimed a deduction of $950,000 for contributions of several items of property he made to a church. The donated items included historical books and paintings. The taxpayer completed a Form 8283 on which he listed the donated items and his estimate of their market value, but he did not obtain an appraisal for any of the items. The IRS audited the taxpayer, and allowed a charitable contribution deduction of only $12,900.

On appeal, the Tax Court agreed with the IRS. It noted that the taxpayer failed to obtain a qualified appraisal of the donated items within the time limits specified by law. In general, persons who donate property valued at more than $5,000 must obtain a qualified appraisal no later than the date they file the tax return on which the contribution deduction is claimed. The taxpayer retained an appraiser only after his tax return was audited. Further, the court noted that the appraiser’s valuations were not credible, since “he gave no persuasive explanation of his methodology, made no reference to comparable sales or a valuation rationale, and made no reference to any experience he had that would support the values at which he arrived. Without any reasoned analysis, his report is useless. His opinions are so exaggerated that his testimony is not credible.”

The court also pointed out that the appraiser’s valuation was not supported by the donor’s actions: “The contributed property was stored in boxes on pallets for many years in a bakery warehouse that only had limited security. The warehouse had a rodent problem and was described as being extremely hot during the summer. The contributed property was not insured, nor was any special precaution taken to preclude loss due to deterioration, theft, or fire.” Such behavior, the court concluded, “renders implausible his claim that the property had substantial value,” since “if the contributed property had a value of $950,000 or anything approaching that value … [the donor] would have treated it with more care.”


Tip. Do not assume that donors are familiar with the substantiation rules that apply to gifts of noncash property. Church treasurers should obtain several copies of Form 8283 each January to give to persons who donate noncash property to the church during the year. You can order multiple copies of Form 8283 by calling the IRS forms hotline at 1-800-TAX-FORM.


Tip. Consider contacting donors of noncash property by the end of the year to be sure that they have obtained a qualified appraisal—if you believe they claimed a charitable contribution deduction of more than $5,000.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Insuring Church-Owned Vehicles

A court addresses an important issue.

Richard R. Hammar, Attorney, CPA
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Church Finance Today

Insuring Church-Owned Vehicles

A court addresses an important issue.

Richard R. Hammar

Stephens v. Conyers Apostolic Church, 2000 WL 306767 (Ga. App. 2000)

Background. Are church-owned vehicles automatically covered under a church’s liability insurance policy? Many church leaders assume that the answer to this question is “yes.” A recent case demonstrates that this may be a dangerous assumption that may expose a church to a potentially substantial uninsured loss.

A recent case. For a number of years a church owned a van that was insured under the church’s insurance policy, which carried a $500,000 liability limit. The church board authorized the pastor to purchase a new van to be titled in the name of the church. This van was to replace the pastor’s personal vehicle. The pastor informed his insurance agent that the new van was a replacement for his personal vehicle. However, the pastor instructed his insurance agent to insure the van under his personal auto insurance policy rather than the church’s policy. The pastor’s personal policy carried a liability limit of $50,000. The church’s policy never listed the van as an insured vehicle.

A woman (the “victim”) was injured when her car was struck by the van while it was being driven by the pastor’s wife. The victim sued the church and the pastor’s wife, and a jury awarded her $425,000 in damages. She attempted to collect on the church’s $500,000 insurance policy, but the church objected on the ground that the van was not covered under the policy. The church claimed that the pastor’s $50,000 insurance policy was the only amount of insurance coverage that applied.

A trial court agreed with the pastor on the basis of the following three conclusions:

(1) the pastor had an “insurable interest” in the van, even though title was placed in the church’s name, and so it was permissible for him to insure the van under his personal auto policy

(2) the pastor instructed his insurance agent to insure the vehicle under his personal auto policy

(3) the church failed to notify the church insurance company to add the van to the church’s policy

The victim appealed, and a state appeals court affirmed the trial court’s ruling in favor of the church. The court concluded that “no legal interest in the insured vehicle as property is necessary to support an insurable interest regarding liability insurance. As the church agent with primary custody of the vehicle [the pastor] had a sufficient insurable interest in the vehicle through his potential legal liability to authorize his decision to insure the vehicle under his personal liability policy, notwithstanding his lack of ownership.”

The court also agreed with the trial court’s conclusion that the pastor “did not properly or timely notify the agent to change the church’s insurance to extend coverage to the van.”

On appeal, the victim claimed that the trial court erred in failing to find coverage under the church policy because the new van clearly fit within the policy’s definition of a “newly acquired vehicle.” The court disagreed, noting that “in order for this policy provision to apply, the insurer must be notified within 30 days of delivery to the insured of the newly acquired vehicle. The evidence is undisputed that the insurer did not know that the church was the title holder of the van until this accident, which occurred almost two months after delivery. Consequently, the circumstances show the failure of one of the contractual criteria. The trial court correctly concluded the church policy did not afford coverage of its own force.”

Relevance to church treasurers. What is the relevance of this ruling? Most importantly, it demonstrates that vehicles may not be covered under a church’s liability insurance policy even if titled in the name of the church, if the church fails to notify the insurance company of the new vehicle in the manner prescribed by the insurance policy.

The lesson is clear—prior to purchasing or leasing any vehicle, church leaders should review the church insurance policy to be sure that all preconditions to insurance coverage will be satisfied as of the time that title is acquired. This is a very simple but important procedure. A failure to comply with the policy’s requirements may expose the church to an uninsured loss as a result of an accident involving a church-owned vehicle. If in doubt regarding coverage, church leaders should speak with the church insurance agent or company.

This case also demonstrates that church leaders should not assume that new vehicles are automatically insured because the church’s insurance policy contains a “newly acquired vehicle” provision. In some cases, such a provision is triggered only after the church provides proper notice, which the church failed to do in this case.

This article originally appeared in Church Treasurer Alert, June 2000.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
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Substantiation of Charitable Contributions

Insufficient substantiation can lead to a denial of charitable deductions.

Richard R. Hammar, Attorney, CPA
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Background. The IRS ruled that a corporation could not deduct a contribution it made to a charity since it failed to properly substantiate the contribution. A corporation made a sizeable contribution to a charity for the care of the needy. The charity issued the corporation a receipt acknowledging the contribution and indicating that the charity did not provide any goods or services in return for the contribution. The IRS ruled that the corporation was not entitled to a charitable contribution deduction for three reasons.

(1) A timely receipt. The income tax regulations require that a charity’s written acknowledgment of a contribution be furnished on or before the earlier of the date on which the taxpayer files a return for the taxable year in which the contribution was made or the due date for filing such return. The IRS concluded that this requirement was not met.

(2) The charity’s written acknowledgment. Second, the IRS concluded that the charity’s written acknowledgment did not comply with the substantiation requirements for contributions valued at $250 or more since it did not indicate whether the charity provided any goods or services in return for the contributed property.

(3) Form 8283.
(3) Form 8283. Since the corporation donated property that it valued at more than $5,000, it was required by the income tax regulations to obtain a qualified appraisal of the property and enclose a “summary” of the appraisal (on IRS Form 8283) with the tax return on which the contribution deduction was claimed. A Form 8283 was not enclosed with the corporation’s tax return. When asked by an IRS agent about the missing Form 8283, the corporation furnished the missing form, but the IRS concluded that this was too late since the form did not accompany the corporation’s tax return.

Relevance to church treasurers. This case demonstrates the importance of church treasurers being familiar with the substantiation requirements that apply to charitable contributions. While the responsibility for complying with these rules is on donors, the fact remains that many donors (and their advisors) are not familiar with these rules. Church treasurers can play a vital role in helping donors comply with these rules by being familiar with them. This case suggests the following specific actions that church treasurers can take: (1) Issuing receipts soon after the close of a calendar year. (2) Advising donors (in church newsletters, bulletins, or letters) not to file their tax returns until they have received their receipt from the church. (3) Confirm that receipts issued to donors comply with the requirements of the income tax regulations. (4) Have several current copies of Form 8283 (with instructions) on hand, and give a copy to each donor who contributes noncash property to the church. Note that donors who contribute publicly traded stock are not required to complete Form 8283. IRS Letter Ruling 200003005.


Resource. All of the requirements for substantiating charitable contributions are addressed fully in chapter 8 of Richard Hammar’s annual Church and Clergy Tax Guide. Church treasurers should be familiar with the information in this chapter.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Revoking an Exemption from Social Security

Church Law and Tax 2000-05-01 Revoking an Exemption from Social Security Richard R. Hammar, J.D.,

Richard R. Hammar, Attorney, CPA
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Church Law and Tax 2000-05-01

Revoking an Exemption from Social Security

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

We have noted in previous issues of this newsletter that ministers who opted out of social security have been given a limited opportunity to revoke their exemption. The IRS announced recently that ministers will use Form 2031 to revoke an exemption, and that the new form would be available in April of 2000. Ministers wanting to revoke an exemption from social security can obtain a copy of Form 2031 by calling the IRS toll-free forms hotline at 1-800-TAX-FORM, or by downloading a copy from the IRS website (www.irs.gov).

Remember that ministers who have opted out of social security will have until April 15, 2002 to revoke their exemption. Ministers who revoke their exemption will have to elect, on Form 2031, to begin coverage as of either January 1, 2000 or January 1, 2001. In order to minimize or avoid paying “back taxes,” ministers wanting to revoke an exemption should file the revocation form as follows:

As soon as the form is issued by the IRS, and elect to begin coverage as of January 1, 2000. The form must be accompanied by a check in the amount of estimated self-employment taxes for previous quarters of year 2000. For example, if the Form 2031 is filed on May 1, 2000, a minister would need to enclose a check in the amount of the first quarter of estimated self-employment taxes for 2000 (due on April 15). If the Form 2031 is filed on June 30, 2000, a minister would need to enclose a check in the amount of the first two quarters of estimated self-employment taxes for 2000 (due on April 15 and June 15). These examples illustrate that ministers who want to begin social security coverage as of January 1, 2000 will need to file the Form 2031 as soon as possible in year 2000 in order to avoid a large liability for back taxes.

• Key point. Some ministers who are nearing retirement will want to elect to begin coverage on January 1, 2000 in order to accumulate four quarters of coverage for the year. In general, it takes forty quarters of coverage to be “permanently insured” for social security and Medicare benefits.

At anytime in the year 2000, and elect to begin coverage on January 1, 2001. This will avoid any liability for back taxes. Ministers will pay self-employment taxes along with their quarterly installments of estimated income taxes on April 15, June 15, and September 15 of year 2001, and January 15 of 2002.

For more information, see the feature article entitled “Revoking an Exemption from Social Security” in the July-August 1999 issue of this newsletter.

© Copyright 2000 by Church Law & Tax Report. 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, PO Box 1098, Matthews, NC 28106. Reference Code: m68 c0300
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

The Annual Earnings Test Is Repealed. Workers 65 to 70 Years of Age Are Affected.

As this newsletter was going to press, President Clinton signed into law a bill that

Richard R. Hammar, Attorney, CPA
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As this newsletter was going to press, President Clinton signed into law a bill that repeals the “annual earnings test” for workers who are 65 to 70 years of age. The repeal is retroactive to January 1, 2000. As a result of this repeal, persons who are 65 to 70 years of age, and who continue to work, will not have their social security benefits reduced by earning income over a specified amount. Prior to the repeal, workers who were between 65 and 70 years of age, and who were receiving social security benefits, could earn up to $17,000 (for year 2000) without any reduction in their social security benefits. However, for every $3 of earned income over this amount, a worker’s social security benefits were reduced by $1.

The annual earnings test for workers who elect to begin receiving social security benefits at ages 62 to 65 is not affected. For every $2 of earned income over $10,060 their social security benefits are reduced by $1 (in year 2000). Workers can earn any amount beginning at age 70 without a reduction in social security benefits.

• Example. Pastor T is a retired minister who is hired by a church as its minister of visitation. Pastor T is 66 years old and is receiving social security benefits. The church pays him $26,000 of taxable compensation for year 2000. If Congress had not repealed the annual earnings test, Pastor T’s social security benefits would have been reduced by $1 for every $3 of earned income over $17,000. Since Pastor T has earned income of $9,000 in excess of $17,000, his social security benefits would have been reduced by $3,000. However, because the annual earnings test has been repealed, Pastor T’s social security benefits are not affected. His benefits are not reduced by $3,000. The repeal of the earnings test means that Pastor T will have an additional $3,000 of income in 2000.

• Example. Same facts, except that Pastor T is 63 years old. There are no plans to repeal the annual earnings test for workers who are age 62 to 65. Therefore, Pastor T’s social security benefits will be reduced by $1 for every $2 of earned income over $10,060. Since Pastor T has earned income of $15,940 in excess of $10,060, his social security benefits would be reduced by a whopping $7,970.

© Copyright 2000 by Church Law & Tax Report. 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, PO Box 1098, Matthews, NC 28106. Reference Code: m68 c0300
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Two men having lunch, one who looks pensive.
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Reimbursing Lunch Expenses

Churches should refer to an important Tax Court decision when reimbursing lunch expenses.

Richard R. Hammar, Attorney, CPA
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There’s a right way churches should go about reimbursing lunch expenses.

In many churches, ministerial lunches are a weekly ritual. Since church matters are discussed, many church treasurers assume that the cost of the lunch can be reimbursed by the church under an accountable arrangement.

As a result, the cost of such lunches is not added to the employees’ taxable compensation for tax reporting purposes.

But is this the correct way to handle lunch expenses? If your church has an accountable reimbursement arrangement, can you reimburse lunch expenses? If so, under what circumstances? Always? Whenever church matters are discussed?

A Tax Court decision addresses this important question.

In Dugan v. Commissioner (T.C. Memo. 1998-373), a medical technician and a physician shared office space.

The two often met at lunchtime to discuss the treatment of their patients and the details of office administration and operations.

The two met at other times as well, but they found that lunchtime was often the best opportunity to meet. They alternated paying for their meals together.

On her federal income tax return, the technician deducted her share of these meal expenses (subject to the 50% reduction that applies to unreimbursed meal expenses).

The IRS disallowed any deduction for the meals on the ground that they were not a legitimate business expense. The technician appealed to the Tax Court.

Were the technician’s lunch expenses deductible?

After all, she discussed both treatment procedures and office operations during these lunches. Unfortunately, the court agreed with the IRS that the expenses were not deductible.

The court began its opinion by noting that “daily meals are an inherently personal expense, and a taxpayer bears a heavy burden in proving they are deductible” as a business expense.

Attorneys’ lunches

The court referred to a previous ruling involving attorneys.

Members of a law firm met every work day at a local restaurant to discuss work-related matters because the lawyers were all litigators and the court was not in session over the noon hour.

A federal appeals court conceded the business purpose for these lunch meetings, and that lawyers “did not dawdle over their lunch,” but it concluded that the meals represented nondeductible personal expenses rather than business expenses.

It observed:

[I]t is undeniable that eating together fosters camaraderie and makes business dealings friendlier and easier. It thus reduces the costs of transacting business, for these costs include the frictions and the failures of communication that are produced by suspicion and mutual misunderstanding, by differences in tastes and manners, and by lack of rapport. A meeting with a client or customer in an office is therefore not a perfect substitute for a lunch with him in a restaurant. But it is different when all the participants in the meal are coworkers, as essentially was the case here …. They know each other well already; they don’t need the social lubrication that a meal with an outsider provides–at least don’t need it daily. If a large firm had a monthly lunch to allow partners to get to know associates, the expense of the meal might well be necessary, and would be allowed by the Internal Revenue Service. But [the law firm in this case] never had more than eight lawyers and did not need a daily lunch to cement relationships among them ….

We may assume it was necessary for the [attorneys] to meet daily to coordinate the work of the firm, and also … that lunch was the most convenient time. But it does not follow that the expense of the lunch was a necessary business expense. The members of the firm had to eat somewhere … Although it saved time to combine lunch with work, the meal itself was not an organic part of the meeting …. Moss v. Commissioner, 758 F.2d 211 (7th Cir. 1985).

Example. The Tax Court ruled that lunch expenses incurred by a group of government attorneys who met for lunch one day each month were not business related despite the fact that business was discussed. The court did concede that “an occasional luncheon meeting with the staff to discuss the operation of the firm would be regarded as an ordinary and necessary expense,” as would “a luncheon to mark an anniversary, retirement or other occasion for an employee” since such expenses “aid in building morale and loyalty and serve as an inducement for others to work more efficiently.” Wells v. Commissioner, 36 T.C.M. 1690 (1977).

The court’s conclusion

Like the attorneys’ lunches, the lunches shared by the medical technician and the physician were not integral to the technician’s business objectives and have not been clearly linked to her production of income.

They met at lunchtime because that was the most convenient and feasible time to meet.

Their business relationship was well established and did not require “social lubrication,” at least not as often as [she and the physician] dined together.

Indeed, the frequency of their lunches together and the reciprocal nature of their meal arrangement belie the existence of any business purpose for the meals …. If taxpayers were permitted to deduct meal expenses in such circumstances then … only the unimaginative would dine at their own expense.

Why does this case matter to how church treasurers reimburse lunch expenses?

Consider the following checklist:

1. Entertainment expenses. Local lunch expenses incurred by church employees qualify as a business expense, and can be reimbursed by a church under an accountable expenses reimbursement arrangement, only if they qualify as entertainment expenses. The requirements for substantiating entertainment expenses are strict. You must demonstrate that the expenses are either (1) directly related to the active conduct of your ministry, or (2) associated with the active conduct of your ministry and the entertainment occurred directly before or after a substantial business discussion.

In order to show that entertainment was directly related to the active conduct of your business, you ordinarily must be able to demonstrate that (1) you had more than a general expectation of deriving income or some other specific business benefit at some indefinite future time; (2) you did engage in business during the entertainment period; and (3) the main purpose of the entertainment was the transaction of business.

In order to show that entertainment was associated with the active conduct of your ministry, you must be able to demonstrate that you had a clear business purpose in incurring the expense, and that the meal or entertainment directly preceded or followed a substantial business discussion.

2. Frequent staff lunches. Frequent lunches with the same members of the church staff are much less likely to qualify as a business expense, even if church business is discussed. For example, if the same three church staff members go out to lunch every Friday, it is very unlikely that any of these lunches will qualify as a business expense. After all, these persons work in the same office, and presumably have considerable interaction during the week. A shared lunch under these circumstances does not constitute an ordinary and necessary business expense.

Key point. It is worth noting that the Tax Court in the Wells case (summarized in an example in this article) met for lunch one day each month. This was considered too frequent to be business related.

3. Occasional lunches with non staff members. Such lunches are more likely to qualify as entertainment expenses, and as a result the costs of these lunches can be reimbursed by the church under an accountable expense reimbursement arrangement. To illustrate, a lunch arranged by a pastor with a local architect to discuss new building plans would qualify as a business expense.

4. Occasional employee lunches. The Tax Court, in a previous decision (the Wells case, summarized in an example in this article) addressing the deductibility of lunch expenses incurred by attorneys one day each month, conceded that “an occasional luncheon meeting with the staff to discuss the operation of the firm would be regarded as an ordinary and necessary expense,” as would “a luncheon to mark an anniversary, retirement or other occasion for an employee” since such expenses “aid in building morale and loyalty and serve as an inducement for others to work more efficiently.”

5. Lunch expenses while traveling. This article only addresses the reimbursement of local lunch expenses. Lunch expenses incurred while church employees are away from town on business travel are business related and can be reimbursed under an accountable arrangement.

6. Other requirements of an accountable arrangement. In order for your church to reimburse expenses under an accountable expense reimbursement arrangement, you must have adopted a reimbursement arrangement that meets the following three requirements: (1) Only business expenses are reimbursed (expenses that would qualify for a business expense deduction on a taxpayer’s personal income tax return). (2) The church only reimburses an expense if the employee substantiates, with written records (including a receipt for expenses of $75 or more), the amount, date, location, and business connection of the expense. In addition, in the case of entertainment expenses (such as local lunch expenses) the employee must document the “occupation or other information relating to the person or persons entertained, including name, title, or other designation, sufficient to establish business relationship to the taxpayer.” (3) Employees must return to the church any reimbursements in excess of substantiated expenses. This article addresses only on the first of these three requirements. Even if a particular lunch qualifies as a business expense, the church may reimburse it under an accountable arrangement only if the other two requirements for an accountable arrangement are met.

If any of these three requirements is not satisfied, the church’s reimbursement of a lunch expense is nonaccountable, and the full amount of the reimbursement must be allocated to the employees’ W-2s.

7. Unreimbursed expenses. This article addresses the tax consequences of a church’s reimbursement of employee lunch expenses. In some cases, church employees pay for their own lunch expenses. Such “unreimbursed” expenses may be deducted as an employee business expense, but only if reimbursement from the church was not available. Further, church employees may deduct only 50% of business related entertainment expenses, including meals. This 50% limitation is incorporated directly into the tax returns (line 9 of Form 2106, and line 24c of Schedule C). Note however that the 50% limitation does not apply to expenses that are reimbursed by an employer under an accountable reimbursement plan. IRS Publication 463 states: “As an employee, you are not subject to the 50% limit if your employer reimburses you under an accountable plan and does not treat your reimbursement as wages.” Publication 463 states that the self employed persons also can avoid the 50% limitation through use of an accountable reimbursement arrangement.

Here are some examples that will illustrate the issues addressed in this article.

Example 1: A church has 3 pastors who for many years have gone out to lunch every Friday. Church business is almost always discussed at these lunches. The cost of these lunches is always charged to a church credit card, and the church treasurer has never reported the church’s reimbursements as taxable income to the pastors by including it on their W-2 forms. This is incorrect. According to the rulings summarized in this article, these lunches do not qualify as business expenses, and as a result they should not be charged to the church credit card. If the pastors continue to charge the lunches to the church credit card, the treasurer will need to allocate the reimbursed expenses to the pastors and report the reimbursements as taxable income on the pastors’ W-2 forms at the end of the year. The treasurer need not withhold additional income taxes because the pastors’ wages are exempt from income tax withholding.

Example 2: Same facts as the previous example, except that nonminister church employees rather than pastors are involved. The answer is the same, except that the church will need to withhold income taxes and FICA taxes from the value of the lunches.

Example 3: A pastor occasionally meets church members for lunch, and charges the cost of these lunches to the church credit card. The purpose of these lunches is for the pastor to become better acquainted with members, and to provide spiritual guidance as needed. These expenses qualify as an entertainment expense. As a result, the expenses reimbursed by the church are accountable so long as the requirements for an accountable reimbursement (summarized in this article) are satisfied.

Example 4: Same facts as the previous example, except that the pastor informs the church treasurer each month of the approximate amount he spent during the previous month on such lunches, and receives a reimbursement check. This arrangement is nonaccountable since the substantiation requirements for an accountable arrangement are not met. As a result, the treasurer will need to add the value of all lunch expense reimbursements to the pastor’s W-2 at the end of the year.

Example 5: A pastor takes the church staff out to lunch twice each year as a means of expressing appreciation for their hard work. The cost of these lunches is charged to the church credit card. These expenses represent a legitimate business expense, and as a result they can be reimbursed by the church under an accountable arrangement so long as they are adequately substantiated. As a result, the church treasurer would not report any of the reimbursements as taxable income. The Tax Court has noted that “an occasional luncheon meeting with the staff to discuss the operation of the firm would be regarded as an ordinary and necessary expense,” as would “a luncheon to mark an anniversary, retirement or other occasion for an employee” since such expenses “aid in building morale and loyalty and serve as an inducement for others to work more efficiently.” Wells v. Commissioner, 36 T.C.M. 1690 (1977).

Example 6: A church’s two pastors go out to lunch once each month. Church business is always discussed, and the cost of the lunches is charged to the church credit card. A federal appeals court has observed that monthly lunches by law firm members “might well be necessary, and would be allowed by the Internal Revenue Service.” Moss v. Commissioner, 758 F.2d 211 (7th Cir. 1985). On the other hand, the Tax Court has ruled that monthly lunch expenses incurred by government attorneys were not business related despite the fact that business was discussed. Wells v. Commissioner, 36 T.C.M. 1690 (1977). In summary, while there is legal support for treating monthly lunch expenses as business-related, but there is also support for the opposite conclusion. This suggests that the business nature of monthly lunch expenses may be challenged by the IRS, but that no penalties would be assessed.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
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