Background. Pastor J is the senior pastor of a church in Town A. He also drives 100 miles to Town B each week to conduct worship services. Are his travel expenses tax-deductible? The answer depends on how long the arrangement lasts. The Tax Court issued a ruling recently that addressed a similar case.
A worker traveled 200 miles each week to perform a temporary job in another town. He returned home each weekend to his family. While the worker was told that the job could be terminated at any time, he ended up working for 27 months. Each year, the worker deducted his travel expenses (mileage, lodging, food) as a business expense. The IRS audited him, and denied the deductions. The worker appealed to the Tax Court.
The court’s ruling. The court conceded that a taxpayer can deduct traveling expenses incurred while away from home, if the following 3 conditions are met: (1) The expense must be reasonable and necessary; (2) it must be incurred while away from home; and (3) it must be incurred in the pursuit of a trade or business. The tax code specifies, however, that a taxpayer “shall not be treated as being away from home during any period of employment if such period exceeds 1 year.” IRC 162(a). The IRS argued that the worker was not “away from home” while he was working in the other town. The court agreed. It noted that a taxpayer’s home generally is
the vicinity of his principal place of employment, not where his personal residence is located. However, if a taxpayer’s principal place of employment is temporary rather than indefinite, the taxpayer’s residence may be considered the taxpayer’s home, and the taxpayer may deduct the expenses associated with traveling to and living at a job site.
The worker claimed that even though his employment in the other town lasted 2 years, it was “temporary” since he was subject to termination at any time. The court dismissed this argument, noting that “in that sense, all employment is temporary in that employees generally serve at the will of the employer.”
The court concluded by noting that the tax code “specifically states that employment in excess of 1 year is not temporary, and [the worker’s] employment exceeded this limitation.”
Relevance to church treasurers. Consider the following:
You know of a pastor who travels to another town to perform services in another church. Do you have a pastor on staff who travels to another town to conduct religious services? Perhaps you know of a retired minister who does so. In either case, the travel expenses can become substantial. Whether they can be deducted by the pastor as a business expense, or reimbursed by the other church under an accountable business expense reimbursement arrangement, depends primarily on the length of the assignment. As this case demonstrates, travel expenses are not “business expenses” unless the work assignment is “temporary” rather than indefinite. The tax code draws the line at 1 year. Any assignment that lasts longer than this is indefinite, which means that the worker’s “tax home” changes and therefore no “travel” expenses are incurred. On the other hand, assignments of less than 1 year generally are temporary, meaning that the travel expenses may constitute a business expense.
Your pastor travels from another town to perform services in your church. If your church employs a pastor who lives in another community, then this case will help you in knowing whether or not you can reimburse the pastor’s travel expenses under an accountable reimbursement arrangement. You can only reimburse legitimate business expenses under such an arrangement, and so if the travel expenses do not qualify as business expenses (because the assignment lasts more than a year) then any reimbursement by the church is not accountable and the full amount of all reimbursements must be added to the pastor’s W-2 at the end of the year. Saric v. Commissioner, T.C. Memo. 2000-8 (2000).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
The Tax Consequences of Reclassifying an Employee as Self-Employed
Background. The Tax Court addressed a question recently that will be of interest to church treasurers. A company treated one of its workers (“John”) as self-employed for 1995, and as a result did not withhold income taxes or FICA taxes from his wages. It assumed that John would pay his own income taxes and self-employment (social security) taxes using the quarterly estimated tax procedure. In fact, John did not pay the full amount of his income taxes.
The IRS later audited John, and determined that he was an employee and not self-employed in 1995. The question then was who was legally responsible for the underpayment of John’s income tax? John claimed that his employer was responsible for his income tax liability for 1995 because it failed to withhold these taxes from his wages when they were earned. He relied on IRS Publication 15 (“Circular E”), which states:
You [meaning the employer] will be liable for Social Security and Medicare taxes and withheld income tax if you do not deduct and withhold them because you treat an employee as a nonemployee.
The Tax Court’s ruling. The Court rejected John’s argument, noting that “IRS publications are not authoritative sources of federal tax law.” It noted that section 3509 of the tax code specifies that an employer who fails to withhold income tax from an employee’s wages (because it misclassified the employee as self-employed) is subject to a penalty equal to 1.5 percent of the employee’s wages (3 percent if no 1099 was issued). However, the Court also noted that section 3509 “specifically provides that the employee’s liability for income tax shall not be affected by the assessment or collection of any tax determined against the employer under section 3509. In other words, the employee remains fully liable for income tax arising from the receipt of gross wages.” Therefore, even though the company misclassified John as self-employed and failed to withhold income taxes, he remained liable for his own income taxes for the year.
The Court concluded:
It is unfortunate that [the company] did not ask [John] to complete a Form W-4 for the year in issue and did not withhold income tax from [his] wages. If it had done so, there might not have been any deficiency in income tax in respect of such wages. However, [it] never withheld, and [John] was paid his gross wages without any reduction for withheld income tax. As a consequence, there is a deficiency in income tax for which [John] is liable.
Application to church treasurers. It is often difficult for church treasurers to know if a worker is an employee or self-employed. This case illustrates the following possible consequences when a worker is improperly classified as self-employed:
1. The worker’s liability. If a church treats a worker as self-employed who is later reclassified as an employee by the IRS, the worker remains liable for paying his or her own income taxes. If the worker fails to pay the correct amount of income taxes using the quarterly estimated tax procedure, he or she cannot hold the church liable for the unpaid taxes on account of the church’s misclassification and failure to withhold the correct amount of taxes.
Key point. It is common for self-employed workers to underpay their estimated taxes. One reason is that they have insufficient funds available to pay the full amount of their quarterly tax installments. Another reason is unfamiliarity with the estimated tax procedure. As a result, whenever a church misclassifies a worker as self-employed, there is a risk that the worker will underpay his or her taxes.
2. The church’s liability. The failure by an employer (including a church) to withhold payroll taxes from a self-employed worker who the IRS later reclassifies as an employee has the following consequences:
the employer is liable for an “income tax” penalty of 1.5 percent of the employee’s wages (3 percent if no 1099 was filed)
the employer is liable for a “FICA” penalty of 20 percent of the employee’s share of FICA taxes (40 percent if no 1099 was filed)
the employer is liable for the full employer’s share of FICA taxes
the employer is liable for the full amount of the employee’s taxes if it intentionally disregards the withholding rules
Example. Joan is a part-time secretary at her church, and works 20 hours per week at an annual salary of $10,000. The church treats Joan as self-employed, and she pays her income taxes and self-employment (social security) taxes by using the quarterly estimated tax procedure. The church issued Joan a 1099 form for compensation paid in 1999. Joan’s 1999 tax return is audited, and she is reclassified as an employee by the IRS. If Joan failed to pay the correct amount of income taxes for 1999, then: (1) She is responsible for the underpayment, and cannot transfer this liability to the church on the ground that it failed to properly classify her as an employee and withhold the correct amount of income taxes. (2) The church is liable for an “income tax” penalty of $150 (1.5 percent of Joan’s wages). (3) The church is liable for a “FICA” penalty of $153 (20 percent of Joan’s share of FICA taxes). (4) The church is liable for the full employer’s share of FICA taxes, or $765 ($10,000 times the employer’s FICA tax rate of 7.65 percent).
Example. Same facts as the previous example, except that Joan paid the correct amount of taxes using the estimated tax procedure. The church’s liabilities are the same as in the previous example.
Example. Same facts as the previous example, except that the church did not issue Joan a 1099 form for 1999. Because it failed to issue a 1099 form, the church’s “income tax” and “FICA” penalties are doubled to $300 and $306.
Example. A church treasurer decides to treat all lay employees as self-employed in order to avoid having to withhold taxes and comply with the payroll tax reporting requirements. Since this amounts to an intentional disregard of the withholding requirements, the church is potentially liable for all of its employees’ taxes.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Persons who begin receiving social security benefits and who continue to work may lose a portion of their benefits if they earn more than a specified amount of income. This limitation (called the “annual earning test”) only applies to persons between 62 and 70 years of age. For year 2000, persons age 65 to 70 can earn up to $17,000 without any reduction in their social security benefits. However, for every $3 of earned income over this amount a worker’s social security benefits are reduced by $1. For workers who elect to begin receiving social security benefits at ages 62 to 65 the penalty is worse. For every dollar of earned income over $10,060 their social security benefits are reduced by $1. Workers can earn any amount beginning at age 70 without a reduction in social security benefits. These rules have impacted a number of ministers and lay employees who want to work for a church without affecting the amount of their social security benefits.
There is good news. By a unanimous vote of 422-0, the House of Representatives has voted to repeal the annual earnings test for workers who are 65 to 70 years of age. The Senate has promised quick action on the initiative, and President Clinton has promised to sign the bill into law. The legislation only repeals the annual earnings test that applies to persons age 65 to 70. The annual earnings test for persons who elect to begin receiving social security benefits at ages 62 to 65 remains in effect.
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. Under current law, Pastor T’s social security benefits would be 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 be reduced by $3,000.
Example. Same facts as the previous example, except that Congress repeals the annual earnings test. Pastor T’s social security benefits are not affected. His benefits are not reduced by $3,000.
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.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Article summary. Many children are poisoned each year by eating lead-based paint. In at attempt to address this problem, the federal government has issued regulations imposing strict requirements on the sale or lease of residential property constructed prior to 1978. There are no exceptions for churches or other nonprofit organizations. Church leaders need to be aware of these requirements whenever they sell or lease church-owned residential property. Failure to comply with these requirements can result in substantial liability, including “triple damages.” This article addresses the application of these requirements to churches.
Many churches own residential properties, including homes, duplexes, and even small apartment buildings. In most cases, homes are acquired as parsonages. But homes, duplexes, and apartment buildings in the immediate vicinity of the church also may be acquired for future expansion, and in some cases they are donated to the church. Church leaders need to be aware of strict federal regulations that regulate the sale or lease of some residential properties. The objective of these regulations is to reduce cases of poisoning among children who consume lead-based paint. This article will describe the background of this problem, summarize the federal regulations, and explain their practical significance to churches.
Background
In General
Lead affects virtually every system of the body. While it is harmful to individuals of all ages, lead exposure can be especially damaging to children, the unborn, and women of childbearing age. Recent studies have raised concern over blood-lead levels once thought to be safe. Since 1978, the federal Centers for Disease Control (CDC) has lowered the blood-lead level of concern from 60 to 10 micrograms per deciliter.
Lead poisoning has been called “the silent disease” because its effects may occur gradually and imperceptibly, often showing no obvious symptoms. Blood-lead levels as low as 10 micrograms per deciliter have been associated with learning disabilities, growth impairment, permanent hearing and visual impairment, and other damage to the brain and nervous system. In large doses, lead exposure can cause brain damage, convulsions, and even death. Lead exposure before or during pregnancy can also alter fetal development and cause miscarriages.
In 1991, the Secretary of the United States Department of Health and Human Services characterized lead poisoning as the “number one environmental threat to the health of children in the United States.” Although the percentage of children with elevated blood-lead levels has declined over the last 20 years, millions of U.S. children still have blood-lead levels high enough to threaten their health. The Third National Health and Nutrition Examination Survey (NHANES III) indicates that over the past two decades, the average child’s blood-lead level has decreased from 12.8 to 2.8 micrograms per deciliter. NHANES III also indicates, however, that in 1991 approximately 1.7 million U.S. children under the age of 6 still had blood-lead levels that exceeded the 10 micrograms per deciliter level of concern.
Lead-based Paint
Efforts to reduce exposure to lead from sources like gasoline and food cans have played a large role in the past reductions of blood-lead levels in the United States. Despite these successes, a significant human health hazard remains from improperly managed lead-based paint. From the year 1900 through the 1940’s, paint manufacturers used lead as a primary ingredient in many oil-based interior and exterior house paints. Usage gradually decreased through the 1950’s and 1960’s, as largely lead-free latex paints became more popular. Although the federal government banned lead-based paints from residential use in 1978, the federal Environmental Protection Agency (EPA) estimates that 83 percent of the privately owned housing units built in the United States before 1980 contain some lead-based paint. By these estimates, approximately 64 million homes may contain lead-based paint that may pose a hazard to the occupants if not managed properly.
Lead from exterior house paint can flake off or leach into the soil around the outside of a home, contaminating children’s playing areas. Dust caused during normal lead-based paint wear (especially around windows and doors) can create a hard-to-see film over surfaces in a house. In some cases, cleaning and renovation activities can increase the threat of lead-based paint exposure by dispersing fine lead dust particles in the air and over accessible household surfaces. If managed improperly, both adults and children can receive hazardous exposures by inhaling the fine dust or by ingesting paint dust during hand-to-mouth activities. Children under age 6 are especially susceptible to lead poisoning.
The Residential Lead-Based Paint Hazard Reduction Act
Congress passed the Residential Lead-Based Paint Hazard Reduction Act of 1992 to address the need to control exposure to lead-based paint hazards. The Act established the infrastructure and standards necessary to reduce lead-based paint hazards in housing. Within this law, Congress recognized lead poisoning as a particular threat to children under age 6 and emphasized the needs of this vulnerable population. Section 1018 of the Act requires EPA to promulgate regulations for disclosure of any known lead-based paint or any known lead-based paint hazards in “target housing” offered for sale or lease.
The key provisions of this Act are summarized below.
Only “target housing” is regulated
Target Housing
The Act only regulates “target housing,” which it defines as follows:
Target housing means any housing constructed prior to 1978, except housing for the elderly or persons with disabilities (unless any child who is less than 6 years of age resides or is expected to reside in such housing) or any 0-bedroom dwelling …. 0-bedroom dwelling means any residential dwelling in which the living area is not separated from the sleeping area. The term includes efficiencies, studio apartments, dormitory housing, military barracks, and rentals of individual rooms in residential dwellings.
There are no exceptions for housing that is owned by churches or other charitable organizations.
Exemptions
The following transactions are exempted from the Act’s requirements:
(1) Sales of target housing at foreclosure.
(2) Leases of target housing that have been found to be lead-based paint free by an inspector certified under the Federal certification program or under a federally accredited State or tribal certification program. Until a Federal certification program or federally accredited State certification program is in place within the State, inspectors shall be considered qualified to conduct an inspection for this purpose if they have received certification under any existing State or tribal inspector certification program. The lessor has the option of using the results of additional test(s) by a certified inspector to confirm or refute a prior finding.
(3) Short-term leases of 100 days or less, where no lease renewal or extension can occur.
(4) Renewals of existing leases in target housing in which the lessor has previously disclosed all information required by the Act and where no new information has come into the possession of the lessor.
Requirements for sellers of target housing
Each contract to sell target housing must include an “attachment” that contains specific disclosure and acknowledgment elements. The required elements are described below:
(1) lead warning statement
Each contract must contain the following lead warning statement:
Every purchaser of any interest in residential real property on which a residential dwelling was built prior to 1978 is notified that such property may present exposure to lead from lead-based paint that may place young children at risk of developing lead poisoning. Lead poisoning in young children may produce permanent neurological damage, including learning disabilities, reduced intelligence quotient, behavioral problems, and impaired memory. Lead poisoning also poses a particular risk to pregnant women. The seller of any interest in residential real property is required to provide the buyer with any information on lead-based paint hazards from risk assessments or inspections in the seller’s possession and notify the buyer of any known lead-based paint hazards. A risk assessment or inspection for possible lead-based paint hazards is recommended prior to purchase.
(2) statement disclosing known lead-based paint
The second requirement is a statement disclosing the presence of any known lead-based paint and lead-based paint hazards in the target housing, or indicating no knowledge of the presence of lead-based paint or lead-based paint hazards. The Act defines a lead-based paint hazard as follows:
Lead-based paint hazard means any condition that causes exposure to lead from lead-contaminated dust, lead-contaminated soil, or lead-contaminated paint that is deteriorated or present in accessible surfaces, friction surfaces, or impact surfaces that would result in adverse human health effects as established by the appropriate federal agency.
The seller must also provide any additional information available concerning the known lead-based paint and lead-based paint hazards, such as (1) the basis for the determination that lead-based paint and lead-based paint hazards exist in the housing, (2) the location of the lead-based paint or lead-based paint hazards, and (3) the condition of the painted surfaces. The statement must also list all records and reports pertaining to lead-based paint and lead-based paint hazards that are available to the seller and that have been provided to the purchaser. If no such records or reports are available to the seller, the statement must so indicate.
(3) receipt of required information
The third requirement is a statement by the purchaser affirming that he or she has received (1) the lead warning statement, (2) the seller’s statement disclosing the presence of any lead paint or lead-based paint hazards, and (3) a lead hazard information pamphlet required (the pamphlet may be the federal pamphlet entitled “Protect Your Family from Lead in Your Home” or a state-developed pamphlet that has been approved by EPA).
(4) 10-day inspection right
The fourth requirement is a statement that the purchaser has received a 10-day opportunity to conduct a risk assessment or inspection for the presence of lead-based paint and/or lead-based paint hazards (unless the parties have mutually agreed to a different period of time), before becoming obligated under the contract to purchase the housing. Alternatively, a purchaser who chooses to waive the risk assessment or inspection opportunity must so indicate in writing.
(5) real estate agents
The fifth requirement is a statement by any agent involved in the transaction that the agent has informed the seller of the seller’s obligations and that the agent is aware of his or her duty to ensure compliance with the requirements of this rule.
(6) signatures of seller
The sixth requirement is the signatures of the seller, real estate agent, and purchaser, certifying the accuracy of their statements on the attachment, along with their dates of signature. These signatures document the acceptance by the parties of the information they have provided on the attachment as a whole and alert the various parties to their respective roles and responsibilities.
Form #1: Sample Disclosure Format for Target Housing Sales
Requirements for lessors of target housing
Each contract to lease target housing must include an “attachment” that contains specific disclosure and acknowledgment elements. The required elements are described below:
(1) lead warning statement
Each contract must contain the following lead warning statement:
Housing built before 1978 may contain lead-based paint. Lead from paint, paint chips, and dust can pose health hazards if not managed properly. Lead exposure is especially harmful to young children and pregnant women. Before renting pre-1978 housing, lessors must disclose the presence of known lead-based paint and/or lead-based paint hazards in the dwelling. Lessees must also receive a federally approved pamphlet on lead poisoning prevention.
(2) statement disclosing known lead-based paint
The second requirement is a statement disclosing the presence of any known lead-based paint and lead-based paint hazards in the target housing, or indicating no knowledge of the presence of lead-based paint or lead-based paint hazards. The Act defines a lead-based paint hazard as follows:
Lead-based paint hazard means any condition that causes exposure to lead from lead-contaminated dust, lead-contaminated soil, or lead-contaminated paint that is deteriorated or present in accessible surfaces, friction surfaces, or impact surfaces that would result in adverse human health effects as established by the appropriate federal agency.
The seller must also provide any additional information available concerning the known lead-based paint and lead-based paint hazards, such as (1) the basis for the determination that lead-based paint and lead-based paint hazards exist in the housing, (2) the location of the lead-based paint or lead-based paint hazards, and (3) the condition of the painted surfaces. The statement must also list all records and reports pertaining to lead-based paint and lead-based paint hazards that are available to the lessor and that have been provided to the lessee. If no such records or reports are available to the lessor, the statement must so indicate.
(3) receipt of required information
The third requirement is a statement by the lessee affirming that he or she has received (1) the lead warning statement, (2) the lessor’s statement disclosing the presence of any lead paint or lead-based paint hazards, and (3) a lead hazard information pamphlet (the pamphlet may be the federal pamphlet entitled “Protect Your Family from Lead in Your Home” or a state-developed pamphlet that has been approved by EPA).
(4) real estate agents
The fourth requirement is a statement by any agent involved in the transaction that the agent has informed the lessor of the lessor’s obligations and that the agent is aware of his or her duty to ensure compliance with the requirements of this rule.
(5) signatures of seller
The sixth requirement is the signatures of the lessor, real estate agent, and lessee, certifying the accuracy of their statements on the attachment, along with their dates of signature. These signatures document the acceptance by the parties of the information they have provided on the attachment as a whole and alert the various parties to their respective roles and responsibilities.
Form #2: Sample Disclosure Format for Target Housing Leases
Recordkeeping Requirements
The Residential Lead-Based Paint Hazard Reduction Act requires sellers and their agents to retain a copy of the completed disclosure and acknowledgment contract attachment (discussed above), for 3 years from the completion date of the sale. Similarly, lessors and their real estate agents are required to retain a copy of the completed lease or attachment for 3 years from the commencement of the lease period.
Legal Liability
Churches may be legally liable for injuries caused by persons who purchase or rent church-owned residential property and who are poisoned by lead-based paint. Summarized below are some of the bases of liability.
(1) the Residential Lead-Based Paint Hazard Reduction Act
Violation of the requirements that apply to sellers and lessors of target housing may result in (1) civil and criminal penalties, (2) potential triple damages in a private civil suit, and (3) an obligation to pay the attorney fees and expert witness fees of victims.
(2) state and local law
The Act specifies that it does not “relieve a seller, lessor, or agent from any responsibility for compliance with state or local laws, ordinances, codes, or regulations governing notice or disclosure of known lead-based paint and/or lead-based paint hazards.”
(3) negligence
Churches may be sued on the basis of negligence for injuries to children (including lead-based paint poisoning) that occur while the children are participating in a preschool or head start program on church premises, even if the program is operated by another organization that leases church property.
Examples
The following examples will illustrate the application of the principles summarized above.
• Example. A church purchased a home in 1960 to use as a parsonage. The church’s senior pastor moves out of the parsonage in 1999 and purchases a home. The church decides to retain the parsonage, and later the parsonage is leased to a family with two young children. Church leaders are not familiar with the Residential Lead-Based Paint Hazard Reduction Act, and do not comply with any of its provisions. After living in the parsonage for several months the lessees’ children begin to exhibit serious neurological problems. A physician diagnoses the condition as lead poisoning, and it is later determined that the children have been eating lead-based paint in the parsonage. The parents sue the church, alleging that their children’s injuries are permanent and severe, and amount to $1 million per child. Since the Residential Lead-Based Paint Hazard Reduction Act permits lessors to be liable for “triple damages,” the church faces damages of up to $6 million. In addition, a court can order the church to pay for the parents’ attorney fees and expert witness fees.
• Example. Same facts as the previous example, except that the parsonage was constructed in 1980 and acquired by the church in 1983. Since the parsonage was constructed in or after 1978, it is not “target housing” and is not subject to the Residential Lead-Based Paint Hazard Reduction Act. However, the church may be subject to local or state regulations, and it may be liable on the basis of ordinary negligence for the children’s lead poisoning.
• Example. A church purchased a home in 1970 to use as a parsonage. In the year 2000, the senior pastor moves out of the parsonage, and the church allows its youth pastor to move in. The youth pastor has three minor children. Is this transaction subject to the Residential Lead-Based Paint Hazard Reduction Act? Since the home was constructed prior to 1978, it is target housing. However, the question is whether or not the transaction constitutes a “lease.” The Act does not define the term “lease,” but it does define a “lessor” as “any entity that offers target housing for lease,” and it defines a “lessee” as “any entity that enters into an agreement to lease, rent, or sublease target housing, including but not limited to individuals, partnerships, corporations … and nonprofit organizations.” Is a youth pastor who moves into a church-owned parsonage a “lessee” under this definition? An argument can be made that the youth pastor is not a lessee, since he did not “enter into an agreement to lease” the parsonage. On the other hand, it could be argued that an oral or implied “agreement” did exist by which the youth pastor and his family were allowed to occupy the parsonage, on a rent-free basis, for such time as he served as youth pastor. Since this interpretation of the Act is certainly possible (and probably would be vigorously asserted by a plaintiff’s attorney), church leaders may wish to comply with the requirements that the Act imposes on lessors who lease target housing. An attorney should be consulted for a legal opinion. Note that compliance with these requirements is relatively simple, and would impose a minimal burden on a church in return for a significant reduction in risk.
• Example. A church leases a portion of its premises to another congregation on Sunday afternoons. The other congregation conducts religious services and education classes for adults and children. While the church is leasing its premises to the other congregation, it is not subject to the provisions of the Residential Lead-Based Paint Hazard Reduction Act because it is not leasing “target housing.”
• Example. A church has a “studio apartment” located on its premises that consists of one room. The church leases this apartment to its custodian. While the church is leasing its premises to the custodian, it is not subject to the provisions of the Residential Lead-Based Paint Hazard Reduction Act because a “studio apartment” is a “0-bedroom dwelling” that does not meet the Act’s definition of “target housing.”
• Example. A denominational agency owns a campgrounds which consists of recreational facilities, a chapel, and several dormitories. The campgrounds are leased to several groups during the year. While the denominational agency is leasing the campgrounds, it is not subject to the provisions of the Residential Lead-Based Paint Hazard Reduction Act because “dormitory housing” is a “0-bedroom dwelling” that does not meet the Act’s definition of “target housing.”
• Example. A church purchases three homes next to its parking lot to accommodate future expansion. The homes were each constructed in the 1950s. The church rents the homes. These rental arrangements are subject to the Residential Lead-Based Paint Hazard Reduction Act, and so the church is required to comply with the requirements summarized above. Failure to do so exposes the church to potentially significant liability, including triple damages.
• Example. Bob donates a home to his church at the end of 1999. The pastor knows a family in the church who are wanting to purchase a home, and he asks if they would be interested in buying Bob’s home. The family visits the home and decides to buy it. The pastor picks up a “legal forms” book at a local bookstore, and prints out a real estate sales contract. If the home was constructed prior to 1978, it is “target housing” and the sales transaction is subject to the Residential Lead-Based Paint Hazard Reduction Act.
• Example. A church sells its sanctuary and buys a larger church building. A church sanctuary is not “target housing,” and so the church’s sale of its sanctuary is not subject to the Residential Lead-Based Paint Hazard Reduction Act.
Risk management for churches
Here is a checklist of steps that church leaders can take to reduce the risk of liability based on the Residential Lead-Based Paint Hazard Reduction Act.
1. Buying residential property. Church leaders should be certain that the seller is complying with the Residential Lead-Based Paint Hazard Reduction Act whenever the church is buying residential property constructed prior to 1978. It is important to note that the Act does not require sellers to remove lead-based paint from their property, or inspect their property for the existence of lead-based paint. Rather, they are only required to notify a buyer of any known lead-based paint or lead-based paint hazards on the property so that the buyer can make an informed decision regarding acquisition of the property and be alerted to any potential health problems in the future.
The fact that a seller is not aware of the presence of any lead-based paint on his or her property does not mean that the property is free of this hazard. The Act gives buyers a 10-day right of inspection to look for the presence of lead-based paint or lead-based paint hazards before becoming obligated under a contract to purchase residential property. A buyer can waive this right. Church leaders should consider the following precautions:
“Ensure compliance with the Act. Be sure that the seller is complying with the terms of the Residential Lead-Based Paint Hazard Reduction Act.
“Review the seller’s disclosures. Did the seller disclose the presence of lead-based paint? If so, church leaders should consider whether or not they want to proceed with the purchase of the property. They may want to condition the purchase of the property on the seller’s removal of the paint, or insist on a reduction in the purchase price to cover the cost of eliminating the hazard.
“Exercise the right of inspection. If the seller is not aware of the presence of any lead-based paint, then consider exercising your 10-day right of inspection. Do not sign any real estate contract containing a provision waiving this right of inspection. Also, the contract should contain a provision allowing you to cancel the contract in the event that lead-based paint or a lead-based paint hazard is discovered during an inspection.
The EPA regulations contain the following sample “contingency” clause that buyers may want to include in a real estate contract (it is not required, however):
This contract is contingent upon a risk assessment or inspection of the property for the presence of lead-based paint and/or lead-based paint hazards at the Purchaser’s expense until 9 p.m. on the tenth calendar-day after ratification [Insert date 10 days after contract ratification or a date mutually agreed upon]. This contingency will terminate at the above predetermined deadline unless the Purchaser (or Purchaser’s agent) delivers to the Seller (or Seller’s agent) a written contract addendum listing the specific existing deficiencies and corrections needed, together with a copy of the inspection and/or risk assessment report. The Seller may, at the Seller’s option, within _______ days after Delivery of the addendum, elect in writing whether to correct the condition(s) prior to settlement. If the Seller will correct the condition, the Seller shall furnish the Purchaser with certification from a risk assessor or inspector demonstrating that the condition has been remedied before the date of the settlement. If the Seller does not elect to make the repairs, or if the Seller makes a counter-offer, the Purchaser shall have _______ days to respond to the counter-offer or remove this contingency and take the property in “as is” condition or this contract shall become void. The Purchaser may remove this contingency at any time without cause.
“Consult with an attorney. Be sure to consult with an attorney concerning your rights, and the potential risks the church faces if lead-based paint is found on the property. This is very important if the church will be renting the property, or making it available as a parsonage.
2. Selling residential property. Church leaders should be certain that they are complying with the Residential Lead-Based Paint Hazard Reduction Act whenever the church is selling residential property constructed prior to 1978. Note the following:
“Using a real estate agent. If the church will use a real estate agent in selling residential property, it is very likely that the agent will be familiar with the requirements of the Act and will help to ensure compliance. However, in some cases churches sell residential property without the assistance of a real estate agent. Under these circumstances it is much more likely that there will not be full compliance with the Act. If you are using an agent, be sure that the agent is familiar with the requirements of the Act and is complying with them.
“Complying with the Act. Be sure that a real estate contract is used, and that it contains the information summarized above, including a lead warning statement, a statement disclosing any known lead-based paint or lead-based paint hazard, a 10-day right of inspection, a statement by the buyer affirming that he or she has received the lead warning statement; the seller’s statement disclosing the presence of any lead paint or lead-based paint hazards; and a lead hazard information pamphlet (the pamphlet may be the federal pamphlet entitled “Protect Your Family from Lead in Your Home” or a state-developed pamphlet that has been approved by EPA).
“Consult with an attorney. Be sure to consult with an attorney concerning your responsibilities under the Act and the potential risks the church faces if it fails to comply.
3. Renting residential property. Church leaders should be certain that they are complying with the Residential Lead-Based Paint Hazard Reduction Act whenever the church is renting residential property constructed prior to 1978. It is important to note that the Act does not require lessors to remove lead-based paint from their property, or inspect their property for the existence of lead-based paint. Rather, they are only required to notify a lessee of any known lead-based paint or lead-based paint hazards on the property so that the lessee can make an informed decision regarding rental of the property and be alerted to any potential health problems in the future. Church leaders should consider the following precautions:
“Using a real estate agent. If the church will use a real estate agent in renting church-owned residential property, it is very likely that the agent will be familiar with the requirements of the Act and will help to ensure compliance. However, in most cases churches rent their property without the assistance of a real estate agent. Under these circumstances it is much more likely that there will not be full compliance with the Act.
“Complying with the Act. Be sure that a lease agreement is used, and that it contains the information summarized above, including a lead warning statement; a statement disclosing any known lead-based paint or lead-based paint hazard; a statement by the lessee affirming that he or she has received the lead warning statement, the lessor’s statement disclosing the presence of any lead paint or lead-based paint hazards, and a lead hazard information pamphlet (the pamphlet may be the federal pamphlet entitled “Protect Your Family from Lead in Your Home” or a state-developed pamphlet that has been approved by EPA).
“Consult with an attorney. Be sure to consult with an attorney concerning your responsibilities under the Act, and the potential risks the church faces if it fails to comply.
• Key point. You should consider complying with the Act when allowing a pastor to occupy a church-owned parsonage constructed prior to 1978. It is possible that a court would conclude that an oral or implied “lease agreement” did exist by which the pastor and his or her family were allowed to occupy the parsonage, on a rent-free basis, for such time as he or she served as pastor. Since this interpretation of the Act is certainly possible (and probably would be vigorously asserted by a plaintiff’s attorney), church leaders may wish to comply with the requirements that the Act imposes on lessors who lease target housing. An attorney should be consulted for a legal opinion. Note that compliance with these requirements is relatively simple, and would impose a minimal burden on a church in return for a significant reduction in risk.
4. Insurance. Discuss with your insurance agent the availability of insurance coverage in the event that the church is sued as a result of lead paint poisoning, or violating the Residential Lead-Based Paint Hazard Reduction Act.
5. Rental of church property by outside groups. Churches may be liable for lead-based paint poisoning when they rent non-residential church property to outside groups, such as a preschool or head start program. Be sure to check with your insurance agent about coverage for such a risk.
• Example. A church leased a portion of its premises to another organization that conducted a head start preschool program. A minor child was injured when she ate lead-based paint while participating in the head start program. The minor and her mother sued the church, along with the head start provider. The church insisted that it could not be liable for the child’s poisoning since it had no notice of a lead paint condition on its premises until after the child left the head start program. A year after the child left the program, the department of health issued a notice of lead paint violations for certain parts of the building. A court refused to dismiss the church from the lawsuit. It noted that the notice from the department of health listed violations including peeling paint in two classrooms and a kitchen, and dust and dirt accumulating in various areas. The court stressed that “a standard higher than common law negligence applies here. Courts have repeatedly held that schools are subject to a higher standard of care [and] must exert the same [duty] of care and supervision over the pupils under [their] control as a reasonably prudent parent would exercise under the same circumstances …. A school owes a special duty to its students because, by taking compulsory custody over them, it temporarily deprives them of the protection of their parents and guardians.” The court concluded that the church, as a landlord, must ensure that “no defective conditions exist which harm the safety of the young children participating in the head start program …. [T]he existence of lead-based paint in nurseries, kindergartens and day care centers is hazardous to children. Indeed, because buildings containing kindergartens, nurseries and day care centers invariably house children, the landlords of these buildings should know that any lead paint problems are extremely dangerous. Given this, a reasonably prudent parent would abate any lead-based paint problems over which it had control. Because of the pervasiveness of the lead paint problem prior to 1960, if given notice of a peeling paint condition in a building containing his or her child and erected before 1960, a reasonably prudent parent would investigate to determine whether there is a lead paint condition. This is true even though laws were not in place regarding lead paint abatement in kindergartens and day care centers, as the issues surrounding lead paint poisoning had been sufficiently publicized to put the landlords of these establishments on notice. Therefore, this court holds that, in a building constructed prior to 1960 that houses a head start program, notice of a peeling paint condition in an area used by the children creates a rebuttable presumption that the landlord had notice of a lead paint hazard.” Espinal v. North Presbyterian Head Start Child Development Center, 667 N.Y.S.2d 223 (Sup. Ct. 1997).
6. State and local regulations. This article has addressed the federal Residential Lead-Based Paint Hazard Reduction Act. Many state and local governments have enacted their own regulations addressing lead-based paint hazards, and it is important for church leaders to consider the application of these additional regulations whenever they buy, sell, or lease property.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Failing to Pay a Subcontractor
Recent case illustrates importance of understanding all construction contracts.
Background. An Ohio court ruled that a church could not avoid paying a subcontractor that provided labor and materials for a church construction project on the ground that the subcontractor failed to file a mechanic’s lien.
In 1995, a church entered into a contract with a general contractor for the construction of a new worship facility. The contract provided that the worship facility would be constructed over a period of seven months for a total cost of $852,650. Payments to the general contractor were to be made in installments upon approval by an independent architect. Over the next several months, substantial work on the project was completed. The architect approved four payment requests from the general contractor, totaling $321,365.05, and the church paid these amounts.
The general contractor later accepted a bid for the fabrication and installation of certain steel structures for the worship facility, and the steel subcontractor fabricated and installed the steel structures in accordance with the terms of its agreement with the general contractor. The steel subcontractor sent the general contractor an invoice for $25,500 for the work and materials it supplied. A few weeks later, the general contractor submitted a request for a fifth payment in the amount of $87,531.10. The architect recommended that the church withhold $58,328, but approved $29,203 of the request. The church in turn paid out $20,000 to those subcontractors who held mechanic’s liens on its property. It did not pay the steel subcontractor because it never perfected a mechanic’s lien on the church property.
The steel subcontractor sued the church, demanding payment for the labor and material that it supplied on the basis of the legal theory of “unjust enrichment.” The church insisted that it was not required to pay the steel subcontractor anything since it had failed to protect itself by filing a mechanic’s lien on the church’s property.
What the court said. A trial court ruled in favor of the steel subcontractor. It concluded that “it would, indeed, be unjust to permit [the church] to pick and choose who it decided to pay and for what services to the detriment of [the steel subcontractor] who dealt in good faith with [the church] and did everything required of it.” The trial court further found that its decision was not by barred by the steel subcontractor’s failure to file a mechanic’s lien on the property, and that the subcontractor was entitled to relief on the basis of its unjust enrichment claim. A state appeals court agreed.
The court noted that to recover under the theory of unjust enrichment, the steel subcontractor had to prove that (1) it conferred a benefit upon the church, (2) the church had knowledge of the benefit, and (3) it would be unjust for the church to retain that benefit without payment. The church insisted that the steel subcontractor could not prove the third requirement. It pointed out that it ultimately paid in excess of the contract price for the completion of the project and paid the general contractor all amounts it was entitled to under the terms of the contract.
The court concluded that the steel subcontractor could pursue a claim of unjust enrichment against the church even though it had failed to file a mechanic’s lien. However, it also acknowledged that if the church had paid the general contractor in full for all performance rendered at the construction site, then it had not received a benefit for which it did not pay and it would not be liable to the steel subcontractor on the basis of unjust enrichment. The key question, then, was whether or not the church had fully paid the general contractor. The court concluded that it had not done so. It noted that the architect had approved only $29,203 of the $87,531.87 requested by the general contractor for its fifth payment, and this is the amount the church paid. Since the church had not fully paid the general contractor for all amounts due under the contract, it would be unjustly enriched if it was not required to pay the steel subcontractor.
Relevance to church treasurers. Most churches enter into construction contracts on occasion. In some cases, a church is constructing a new worship facility, as in this case. In others, a church is remodeling its present facility. Under most construction contracts, the church will be responsible for paying the general contractor the contract price. It is then the general contractor’s responsibility to pay its subcontractors. In some cases, a subcontractor that provides labor or material in a construction project is not paid by the general contractor. Subcontractors can protect themselves against nonpayment by filing a mechanic’s lien against the church’s property. Such a lien enables the subcontractor to sell the church’s property in order to obtain payment for any labor or material that it provided. But subcontractors do not always file mechanic’s liens. This case illustrates the following important points:
Subcontractor files a mechanic’s lien
If a subcontractor files a mechanic’s lien, then its right to payment for any labor or materials that it provided will be protected by state law. If the general contractor does not pay the subcontractor, then the church will be required to do so. If it does not, the subcontractor can sell the church’s property in a foreclosure sale to obtain payment for the labor or materials that it provided.
Key point. Churches can protect themselves from having to pay twice for the same services or material in various ways. Here are some common precautions: (1) Only deal with reputable contractors who have been in business in your community for several years and who have an excellent reputation. Many churches use a contractor who is a member of their congregation. (2) Require the contractor to provide you with “lien waivers” from all suppliers and workers before making payments for the job. (3) Hold back a portion of the contract price until you are assured that all suppliers and workers have been paid. (4) Ask the contractor to submit bills from suppliers and workers directly to the church, and inform the contractor that the church will pay these bills directly. (5) If you sign a contract, you may want to address some of these options in the contract. The assistance of an attorney is essential.
Subcontractor does not file a mechanic’s lien
The fact that a subcontractor fails to file a mechanic’s lien does not necessarily prevent the subcontractor from seeking payment from a church. If the general contractor fails to pay the subcontractor, then the subcontractor may sue the church for payment on the basis of the legal doctrine of “unjust enrichment.” This court made the following two conclusions regarding unjust enrichment:
(1) If the church has paid the full contract price to the general contractor, then it has not received a benefit for which it did not pay and it has not been unjustly enriched. According to this court, the church would not be legally required to pay the subcontractor again.
(2) If the church has not paid the full contract price to the general contractor, then it has received a benefit for which it did not pay. Under these circumstances, the court concluded that the church had been unjustly enriched, and as a result it was required to pay the subcontractor’s claim. Wickford Metal Products v. Tri-Village Church of Christ, Inc., 1999 WL 3973 (Ohio App. 1999).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Paying Taxes with a Credit Card
Using credit cards for payments might not be as advantageous as taxpayers hope.
In 1999, the IRS for the first time allowed taxpayers to pay their federal taxes with a credit card. Some taxpayers saw this as a way to accumulate frequent flier miles—by charging taxes to a credit card that offers frequent flier miles for dollars charged. Unfortunately, a recent IRS news release confirms that there are some features to this program that make it unlikely that taxpayers will be able to fly anywhere soon. Here are the details:
2 ways to pay taxes by credit card. There are 2 ways for you to pay your taxes by credit card:
(1) Phone option. The pay-by-phone option allows you to charge taxes to American Express, Discover, or MasterCard accounts by calling 1-888-2PAY-TAX. An automatic voice response system will guide you through the process. Visa cards are not accepted, even though they represent about one-half of all credit cards used in this country. It is possible that Visa cards will be accepted in the future.
Key point. Taxpayers charging an estimated tax payment will not have to file the paper Form 1040-ES. The phone system, operated by Official Payments Corporation of San Ramon, Calif., will open January 14, 2000. The estimated tax payment option will become available March 1, 2000.
(2) Computer option. Three tax software developers (Intuit, Nelco, and Orrtax) offer electronic filing (e-file) and pay combinations for individuals. In these programs, the credit card payment information is part of the electronic return filed. The Intuit program (TurboTax) currently allows tax payments with the Discover card, Visa, MasterCard, Optima, or American Express.
What taxes can I pay by credit card? The phone option will accept three types of payments: the balance owed on a 1999 return; a projected balance of 1999 taxes due on a request for an automatic extension of time to file; or an estimated tax payment for tax year 2000. The computer option will accept the actual tax liability paid with your electronically-filed tax return.
Is there a maximum amount that I can charge? The maximum charge accepted by phone will be $99,999.99. There is no limit on taxes paid using the computer option.
How much will it cost me? The IRS does not set or collect any fees for credit card payments, but two other fees may apply.
(1) Convenience fee. There is a “convenience fee” that is charged by the company that processes the credit card payments. This fee is based on the amount of taxes charged. For example, the fee for a $1,000 charge is $35; the fee for a $2,000 charge is $68; and the fee for a $5,000 charge is $133. If you file electronically using TurboTax or MacInTax software and charge your balance due, your credit card company will process your payment and charge you a convenience fee.
(2) Cash advance fees. Credit card companies may charge a “cash advance” fee when taxpayers charge taxes to their credit card—if the charge is treated as a cash advance rather than a payment. You should check with your credit card company to see if imposes a cash advance fee on such charges, and if so, the amount of the fee. To illustrate, “cash advances” charged to a Visa credit are assessed a 3% fee.
The bottom line. Is it worth charging taxes to a credit card in order to earn frequent flier miles? Here are the factors to consider:
(1) Amount of miles needed for free travel. How many miles are needed for a free round-trip coach class ticket on my preferred airline? In most cases, the answer is 25,000 miles. This means that you will need to charge $25,000 (at a rate of one mile per dollar charged) to earn a single round-trip domestic ticket. That’s a lot of taxes! But, if other expenses are charged to the same credit card, a free ticket eventually will be earned. Also note that more miles may be needed to claim a free ticket during certain times of the year.
(2) Amount of the convenience and cash advance fees. The biggest limitation in earning frequent flier miles by charging taxes to a credit card is the cost of doing so. At a minimum, you will need to be pay the “convenience fee.” If you pay by phone, the fee for charging $25,000 will be substantial (close to $1,000)—far more than the cost of a discounted round-trip domestic ticket. If you pay by computer and charge your taxes to a credit card, you will need to check with your credit card company to determine if it imposes a fee, and if so, in what amount.
(3) Credit card interest. The exorbitant interest rates charged by credit card companies is another “cost” that must be considered when deciding whether or not to pay taxes by credit card. If you do not pay your credit card balance immediately, you will begin to incur interest on your balance. Interest payments will skyrocket if you pay the minimum balance on your credit card each month. Some credit card companies charge even higher rates for “cash advances,” and eliminate any “grace period.”
Tip. The credit card payment options will help some taxpayers who don’t have the full balance due when they file their tax return. Such taxpayers have other options available to them, including a bank loan or setting up an installment agreement with the IRS. Taxpayers may use Form 9465 to request an installment agreement. The law gives taxpayers a right to an installment agreement when they are unable to pay if the balance due is not more than $10,000, the tax will be fully paid within three years, and, during the previous five years, the taxpayer has not failed to either file returns or pay taxes and has not had an installment agreement.
In summary, there are both advantages and disadvantages to paying taxes with a credit card. This option clearly appeals to some taxpayers, since more than 129,000 people paid their federal taxes by credit card during 1999.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
IRS Defines “Last Known Address”
Clarifications may still not result in all notices making it to the right taxpayer.
The IRS generally has three years from the date a federal tax return is filed (or the due date for the return if the return is filed early) to audit the return and assess additional taxes and penalties. However, the IRS may not assess additional taxes and penalties unless it mails a “notice of deficiency” to the taxpayer giving the taxpayer an opportunity to challenge the IRS position before the United States Tax Court. An IRS notice of deficiency must be mailed to the taxpayer’s “last known address,” even if it is not received by the taxpayer. In the past, the term “last known address” was not defined by the tax code or regulations.
The IRS has released regulations defining this important term. There are two key points to note. First, the regulations define “last known address” as the address that appears on a taxpayer’s most recently filed federal tax return, unless the IRS is given clear and concise notification of a different address. Second, while the tax code does not require the IRS to check with the United States Postal Service concerning a change in a taxpayer’s address, the new regulations provide that beginning in May 2000 (and every November thereafter) the IRS will refer to the Postal Service’s National Change of Address (NCOA) database to obtain a taxpayer’s address for purposes of determining the taxpayer’s last known address. Any citizen can update his or her residential address with the Postal Service by submitting a Form 3575 containing a new address, and the new address is thereafter maintained in the NCOA database.
Beginning in May, before sending correspondence to a taxpayer, the IRS will review the NCOA database to see if the taxpayer has submitted a Form 3575 to the Postal Service with a more recent address. If so, the following will occur: (1) the correspondence will be mailed to the address obtained from the NCOA database, and (2) the IRS will use the new address from the NCOA database to update the automated master file. This updated address will be the taxpayer’s last known address. A new NCOA address will be the taxpayer’s last known address, unless the IRS is given clear and concise notification of a different address.
Using the NCOA database will increase customer service by allowing faster delivery of IRS correspondence to a taxpayer. Rather than mailing correspondence to an address which is no longer a taxpayer’s address and relying on the Postal Service to forward mail to the taxpayer’s most recent address, the IRS will mail the correspondence directly to the taxpayer’s most recent address. In addition, by updating the automated master file with the most recent address, future IRS correspondence will be mailed to the taxpayer’s most recent address.
Key point.Since the IRS will review the NCOA database only once each year, it is still possible if not likely that many IRS notices of deficiency will be mailed to the wrong address. Taxpayers can avoid this possibility by completing and submitting to the IRS a Form 8822. This form is used to notify the IRS of a change in address.
Tip. Place a notice in your church newsletter reminding members who have moved recently to inform the IRS of their new address by submitting Form 8822. Here’s an example: “Notifying the IRS of a new address. If you recently changed addresses you may want to inform the IRS of your new address. Failure to do so could result in a delay in receiving refunds or important tax notices. You can use Form 8822 to let the IRS know your new address. You can obtain this form by calling 1-800-TAX-FORM.”
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Vollmann v. Rosenburg, 972 S.W.2d 490 (Mo. App. 1998)
Background. It can happen to any church. Someone donates or sells real estate to a church. The deed contains a clause stating that title will revert back to the previous owner if a specified condition occurs. Years go by, and the condition is forgotten. The church inadvertently violates the condition, and the previous owner (or his or her heirs) claim title to the property! A similar scenario occurred in a recent case. A woman died in 1977, leaving a will that contained the following provision: “I give, bequeath and devise … my real estate propertyconsisting of 10 acres … to the Salvation Army to be used, in perpetuity as a children’s camp, the aforesaid property never to be sold.”
After a number of years, the Salvation Army concluded that it was no longer feasible to use the property as a children’s camp because of unanticipated changes in the surrounding area, and it sold the property to a third party. The previous owner’s heirs immediately filed a lawsuit asking the court to award them title to the 10 acres because of the Salvation Army’s sale of the property in violation of the provision in the previous owner’s will. A court agreed that the Salvation Army forfeited all of its ownership in the property as a result of the attempted sale.
Application. Church leaders should not even consider selling church property without first examining the deed to see if there are any restrictions on the sale of the property. The last thing you want to do is trigger a reversion of the property to the previous owner. Further, carefully review any proposed deed when acquiring property through purchase or gift. Has the owner inserted a provision in the deed restricting the church’s use or disposition of the property? If so, you will need to determine if the restriction is acceptable. You should also try to persuade the owner either to eliminate the restriction, or make it as flexible as possible. Ask yourself this question, “How will future generations of church leaders view this restriction?”
This article originally appeared in Church Treasurer Alert, February 2000.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
McBrayer v. Commissioner, T.C. Memo. 1999-360 (1999)
Ministers and lay church employees often travel on church-related business. What are the tax consequences associated with a loss of one’s luggage while traveling on a business trip? The Tax Court addressed this question in a case.
A teacher claimed a Schedule C expense deduction in the amount of $530 for luggage that she claimed had been stolen while she was using a restroom at Reagan National Airport. The only evidence she produced in support of the deduction were receipts for two pieces of replacement luggage she purchased shortly after the loss. The IRS denied the deduction, and the Tax Court agreed. The court concluded that no loss deduction was available, for the following three reasons:
(1) The teacher failed to establish that her luggage had been stolen. The court noted that “to be entitled to a [loss] deduction a taxpayer is required to substantiate the deduction through the maintenance of books and records or other sufficient evidence.” It acknowledged that the teacher had provided the court with receipts for two pieces of replacement luggage, but concluded that this did not constitute sufficient substantiation of the loss. It concluded: “It is well settled that we are not required to accept petitioner’s self-serving testimony in the absence of corroborating evidence. [The teacher] failed to submit corroborating evidence, such as a police report. Such evidence would have been helpful in establishing the items stolen and the date of the theft.”
(2) The teacher failed to prove the amount of the loss. The court pointed out that she failed to substantiate the amount of the loss by documenting the “adjusted basis” of the lost luggage. In general, the first step in determining amount of a theft loss is to compute the property’s adjusted basis. This amount is the original cost of the property, with certain adjustments. Since the teacher failed to produce any evidence as to the original cost of her luggage, she failed to adequately substantiate her loss.
(3) The teacher failed to prove that the loss was not compensated for by insurance. A taxpayer must demonstrate that a loss was not covered by insurance.
What can church treasurers do to help? If a minister or lay church employee experiences a theft of personal property, here are some suggestions you can make soon after the loss to increase the likelihood of a loss deduction:
Encourage the pastor or lay employee to immediately file a police report. As the Tax Court noted, this will help to substantiate that the property in fact was stolen, and the date of the loss.
Encourage the pastor or lay employee to locate records substantiating the cost of the stolen property. This evidence will be required in order to support a loss deduction.
Key point. Even if all the required records are maintained, a loss deduction is subject to additional limitations. To illustrate, the amount of each loss (adjusted basis) must be reduced by $100, and total theft losses must be reduced by 10% of adjusted gross income (this rule is applied after the $100 reduction for each loss).
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Liability for Disclosing Confidential Information
A New York court issues an important ruling-Lightman v. Flaum, 687 N.Y.S.2d 562 (1999)
A New York court issues an important ruling- Lightman v. Flaum, 687 N.Y.S.2d 562 (1999) [The Clergy-Penitent Privilege ]
Article summary. In a landmark case that should be reviewed by every minister and seminary student, a New York court ruled that a woman could sue two rabbis for disclosing extremely confidential information that she had divulged to them separately in the course of confidential marital counseling. This case illustrates the importance of clergy maintaining the confidentiality of information shared with them in the course of conversations protected by the clergy-penitent privilege. A failure to do so may result in civil liability for breach of a fiduciary duty to preserve confidential information.
A recent New York court ruling makes it more likely that clergy who disclose information shared with them in confidence will be subject to civil liability. This feature article will review the facts of this important ruling, summarize the court’s opinion, and evaluate the significance of the case to clergy and lay church leaders.
Facts
In 1995, a married woman (the “plaintiff”) sought counseling from two different rabbis. She shared with each of them, in separate counseling sessions, information of an extremely personal and confidential nature. The rabbis were employed by congregations that the plaintiff and her husband attended. A few months later, the plaintiff sued her husband for divorce. She also asked the court to award her custody of the couple’s four minor children. In response, the husband submitted affidavits in support of his claim to the custody of his children. These affidavits were prepared by the two rabbis, and they disclosed some of the confidential information that the plaintiff had shared with them during the counseling sessions.
The affidavit of one of the rabbis stated:
[The plaintiff] admitted to me that she stopped engaging in our religious purification laws since September 1995 and hence, all sexual activity has stopped by her own decision. [She also] admitted to me that she was seeing a man in a social setting and admitted, “I am doing the wrong things.” I spoke to her and counseled her against this.
The affidavit of the second rabbi stated:
[The plaintiff] admitted to me that she freely stopped her religious bathing so that she did not have to engage in any sexual relations with [her husband]. She told me she was not getting fulfillment. When I inquired what that meant, she simply answered, he doesn’t relate to me. Nothing was stated that amounted to cruel conduct by [the husband]. Her religious behavior has changed. She does not want to adhere to Jewish law despite the fact that she is an Orthodox Jew and her children are being raised Orthodox as well. She has engaged in bizarre behavior. I have no loyalty to either party except to state what I observed and to issue an opinion based on those observations from a religious point of view.
Based on these affidavits, the plaintiff sued both rabbis, claiming that they violated the clergy-penitent privilege and committed intentional infliction of emotional distress. She also sued one of the rabbis who submitted the second affidavit for defamation. The plaintiff claimed that the rabbis should be found legally liable and pay money damages for disclosing privileged and sensitive communications they had received from her.
The rabbis insisted that they were compelled by Jewish law to reveal the confidences to plaintiff’s husband, his attorney, and the court for the protection of both the husband and the children. Additionally, one of the rabbis asserted that the plaintiff was not seeking spiritual counseling or advice when she met with him, and both rabbis insisted that a third person was present when they met with her. One of the rabbis alleged that the plaintiff described “the most intimate details of her marriage” when he met with her in the presence of her friend, which surprised him. The other rabbi alleged that the husband had informed him that he and his wife were having marital problems, that she was deviating from Orthodox tradition, and that she was in “adulterous relationships.” Weeks later, the plaintiff and her mother appeared at his office and berated him for speaking to the plaintiff’s husband. In the course of the heated exchange, plaintiff admitted “she had stopped engaging in religious purification laws” and was “seeing men in social settings even though she was still married to [her husband].”
Both rabbis admitted notifying the husband and claimed that, in doing so, they were acting in accordance with their obligation as rabbis and spiritual advisers and, further, that this was to protect the four “innocent” children of the marriage.
The rabbis claimed that the plaintiff’s request for damages because of the alleged violation of the clergy-penitent privilege must be dismissed since no private cause of action existed for violating the privilege. They claimed that breach of the privilege is merely a violation of a rule of evidence, and that the sole remedy is the exclusion of the communication from evidence.
The Court’s Ruling
the clergy-penitent privilege imposes a fiduciary duty of confidentiality
The plaintiff’s primary claim was that the clergy-penitent privilege imposes a “fiduciary duty of confidentiality” upon clergy, and that this duty is breached when clergy disclose, without authorization, information that is shared with them in the course of a privileged conversation.
The court began its opinion by acknowledging that New York courts have allowed physicians to be sued for breaching the physician-patient privilege, and attorneys for violating the attorney-client privilege. The plaintiff conceded that no court in New York, or in any other state, had ever ruled that a member of the clergy can be sued for violating the clergy-penitent privilege. She insisted, however, that if physicians and attorneys can be sued for disclosing privileged information, then clergy should be held to the same standard. She pointed to the “care and diligence by most responsible members of the clergy in safeguarding confidences” as the reason the issue had never arisen.
The rabbis insisted that holding clergy personally liable for disclosing information shared with them in a communication protected by the clergy-penitent privilege would “impinge upon the free exercise of their religious rights, preserved by the first amendment.” The court agreed that
the imposition of liability … for conduct or activities of a religious society or its members, in furtherance of religious beliefs, is barred where the imposition of liability would result in the abridgement of the free exercise of religion, in violation of the first amendment. The same holds true where the court would be required to become excessively entangled with religious doctrine and its standards. In such instances, it has been recognized that a court must refrain from determining ecclesiastical questions.
However, the court continued:
[W]hile the first amendment does prohibit the intrusion upon the exercise of religious beliefs, the conduct of a religious entity remains subject to regulation for the protection of society. This is especially so where the imposition of liability or sanctions for the conduct complained of is secular in nature, namely, where liability is imposed equally, for religious institutions and parties, as well as for others, and where the basis for such liability may be determined without examination into religious law or policies. Thus, the free exercise clause is not an absolute defense where, as here, liability for tortious conduct is sought to be imposed upon members of the clergy. It may only serve as a defense where the alleged tortious conduct was undertaken pursuant to religious principles or doctrine.
Even where the conduct is predicated upon religious beliefs, it may nevertheless form the basis for liability where significant societal interests are involved. Thus, it has been held that the intentional torts of the clergy may be actionable, notwithstanding the allegation that they are incidents of religious beliefs. Other courts have sustained causes of action against religious organizations for negligent supervision and retention, upon the ground that a liability determination would not require examination of any religious doctrine, nor would it inhibit any religious practice. In such instances, the first amendment will not serve as a defense because it is not implicated.
Based upon the foregoing legal principles, in determining whether the first amendment is a viable defense, the threshold inquiry must be whether the complained of conduct is actually motivated by or involves religious practices or beliefs. If it is not, liability may be imposed without raising any constitutional inhibition or restriction. In such case, plainly, there is no entanglement with religion.
The court concluded that both rabbis could be sued for breach of the fiduciary duty of confidentiality on the basis of disclosing confidential information that was communicated to them in the course of a conversation protected by the clergy-penitent privilege. The court noted that “absent any religious or first amendment implication, there is no compelling reason here to shield these Rabbis from liability in tort for revealing such sensitive, personal communications, when other similarly situated professionals are subject to potential liability under statutory provisions analogous in scope and purpose to that at issue here.”
The court concluded,
It is beyond peradventure that, when one seeks the solace and spiritual advice and guidance of a member of the clergy, whether it be a priest, rabbi or minister, on such sensitive, personal matters as those involved in our case, this is not done as a prelude to an announcement from the pulpit. On this record, it is equally clear that these protectors of the faith, under the guise of religious necessity, the protection of the children and the sanctity of the marital institution, have taken upon themselves the disclosure to others of what, from its very nature and subject, was imparted in confidence, unless the privilege was waived by the presence of some third party or, from the nature of the meeting, the disclosure and communication was not made to the rabbis in their spiritual capacity. And, not only were disclosures made to [the husband], both [rabbis] readily acceded to his request that they be repeated to counsel and to the court in the matrimonial action, so as to influence the issue of temporary custody and/or visitation.
In my view, this was not only improper, it was outrageous and most offensive, especially considering the stature of [the rabbis] within the community, a standard which they readily abdicated here. From what was done, it is palpably clear why this determination is one of apparent first impression-no member of the clergy … would dare breach the sanctity of his or her office to make public the type of confidential, private disclosures at issue in this case. And, while both profess that religious law “compelled” disclosure, to the contrary, both were bound by civil law, which mandated strict confidentiality. After all, the privilege belongs to the penitent, not the clergy, and must be honored.
Moreover, to violate such basic rights under the guise of religious necessity, conviction or the protection of the Torah is not only wrong, it is outrageous. Under the factual scenario admitted by these [two rabbis], disclosure was not required to prevent [the husband] from violating Jewish law or tradition. Both [rabbis] knew that the couple was experiencing marital difficulties when they were told that plaintiff was no longer going to the Mikvah, the ritual bathing to purify the woman during her menstrual period. Clearly, this is a peculiarly sensitive matter, not readily discussed with others, nor in open, public exchanges. Notwithstanding that future marital relations would cause [the husband] to violate Jewish law, neither [rabbi] had a “religious obligation as a rabbi” to make public what had been imparted to them. In lieu of such, all that they had to do was ask the husband whether, notwithstanding their marital difficulties, the parties were still having normal relations. If so or, in the alternative, without such an inquiry, [they] could have emphasized to the husband the importance of ensuring that his wife was still going to the Mikvah. This, however, was not done. Moreover, as is apparent from [one rabbi’s affidavit] the disclosure was palpably unrelated to any religious doctrine, since what had been told to [him] was that “plaintiff admitted that she had stopped engaging in religious purification laws (which resulted in the cessation of all sexual activity with her husband).” Thus, since he had been told there was no sexual relationship, there was no need for disclosure, especially under the pretext of preventing any violation of religious doctrine, unless this was to serve some other male, Orthodox, but equally irrelevant role.
Notwithstanding the foregoing, disclosure in this case hardly equates with the overwhelming public and societal interest in preserving the sanctity of such confidential communications. Plainly, there is no justification, religious or otherwise, for disclosing that plaintiff had been seeing men outside the marriage. The alleged negative impact upon the four children, in terms of “their level of religious observance as well as their general well being” is so general that, in terms of importance, it cannot possibly measure against the overriding state and public interest in preserving confidentiality. The same holds true with respect to the alleged “religious obligation” to prevent the husband from having relations with a woman “who admittedly socialized with other men” or, in terms of the children, “to shield them from their mother’s improper conduct.” To acknowledge such would improperly and unwisely create a standard for these defendants, as Orthodox rabbis, different from that followed by the rest of society.
Did the clergy-penitent privilege apply in this case?
The court then addressed the rabbis’ defense that their conversations with the plaintiff were not subject to the clergy-penitent privilege, and so no fiduciary duty of confidentiality arose. In particular, they asserted that a third person was present during their conversations with the plaintiff, and one rabbi insisted that he had not been sought out by the plaintiff in his capacity as a spiritual adviser.
The court conceded that the fiduciary duty of confidentiality only arises in the course of communications that are subject to the clergy-penitent privilege, and therefore such a duty would not exist if the plaintiff’s statements to the rabbis were made in the presence of a third person or if the plaintiff did not consult with the rabbis as spiritual advisers. However, the court concluded that it lacked sufficient information to resolve these issues, and decided to let a jury decide whether or not the privilege applied to the plaintiff’s conversations with each rabbi.
infliction of emotional distress
The plaintiff claimed that the rabbis’ unauthorized disclosure of information she had shared with them in confidence amounted to an intentional infliction of emotional distress for which she was entitled to money damages. The court noted that
to state a cause of action for intentional infliction of emotional distress, the conduct complained of must be so outrageous in character, and so extreme in degree, as to go beyond all possible bounds of decency, and to be regarded as atrocious, and utterly intolerable in a civilized community. The conduct must be of such a nature that it so transcends the bounds of decency as to be regarded as atrocious and intolerable in a civilized society. More must be involved than hurt feelings; mere insults, indignities, threats or annoyances are insufficient. Intent or recklessness is an essential element of the cause of action.
The plaintiff insisted that the disclosure of privileged communications made to a rabbi by a penitent, done with malicious intent, meets this standard. The court agreed:
Bearing in mind the sanctity to be accorded such communications between clergy and penitent, and the necessity for confidentiality in conjunction with such spiritual counseling, without the fear of any reprisal or disclosure, it is both outrageous and intolerable that such communications would be revealed, even where, as here, this occurs in part in the context of a judicial proceeding. In my view, the conduct so transcends the bounds of decency as to be regarded as both intolerable and atrocious … .
The court cautioned that the plaintiff would have to persuade a jury that the rabbis’ acts were intentional or reckless.
Defamation
The plaintiff claimed that some of the statements contained in one of the rabbi’s affidavits were defamatory. The court rejected this claim, noting that “a written statement in the course of a judicial proceeding is absolutely privileged if, by any view or under any circumstances, it may be considered pertinent to the litigation.” The court concluded,
Clearly, the statements were pertinent to the litigation in that they were intended to reflect upon plaintiff’s fitness to be a good mother. Plaintiff claims that the statements fall without the scope of the privilege, since they must have been discussed and, therefore, published to her husband and his attorney prior to their having been reduced to writing for submission on the motion. She contends that this publication is not subject to any privilege. However, it is patently clear from the complaint that the statements, whenever published, were made in connection with the above action for divorce. The absolute privilege is not limited to statements made or documents used in open court. Thus, the statements are absolutely privileged since made for the purpose of litigation and may not be the subject of a claim for defamation.
Significance of the case to clergy
What is the significance of this case to clergy? A decision by a New York court has limited effect. It is not binding in any other state, and it is subject to reversal by the New York Court of Appeals (the highest state court in New York). Nevertheless, the case represents one of the few extended discussions of clergy liability for divulging confidences. As a result, it may be given special consideration by other courts. For these reasons the case merits serious study by clergy in every state. With these factors in mind, consider the following:
1. The fiduciary duty of confidentiality. By far the most significant aspect of the court’s decision was its conclusion that a “fiduciary duty of confidentiality” arises whenever confidential information is shared with a minister in a conversation that is protected by the clergy-penitent privilege. Ministers can be sued if they breach this duty by disclosing confidential information without authorization.
2. The fiduciary duty arises only in the context of privileged communications. The court ruled that the fiduciary duty of confidentiality arises only in the context of a communication that is protected by the clergy-penitent privilege. Every state recognizes this privilege, although the definition varies slightly from state to state. The clergy-penitent privilege in New York simply states that “unless the person confessing or confiding waives the privilege, a clergyman, or other minister of any religion or duly accredited Christian Science practitioner, shall not be allowed to disclose a confession or confidence made to him in his professional character as spiritual adviser.” As in most other states, the clergy-penitent privilege in New York only applies to (1) communications; (2) made in confidence; (3) to a minister; (4) acting in a professional capacity as a spiritual adviser. Communications meeting these requirements are protected by the clergy-penitent privilege, and they give rise to a fiduciary duty of confidentiality.
Example. G, a married man, seeks out his pastor for counseling and confesses to adultery. The conversation between G and the minister was protected by the clergy-penitent privilege. The minister later discloses this information to the church board. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. The minister also may be liable for intentional infliction of emotional distress.
Example. Same facts as the previous example, except that G was accompanied by a friend while meeting with the minister. In some states, the presence of a third person during a conversation with a minister will prevent the conversation from being privileged since it is not “confidential.” In such a state (assuming that it follows the decision of the New York court addressed in this article) the minister would not liable for breaching a fiduciary duty of confidentiality, since this duty only arises in the context of a conversation protected by the clergy-penitent privilege.
Example. A church adopts a policy prohibiting its minister from engaging in opposite sex counseling without a third person being present. During an opposite sex counseling session in which a third person is present, a counselee discloses highly confidential information which the minister later shares with the church board. In many states, the clergy-penitent privilege is not destroyed by the presence of a third person so long as that person is present “in furtherance of the communication.” A strong case can be made that the third person in this example is present “in furtherance of the communication.” As a result, if the state clergy-penitent privilege applies even if such a third person is present during the conversation between the minister and counselee, then the minister may be liable for breaching the duty of confidentiality in New York or in any other state that follows the decision of the New York court addressed in this article.
Example. A church member sees her minister at a high school soccer game. The two engage in a conversation at the end of the game while waiting to see some of the players. There are several people nearby. It is likely that a court would conclude that this conversation was not privileged since it was not “confidential” and the context of the conversation suggests that the member was not seeking out her minister in his professional capacity as a spiritual adviser. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister would not be personally liable for breaching a duty of confidentiality by disclosing confidential information shared with him by the member during their brief conversation, assuming that a court would conclude that the conversation was not privileged.
Example. A minister counsels with J, a church member. J informs the minister that he committed an unsolved crime. The minister shares this information with the police. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. The minister also may be liable for intentional infliction of emotional distress.
Example. A minister counsels with K, a church member. K informs the minister that her husband sexually molested their 6-year-old daughter. The minister is a mandatory child abuse reporter under state law, and so he promptly shares this information with the police. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. However, the New York court did not address the question raised by this example-whether or not a mandatory duty to report child abuse prevents liability based on a breach of a duty of confidentiality.
Example. Same facts as the previous example, except that the minister is a “permissive” rather than a mandatory child abuse reporter under state law. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. However, the New York court did not address the question raised by this example-whether or not a non-mandatory duty to report child abuse prevents liability based on a breach of a duty of confidentiality. It is less likely that a non-mandatory duty to report child abuse would prevent a minister from being found personally liable for breaching the fiduciary duty of confidentiality.
Example. A minister counsels with C, a church member. C informs the minister that he molested a child during a youth activity sponsored by the church. The minister promptly shares this information with the police. A state law makes ministers mandatory reporters of child abuse, except when they learn of abuse in the course of a conversation protected by the clergy-penitent privilege. In New York, or in any state that follows the decision of the New York court addressed in this article, the minister may be personally liable for breaching a duty of confidentiality by disclosing confidential information without consent. However, the New York court did not address the question raised by this example-whether ministers who are mandatory reporters of child abuse, except when they learn of abuse in the course of a privileged communication, may be personally liable for breaching a fiduciary duty of confidentiality when they elect to share with the police or civil authorities information concerning child abuse that they learned in the course of a privileged conversation. It is possible that the New York court would find the minister liable for breaching the fiduciary duty of confidentiality under these circumstances, since the disclosure is not required by law.
3. The importance of being familiar with the clergy-penitent privilege in your state. The examples presented above demonstrate the importance of ministers being familiar with their own state’s clergy-penitent privilege.
4. Other precedent. The court concluded that this was only the second case in any state to address directly the liability of a minister for disclosing confidential information communicated in the course of a privileged conversation. The other case was a 1989 decision by a California appeals court. This decision, along with one other case cited by the New York court, are summarized below.
A bishop confessed to two denominational leaders that he was involved in an extramarital affair with a church member. The bishop asked the denominational leaders to keep his confession in confidence, and they promised to do so. A short time later, the female church member who was the other party to the affair confessed to a denominational leader, who promised to keep her confession in confidence. The denominational leaders allegedly disclosed these confidences to the local church’s board of elders, and to numerous other persons. One of the denominational leaders allegedly disclosed the confidences to the assembled congregation in a Sunday worship service, and then proceeded to “excommunicate” the bishop and “cast his spirit” from the church. The bishop also alleged that one of the denominational leaders disclosed his confession to a “gathering of local priests, ministers, pastors, and guests.”
As a result of these disclosures, the bishop and the female church member were shunned by friends, family, and members of their local church and denomination. The two sued the denomination and various officials, alleging invasion of privacy, breach of fiduciary duty, false imprisonment, emotional distress, and malpractice. The denomination countered by arguing that the civil courts lacked jurisdiction over the controversy since “the conduct complained of is ecclesiastical in nature.”
A trial court agreed with the church’s position, and dismissed most of the claims. On appeal, a state appeals court ruled that the church could be sued for emotional distress and related claims, and it ordered the case to proceed to trial. The court began its opinion by noting that “religious disputes can take a number of forms … and do not always result in immunity from liability.” The court acknowledged that the civil courts may not intervene in disputes over church doctrine, but it was not willing to accept the trial court’s summary conclusion that this dispute involved church doctrine. It observed,
The trial court was not told, and we do not know, whether it is a canon of [the church’s] belief that confessions (penitential or not) are revealed to the congregation … whether it is church practice for the substance of a confession to be shared among church officials; or whether it is consistent with church doctrine to reveal the substance of a confession to anyone outside the church, and if so, under what circumstances.
The court recognized that any government action that burdens a religious practice, such as allowing a minister to be sued for disclosing confidential information, involves substantial constitutional considerations. It cautioned that various factors must be taken into account, including whether the religious practice is rooted in church doctrine, and whether a government interest outweighs any burden on religion.
The court applied a four-part balancing test to determine whether the government can interfere with religious practices: (1) the government action limiting a religious practice must be in furtherance of some compelling government interest; (2) the burden on religious practice must be essential to further the government’s interest; (3) the type and level of the burden must be the minimum necessary to achieve the government interest; and (4) the burden must apply to everyone, not merely to those who have a religious belief.
In applying this four-part test, the court concluded that even if church doctrine required the disclosure of confidences, this would not end the analysis, since certain types of behavior may be regulated or subjected to legal liability by state law even if rooted in religious doctrine-so long as the state has a compelling interest that justifies the burden on religious conduct, the burden on religious practice is essential to the government interest, and the burden is the least restrictive means of achieving the government interest. The court noted that “under the banner of the first amendment provisions on religion, a clergyman may not with impunity defame a person, intentionally inflict serious emotional harm on a parishioner, or commit other torts.” In other words, the first amendment guaranty of religious freedom does not necessarily insulate clergy from liability for their actions.
The court acknowledged that “apparently there are no generally reported opinions where a counselee or communicant has sought to hold a religious officer liable in tort for [an unauthorized disclosure of confidential communications].” However, it saw no reason why clergy and church leaders should not be held legally accountable for injuries they inflict when they disclose confidential information to others without consent.
Alexander v. Culp, 705 N.E.2d 378 (Ohio App. 1993)
A church member (the “plaintiff”) met with his pastor for marital counseling. He confessed to having been involved in several affairs during his marriage, and that he was currently having an affair. The minister later disclosed these confessions to plaintiff’s wife and, after noting that the plaintiff was a liar and not to be trusted, suggested that the wife obtain a restraining order, change the locks on the doors, and retain counsel to secure a divorce. Since the plaintiff also stated he intended to take the children to another state, the minister suggested that she keep them away from their father. The court allowed the plaintiff to sue his pastor for negligence. It observed:
Public policy supports an action for breach of confidentiality by a minister. There is a public policy in favor of encouraging a person to seek religious counseling. People expect their disclosures to clergy members to be kept confidential… . Whether a particular case interferes with first amendment freedoms can be determined on a case by case basis.
Although Ohio had a statute which prohibited clergy from testifying as to confidences communicated during religious counseling, the provision had no application to any disclosure outside any legal proceeding. In holding that the facts set forth a claim for ordinary negligence, not malpractice, the Ohio court observed, “Although the duty not to disclose arose from the clergy/parishioner relationship, the breach of the duty to preserve [the plaintiff’s] confidences neither involved nor compromised any religious tenets.”
5. How clergy can respond. There are a number of steps that ministers can take to reduce the risk of liability based on unauthorized disclosures of confidential information. Consider the following:
Familiarity with your state’s clergy-penitent privilege. Be familiar with the provisions of the clergy-penitent privilege in your state. Remember, according to the New York court, liability based on a breach of the fiduciary duty of confidentiality is based on the clergy-penitent privilege. In most states, the clergy-penitent privilege will apply to any communication made to a minister, in confidence, while acting in a professional capacity as a spiritual adviser. Unfortunately, it is not always easy to determine if a particular conversation is privileged. Consider the following circumstances:
It is not always easy to determine if a person sought out a minister in his or her professional capacity as a spiritual adviser. The location of a conversation will be relevant, though not determinative, in resolving this question.
Sometimes a counselee will share confidential information with a minister, and later disclose the same information to other persons. What effect do these subsequent disclosures by the counselee have on the privileged nature of the previous conversation with the minister? Does the previous conversation cease to be privileged, because it is no longer “confidential”?
Does the clergy-penitent privilege apply to child abuse reporting? To illustrate, if a church member confesses to a minister that he has molested his minor child, is this communication privileged? What if the applicable state child abuse reporting law makes clergy mandatory child abuse reporters? What if clergy are not mandatory child abuse reporters? What if the child abuse reporting law specifies that ministers are not required to report child abuse that they learn of in the course of a privileged conversation?
The New York court’s decision addressed in this article presents clergy who are “mandatory” child abuse reporters under state law with a difficult dilemma: they may be criminally liable for not reporting known or reasonably suspected incidents of child abuse, and yet they may be liable for breaching a fiduciary duty of confidentiality if they do not report it. The New York court did not address this dilemma. It is possible, though not certain, that it would have concluded that ministers who are mandatory child abuse reporters under state law cannot be liable for breaching a fiduciary duty of confidentiality by complying with their legal duty to report child abuse, even if they learn of the abuse in the course of a privileged conversation. On the other hand, this conclusion is less certain in the case of ministers (1) who are permissive as opposed to mandatory child abuse reporters under state law, or (2) who are mandatory reporters in a state that excuses them from reporting child abuse they discover in the course of a conversation that is protected by the clergy-penitent privilege.
Does the clergy-penitent privilege apply when third persons are present? In some states, communications made to a minister in the presence of one or more “third persons” are not “confidential” and as a result are not privileged. In other states, the presence of a third person will not prevent a communication from being privileged, so long as the third person’s presence is “in furtherance of the communication.” Again, it is essential for ministers to be familiar with their state’s clergy-penitent privilege.
Tip. If the presence of a third person prevents a conversation with a minister from being privileged in your state, then you may want to consider having a third person present in some situations to reduce the risk of liability based on a breach of the fiduciary duty of confidentiality.
Resist the urge to disclose confidential information. In some cases, a minister’s disclosure of confidences is inadvertent, such as a spontaneous sermon illustration. In others, it is deliberate, such as a disclosure of confidential information to the church board. Ministers must realize that disclosing confidences may expose them to personal liability.
Obtain authorization in writing. In some cases, ministers may believe that they have a legitimate reason to disclose confidences. Consider the following examples: (1) A minister feels compelled to report child abuse; (2) a minister feels obligated to share a counselee’s personal failings with the church board because they disqualify the counselee from membership according to the church’s bylaws; or (3) a counselee informs a minister that he intends to kill or injure another person. Ministers can reduce the risk of liability in such cases by obtaining written consent from the counselee prior to disclosing the confidential information. One way to do this would be develop a written “counseling policy” that counselees must read and sign as a condition to any counseling relationship with a minister. The policy could state that counseling is provided subject to a number of conditions, including the consent of the counselee to the minister making disclosures under specified circumstances (in the case of child abuse, departures from the church’s standard of membership, threats to injure or kill others, etc.). Any such policy should be prepared or reviewed by an attorney.
6. Education. The case discussed in this article addresses a question of fundamental importance to ministers. Denominational offices and seminaries should be educating ministers and students preparing for ministry about the clergy-penitent privilege and the potential personal liability of ministers for disclosing confidences without consent.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Notifying Your Insurer of a Loss
Failure to do so may result in a loss of coverage.
A church’s failure to comply with all of the terms and conditions in its insurance policy following a personal injury or damage to its property may result in a loss of coverage. One charity learned this lesson the hard way.
Background. A charity leased a building that it used as a shelter for the homeless. The lease required the charity to maintain liability and property insurance coverage on the building. The charity purchased insurance, and used the building for a few years. Shortly after the charity vacated the building at the end of its lease, it was sued by the property owner as a result of severe water damage that had occurred during the charity’s lease. The charity notified its insurance company of the claim, and was asked by its insurer to submit a written “proof of loss” form within 60 days as required by the insurance policy. The charity did not submit the required proof of loss form until after the 60-day period had expired, and the insurer denied coverage on this basis. The charity sued its insurer for breach of contract. The insurer defended itself by pointing to the charity’s failure to submit written proof of loss in a timely manner, and its failure to cooperate with the insurer’s investigation of the claim. The court agreed with the insurer, and awarded it $20,000 in attorney fees.
The court’s decision. Did the charity’s failure to submit written proof of loss within 60 days bar recovery under the insurance policy? The charity acknowledged that it failed to comply with the policy’s proof of loss requirement, but it insisted that timely filing was not a legal requirement that should result in a loss of coverage unless the insurer was somehow prejudiced by the delay.
The court concluded that the charity’s failure to comply with the proof of loss requirement resulted in a loss of coverage. It pointed out that the policy “unambiguously makes submission of written proof of loss within 60 days after request from the insurer” a precondition to coverage. The policy states:
Duties in the event of loss or damage. You must see that the following are done in the event of loss or damage to covered property … send us a signed, sworn proof of loss containing the information we request to investigate the claim. You must do this within 60 days after our request. We will supply you with the necessary forms.
No one may bring a legal action against us unless … there has been full compliance with all of the terms of this coverage part.
The court concluded, “Because the language of the insurance policy is clear … submission of written proof of loss within 60 days after request from [the insurer] is a condition precedent to recovery.” It rejected the charity’s argument that the insurer must have been “prejudiced” by the delay in order to deny coverage, noting that “when a time limit in a policy for providing notice of loss is authorized by statute and an insured fails to comply, recovery is barred regardless of whether the insurer was prejudiced.”
Relevance to church treasurers. The tragic lesson of this case is clear—church treasurers should be familiar with all of the provisions of their church’s liability and property insurance policies, and ensure that all “conditions” are satisfied. Special attention should be paid to those provisions calling for notice following a loss or potential claim. It is imperative that all conditions be met in order to avoid denial of coverage. Leamington Co. v. Nonprofits Insurance Association, 1999 WL 561951 (Minn. App. 1999).
Key point. After reviewing your policies, discuss any questions regarding the notice provisions and other “conditions” with your insurance agent.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
On October 1, 1999, the Social Security Administration (SSA) launched the largest customized mailing ever undertaken by a federal agency when it began mailing an annual Social Security statement to 125 million workers. The 4-page statement is designed to help workers with financial planning by providing estimates of their retirement, disability and survivors’ benefits. The statement will also provide workers an easy way to determine whether their earnings are accurately posted on their Social Security records. This is an important feature because Social Security benefits are based on an individual’s career wage record—not on taxes actually paid.
Here are some points for church treasurers to note:
The SSA will send the annual statements to workers who are ages 25 and older and not receiving Social Security benefits. SSA will stagger the mailing of the statements throughout the year, with approximately 500,000 statements delivered each day. Workers will automatically receive their statements about three months before their birth month.
An annual statement will contain the following information: (1) an estimate of the monthly retirement benefit that the worker would receive at age 62, full retirement age, and age 70; (2) an estimate of the amount of monthly disability benefits the worker would be entitled to receive if he or she became disabled; (3) an estimate of the monthly benefits the worker’s family would receive in the event of the worker’s death; (4) an annual breakdown of the worker’s earnings to date; and (4) a total of the Social Security taxes paid by the worker and his or her employer over the individual’s working career.
The SSA recently redesigned the statement to make it more user-friendly. For example, the language was simplified, the number of pages was reduced from six to four, and the redesigned statement was tested with focus groups and through a mail survey of 16,000 workers.
Church treasurers should inform compensated staff members that they will receive their annual statement within three months prior to their birthday, and encourage them to check the accuracy of the “earnings” and “taxes paid” sections of the statement.
Key point. Each annual statement will report a worker’s lifetime earnings on an annual basis, along with total Social Security taxes paid each year by the worker and his or her employer. It is important for church workers to check the accuracy of the earnings reported on their statement, since this will determine the amount of Social Security benefits they will receive in the future. Workers who can prove that the earnings information reported on their statement is incorrect should contact their local Social Security office for assistance in correcting the record.
Key point. It is especially important for ministers to check their statements carefully, because their earnings history is vulnerable to error for two reasons. First, many ministers who report their income taxes as employees erroneously report their social security taxes as employees (the church withholds FICA taxes from their wages like any nonminister church employee). In fact, ministers always are self-employed for social security with regard to the exercise of their ministry. Some ministers who report their social security taxes as employees have discovered errors in their earnings history, presumably because of their incorrect reporting status. Second, ministers who continue to work after beginning to receive social security retirement benefits are assumed by the SSA to be receiving twice their reported income. This is because such ministers will report income as wages on Form 1040 (line 7) and also as self-employment earnings on Schedule SE (Form 1040). SSA computers assume that amounts reported in these two places reflect different sources of income. While this is true for most workers, it is not true for ministers. Again, the reason is that their income must be reported as self-employment earnings on Schedule SE even though the same income is reported as employee wages on Form 1040. What appears to be “two” different sources of income in fact is only one. The result is that the minister appears to be earning more than the “annual earning test” (the amount that a retired person can earn between ages 62 and 70 without triggering a reduction in Social Security benefits). The bottom line is this—ministers should carefully review their yearly earnings history as reflected on their annual Social Security statement so they can correct errors.
Church treasurers should consider including a notice to church members in the weekly bulletin or church newsletter. Here is a sample notice: “SOCIAL SECURITY ANNUAL EARNINGS STATEMENT. Beginning on October 1, 1999, the Social Security Administration began mailing annual statements to workers 25 years of age and older. The 4-page statement will contain several items of information, including an estimate of the monthly benefit the worker will receive at retirement, and an annual breakdown of the worker’s earnings to date. Since your social security benefits will be based on your prior earnings, it is important to check your statement for accuracy. Any errors should be reported to the nearest Social Security office. You also can use the statement to determine if you need to increase annual contributions to your retirement plan.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Reimbursing Medical Expenses Without a Formal Plan
Background. It is common for churches to pay some or all of the medical expenses of their ministers or lay employees. This can include direct payment of expenses, reimbursing employees for expenses they have incurred, and paying a “deductible” amount on an employee’s medical insurance. The tax consequences of such payments and reimbursements are not well understood.
Section 105 of the tax code permits employees to exclude from gross income amounts received under an employer financed “accident and health plan” as payments for permanent injury or loss of bodily function, or as reimbursements of medical expenses. The payments can be made on behalf of a spouse or dependent of the employee. This exclusion assumes that the employer has established an “accident or health plan.” Unfortunately, the requirements for such a plan are not specified in the tax code. The regulations simply state that “an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness.” The regulations further specify that “an accident or health plan may be either insured or uninsured, and it is not necessary that the plan be in writing or that the employee’s rights to benefits under the plan be enforceable.” Of course, a written plan is preferable, since it generally will eliminate any doubt regarding the existence or date of a plan. The regulations do require that notice of a plan be “reasonably available” to employees (if employees’ rights under the plan are not enforceable).
Employers may reimburse employee medical expenses under either a self insured plan (e.g., reimbursements are paid out of the employer’s own funds rather than through an insurance policy), or an insured plan. However, if reimbursements are made under a self insured plan, then nondiscrimination rules apply. Generally, these rules require that the plan not discriminate in favor of highly compensated individuals with regard to either amount of benefits or eligibility to participate. If a self-insured plan is discriminatory, then highly compensated individuals ordinarily must report some or all of the amount of the employer’s reimbursements as taxable income. If a reimbursement arrangement discriminates in favor of highly compensated individuals on the basis of the amount of benefits (e.g., highly compensated individuals receive a greater benefit than other participants in the plan), then such individuals must report the entire amount of the reimbursements as income. More complicated rules determine how to compute the taxable portion of an employer’s reimbursements if the plan discriminates on the basis of participation (rather than the amount of benefits). In general, a plan discriminates in favor of highly compensated individuals on the basis of eligibility to participate unless the plan benefits 70 percent or more of all employees. Some employees can be disregarded in applying this test, including those who have not completed 3 years of service, or who have not attained age 25, or part time or seasonal employees, if they are not participants in the employer’s plan.
Key point. Who are highly compensated individuals? For churches, they include (1) one of the 5 highest paid officers, or (2) those employees among the highest paid 25 percent of all employees (some employees are not considered, including those who have not completed 3 years of service, or who have not attained age 25, or part time or seasonal employees—and who are not participants in the employer’s plan).
The regulations specify that “benefits paid to participants who are not highly compensated individuals may be excluded from gross income … even if the plan is discriminatory.” The fact that highly compensated employees must report some or all of their reimbursements as income does not affect the ability of non highly compensated employees to fully exclude employer reimbursements.
A recently published internal IRS policy provides church treasurers with some helpful guidance on these rules.
The IRS ruling. The IRS policy addresses this question: “Are employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan excludable from gross income by the employee under section 105(b) of the Internal Revenue Code?” The IRS policy concludes that “employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan are not excludable from gross income by the employee.”
The IRS noted that employers often adopt self-insured accident and health plans to cover medical expenses incurred prior to the date of the adoption of the plan but within the same taxable year. This is done in an attempt to allow employees to exclude these medical expense reimbursements from income.
Example 1. A church employee experiences a severe illness. The church board agrees to pay the $2,500 “deductible” on the employee’s health insurance policy. The board assumes that this amount is nontaxable because it was motivated by charity. Several weeks later, the board learns that the payment is nontaxable only if the church had a formal accident and health “plan” in place. The board hastily drafts a few paragraphs describing its “plan,” and inserts the text in the minutes of a board meeting.
The IRS noted that
The basic tenet of income taxation is that unless wages, benefits or other income fall within an explicit exclusion to the Internal Revenue Code’s definition of gross income, they are included within that term. Exclusions and exemptions from income are matters of legislative grace and are construed narrowly …. [Code section] 105(b) states that gross income does not include amounts paid, directly or indirectly, to the employee to reimburse the employee for expenses incurred by him, his spouse or dependents for medical care …. However, section 105(b) does not apply unless the medical expense reimbursements are received under an accident or health plan.
The IRS pointed out that the income tax regulations define a “plan” as “an arrangement for the payment of amounts to employees in the event of personal injuries or sickness.” The IRS conceded that a plan “need not be enforceable and need not be in writing.” However, in order for there to be a plan, the employer “must be committed to certain rules and regulations governing payment. These rules must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.”
The IRS concluded that “payments for reimbursement of medical expenses incurred prior to the adoption of a plan are not paid or received under an accident or health plan for employees. Thus, these amounts are includible in the employee’s gross income … and are not excludable under section 105(b) of the Code.”
Relevance to church treasurers. The relevance of the IRS policy to church treasurers is clear. church leaders often distribute funds to ministers and lay employees to cover medical expenses without any serious consideration of the tax consequences. In most cases, they simply assume that these payments are nontaxable. The IRS policy addressed in this article suggests that such an assumption may be erroneous and lead to needless tax complications. In many cases a church not only is required to report the payments or reimbursements as taxable income and add them to the employee’s W-2, but the employee will need to report them on his or her tax return and pay taxes on them. All of this can be avoided, the IRS concluded, if the church simply adopted an adequate “plan” in advance of making the medical payments.
Key point. The tax code and regulations do not define a “plan.” The IRS policy simply states that an employer “must be committed to certain rules and regulations governing payment,” and that these rules “must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.” While a plan need not be in writing, it certainly will be desirable for a church to set forth a plan in writing to eliminate any question regarding when it when it was adopted.
Key point. A plan may not operate retroactively. A church cannot reimburse an employee’s medical expenses, and later attempt to insulate these payments from tax by belatedly adopting a medical payment plan.
Let’s illustrate these important rules with some practical examples.
Example 2. Rev. M is a minister at First Church. He undergoes major surgery and incurs $10,000 of expenses that are not covered under any insurance policy. The church board decides to reimburse Rev. M for the full amount of $10,000. The church has no formal plan of reimbursing any employee’s medical expenses. Several weeks after making the $10,000 reimbursement, the church treasurer learns that the reimbursement will represent taxable income to Rev. M unless it was made pursuant to an “accident and health plan.” The church board quickly adopts a written plan. The board’s action is too late to avoid reporting the $10,000 reimbursement as taxable income to Rev. M under section 105 of the tax code.
Example 3. Same facts as example 2, except that the church board decides that their previous decision to reimburse the pastor’s medical expenses constituted an accident and health “plan.” They rely on the fact that such a plan need not be in writing. It is likely that the board’s argument will fail. According to the IRS internal policy, an employer “must be committed to certain rules and regulations governing payment,” and these rules “must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.” It is very unlikely that the IRS would consider the mere act of reimbursing the pastor’s medical expenses to constitute a “plan.” If the church’s argument were accepted, it would render the plan requirement meaningless, since any employer’s payment or reimbursement of medical expenses would automatically constitute a plan.
Example 4. Same facts as example 2, except that the church treasurer learned of the “plan” requirement a few weeks before the reimbursement was made. Prior to making the reimbursement, the church board adopted a “plan” that stated: “Resolved, that the church will pay the unreimbursed medical expenses of the pastor.” It is possible that this action will not constitute a valid plan. According to the IRS internal policy, an employer “must be committed to certain rules and regulations governing payment,” and these rules “must be made known to employees as a definite policy and must be determinable before the employee’s medical expenses are incurred.” Does the one-sentence resolution by the church board satisfy this test? Unfortunately, the answer is not clear. The church could have eliminated any doubt by providing more detail in the resolution.
Example 5. Same facts as example 2. The church treasurer realizes by now that the $10,000 reimbursement cannot be excluded from the pastor’s income as a payment under an accident and health plan under section 105 of the tax code. The church treasurer is wondering if the amount can be excluded from the pastor’s income as a charitable or benevolent distribution from the church. This is a possibility, depending on the circumstances. Churches certainly are free to make distributions to the poor and needy, since such distributions further a church’s religious and charitable purposes. However, when churches make distributions to one of their own employees (such as the pastor in this example), it is less likely that the distribution will be viewed by the IRS or the courts as serving the church’s religious and charitable purposes. This is so for the following two reasons: (1) Whenever an employee is the recipient of a church distribution, the immediate assumption is that the distribution represents additional taxable compensation for services rendered. (2) The income tax regulations define “charitable” quite narrowly. The term includes the “relief of the poor and distressed or of the underprivileged.” The regulations define “needy” as “being a person who lacks the necessities of life, involving physical, mental, or emotional well being, as a result of poverty or temporary distress. Examples of needy persons include a person who is financially impoverished as a result of low income and lack of financial resources, a person who temporarily lacks food or shelter (and the means to provide for it), a person who is the victim of a natural disaster (such as fire or flood), a person who is the victim of a civil disaster (such as civil disturbance), a person who is temporarily not self sufficient as a result of a sudden and severe personal or family crisis (such as a person who is the victim of a crime of violence or who has been physically abused).” It is unlikely, though not impossible, that the church’s reimbursement of the pastor’s medical bills would be deemed a “charitable” distribution under this definition.
Example 6. Same facts as example 2, except that the church board adopted a plan several months before reimbursing the pastor’s medical bills that spelled out the church’s commitment to paying the senior pastor’s medical bills not covered under any available insurance coverage. The plan did not provide for the payment of any other employee’s medical bills. Assuming that the board’s action qualifies as an accident and health “plan,” it will not prevent the $10,000 reimbursement from being treated as taxable income to Rev. M. Why? Since the church’s plan is self-insured (the pastor’s medical expenses will be paid out of the church’s general fund), the $10,000 is excludable from Rev. M’s income only to the extent that the church’s plan is not discriminatory. If Rev. M is one of the 5 highest paid officers, or is among the highest paid 25 percent of all employees, he may not exclude any of the $10,000 from his income for tax purposes if the same benefit is not available to non highly compensated individuals.
Example 7. First Church provides health insurance for Rev. G, who reports his income taxes as an employee. In order to reduce the cost of the insurance, the church elects a $1,000 deductible (e.g., the insurance pays for any expense only to the extent that it exceeds $1,000). The church established a “medical fund” for Rev. G in order to reimburse all of his medical expenses that are less than $1,000 (and not covered by insurance). The church does not provide health insurance, or a “medical fund,” for any other employee. The church’s “medical plan” is self insured and discriminatory (in favor of Rev. G, a highly compensated individual), and accordingly all of Rev. G’s medical expenses reimbursed by the church represent taxable income and must be included on his W 2 and Form 1040 (as wages). However, the health insurance premiums paid by the church are not taxable to Rev. G.
Payment of Employee Medical Expenses
Here are some important points to consider before paying some or all of an employee’s medical expenses:
Do you want the payments to be nontaxable? There are only two ways for this to occur: (1) The payments satisfy the IRS definition of “charitable.” This definition is quoted in the article. Note that this is a narrow definition, especially in the context of employees. (2) The payments are made pursuant to an accident and health plan.
If you are considering the adoption of an accident and health plan, note the payments made under the plan will be nontaxable only if they meet the following conditions: (1) an adequate plan is established prior to the payment or reimbursement of medical expenses, and (2) the plan does not discriminate in favor of “highly compensated individuals” as defined in this article.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Reimbursing Business Expenses Through Salary “Restructuring”
The IRS reconsiders its position – Letter Ruling 99916011
Article summary. The tax code prohibits employers from paying for the reimbursement of their employees’ business expenses under an “accountable” arrangement through salary reductions. In a 1993 ruling, the IRS extended this prohibition to salary “restructuring” arrangements. Since such arrangements were a common church practice, this ruling had a significant impact on churches. The IRS recently issued a new ruling addressing salary restructuring arrangements. The new ruling repudiates the 1993 ruling, and suggests that salary restructuring arrangements may be used in the context of accountable plans.
In a surprise development, the IRS has issued a private letter ruling suggesting that some salary “restructuring” arrangements may be used in connection with accountable business expense reimbursement arrangements. This is a very significant development for churches, since nearly 90 percent of churches now use accountable arrangements to reimburse staff members’ business expenses, and many use some form of salary “restructuring” to pay for the reimbursements. The recent IRS ruling repudiates a 1993 ruling in which the IRS concluded that employers could not use salary “restructuring” arrangements to fund reimbursements under an accountable plan. This feature article will review the prohibition on the use of salary reductions to fund business expense reimbursements under an accountable arrangement. It also will address the 1993 and 1999 IRS rulings, and evaluate the relevance of the most recent IRS ruling to church compensation practices.
The requirements of an accountable reimbursement arrangement
The income tax regulations list three requirements that must be met in order for a business expense reimbursement arrangement to be accountable:
(1) Business Connection
A reimbursement arrangement meets the business connection requirement if it reimburses employee expenses that could be claimed by the employee as a business expense deduction, and that are paid or incurred by the employee in connection with the performance of services as an employee. The business connection requirement will not be satisfied if the employer “arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur business expenses.”
(2) Substantiation
A reimbursement arrangement meets the substantiation requirement if it requires each business expense to be substantiated to the employer within a reasonable period of time. An arrangement that reimburses business expenses governed by section 274(d) of the tax code (travel, transportation, entertainment, business gifts, cell phones, and personal computers) meets this requirement if the information submitted to the employer substantiates the elements of each expenditure. For example when substantiating expenses for travel away from home, the employee is required to substantiate the amount, time, place, and business purpose of the expenses.
(3) Returning Excess Reimbursements
A reimbursement arrangement, to be accountable, must require the employee to return to the employer within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated. If a reimbursement arrangement meets the three requirements, but the employee fails to return, within a reasonable period of time, any amount in excess of the amount of the expenses substantiated, only the amounts paid under the arrangement that are not in excess of the substantiated expenses are treated as paid under an accountable plan. The excess amounts are treated as paid under a nonaccountable plan.
Using salary reductions to fund employee business expenses
The “reimbursement requirement”
The regulations caution that in order for an employer’s reimbursement arrangement to be accountable, it must meet a reimbursement requirement in addition to the three requirements summarized above. The reimbursement requirement is defined by the regulations as follows:
If [an employer] arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses … the arrangement does not satisfy [the reimbursement requirement] and all amounts paid under the arrangement are treated as paid under a nonaccountable plan. Treas. Reg. 1.62-2(d)(3).
Application of the reimbursement requirement
The IRS interprets this regulation to prohibit accountable reimbursement plans from reimbursing employee business expenses through salary reductions. Employers who agree to pay an employee a specified annual income, and also agree to reimburse the employee’s business expenses out of salary reductions, have “arranged to pay an amount to an employee regardless of whether the employee incurs business expenses.”
In explaining this regulation, the IRS observed:
Some practitioners have asked whether a portion of an employee’s salary may be recharacterized as being paid under a reimbursement arrangement. The final regulations clarify that if [an employer] arranges to pay an amount to an employee regardless of whether the employee incurs … deductible business expenses … the arrangement does not meet the business connection requirement of [the regulations] and all amounts paid under the arrangement are treated as paid under a nonaccountable plan …. Thus no part of an employee’s salary may be recharacterized as being paid under a reimbursement arrangement or other expense allowance arrangement.
Let’s illustrate this rule with an example. Assume that a church pays its senior pastor, Rev. G, an annual salary of $52,000 ($1,000 each week). The church also agreed that it would reimburse Rev. G’s substantiated business expenses through salary reductions. At the beginning of each month, Rev. G substantiates his business expenses for the previous month, and he is issued a paycheck for the first week of the next month consisting of both salary and expense reimbursement. To illustrate, assume that Rev. G substantiated $400 of business expenses for January of 1999 during the first week of February. The church issued Rev. G his customary check of $1,000 for the first week of February, but only $600 of this check represents taxable salary while the remaining $400 represents reimbursement of Rev. G’s business expenses. The church only accumulates the $600 to Rev. G’s W-2 or 1099 that it will issue at the end of the year.
Such arrangements are used by many churches. However, they are nonaccountable according to the regulation quoted above, since Rev. G would receive his full salary of $52,000 if he chose not to incur any business expenses. As a result, the church would report the full salary of $52,000 as income on Rev. G’s W-2 or 1099.
The above-quoted regulation (imposing the reimbursement requirement) effectively put an end to a common church practice that allowed many clergy to enjoy the advantages of an accountable plan without any additional cost to the church. Unfortunately, regulation 1.62-2(d)(3), by imposing the reimbursement requirement, makes such arrangements nonaccountable. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that continue to use such arrangements must recognize that all reimbursements paid through salary reduction are treated as paid under a nonaccountable plan. This means that all salary reduction “reimbursements” are treated as taxable income to the employee, and the church must withhold any applicable taxes from these reimbursements.
The IRS national office, in correspondence with your editor, confirmed that the regulation prohibits churches from using salary reductions to fund business expense reimbursements under accountable reimbursement arrangements. In explaining its interpretation, the IRS noted that the tax benefits available to accountable reimbursement arrangements (i.e., the employer’s reimbursements are not reportable as income to the employee, and are not subject to tax withholding) are based on the fact that the reimbursements are coming out of the employer’s resources and accordingly it “has an incentive to require sufficient substantiation to ensure that the allowance to the employee is limited to actual business expenditures incurred on the employer’s behalf and for the employer’s benefit.” This justification simply does not apply when an employee’s business expenses are reimbursed out of his or her own salary (through salary reductions). The IRS gave the following example:
for example, assume that an employee working for Corporation A is paid $40,000, designated as salary, and is not entitled to any additional amount under a nonaccountable plan. If the employee decides to incur $2,000 in employee business expenses, that amount is deductible only as a miscellaneous itemized deduction, subject to the two-percent floor. By contrast, assume that an employee working for Corporation B is paid $37,000, designated as salary, and is given an additional $4,000 for the year, designated as an expense allowance pursuant to a nonaccountable plan. Under the arrangement the employee may retain any part of the $3,000 whether or not the employee substantiates to the employer, regardless of the amount of employee business expenses …. [T]here is no justification for different tax treatment of these two employees who receive (and are allowed to retain) identical dollar amounts from their employers and who make identical employee business expenditures.
The IRS concluded:
A salary reduction arrangement which “reimburses” an employee for employee business expenses by reducing the employee’s salary will not be treated as an accountable plan because it does not meet the reimbursement requirement. This is the result regardless of whether a specific portion of the employee’s compensation is designated for employee expenses … or the portion of the compensation to be treated as the expense allowance varies from pay period to pay period depending on the employee’s expenses. As long as the employee is entitled to receive the full amount of annual compensation regardless of whether or not any employee business expenses are incurred during the taxable year, the arrangement does not meet the reimbursement requirement.
In summary, regulation 1.62-2(d)(3), by imposing the so-called reimbursement requirement, effectively prohibits employers (including churches) from allowing employees to pay for their own business expenses under an accountable arrangement through salary reductions. Even if such arrangements meet the three requirements for an accountable reimbursement arrangement (described above), they do not meet the regulations’ “reimbursement requirement.” This is so for the following two reasons:
(1) The employer is not “reimbursing” the employee’s expenses. A reimbursement assumes that the employer is paying for the employee’s business expenses out of its own funds. When an employer pays an employee for his or her business expenses through a salary reduction, it is the employee and not the employer that is paying for the expenses. Such an arrangement is not an employer “reimbursement.”
(2) The church has agreed “to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses,” in violation of the reimbursement requirement prescribed by the regulations.
Employers are free to pay for an employee’s business expenses through salary reductions, but they must recognize that such an arrangement is nonaccountable. The effect of this is that the salary reductions must be accumulated to the employee’s taxable income, and the employer is obligated to withhold applicable taxes on the salary reductions. In summary, there are no tax advantages associated with such arrangements.
• Example. First Church agreed to pay its youth minister, Rev. P, an annual salary for 1999 of $36,000 ($692 per week). On February 1, 1999, Rev. P “accounts” to the church treasurer for $300 of business and professional expenses that he incurred in the performance of his ministry in January of 1999. Rev. P receives two checks for the first week in February-a check in the amount of $300 reimbursing him for the business and professional expenses that he accounted for, and a paycheck in the amount of $392 (the balance of his weekly pay of $692). His weekly compensation remains $692, but $300 of this amount constitutes a business expense reimbursement. The same procedure is followed for every other month during the year. Because of the income tax regulation discussed in this article, this arrangement constitutes a nonaccountable plan. As a result: (1) Rev. P’s W-2 (or 1099) for 1999 must include the full salary of $36,000; (2) Rev. P must report $36,000 as income on his Form 1040; (3) if Rev. P reports his income taxes as an employee (or as self-employed but is reclassified as an employee by the IRS in an audit) he can deduct his business expenses only as miscellaneous itemized deductions on Schedule A, to the extent they exceed 2% of adjusted gross income. The key point is this-accountable reimbursement arrangements cannot fund business expense reimbursements out of an employee’s salary.
The 1993 IRS ruling-salary “restructuring” is the same as a salary reduction
Can the regulation prohibiting the funding of business expenses under an accountable arrangement through salary reductions be avoided by proper drafting of an employee’s compensation package?
Let’s illustrate this important question with an example. Assume that Rev. K and his church are discussing compensation for the next year, and that the church board proposes to pay Rev. K $50,000. However, since it will require Rev. K to pay his own business expenses, the church board decides to pay Rev. K a salary of $46,000, and establish a separate church account for $4,000 out of which substantiated business expenses will be reimbursed. At the end of the year, any balance remaining in the reimbursement account would belong to the church, not Rev. K. It would not be distributed to Rev. K as a “bonus” or as additional compensation. Since Rev. K has no right to any of the reimbursement account funds ($4,000) unless he adequately substantiates his business expenses, this arrangement should be permissible under the regulation. The church has not “agreed to pay an amount to an employee regardless of whether the employee incurs deductible business expenses.” Unfortunately, the IRS disagreed with this conclusion in a 1993 private letter ruling. IRS Letter Ruling 9325023.
In the 1993 ruling, the IRS addressed the question of whether the following arrangement could be considered to be accountable:
Company X proposes to modify the district manager’s compensation arrangement to allow each district manager to elect on an annual basis and prior to the beginning of each calendar year to reduce the amount of gross commission payable to him for the upcoming calendar year. Under the arrangement, the district manager may elect to reduce his gross commissions by a percentage ranging from 0 to 40%. In exchange for the reduction in commissions, Company X will pay the district manager’s business expenses for the calendar year up to a maximum amount equal to the amount by which the district manager elected to reduce his commissions. Company X will pay only for expenses that satisfy the business connection and substantiation requirements of … the income tax regulations. If the expenses a district manager incurs in a calendar year are less than the amount by which the gross commissions were reduced, the excess amounts will be forfeited and may not be carried over and used for expenses incurred in the next calendar year.
The IRS began its ruling by noting that “a gratuitous assignment of income does not shift the burden of taxation and the donor is taxable when the income is received by the donee.” The IRS continued:
If a district manager of Company X elects to forgo future compensation under the reimbursement arrangement in consideration of Company X’s agreement to reimburse his business expenses up to an equivalent amount, the district manager is making an anticipatory assignment of future income to Company X for consideration (the reimbursements). Thus, when Company X reimburses a district manager, the district manager is treated as currently receiving the forgone compensation for which the reimbursement is a substitute. Accordingly, we conclude that when Company X reimburses a district manager for employee business expenses, the reimbursements will be includible in the district manager’s gross income in the taxable year when paid just as if the district manager had received the forgone compensation. We also conclude, as explained below, that the reimbursements are subject to employment taxes because they are not paid under an arrangement that is an accountable plan.
The IRS then quoted the following example that appears in the income tax regulations:
Employer S pays its engineers $200 a day. On those days that an engineer travels away from home on business for Employer S, Employer S designates $50 of the $200 as paid to reimburse the engineer’s travel expenses. Because Employer S would pay an engineer $200 a day regardless of whether the engineer was traveling away from home, the arrangement does not satisfy the reimbursement requirement of [the regulations]. Thus, no part of the $50 Employer S designated as a reimbursement is treated as paid under an accountable plan. Rather, all payments under the arrangement are treated as paid under a nonaccountable plan. Employer S must report the entire $200 as wages or other compensation on the employees’ Forms W-2 and must withhold and pay employment taxes on the entire $200 when paid.
The IRS noted that “the conclusion to be reached from this example is that an employer may not recharacterize a portion of an employee’s salary as being paid under a reimbursement arrangement or other expense allowance arrangement.” Further, the example illustrates that
in order to have an accountable plan … the code and regulations contemplate that the reimbursement or other expense allowance arrangement provided by an employer should be amounts paid to an employee in addition to salary. This conclusion is supported by the preamble to the final regulations published in the Federal Register on December 17, 1990, which provides that no part of an employee’s salary may be recharacterized as being paid under a reimbursement arrangement or other expense allowance arrangement.
The IRS concluded that the reimbursement arrangement proposed by Company X would
result in a portion of the district manager’s salary being recharacterized as paid under a reimbursement or other expense allowance arrangement. Therefore, we conclude that the arrangement proposed by Company X would fail the reimbursement requirement of section 1.62-2(d)(3) of the regulations. Thus, the business connection requirement of section 1.62-2(d) would not be satisfied. Therefore, all amounts paid under the arrangement would be treated as paid under a nonaccountable plan. In accordance with section 1.62-2(c)(5) all amounts paid under the arrangement are includible in the district managers’ gross incomes, must be reported as wages or other compensation on the district managers’ Forms W-2, and are subject to the withholding and payment of employment taxes (FICA, FUTA, and income tax).
IRS Audit Guidelines for Ministers
The IRS has issued audit guidelines for its agents to follow when auditing ministers. The guidelines inform agents that if a church has a salary reduction arrangement which “reimburses” a minister for employee business expenses by reducing his or her salary, the arrangement will be treated as a nonaccountable plan. This is the result
regardless of whether a specific portion of the minister’s compensation is designated for employee expenses or whether the portion of the compensation to be treated as the expense allowance varies from pay period to pay period depending on the minister’s expenses. As long as the minister is entitled to receive the full amount of annual compensation, regardless of whether or not any employee business expenses are incurred during the taxable year, the arrangement does not meet the reimbursement requirement.
The guidelines instruct IRS agents to be alert to salary reduction arrangements that are used to fund reimbursements under an “accountable” arrangement. According to the IRS, accountable plans cannot reimburse employee business expenses out of salary reductions. The important point is this-the guidelines are educating IRS agents as to this issue, and so it is now far more likely that salary restructuring and salary reduction arrangements will be discovered and questioned in an audit.
The 1999 IRS ruling
Background
A securities firm employed investment consultants who incur travel and other employee business expenses in connection with the performance of services for their employer. The company adopted a plan to provide for the reimbursement of employee business expenses incurred by the investment consultants. It contains the following features:
The plan is mandatory for all investment consultants within the company.
Investment consultants are reimbursed for employee business expenses that would be deductible as business expenses on their personal tax returns.
Prior to the start of a calendar year, each investment consultant’s manager determines the amount, if any, to be excluded from the consultant’s commissions in the next year. If the manager reduces a consultant’s commissions, such amount is not less than $600 and not more than the reimbursement “cap.” The reimbursement cap equals the greater of $10,000 or 2.5% of the consultant’s commissions in the prior year. The amount of reimbursement that a consultant may receive under the plan in a calendar year may not exceed the lesser of the actual expenses or the reimbursement cap.
If a consultant’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the consultant and will not be carried over from one calendar year to the next.
If a consultant does not request reimbursement under the plan, he or she receives no additional compensation and remains subject to the base compensation reduction.
All consultants requesting reimbursement are required to prepare an expense report within 45 days after the expense is incurred. In preparing an expense report, a consultant must enter, in detail, the elements of each expense. For business travel expenses, a consultant must show the business purpose, the amount of each separate expense, when the expense was incurred, and the travel locations. For other employee business expenses, the consultant must show the business purpose, amount, and date of each expense item. Consultants must submit a receipt for any expense item exceeding $25 (this amount may be increased from time to time up to the applicable legal limit of $75). Business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense.
The employer examines all expense reports prior to payment to determine if the business purpose set forth on the report is reasonable and if the amounts claimed are reasonable. The employer approves, denies, or asks for additional information within 15 days of receiving the request for reimbursement. If additional information is requested, the consultant must provide it within 15 days, or the request will be denied.
The employer asked the IRS for a ruling that (1) the amounts reimbursed under the plan will be fully excludible from gross income of the consultants, and (2) that the amounts reimbursed are not wages subject to employment taxes and withholding, and need not be reported on Form W-2.
The IRS Ruling
The IRS began its ruling by noting that if an employer’s reimbursements of an employee’s business expenses are “accountable,” they are not included in the employee’s income, they are not reported on the employee’s W-2, and they are not subject to tax withholding. To be accountable, the “business connection,” substantiation, and “return of excess reimbursements” requirements explained above must be met. The IRS cautioned that “if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan.” The result is that such reimbursements “are included in the employee’s gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to the withholding and payment of employment taxes.”
The IRS concluded that the company’s plan satisfied all three requirements for an accountable plan. With respect to the third requirement, the IRS noted that “because the plan is a reimbursement arrangement, the amount reimbursed should not exceed the amount substantiated; thus, there should not be an excess to return.” As a result, assuming that expenses “are properly deductible and substantiated,” the IRS reached the following conclusions:
(1) Reimbursements made to a consultant under the plan may be excluded from the consultant’s income as payments made under an accountable plan.
(2) Reimbursements made to a consultant under the plan are not wages subject to employment taxes, and are not reportable on the consultant’s Form W-2.
Comparing the 1993 and 1999 IRS Rulings
Features of the employer’s reimbursement plan
1993 ruling
1999 ruling
Mandatory for all employees.
yes
yes
Employees reimbursed only for those business expenses that would be deductible as a business expense on their personal tax returns.
yes
yes
Prior to the start of each year, each employee’s manager determines the amount, if any, to be excluded from the employee’s commissions in the next year.
yes
yes
Reimbursements cannot exceed a “cap” specified by the employer. If a consultant’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the employee and will not be carried over from one calendar year to the next.
yes
yes
If a consultant does not request reimbursement under the plan, he or she receives no additional compensation and remains subject to the base compensation reduction.
not mentioned in the IRS ruling
yes
All employees requesting reimbursement are required to prepare an expense report within 45 days after the expense is incurred. In preparing an expense report, an employee must enter, in detail, the elements of each expense. For business travel expenses, a consultant must show the business purpose, the amount of each separate expense, when the expense was incurred, and the travel locations. For other employee business expenses, the employee must show the business purpose, amount, and date of each expense item. Employees must submit a receipt for any expense item exceeding $25 (this amount may be increased from time to time up to the applicable legal limit of $75). Business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense.
not mentioned in the IRS ruling
yes
The employer examines all expense reports prior to payment to determine if the business purpose set forth on the report is reasonable and if the amounts claimed are reasonable. The employer approves, denies, or asks for additional information within 15 days of receiving the request for reimbursement. If additional information is requested, the employee must provide it within 15 days, or the request will be denied.
not mentioned in the IRS ruling
yes
The employer’s reimbursement arrangement was deemed to be accountable.
no
yes
What ministers and lay church leaders need to know
Ministers, lay staff members, church treasurers, and church board members should be aware of the following points:
1. Reimbursing employee business expenses out of church funds. Churches and clergy wanting to eliminate any of the questions concerning the use of salary restructuring arrangements should adopt accountable reimbursement policies that reimburse business expenses out of church funds. Churches that are concerned with unlimited reimbursement arrangements can set a maximum amount that will be reimbursed per employee.
2. Salary reduction agreements. Some churches prefer to “reimburse” employee business expenses out of their employee’s own compensation, through a salary reduction arrangement. The objective is to eliminate any additional cost to the church for an employee’s business expenses. The tax code prohibits employers from paying for accountable reimbursements out of salary reductions. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that use such an arrangement must recognize that all reimbursements paid through salary reduction are “nonaccountable,” and must be reported on the minister’s W-2. The 1999 IRS ruling addressed above does not change this limitation.
3. Salary restructuring arrangements. What about salary restructuring arrangements? Does the ban on using salary reduction arrangements to fund accountable expense reimbursements apply to these arrangements as well? The IRS answered “yes” to this question in a 1993 private letter ruling. However, in 1999 the IRS issued a private letter ruling that signals a retreat from the 1993 position.
Many churches use salary restructuring arrangements. The 1999 IRS ruling suggests that such arrangements can be accountable, if the following three conditions are met:
(1) Meet the three requirements of an accountable arrangement
These requirements (“business connection,” substantiation, and “return of excess reimbursements”) are summarized above. Each of these requirements must be met in order for a church’s reimbursement arrangement to be accountable.
(2) Meet the reimbursement requirement
Even if a reimbursement arrangement meets the three requirements of an accountable plan (business connection, substantiation, and return of excess reimbursements), it will not be accountable unless it meets the so-called reimbursement requirement. As noted above, the regulations define this requirement as follows:
If [an employer] arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses … the arrangement does not satisfy [the reimbursement requirement] and all amounts paid under the arrangement are treated as paid under a nonaccountable plan.
To meet this requirement, it is essential that a church or other employer not agree to pay an employee a specified amount of compensation out of which business expenses may or may not be reimbursed. Salary reduction arrangements are not accountable because of this requirement. Why? Because with such an arrangement the employer agrees to pay the employee a specified amount of compensation for the year whether or not the employee submits any business expenses for reimbursement. And, when expenses are reimbursed, the reimbursements come out of the employee’s own compensation rather than out of church funds. This kind of arrangement is not really a “reimbursement” plan, since the church is not reimbursing anything. Rather, it is reducing the pastor’s reportable compensation to pay for the expenses.
Can a salary restructuring arrangement meet the reimbursement requirement? Possibly. In fact, this is the conclusion the IRS reached in its 1999 ruling. But this conclusion will not apply to any salary restructuring arrangement. There were several conditions present in the 1999 ruling that must be met for a salary restructuring arrangement to meet the reimbursement requirement.
• Tip. To increase the likelihood that a salary restructuring arrangement will be deemed accountable, a church should consider designating a minister’s salary and establishing a business expense reimbursement account as two separate actions of the board or compensation committee, without any indication that the reimbursement account is being funded out of what otherwise would be the minister’s salary. These separate actions may be viewed as sufficiently unrelated to be consistent with an accountable reimbursement arrangement.
(3) Meet the following essential conditions of the 1999 IRS ruling
The IRS concluded that a salary restructuring arrangement was “accountable” in its 1999 ruling. There were some factors present in that ruling that were essential to the conclusion reached by the IRS. These include the following:
Employees were reimbursed only for those business expenses that would be deductible as a business expense on their personal tax returns.
Prior to the start of each year, each employee’s manager determines the amount, if any, to be excluded from the employee’s commissions in the next year.
If an employee’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the employee and will not be carried over from one calendar year to the next.
If an employee does not request reimbursement under the plan, he or she receives no additional compensation.
4. Examples. The following examples illustrate the most important principles addressed in this article.
Example 1. A church pays its senior pastor compensation of $50,000 in 1999. In addition, the church agreed to reimburse business expenses incurred by the pastor during the year up to $5,000, if the pastor provided adequate substantiation of each expense within 30 days. This is an accountable reimbursement arrangement. Amounts reimbursed by the church are not reported on the pastor’s W-2, or by the pastor on Form 1040 (line 7).
Example 2. Same facts as the example 1, except that the church also reimburses some personal expenses of the pastor, such as the personal use of a car. The regulations specify that if an employer reimburses both business and personal expenses of an employee, the employer “is treated as maintaining two arrangements. The portion of the arrangement that provides payments for the deductible employee business expenses is treated as one arrangement that satisfies [reimbursement requirement]. The portion of the arrangement that provides payments for the nondeductible employee expenses is treated as a second arrangement that does not satisfy [the reimbursement requirement] and all amounts paid under this second arrangement will be treated as paid under a nonaccountable plan.” As a result, the church does not accumulate “business expense” reimbursements on the pastor’s W-2, and the pastor does not report these reimbursements as taxable income on Form 1040 (line 7). However, the reimbursements of personal expenses are deemed to be nonaccountable. The church must report these reimbursements on the pastor’s W-2, and the pastor must include them as taxable income on Form 1040 (line 7).
Example 3. Same facts as example 1, except that the church accepts the pastor’s signed statement as to the amount of business expenses he incurs each month without any additional substantiation. This arrangement does not meet the “substantiation” requirement, and so is not accountable. Amounts reimbursed by the church are reported on the pastor’s W-2, and the pastor must include them as taxable income on Form 1040 (line 7). He may be able to claim a business expense deduction on his tax return for business expenses that he is able to substantiate.
Example 4. A church provides a pastor with a monthly $400 “car allowance.” The church board is certain that the pastor incurs business expenses of at least this much each month, and so does not require any additional substantiation. This arrangement does not meet the “substantiation” requirement, and so is not accountable. Amounts reimbursed by the church are reported on the pastor’s W-2, and the pastor must include them as taxable income on Form 1040 (line 7). He may be able to claim a business expense deduction on his tax return for expenses incurred in the use of his car for business that he is able to substantiate.
Example 5. A church issues its senior pastor a cash advance of $1,500 to cover all expenses incurred by the pastor in attending a church convention. The pastor is not required to substantiate any of her expenses. The entire amount represents a nonaccountable reimbursement, since the pastor is not required to substantiate expenses or return any “excess” reimbursement (in excess of substantiated expenses). The full amount of the cash advance must be reported by the church on the pastor’s W-2, and the pastor must report it as taxable income on Form 1040 (line 7). She may be able to claim a business expense deduction on her tax return for business expenses incurred during the trip that she is able to substantiate.
Example 6. Same facts as example 5, except that the pastor substantiates $1,200 of business expenses, but is allowed to keep the “excess” reimbursement ($300). The regulations specify that this arrangement is accountable up to the amount the pastor actually substantiates ($1,200), and it is nonaccountable with regard to the excess. As a result, the church must report the $300 excess on the pastor’s W-2, and the pastor must include this amount as taxable income on Form 1040 (line 7).
Example 7. In December of 1998, a church board agreed to pay its senior pastor a salary of $60,000 for 1999 ($1,154 per week). In addition, the church agreed to “reimburse” the pastor’s business expenses by reducing his salary. Each month, the pastor provided the church treasurer with the total amount of business expenses that he incurred for the previous month. The pastor provided no substantiation other than his own statement. Some months the pastor orally informed the treasurer of the amount of expenses for the previous month, while in other months he provided the treasurer with a note showing the total expense amount. The treasurer allocated the next weekly paycheck between salary and business expense “reimbursement”. To illustrate, in the first week of September the pastor informed the treasurer that he had incurred business expenses of $400 in August. The church treasurer issued the pastor his customary check in the amount of $1,154 for the next week-but it was allocated between business expense reimbursement ($400) and salary (the balance of $754). Assume that the pastor incurs $5,000 of business expenses during 1999. The church treasurer issues the pastor a W-2 showing compensation of $55,000 (salary of $60,000 less the “salary reductions” that were allocated to substantiated business expenses). This is incorrect. This arrangement does not meet the “reimbursement requirement” since: (1) The employer is not “reimbursing” the pastor’s expenses. A reimbursement assumes that the employer is paying for the employee’s business expenses out of its own funds. When an employer pays an employee for his or her business expenses through a salary reduction, it is the employee and not the employer that is paying for the expenses. Such an arrangement is not an employer “reimbursement.” (2) The arrangement fails the regulations’ “reimbursement requirement” since the church has agreed “to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses.” The church treasurer should have treated this arrangement as nonaccountable. The full amount of the salary reductions should have been reported on the pastor’s W-2, and the pastor should include this amount with taxable income on Form 1040 (line 7). He may be able to claim a business expense deduction on his tax return for expenses that he is able to substantiate.
Example 8. Same facts as example 7, except that the church requires the pastor to adequately substantiate (amount, date, location, and business connection) each expense in order to be reimbursed for it through salary reduction. Even though this arrangement meets the three requirements of an accountable plan (business connection, substantiation, return of excess reimbursements), it is not accountable since it does not meet the reimbursement requirement for the same reasons mentioned in example 7.
Example 9. In December of 1998, a church board agreed to set aside $60,000 for the pastor’s compensation package for 1999. It allocated this amount as follows: $45,000 salary, and $10,000 housing allowance, for total compensation of $55,000. In addition, the church agreed to reimburse substantiated business expenses of up to $5,000. The pastor was informed that if she incurred business expenses of less than $5,000 in 1999, she would not be paid or credited any portion of the unused balance. This arrangement would have been nonaccountable under the 1993 IRS ruling. However, the 1999 IRS ruling suggests that such an arrangement may be accountable, if the following factors are present: (1) The pastor is reimbursed only for those business expenses that would be deductible as a business expense on his personal tax returns; (2) prior to the start of each year, the church determines the amount to be excluded from the pastor’s compensation for the next year; (3) if the pastor’s expenses are less than the reimbursement cap ($5,000), the difference between the expenses and the reimbursement cap will not be paid to the pastor and will not be carried over from one calendar year to the next; and (4) if the pastor does not request any reimbursements under the plan, he receives no additional compensation. Remember that this conclusion is based on an IRS private letter ruling. Technically, such a ruling cannot be used as precedent for a particular tax position. However, the important point to note is that this ruling is of no less value than the 1993 IRS private letter ruling suggesting that such arrangements are not accountable. To increase the likelihood that this arrangement will be deemed to be accountable, the church board should adopt two resolutions-one establishing the “total compensation” amount (salary plus housing allowance), and the second establishing the reimbursement limit. Churches that use such arrangements should recognize that there is no guaranty that they will be deemed to be accountable by the IRS or the courts. It is still possible that the IRS will challenge the accountable nature of such arrangements. However, as a practical matter, ministers who can show an IRS agent during an audit that their situation is substantially similar to the 1999 IRS private letter ruling have a reasonable chance of prevailing.
Example 10. Same facts as example 9, except that the church distributes to the pastor any unused portion of the reimbursement cap at the end of the year. To illustrate, if the pastor only requests reimbursement of $3,500 of business expenses during 1999, the church treasurer issues her a “bonus” of $1,500 (the unused portion of the $5,000 cap) at the end of the year. The better view is that this entire arrangement is nonaccountable. The full $5,000 “reimbursement account” must be reported on the pastor’s W-2, and the pastor should include this amount with taxable income on her Form 1040 (line 7). She may be able to claim a business expense deduction on her tax return for expenses that she is able to substantiate. These conclusions are based on the following two considerations: (1) The income tax regulations contain the following example: “Employer Y provides expense allowances to certain of its employees to cover business expenses of a type described in paragraph (d)(1) of this section under an arrangement that requires the employees to substantiate their expenses within a reasonable period of time and to return any excess amounts within a reasonable period of time. Each time an employee returns an excess amount to Employer Y, however, Employer Y pays the employee a “bonus” equal to the amount returned by the employee. The arrangement fails to satisfy the requirements of paragraph (f) (returning amounts in excess of expenses) of this section. Thus, Employer Y must report the entire amount of the expense allowance payments as wages or other compensation and must withhold and pay employment taxes on the payments when paid.” (2) The regulations specify that the “return of excess reimbursements” requirement is met, and so a reimbursement arrangement is accountable, “only if the amount of money advanced is reasonably calculated not to exceed the amount of anticipated expenditures ….” A more aggressive view would be to treat only the “bonus” ($1,500) as nonaccountable, rather than the entire reimbursement account ($5,000). This outcome is based on examples in the income tax regulations illustrating that if employees are reimbursed more than their substantiated reimbursed business expenses, only the excess is deemed nonaccountable. This approach should not be adopted without the advice of a tax professional.
5. Private letter rulings. A private letter ruling cannot be used as legal precedent. It is a very limited decision that applies only to the taxpayer who requested it. This means that ministers and other taxpayers cannot rely on the 1999 private letter ruling addressed in this article as a basis for treating a salary “restructuring” arrangement as an accountable plan. On the other hand, the 1993 IRS ruling that treated a salary restructuring arrangement as a salary reduction plan was also a private letter ruling. As such, it is entitled to no more weight that the 1999 ruling. Neither can be used as a legal basis for a particular position. At best, they suggest what an official IRS ruling might be.
Article summary. Congress enacted the Volunteers for Children Act to allow private charities to obtain nationwide FBI criminal records checks on employees and volunteers who work with minors. The Act amends the earlier National Child Protection Act. It is now likely that churches in many states will be able to obtain FBI background checks. This article provides church leaders with a full explanation of the new law and its relevance to church practices.
In 1993, Congress passed the National Child Protection Act as a bold new attack against the molestation of children in youth serving organizations. Unfortunately, the Act never lived up to its purpose because of a technical problem in the legislation. A few months ago, Congress enacted the Volunteers for Children Act, which is designed to correct the problem with the earlier legislation and allow the Act to fully serve its important purpose. As a result, church leaders need to be familiar with the provisions of the original National Child Protection Act, since it now will present them with crucial options and decisions. This article will review the background and purpose of the National Child Protection Act as well as the Volunteers for Children Act, and fully explain their impact on churches and other religious organizations. It is essential for church leaders to be familiar with this information.
National Child Protection Act of 1993 – Introduction
Many churches take the issue of child sexual abuse seriously and screen children’s workers to determine their suitability for working with minors in the church. Some churches attempt to obtain information from local law enforcement agencies on the criminal records of persons who want to work with children. Other churches seek this information only in special cases where serious but unsubstantiated allegations have been made about a prospective worker. Unfortunately, in many communities churches are unable to obtain this information from law enforcement agencies. Even if a law enforcement agency is willing to assist, the criminal records check ordinarily covers only local or state records. Information about criminal convictions in other states is not available. Many other institutions that provide child care face these same frustrations.
Congress enacted the National Child Care Act of 1993 to respond directly to these concerns. The Act was described by one senator as follows:
[This legislation is designed] to confront what I believe is one of the most threatening dangers confronting the nation-the tragedy of child abuse. The national extent of child abuse and neglect has grown to shocking epidemic proportions-more than 2 1/2 million reports of child abuse and neglect are made each year. Many abused children are victimized in their homes, but there is a large and growing number of children being victimized outside the home. Today, about 6 million preschool children are in a day care program for some or all of their day. By 1995, at least 8 million preschoolers will be in day care. This rapidly growing rise in children being cared for outside their homes must be met by an expanded national effort to protect these children. This is the goal of the National Child Protection Act ….
The idea behind the National Child Protection Act of 1993 is clear: We must do everything we can to detect convicted criminals before they are hired as child care workers, not after another tragedy takes place. … [T]his act will help build state and national systems necessary to prevent convicted criminals from being hired as child care workers. In 1991, similar systems in just six states identified more than 6,200 individuals convicted of serious criminal offenses-such as sex offenses, child abuse procedures for checking criminal records.
National Child Protection Act of 1993 – Key Provisions
The most important provision in the Act specifies:
A state may have in effect procedures (established by state statute or regulation) that require qualified entities designated by the state to contact an authorized agency of the state to request a nationwide [FBI] background check for the purpose of determining whether a provider has been convicted of a crime that bears upon the provider’s fitness to have responsibility for the safety and well-being of children, the elderly, or individuals with disabilities.
There are a number of important points here for church leaders to understand:
Criminal records checks are optional
The Act specifies that a state “may” enact statutes or regulations authorizing qualified entities to obtain nationwide background checks. States are not required to enact legislation giving youth-serving organizations the right to obtain nationwide background checks.
Qualified Entities
The Act permits “qualified entities” that are designated by the states to obtain nationwide criminal records checks. The Act defines a qualified entity as “a business or organization, whether public, private, for-profit, not-for-profit, or voluntary, that provides child care or child care placement services ….” There is little doubt that this definition will include churches that operate child care or preschool facilities. But does it also include churches that do not operate a school or preschool, but that offer Sunday School, nursery services, and other youth activities and programs involving supervision or instruction of minors? The Act does not address this question directly, but it does define the term “child care” to include “the provision of care, treatment, education, training, instruction, supervision, or recreation to children by persons having unsupervised access to a child.” It is likely that the operation of a Sunday School, nursery, and many if not most kinds of youth and children’s programs would constitute “the provision of education, training, instruction, supervision, or recreation to children.” As a result, it is entirely possible that a church will be considered to be a “qualified entity” even if it does not operate a school or a formal child care or preschool program.
Providers
It is also important to review the Act’s definition of the term provider, since a qualified entity may request an FBI criminal background check to determine if a provider has been convicted of a crime that bears upon that person’s fitness to have responsibility for the safety and well-being of children. The Act defines the term provider as a person who
(1) is employed by or volunteers with a qualified entity; owns or operates a qualified entity; or has or may have unsupervised access to a child to whom the qualified entity provides child care; and
(2) seeks to be employed by or volunteer with a qualified entity; seeks to own or operate a qualified entity; or seeks to have or may have unsupervised access to a child to whom the qualified entity provides child care
There is no question that this definition will include the vast majority of persons who work with minors in a church. Note also that the law defines a provider as someone who “has or may have unsupervised access to a child to whom the qualified entity provides child care.” This definition is so broad that it undoubtedly includes a much longer list of individuals, including custodians and spouses or friends of child care workers. Indeed, it is so broad that it could be interpreted to include any person who enters church property or attends any church activity. This would include church members and others who attend church services (no matter how infrequently), guests who attend weddings, visitors from out-of-town, and postal workers. Any of these persons “may have unsupervised access to a child to whom the qualified entity provides child care” and accordingly may meet the definition of the term provider. Clearly, this was not the intention of Congress, and it will be left for the courts to clarify the meaning of the term provider.
The Act makes it clear that the states specify which types of child care positions require criminal history checks. As noted above the Act contains a very broad definition of a child care “provider,” but the committee report explaining the Act emphasizes that
[not] all occupations and volunteer positions within that broad definition merit the time and expense of criminal history records checks. There are other means available to protect children from abuse, including the checking of prior employment history and character references and proper training and supervision of employees and volunteers. The committee expects that the states, in deciding which types or categories of positions require criminal history background checks, will consider the degree to which a particular position or child care activity offers opportunities to those who would abuse children. The committee expects that the states will find, for example, that positions involving long-term or ongoing contact with children in one-on-one situations merit criminal history record checks and that positions that involve infrequent direct contact or contact only in group settings do not merit such checks. The bill as amended leaves that decision to the respective states.
This language is critical, for it can be interpreted as establishing two levels of scrutiny in screening youth workers:
Level 1-Criminal Records Check
This level is required of those child care workers (providers) designated by state law. The committee report suggests that this level of screening be performed for “positions involving long-term or ongoing contact with children in one-on-one situations.”
level 2-Other Screening Methods
This level, according to the committee report, includes one or more of the following kinds of activities:
check prior employment history
check references
training
supervision
The committee report suggests that this level of screening be performed for “positions that involve infrequent direct contact or contact only in group settings.”
Procedures for checking criminal records
The Act establishes minimum requirements for state procedures for background checks. It clarifies that:
Such checks must be based on fingerprints.
A qualified entity may not request a background check of a provider unless the provider first provides a set of fingerprints and completes and signs a statement that (1) contains the name, address, and date of birth of the provider; (2) represents that the provider has not been convicted of a crime or, if the provider has been convicted of a crime, contains a description of the crime and the particulars of the conviction; (3) notifies the provider that the qualified entity may request a background check; (4) notifies the provider of the provider’s “due process” rights (described below); and (5) notifies the provider that prior to the completion of the background check the qualified entity may choose to deny the provider unsupervised access to a child to whom the qualified entity provides child care.
Providers must be informed by qualified entities that they have the right: (1) to obtain a copy of any background check report; and (2) to challenge the accuracy and completeness of any information contained in any such report and obtain a prompt determination as to the validity of such challenge before a final determination is made by the state agency regarding the provider’s suitability for working with children.
The designated state agency, upon receipt of a background check report lacking final disposition data (that is, no indication of how a criminal charge was resolved) shall conduct research in whatever state and local recordkeeping systems are available in order to obtain complete data.
The designated state agency shall make a determination whether the provider has been convicted of a crime that bears upon his or her fitness to have responsibility for the safety and well-being of children and shall convey that determination to the qualified entity.
The actual criminal record on a provider will not be conveyed to the qualified entity, but only an indication from the designated state agency whether the individual has been convicted of or is under pending indictment for a crime that bears upon his or her fitness to have responsibility for the safety and well-being of children.
National Child Protection Act of 1993 – other provisions of interest
Reporting child abuse crime information
The Act requires that states submit child abuse crime information to the national criminal history background check system maintained by the FBI. Previously, the states submitted criminal history information to the national system voluntarily.
The FBI has maintained for many years criminal history records submitted by state, local and federal agencies consisting of fingerprints, personal identification data (such as name, date of birth and physical descriptions) and reports of arrests and convictions. The records are used for a variety of criminal justice purposes as well as for background screening under certain conditions. Prior to the enactment of the National Child Protection Act, the FBI criminal history record system could be accessed for pre-employment purposes only if there was a state law requiring such a check. Many states already have such laws covering some types of positions that involve contact with children. For example, the FBI says that thirty-one states and the District of Columbia have enacted laws that require criminal history screening (through the FBI) for some category of child care providers. These laws, however, vary widely in coverage. The National Child Protection Act will encourage the remaining states to adopt similar laws requiring background checks through the national system, and to improve the quality of the criminal history records used for the checks.
The FBI national criminal history system is in the final stages of a major project that will link federal and state computers. This project, the “Integrated Automated Fingerprint Identification System” (or IAFIS) will allow the electronic transmission and searching of fingerprints for background screening purposes and the return of relevant records to requesting agencies via computer. This will greatly increase the speed of responses, possibly reducing the turn-around time from weeks or even months to a few hours.
Enforcement
The Act specifies that a state that does not enact legislation implementing the Act may lose some of its allocated funds under title I of the Omnibus Crime Control and Safe Streets Act of 1968.
Liability
The Act specifies that a child care provider “shall not be liable in an action for damages solely for failure to conduct a criminal background check on a [worker].” This is a very important provision. It means that a church cannot be sued solely as a result of its failure to conduct a criminal records check on a prospective youth worker. However, it is important to recognize that this provision does not insulate churches and other child care providers from all liability. For example, it is possible that churches could be sued for failing to use criminal records information properly, for disseminating such information to persons with no legitimate need to know about it, or for failing to screen those workers for whom you are not required by state law to obtain criminal records checks.
Use of criminal records information
The committee report accompanying the Act provides:
A law involving criminal record checks must balance the interests to be served by a check (protecting children from those who might abuse them) with the interests of the individual job applicant or volunteer and the interests of the states, which have a necessary role in the reporting and dissemination of criminal history records. Checks must be based on fingerprints in order to ensure accurate identification and avoid both false positive and false negative results. Legislation must take into account the poor quality of the criminal history records, many of which are incomplete. Legislation must guard against uncontrolled dissemination of criminal history records and their misuse or misinterpretation. Finally, the states should be given flexibility and discretion to structure their own laws.
Many of the records currently in the national criminal history record system are incomplete in that they indicate that a person was arrested for a particular crime but do not indicate the disposition of the charge. This poses a dilemma. On the one hand, it is grossly unfair to deny a person a job based on a mere arrest, since the accusation may have been false and the charges may have been dropped. On the other hand, an arrest may well have resulted in a conviction. To ignore incomplete records altogether would create a risk that persons who had been convicted would be allowed to assume positions from which they should be disqualified.
To address this dilemma, criminal history background screening is currently accomplished by providing the complete criminal history record in the FBI system to a state or local agency authorized by state law to receive such records. Employers do not receive the applicant’s criminal history record. This approach has a number of important benefits: (1) A governmental agency, reviewing numerous criminal history records, will be in a better position to interpret the records, which often use confusing code citations instead of plain English. (2) A governmental agency will be in a better position to obtain dispositions on the many arrest records that will be received lacking dispositions. A child care provider, for example, would not be in as good a position to make the contacts to courts or correctional authorities necessary to obtain disposition data. (3) Providing the records to a government agency ensures uniform standards with respect to whether convictions for a certain type of offense will be treated as disqualifying. (4) Control of the information, which is generally sensitive and not for general dissemination, is greater with governmental agencies. Keeping the rap sheets at the governmental level obviates the need for employers or volunteer organizations to develop confidentiality procedures for the receipt and storage of criminal history information. (5) Since the record subject should have an opportunity to challenge the accuracy of a record, it makes sense that a state agency handle those appeals. It would be a substantial burden on volunteer organizations to require them to resolve disputes over the accuracy of criminal history records. (6) Returning the record to the employer, such as the owner of a child care facility, would not protect against situations, which have arisen, where the operator of the child care program is himself or herself involved in child abuse. (7) Finally, it offers the best assurance that employment decisions will not be based on mere arrests, since otherwise employers could easily place an application from somebody with an arrest “at the bottom of the pile,” and never give the existence of the record as a reason.
These remarks underscore the importance of treating criminal records information as highly confidential material.
Fees
How much will it cost a church to obtain a criminal records check on a child care worker? The Act simply states that “in the case of a background check conducted with fingerprints on a person who volunteers with a qualified entity, the fees collected by authorized state agencies and the FBI may not exceed the fees otherwise established and collected for name checks.” The committee report accompanying the Act states: “Currently, state agencies and the FBI charge fees for record checks conducted with a fingerprint. The FBI fee is currently $23. The fee is used not only to pay the cost of each check but also to finance automation of the FBI’s records. Witnesses at the Subcommittee hearing noted that, with a separate state fee, the total can discourage volunteers and place financial burdens on voluntary organizations.”
Upgrading criminal records data
The Act requires the Attorney General to investigate the criminal history records system of each state and determine for each state a timetable by which the state should be able to provide child abuse crime records via computer through the national criminal history background check system. The law further provides:
The Attorney General shall require as a part of each state timetable that the state by not later than the date that is 3 years after the date of enactment of this Act, have in a computerized criminal history file at least 80 percent of the final dispositions that have been rendered in all identifiable child abuse crime cases in which there has been an event of activity within the last 5 years; continue to maintain a reporting rate of at least 80 percent for final dispositions in all identifiable child abuse crime cases in which there has been an event of activity within the preceding 5 years; and take steps to achieve 100 percent disposition reporting, including data quality audits and periodic notices to criminal justice agencies identifying records that lack final dispositions and requesting those dispositions.
The Volunteers for Children Act
The National Child Protection Act had two flaws that prevented it from accomplishing its noble objective. First, it required states to enact implementing legislation giving nonprofit youth-serving organizations access to FBI criminal records checks. Second, it did not require the states to enact such legislation. Unfortunately, only a few states did so. As a result, churches and other youth-serving organizations (Red Cross, Boy/Girl Scouts, Boys/Girls Clubs, Big Brother/Sister, Little League, Salvation Army, etc.) were unable to obtain FBI criminal records checks. They were left with the options of (1) doing no criminal records checks, (2) doing criminal records checks using county courthouse records, or, in some state (3) doing criminal records checks using state criminal records. The benefits of doing a national criminal records check were unavailable. This is the reason that the Volunteers for Children Act was enacted-to enable youth-serving organizations in all states to conduct FBI criminal records checks.
The Volunteers for Children Act remedies the flaws in the National Child Protection Act by amending it to read:
In the absence of state [implementing legislation] a qualified entity [designated by the state] may contact an authorized agency of the state to request nationwide criminal fingerprint background checks.
• Key point. A 1997 General Accounting Office (GAO) report concluded that “national fingerprint-based background checks may be the only effective way to readily identify the potentially worst abusers of children, that is the pedophiles who change their names and move from state to state to continue their sexually perverse patterns of behavior.”
Congressman Mark Foley, in remarks made before Congress regarding the Volunteers for Children Act, observed:
The Volunteers for Children Act is a very simple proposal. In 1993, this subcommittee helped enact into law the National Child Protection Act …. The law gave organizations such as schools, day care facilities and youth-serving volunteer organizations access to FBI fingerprint background checks to help ensure that they weren’t inadvertently hiring convicted child molesters to tend to their young charges. In doing this, the law recognized – as virtually every law enforcement official in the country does – that fingerprint-based background checks are the only way of conclusively identifying someone who has a criminal conviction. Name checks can be fooled by changing a name or a birth date or a Social Security number. But a fingerprint check cannot be fooled.
The only hitch to the National Child Protection Act was this: Under the law, a school or day care or volunteer organization can have access to the FBI fingerprint database – but only if the state in which they are located has enacted a state law, approved by the U.S. Attorney General, allowing that access. The good news is that, thanks to the National Child Protection Act, most states have responded by requiring either voluntary or mandatory fingerprint background checks for school teachers, school bus drivers and licensed day care providers who have direct contact with children. The bad news is that volunteer organizations have been left out. Only about six states have any significant provisions allowing youth-serving organizations access to fingerprint-based checks. So if convicted sexual predators want easy access to children, all they have to do is look respectable, be nice and offer to help in scouting events, in soccer coaching, in any volunteer setting involving children which is notlocated in those handful of states.
The Volunteers for Children Act is no panacea. It cannot help organizations identify child molesters who have not been convicted of an offense – and sadly, that seems to be the case in most instances, because many allegations of child molestation are either not reported or involve someone who is caught for the first time. But the Volunteers for Children Act can help organizations screen out the known predators – the hardcore ones who have been convicted and who are bent on preying on children again. …
[H]iring a sexual predator is every volunteer organization’s worst nightmare. For years, many of them – most prominently the Boys and Girls Clubs of America – have begged us to let them have access to the only tool that will prevent this nightmare from happening – at least where known convicted child predators are concerned. I urge this committee to support those pleas now by supporting the Volunteers for Children Act. The legislation does not usurp state laws. It merely allows volunteer organizations access to the FBI data – if they want that access – in the absence of state laws ….
In summary, the Volunteers for Children Act allows those organizations that are designated as “qualified entities” by state law to obtain nationwide criminal fingerprint background checks on those youth workers designated by state law as “providers” whether or not their state has enacted legislation authorizing such checks.
Conclusions
How will the Volunteers for Children Act affect churches and other religious organizations? Consider the following points:
1. State enabling legislation no longer required. It no longer matters that your state has failed to enact enabling legislation allowing churches to obtain FBI criminal records checks. The Volunteers for Children Act allows churches to obtain such checks if they meet the definition of a “qualified entity” under state law.
2. Churches as “qualified entities.” Even with the enactment of the Volunteers for Children Act, churches will not be able to conduct criminal records checks using FBI data unless they meet the definition of a “qualified entity” under state law. Will churches be designated as qualified entities? In most states, it is too soon to say. However, it is our prediction that many states will designate churches as qualified entities. Few organizations provide more child care and children’s programs than churches.
• Tip. How can you find out if churches meet the definition of a qualified entity in your state? Try calling your state legislators, a local attorney, the state attorney general, the governor’s office, or other youth-serving charities in your community (Big Brothers/Sisters, Boy/Girl Scouts, Boys/Girls Clubs, etc.).
On the whole, we believe most churches will benefit from being designated as a qualified entity under state law. Why? For several reasons, including the following:
An Effective Screening Tool
States that define the term “qualified entity” to include churches will provide churches with a simple, effective, and relatively inexpensive means of screening youth workers. By requesting a designated state agency to conduct a criminal records check of prospective workers, a church will be reducing significantly its risk of being sued for “negligence” if a worker molests a child on church premises or in the course of a church activity. Here’s why. In many cases, a church’s legal liability for acts of child molestation is based on the church’s alleged failure to adequately screen the offender. Lawyers refer to this as “negligent selection.” The church failed to exercise reasonable care in selecting those persons (whether compensated or volunteer) who will work with minors. Conducting adequate background checks on church workers can be a cumbersome and time-consuming process. Further, local law enforcement agencies often refuse to accommodate a church’s request to conduct a background check on church workers. Even when law enforcement agencies are willing to conduct a criminal records search, they generally will search only state or local records. An individual may have been convicted for child molestation on several occasions in a neighboring state but a criminal records check of your state and local records will turn up nothing. The person appears to be “safe.” On the other hand, if churches are designated qualified entities under state law, then they will have the right (and duty) to request that a state agency conduct a nationwide criminal records search. In time, these searches will be conducted by computer and will take very little time. Further, they will include the entire FBI national criminal history record system, so you will know if an applicant was convicted of a crime in another state.
The state determines a worker’s suitability
States that define the term “qualified entity” to include churches will enable churches to transfer to the state the sometimes difficult task of determining a worker’s suitability for working with minors. The National Child Protection Act states that the designated state agency “shall make a determination whether the provider has been convicted of a crime that bears upon an individual’s fitness to have responsibility for the safety and well-being of children and shall convey that determination to the qualified entity.” This is a very important provision. There are many cases in which the criminal record of an applicant for youth work is ambiguous or inconclusive. Consider the following examples.
Example 1. B applies for a position as a volunteer youth worker at a church. The church conducts a criminal records check using state records, and discovers that B was arrested and charged with child molestation three years ago, but the charges were dropped.
Example 2. Same facts as the previous example, except that B was acquitted by a jury.
Example 3. Same facts as example 1, except that B pled guilty to a lesser charge (disorderly conduct) and was given two years probation.
Example 4. G applies for a position as a volunteer youth worker at a church. The church conducts a criminal records check using state records, and discovers that G was convicted of child molestation 25 years ago, and served one year in prison. Does one conviction occurring 25 years ago render G unsuitable for working with minors today?
Example 5. Same facts as example 4, except that G was convicted two times for molesting children-the first occurred 25 years ago, and the second 10 years ago.
Example 6. Same facts as example 4, except that G insists that “they convicted an innocent man.”
Example 7. Same facts as example 4, except that G claims that he “got religion” while in prison, and no longer poses a risk of harm to children.
Example 8. J applies for a position as a volunteer youth worker at a church. The church conducts a criminal records check using county courthouse records, and discovers convictions for burglary and a drug crime. Do these convictions render J unfit for working with children?
Example 9. Same facts as example 6, except that J had an additional conviction for assault and battery.
Deciding whether or not any of these applicants should be used as volunteers in a church’s youth or children’s ministry can present church leaders with an agonizing decision, for it is not clear in many of these examples whether the applicant’s criminal background renders him or her unsuitable for working with children. Here is the good news-if a church is designated as a qualified entity under state law, it will not have to make these decisions! The state agency will make them for you. This provision obviously will decrease a church’s legal risk, and insulate church leaders from the responsibility for deciding whether a particular criminal record renders an applicant unsuitable.
Dealing with incomplete criminal records
Many churches have requested a criminal records check on a prospective youth worker only to be told that the record shows an arrest or prosecution for a criminal offense but does not show the final disposition of the case. This can be very frustrating. How should church leaders respond to this information? Does it disqualify the individual from working with minors in the church? What if there was no conviction? Isn’t everyone presumed to be innocent unless proven guilty? Could the church be sued for disqualifying someone who was never convicted of a crime? Again, many churches have agonized over these questions. The committee report accompanying the new law observes:
Many of the records currently in the national criminal history record system are incomplete in that they indicate that a person was arrested for a particular crime but do not indicate the disposition of the charge. This poses a dilemma. On the one hand, it is grossly unfair to deny a person a job based on a mere arrest, since the accusation may have been false and the charges may have been dropped. On the other hand, an arrest may well have resulted in a conviction. To ignore incomplete records altogether would create a risk that persons who had been convicted would be allowed to assume positions from which they should be disqualified.
The National Child Protection Act addresses these questions directly by requiring that a state agency that receives “a background check report lacking disposition data, shall conduct research in whatever state and local recordkeeping systems are available in order to obtain complete data.” What does this mean? If a criminal record is incomplete, it is the duty of the state agency that you asked to conduct the background check to find out what happened. This is not your responsibility. Once again, this provision decreases the potential liability of a qualified entity, and it is another reason why churches will benefit from such a designation.
3. Church workers as “providers”. If your state defines the term “qualified entity” to include churches, this means that your church will be required to request a nationwide criminal background check to determine if any provider has been convicted of a crime that bears upon that person’s fitness to have responsibility for the safety and well-being of children. Obviously, it is essential to know what workers within a church will be deemed providers. As noted above, the Act defines the term provider as a person who
is employed by or volunteers with a qualified entity; owns or operates a qualified entity; or has or may have unsupervised access to a child to whom the qualified entity provides child care; and
seeks to be employed by or volunteer with a qualified entity; seeks to own or operate a qualified entity; or seeks to have or may have unsupervised access to a child to whom the qualified entity provides child care
There is no question that this definition will include the vast majority of persons who work with minors in most churches. The list includes Sunday School teachers, nursery workers, children’s choir directors, counselors, youth ministers, child care or preschool workers, parents’ day out workers, camp workers, and scouting leaders. It does not matter whether the individual is compensated or not. Note also that the law defines a provider as someone who “has or may have unsupervised access to a child to whom the qualified entity provides child care.” This could include a much longer list of individuals, including custodians, spouses or friends of child care workers, and virtually anyone who sets foot on church property or attends church activities.
While the Act’s definition of a provider is broad, the committee report explaining the Act contains the following comment: “The bill includes a very broad definition of child care provider, but the committee does not believe that all occupations and volunteer positions within that broad definition merit the time and expense of criminal history records checks.” The committee report further clarifies that “[t]he bill as amended makes it clear that the states must specify by statute or regulation which types of child care positions require criminal history checks.” In other words, a state not only designates which organizations are qualified entities, but it also will designate which providers will require criminal records checks. The important point is that a state may decide that a criminal records check is only required for some kinds of providers. The committee report specifies:
There are other means available to protect children from abuse, including the checking of prior employment history and character references and proper training and supervision of employees and volunteers. The committee expects that the states, in deciding which types or categories of positions require criminal history background checks, will consider the degree to which a particular position or child care activity offers opportunities to those who would abuse children. The committee expects that the states will find, for example, that positions involving long-term or ongoing contact with children in one-on-one situations merit criminal history record checks and that positions that involve infrequent direct contact or contact only in group settings do not merit such checks. The bill as amended leaves that decision to the respective states.
What is the significance of this language? It can be interpreted as establishing the following two levels of scrutiny in screening youth workers:
Level 1-criminal records check. This level is required of those child care workers (providers) designated by state law. The committee report suggests that this level of screening be performed for “positions involving long-term or ongoing contact with children in one-on-one situations.”
Level 2-other screening methods. This level, according to the committee report, includes one or more of the following kinds of activities:
check prior employment history (for example, check other churches or child care institutions in which the prospective worker has been employed to determine his or her suitability for working with minors)
check references (contact references, including former churches and any organization in which the prospective worker has worked with children on a paid or volunteer basis, to determine his or her suitability for working with minors
training
supervision
The committee report suggests that this level of screening be performed for “positions that involve infrequent direct contact or contact only in group settings.”
There is no question that plaintiffs’ attorneys representing children who are abused or molested on church premises or during church activities will be pointing to the National Child Protection Act and the committee report, as well as the Volunteers for Children Act, as establishing a minimum duty of care in the screening of workers. Churches that continue to do nothing to screen youth workers are significantly increasing their risk of legal liability.
• Example. First Church (a qualified entity under state law) is not required to obtain criminal records checks on occasional helpers in the church nursery or Sunday School. A volunteer worker (for whom a criminal records check was not available) molests a child. The church had no screening procedure in place for such workers. An attorney representing the victim claims that the church was guilty of negligent selection. The attorney points to the following language in the committee report to the National Child Protection Act of 1993: “There are other means available to protect children from abuse, including the checking of prior employment history and character references and proper training and supervision of employees and volunteers.” The attorney claims that such language recognizes a legal duty on the part of a church to screen workers (including those for whom a criminal records check is not required).
And remember this-church board members can be personally liable for failing to take action, especially in light of this historic legislation. Failure by church board members to act may be deemed gross negligence or willful and wanton misconduct (eliminating any immunity that uncompensated board members may have under state law).
4. Church liability issues. The National Child Protection Act specifies that a qualified entity “shall not be liable in an action for damages solely for failure to conduct a criminal background check on a provider.” This presumably means that if your church is a qualified entity under state law, and state law permits criminal records checks to be obtained for church youth workers, your church cannot be legally liable for failing to conduct such a check on a particular worker. Failure to obtain such checks could be due to a church’s unfamiliarity with the law, or to neglect or inadvertence. Perhaps someone was hired before a criminal records check could be obtained. Or the person in charge of requesting criminal records checks was away temporarily on vacation or business and there was a need to hire youth workers immediately. There are many reasons why a church might fail to request a criminal records check on a worker. The important point is this-a church cannot be legally liable for a youth worker’s acts of sexual molestation solely on the basis of the church’s failure to request a criminal records check. This of course assumes that the church is a qualified entity under state law and that the worker was a provider for whom a criminal records check could have been obtained under state law.
• Key point. The fact that a qualified entity “shall not be liable in an action for damages solely for failure to conduct a criminal background check on a provider” does not insulate churches and other child care providers from all liability. It is possible that churches could be sued for failing to use criminal records information properly, for improperly disseminating such information in a manner that could cause emotional distress or constitute defamation or invasion of privacy, or for failing to adequately screen those persons for whom a criminal records check is not required by state law.
• Example. First Church (a qualified entity under state law) asks the designated state agency to conduct a nationwide criminal records check on Rob (a prospective youth worker) and is advised by the agency that Rob has been convicted of a crime that bears upon his fitness to have responsibility for the safety and well-being of children. However, the church goes ahead and uses Rob as a youth worker because of a lack of other volunteers. A few months later the church receives an allegation that Rob has molested a child. Can the church be sued? Absolutely. The fact that the new law specifies that qualified entities “shall not be liable in an action for damages solely for failure to conduct a criminal background check on a provider” does not insulate them from liability for negligently using criminal record information shared with them by the state.
• Example. First Church (a qualified entity under state law) needs several workers in its nursery and children’s programs. The church is not aware that it is a qualified entity under state law or that it has the right to request nationwide background checks on designated providers. The church begins using Tim as a youth worker, but does not ask the designated state agency to conduct a nationwide criminal records check on him. A few months later the church receives an allegation that Tim has molested a child. Can the church be sued? Not because it failed to request a criminal records check, since the new law specifies that qualified entities “shall not be liable in an action for damages solely for failure to conduct a criminal background check on a provider.” However, it is possible that the church could be legally responsible for Tim’s acts on the basis of negligent selection or negligent supervision.
• Example. Same facts as the previous example, except that the church was aware that it was a qualified entity and could have obtained a nationwide criminal records check on Tim. The fact that it intentionally failed to obtain such a check available to it under the National Child Protection Act cannot by itself serve as a basis for legal liability. However, the Act does not limit the victim from suing the church on the basis of negligent selection. As long as the lawsuit does not attempt to prove negligent selection by referring to the church’s failure to request a nationwide criminal records check, it can proceed. To illustrate, negligent selection may be proven by the following evidence: (1) the church failed to have Tim complete an application; (2) the church failed to interview Tim; (3) the church failed to check references.
Recall that qualified entities are not required to request criminal records checks on all providers, but rather only on those providers who are designated by state law. What if a person in your church molests a child and this person was a provider but not among the list of providers required to have criminal records checks under state law? The committee report accompanying the new law simply notes that “[t]here are other means available to protect children from abuse, including the checking of prior employment history and character references and proper training and supervision of employees and volunteers.”
5. Should churches that request nationwide criminal records checks do additional screening? Many church leaders soon will be asking, “If our church is a qualified entity under state law, do we need to do any additional screening of youth workers or is the nationwide criminal records search enough”? It is our opinion that all churches should conduct additional screening procedures for anyone who will have access to minors on church premises or during church activities. These procedures include, at a minimum, a “6-month rule” (don’t use a person who has not been a member of your church for at least 6 months), application forms, reference checks, an educational program for church staff, and adequate supervision. We base this conclusion on the following factors:
Not all of the persons who have contact with minors in your church will be designated by state law as “providers” for whom a criminal records check must be obtained.
Many child molesters have no history of criminal convictions.
Many child molesters plead guilty to lesser charges giving little if any indication of their risk to children in your church.
Few churches will be able to request a criminal records check on every designated provider. The person responsible for requesting these checks may be temporarily absent (away on vacation or business) at a time when new youth workers are needed. Or, in larger churches, there may be so many workers that some are inadvertently omitted from a request for criminal records checks. Other workers may refuse to provide you with their fingerprints (this will be required in order for your to request a criminal records search).
Adopting additional screening procedures imposes minimal inconvenience on a church, and reduces substantially the possibility that a church will be sued as a result of an incident of sexual molestation. Many attorneys would consider suing a church for negligence if a church worker molests a child-even if the church conducted a criminal records search and was advised by a state agency that the worker had no history of criminal convictions that would render him or her unfit for working with minors. The argument in such a case would be that there are so many limitations on the effectiveness of criminal records searches (as summarized above) that it is negligent for a church to do nothing more. Churches that conduct screening procedures in addition to the criminal records check reduce substantially the likelihood of a lawsuit. This protects the church from potential financial liability and negative publicity in the local media. Churches whose liability insurance policies exclude any coverage for sexual misconduct, or reduce the policy limits, definitely should adopt additional screening procedures.
Applying the same screening procedures to all persons who will have contact with minors will avoid apparent “discriminatory” treatment. If you only require application forms and other screening procedures for those workers for whom you are not required to obtain a criminal records check under state law, then these persons may object to being singled out for intrusive procedures that are not applied to the very persons who present the highest risk (those for whom criminal records checks are required). Applying your screening procedures to all workers will avoid such apparent “double standards” and will be perceived by your workers to be more fair.
All of the above considerations assume that your state will include churches within the definition of a qualified entity. This will not necessarily be the case in every state. If your state does not include churches within the definition of a qualified entity, then you will not have access to the FBI criminal records database and you must implement your own screening program.
A related question is whether a church avoids legal liability for negligent selection simply by requesting a criminal records check and being told by a state agency that there is no apparent reason why a prospective worker cannot be used. To illustrate, assume that a church asks a state agency to conduct a criminal records check on a prospective youth worker, and is later informed by the agency that the worker has not been convicted of a crime that bears upon his or her fitness to have responsibility for the safety and well-being of children. Can the church safely assume that it can use the worker without conducting any additional screening? The new law does not address this question. Obviously, the mere fact that someone does not have a record of criminal convictions does not mean that he or she poses no risk of harm to minors. Many child molesters have never been convicted of a crime, and so a “clean record” is no guarantee of safety. It is possible that a court could find a church legally liable for a worker’s act of child molestation even though a criminal records search revealed no criminal history, if the church did nothing else to determine the person’s suitability for working with minors. For this reason, we recommend that churches continue to screen workers even if they are qualified entities under state law and are permitted to request criminal background checks on youth workers.
Also note that even if the courts of your state determine that churches cannot be liable on the basis of negligent selection for using a worker with no history of criminal convictions, it is possible for churches to be liable for a worker’s act of child molestation on the basis of “negligent supervision.” Negligent supervision is a legal theory that imposes liability on an institution or employer for failing to exercise reasonable care in the supervision of its workers (whether volunteer or paid).
• Example. First Church (a qualified entity under state law) asks the designated state agency to conduct a criminal records check on Don (a prospective youth worker) and is advised by the agency that Don has never been convicted of a crime that bears upon his fitness to have responsibility for the safety and well-being of children. Based entirely on this information, the church decides to use Don as a youth worker. A few months later the church receives an allegation that Don has molested a child. Can the church be sued? The National Child Protection Act does not answer this question. It is possible that a civil court would conclude that the church exercised “reasonable care” by requesting a criminal records check on Don and therefore is not guilty of “negligent selection.” However, it is also possible that a civil court may conclude that a church must do more than request a criminal records check and be informed that a worker has no history of criminal convictions. Until the courts clarify this issue in your state the safest course is to use additional screening procedures besides requesting a criminal records check (such as an application form, interview, and reference checks). Remember, the fact that a person has no history of criminal convictions for sex offenses does not mean that he or she is “safe.” Many child molesters have never been convicted of a crime. Also, remember that your church will be accused of “negligence” in selecting Don. There will be many plaintiffs’ attorneys who will allege that a church is negligent for not conducting screening procedures in addition to the criminal records check (for the reasons summarized above). To avoid this accusation, and to decrease significantly the likelihood that an attorney would sue your church, additional screening procedures are recommended.
• Example. Same facts as the previous example. Even if the state courts determine that First Church is not guilty of negligent selection for using a worker without any screening other than the nationwide criminal records check permitted by the National Child Protection Act, it is possible for the church to be liable for a child’s injuries on the basis of negligent supervision. Negligent supervision is a legal theory that imposes liability on organizations for injuries caused by their failure to adequately supervise workers.
It is also important to review the potential liability of churches if they are not designated as qualified entities under state law. If your state does not define the term qualified entity to include churches, then you will not be able to request criminal records checks on youth workers and you will need to implement an effective screening program to reduce the likelihood of child molestation and to reduce your legal risks and potential liability. This is especially true if your church liability insurance policy excludes any coverage for sexual misconduct, or reduces the policy limits in such cases.
• Example. First Church is not a qualified entity under state law, and accordingly it is unable to obtain a nationwide criminal records check on prospective youth workers under the National Child Protection Act. The church must implement a program for screening youth workers. Such a program should include, at a minimum, a “6-month rule” (don’t use a person who has not been a member of your church for at least 6 months), application forms for all workers, interviews, reference checks, an educational program for church staff, and adequate supervision. In some communities, churches also may be able to access local or state criminal databases through a local law enforcement agency.
5. Options. Here is a checklist of options that are available to church leaders:
(1) Determine if your state defines the term qualified entity to include churches
To find out if your state has defined qualified entities to include churches, call your state legislators, a local attorney, the state attorney general, the governor’s office, child welfare agency, or other youth-serving charities in your community (Big Brothers/Sisters, Boy/Girl Scouts, Boys/Girls Clubs, etc.).
(2) Your state defines the term qualified entity to include churches
If churches are qualified entities under state law, then you can request a nationwide criminal records check on those child care workers (“providers”) designated by state law. This may not include all persons who work with minors in your church. You will need to determine which child care workers are designated and which are not. Consider the following points:
Nationwide criminal records checks are obtained as follows: (1) The employee or volunteer completes a form authorizing the request, and containing the required information summarized previously in this article. The state agency should have acceptable forms for you to use. (2) Obtain ten sets of fingerprints on the employee or volunteer. (3) Submit the application, with fingerprints, and the applicable fee, to the designated state agency.
You can obtain nationwide criminal records checks on all persons who meet the definition of a provider. This certainly will reduce a church’s risk of liability based on negligent selection, especially if other screening tools (i.e., application, interview, reference checks) are used. But, such checks are expensive, require weeks or months to process, and are highly intrusive (requiring ten sets of fingerprints). As a result, many churches will elect not to use them as a routine screening tool.
You can obtain nationwide criminal records checks in selected cases. For example, such checks are ideal for persons with inconclusive criminal records, or with prior convictions for non-violent crimes. As noted earlier in this article, church leaders often agonize over how to treat such persons. The National Child Protection Act transfers that decision to the designated state agency which processes the criminal records check request. The church is simply advised whether or not the individual is suitable for working with children.
If your church elects not to conduct nationwide criminal records checks on all providers, then it is imperative that it implement other screening procedures to demonstrate that it is using reasonable care in the selection of employees and volunteers. The degree of screening depends on the nature of the position. The committee report to the National Child Protection Act contains useful guidance. As noted above, the report distinguishes between “level 1” and “level 2” screening. Level 1 screening requires a criminal records check. This level applies to “positions involving long-term or ongoing contact with children in one-on-one situations.” Level 2 screening applies to “positions that involve infrequent direct contact [with minors] or contact only in group settings.” This level includes one or more of the following kinds of activities: (1) check prior employment history for applicants for employment; (2) check references; (3) training; and (4) supervision.
It is important to note that the committee report concluded that criminal records checks are a necessary screening tool for positions involving long-term or ongoing contact with children in one-on-one situations (“level 1” positions). Churches that elect not to obtain nationwide criminal records checks on providers under the National Child Protection Act must recognize that: (1) The committee report contains a strong endorsement of criminal records checks for “level 1” positions. It states that “positions involving long-term or ongoing contact with children in one-on-one situations merit criminal history record checks.” (2) A 1997 General Accounting Office report concluded that “national fingerprint-based background checks may be the only effective way to readily identify the potentially worst abusers of children, that is the pedophiles who change their names and move from state to state to continue their sexually perverse patterns of behavior.” (3) If a church elects not to obtain nationwide criminal records checks on some or all providers, it must be able to demonstrate that it exercised reasonable care in the selection of those providers. At a minimum, this will include application forms, interviews, and reference checks. Churches also should consider conducting state or county criminal records checks (which often are cheaper, faster, and less intrusive), especially for persons in “level 1” positions. Remember, the committee report to the National Child Protection Act concludes that such positions “merit criminal history record checks.”
You must implement screening procedures for persons who do not meet your state’s definition of a “provider.”
(3) Your state does not define the term qualified entity to include churches
If you are not a qualified entity under state law, then you will need to implement other means of screening persons who will have access to minors in your church. These will include applications, interviews, reference checks, and adequate supervision. You also should consider conducting state or county criminal records checks, at least on some workers in higher risk positions. It is worth noting again that the committee report to the National Child Protection Act concludes that “level 1” positions “merit criminal history record checks.”
Comparing Criminal Records Check Options
Type of criminal records checkAdvantagesDisadvantages
FBI nationwide checks
covers criminal records in all 50 states
such checks provide churches with a defense to negligent selection claims
the designated state agency through which such checks are obtained determines an applicant’s suitability for working with minors based on the results of the criminal records search
records often incomplete
expensive, especially if several persons are screened
requires 10 sets of fingerprints per applicant
may require weeks to process
only available to churches if they have been designated as “qualified entities” by state law
state checks
covers an entire state
such checks provide churches with a defense to negligent selection claims
records often incomplete
may not be available to churches
may be expensive, especially if several persons are screened
may require fingerprints
may require weeks to process
limited to criminal records in one state
county checks
very accurate
such checks provide churches with a defense to negligent selection claims
no fingerprints required
very fast (results available in hours or days)
may be expensive, especially if several persons are screened
none
no cost
no fingerprints
increased risk of liability based on negligent selection (this risk can be reduced in the case of applicants for volunteer positions involving contact with minors, or any paid staff position, by using applications and interviews, obtaining references from other organizations in which an applicant has worked with minors, and obtaining references from persons who are familiar with the applicant)
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. A church wants to help its pastor purchase a new home, and so it agrees to pay $50,000 of the purchase price. The pastor signs a promissory note agreeing to pay back the $50,000 in ten annual installments. The church board assures the pastor that the church will “forgive” each annual installment on the date it is due, and so the pastor will not have to pay back anything. Is this transaction legitimate? What are the tax consequences? Church treasurers need to understand the answer to these questions, since this kind of arrangement is common and often misunderstood.
An IRS memorandum. The IRS recently released an internal memorandum (a “field service advisory”) that addresses the tax consequences of debt forgiveness. Here are the facts of the arrangement the IRS was addressing. A widow and mother of three adult children owned a partial interest in farm land. She suffered a stroke and was later determined by a court to be incompetent. A guardian was appointed to handle her financial affairs. The guardian sold the farm land to the children in exchange for non-interest bearing promissory notes signed by each child. The sales agreement called upon each child to pay the guardian $10,000 annually. However, the agreement contained a “cancellation” provision specifying that the payments owed by the children each year would be “forgiven” by the guardian. The children and guardian recognized that these annual cancellations of debt constituted gifts, but they had no tax impact since they were not more than the annual gift tax exclusion of $10,000 for each child.
An IRS auditor determined that a completed gift had been made in the year the original sales agreement was signed, and not each year that the annual payments under the promissory notes were forgiven. As a result, the full amount of the notes represented a gift to the children in the year of the sale. Since these amounts were far more than $10,000, the children’s attempt to purchase their mother’s farm land without exceeding the annual gift tax exclusion failed.
The IRS national office was asked to evaluate this arrangement. Specifically, it was asked whether a gift to the children occurred when the property was transferred in exchange for the non-interest bearing notes. It also was asked to clarify its position “concerning taxpayers’ persistent use of the installment sale as an estate and gift tax avoidance technique.”
The IRS noted that the tax code imposes a “gift tax” on gifts, and that “the value of the property transferred, determined as of the date of the transfer, is the amount of the gift.” Further the code specifies that if property is transferred for less than full value “the amount by which the value of the property exceeds the value [received] shall be deemed a gift.”
The IRS observed:
If an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan. However, if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the donor will have made a gift only at the time of the forgiveness …. Transactions within a family group are subject to special scrutiny, and the presumption is that a transfer between family members is a gift.
Whether the transfer of property is a sale or a gift depends upon whether, as part of a prearranged or preconceived plan, the donor intended to forgive the notes that were received at the time of the transfer.
The IRS noted that the intent to forgive the notes was the determinative factor in this case, and that “a finding of a preconceived intent to forgive the notes relates to whether valuable consideration was received and thus to whether the transaction was in reality a bona fide sale or a disguised gift.”
The IRS pointed out that the children “did not execute separate notes” for each year, but rather “the indebtedness of each child … was represented by only one note.” The children insisted that their arrangement represented a valid installment sale. The IRS disagreed:
It is difficult to conceive of this exchange as an installment sale where the intent of the [children] to make a gift to themselves … is so clearly evident at the time of the [sale agreement]. The [children] have not come forward with evidence to show that the notes represented an obligation portions of which could be forgiven annually …. The [IRS auditor] in this case has appropriately treated this entire transaction as a sham …. It is axiomatic that questions of taxation are to be determined with regard to substance rather than form. An examination of the objective facts of this case, therefore, can only lead to the conclusion that the children are entitled to a gift tax exclusion for [one year] only.
The IRS national office conceded, in its internal memorandum, that “it is conceivable that a court would be inclined to treat this exchange as a bona fide transfer and strictly construe the relevant documents in accordance with their terms.” In other words, the children might persuade a court that the transaction was legitimate, and that they in fact made gifts each year in which the annual payments under the promissory notes were “forgiven.”
The IRS cautioned, however, that at a minimum the children had to prove “by some overt act” that the guardian had the “authority and discretion” to forgive the annual payments due under the promissory notes. It noted that an example of such an overt act “would be the cancellation by the [guardian] of a series of promissory notes on an annual basis.” The IRS concluded that such evidence was not present in this case. It acknowledged that the sales agreement contained a “cancellation” provision calling for the cancellation of the annual installment payments each year under the notes. However, the IRS concluded that “the conspicuous absence of any evidence of forgiveness in any of the subsequent years” effectively negated the legal effect of the cancellation provision. It observed:
The facts of this case clearly indicate that an intent to make a disguised gift for illusory consideration was formed at the time of the original transaction, and at no time subsequent …. In the absence of a showing that there was no prearranged or preconceived plan to forgive any indebtedness, a transfer of real property for non-interest bearing notes must be treated as a gift at the time of the original transfer. Further, the substance of a transaction must prevail over its form where an examination of the facts and circumstances of a transaction suggests that it lacks economic substance.
Relevance to church treasurers. There are important lessons for church treasurers to learn from the IRS memorandum. Consider the following:
No documentation
Many churches have advanced funds to a pastor to assist with the payment of a home. In some cases, there is no clear understanding as to the nature of the arrangement, and no documents are signed. It may not be until it is time for the church treasurer to issue the pastor a W-2 that the tax consequences of the transaction are addressed. If the amount advanced by the church is substantial, church leaders may attempt to characterize it as a “loan” to avoid reporting it as taxable compensation to the pastor. The IRS memorandum demonstrates that this may not be possible.
Example. A church wants to help its pastor buy a new home, and so it gives him $50,000 cash in September of 1999 to assist with the down payment. In January of year 2000, the church treasurer is preparing the pastor’s W-2 for 1999, and wonders whether to report the $50,000 as additional compensation. She presents this question to the church board, which is opposed to treating the full amount as taxable in 1999. They come up with the idea of treating the $50,000 as a tax-free gift. As a result, the treasurer reports no part of the $50,000 as additional compensation on the pastor’s W-2 for 1999 or any future year. This is incorrect. The $50,000 cannot be treated as a nontaxable “gift” to the pastor. See pages 111-114 in Richard Hammar’s 1999 church and Clergy Tax Guide for a full explanation.
Example. Same facts as the previous example, except that the pastor, treasurer, and board recognize that the $50,000 cannot be treated as a nontaxable gift. The board wants to minimize the tax impact to the pastor, and so it comes up with idea of treating the $50,000 as a non-interest bearing loan payable over ten years. They also agree informally to forgive each annual installment of $5,000. However, no documents are signed. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum addressed in this article suggests that the correct answer is (2). Why? The memorandum, which represents the thinking of the IRS national office, states that “if an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan.” Since such a “gift” must be treated as taxable compensation, the entire $50,000 represents taxable income in 1999.
Adequate documentation
The IRS memorandum makes it clear that the existence of adequate documentation may lead to a different result. Consider the following examples.
Example. A church wants to help its pastor buy a new home. The board agrees to loan $50,000 to the pastor in September of 1999 to assist with the down payment. It prepares a non-interest bearing ten-year promissory note in the amount of $50,000, which the pastor signs. The note is secured by a second mortgage on the pastor’s new home. The board minutes reflect the board’s intention that each annual payment ($5,000) will be forgiven when due. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum suggests that the correct answer is (2). The memorandum, which represents the thinking of the IRS national office, states that “if an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan.” The board minutes make it clear that there was a “prearranged” plan to forgive each year’s installment, and so the entire amount of the “loan” must be reported as income in the year of the transaction (1999).
Example. Same facts as the previous example, except there was no explicit understanding or agreement that the board would “forgive” each annual installment. Rather, the board left the question open. As a result, the board minutes contain no indication of any “prearranged” plan to forgive each annual installment. How much additional compensation should the treasurer add to the pastor’s W-2 form for 1999: (1) $5,000 (the amount of the first annual installment that the church forgives); (2) $50,000 (the full amount of the “loan”); or (3) some other amount? The IRS memorandum suggests that the correct answer is (1). The memorandum states that “if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the [church] will have made a gift only at the time of the forgiveness.” This means that income is realized by the pastor each year to the extent that the board decides to forgive the annual installment due under the promissory note. Of course, if the board forgives each annual installment in the year it is due, it becomes increasingly possible that the IRS might view the entire arrangement as “prearranged.” If so, the analysis of the previous example might apply.
Example. Same facts as the previous example, except that the church issues the pastor ten promissory notes for $5,000 each. The notes have “rolling” maturity dates, so that one note matures each year over the next ten years. The IRS memorandum suggests that this arrangement will have an even greater likelihood of avoiding the inclusion of the entire $50,000 amount as income on the pastor’s 1999 W-2. The IRS noted that to avoid treating the entire loan amount as a gift (or as income) in the year of the original transaction, the “borrower” must be able to prove “by some overt act” that the lender had the “authority and discretion” to forgive the annual payments due under the promissory note. It cited as an example of an “overt act” the cancellation by the lender of a series of promissory notes on an annual basis. Such acts, concluded the IRS, was evidence of “forgiveness in subsequent years.”
Key point. This article only addresses the tax consequences of a church’s “forgiveness” of a loan made to a pastor. It does not address the tax consequences of a church making a non-interest bearing loan to a pastor. That issue is addressed on page 122 of Richard Hammar’s 1999 church and Clergy Tax Guide.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Reimbursing Business Expenses Through Salary Reductions
Background. A securities firm employs investment consultants who incur travel and other employee business expenses in connection with the performance of services for their employer. The company adopted a plan to provide for the reimbursement of employee business expenses incurred by the investment consultants. It contains the following features:
The plan is mandatory for all investment consultants within the company.
Investment consultants are reimbursed for employee business expenses that would be deductible as business expenses on their personal tax returns.
Prior to the start of a calendar year, each investment consultant’s manager determines the amount, if any, to be excluded from the consultant’s commissions in the next year. If the manager reduces a consultant’s commissions, such amount is not less than $600 and not more than the reimbursement “cap.” The reimbursement cap equals the greater of $10,000 or 2.5% of the consultant’s commissions in the prior year. The amount of reimbursement that a consultant may receive under the plan in a calendar year may not exceed the lesser of the actual expenses or the reimbursement cap.
If a consultant’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the consultant and will not be carried over from one calendar year to the next.
If a consultant does not request reimbursement under the plan, he or she receives no additional compensation and remains subject to the base compensation reduction.
All consultants requesting reimbursement are required to prepare an expense report within 45 days after the expense is incurred. In preparing an expense report, a consultant must enter, in detail, the elements of each expense. For business travel expenses, a consultant must show the business purpose, the amount of each separate expense, when the expense was incurred, and the travel locations. For other employee business expenses, the consultant must show the business purpose, amount, and date of each expense item. Consultants must submit a receipt for any expense item exceeding $25 (this amount may be increased from time to time up to the applicable legal limit of $75). Business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense.
The employer examines all expense reports prior to payment to determine if the business purpose and amounts are reasonable. The employer approves, denies, or asks for additional information within 15 days of receiving the request for reimbursement. If additional information is requested, the consultant must provide it within 15 days, or the request will be denied.
The employer asked the IRS for a ruling that (1) the amounts reimbursed under the plan will be fully excludible from gross income of the consultants, and (2) that the amounts reimbursed are not wages subject to employment taxes and withholding, and need not be reported on Form W-2.
The IRS ruling. The IRS began its ruling by noting that if an employer’s reimbursements of an employee’s business expenses are “accountable,” they are not included in the employee’s income, they are not reported on the employee’s W-2, and they are not subject to tax withholding. To be accountable, three requirements must be met: (1) the reimbursed expenses are “business connected”; (2) the employee adequately substantiates the expenses within a reasonable time; and (3) the employee is required to return to the employer any portion of a reimbursement in excess of substantiated expenses.
The IRS cautioned that “if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan.” The result is that such reimbursements “are included in the employee’s gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to the withholding and payment of employment taxes.”
The IRS then briefly explained the three requirements of an accountable expense reimbursement arrangement:
#1—business connection
The IRS explained this requirement as follows:
An arrangement meets the business connection requirement … if it provides advances, allowances (including per diem allowances, allowances for meals and incidental expenses, and mileage allowances), or reimbursements for business expenses that are allowable as deductions under … the Code, and that are paid or incurred by the employee in connection with the performance of services as an employee. [The regulations] impose a reimbursement requirement, which will not be satisfied if the payor arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur allowable business expenses.
#2—substantiation
The IRS explained this requirement as follows:
[The] regulations provide that the substantiation requirement is met if the arrangement requires each business expense to be substantiated to the payor (the employer, its agent or a third party) within a reasonable period of time. An arrangement that reimburses business expenses governed by section 274(d) of the Code [pertaining to travel, transportation, entertainment, business gifts, cell phones, and personal computers] meets the substantiation requirement if the information submitted to the payor sufficiently substantiates the requisite elements of each expenditure or use. For example, when substantiating expenses for travel away from home [the regulations] require that information sufficiently substantiating the amount, time, place and business purpose of the expense must be submitted.
If an arrangement covers expenses not governed by section 274(d) of the Code [the regulations specify] that the substantiation requirement will be satisfied if information sufficient to enable the payor to identify the specific nature of each expense and to conclude that the expense is attributable to the payor’s business activities. Each element of an expenditure or use must be substantiated to the payor. It is not sufficient if an employee merely aggregates expenses into broad categories or reports individual expenses using vague, nondescriptive terms, such as miscellaneous business expenses.
#3—returning excess reimbursements
The IRS explained this requirement as follows:
With respect to the third requirement that amounts in excess of expenses must be returned to the payor, the … regulations provide that this requirement is met if the arrangement requires the employee to return to the payor within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated.
The IRS concluded that the company’s plan satisfied all three requirements for an accountable plan. With respect to the third requirement, the IRS noted that “because the plan is a reimbursement arrangement, the amount reimbursed should not exceed the amount substantiated; thus, there should not be an excess to return.” As a result, assuming that expenses “are properly deductible and substantiated,” the IRS reached the following conclusions:
(1) Reimbursements made to a consultant under the plan may be excluded from the consultant’s income as payments made under an accountable plan.
(2) Reimbursements made to a consultant under the plan are not wages subject to employment taxes, and are not reportable on the consultant’s Form W-2.
Significance of the case to church treasurers. Church treasurers should be aware of the following points:
1. Salary reduction agreements. The tax code prohibits employers from paying for accountable reimbursements out of salary reductions. Consider an example. A church pays Rev. J $1,000 each week, and also agrees to reimburse his substantiated business expenses for each month out of the first payroll check for the following month. Assume further that Rev. J substantiated $300 of business expenses for January. The church issued Rev. J his customary check of $1,000 for the first week of February, but only $700 of this check represents taxable salary while the remaining $300 represents a nontaxable reimbursement under an accountable plan. Only the $700 salary component of this check is included on Rev. J’s W 2 form at the end of the year. The code prohibits this practice for accountable reimbursement plans. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that use such an arrangement must recognize that all reimbursements paid through salary reduction are “nonaccountable,” and must be reported on the minister’s W-2.
2. Salary restructuring arrangements. What about salary restructuring arrangements? Does the ban on using salary reduction arrangements to fund accountable expense reimbursements apply to these arrangements as well? The IRS answered “yes” to this question in a 1993 private letter ruling. However, the private ruling addressed in this article signals a retreat from the 1993 position. The two rulings involve very similar facts, and in the 1999 ruling the IRS appears to be saying that employers may pay for reimbursements of employee business expenses under an accountable arrangement through salary “restructuring.” There are two important points to note:
The 1993 IRS ruling interpreting “salary reduction” arrangements to include salary “restructuring” arrangements was a private letter ruling that by law applied only to the taxpayers who requested it. The IRS has not reaffirmed the 1993 ruling in any official or binding precedent. The 1999 ruling discussed in this article is also a private letter ruling. What is the significance of this? To the extent that the 1993 ruling has been used in the past to prevent the use of salary restructuring arrangements to fund accountable expense reimbursements, the 1999 ruling can be interpreted as overruling the earlier ruling. While the 1999 ruling is of no more legal weight than the 1993 ruling, it is the same type of ruling and it entitled to the same weight.
The 1999 ruling, while binding only on the taxpayer who requested it, suggests that an accountable expense reimbursement arrangement can be funded out of a salary restructuring arrangement having most if not all of the following characteristics: (1) the plan is mandatory for all employees; (2) employees are reimbursed only for those business expenses that would be deductible as a business expense on their personal tax returns; (3) prior to the start of each year, the employer determines the amount, if any, to be excluded from the employee’s compensation in the next year; (4) reimbursements cannot exceed a “cap” specified by the employer; (5) if an employee’s expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the employee and will not be carried over from one calendar year to the next; (6) if an employee does not request reimbursement under the plan, he or she receives no additional compensation; (7) all employees requesting reimbursement are required to prepare an expense report within a reasonable time that substantiates the business purpose, amount, and date of each expense item (including a receipt for any expense item exceeding $75; (8) business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense; and (9) the employer examines all expense reports prior to payment to determine if the business purpose set forth on the report is reasonable and if the amounts claimed are reasonable.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Workers Compensation Benefits
No benefits for dancing-related injuries, court rules.
Karastamatis v. Industrial Commission, 1999 WL 391347 (Ill. App. 1999)
Background. Workers compensation laws have been enacted in all fifty states. These laws provide compensation to employees as a result job-related injuries and illnesses. The amount of compensation is determined by law and generally is based upon the nature and extent of the employee’s disability. In exchange for such benefits, employees give up the right to sue an employer directly. Fault is irrelevant under workers compensation laws. The only issues are (1) did an employment relationship exist; (2) did the injury occur during the course of employment; and (3) what were the nature and extent of the injuries?
church employees are protected by workers compensation laws in most states. However, there are exceptions. A few states exempt churches and nonprofit organizations from workers compensation coverage, and some states exempt employers having less than a specified number of employees.
Caution. If a church is not exempt from workers compensation law, what is the effect of its failure to obtain workers compensation insurance? Most workers compensation laws are compulsory. The employer cannot elect to remain outside the system. In a “compulsory” jurisdiction, a covered employer that fails to obtain workers compensation insurance will ordinarily be subject to a lawsuit by an injured employee, or may be treated as a “self-insurer” and be liable for the damages specified by the workers compensation law. A few states permit employers to elect coverage under workers compensation law. To coerce employers into electing coverage, these states impose various penalties upon employers that do not elect coverage.
A recent case. A recent case illustrates the application of workers compensation law to church workers. A church hired a man to work at its annual 3-day picnic which was held each year in the church’s parking lot. The worker set up tents, drove a van, cleaned, and stocked beverages and food. On the last day of the picnic, the worker served food and beverages. He took a break at 2 p.m. He resumed work and took his next break at 11:30 p.m. By this time the picnic was winding down and the worker asked a church officer if he could join other workers and guests who were dancing. He was told to “go ahead.” The worker then joined the other dancers and apparently became the leader in performing a “Greek dance”. After five or six minutes of dancing, he slipped and fell backwards to the ground, injuring his knee. He later claimed that the parking lot had oil spots on it which caused him to slip.
The worker filed an application for workers compensation benefits, claiming that he was a church employee and that his injury occurred during the course of his employment. A state workers compensation commission determined that the worker’s injury had not occurred in the course of his employment, and denied any benefits. The worker appealed.
The court began its opinion by noting that for the worker to qualify for workers compensation benefits he “must demonstrate that his injuries arose out of and in the course of his employment.” For an injury to arise out of the employment: “[T]he risk of injury must be a risk peculiar to the work or a risk to which the employee is exposed to a greater degree than the general public by reason of his employment.” An injury is not eligible for workers compensation benefits “if it resulted from a risk personal to the employee rather than incidental to the employment.” The court noted a “personal risk” is not necessarily converted into an employment risk simply because the employer allowed it. The court concluded:
[The worker’s] injuries did not result from some risk or hazard peculiar to his employment. [He] was hired to set up and stock the picnic and serve beer and food. He was not hired to dance. The risk of injury from dancing was not peculiar to [his] work or incidental to his employment because it did not belong to, nor was it in any way connected with, what [he] had to do in fulfilling his contract of service. [The worker] voluntarily exposed himself to an unnecessary danger entirely separate and apart from the activities and responsibilities of his job. His act of dancing was a personal act, solely for his own convenience; an act outside any employment risk. Further, [he] presented no evidence to show he was at an increased risk of injury from dancing because he was working at a picnic sponsored by a … church where his duties were to stock the picnic and serve food and beverages. Simply put, the risk of injury [the worker] was exposed to while dancing was neither peculiar to nor increased by the nature of his employment.
The worker insisted that his injuries arose out of his employment because he was injured while on a break and therefore the “personal comfort doctrine” applied. The court defined the personal comfort doctrine as follows: “Employees who, within the time and space limits of their employment, engage in acts which minister to personal comfort do not thereby leave the course of employment, unless the … method chosen is so unusual and unreasonable that the conduct cannot be considered an incident of the employment.”
The court noted that the personal comfort doctrine generally applies when an employee is on break and sustains an injury. It covers acts such as eating and drinking, obtaining fresh air, seeking relief from heat or cold, showering, resting, and restroom breaks. However, for the personal comfort doctrine to apply, an employee’s injury must “still be related to the employment environment and not a hazard to which [the employee] would have been equally exposed apart from his employment.” In this case, it was not the employment environment or premises that caused the worker’s injury, but rather the worker’s decision to engage in dancing while on break. Such conduct was simply too far removed from the employment environment to qualify for workers compensation benefits. The court observed that “there is no evidence that the conditions of the employment or the premises caused [the worker’s] injury nor is there any evidence that [he] was at an increased risk.” It concluded that “the risk of injury from dancing was personal to [the worker] and neither peculiar to his job nor a risk to which he was exposed to a greater degree than the general public.”
Significance to church treasurers. What is the significance of this case to church treasurers? Consider the following points:
Are we subject to workers compensation? Church treasurers should know whether their church is subject to state workers compensation law. If you are not sure if your church is covered, consider one or more of the following steps: (1) ask a local attorney; (2) ask your church insurance agent; or (3) call the agency in your state that administers the workers compensation program.
The risk of being uninsured. Employers that are covered by workers compensation law generally pay insurance premiums to cover the cost of benefits paid to injured workers. However, many churches have failed to obtain workers compensation insurance, often because of a false assumption that they are not covered by workers compensation law. This can expose a church to significant liability, for two reasons. First, an injured employee may be able to sue the church for damages in a civil lawsuit. Unlike workers compensation benefits, there is no limit on the amount a court can award in a civil lawsuit. Second, the damages a court awards in a civil lawsuit will not be covered under most church insurance policies. Often, general liability policies exclude employee injuries on the assumption that they are covered under a workers compensation policy. This can create a dangerous gap in coverage.
Do we have workers compensation insurance? If your church is subject to workers compensation law, then be sure you have obtained workers compensation insurance. If in doubt, ask your church insurance agent.
Employees. Workers compensation laws only cover injuries and illnesses suffered by employees on the job, but the term employee is defined very broadly to further the objectives of workers compensation law. As a result, persons whom a church may deem self-employed for income tax purposes may be deemed employees for purposes of the workers compensation law. This case is a good example. The employee status of the worker was not questioned, even though he was hired to work only for three days at a church picnic.
Injuries occurring in the course of employment. This case provides a useful clarification of workers compensation law. It demonstrates that church employees may qualify for workers compensation benefits for injuries they while on a job-related break. This no doubt will come as a surprise to many church leaders. However, not every injury occurring to an employee during a break will qualify for benefits. Such injuries must be related to the employment environment or premises. In this case, there were witnesses who directly contradicted the worker’s claim that he slipped on oil in the parking lot. As a result, the court concluded that the injury was not directly associated with the employer’s premises. Further, the act of dancing was so far removed from the employment environment that the injury did not qualify for benefits.
Key point. The court’s ruling exposes the church to a civil lawsuit by the injured employee. However, since the court determined that the injury did not occur in the course of the worker’s employment, the church ‘s general liability insurance policy should provide coverage in the event the worker sues the church.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Federal Court: Revocation of Church’s Tax-Exempt Status Was Proper
Ruling upholds rare instance when IRS took away exemption for political activities.
In order to maintain their tax-exempt status for federal income tax purposes, churches and other religious organizations must comply with several requirements specified in section 501(c)(3) of the tax code. One of these requirements is that the organization must not participate or intervene in any political campaign on behalf of (or in opposition to) any candidate for public office. Many churches have violated this requirement in the past with no adverse consequences. However, the landscape is changing.
In 1995 the IRS for the first time revoked the exempt status of a church for intervening in a political campaign. The church had published full-page ads in two national newspapers, warning Christians not to vote for candidate Bill Clinton in the 1992 presidential election. The IRS ruling was upheld recently by a federal court. The court rejected the church’s claim that the revocation of its tax-exempt status violated the first amendment and the Religious Freedom Restoration Act.
A federal court has upheld a ruling by the IRS revoking the tax-exempt status of a church on account of its intervention in the 1992 presidential campaign. This case makes it essential for church leaders to be familiar with the limitation on political involvement. This article reviews the court’s ruling, summarizes the limitation on political activities, and addresses the impact of the ruling on church practices.
Details of the case
On October 30, 1992, four days before a presidential election, Branch Ministries, Inc., doing business as the Church at Pierce Creek (the “church”), expressed its concern about the moral character of candidate Bill Clinton in a full page advertisement in the Washington Times and in USA Today. The advertisement proclaimed “Christian Beware. Do not put the economy ahead of the Ten Commandments.” It asserted that Bill Clinton supported abortion on demand, homosexuality and the distribution of condoms to teenagers in public schools.
The advertisement cited various Biblical passages and stated that “Bill Clinton is promoting policies that are in rebellion to God’s laws.” It concluded with the question, “How then can we vote for Bill Clinton?” At the bottom of the advertisement, in fine print, was the following notice: “This advertisement was co-sponsored by The Church at Pierce Creek, Daniel J. Little, Senior Pastor, and by churches and concerned Christians nationwide. Tax-deductible donations for this advertisement gladly accepted. Make donations to: The Church at Pierce Creek,” and provided a mailing address.
At the time the advertisement was published, the church was a tax-exempt organization. On October 31, 1992, the New York Times published an article entitled “Religious Right Intensifies Campaign for Bush.” The article discussed the role of the religious right in the 1992 presidential campaign and mentioned the advertisement described above, but it did not mention Branch Ministries or the Church at Pierce Creek by name. On December 1, 1992, the New York Times published an op-ed piece entitled “Tax-Exempt Politics?” The article discussed the “use of tax-exempt money for politics,” and, as a case in point, focused on the advertisement in USA Today by the Church at Pierce Creek. The article observed that “[t]he sponsors [of the advertisement] almost certainly violated the Internal Revenue Code.”
On November 20, 1992, the Regional Commissioner of the Internal Revenue Service sent the Church at Pierce Creek a letter stating that he was authorizing the District Director to begin “a church tax inquiry because a reasonable belief exists that you may not be tax-exempt or that you may be liable for tax. The general subject matter of the inquiry concerns political expenditures which you may have paid or incurred, as well as whether you are tax-exempt.” The letter also requested certain information “[i]n order to better understand your activities,” including information about the USA Today advertisement, any political campaigns for public office in which the church had sponsored advertisements, the political expenditures of the church, the total amount of contributions received in response to the USA Today advertisement, and the purpose of the church.
On December 23, 1992, the church sent a response to the request for information. The church took the position that it had not engaged in any political activity. Rather, the advertisement printed in USA Today and the Washington Times constituted a “warning to members of the Body of Christ,” and the warning “did not constitute participation in a political campaign.” The church refused to respond to most of the requests made by the IRS, including the request for the identities of persons who had contributed money in response to the USA Today and Washington Times advertisement.
By letters dated February 11, 1993 and August 11, 1993, the IRS informed the church that it was beginning a church tax examination, and it again requested certain documents from the church. At one point, the IRS drafted a summons to require the church to submit the requested information, but the summons was never issued. Finally, on January 19, 1995, the IRS issued a letter stating that the church’s status as a section 501(c)(3) tax-exempt organization was revoked, retroactive to January 1, 1992.
Three months after the revocation letter was issued, the church filed a lawsuit in federal court asserting that the revocation of its status as a Section 501(c)(3) organization was improper. The basic premise of the church’s claim was that once a church applies for and is deemed a section 501(c)(3) organization, the IRS lacks authority to revoke that status unless it concludes that the church is not a bona fide church. The church also contended that the IRS selectively prosecuted it on the basis of its conservative political or religious views in violation of the equal protection clause of the fifth amendment, and that the revocation of its exempt status violated the first amendment and the Religious Freedom Restoration Act.
The Court’s Ruling
Church Status
The church argued that the IRS has no authority to revoke the section 501(c)(3) status of a church unless it determines that the church is not a bona fide church. It insisted that the Church Audit Procedures Act (“CAPA”) provides a “zone of protection” that prevents the IRS from revoking the section 501(c)(3) status of a church on the basis of partisan political activity. The church also claimed that CAPA only permits the IRS to revoke the exempt status of “sham churches.” If the church is bona fide, the IRS can only impose a tax or seek an injunction to stop the activities of the church. It cannot revoke its exempt status.
The IRS conceded that the church in this case is a bona fide church. However, it asserted that it revoked the section 501(c)(3) status because the church engaged in partisan political activity in direct violation of section 501(c)(3). The IRS rejected the church’s claim that CAPA allows revocation only in the case of sham churches:
The clear statutory language of CAPA, however, provides that the [IRS] is authorized to revoke the tax-exempt status upon a determination that the organization “is not a church which (i) is exempt from taxation by reason of section 501(a) ….” Section 501(a) in turn provides that an “organization described in subsection [501](c) … shall be exempt from taxation under this subtitle ….” Subsection (c)(3) describes “corporations … organized and operated exclusively for religious … purposes … which do not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”
The court pointed out that the IRS determined, in compliance with the procedures set forth in CAPA, that the church, while it remained a bona fide church, was not an organization described in section 501(c)(3) because it had published or distributed a statement in opposition to a candidate for public office. Because the IRS determined that the church was not an organization described in section 501(c)(3), it had the legal authority to determine that it was no longer a church that was exempt from taxation.
Equal Protection of the Laws
The church claimed that the decision of the IRS to revoke its tax-exempt status was unconstitutionally motivated by the conservative political and religious beliefs of the church. The court noted that to win a selective prosecution claim, the church must clearly establish “(1) that the prosecutorial decision had a discriminatory effect, and (2) that it was motivated by a discriminatory purpose or intent.” The court continued:
A showing of discriminatory effect requires [the church] to demonstrate that similarly situated persons of other religions or political beliefs have not been prosecuted. Discriminatory purpose may be established either with direct evidence of intent or with “evidence concerning the unequal application of the law, statistical disparities and other indirect evidence of intent.” For obvious reasons, the selective prosecution standard is a “demanding one,” and [the church] must present “clear evidence” of both discriminatory effect and intent in order to establish their claim.
The court concluded that the church had failed to present “clear evidence” of either requirement, and the IRS therefore was entitled to summary judgment on this claim:
[The church has] presented little or no evidence of discriminatory effect. As the government has pointed out [the church has] not identified any “similarly situated” organization that retained its section 501(c)(3) status. [The church’s] evidence of similarly situated entities relates only to churches that have allowed political leaders to appear at religious services or churches that have used the pulpit to advocate a certain message. For purposes of deciding whether to begin an investigation, however, those entities are not similarly situated to the church. The IRS decided to revoke the tax-exempt … because the church had run a print advertisement in two national newspapers that was fully attributable to the church and that solicited donations. [The church has] pointed to no other instance in which a church so brazenly claimed responsibility for a political advertisement in a national newspaper and solicited tax-deductible donations for that political advertisement. In fact, [the church has] provided no evidence of an instance in which a political act could so easily be attributed to a tax-exempt church.
Virtually all of the 65 examples cited by [the church] are of candidates or other political figures speaking from the pulpits of churches or at synagogues-Reverend Jesse Jackson, Senators Al Gore, Charles Robb, Frank Lautenberg and Tom Harkin, Senate candidates Oliver North and Harvey Gantt, Governors Bill Clinton, Mario Cuomo and Douglas Wilder, gubernatorial candidates James Gilmore, III and Don Beyers, Jr., Mayors Marion Barry, Kurt Schmoke and Rudolph Giuliani, and numerous others. [The church maintains] that this conduct is similar to that of the church because, like the advertisement at issue here, those instances involve “public declarations” urging people to vote for or against particular candidates. As the court previously noted, however, “candidates giving speeches from pulpits or churches or churches sponsoring political debates or forums … are substantially dissimilar to the instant case.”
The court pointed out that in the only two instances with arguably similar circumstances, the IRS in fact did revoke the tax-exempt status of the two religious organizations. Each case is summarized below.
(1) Christian Echoes National Ministry, Inc. v. United States 470 F.2d 849 (10th Cir. 1964). In 1964, the IRS revoked the tax-exempt status of Christian Echoes National Ministry in part because “it had directly and indirectly intervened in political campaigns on behalf of candidates for public office.”
(2) The Way International. In 1985 the IRS revoked the section 501(c)(3) tax-exempt status of The Way International retroactively, in part because The Way had engaged in political activity. The Way International challenged the revocation of its exemption in federal court. While the case was pending, the parties entered into a settlement. The Way International was granted an exemption effective September 1, 1983, but the revocation for the prior years was allowed to stand.
The church argued that the fact that the IRS took actions against Christian Echoes and The Way does not undermine its selective prosecution claim because neither organization was a church. The court noted that this claim only bolstered the position of the IRS that there were no other “similar” cases in which the IRS treated politically active churches more leniently. The court concluded:
In the circumstances presented here-where a tax-exempt church bought an advertisement that stated its opposition to a particular candidate for public office, attributed the advertisement to the church and solicited tax-deductible contributions for the advertisement-the IRS was justified in revoking the tax-exempt status of the church, even if it might refrain from revoking the status of churches where attribution is less clear. In the absence of any showing that any other churches engaged in similar conduct and did not have their tax-exempt status revoked [the church has] failed to establish discriminatory effect.
The court then addressed the second requirement for a selective prosecution claim-clear evidence of discriminatory motivation by the IRS. As proof of this requirement, the church pointed to the fact that the IRS had not previously revoked the section 501(c)(3) status of a church for its involvement in a campaign for political office. The court rejected this argument, noting that “while statistical evidence may be used to establish discriminatory intent, it is not sufficient for [the church] to assert that the lack of any other revocations must mean that the IRS had a discriminatory intent where, as here, [the church has] failed to provide any evidence that there are any similarly situated churches that retained their section 501(c)(3) status.”
Free Exercise of Religion
The church also asserted that the revocation of its tax-exempt status violated the right to free exercise of religion guaranteed by the Religious Freedom Restoration Act (RFRA) and the first amendment. RFRA provides that the government “shall not substantially burden a person’s exercise of religion … [unless] it demonstrates that application of the burden to the person (1) is in furtherance of a compelling governmental interest; and (2) is the least restrictive means of furthering that compelling governmental interest.”
In order to invoke the protections of RFRA, the church first must demonstrate that the government has substantially interfered with its exercise of religion. If, and only if, the church can demonstrate a substantial burden, then the government has the burden under RFRA of establishing that the revocation serves a compelling governmental interest and that revocation is the least restrictive means of accomplishing that compelling interest. The court concluded that the church had failed to establish that the revocation of its tax-exempt status substantially burdened its right to freely exercise its religion:
A substantial burden exists where the government puts substantial pressure on an adherent to modify his behavior and to violate his beliefs, or where the government forces an individual to choose between following the precepts of her religion and forfeiting benefits, on the one hand, and abandoning one of the precepts of her religion.
The court stressed that the church had provided no evidence that the revocation of its exempt status by the IRS was in any way connected to its “refusal to violate its religious beliefs or abandon a precept of their religion.” Instead, the revocation was undertaken “because of the church’s involvement in partisan political activity.”
The church claimed that the decision of the IRS to revoke its section 501(c)(3) status had imposed a number of burdens, including exposure to federal income taxation, and the likelihood that contributions will decrease since donors will not be eligible to deduct their contributions to the church. The court acknowledged that the church was “probably correct” in claiming that the revocation had imposed these burdens, but it insisted that the church had “failed to establish that the revocation has imposed a burden on their free exercise of religion.” The court emphasized that the church had a choice-it “could engage in partisan political activity and forfeit its section 501(c)(3) status or it could refrain from partisan political activity and retain its section 501(c)(3) status.” The court insisted that this choice was unconnected to the church’s ability to freely exercise its religion.
The court noted that the only way in which the revocation of section 501(c)(3) status had any effect on the church’s exercise of religion was that the church had less operating money to spend on religious activities because it was now a taxable entity. But, the fact that the church had less money to spend on religious activities as a result of its participation in partisan political activity “is insufficient to establish a substantial burden on their free exercise of religion.”
Since the church had failed to demonstrate that the revocation of its tax-exempt status had “substantially interfered” with its exercise of religion, there was no violation of either RFRA or the first amendment guaranty of religious freedom, and there was no need for the IRS to demonstrate that the revocation served a compelling governmental interest. However, the court added that even if the church had demonstrated a substantial burden on the exercise of its religion, the IRS had met the compelling governmental interest standard and therefore the church’s rights were not violated. The court observed: “The government has a compelling interest in maintaining the integrity of the tax system and in not subsidizing partisan political activity, and section 501(c)(3) is the least restrictive means of accomplishing that purpose.”
Branch Ministries, Inc. v. Commissioner, 99-1 USTC ¶50,410 (D.D.C. 1999)
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. A few weeks ago the IRS released an internal memorandum (a “field service advisory”) addressing the question of whether parents can claim a charitable contribution deduction for tuition payments they make for their children who attend an Orthodox Jewish school. This memorandum will be instructive to any church or religious organization that operates a school.
Facts. The parents cited the following facts in supporting their claim that tuition payments they made on behalf of their children were deductible as charitable contributions:
The act of religious study for Orthodox Jews is an observance of their religion that begins at an early age and continues for life. As a result, tuition payments they make to Jewish religious schools are in furtherance of this religious function and are deductible as charitable contributions.
For the Orthodox Jew, the obligation to study the Torah and the Talmud is a matter of duty and adherence to Jewish law, a lifelong commitment ranking aside the obligation to pray. The observance of such duties primarily benefits the community, not the individual.
The primary purpose of Jewish schools is religious study. A significant portion of a student’s time at a Jewish school is devoted to religious study.
The United States Supreme Court ruled in 1990 that payments made directly to of two Mormon missionaries by their parents were not deductible since they were not made “to or for the use of” the Mormon Church. Davis v. Commissioner, 495 U.S. 472 (1990). The parents of the children attending the Jewish school argued that if the Mormon parents had made their payments to the Mormon Church with the understanding that such payments were for the support of the taxpayers’ sons, then such payments would have been deductible as charitable contributions. Similarly, since payments to Jewish religious schools are placed under the unfettered control of the school to help it carry out its religious function of providing religious study and worship, they should be deductible.
The payment of tuition to Jewish religious schools yields only an incidental benefit to the parent, and therefore avoids the Supreme Court’s holding in Hernandez v. Commissioner, 490 U.S. 680 (1989). In Hernandez, the Court held that payments to the Church of Scientology for auditing and training represent a “quid pro quo” exchange for direct benefits by the payor and as such were not deductible as charitable contributions. The parents insisted that this ruling did not apply to them, since the payment of tuition for religious study results in only an “incidental benefit” to themselves but a direct benefit to members of the Jewish religion. Tuition payments to Jewish religious schools, the parents argued, provide the students with the religious observance of their religion through religious study, but this benefit is only incidental to both students and their parents. The primary beneficiaries are the Jewish people who have had their religion preserved for thousands of years through careful adherence to the study of Judaism by members of the faith.
What the IRS concluded. The IRS rejected all of the parents’ arguments, and concluded that the tuition payments were not deductible as charitable contributions. The IRS based this conclusion on the following considerations:
The definition of a charitable contribution
The IRS noted that “a transfer of money or property to a charity is deductible … unless the taxpayer receives a valuable return benefit by reason of the transfer.” It quoted from the Supreme Court’s opinion in the Hernandez case: “The code makes no special preference for payments made in the expectation of gaining religious benefits or access to a religious service.” In other words, a charitable contribution is a transfer of cash or property to a charity without any equivalent return benefit to the donor. A charitable contribution exists only to the extent that the value of the cash or money exceeds the value of any goods or services received by the donor in exchange. The IRS memorandum concludes with the observation that the parents “clearly derive a substantial benefit on account of the payment of tuition and accordingly, such payments are not deductible.”
The implications of accepting the parents’ position
The IRS expressed concern that an acceptance of the parents’ position “would expand the charitable contribution deduction far beyond what Congress has provided.” It continued:
Numerous forms of payments to eligible donees plausibly could be categorized as providing a religious benefit or as securing access to a religious service. For example, some taxpayers might regard their tuition payments to parochial schools as generating a religious benefit or as securing access to a religious service; such payments, however, have long been held not to be charitable contributions ….
Other precedent
The IRS referred to a number of court decisions addressing the deductibility of tuition payments, including the following:
• Revenue Ruling 83-104. In 1983, the IRS issued a ruling addressing the deductibility of tuition payments. This ruling contained the following example:
A school requests parents to contribute a designated amount (e.g., $400) for each child enrolled in the school. Parents who do not make the $400 contribution are required to pay tuition of $400 for each child. Parents who neither make the contribution nor pay the tuition cannot enroll their children in the school. A parent who pays $400 to the school is not entitled to a charitable contribution deduction because the parent must either make the contribution or pay the tuition in order for his child to attend the school.
The IRS noted that no charitable contribution deduction is allowable in this example because the tuition payment “was not voluntary and was not made without the expectation of a commensurate benefit.”
DeJong v. Commissioner, 309 F.2d 373 (9th Cir. 1962). Parents made a “contribution” of $1,075 to the Society for Christian Instruction which operated full-time schools accredited by the state. The Society charged no tuition but raised funds from parents of enrolled students, churches and other entities. The stipulated annual cost of providing instruction for each child was $400. Although no tuition was charged, the parents who could so afford were expected to contribute to the Society at least to the extent of the cost of providing their children with an education. Though the cost of tuition covered both secular and religious education, the court concluded that the tuition payment ($400) was not deductible as a charitable contribution because it was not voluntary and was induced in substantial part by the benefits sought and anticipated from enrollment in the school.
Oppewal v. Commissioner, 468 F.2d 1000 (1st Cir. 1972). Parents deducted $900 as a charitable contribution to the Whitinsville Society for Christian Instruction. The court disallowed that part of the payment which represented the cost of educating the taxpayers’ children in the religiously-oriented school.
Winters v. Commissioner, 468 F.2d 778 (2d Cir. 1972). Parents claimed a charitable contribution deduction for payments made to a church fund established to support certain Christian schools, enrollment in which did not require payment of tuition. The court concluded that to the extent that the taxpayers received a benefit in return, the payment constituted nondeductible tuition.
Hernandez v. Commissioner, 490 U.S. 680 (1989). The Supreme Court ruled “contributions” made to the Church of Scientology for “auditing” were not deductible as charitable contributions. Auditing involves a counseling session between a Church official and a counselee during which the counselor utilizes an electronic device (an “E meter”) to identify areas of spiritual difficulty by measuring skin responses during a question and answer session. Counselees are encouraged to attain spiritual awareness through a series of auditing sessions. The Church also offers members doctrinal courses known as “training.” The Church charges fixed “donations” for auditing and training sessions (the charges are set forth in published schedules). The system of fixed charges was based on a tenet of Scientology (the doctrine of exchange) that requires persons to pay for any benefit received in order to avoid “spiritual decline.” The Court concluded that payments made to the Church of Scientology for auditing and training sessions were a non deductible reciprocal exchange—specific benefits in exchange for specific fees:
the Church established fixed price schedules for auditing and training sessions in each branch church; it calibrated particular prices to auditing or training sessions of particular lengths and levels of sophistication; it returned a refund if auditing and training services went unperformed; it distributed account cards on which person who had paid money to the Church could monitor what prepaid services they had not yet claimed; and it categorically barred provision of auditing or training services for free. Each of these practices reveals the inherently reciprocal nature of the exchange.
In other words, “contributions” to the Church (1) were mandatory, in the sense that no benefits or services were available without the prescribed payment, and (2) represented a specified fee for a specified service.
The IRS, in commenting on the Hernandez case, observed:
The Scientology ‘training’ at issue in Hernandez involved the intensive study of the writings and tenets of Scientology. This training did not involve secular education, and was a means of progressing up the Scientology ‘Bridge.’ There seems to be no relevant distinction between such training and the intensive study of Jewish writing and tenets. The parents stress the amount of time spent in study by students at Orthodox Jewish schools. Even if it is true that they devote more time to the activity than students of Scientology, this is simply a question of degree, and we see no reason why this distinction supports a result different from the result in Hernandez. Thus, whether the payment involved is in consideration for training to become a good Scientologist, Christian or Jew, we conclude that, under Hernandez, such payments do not qualify as charitable contributions ….
The IRS memorandum concludes by noting that the parents in this case “are required to make specific payments in return for which they receive a benefit—religious and secular education for their children. Under the rationale postulated in Hernandez, the parents are not entitled to a charitable contribution deduction for tuition payments made to Jewish religious schools.”
Relevance to church treasurers. Does your church operate a school or preschool? If so, are you allowing parents to deduct tuition payments as charitable contributions? Unfortunately, many church schools do so because of an unfamiliarity with the law. The IRS memorandum, and the cases it cites, demonstrate that tuition payments should not be treated or receipted as charitable contributions. There are three limited exceptions to this general rule:
1. Undesignated contributions to a scholarship fund. Church members are free to make undesignated payments to a school’s scholarship fund. Such payments can be treated as deductible charitable contributions. However, note that this assumes that the contribution in fact is undesignated, and is not accompanied by any “secret” understanding that the church or school will use the funds for a specific student. To illustrate, a parent cannot deduct an “undesignated” contribution that church or school officials apply to the tuition of the parent’s child. Further, the class of potential scholarship recipients must be substantial. A parent could not claim a charitable contribution deduction for “undesignated” contributions to a preschool’s scholarship fund if the preschool has only four students (one of whom is the donor’s daughter).
2. Payments in excess of tuition. The IRS and the courts have ruled that donors can claim a charitable contribution deduction to the extent that their donation exceeds the value of goods or services they receive in return. To illustrate, if a church school charges annual tuition of $3,000, and a parent makes a “contribution” of $4,000 to the school that is used to pay the tuition of the parent’s child, the parent qualifies for a charitable contribution deduction in the amount of $1,000.
3. A 1983 IRS ruling. In 1983, the IRS recognized the following limited exception to the general rule of the nondeductibility of tuition payments:
A church operates a school providing secular and religious education that is attended both by children of parents who are members of the church and by children of nonmembers. The church receives contributions from all of its members. These contributions are placed in the church’s general operating fund and are expended when needed to support church activities. A substantial portion of the other activities is unrelated to the school. Most church members do not have children in the school, and a major portion of the church’s expenses are attributable to its nonschool functions. The methods of soliciting contributions from church members with children in the school are the same as the methods of soliciting contributions from members without children in the school. The church has full control over the use of the contributions that it receives. Members who have children enrolled in the school are not required to pay tuition for their children, but tuition is charged for the children of nonmembers. A church member whose child attends the school contributes $200 to the church for its general purposes. The IRS ordinarily will conclude that the parent is allowed a charitable contribution deduction of $200 to the church. Because the facts indicate that the church school is supported by the church, that most contributors to the church are not parents of children enrolled in the school, and that contributions from parent members are solicited in the same manner as contributions from other members, a parent’s contributions will be considered charitable contributions, and not payments of tuition, unless there is a showing that the contributions by members with children in the school are significantly larger than those of other members. The absence of a tuition charge is not determinative in view of these facts.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
