The Supervision of Small Children

A Georgia court addresses church liability-Bull Street Church of Christ v. Jensen, 504 S.E.2d 1 (Ga. App. 1998)

Bio

Article summary. Churches minister to children in a variety of ways, including Sunday Schools, nurseries, day care programs, private schools, youth groups, and scouting programs. In smaller churches, only a few children may be involved, but in larger churches the number swells to hundreds or even thousands. Unfortunately, children occasionally are injured on church premises, or during church activities. In some of these cases, parents sue the church, alleging either negligent selection of a youth worker who was responsible for the injury, or negligent supervision of the injured child. A recent Georgia case addressed the liability of a church for the molestation of a 4-year-old girl by a 10-year-old boy on church premises. The court concluded that churches have a duty to exercise reasonable care in the supervision of young children, and that this duty was breached in this case because the victim had been released from a nursery area and was allowed to roam freely throughout the church without adult supervision. While unsupervised, the victim was taken to a vacant classroom and molested by the older boy. The court’s opinion will provide church leaders with helpful insights into how such incidents occur, a church’s risk of liability, and steps churches can take to minimize this risk.

A Georgia court ruled that a church was legally responsible for the molestation of a 4-year-old girl by a 10-year-old boy on church premises. This feature article will summarize the facts of the case, review the ruling, and evaluate the significance of the case to other churches.

Facts

A 4-year-old girl attended a class at her church for 3-year-old to 6-year-old children, while her mother attended an adult church service. The mother left her daughter with a husband and wife who were the teachers of the children’s class. A church elder later testified that the church had no written policies or procedures regarding the operations of Sunday School classes for children.

The victim ordinarily waited in the classroom for her mother to retrieve her after church. However, on one occasion, the children were allowed to leave the classroom and find their parents on their own without any adult supervision. While the victim waited for her mother next to a stairway leading to her classroom, she was approached by a 10-year-old boy (Corey) who asked her if she wanted to see his classroom. The victim followed Corey into an unoccupied classroom, where he pushed her underneath a table and sexually molested her. Corey later released the victim, who returned downstairs to find her mother. After telling her mother what Corey had done, the mother immediately confronted the pastor and informed him of the attack. She later testified that the pastor’s response was “oh no, it’s happened again,” and that he acknowledged that Corey had acted inappropriately towards a child of another church family. The mother also testified that the church’s elders advised her that they wanted to keep the incident quiet in order to avoid a conflict in the church.

Following the attack, the victim received treatment from a psychotherapist, and was hospitalized when she was 6 years old, and again at age 8, after expressing suicidal thoughts. A psychiatrist who treated the victim during her second hospitalization testified that the victim was severely depressed, tearful, had no interest in normal activities, and isolated herself. He concluded that Corey’s attack was the major cause of her problems.

The victim’s parents later sued their church, claiming that it negligently failed to protect their daughter from Corey despite having prior notice of his sexual propensities. A jury determined that the church had been negligent, and ordered it to pay damages to the victim. The church appealed, insisting that it could not be liable for the attack because it had no prior knowledge of any sexual misconduct by Corey.

The Court’s Ruling

The court began its opinion by noting that

as a general rule, a person who undertakes the control and supervision of a child, even without compensation, has the duty to use reasonable care to protect the child from injury. Such a person is not an insurer of the safety of the child. He is required only to use reasonable care commensurate with the reasonably foreseeable risk of harm ….

What is at issue in a case alleging negligent supervision of a child is whether the danger of the type of harm the child suffered was reasonably foreseeable. And, what is reasonably foreseeable is not exclusively dependent upon what is known about a specific place. The danger is not only what may happen at a specific place but what may happen to any child at any place, given that children are mobile and may … wander away from the place where they are supposed to be if they are not adequately supervised …. Accordingly, the issue is whether there was evidence that the danger of the sexual assault on the victim was reasonably foreseeable to the church.

In summary, a church can be liable for an injury to a child occurring on church premises or during a church activity based on negligent supervision if the injury was reasonably foreseeable. The court concluded that an injury to a child can be foreseeable in either or both of two ways.

Foreseeable “General Risks”

The court concluded that some injuries are foreseeable because of the “general risks” associated with certain kinds of conduct, even if no similar injury has ever occurred in the past. It explained this type of foreseeability as follows:

Clearly, in this case the church assumed responsibility for caring for a class of 3-year-old to 6-year-old children, including the 4-year-old victim. Thus, the church had the duty to use reasonable care to protect the children from a reasonably foreseeable risk of harm. There is also evidence that the church, through the volunteer church teachers, breached that duty by allowing the victim and other young children to wander through the church without adult supervision ….

[W]e hold that the church had reasonable grounds for apprehending that if the teachers left the victim unsupervised, there was a general risk that the child could be harmed …. [T]hose who agree to supervise small children cannot avoid liability simply because the injury to a child without adult supervision occurred off the premises or because no prior, similar injury to the small child had occurred so as to place the supervisors on notice of the potential for such harm. Instead, care providers must realize that it is foreseeable that a small child, such as the victim, leaving a church classroom could wander off the church premises and be hit by a car, abducted or otherwise injured. Even if the child remained on the premises, the potential for harm exists-e.g., she could fall down stairs, fight with another child, or get into various forms of mischief that would cause injury. Even absent actual knowledge of a specific risk, those who agree to supervise small children are charged with constructive notice of the general risks of harm, including assault and molestation, that may befall an unsupervised child.

Accordingly, we conclude that [there was sufficient evidence in this case] even without evidence of [Corey’s] prior behavior, to find that the church had a duty to supervise the victim, which it breached by allowing the victim to roam free in the church where it was foreseeable that she could be harmed by a plethora of environmental and societal dangers.

In summary, a church is liable on the basis of negligent supervision for foreseeable injuries resulting from its failure to adequately supervise young children. Foreseeable injuries include those “general risks” that result from a failure to supervise, and one of those risks is sexual assault. It does not matter that no child has ever been assaulted before on a church’s premises. Such a risk is a foreseeable consequence of allowing children to roam unattended on church premises.

Foreseeability based on prior knowledge

The court also concluded that the victim’s injuries were foreseeable because the church had actual knowledge of previous sexual misconduct by Corey. It based this conclusion on the following two considerations:

1. The pastor’s response. The mother claimed that the pastor’s immediate response to the incident was “oh no, it’s happened again.” She later testified that when she asked the pastor what he meant, he explained that Corey had previously acted inappropriately towards a child from another family in the church.

2. A church elder’s knowledge. A few years before Corey assaulted the victim, another incident occurred involving Corey. A number of families from the church met at the home of a host family for a “casual get-together.” The host family’s 4-year-old daughter was in the bathtub when Corey “came in an exposed himself” to her. The girl’s mother later informed a church elder of this incident. The elder, who was a physician, informed the mother that the incident was “benign” and merely a form of “show and tell” that should not be overemphasized. He did not think the incident was serious, and advised the mother to “let the matter drop.”

Based on these facts, the court concluded that “there was sufficient evidence for a jury to conclude that … the church had notice that [Corey] had inappropriately acted in a sexual manner towards a smaller child prior to his attack on the victim.”

Hearsay Testimony

The church argued that the only evidence that it had prior knowledge of Corey’s sexual propensities was hearsay which was not admissible in court and therefore was insufficient to establish knowledge. Hearsay evidence consists of out-of-court statements that are introduced in court to prove the truth of those statements. Such evidence generally is not admissible in court. However, the court noted that “the definition of hearsay does not include out-of-court statements that are not offered as proof of the facts asserted in such statement, but are offered merely as proof that such a statement was made.” It concluded that the statements made to the elder by the mother of the girl to whom Corey exposed himself were not offered into evidence to prove the truth of the matter alleged, but rather to demonstrate that the church had notice of Corey’s alleged propensities.

Relevance of the case to church leaders

What is the relevance of this ruling to other churches? Obviously, a decision by a Georgia appeals court is of limited significance since it has no direct or binding effect in any other state. Nevertheless, there are a number of aspects to the ruling that will be instructive to church leaders in every state. Consider the following:

1. Churches are not “guarantors” of the safety of children. The court acknowledged that churches are not “guarantors” of the safety of children. That is, a church is not automatically liable for every injury to a child that occurs on its premises or in the course of a church-sanctioned activity. For a church to be legally responsible for an injury to a child, it must be guilty of negligence or some other legal wrong.

2. Negligent supervision. A church can be liable for an injury to a child if it was negligent in the supervision of the child or its premises and activities. The court concluded that churches have a legal duty to properly supervise children, and they can be liable on the basis of negligent supervision for those “reasonably foreseeable” injuries that result from a lack of adequate supervision. The court concluded that an injury to a child can be reasonably foreseeable in two ways:

“General risks. There are “general risks” associated with certain church practices that are reasonably foreseeable even if such risks have never occurred before. For example, when a church allows young children to wander about unsupervised, there are a number of “general risks,” including (1) leaving church premises and being struck by a car; (2) kidnapping; (3) falling down stairs; (4) molestation; or (5) fights with other children. A church is liable on the basis of negligent supervision for any of these kinds of injuries, even if they have never occurred before, because they are general risks that common sense indicates are “reasonably foreseeable” whenever young children are allowed to roam about unsupervised.

“Prior knowledge. An injury may be foreseeable if a similar injury has occurred in the past.

• Example. A church worker releases a group of 5-year-old children before they are picked up by their parents following a morning worship service. One of the children wanders off church premises and is struck by a car. Church leaders insist that the church is not responsible since such an accident has never occurred before and so they were not “on notice” of the risk. The Georgia court rejected such a defense. It concluded that churches have a duty to supervise young children, and they will be legally responsible for “reasonably foreseeable” injuries that occur to children as a result of inadequate supervision. The fact that no child has ever wandered off of the church’s premises and been struck by a car is not relevant. The fact remains that any reasonable adult would recognize that such an injury is one of the “general risks” associated with allowing young children to wander about unsupervised, and as a result the church is liable on the basis of negligent supervision since the risk is “reasonably foreseeable.”

• Example. Same facts as the previous example, except that the child is injured when she stumbles down a church stairway. Once again, churches have a duty to supervise young children, and they will be legally responsible for “reasonably foreseeable” injuries that occur to children as a result of inadequate supervision. The fact that no child has ever stumbled down a church stairway is not relevant. The fact remains that any reasonable adult would recognize that such an injury is one of the “general risks” associated with allowing young children to wander about unsupervised, and as a result the church is liable on the basis of negligent supervision since the risk is “reasonably foreseeable.”

• Example. Same facts as the previous example, except that the child is abducted by an unknown person. The church had a duty to supervise young children, and it will be legally responsible for “reasonably foreseeable” injuries that occur to children as a result of inadequate supervision. The fact that no child has ever been abducted is not relevant. The fact remains that any reasonable adult would recognize that such an incident is one of the “general risks” associated with allowing young children to wander about unsupervised, and as a result the church is liable on the basis of negligent supervision since the risk is “reasonably foreseeable.”

• Example. Same facts as the previous example, except that the child is molested by an adult in a church restroom. Assume that a similar incident occurred at the church two years ago. According to the Georgia court, the church had a duty to supervise young children, and it will be legally responsible for “reasonably foreseeable” injuries that occur to children as a result of inadequate supervision. The child’s injuries are foreseeable in two ways. First, any reasonable adult would recognize that such an incident is one of the “general risks” associated with allowing young children to wander about unsupervised, and as a result the church is liable on the basis of negligent supervision since the risk is “reasonably foreseeable.” Second, the child’s injuries are foreseeable because of the similar incident that occurred two years before.

In conclusion, a church is assuming a significant risk of liability when it allows young children to wander about unsupervised. It will be liable for any reasonably foreseeable injury to a child, even if such an injury has never occurred before on church premises.

3. No policies. The church in this case did not have any policy regarding “early release” of young children. If such a policy had been adopted, and it permitted the release of children only to their parent or other designated adult, it is more likely that the teachers would not have released the victim. Church leaders should consider the adoption of such a policy. Of course, if adopted, the policy should be carefully explained to all teachers and workers to insure compliance.

4. The unsupervised room. The molestation in this case occurred in a vacant and unsupervised classroom. To the extent possible, church leaders should close off access to areas of the church that are not being utilized. This will reduce the risk of injuries to minors.

5. The offender’s age. In this case, the perpetrator was a 10-year-old boy. There are two points to note:

“Some child molesters are children. Several studies have indicated that about twenty percent of all child molesters are themselves minors. As a result, church leaders should consider ways to reduce the risk of children molesting children. Here are some suggestions:

(1) Do not release children up to a specified age unless they are picked up by a parent or designated adult. Many churches apply this rule to children through elementary grades. In this case, the victim would not have been molested if the 10-year-old boy had not been released. Obviously, it is more difficult to retain older children. But a policy requiring the church to retain custody of children through the elementary grades until they are picked up by a parent or designated adult will reduce the risk of injuries.

(2) Do not allow minors to be the sole custodians of younger children.

(3) Adopt a screening program for adolescents who will work with adults in children’s programs. This could include references from the child’s parents and a coach or teacher.

“Acting out.” When a 10-year-old boy molests a younger child, it is possible if not probable that the molester is himself a victim of molestation, and that he is “acting out” the behavior that is being inflicted on him by an older, dominant person.

6. Intervening criminal acts. Generally, intervening criminal acts cut off liability for negligence. That is, a church should not be liable for its failure to properly supervise children or activities when a child is injured because of an intervening criminal act, since such an act ordinarily is not foreseeable. The court rejected this defense, noting that “we cannot rule that [Corey’s] intervening criminal act was unforeseeable as a matter of law.”

7. Taking incidents seriously. The court concluded that Corey’s molestation of the victim was foreseeable, in part, because of a prior incident in which Corey had “exposed” himself to another 4-year-old girl at a church member’s home. What is interesting about this incident is that neither the girl’s mother nor a church elder who was informed of the incident considered it to be serious. The elder, who was a physician, considered it to be a benign matter of sexual exploration that is normal among young children. The court viewed this incident far more seriously, noting that it constituted “sufficient evidence for a jury to conclude that … the church had notice that [Corey] had inappropriately acted in a sexual manner towards a smaller child prior to his attack on the victim.” While it remains true that some degree of sexual exploration is normal among young children, church leaders must recognize that ignoring or minimizing such incidents as normal “child’s play” can expose the church to substantial legal risk.

Bull Street Church of Christ v. Jensen, 504 S.E.2d 1 (Ga. App. 1998)

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

IRS Ruling Addresses Backup Withholding

Important guidance for church treasurers.

Richard R. Hammar, Attorney, CPA

Bio

IRS Letter Ruling 19990603

Background. A used car dealer made payments in excess of $600 during the year to various independent contractors for personal services provided to his business. For example, the dealer paid auto repair shops, auto body shops, and auto detail services for work performed on his dealership’s cars. These independent contractors were paid by checks drawn on the dealer’s business account. At the time the dealer made payments to the independent contractors, no taxpayer identification numbers were obtained, and the dealer did not issue a Form 1099 to any of the contractors. The dealer asked the IRS if he was required to engage in “backup withholding” on payments he made to these contractors.

What the IRS said. The IRS ruled that the dealer was required to engage in backup withholding at the time it made payments to the contractors, since it failed to obtain their taxpayer identification numbers. Here are the points the IRS made:

(1) Form 1099 reporting requirement. Any employer engaged in a “trade or business” that makes payments of $600 or more in the course of that trade or business to an independent contractor, as compensation for services rendered, must issue the contractor a Form 1099 reporting the contractor’s name, address, taxpayer identification number, and amount of compensation.

(2) The $600 requirement. The Form 1099 reporting requirement is triggered “if the aggregate amount of the current payment and all previous payments to the payee during the calendar year equal $600 or more. The amount subject to withholding is the entire amount of the payment that causes the total amount paid to the payee to equal $600 or more and the amount of any subsequent payments made to the payee during the calendar year.”

(3) Backup withholding. An employer is required to withhold at a rate of 31 percent on any payment subject to the Form 1099 reporting requirement, at the time of the payment, if the employer has not received the contractor’s taxpayer identification number.

The IRS concluded that the dealer’s payments to the independent contractors were subject to the Form 1099 reporting requirement. And, since he failed to obtain the contractors’ taxpayer identification numbers, his “obligation to backup withhold commenced with the entire amount of the payment that caused the total amount paid to an independent contractors to equal $600 or more for the calendar year.”

Relevance to church treasurers. This ruling demonstrates that a church must issue a 1099 form to a person if the following five requirements are satisfied: (1) the church is “engaged in a trade or business”; (2) the church pays the person compensation of $600 or more during the calendar year; (3) the person is an independent contractor (not an employee of the church); (4) the payment is in the course of the church’s “trade or business”; and (5) no exception exists. The income tax regulations specify that the term “person engaged in a trade or business” includes not only “those so engaged for gain or profit, but also organizations the activities of which are not for the purpose of gain or profit” including organizations exempt from federal income tax under section 501(c)(3) of the Code. This includes churches and other religious organizations. There is no doubt that churches are required to issue 1099 forms if the other requirements are satisfied.

It is important for church treasurers to recognize that if an independent contractor performs services for the church (and earns at least $600 for the year), but fails to provide you with his or her taxpayer identification number, then the church is required by law to withhold 31 percent of the amount of compensation as “backup withholding.” And, this must be done at the time of payment. There is no way to do it retroactively, since the compensation has been paid.

Here are some tips for church treasurers to consider in complying with the backup withholding requirement:

• Know when a Form 1099 is required. Be familiar with the requirements summarized above. In particular, note that the Form 1099 reporting requirement only applies to payments made to independent contractors. Be aware of common examples of independent contractors, including guest speakers, and contract laborers. Examples of contract laborers include custodians and computer consultants who are hired for a specified fee, do not work full-time, advertise their services to other employers in the community, provide their own equipment and supplies, and perform their services without any direction or control from the church.

No Form 1099 is required for some kinds of payments, including (1) payments to a corporation; (2) travel expense reimbursements paid under an “accountable” reimbursement arrangement; and (3) payments of bills for merchandise, telegrams, telephone, freight, storage, and similar charges.

Example. A church hires a local landscaping company to maintain the church grounds. There is no need for the church to issue a Form 1099 if the company is a corporation. Note, however, that this exception only applies to corporations—and not to partnerships.

Tip. An independent contractor informs you that he is incorporated, and so the church is not required to issue him a Form 1099. Do you take the person’s word for it, or are you required to do more? Here are two options: (1) Have the person complete and sign Form W-9, checking the “corporation” box and writing “exempt” in Part II. Note that a taxpayer identification number should be provided, even though the church will not be issuing a Form 1099. This will be the corporation’s “employer identification number.” (2) Ask the independent contractor for proof of incorporation before relying on this exemption. This could include a copy of the certificate of incorporation issued by the state. Or, call the office of secretary of state (in the state of incorporation) and confirm the existence of the corporation.

• Obtaining taxpayer identification numbers. For many independent contractors, their taxpayer identification number will be their social security number. The income tax regulations state that you can obtain an independent contractor’s taxpayer identification number either orally or in writing.

Tip. Before making a payment to an independent contractor of $600 or more (or a lesser amount that increases annual compensation paid by the church to $600 or more), require the contractor to complete an IRS Form W-9. This form asks for the contractor’s taxpayer identification number. It is a good practice to have several of these forms on hand in the church office. Be sure you have the current version, since they are updated each year.

Key point. Churches can be penalized if the social security number they report on a Form 1099 is incorrect, unless they have exercised “due diligence.” A church will be deemed to have exercised due diligence if it has independent contractors provide their social security numbers using Form W-9.

The backup withholding requirements were designed to ensure that independent contractors fully report their income. Without backup reporting, such persons can often underreport their true income (without detection) by simply refusing to provide their social security numbers to employers. Of course, to avoid backup withholding, some independent contractors may consider providing you with a false social security number. The IRS will discover such a scheme when it receives the Form 1099 containing the false number. At such time, the IRS will notify the church to commence backup withholding on any future payments to the individual (until a correct social security number is provided).

• Form 941. Don’t forget to report backup withholdings on your quarterly Form 941 (employer’s quarterly tax return).

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

Revoking an Exemption from Social Security

Ministers may soon be allowed to revoke an exemption

Richard R. Hammar, Attorney, CPA

Bio

Summary.
Many ministers have exempted themselves from self-employment tax by filing a timely application form (Form 4361) with the IRS. Unfortunately, most of these ministers were not eligible for the exemption. In recognition of this fact, and because a growing number of exempt ministers were desperate to rejoin the Social Security program in order to qualify for Medicare benefits, Congress gave ministers a brief “window” of time in 1977, and again in 1987, to revoke an exemption from self-employment tax. Few did so. Ministers soon may be given another window to revoke an exemption from self-employment taxes. It is important for exempt ministers to be aware of these developments so they are ready to respond quickly if another window is provided. The lesson of the 1977 and 1987 legislation is that the longer ministers wait to revoke an exemption, the less likely it is that they will do so. This article reviews the status of current legislative efforts, assesses the likelihood of success, and provides ministers with recommendations to consider.

Ministers are allowed by federal law to exempt themselves from social security (self-employment) taxes by filing a timely exemption application (Form 4361) with the IRS. To qualify for exemption, ministers must meet the following six requirements:

1. The minister must be an ordained, commissioned, or licensed minister of a church.

2. The church or denomination that ordained, commissioned, or licensed the minister must be a tax-exempt religious organization.

3. The minister must file an exemption application (Form 4361) in triplicate with the IRS. A minister certifies on Form 4361 that “I am conscientiously opposed to, or because of my religious principles I am opposed to, the acceptance (for services I performed as a minister …) of any public insurance that makes payments in the event of death, disability, old age, or retirement, or that makes payments toward the cost of, or provides services for, medical care.” The form states that “public insurance includes insurance systems established by the Social Security Act.” There are three important factors to note. First, the regulations interpreting this language reject the view that ministers can be eligible for exemption from social security coverage on the basis of “conscientious opposition” alone. The conscientious opposition must be rooted in religious belief. Second, the exemption is available only if a minister is opposed on the basis of religious considerations to the acceptance of social security benefits rather than to payment of the tax. A minister may have religious opposition to payment of the tax, but this alone will not suffice. The individual must have religious opposition to accepting social security benefits upon his or her retirement or disability. This is an extraordinary claim that few ministers in good faith will be able to make. Third, the applicant’s opposition must be to accepting benefits under the social security program (or any other “public insurance” system that provides retirement and other specified benefits). As a result, a minister who files the exemption application may still purchase life insurance or participate in retirement programs administered by non-governmental institutions (such as a life insurance company).

4. The exemption application (Form 4361) must be filed on time. The deadline is the due date of the federal tax return for the second year in which a minister has net earnings from self-employment of $400 or more, any part of which derives from the performance of services in the exercise of ministry.

5. Notification of ordaining, commissioning, or licensing church or denomination. An applicant for exemption must inform “the ordaining, commissioning, or licensing body of the church or order that he is opposed” to social security coverage (Form 4361 contains a statement that the applicant has satisfied this requirement), and presumably, that he or she intends to apply for an exemption from social security coverage.

6. IRS verification. No application for exemption will be approved unless the IRS or the Secretary of the Department of Health and Human Services (or a designated representative) “has verified that the individual applying for the exemption is aware of the grounds on which the individual may receive an exemption … and that the individual seeks an exemption on such grounds.”

Key point. In this article, the term “self-employment tax” is used to describe the social security tax paid by self-employed persons, including ministers. Ministers always are deemed to be self-employed for social security purposes with respect to services performed in the exercise of their ministry (with the exception of some chaplains), and so they pay the self-employment tax rather than “FICA” taxes.

Revoking an exemption from social security

The tax code clearly states that ministers who exempt themselves from self-employment taxes cannot revoke their exemption. The decision to become exempt from self-employment taxes is “irrevocable.” IRC 1402(e)(4). Form 4361 itself warns that “once the application is approved, you cannot revoke it.”

On two occasions in the past, Congress has enacted special legislation giving ministers a brief “window” of time to revoke an exemption from self-employment taxes.

The 1977 Legislation

Congress allowed ministers who were exempt as of December 20, 1977, to revoke their exemption by the due date of their federal income tax return for 1977 (April 15, 1978) by filing a Form 4361-A.

The 1987 Legislation

The Tax Reform Act of 1986 gave exempt ministers another limited opportunity to revoke an exemption from self-employment taxes, by filing a Form 2031 with the IRS by the due date for their federal income tax return for 1987 (April 15, 1988). Congress provided this limited opportunity for ministers to revoke an exemption from self-employment taxes because of a recognition that many of these ministers did not qualify in the first place.

Ministers who revoked an exemption by April 15, 1988 did not become liable for self-employment taxes all the way back to the date of their original exemption. Rather, they were required to pay self-employment taxes effective January 1, 1986 or January 1, 1987. This meant, for example, that a minister who revoked an exemption by April 15, 1988 had to pay not only the first quarter’s estimated self-employment tax for 1988 by that date, but also (1) the entire social security tax liability for 1986 and 1987, or (2) the entire social security tax liability for 1987. The minister elected on the Form 2031 whether to pay taxes for both 1986 and 1987, or just for 1987.

The decision to revoke an exemption from self-employment tax was irrevocable.

Very few exempt ministers revoked their exemption. The reason is simple. Most ministers who were seriously considering revoking their exemption waited until the deadline, only to discover that pursing the revocation of their exemption would make them liable for at least five quarters of self-employment tax. Even on modest income, this was a crushing liability that few could afford. As a result, very few ministers revoked their exemption.

Recent Developments

A number of bills have been introduced in Congress over the past few years to provide ministers with another opportunity to revoke an exemption from self-employment coverage. Here are the key bills:

(1) House Bill H.R. 939

In 1997, Congressman English of Pennsylvania introduced House Bill 939, which provided, in part:

[A]ny exemption which has been received … by a duly ordained, commissioned, or licensed minister of a church … and which is effective for the taxable year in which this Act is enacted, may be revoked by filing an application therefor … if such application is filed no later than the due date of the federal income tax return (including any extension thereof) for the applicant’s second taxable year beginning after December 31, 1997. Any such revocation shall be effective … as specified in the application, either with respect to the applicant’s first taxable year beginning after December 31, 1997, or with respect to the applicant’s second taxable year beginning after such date, and for all succeeding taxable years; and the applicant for any such revocation may not thereafter again file application for an exemption …. If the application is filed after the due date of the applicant’s federal income tax return for a taxable year and is effective with respect to that taxable year, it shall include or be accompanied by payment in full of an amount equal to the total of the taxes that would have been imposed by … the Internal Revenue Code of 1986 with respect to all of the applicant’s income derived in that taxable year which would have constituted net earnings from self-employment … except for the exemption ….

This bill attracted only a few sponsors, and died in committee.

(2) the “ticket-to-work” bill

On June 4, 1998, the House of Representatives passed the “Ticket to Work and Self-Sufficiency Act of 1998” by an overwhelming vote of 410 to 1. This bill was designed to make it easier for disabled adults to receive vocational training without losing their social security disability (or SSI) payments. The bill was amended to include a provision allowing clergy to revoke an exemption from self-employment taxes. Section 8 of the bill provided, in part:

[A]ny exemption which has been received … by a duly ordained, commissioned, or licensed minister of a church, a member of a religious order, or a Christian Science practitioner, and which is effective for the taxable year in which this Act is enacted, may be revoked by filing an application therefor … if such application is filed no later than the due date of the federal income tax return (including any extension thereof) for the applicant’s second taxable year beginning after December 31, 1998. Any such revocation shall be effective … as specified in the application, either with respect to the applicant’s first taxable year beginning after December 31, 1998, or with respect to the applicant’s second taxable year beginning after such date, and for all succeeding taxable years; and the applicant for any such revocation may not thereafter again file application for an exemption …. If the application is filed after the due date of the applicant’s federal income tax return for a taxable year and is effective with respect to that taxable year, it shall include or be accompanied by payment in full of an amount equal to the total of the taxes that would have been imposed … with respect to all of the applicant’s income derived in that taxable year which would have constituted net earnings from self-employment … except for the exemption under section 1402(e)(1) of such Code.

Following the bill’s approval by the House of Representatives, it was sent to the Senate. The Senate failed to act on the bill by the end of the legislative session.

While this effort was unsuccessful, it is worth noting that the House of Representatives voted 410 to 1 to adopt a bill containing a provision allowing ministers a limited opportunity to revoke an exemption from self-employment tax.

(3) Senate Bill 331

On January 28, 1999, the “Work Incentive Improvement Act of 1999” (S. 331) was introduced in the United States Senate. The bill has the same purpose as the “Ticket to Work and Self-Sufficiency Act of 1998”-to assist disabled adults to participate in vocational training and employment programs. This bill currently has 73 cosponsors. Section 403 states, in part:

[A]ny exemption … by a duly ordained, commissioned, or licensed minister of a church, a member of a religious order, or a Christian Science practitioner, and which is effective for the taxable year in which this Act is enacted, may be revoked by filing an application therefore … if such application is filed no later than the due date of the federal income tax return (including any extension thereof) for the applicant’s second taxable year beginning after December 31, 1999. Any such revocation shall be effective … as specified in the application, either with respect to the applicant’s first taxable year beginning after December 31, 1999, or with respect to the applicant’s second taxable year beginning after such date, and for all succeeding taxable years; and the applicant for any such revocation may not thereafter again file application for an exemption …. If the application is filed after the due date of the applicant’s federal income tax return for a taxable year and is effective with respect to that taxable year, it shall include or be accompanied by payment in full of an amount equal to the total of the taxes that would have been imposed … with respect to all of the applicant’s income derived in that taxable year which would have constituted net earnings from self-employment …. except for the exemption ….

There are a number of important points to note:

(1) This provision is identical (except for the effective date) to the one contained in the Ticket to Work and Self-Sufficiency Act of 1998, which was approved by the House of Representatives in 1998 by a vote of 410 to 1.

(2) This bill was introduced on January 28, 1999 with 39 sponsors. By early May there were 72 sponsors.

(3) The provision allowing clergy to revoke an exemption from self-employment taxes is an amendment to a popular bill that is designed to assist disabled adults return to work.

(4) If enacted, this bill would allow exempt ministers to revoke their exemption by filing a form with the IRS by April 15, 2002. Ministers can choose to revoke their exemption beginning either with year 2000 or year 2001.

(5) Ministers who revoke their exemption will not be permitted to apply for exemption at a later time. The decision to revoke an exemption is irrevocable.

(6) Ministers who file for revocation of their exemption after the due date of the federal income tax return for a year in which they have elected to be covered by social security must include with their return payment of their entire self-employment tax liability for that year.

The following examples all assume that Senate Bill 331 will be enacted:

Example. Rev. D opted out of social security in 1980 because he did not want to pay the self-employment tax. He now recognizes that he was not eligible for the exemption, and would like to revoke it. If Senate Bill 331 is enacted, Rev. D will be able to file a form with the IRS revoking his exemption. On this form, Rev. D will designate whether he wants to revoke his exemption beginning with either the year 2000 or the year 2001.

Example. Same facts as the previous example. Rev. D waits until July 1, 2002, to file his revocation form. He has waited too long. The form must be filed no later than April 15, 2002.

Example. Same facts as the previous example, except that Rev. D obtained a four-month extension to file his year 2001 tax return (until August 15, 2002) by filing IRS Form 4868. It is not too late for Rev. D to file a revocation form, since the deadline is the due date for the federal tax return for the second year following December 31, 1999. The second year is 2001, and the due date for the federal tax return for that year is April 15, 2002. However, the proposed law specifies that the deadline for filing the revocation form for ministers who applied for a four-month extension to file their year 2001 tax return is August 15, 2002.

Example. Assume that Rev. D has net self-employment earnings of $50,000 in 2000 and 2001, including his church-designated housing allowance. Rev. D plans to file his year 2001 tax return by April 15, 2002 (he does not plan on filing for a four-month extension). He waits until April 15, 2002 to decide whether to revoke his exemption from self-employment tax. By delaying his decision, he how has two options: (1) Revoke his exemption beginning with the year 2000. He will be liable for “back taxes” to January 1, 2000-that is, for two years plus the first quarter of year 2002 self-employment taxes. This will amount to approximately $17,200 (multiply the 15.3% self-employment tax rate times two years of net self-employment earnings of $50,000, plus the first quarter of compensation for 2002). Obviously, this liability is so large that it is doubtful that Rev. D will be able to afford it. (2) Revoke his exemption beginning with the year 2001. He will be liable for “back taxes” to January 1, 2001, or one year plus the first quarter of year 2002 self-employment taxes. This will amount to approximately $9,600 (multiply the 15.3% self-employment tax rate times one year of net self-employment earnings of $50,000, plus the first quarter of compensation for 2002). Obviously, this liability is also substantial, making it unlikely that Rev. D will be able to afford revoking his exemption. The problem in this example is that Rev. D waited too long to decide whether or not to revoke the exemption. The key point is this-the longer ministers delay in making this decision, the less likely they will be able to afford revoking their exemption.

Example. Assume that Rev. D has net self-employment earnings of $50,000 in 2000 and 2001, including his church-designated housing allowance. Rev. D learns of the new law, and decides to revoke his exemption immediately by filing a revocation form with the IRS in January of 2000. He designates on the form that he wants to revoke his exemption beginning with the year 2000. Rev. D uses the quarterly estimated tax procedure to pay his taxes, and so he simply begins basing his quarterly estimates on both income taxes and self-employment taxes. This will increase his quarterly payments by approximately $1,900 (one-fourth of his annual self-employment tax, computed by multiplying net self-employment earnings of $50,000 times the self-employment tax rate of 15.3%). By making the decision to revoke the exemption early, Rev. D is avoiding the problem of having to make large payments of “back taxes”. It is more likely that Rev. D will be able to “afford” revoking his exemption in the event that he would like to do so.

Example. Rev. D revokes his exemption in January of 2000. After a few years, he regrets having done so, and wants to revert back to exempt status. He will not be permitted to do so. A decision to revoke an exemption is irrevocable.

Tip. Here is a very important point to note-if the new bill does become law, ministers who would like to revoke an exemption from social security should do so as soon as possible. Back in 1987, ministers were given an opportunity to revoke an exemption, and they could do so from January 1, 1987 through April 15, 1988. The problem was that ministers who revoked an exemption were liable for self-employment taxes back to January 1, 1987. Most ministers who were seriously considering revoking their exemption waited until the deadline, only to discover that the revocation of their exemption would make them liable for five quarters of self-employment tax. Even on modest income, this was a crushing tax liability that few could afford. As a result, very few ministers revoked their exemption.

(4) Senate Bill 170

On January 19, 1999, Senator Bob Smith (R-NH) introduced Senate Bill 170. The bill currently has 11 cosponsors (Senators Moynihan, Harkin, Lott, Dodd, Kerrey, Chafee, Mack, Murkowski, Santorum, Reid, Inouye). The text of this bill is identical to that of Senate Bill 331, quoted above.

In explaining the bill, Senator Smith observed:

Today I am introducing a bill to allow qualified members of the clergy of all faiths to participate in the Social Security program. This bill would provide a two-year open season during which certain ministers who previously had filed for an exemption from Social Security coverage could revoke their exemption. These members of the clergy would become subject to self-employment taxes, and their earnings would be credited for Social Security and Medicare purposes. Before 1968, a minister was exempt from Social Security coverage unless he or she chose to elect coverage. Since 1968, ministers have been covered by Social Security unless they file an irrevocable exemption with the Internal Revenue Service, usually within two years of beginning their ministry. On two other occasions, in 1977 and again in 1986, ministers were given a similar opportunity to revoke their exemption from Social Security coverage. Despite the existence of these brief open season periods, many exempt ministers did not take advantage of or have not had the opportunity to revoke their exemption from Social Security coverage. Because the exemption from Social Security is irrevocable, there is no way for them to gain access to the program under current law. Only an individual who is a duly ordained, commissioned, or licensed minister of a church, or a member of a religious order who has not taken a vow of poverty, would be able to revoke his or her exemption from Social Security, under my bill. Of course, this measure would not permit ministers who already have reached retirement age to gain access to the Social Security program.

This bill primarily would benefit modestly paid clergy, who are among the most likely to need Social Security benefits upon retirement. Many chose not to participate in the Social Security program early in their careers, before they fully understood the ramifications of filing for an exemption. If enacted, this measure would raise about $45 million over the next five years, according to the Congressional Budget Office. CBO has scored the bill as a revenue raiser and, as a result, it will require no budget offset. Over the long-term, the legislation would cost money, but I do not expect its costs to be that significant because CBO has estimated that only about 3,500 members of the clergy would exercise the option that this bill provides.

Similarly, Senator Moynihan observed:

Today I join my colleague, Senator Bob Smith of New Hampshire, in introducing a bill to allow certain members of the clergy who are currently exempt from Social Security an open season to opt in. Under section 1402 of the Internal Revenue Code, a member of the clergy who is conscientiously, or because of religious principles, opposed to participation in a public insurance program generally, may elect to be exempt from Social Security coverage and payroll taxes by filing an application of exemption with the Internal Revenue Service within two years of beginning the ministry. To be eligible for the exemption, the member of the clergy must be an individual who is a fully ordained, commissioned, or licensed minister of a church, or a member of a religious order who has not taken a vow of poverty. Once elected this exemption is irrevocable. This legislation would allow members of the clergy who are not eligible for Social Security a two-year open season in which they could revoke their exemption. At the time of exemption, many clergy did not fully understand the ramifications of their actions, and it is not until later in life, when they are blocked from coverage, that they realize their need for Social Security and Medicare. This decision to “opt in” would be irrevocable and all post-election earnings would be subject to the payroll tax and credited for the purposes of Social Security and Medicare. The Congressional Budget Office estimates that this legislation would affect approximately 3,500 members of the clergy and would increase revenues by about $45 million over the next five years. Similar legislation was passed both in the 1977 Social Security Amendments (Section 316) and in the Tax Reform Act of 1986 (Section 1704). This bill has been endorsed by the United States Catholic Conference and the National Conference of Catholic Bishops. It is a simple but much-needed measure, and I urge every member of the Senate to support it.

Conclusions

There are several important conclusions for ministers to note:

1. Nothing has been enacted, yet. No law giving ministers an opportunity to revoke an exemption from self-employment tax has been enacted yet. Ministers who would like to revoke an exemption should do nothing now-except to review their options and be prepared to act quickly if any of the pending bills becomes law.

Key point. As soon as any of the pending bills allowing ministers to revoke an exemption from self-employment tax is enacted, we will alert you immediately in this newsletter and in our weekly email newsletter for subscribers to our website library.

2. Enactment is likely. It is very likely that Congress will enact legislation giving ministers an opportunity to revoke an exemption from self-employment tax. Remember that 72 of 100 senators are sponsoring one of the pending bills (Senate Bill 331), and this bill is identical to the one contained in the Ticket to Work and Self-Sufficiency Act of 1998 which was approved by the House of Representatives by a vote of 410 to 1.

3. Be prepared to act. Since it is likely that Congress will enact legislation giving ministers an opportunity to revoke an exemption from self-employment tax, ministers should be reviewing their options at this time. Here are some questions to ask:

“Am I am exempt from self-employment tax? You are if you filed a timely Form 4361 in triplicate with the IRS, and received back one of the forms marked “approved.”

“Was I eligible for exemption at the time I filed Form 4361? Review the conditions for exemption that are summarized at the beginning of this article. Many ministers were not.

“Do I want to revoke my exemption? Some ministers will want to revoke an exemption because they now realize that they were not eligible. It is an ethical matter for them. For others, the inducement to revoke an exemption may be to qualify for Medicare coverage and the other benefits of social security.

“If I decide to revoke my exemption, when should I do so? Remember that the longer you wait to revoke your exemption, the more “back taxes” you will have to pay-up to a maximum of two years plus one quarter of self-employment taxes. Even on modest incomes, this can result in a crushing tax liability. If you decide to revoke your exemption, consider doing so as soon as the law allows. This will minimize the financial impact of your decision, and make it more “affordable” by avoiding a large “back taxes” liability.

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

IRS Modifies Rules for Electronic Depositing of Payroll Taxes

What churches should know about the new requirements.

Richard R. Hammar, Attorney, CPA

Bio

Congress enacted legislation a number of years ago requiring the IRS to develop a system for the electronic filing of payroll taxes. Congress wanted a simple, “paperless” way for employers to deposit their payroll taxes. In response, the IRS came up with the Electronic Federal Tax Payment System (or EFTPS). Traditionally, employers have used a paper coupon and a check to make federal tax deposits (FTDs). EFTPS eliminates most of the paperwork in the old FTD coupon system. With EFTPS, deposits may be made by telephone or personal computer, or through the financial institution of the employer.

The new electronic system is being phased in over a period of years by increasing the percentage of total taxes subject to the new EFTPS system each year. Congress mandated that 94 percent of employment taxes be collected electronically in 1999. The IRS previously assumed that this meant that employers with $50,000 or more in payroll tax deposits would have to deposit payroll taxes electronically. As a result, employers with $50,000 or more in payroll tax deposits for 1997 were required to begin depositing payroll taxes electronically by January 1, 1999.

Key point. The IRS announced in 1998 that it would not assess any penalty for failure to comply with the EFTPS system until July 1, 1999 for an employer with at least $50,000 in payroll tax deposits for 1997 that continues to deposit payroll taxes using paper forms. IRS Announcement IR-98-68.

Recent experience has demonstrated that the 94 percent requirement can be met by increasing the $50,000 threshold to $200,000. As a result, the IRS has issued important new regulations that contain the following provisions that will be of interest to church treasurers:

$200,000 threshold

Employers (including churches) do not need to deposit payroll taxes electronically unless they deposited payroll taxes of $200,000 or more in 1998. This is up from the $50,000 threshold that was scheduled to apply this year. Payroll taxes include withheld FICA and income taxes, as well as the employer’s share of FICA taxes. Employers that exceed the $200,000 threshold in a future year will be required to deposit payroll taxes electronically following a one-year grace period. If an employer’s deposits drop below $200,000 in a future year, it will not be allowed to revert back to making manual deposits at a local bank.

The higher threshold will apply to deposits made on or after January 1, 2000. The IRS has announced that it will waive penalties for employers with $50,000 or more in payroll tax deposits that continue to deposit manually through the end of 1999. However, the IRS is reminding employers eligible for the penalty relief that deposits must still be made on time even when using paper coupons or they risk a late deposit penalty.

A “Fresh Start”

Employers that have been making electronic deposits in anticipation of the $50,000 threshold will be allowed to revert to depositing payroll taxes manually at a bank if they do not meet the new $200,000 threshold for 1998. The IRS estimates that 65 percent of employers that would have met a $50,000 threshold will not meet the $200,000 threshold. The IRS estimates that 91 percent of all employers make less than $200,000 in payroll tax deposits. These are the employers that now can voluntarily deposit their payroll taxes electronically.

Voluntary Compliance Expected

The IRS is assuming that most employers who are not required to deposit electronically will realize the simplicity and convenience of doing so, and will voluntarily comply.

Conclusion

The IRS commissioner recently noted that the large number of employers who have voluntarily begun depositing payroll taxes electronically means that “most businesses can voluntarily participate.” However, he also expressed confidence that “most of the employers that are currently using the system will continue to do so because they find it easier to use.”

The President and CEO of the National Association for the Self-Employed recently observed: “The new $200,000 threshold shows that IRS has listened to small employers’ concerns on this issue, and we appreciate it. While electronic payment of taxes is increasingly popular due to its speed and convenience, the decision to raise the threshold requiring the use of EFTPS shows understanding and flexibility for the needs of smaller employers.”

Need more information? For information on EFTPS or to get an enrollment form, call EFTPS Customer Service at (800) 555-4477 or (800) 945-8400. Employers can begin using EFTPS as soon as they receive their payment instruction packet and personal identification number.

Examples

Here are some examples that will assist you in understanding the new rules:

Example. A church employs four persons—a minister, office secretary, bookkeeper, and custodian. In 1998, the church deposited payroll taxes of $15,000. The church is not required to deposit payroll taxes electronically.

Example. Same facts as the previous example. The church treasurer decides that depositing payroll taxes electronically would be easier, and she would like to do so. Can the church voluntarily deposit payroll taxes electronically using the EFTPS system, even though it deposited only $15,000 of payroll taxes in 1998? Yes, it may.

Example. A church has 20 employees. Over the past few years, it has been depositing payroll taxes of about $75,000 per year. Since deposits exceeded $50,000, the church treasurer began depositing payroll taxes electronically in 1998 in anticipation of being required to do so under the old rules. Under the new rules, the church has the following two options. First, it can continue to deposit payroll taxes electronically. Second, it can revert to depositing payroll taxes manually at a bank—assuming that it did not meet the new $200,000 threshold for 1998.

Example. A church has 15 employees. Over the past few years, it has been depositing payroll taxes of about $60,000 per year. The church decides not to voluntarily switch to electronic deposits in 1999, and continues making deposits manually at a local bank. The IRS has announced that a church with $50,000 or more of payroll tax deposits in 1998 will not be subject to any penalties for continuing to deposit payroll taxes manually. Under the old rules, this church would have been subject to penalties for not switching to electronic deposits by July 1, 1999.

Example. A church has 75 employees. In 1998 it deposited payroll taxes of $215,000. This church must begin depositing payroll taxes electronically no later than January 1, 2000. It will not be subject to penalties for continuing to deposit taxes manually up to that date.

Example. Same facts as the previous example. Assume that the church deposits payroll taxes of $220,000 in 2000, and $185,000 in 2001. Since its deposits dropped below $200,000 for 2001, can it revert to manual deposits in 2002? The new regulations clarify that once an employer has $200,000 in payroll tax deposits for 1998 or any future year, it must begin depositing payroll taxes electronically and cannot revert to manual deposits in a later year if its deposits drop below $200,000.

Example. A church manually deposits payroll taxes of $150,000 in 1998, and also in 1999 and 2000. In the year 2001 it deposits $210,000. The new regulations specify that the church has a one-year “grace period” to convert over to electronic deposits. This means that it can continue to deposit payroll taxes manually in 2002 if it chooses to do so.

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

Substantiating Cash Contributions

The Tax Court issues helpful guidance.

Richard R. Hammar, Attorney, CPA

Bio

Gomez v. Commissioner, T.C. Memo. 1999-94

Background. A donor claimed charitable contribution deductions totaling $26,000 on his 1993 tax return. The donor claimed that he had made contributions to two churches, and two church-affiliated colleges. The amount of the charitable contribution deduction was estimated by the donor and given to his tax return preparer who prepared his 1993 return. The donor did not maintain any documentation supporting the contributions claimed. The IRS audited the donor’s 1993 tax return, and allowed a charitable contribution deduction of only $1,300. The donor appealed to the Tax Court.

The Court’s decision. The Court began its opinion by noting that “deductions are a matter of legislative grace, and the taxpayer bears the burden of proving that he or she is entitled to the claimed deductions.”

The Court noted that in 1993 a donor could claim a charitable contribution deduction for cash contributions that were substantiated with any one or more of the following items:

(1) a canceled check

(2) a receipt, letter, or other communication from the charity acknowledging receipt of the contribution and showing its name, the date of the contribution, and the amount of the contribution, or

(3) in the absence of a canceled check or receipt from the charity, any other reliable written records showing the name of the charity and the date and amount of the contribution

Key point. These requirements still apply to individual cash contributions of less than $250. Since 1994, however, new substantiation requirements apply to cash contributions of $250 or more.

The Court noted that the taxpayer has the burden of proving entitlement to a charitable contribution deduction, and that the donor in this case did not meet this burden. It observed:

In this case, [the donor] did not substantiate the charitable contributions claimed on his 1993 return in excess of those allowed by [the IRS]. He kept no records regarding his 1993 contributions. In addition, his testimony regarding his charitable deductions was not credible. He testified at trial that he made a cash contribution of $5,000 to [his church] during a stewardship dinner in January 1993 and that the funds to make the contribution were withdrawn from his bank account at [a credit union] the day before the dinner. However, [the church] had no record of any charitable contribution, much less a substantial one, from the donor during 1993.

Similar claims were made concerning alleged contributions to [the other church and church-affiliated colleges]. The donor testified that he made a cash contribution of $5,000 to [one college] in November 1993 and a cash contribution of $5,000 to [another church] in December 1993. He also testified that, the day before each contribution was made, he withdrew the cash to make the contribution from his bank account at [the credit union]. However, [the college], one of the alleged donees, had no record of any charitable contribution, much less a substantial one, from the donor during 1993, and the record contains nothing to substantiate his testimony regarding the alleged $5,000 gift to [the second church]. We hold, therefore, that the donor has failed to prove that he is entitled to any charitable deduction for 1993 in excess of that allowed by the IRS.

Relevance to church treasurers. What is the relevance of this case to church treasurers? Consider the following:

1. The Court’s ruling applies to cash contributions of less than $250. It must be emphasized that this case was addressing contributions made in 1993—a year before the requirements for substantiating charitable contributions were overhauled by Congress. However, the pre-1994 substantiation rules applied by the Court still govern individual cash contributions of less than $250, and so the Court’s ruling provides helpful insights. The fact that the vast majority of individual contributions made to churches are for less than $250 underscores the relevance of the Court’s decision.

2. Substantiating individual cash contributions of less than $250. In order for donors to substantiate an individual cash contribution of less than $250 made to their church, they must maintain at least one of the three categories of documentation noted by the Court–a canceled check, a receipt or letter issued by the church, or “any other reliable written records” showing the name of the church and the date and amount of the contribution.

3. Evidence that is not sufficient. This case illustrates that some cash contributions of less than $250 to a church will be denied because of a lack of substantiation. The donor in this case maintained no canceled checks, and had no written receipt issued by any of the churches or colleges substantiating his alleged cash contributions of $26,000. In fact, two of the four charities that allegedly received contributions from the donor had no record of any contribution. In addition, the donor failed to produce bank records to substantiate his assertion that he withdrew funds the day before he made large contributions to the charities in question.

Tip. Most cash donations to churches are for less than $250. Such contributions must be substantiated with any of the three kinds of records mentioned by the Court in its decision. One of those methods of substantiation is with a receipt, letter, or other communication from the charity acknowledging receipt of the contribution and showing its name, the date of the contribution, and the amount of the contribution. Churches can help to ensure the deductibility of such contributions by issuing timely receipts or contribution summaries to donors.

4. Penalties. The Court upheld the assessment of penalties against the donor by the IRS. Code section 6662 authorizes the imposition of a 20-percent penalty on the portion of an underpayment of tax attributable to negligence or disregard of rules or regulations. For purposes of section 6662, the term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the tax code. Negligence also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. The term “disregard” includes any careless, reckless, or intentional disregard. The Court concluded that the donor in this case “did not make a reasonable effort to comply with the requirements of the code or the regulations” and “failed to maintain any records sufficient to support entitlement to the deductions claimed. Failure to maintain documentation in support of claimed deductions has been held to constitute negligence or disregard of rules or regulations for purposes of [the negligence penalty]. We conclude, therefore, that the donor is liable for the accuracy-related penalty under section 6662.”

Need more information? Chapter 7 of Richard Hammar’s 1999 Church and Clergy Tax Guide addresses all of the charitable contribution substantiation rules in detail, with many helpful examples, tables, and forms.

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

Changes in “Offer in Compromise” Program Will Benefit Taxpayers

IRS says it will accept more compromises in settling outstanding tax liabilities.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

Changes in “Offer in Compromise” Program Will Benefit Taxpayers

IRS says it will accept more compromises in settling outstanding tax liabilities.

Richard R. Hammar

Sometimes taxpayers find themselves with a crushing tax liability, and no means to pay it. To illustrate, assume that Rev. G filed an application for exemption from self-employment tax (Form 4361) several years ago, and has assumed that he is exempt from the tax. In fact, he never received acknowledgement of his exemption from the IRS, and so he never was legally exempt. The IRS audits Rev. G, and assesses self-employment taxes for the previous three years, amounting to $25,000.

Or consider Rev. K. He has always assumed that the housing allowance is an exclusion in computing both income taxes and self-employment taxes. He is audited by the IRS, and is assessed several thousand dollars in additional taxes because he incorrectly applied the housing allowance exclusion in computing his self-employment taxes.

Both Rev. G and Rev. K have inadequate resources to pay their tax liability. Over the past several years, such taxpayers could apply for relief by making an “offer in compromise” to the IRS on Form 656. This form lists a taxpayer’s sources of income, and net worth, and lets taxpayers make an offer to the IRS to pay a reduced amount of tax. The IRS often makes counterproposals to these offers, and about one-fourth are eventually accepted. For example, in 1998 only 25,052 offers out of 105,255 (23.8 percent) were accepted, leading to the collection of $290 million out of $1.9 billion in outstanding tax bills.

The IRS announced recently that it is liberalizing its offer in compromise program, to ensure that more of these offers are accepted. This is good news for taxpayers with huge tax liabilities. Here are some steps the IRS has taken:

(1) In evaluating a taxpayer’s ability to pay, the IRS will consider the taxpayer’s own expenses, rather than using national “averages”.

(2) Instead of the old, stringent application guidelines that often led to immediate rejections, the IRS will now work with taxpayers to fine tune their compromise offers–a step that will lead to the acceptance of more offers.

(3) Taxpayers will be asked to provide fewer financial documents to qualify for smaller compromise offers.

(4) New deferred payment procedures provide more opportunities for compromise offers to be submitted by taxpayers who may have been excluded under the old guidelines.

(5)A short-term deferred payment option allows taxpayers up to two years to pay the compromise offer.

(6) Specially trained IRS experts will be devoted to handling compromise offers. These new offer specialists will bring more consistency to the offer in compromise program and centralize offer processing.

(7) There will be new independent reviews for each rejected compromise offer. These reviews assess whether rejection is in the best interest of the taxpayer and the government. Many of these changes are reflected in a new version of Form 656. IRS Information release, IR-1999-30.

This article originally appeared in Church Treasurer Alert, May 1999.

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

What Church Treasurers Should Know about “New Hire” Reporting

Federal law requires employers to report certain information about new employees.

Richard R. Hammar, Attorney, CPA

Bio

Background. Churches are subject to new hire reporting requirements, mandated by Congress as part of comprehensive welfare reform legislation enacted a few years ago. This article will explain the application of the new reporting requirements to churches.

What is new hire reporting? New hire reporting is a procedure used by employers to report information about all new hires to a designated state agency. The purpose of the reporting requirement is to lower welfare costs by increasing child support collections and reducing welfare and food stamp payments. Another purpose is to reduce fraudulent unemployment benefits payments to persons who are working.

Key point. Technically, states are not required to mandate new hire reporting. But, if they fail to do so, they will forfeit federal funding under certain programs. To date, all states have enacted legislation mandating new hire reporting.

Why is new hire reporting necessary? New hire reporting facilitates the collection of child support from parents who change jobs frequently to avoid paying child support. It also will be used to detect and prevent erroneous welfare and unemployment benefits payments.

How will the information be used? When employers (including churches) report new hire information to their designated state agency, the agency will match the information against its own child support records to locate parents and enforce existing child support orders. Once these matches are done, the information is sent to the “National Directory of New Hires,” so other states can compare the information with their own child support records. The information also will be shared with state welfare and unemployment agencies, to detect and prevent fraudulent or erroneous payments.

Are churches exempt from the new hire reporting requirements? No, they are not. The new hire reporting requirements apply to all “employers.” The new law defines the term “employer” as “the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person.” There is no exception for religious organizations. And, there is no exception for “small” employers having only one or two employees. But remember—reporting is only for new hires, as defined by state law. This generally will be any employee hired after a date specified by state law.

What are the penalties for not reporting? The federal welfare reform law prohibits states from assessing a penalty in excess of $25 for each failure to report a new hire. However, states may impose a penalty up to $500 if an employer and employee “conspire” to avoid the reporting requirements, or agree to submit a false report.

What information must be reported? The federal welfare reform legislation requires that employers include the following information in their new hire reports:

employee’s name
employee’s address
employee’s social security number
employer’s name
employer’s address
employer’s federal employer identification number (EIN)

Note that most of this information is contained on the W-4 form (“withholding allowance certificate”) completed by each new employee at the time of hire, and as a result most states allow employers to comply with the reporting requirements by sending a copy of each W-4 form completed by a newly hired employee.

Tip. The employer’s federal identification number is inserted on line 10 of Form W-4 only when the form is sent to the IRS. Since this happens infrequently, the employer’s identification number generally does not appear on the form. So, for an employer to use W-4 forms to comply with the new hire reporting requirements, it must manually insert its federal employer identification number (EIN) on line 10. The employer’s name and address also may need to be manually inserted on line 8.

Key point. Some states ask employers to voluntarily report additional information, such as date of hire, or medical insurance information.

What is the deadline for filing a new hire report? The deadline is specified by state law. However, it may not be later than 20 days after an employee is hired.

How do we make a new hire report? Most states allow employers to comply with the new hire reporting requirement in any one of three ways:

• Electronic or magnetic reporting. Some states permit employers to report by electronic file transfer (EFT); file transfer protocol (FTP); magnetic tape; or 3.5″ diskette.

• Fax or mail. Most states permit employers to fax or mail any one or more of the following:

(1) A copy of a new employee’s W-4. Be sure it is legible, and that the church’s federal employer identification number (EIN) is included on line 10. Also be sure that the church’s name and address are included on the form.

(2) A printed list.

(3) A new hire reporting form provided by your designated state agency.

Tip. If your church hires new employees infrequently, the easiest way to comply with the reporting obligation may be to use the state reporting form. Simply complete one form with your federal employer identification number, name, and address, and then make several copies. This way, you will only need to add an employee’s name, address, and social security number when a new employee is hired.

• Voice reporting. In some states, employers can report new hires by leaving a voice message on a special voice response system.

Tip. Be sure to check with your designated state agency to find out what reporting options are available in your state. Telephone numbers for all state agencies are included in a table in this newsletter. Use the option that is easiest for you.

Tip. Does your church use a payroll reporting service? If so, it may be automatically making the new hire reports for you. Check to be sure.

What about privacy concerns? Federal law requires each state to implement safeguards to protect the confidentiality of new hire reports. In addition, all data transmitted by states to the National Directory of new Hires is done over secure and dedicated lines.

Telephone Numbers of Designated State Agencies StateTelephoneStateTelephoneStateTelephone

AL	334-353-8491	KY	800-817-2262	ND	800-755-8530
AK	907-269-6685	LA	888-223-1461	OH	800-208-8887
AZ	602-252-4045	ME	207-287-2886	OK	800-317-3785
AR	501-682-3087	MD	888-634-4737	OR	503-986-6053
CA	916-657-0529	MA	617-577-7200	PA	888-724-4737
CO	303-297-2849	MI	800-524-9846	RI	888-870-6461
CT	860-424-5044	MN	800-672-4473	SC	800-768-5858
DE	302-369-2160	MS	800-866-4461	SD	888-827-6078
DC	888-689-6088	MO	800-859-7999	TN	888-715-2289
FL	904-922-9590	MT	888-866-0327	TX	888-839-4473
GA	888-541-0469	NE	888-256-0293	UT	801-526-4361
HI	808-586-8984	NV	888-639-7241	VT	802-241-2194
ID	800-627-3880	NH	888-803-4485	VA	800-979-9014
IL	800-327-4473	NJ	609-588-2355	WA	800-562-0479
IN	800-437-9136	NM	888-878-1607	WV	800-835-4683
IA	515-281-5331	NY	800-972-1233	WI	888-300-4473
KS	888-219-7801	NC	888-514-4568	WY	800-970-9258

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

Church Guide to “New Hire” Reporting

Most churches are subject to new federal reporting requirements

Richard R. Hammar, Attorney, CPA

Bio

Most churches are subject to new federal reporting requirements [Reporting Requirements for Churches]

Article summary. Congress enacted comprehensive welfare reform legislation a few years ago that contained a provision requiring employers to report all “new hires” to a designated state agency. The purpose of this reporting requirement is to reduce welfare payments by locating “deadbeat dads” who are ignoring or avoiding child support orders. Churches are subject to the new reporting rules. This article explains how your church can comply with the new rules.

In 1996 Congress enacted the Personal Responsibility and Work Opportunity Reconciliation Act, popularly known as the “welfare reform” bill. The Act had many provisions designed to reduce welfare payments and address welfare fraud. One of these provisions requires employers to report all “new hires” to a designated state agency. The purpose of this requirement is locate “deadbeat dads” who avoid their child support obligations by changing jobs and their place of residence. Forcing these persons to honor their support obligations will enable many women to go off welfare. Another purpose of the new law is to reduce fraudulent unemployment benefits payments to persons who are working.

Technically, states are not required to mandate new hire reporting. But, if they fail to do so, they will forfeit federal funding under certain programs. To date, all states have enacted legislation mandating new hire reporting, and the laws of all 50 states are summarized in a table that accompanies this article.

Church Coverage

The new hire reporting requirements apply to all “employers.” The new law uses the same definition of “employer” as is contained in section 3401(d) of the tax code. This definition defines an employer as “the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person.” This definition contains no exception for religious organizations. And, there is no exception for “small” employers having only one or two employees. But remember-reporting is only for new hires, as defined by state law. This generally will be any employee hired after a date specified by state law.

How it Works

When employers (including churches) report new hire information to their designated state agency, the agency will match the information against its own child support records to locate parents and enforce existing child support orders. Once these matches are done, the information is sent to the “National Directory of New Hires,” so other states can compare the information with their own child support records. The information also will be shared with state welfare and unemployment agencies, to detect and prevent fraudulent or erroneous payments.

The federal welfare reform legislation requires that employers include the following information in their new hire reports:

employee’s name
employee’s address
employee’s social security number
employer’s name
employer’s address
employer’s federal employer identification number (EIN)

Note that most of this information is contained on the W-4 form (“withholding allowance certificate”) completed by each new employee at the time of hire, and as a result most states allow employers to comply with the reporting requirements by sending copies of each new W-4 form completed by a newly hired employee.

• Key point. The employer’s federal identification number is inserted on line 10 of Form W-4 only when the form is sent to the IRS. Since this happens infrequently, the employer’s identification number generally does not appear on the form. So, for an employer to use W-4 forms to comply with the new hire reporting requirements, it must manually insert its federal employer identification number (EIN) on line 10. The employer’s name and address may need to be manually inserted on line 8.

• Key point. Some states ask employers to voluntarily report additional information, such as date of hire, or medical insurance information. A summary of each state’s law is contained in a table in this newsletter.

The deadline for filing a report is specified by state law. However, it may not be later than 20 days after an employee is hired.

Most states allow employers to comply with the new hire reporting requirement in any one of three ways:

(1) Electronic or Magnetic Reporting

Some states permit employers to report by electronic file transfer (EFT); file transfer protocol (FTP); magnetic tape; or 3.5 inch diskette.

(2) Fax or Mail

Most states permit employers to fax or mail any one or more of the following:

A copy of a new employee’s W-4. Be sure it is legible, and that the church’s federal employer identification number (EIN) is included on line 10. Also be sure that the church’s name and address are included on the form.
A printed list.
A new hire reporting form provided by your designated state agency.

• Key point. If your church hires new employees infrequently, the easiest way to comply with the reporting obligation may be to use the state reporting form. Simply complete one form with your federal employer identification number, name, and address, and then make several copies. This way, you will only need to add an employee’s name, address, and social security number when a new employee is hired.

(3) Voice Reporting

In some states, employers can report new hires by leaving a voice message on a special voice response system.

• Key point. Be sure to check with your designated state agency to find out what reporting options are available in your state. Telephone numbers for all state agencies are included in a table in this newsletter. Use the option that is easiest for you.

• Key point. Does your church use a payroll reporting service? If so, it may be automatically making the new hire reports for you. Check to be sure.

Penalties

The federal welfare reform law prohibits states from assessing a penalty in excess of $25 for each failure to report a new hire. However, states may impose a penalty up to $500 if an employer and employee “conspire” to avoid the reporting requirements, or agree to submit a false report.

Employees in More than one State

Some denominational agencies and parachurch ministries have employees in more than one state. How do they comply with the new hire reporting rules? They may report newly hired employees to the state in which the employees are working; or, they may select one state to receive all new hire reports. If one state is selected, the employer must submit new hire reports electronically or by magnetic tape. The employer should check with the designated state agency to discuss the technical requirements for such a report.

• Key point. “One state” reporting requires new hire information to be reported twice a month, not less than 12 nor more than 16 days apart.

• Key point. A multistate employer that elects to report all new hire information to one state must inform the Secretary of the United States Department of Health and Human Services of its decision, by writing National Director of New Hires, DHHS-OCSE, Multistate Employer Registration, P.O. Box 509, Randallstown, MD 21133.

Examples

The application of the new hire law to churches is illustrated in the following practical examples:

• Example. A church hires a full-time office secretary in July of 1999. The pastor has learned of the new hire reporting rules, but assumes that the church is exempt. This assumption is incorrect. The new hire reporting law defines an employer as “the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person.” Since a full-time office secretary hired by a church will always be an employee, the church is an “employer” subject to the reporting requirements.

• Example. Same facts as the previous example. What are the legal consequences of failing to comply with the new hire reporting requirements? The church would be subject to a penalty of up to $25, depending on state law.

• Example. A church treats all of its nonminister staff as “self-employed” persons in order to avoid any payroll tax reporting obligations and the new hire reporting requirements. The church has five nonminister workers, all of whom work full-time. It is virtually certain that all the nonminister workers are in fact employees rather than self-employed. As a result, the church is subject to significant penalties for failing to comply with the payroll tax reporting rules, and will be subject to a penalty of up to $25 (as determined by state law) for each new hire that is not reported to the designated state agency. If the agency determines that the church and its workers “conspired” to avoid the reporting requirement, then it may be able to assess a penalty of up to $500 per worker.

• Example. A church would like to hire Brad as a custodian. Brad asks the pastor if the church complies with the new hire reporting law. The pastor informs Brad that it does. Brad reveals that he has not been honoring a child support obligation based on a court order in another state, and says that his life “will be ruined” if the pastor reports him. He assures the pastor that he is doing his best to comply with the order, but needs more time to “work things out.” The pastor agrees not to report Brad as a new hire. The church is subject to a penalty of up to $500 as provided by state law.

• Example. A church hires Rev. D as a youth pastor. Rev. D asks to be treated as a self-employed worker for federal income tax reporting purposes. The church agrees to do so. The church treasurer assumes that since Rev. D is “self-employed” for tax reporting purposes, the new hire reporting requirement does not apply to Rev. D. This assumption is incorrect. As a full-time youth pastor, Rev. D is almost certainly an employee for federal income tax reporting purposes. This in turn makes the church an “employer” subject to the new hire reporting requirement.

• Example. A church hires a part-time custodian who will work less than 10 hours each week for an hourly rate of pay. The church will exercise little if any control over the methods the custodian will use in performing custodial services. The custodian probably is self-employed for federal income tax reporting purposes. As a result, the church is not an “employer,” and the new hire reporting requirement does not apply to this worker.

Complying with the New Hire Reporting Requirement

A state-by-state summary

Note: Explanation of codes used in this table: A (W-4 information, including employee’s name, address, social security number, plus the employer’s name, address, and employer identification number); B (state employer identification number); C (date of hire); D (date of birth); E (salary); F (employer contact person and phone number); G (medical insurance information). Code letters in brackets (e.g., [A]) refer to information that may voluntarily be reported by an employer, but which is not required by law. Be sure to check with your designated state agency for the most up-do-date information.

StateWhat to reportWhen to report (days after hire)PenaltyTelephone assistance

AL	A,B	7	$25	334-353-8491
AK	A	20	$10 ($100 for conspiracy)	907-269-6685
AZ	A	30	none	602-252-4045
AR	A	20	none	501-682-3087
CA	A,B,C	20	$24 ($490 for conspiracy)	916-657-0529
CO	A	20	none	303-297-2849
CT	A,B	20	none	860-424-5044
DE	A	20	$25 ($500 for conspiracy)	302-369-2160
DC	A,C,D,E [F,G]	20	$25 ($500 for conspiracy)	888-689-6088
FL	A,C[D]	20	None	904-922-9590
GA	A,B,D	10	written warning	888-541-0469
HI	A	20	$25 ($500 for conspiracy)	808-586-8984
ID	A,B,C	20	none	800-627-3880
IL	A [C]		$15 ($500 for conspiracy)	800-327-4473
IN	A	20	$500 for conspiracy	800-437-9136
IA	A,D,F	15	contempt of court	515-281-5331
KS	A	20	none	888-219-7801
KY	A	20	$250 for third and each additional offense, and conspiracy	800-817-2262
LA	A	20	$25 ($500 for conspiracy)	888-223-1461
ME	A,B,D	7	written warning for first offense; up to $200 for additional offenses	207-287-2886
MD	A,B,C	20	$20 ($500 for conspiracy)	888-634-4737
MA	A,C	14	$25 ($500 for conspiracy)	617-577-7200
MI	A	20	none	800-524-9846
MN	A [D]	20	$25 ($500 for conspiracy)	800-672-4473
MS	A,B,C,D	15	$25 ($500 for conspiracy)	800-866-4461
MO	A [C]	20	$25 ($350 for conspiracy)	800-859-7999
state	what to report	when to report (days after hire	penalty	telephone assistance
MT	A,C [D,F]	20	none	888-866-0327
NE	A	20	$25	888-256-0293
NV	A	20	$25	888-639-7241
NH	A,B	20	none	888-803-4485
NJ	A,D	20	$25 ($500 for conspiracy)	609-588-2355
NM	A	20	$20 ($500 for conspiracy)	888-878-1607
NY	A	20	$25 ($450 for conspiracy)	800-972-1233
NC	A,B	20	$25 ($500 for conspiracy)	888-514-4568
ND	A	20	$25 ($250 for conspiracy)	800-755-8530
OH	A,C,D	20	less than $25 ($500 for conspiracy)	800-208-8887
OK	A,C	20	none	800-317-3785
OR	A	20	none	503-986-6053
PA	A,C,G	20	warning for first offense; $25 for additional offenses ($500 for conspiracy)	888-724-4737
RI	A,D,F	14	$25 ($500 for conspiracy)	888-870-6461
SC	A	20	$25 for second and additional offenses ($500 for conspiracy)	800-768-5858
SD	A	20	petty offense	888-827-6078
TN	A	20	$20 ($400 for conspiracy)	888-827-2280
TX	A	20	$25 ($500 for conspiracy)	888-839-4473
UT	A	20	$25 ($500 for conspiracy)	801-526-4361
VT	A	20	$25 ($500 for conspiracy)	802-241-2194
VA	A	20	none	800-979-9014
WA	A,D	20	$25 ($500 for conspiracy)	800-562-0479
WV	A [D,E]	14	$25 ($500 for conspiracy)	800-835-4683
WI	A,C,D	20	$25 ($500 for conspiracy)	888-300-4473
WY	A	20	none	800-970-9258

© Copyright 1999 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m43 c0399

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

Defamation of Pastors

A Louisiana court issues an important decision-Steed v. St. Paul’s United Methodist Church, 1999 WL 92626 (La. App. 1999)

Richard R. Hammar, Attorney, CPA

Bio

Church Law and Tax1999-05-01

Defamation of Pastors

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

A Louisiana court issues an important decision-Steed v. St. Paul’s United Methodist Church, 1999 WL 92626 (La. App. 1999) [Defamation, The Civil Rights Act of 1964]

Article summary. While the law allows pastors to sue parishioners or employees for defamation, it makes it difficult for them to do so. As “public figures,” they must be prepared to tolerate criticism and even false allegations. Only when those allegations are made maliciously can they sue for defamation. A Louisiana court ruled that a pastor could sue a former employee for defaming him by spreading false allegations of sexual misconduct. It concluded that she had acted with malice, and ordered her to pay him $90,000 in damages. The court also rejected the woman’s sexual harassment claims under state and federal law.

Imagine the pastor of your church being accused of sexual harassment of an employee. The pastor insists that he is innocent, and is cleared by a denominational board of inquiry. The congregation becomes aware of the allegations, and this results in a drastic decline in attendance and finances. The woman is interviewed by two local television stations, and a newspaper, and makes damaging allegations against the pastor. The pastor is forced to move to another city amidst the turmoil. What options does the pastor have in such a tragic scenario? Can he sue the former employee for defamation? That was the question addressed by a Louisiana state appeals court in a recent decision. This article will review the facts of the case, summarize the court’s ruling, and assess the significance of the case to other churches and clergy.

Facts

A woman (the “defendant”) was employed as choir director by a Methodist church. Shortly after she came to work, she claimed that the pastor started hugging her. At first the hugs seemed innocent, but they soon became lingering and made her uncomfortable. The hugs allegedly occurred in the pastor’s office and would often occur after staff meetings. She wanted to give him the benefit of the doubt and at first did not think anything was wrong. On one occasion the pastor came into the choir room and seemed visibly upset. She asked him what was wrong, and when he did not answer her, she put her hands on his shoulders and asked again. According to the defendant, the pastor then grabbed her around the waist, pulled her close to him, and tried to kiss her on her lips. She reportedly turned her head, at which time he kissed her hard on the cheek. She tried to pull away, and he let her go when he heard the organist coming into the room. Later, he asked the defendant if she thought the organist had seen them. The defendant replied no, and told him never to touch her again.

The defendant also testified that there were times when the pastor attempted to grab or touch her in the hall, in the sanctuary, and near the door of the lobby. She stated that on numerous occasions the pastor would tell her not to tell anyone about the incidents. He also frequently quizzed her about whom she had told. When asking these questions, the pastor would either grab her by the arm or block her exit from the office. The defendant reported that she told her husband, and then told the pastor that if he did not stop touching her and talking about the incidents, she would tell his wife and denominational officials (the district superintendent and bishop). She assured him that if he would quit talking about it, she would let the matter drop.

The defendant claimed that the pastor continued to badger her, so she told the organist, a church member, and the pastor-parish relations committee (which functioned as the church board). The defendant then met with the chairman of the pastor-parish relations committee to discuss the situation. According to her, the chairman acknowledged that the pastor had “a thing going on” with her, but that it was harmless. She claimed that she was never asked out on a date, never asked to have sex, and never propositioned in any way.

For his part, the pastor asserted that he first became aware of the accusations when the defendant was in his office and told him that she thought he was “making a play” for her. He closed the office door (after asking her permission) and asked if she was joking. When told she was not, the pastor informed her that she was obviously misinterpreting his actions, and that he was a happily married man and was not interested in her in that way. The pastor claimed that their next conversation occurred in the choir room. As he turned to leave he reached for her and she told him not to touch her. He later called her into his office, where she again accused him of making a play for her and informed him that she had told her husband. Later that week, the pastor called the defendant’s husband to tell him that nothing had happened. The husband later testified that the pastor had called to apologize for his actions. The pastor steadfastly denied all allegations of wrongful conduct.

The pastor-parish relations committee began discussing the defendant’s allegations. The only corroborating evidence she presented was the testimony of a person who had borrowed substantial amounts of money from the defendant and her husband on an interest-free basis, and who had purchased a car from them and instead of paying for it, worked it off through yard work. The pastor-parish relations committee proposed various solutions to the problem, all of which were rejected by both the defendant and pastor. The defendant would not accept any solution that did not involve counseling and a full acknowledgment by the pastor of his guilt before the pastor-parish relations committee, while the pastor refused to attend any counseling or admit to any wrongdoing. During this time the congregation began hearing about the accusations, and rumors started spreading. In an attempt to defuse the rumors, the pastor-parish relations committee read a statement to the congregation to the effect that the defendant had made allegations against the pastor, that the pastor-parish relations committee had conducted an investigation, and that there was no factual support for the allegations.

The defendant later filed a formal complaint with the district superintendent, who directed the complaint to be resolved by a “board of ordained ministers” pursuant to Methodist practice. She later withdrew her complaint since she was not allowed to have an attorney present or to call witnesses. The superintendent directed the board to resolve the complaint, and it later issued a statement after considering all the evidence that the pastor had been exonerated.

Church attendance, membership, and financial support to the church plummeted as a result of the defendant’s allegations. The bishop stepped in, transferred the pastor to a church in another part of the state, and appointed a new pastor for the church. The new pastor accepted the appointment on the condition that he could hire his own staff. As a result, the PPR terminated the entire staff, many of whom were later rehired by the new pastor. The defendant, however, was not rehired. Several pastor-parish relations committee members testified that the defendant’s allegations about the former pastor had nothing to do with her termination.

The defendant later sued the former pastor, her church, and state and national Methodist bodies alleging discrimination in employment in violation of Title VII of the Civil Rights Act of 1964, and sex discrimination and retaliatory discharge under state law. After filing her lawsuit, the defendant discussed her claims on two local television stations and a newspaper. A year later, the pastor sued the defendant for defamation of character.

The trial court dismissed the state and national church bodies because they were not the defendant’s employer as required by state and federal sexual discrimination statutes. The case went to a jury which dismissed the Title VII sex discrimination claim since the church had fewer than 15 employees (Title VII prohibits employers with 15 or more employees, and engaged in interstate commerce, from engaging in sex discrimination in employment decisions). The jury also dismissed the defendant’s sex discrimination claims against the pastor, since only employers can be sued under state and federal discrimination statutes. It dismissed the sex discrimination claims under state law against the church, and found the defendant liable for defaming the pastor. It ordered her to pay him $90,000 in damages. The defendant appealed.

The Court’s Ruling

Defamation

The appeals court only addressed the trial court’s defamation award in favor of the pastor. It began its opinion by noting that in order for ministers to win a defamation claim, they must prove the public and malicious disclosure of false allegations, resulting in an injury to reputation. The court defined “malice” as “the lack of reasonable belief in the truth of the words.” However, when words accuse a person of criminal conduct, they are presumed to be false and malicious, and defamation is assumed.

The court noted that

the record amply supports the finding that [the defendant’s] words were defamatory. [The pastor’s] reputation was diminished to the point that he was transferred from [his church] and in fact relocated in the southeast portion of the state, an extraordinary move necessary to distance him from the scandal. A rational juror could find, more probably than not, that his reputation, and his ability to serve as a minister in north Louisiana, were damaged by [the defendant’s] accusations. Moreover, [her] charges that [he] grabbed her, tried to kiss her, and physically blocked her from leaving his office, amount to accusations of at least simple battery. Additionally, by accusing him of sexual harassment, [the defendant] launched allegations which by their nature tended to injure his personal and professional reputation.

Even though malice was assumed because the defendant accused the pastor of criminal behavior, the court noted that the defendant’s own testimony provided additional proof of malice. Specifically, she admitted in court that when she told the television reporters that the pastor had grabbed her thigh, she was incorrect. Further, “the general absence of evidence to support her allegations could persuade a rational juror that [she] had no reasonable belief that her statements were true.”

Privilege

The defendant insisted that her statements could not be defamatory because they were privileged. The court acknowledged that “privilege is one of the defenses to a defamation suit.” In this case, the defendant claimed the “qualified privilege” that applies “when a statement is made in good faith, on a subject matter in which the person communicating it has an interest … to a person having a corresponding interest.” As an example of this privilege the court referred to “communications between appropriate persons within the employer’s walls, concerning allegations of conduct by an employee that bears on the employer’s interest.” This often is referred to as the “common interest” privilege. It is a “qualified” privilege rather than an absolute privilege, since it only applies if the person making the statements does so in good faith. The court noted that good faith exists “if the person making the statements had reasonable grounds for believing that the statements were true and he honestly believed them to be true.”

The defendant insisted that she made the statements in good faith, that she had an interest in reporting the pastor’s alleged sexual harassment, and that the people to whom she reported (members of the pastor-parish relations committee) had a duty to her as an employee and to the church to deal with ministers who engaged in sexual harassment. The court disagreed, noting that

with all the evidence in this record, the jury was not plainly wrong to conclude that [the defendant] was not in good faith. There was conflicting testimony regarding whether or not any sexual harassment had occurred; notably, [the defendant] admitted that her televised accusation was false. [The pastor] denied each and every accusation. The jury was entitled to find the evidence of [the pastor] more credible, and that of [the defendant] and her only corroborating witness … less so. In view of the conflicting evidence, this privilege does not apply.

Amount of Damages

The defendant asserted on appeal that the jury’s verdict of $90,000 was excessive. The pastor responded that the amount was inadequate. The court noted that in a defamation case a jury can award damages based on injury to reputation, personal humiliation, embarrassment, mental anguish, anxiety, and hurt feelings. In addition, a jury can award damages based on a loss of income. The court noted that several denominational officials testified that the pastor’s reputation had suffered because of the woman’s allegations. They pointed to the fact that he had to be transferred to a church in another part of the state. As a result,

it was reasonable for the jury to find that [the pastor’s] general reputation was injured by the allegations. [He] testified that due to the transfer his salary was reduced by $18,000 per year. The record clearly shows that [he] has suffered extreme embarrassment, humiliation, and loss of reputation from his fellow ministers and family, that he was transferred due in part to the accusations, and that he has suffered a loss of income due to the transfer. It was not manifestly erroneous for the jury to award [him] a lump sum of $90,000 in damages for his loss of reputation, his embarrassment and humiliation, and his loss of income.

Homeowner’s Insurance

The defendant’s homeowner’s insurance carrier refused to provide her with a legal defense, or pay any portion of the $90,000 verdict. It based its position on the policy’s exclusion of “bodily injury or property damage … intended by the insured.” The court noted that “insurance policies should be construed to effect, not deny, coverage,” and that “an exclusion from coverage should be narrowly construed.” The court concluded that the plain language of the exclusion restricted it to “injuries which were intended” rather than to “injuries from an intended act.” It concluded that the exclusion did apply, because the defendant clearly intended to injure the pastor:

[The defendant] made allegations that [the pastor], a married minister, was sexually harassing her. She repeated these allegations to various members of the congregation, reported them to [the pastor’s] supervisors, and instituted an interview which led to the airing of these allegations over two television stations … and a newspaper. Notably, when [the pastor-parish relations committee] attempted to resolve this situation, [the defendant] refused to accept any solution which did not include [the pastor’s] attending counseling and admitting … that he had sexually harassed her. Additionally, when asked about these statements [she] testified that she intended to accuse [him] of sexual harassment and that she was aware that his reputation would suffer. In sum, by making and repeating allegations of sexual harassment against a Methodist minister, [the defendant] either knew that [he] would suffer humiliation, loss of reputation, and a job transfer, or was substantially certain that these damages would follow. As such, she intended the accusations and the injuries; thus, the intentional act exclusion in her homeowner’s policy applies.

Relevance of the case to other churches and ministers

What is the relevance of this ruling to other churches? Obviously, a decision by a Louisiana appeals court is of limited significance since it has no direct or binding effect in any other state. Nevertheless, there are a number of aspects to the ruling that will be instructive to church leaders in every state. Consider the following:

1. Defamation-in general. The court noted that it is more difficult for “public figures,” including pastors, to establish defamation. There is a simple reason for this. Public figures, by assuming highly visible and prominent positions, must assume that they will be the subject of discussion, criticism, and even false allegations. As a result, they cannot be defamed, like ordinary citizens, by false statements that tend to injure their reputation. They also must prove that the person making the false statement did so maliciously. In this context, malice means that the person making the false statement either knew that the statement was false, or made it with a reckless disregard for its truth or falsity. This is a very difficult standard to meet. But this case illustrates that it is not impossible. The court concluded that the defendant acted maliciously when she made false statements about the pastor, and it based this conclusion on “the general absence of evidence to support her allegations” which “could persuade a rational juror that [she] had no reasonable belief that her statements were true.”

Note that persons who are not public figures do not have to prove malice in order to win a defamation claim. They need only prove that another person made a false statement about them, the false statement was “published,” and it injured their reputation.

Elements of Defamation Non-public FigurePublic Figure

(1) Oral or written statement	(1) Oral or written statement
(2) Concerning another person	(2) Concerning another person
(3) The statement is false	(3) The statement is false
(4) The statement is publicized (made public through communication to other persons)	(4) The statement is publicized (made public through communication to other persons)
(5) Injury to the defamed person’s reputation	(5) Injury to the defamed person’s reputation
	(6) The person making the defamatory statement did so with “malice,” meaning that he or she either knew the statement was false, or made it with a reckless disregard as to its truth or falsity

2. Defamation – statements concerning criminal activity. When words accuse a person of criminal conduct, they are presumed to be false and malicious, and defamation is assumed. In this case, the woman accused the pastor of various acts of hugging, touching, and fondling – all of which amount to the crime of “simple battery.” As a result, the defendant’s words were presumed to be false and malicious. This presumption can be overcome through opposing evidence, but the court concluded that the defendant failed to produce sufficient evidence to overcome the presumption.

• Key point. When persons make allegations of sexual misconduct against a pastor or other church worker, they often are alleging behavior that constitutes a crime under state law. Such accusations are so serious that the law creates a presumption that they are false and malicious, and defamation is assumed, unless the person making them “rebuts” the presumption of defamation by producing evidence to support the charges. As a result, persons should refrain from making charges of criminal misconduct against other church members or staff unless they have evidence that supports their allegations.

• Example. Two female church employees accuse their pastor or sexual harassment. The alleged harassment included numerous acts of inappropriate and unwelcome touching and hugging. The women submit their accusations to their church board. They support their charges with the testimony of two other church employees who witnessed the pastor engaging in some of the inappropriate acts. The women’s accusations, if true, would mean that the pastor committed the crime of simple battery. As a result, in many states their accusations are presumed to be false and malicious, and defamation is assumed. However, they can rebut this presumption through evidence that substantiates their charges. In this case, they will meet that burden. Not only are there two victims whose testimony is mutually corroborative, but there are two additional witnesses who observed the pastor engaging in some of the inappropriate behavior.

• Example. A mother informs her pastor and members of the church board that a volunteer youth worker sexually molested her son during an overnight church activity. The youth worker threatens to sue the mother for defamation. There were no witnesses to the alleged incident; however, the mother took her son to a physician who confirmed that sexual molestation had occurred. The women’s accusations, if true, would mean that the youth worker committed a crime (aggravated child molestation) under state law. As a result, in many states the mother’s accusations are presumed to be false and malicious, and defamation is assumed. However, she can rebut this presumption through evidence that substantiates her charges. In this case, she probably will meet that burden through her physician’s testimony.

3. Privileges to defamation. There are a number of privileges to defamation. A privileged statement is not defamatory. Some privileges are absolute, including statements that are truthful, or that are made before a court or legislature. Other privileges are qualified, meaning that they are subject to some exception or limitation. This case illustrates one example of a qualified privilege-statements concerning matters of common interest. Most courts have recognized that persons with a common interest in information about another person should be free to share information about that person without fear of being liable for defamation. But this privilege is not absolute. It only applies if the person making the allegedly defamatory statement does so in “good faith.” This means that the “the person making the statements had reasonable grounds for believing that the statements were true and he honestly believed them to be true.” Other courts simply say that the privilege can be lost if the person making a statement concerning a matter of common interest does so with malice. This is another way of saying that the person making the statement did not do so in good faith. Once again, malice in the context of defamation means that the person making the statement either knew that it was false, or made it with a reckless disregard as to its truth or falsity.

The defendant made a plausible claim that she disclosed information about the pastor’s alleged acts of sexual harassment to members of the pastor-parish relations committee because they had a legitimate interest in learning about such information. The court rejected this argument, and as a result concluded that the defendant’s remarks were not privileged. It based this conclusion in part on the false statement (“the pastor grabbed my thigh”) the defendant made in her television and newspaper interviews, and which she later admitted was false.

4. Proving a sexual harassment claim. Claims of sexual harassment often are difficult to resolve, because the evidence is conflicting. This case is illustrative. The evidence submitted by the parties is summarized in the following table:

Evidence Supporting the Defendant	Evidence Supporting the Pastor
Her own testimony	His own testimony
The testimony of an alleged witness	The defendant’s witness was not credible, since he had received preferential financial treatment from the defendant
	The defendant made a statement (the pastor grabbed her thigh) in television and newspaper interviews that she later admitted was false
	A denominational “board of ordained ministers” investigated the defendant’s charges, and exonerated the pastor
	A jury did not accept the defendant’s accusations of sexual harassment

5. Title VII of the Civil Rights Act of 1964. Title VII prohibits employers with 15 or more employees, and that are engaged in interstate commerce, from discriminating in employment decisions on the basis of sex. Sexual harassment is a form of prohibited sex discrimination. The defendant claimed that the pastor’s behavior amounted to sexual harassment for which her employing church was liable under Title VII. The court dismissed this claim on the ground that the church employed fewer than 15 persons and so was not subject to Title VII.

6. Reducing the risk of similar claims. The effects of the defendant’s allegations were dramatic. Her allegations soon were spread throughout the congregation, resulting in a drastic decline in attendance and revenue. In addition, the church board had to call a meeting of the congregation to confront the matter, and the accused pastor was unceremoniously replaced and transferred to another part of the state. While it is impossible to eliminate the risk of such an ordeal, the good news is that church leaders can take steps to reduce the risk. Consider the following two suggestions:

#1 – Adopt a Sexual Harassment Policy

As we have pointed out in previous issues of this newsletter, it is very important for any church having employees to adopt a sexual harassment policy. Such a policy has a number of significant advantages. First, it will reduce the likelihood of such claims. Why is this so? Because a properly drafted policy will provide employees and employers with a definition of sexual harassment. Unfortunately, sexual harassment is more likely to flourish where employees and employers lack a clear understanding of what it means. By clearly defining the term in a policy, employees will be effectively warned against behaviors, however “innocent,” that cross the line. And, employers will be better informed about behavior that is inappropriate. In summary, a properly drafted sexual harassment policy can be an effective tool in reducing the risk of sexual harassment, and the turmoil that often is associated with such claims.

Second, a sexual harassment policy will provide a church with a potent legal defense in the event of a sexual harassment claim.

Here is a list of some of the terms that should be incorporated into a written sexual harassment policy:

Define sexual harassment (both quid pro quo and hostile environment) and state unequivocally that it will not be tolerated and that it will be the basis for immediate discipline (up to and including dismissal).
Contain a procedure for filing complaints of harassment with the employer.
Encourage victims to report incidents of harassment.
Assure employees that complaints will be investigated promptly.
Assure employees that they will not suffer retaliation for filing a complaint.
Discuss the discipline applicable to persons who violate the policy.
Assure the confidentiality of all complaints.

In addition to implementing a written sexual harassment policy, a church should also take the following steps:

Communicate the written policy to all workers.
Investigate all complaints immediately. Some courts have commented on the reluctance expressed by some male supervisors in investigating claims of sexual harassment. To illustrate, a federal appeals court observed: “Because women are disproportionately the victims of rape and sexual assault, women have a stronger incentive to be concerned with sexual behavior. Women who are victims of mild forms of sexual harassment may understandably worry whether a harasser’s conduct is merely a prelude to violent sexual assault. Men, who are rarely victims of sexual assault, may view sexual conduct in a vacuum without a full appreciation of the social setting or the underlying threat of violence that a woman may perceive.”
Discipline employees who are found guilty of harassment. However, be careful not to administer discipline without adequate proof of harassment. Discipline not involving dismissal should be accompanied by a warning that any future incidents of harassment will not be tolerated and may result in immediate dismissal.
Follow up by periodically asking the victim if there have been any further incidents of harassment.

• Key point. EEOC guidelines contain the following language: “Prevention is the best tool for the elimination of sexual harassment. An employer should take all steps necessary to prevent sexual harassment from occurring, such as affirmatively raising the subject, expressing strong disapproval, developing appropriate sanctions, informing employees of their right to raise and how to raise the issue of harassment under Title VII, and developing methods to sensitize all concerned.”

• Key point. The assistance of an attorney is vital in the drafting of a sexual harassment policy.

#2 – boundaries

Clergy and lay staff should understand the importance of establishing and honoring “boundaries” in their interactions with minors as well as members of the opposite sex. Boundaries not only reduce the risk of inappropriate behavior, but just as importantly they reduce the risk of false allegations which can be devastating to an innocent person. We have discussed appropriate boundaries on several occasions in this newsletter. Listed below are examples of boundaries that have been adopted by some churches. You may want to consider adopting some of them:

Only permit opposite sex counseling by clergy if a third person is present. The third person can be the pastor’s spouse, a staff member, board member, or some other person who is capable of maintaining confidences.
Only permit counseling of minors by clergy and lay employees and volunteers if a third person is present. The third person can be the counselor’s spouse, a staff member, board member, or some other person who is capable of maintaining confidences.
Require a third person to be present for any pastoral counseling occurring off of church premises. For example, if a woman calls the pastor at 3 AM and asks him to come to her apartment for counseling, the pastor can only go if a third person comes along.
Permit counseling to occur on church premises only during office hours when other staff are present and visible (through a window or doorway).
Require a third person to be present for any pastoral counseling occurring on church premises after hours and on weekends, or at any other time when there are not staff members who are present and visible during the counseling session.
Limit counseling sessions to a reasonable amount of time, such as 45 minutes.
Limit the number of counseling sessions with the same person to a reasonable number, such as 4 or 5 during the same calendar year.
Adopt a policy requiring women to be counseled by women.
Install a video camera in the pastor’s office, or wherever counseling occurs, that provides a video feed (not audio) to a terminal at another staff member’s desk. The staff member is instructed to remain at the desk throughout the counseling session, and to frequently monitor the screen. Alternatively, the counseling session can be recorded on video tape (without audio), and later played back in fast forward by a staff member who then prepares and signs a dated memorandum acknowledging that no inappropriate behavior was observed.

Churches that want to implement any one or more of these suggestions should do so by adopting an official policy through appropriate action of the board. This will remove any element of discretion. When a person calls the pastor and asks for counseling off of church premises, the pastor can simply respond that he or she is prohibited by church policy from accommodating the person without the presence of a third person.

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

The Religious Liberty and Charitable Donation Protection Act of 1998

A federal law protects the charitable giving of donors who declare bankruptcy

Richard R. Hammar, Attorney, CPA

Bio

A federal law protects the charitable giving of donors who declare bankruptcy

Article summary. Last year Congress enacted the Religious Liberty and Charitable Donation Protection Act. The Act accomplishes two important results. First, it protects churches and other charities from demands by bankruptcy courts that they return contributions made by a bankrupt donor. Second, the Act allows most persons who file for bankruptcy to continue making contributions to their church or charity. In the past, many courts rejected both of these protections. This article provides church leaders with a practical understanding of how the new law will affect them.

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

Authority of bankruptcy trustees to recover charitable contributions

Background

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

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

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

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

Beginning in 1993, several events occurred that culminated in the enactment of the Religious Freedom and Charitable Donation Protection Act of 1998. Here is a brief summary of what happened.

Round 1-the First Young Case

In 1993, a federal district court in Minnesota ruled that a church had to turn over contributions made by a couple to their church within a year of filing a bankruptcy petition. In re Young, 152 B.R. 939 (D. Minn. 1993). The debtors (husband and wife) contributed a total of $13,450 to their church before filing a chapter 7 bankruptcy petition. The bankruptcy trustee opposed the bankruptcy petition on the ground that the contributions were for less than reasonably equivalent value. The court agreed, and concluded that the trustee could recover the contributions so long as the first amendment guaranty of religious freedom was not violated. The court looked to the Supreme Court’s decision in Employment Division v. Smith, 494 U.S. 872 (1990), in which the Court ruled that a “general law of neutral applicability” can be applied to religious practices without offending the first amendment even if the law is not supported by a “compelling government interest.” This ruling repudiated the Supreme Court’s longstanding position that a law that offends religious freedom is valid only if it is supported by a compelling government interest. The Court ruled that its prior decisions “have consistently held that the right of free exercise does not relieve an individual of the obligation to comply with a valid and neutral law of general applicability on the ground that the law proscribes (or prescribes) conduct that his religion prescribes (or proscribes).”

The bankruptcy court concluded that the Smith decision stood for the proposition that “an individual cannot escape a valid and neutral law of general applicability by merely asserting that the law violates his or her religious beliefs.” It further observed that a bankruptcy trustee’s authority to deny bankruptcy relief on the basis of “fraudulent transfers” for less than reasonably equivalent value was “a neutral law of general applicability,” and that “[t]he purpose of the statute is to enlarge the pool of funds for creditors by recovering gratuitous transfers made on the eve of bankruptcy by insolvent debtors.” The court, therefore, dismissed the church’s constitutional challenge, and allowed the trustee to recover the debtors’ contributions from the church.

Round 2-the Religious Freedom Restoration Act

In 1990, the United States Supreme Court ruled that a “neutral law of general applicability” that burdens the exercise of religion need not be supported by a “compelling governmental interest” to be permissible under the first amendment’s free exercise of religion clause. Employment Division v. Smith, 494 U. S. 872 (1990). In so ruling, the Court repudiated a quarter of a century of established precedent and severely diluted this basic constitutional protection. The results were predictable. Scores of lower federal courts and state courts sustained laws and governmental practices that directly restricted religious practices. In many of these cases, the courts based their actions directly on the Smith case, suggesting that the result would have been different had it not been for that decision.

Congress responded to the Smith case by enacting the Religious Freedom Restoration Act of 1993. The Act restored the “compelling interest test” through the following provision: “Government shall not burden a person’s exercise of religion even if the burden results from a rule of general applicability [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 explaining this provision, the Senate Judiciary Committee commented that the Act “permits government to burden the exercise of religion only if it demonstrates a compelling state interest and that the burden in question is the least restrictive means of furthering the interest.”

Round 3-the Second Young Case

The church and debtors involved in the original Young case (discussed above) appealed the district court’s ruling to a federal appeals court. The appeals court acknowledged that the debtors received valuable benefits in exchange for their contributions to the church, including preaching, teaching, and counseling. But, it concluded that these benefits were provided to members whether or not they tithed, and as a result they were not provided “in exchange” for the debtors’ contributions. Therefore, under the bankruptcy law the trustee had the authority to recover the debtors’ contributions from the church. However, the court further concluded that allowing the trustee to do so would violate the rights of the church and debtors under the newly enacted Religious Freedom Restoration Act. This Act, as noted above, specifies that the government may not “substantially burden” a person’s religious practices unless a compelling governmental interest exists. In effect, the Act overturned the Supreme Court’s decision in the Smith case (discussed above). The court noted that the debtors believed in tithing, and faithfully tithed up until the time they filed for bankruptcy. It concluded that the practice of tithing was a religious practice that would be substantially burdened if the trustee could recover the debtors’ tithes since it would discourage persons from tithing to their church if they suspected that they might file for bankruptcy within the next year. Further, the court concluded that there was no compelling governmental interest that would justify the substantial burden on the practice of tithing. In re Young, 82 F.3d 1407 (8th Cir. 1996).

Round 4-the Supreme Court strikes down the Religious Freedom Restoration Act

In 1997, the United States Supreme Court struck down the Religious Freedom Restoration Act on the ground that Congress exceeded its authority in enacting the law. City of Boerne v. Flores, 521 U.S. 507 (1997). The Court began its opinion by noting that the federal government “is one of enumerated powers.” That is, each branch (legislative, executive, judicial) can only do those things specifically authorized by the Constitution. The Court concluded that nothing in the Constitution gave Congress the authority to enact a law overturning the Supreme Court’s interpretation of the first amendment in the Smith case. The Court acknowledged that section 5 of the fourteenth amendment gave Congress the authority to “enforce” the provisions of the first amendment, and therefore Congress can enact legislation “enforcing the constitutional right to the free exercise of religion.” However, the Court then observed that “[l]egislation which alters the meaning of the free exercise [of religion] clause cannot be said to be enforcing the clause. Congress does not enforce a constitutional right by changing what the right is.”

Round 5-the third Young case

Following its decision in the City of Boerne case striking down the Religious Freedom Restoration Act, the Supreme Court vacated and remanded the federal appeals court ruling in the second Young case summarized above. Presumably, the Court assumed that its decision would cause the appeals court to reverse its earlier decision that had been based squarely on the Religious Freedom Restoration Act. On remand, the appeals court reaffirmed its earlier decision rejecting the bankruptcy trustee’s attempt to compel the church to return the bankrupt debtors’ tithes. The court based its decision on a provision in the Constitution giving Congress broad authority to enact bankruptcy laws. It observed:

We conclude that RFRA [the Religious Freedom Restoration Act] is an appropriate means by Congress to modify the United States bankruptcy laws. In attempting to [recover the [debtors’] tithes to the church, the trustee relied on an affirmative act of Congress defining which transactions of debtors in bankruptcy may be [recovered]. RFRA, however, has effectively amended the Bankruptcy Code, and has engrafted the additional clause to section 548 … that a recovery that places a substantial burden on a debtor’s exercise of religion will not be allowed unless it is the least restrictive means to satisfy a compelling governmental interest. The trustee has not contended, and we can conceive of no argument to support the contention, that Congress is incapable of amending the legislation that it has passed. Neither can we accept any argument that allowing the discharge of a debt in bankruptcy and preventing the recovery of a transfer made by insolvent debtors is beyond the authority of Congress. We therefore conclude that Congress had the authority to enact RFRA and make it applicable to the law of bankruptcy. In re Young, 141 F.3d 854 (8th Cir. 1998).

The third Young case is controlling (unless later reversed by the Supreme Court) in the eighth federal circuit, which includes the states of Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota. In these states, a bankruptcy trustee cannot recover tithes made by bankrupt debtors to their church-so long as the debtors consider tithing to be an important religious practice that would be “substantially burdened” if bankruptcy trustees had the power to recover debtors’ contributions. However, this was a very limited ruling: (1) it only applied in states in the eighth federal circuit; (2) it only applied to debtors who regarded tithing as a central religious practice; and (3) it is a controversial ruling that probably will be reversed at a later time by the Supreme Court.

Round 6-the Religious Freedom and Charitable Donation Protection Act of 1998

In response to the developments summarized above, the Religious Freedom and Charitable Donation Protection Act was introduced in the Senate by Senator Grassley and in the House of Representatives by Congressman Packard. In introducing the House bill, Congressman Packard observed:

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

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

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

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

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

Congress enacted the Religious Freedom and Charitable Donation Protection Act by unanimous vote of both houses, and so this important provision is now the law. Its meaning was addressed in a committee report accompanying the Act. The report reads, in part:

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

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

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

Examples

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

• Example 1. Bob has attended his church for many years. For the past few years, his contributions to his church have averaged $50 per week, or about $2,500 per year. Bob’s gross annual income for 1998 and 1999 is about $40,000. On May 15, 1999, Bob files for bankruptcy. A bankruptcy trustee contacts the church treasurer, and demands that the church turn over all contributions made by Bob from May 15, 1998 through May 15, 1999. The Religious Freedom and Charitable Donation Protection Act of 1998 applies directly to this scenario, and protects the church from the reach of the trustee, since: (1) the amount of Bob’s annual contributions in both 1998 and 1999 (the years in which the contributions were made) did not exceed 15 percent of his gross annual income (15 percent of $40,000 = $6,000); and (2) the timing, amount, and circumstances surrounding the contributions, as well as the lack of any change in the debtor’s normal pattern or practice, suggest that Bob did not commit intentional fraud, and so the trustee cannot recover contributions on this basis. See step #4 in the sidebar.

• Example 2. Same facts as example 1, except that in addition to his weekly giving Bob made a one-time gift to the church building fund on December 1, 1998, in the amount of $5,000. Bob’s total giving for the year preceding the filing of his bankruptcy petition now totals $7,500, or nearly 19 percent of his gross annual income. As a result, he is not eligible for the 15 percent “safe harbor” rule described in step #4 of the sidebar. The trustee will be able to recover the $7,500 in contributions made by Bob to the church within a year of filing the bankruptcy petition, unless Bob can demonstrate that giving 19 percent of his gross annual income is consistent with his normal practices in making charitable contributions. It is unlikely that Bob or the church will be able to satisfy this condition, since the gift to the building fund was a “one time” extraordinary gift for Bob that was unlike his giving pattern in any prior year.

• Example 3. Barb believes strongly in giving to her church, and for each of the past several years has given 20 percent of her income. On June 1, 1999, she files for bankruptcy. A bankruptcy trustee contacts the church treasurer, and demands that the church turn over all contributions made by Barb from June 1, 1998 through June 1, 1999. The Religious Freedom and Charitable Donation Protection Act of 1998 applies directly to this scenario, and protects the church from the reach of the trustee, since: (1) the amount of Barb’s annual contributions in both 1998 and 1999 (the years in which the contributions were made) exceeded 15 percent of her gross annual income, but she had a consistent practice in prior years of giving this amount; and (2) the timing, amount, and circumstances surrounding the contributions, as well as the lack of any change in the debtor’s normal pattern or practice, suggest that Barb did not commit intentional fraud, and so the trustee cannot recover contributions on this basis. See step #5 in the sidebar.

• Example 4. Bill has attended his church sporadically for the past several years. For the past few years, his contributions to his church have averaged less than $1,000 per year. Bill’s gross annual income for 1998 and 1999 is about $80,000. Bill is facing a staggering debt load due to mismanagement and unrestrained credit card charges. He wants to declare bankruptcy, but he has a $15,000 bank account that he wants to protect. He decides to give the entire amount to his church in order to keep it from the bankruptcy court and his creditors. He gives the entire balance to his church on June 1, 1999. On July 1, 1999, Bill files for bankruptcy. A bankruptcy trustee contacts the church treasurer, demanding that the church turn over the $15,000 contribution. The Religious Freedom and Charitable Donation Protection Act of 1998 does not protect Bill or the church. The timing, amount, and circumstances surrounding the contribution of $15,000 strongly indicate that Bill had an actual intent to hinder, delay, or defraud his creditors. This conclusion is reinforced by the fact that the gift was contrary to Bill’s normal pattern or practice of giving. As a result, the trustee probably will be able to force the church to return the $15,000. See step #2 in the sidebar.

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

Making charitable contributions after filing for bankruptcy

Background

Up until now, this article has addressed the authority of bankruptcy trustees to recover contributions made by bankrupt debtors within a year prior to filing a bankruptcy petition. There is a second bankruptcy issue that is of direct relevance to churches-can church members who file for bankruptcy continue to make regular contributions to their church? This issue was also addressed by the Religious Freedom and Charitable Donation Protection Act of 1998.

Section 707(b) of the bankruptcy code provides for the dismissal of chapter 7 bankruptcy petitions in the case of debtors who can pay their debts from their excess disposable income. Consider the following examples.

In re Breckenridge, 12 B.R. 159 (S.D. Ohio 1980). A court denied confirmation of a chapter 13 plan because the debtors had not presented the plan in good faith. In determining good faith the court looked to the overall picture presented by the debtors. The court considered several factors: (1) the “reasonably recent prior bankruptcy of [the debtor], combined with the low percentage dividend to unsecured claimants; (2) retention of imprudently purchased assets; and (3) the devotion of a significant portion of the debtors’ income to the payment of an entirely discretionary expenditure, a church tithe ….” While stating that tithes are not automatically objectionable, the court stressed that because of the debtors’ severe financial condition they should “devote maximum resources” to the repayment of their obligations and leave tithing to a time when they could better afford it. The court also noted that without the tithing allocation the debtors could propose a chapter 13 plan whose dividend to creditors would be well over 70%. The court, therefore, denied confirmation of the plan.

In re Curry, 77 B.R. 969 (S.D. Fla. 1987). The debtor presented a chapter 13 plan for confirmation in which he proposed monthly payments of $125 and tithes to his church of $103. The debtor was an ordained minister employed by the church as a teacher. The church did not require the donations. The court emphasized that the contributions constituted almost half of the debtor’s disposable income. While the court did not question the sincerity of the debtor’s religious convictions and recognized that the contributions had also been made before the bankruptcy, the court held that the contributions were not a necessary living expense. The court reasoned that the contributions would have the effect of requiring the debtor’s creditors to contribute to his church and refused to confirm the plan.

In re Green, 73 B.R. 893 (W.D. Mich. 1987) aff’d, 103 B.R. 852 (W.D. Mich. 1988). A debtor’s budget included a payment of 10% of her gross monthly income to her church. The debtor testified that “her church and her own religious beliefs require her to tithe.” The creditor did not contest the sincerity of the debtor’s belief. The court referred to the United States Supreme Court decision in Hobbie v. Unemployment Appeals Commission of Florida, 480 U.S. 136 (1987). In Hobbie, an employer discharged an employee who had recently converted to become a Seventh Day Adventist and so could no longer work Friday nights or Saturdays. After the employee’s termination, the state refused to grant her unemployment compensation benefits. The Supreme Court found that the state’s denial of benefits violated the employee’s right to the free exercise of religion because the state required her “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 in order to accept work on the other. Governmental imposition of such a choice puts the same kind of burden upon the free exercise of religion as would a fine imposed against [her] for her Saturday worship.” The Supreme Court, in the Hobbie case, also held that:

Where the state conditions a receipt of an important benefit upon conduct proscribed by a religious faith, or where it denied such a benefit because of conduct mandated by religious belief, thereby putting substantial pressure on an adherent to modify his behavior and to violate his beliefs, a burden upon religion exists. While the compulsion may be indirect, the infringement upon free exercise is nonetheless substantial.

The Green court reasoned that chapter 13 relief is at least as important as unemployment benefits. The court held that “[t]o deny confirmation of this plan solely because Mrs. Green tithes would be to deny her the benefits of the Bankruptcy Code because of conduct mandated by her religious beliefs.” The court concluded that in the absence of a compelling state interest, it must confirm the plan.

In re Navarro, 83 B.R. 348 (E.D. Pa. 1988). A court held that tithing was necessary for the support and maintenance of a debtor. A creditor objected to the confirmation of a chapter 13 plan because the plan provided for a tithe to the debtor’s church. The debtor testified that she and her family were devoutly religious and that she considered her obligation to tithe “central to her personal beliefs and tenets of her faith.” The debtor also stated that “she considered her obligation to tithe to be indispensable so that she would find a way to continue to do so no matter how the court rules in this matter.” The court reasoned that religious contributions are not luxury items because the debtors do not obtain a tangible benefit or increased standard of living. Rather the contributions arose “purely out of the debtors’ conviction that they are essential for the spiritual and moral well-being of the family.” The court also noted the debtor’s testimony that “tithing is a family practice of long-standing.” The court concluded that religious contributions may be “consistent with expenditures reasonably necessary for the maintenance and support of chapter 13 debtors” and allowed the tithes. The court criticized the Green decision (summarized above) for improperly comparing denial of unemployment benefits to a court’s decision to confirm a bankruptcy plan. The court reasoned that in chapter 13 bankruptcy proceedings the role of the court is “not to award or deny substantive governmental benefits, but rather to balance the interest of various private parties according to neutral principals [sic] emanating from Congress.” More importantly, the court held that the administration of the bankruptcy system and the protection of creditors are sufficiently compelling interests to outweigh the free exercise of religion.

In re Bien, 95 B.R. 281 (D. Conn. 1989). A court allowed a debtor to make religious contributions. The issue again was whether a tithe in a chapter 13 debtor’s plan is “reasonably necessary … for the maintenance and support of the debtor.” The relevant inquiry, the court stated, was “whether the proposed expense fulfills a bona fide personal commitment intended to serve or promote some religious or spiritual purpose, rather than an effort to hinder, delay or defraud creditors.” The debtor had been a full tithe-paying member of the Mormon church for five and one-half years. A full tithe-paying member must pay 10% of gross monthly income to the Church and in return may attend services and pray in the central church in Salt Lake City, Utah. Additionally, a full tithe-paying member enjoys eligibility for positions of service within the church. After examining the totality of the circumstances, the court upheld the religious contribution because “(1) [r]eligious participation is a fundamental part of many people’s lives … (2) [t]he church tithe is a condition precedent to full participation in the debtor’s religion, and (3) the … expense … serves a bona fide religious and spiritual purpose.”

In re Miles, 20 Collier Bankruptcy Cases 912 (N.D. Fl. 1989). Can a debtor who files a “Chapter 13” bankruptcy plan continue to make monthly contributions to his church? No, concluded a federal district court in Florida. The debtor filed a plan under which he proposed to pay only $50 per month for three years (a total of $1,800) against $90,000 in unsecured debts. The plan reflected monthly take-home pay of $1,150 out of which the debtor donated $160 to his church. The bankruptcy trustee objected to the debtor’s plan, arguing that by making the monthly contributions of $160 to his church the debtor was not applying all of his “disposable income” toward the payment of his debts. The issue, as stated by the court, was whether “the court, over the objection of the trustee, can confirm a plan which pays only a minimal dividend to unsecured creditors while the debtor continues to devote substantial amounts of his income to the support of his church.” The court concluded that the trustee was correct in objecting to the plan, and accordingly it denied the debtor’s bankruptcy petition. The court observed: “[We] reject the proposition … that the constitutional separation of church and state protects debtors who with the ability to make payments to their creditors choose instead to donate those funds to their church. While church donations may be a source of inner strength and comfort to those who feel compelled to make them, they are not necessary for the maintenance or support of the debtor or a dependent of the debtor” and accordingly the debtor failed to meet the “disposable income test required for confirmation of the plan.”

In re Tucker, 102 B.R. 219 (D.N.M. 1989). A bankruptcy court rejected a debtor’s bankruptcy petition on the ground that it called for monthly contributions of $100 to his church. The debtor filed a “Chapter 13” (wage-earner’s) bankruptcy petition that listed $22,000 in debts. The plan called for only 2% of unsecured debts to be satisfied over the next four years. The largest unsecured creditor (a local bank) objected to the petition on the ground that the plan did not provide for the payment of all of the debtor’s disposable income to the bankruptcy trustee. Among other things, the bank pointed out that the debtor’s plan called for monthly contributions of $100 to his church. The court observed: “By allowing a debtor to deduct contributions to any organization, the court necessarily is forcing the debtor’s creditors to contribute to the debtor’s church or favorite charity. Congress could have intended no such result.” Accordingly, the court rejected the debtor’s bankruptcy petition.

In re McDaniel, 126 B.R. 782 (D. Minn. 1991). The issue was not whether the court would allow the debtor to tithe, but whether the proposed plan contained excessive contributions to his church. While the debtor proposed to pay $540 per month to his church, the proposed monthly chapter 13 plan payment was $600. The court rested its analysis upon the assumption that an absolute ban on tithing would violate the first amendment guaranty of religious freedom. The court reasoned, however, that a determination that the contribution was excessive would not violate the first amendment. In its analysis, the court emphasized that contributions must be made in good faith and not in an effort to divert funds from creditors. The debtors met this requirement with evidence that they had tithed for several years prior to the filing of their petition. The court also noted that the debtors “felt a strong moral obligation to continue” tithing but “would not be denied full participation in their church if they did not tithe.” The court held that the debtors’ proposed contribution was excessive primarily because the tithe nearly equaled the amount the debtors proposed to pay under their chapter 13 plan. The court ordered that the debtors resubmit a plan with a smaller contribution provision.

“In re Packham, 126 B.R. 603 (D. Utah 1991). A federal court in Utah ruled that a church member’s bankruptcy plan could not be approved since he proposed to “tithe” or give 10 percent of his income to his church. The church member had debts of $50,000 and an annual household income of $25,000. He filed a “Chapter 13” wage-earners bankruptcy plan, under which he agreed to pay his creditors 20 percent of their debts. A creditor objected to the proposed plan on the ground that it listed the church member’s tithe to his church as a reasonably necessary living expense not available for distribution to creditors. Chapter 13 of the bankruptcy law requires that all of a debtor’s “disposable income” be made available for distribution to creditors, except an amount that is reasonably necessary for living expenses. The church member claimed that he believed tithing to be mandatory rather than optional. He testified that tithing “is a commandment from the Lord to pay as a debt to him for what he has done for us, for what God has done for us …. I believe that the tithing should be paid before the creditors. I believe that our greatest creditor is the Lord. He is the one that has given us the most.” The court rejected this argument, and ruled that the bankruptcy plan could not be approved unless the tithe was canceled and the funds made available to the creditors. The court emphasized that failure to tithe would not prevent the debtor from full participation in the activities of his church, and therefore the practice of his religion would not be adversely affected. The court emphasized that neither the debtor nor his church was “in a position to make the Lord a priority creditor in bankruptcy.”

In re Lee, 162 B.R. 31 (N.D. Ga. 1993). A debtor filed a bankruptcy petition under chapter 7 of the bankruptcy code. His bankruptcy petition showed total unsecured debts of $15,384.71, net monthly income of $3,581.43, and total monthly living expenses of $2,064.00 leaving a net disposal income of $1,517.43. In summary, the debtor had sufficient disposable monthly income to pay off his entire unsecured debts in less than 12 months. As a result, the bankruptcy trustee dismissed the debtor’s bankruptcy petition. A court agreed that allowing a discharge of debts in this case would constitute a substantial abuse of the bankruptcy law, since the debtor’s disposable income (not reduced by charitable contributions) was sufficient to pay his debts in a timely manner. The court concluded: “In those cases in which courts have found a constitutional right to tithe, the courts premised their decisions on a finding that the debtors had tithed consistently and that either the debtors’ church required tithing or the debtors had a strong commitment to continue tithing …. In [this] case, [the debtor has] not established a consistent practice of tithing. Neither [has he] introduced credible evidence of strong commitment to tithe. [He] failed to tithe in times of financial difficulty. Additionally, [he has] been a church member since June 1992, but has contributed only since January 1993 …. This court does not dispute the debtor’s commitment to his church or his honest desire to tithe. This court also does not deny the debtor’s right to tithe. He may choose to adjust his budget elsewhere and continue to tithe. It is inequitable to allow him to tithe at the expense of his creditors, when, in the past, he has been able to adjust his moral commitment to tithing to allow for his other financial commitments.”

The Religious Liberty and Charitable Donation Protection Act of 1998

The Religious Liberty and Charitable Donation Protection Act of 1998 directly addressed the ability of bankrupt debtors to continue making contributions to their church following the filing of a bankruptcy petition. The bankruptcy code says that a court may not approve a bankruptcy plan unless it provides that all of a debtor’s “projected disposable income to be received in the three-year period beginning on the date that the first payment is due under the plan will be applied to make payments under the plan.” In addition, a court can dismiss a bankruptcy case to avoid “substantial abuse” of the bankruptcy law. Many courts have dismissed bankruptcy cases on the ground that a debtor’s plan called for a continuation of charitable contributions.

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

The committee report accompanying the Act states:

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

Examples

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

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

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

The Religious Freedom and Charitable Donation Protection Act – A Checklist

Here is a checklist that will be a helpful resource in applying the new law:

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

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

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

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

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

If yes, stop here. A bankruptcy trustee cannot recover the debtor’s contributions from the church.
If no, go to step #4.

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

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

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

If yes, stop here. A bankruptcy trustee cannot recover the debtor’s contributions from the church.

If no, a bankruptcy trustee can recover from the church contributions made by the debtor within a year prior to the filing of the bankruptcy petition.

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

Property Ownership and Accountable Expense Reimbursement

Navigating the vague legal rules on this can be tricky.

Richard R. Hammar, Attorney, CPA

Bio

The problem. According to our annual surveys of church financial practices, we know that most churches by now have adopted “accountable” expense reimbursement arrangements. This means that they reimburse business expenses incurred by their pastor, and perhaps lay employees, which are adequately substantiated (“accounted for”) in a timely manner. A question that often arises is who owns property purchased by a pastor or lay employee if the purchase price is reimbursed by the church under an accountable arrangement? The pastor (or lay employee)? The church? What difference does it make? Church treasurers should be able to answer these questions.

Let’s illustrate the practical significance of this subject with a few examples.

Example 1. First Church adopted an accountable expense reimbursement arrangement several years ago. It reimburses those expenses incurred by any of its employees that are adequately substantiated. To substantiate an expense, an employee must submit proof of its amount, date, location, and business purpose. Receipts are required for any expense of $75 or more. Substantiation of each expense must be completed within a month of the date the expense was incurred. Such an arrangement qualifies as an accountable expense reimbursement arrangement. Assume that Pastor D purchased a personal computer for $2,000 in 1998 that he uses entirely for work-related duties (sermon preparation, research, and communicating with church members and other ministers). In 1999, one year after purchasing the computer, Pastor D accepts a position at Second Church. A few days before moving, the treasurer at First Church asks Pastor D about the computer. Will he be leaving it, or taking it with him? Pastor D is unsure who should keep it, and so is the church treasurer.

Example 2. Pastor B has served as pastor of First Church for 20 years. Over that time, he has purchased several books and commentaries for a professional library that he maintains in his church office. Many of the books were purchased in the past few years. The church has reimbursed Pastor B for the purchase of all of these books. The reimbursements have amounted to $3,000. Pastor B accepts a position at Second Church. As his last day at First Church approaches, he begins to wonder about his library. Should he leave it for his successor at First Church? After all, the church paid for it. Or, should he pack it up and take it with him? He asks the church treasurer for her opinion, but she is unsure. They agree to let the pastor take the library with him. This decision is based on the fact that a pastor’s library is a matter of personal preference, and that Pastor B’s library may be of little if any use to his successor. Further, they assume that the next pastor probably will be bringing his own library with him from his previous church. An accountant who attends First Church learns that Pastor B will be taking the library with him. The accountant questions the legality of this arrangement. The church board addresses this issue, but does not know how to resolve it. They want to let Pastor B take the library with him, but they do not how to explain such a decision to the accountant.

Example 3. Same facts as example 2, except that Pastor B is retiring.

Example 4. Pastor T is the youth pastor and resident “computer expert” at his church. During the three years he is employed by the church, he purchases several CDs and software programs to assist in the performance of his duties. The church reimbursed him for all of these purchases, which amounted to nearly $1,500. Pastor T accepts a position at another church. A question arises as to the ownership of the CDs and computer programs.

How church treasurers should respond. Unfortunately, the tax code and regulations do not address the question of who owns property purchased by an employee if the purchase price is reimbursed by the employer under an accountable reimbursement arrangement. And no guidance has been provided by the IRS or the courts.

So what should church treasurers do? Here are our suggestions:

The general rule

In general, when an employer reimburses an employee for the cost of property purchased by the employee for business use, it is the employer rather than the employee that is the legal owner of the property. After all, property purchased by an employee cannot be reimbursed under an accountable arrangement unless the employee substantiates the cost and business purpose of the property. In other words, it must be clear that the property will be used solely for the business purposes of the employer. Under these circumstances, there is little doubt as a matter of law that the employer is the legal owner of the property. It paid for it, and the accountable nature of the reimbursement arrangement ensures that it will be used by the employee within the course of his or her employment on behalf of the employer.

Key point. In many states, a “resulting trust” arises by operation of law in favor of the person who purchases property in the name of another. The law presumes that it ordinarily is not the intention of a person paying for property to make a gift to the one receiving title.

Example 5. A court ruled that a home purchased by a church for its pastor was subject to a “purchase money resulting trust” in favor of the church and therefore the home could not be considered in a property settlement following the pastor’s divorce. The court ruled that when property is purchased by one person, but title is vested in another, the person holding title does so subject to a “purchase money resulting trust” in favor of the person who paid for the property. Cayten v. Cayten, 659 N.E.2d 805 (Ohio App. 1995).

A possible exception

In many cases, the value of property diminishes rapidly, and in a sense is “used up” within a period of months or a few years. As a result, the question of “ownership” of the property when the employee leaves his or her job has little relevance, since the value is so minimal.

Example 6. A pastor purchases a small dictation machine for $49 in 1995. The church treasurer reimburses her for the cost of the machine under the church’s accountable reimbursement arrangement. When she leaves the church in 1999, the value of the machine is negligible. The “value” of the machine has been “used up” over its useful life. The church in essence has received full value for the purchase, and it would be pointless to insist that the machine remain with the church.

Example 7. Pastor G purchases a “state of the art” computer in 1992 at a cost of $2,500. First Church reimbursed the full purchase price, since the pastor used the computer exclusively for church-related work. The computer is an IBM compatible 20 megahertz “286” model, with 1 RAM of memory and a hard disk storage space of 200 megabytes. It has no modem and no CD drive. Pastor G accepts a position at Second Church in 1999. He is still using the same computer, and a question arises as to the ownership of the machine. While the computer may have been “state of the art” in 1992, it is essentially worthless in 1999. Like the dictation equipment described in example 6, the church has received full value for its purchase of the computer, and it would be pointless to insist that the computer remain with First Church.

Inurement

Churches need to be concerned about the issue of inurement when they allow a minister or other employee to retain ownership and possession of property purchased by the church for church use. Churches are exempt from federal income taxes so long as they comply with a number of conditions set forth in section 501(c)(3) of the tax code. One of those conditions is that “no part of the net earnings [of the church or charity] inures to the benefit of any private shareholder or individual.” What does this language mean? The IRS has provided the following clarification:

An organization’s trustees, officers, members, founders, or contributors may not, by reason of their position, acquire any of its funds. They may, of course, receive reasonable compensation for goods or services or other expenditures in furtherance of exempt purposes. If funds are diverted from exempt purposes to private purposes, however, exemption is in jeopardy. The Code specifically forbids the inurement of earnings to the benefit of private shareholders or individuals …. The prohibition of inurement, in its simplest terms, means that a private shareholder or individual cannot pocket the organization’s funds except as reasonable payment for goods or services.” IRS Exempt Organizations Handbook section 381.1.

It is possible that prohibited inurement occurs when a church allows a minister or other employee to retain ownership and possession of property purchased with church funds for church use. However, in many cases the value of the property will be so minimal that inurement probably is not a problem. To avoid any question, especially if the property has some appreciable residual value, the church could “sell” the property to the employee, or it could determine the property’s market value and add this to the employee’s final W-2 or 1099 as additional compensation. In either case, the inurement problem would be avoided.

In deciding whether or not inurement has occurred, the relevant considerations will be as follows:

(1) the purchase price paid (or reimbursed) by the church

(2) the “useful life” of the property

(3) the date of purchase

(4) the residual value of the property at the time the pastor or lay employee is leaving his or her employment with the church

IRS regulations specify the useful life of several different kinds of property in order to allow taxpayers to compute depreciation deductions. These guidelines can be a helpful resource in deciding whether or not inurement has occurred.

Let’s apply the inurement principle to the above examples.

Example 1. Inurement is a possibility according to the above criteria, since (1) the purchase price paid by the church was substantial; (2) a one-year old computer still has a remaining “useful life” (according to IRS regulations, the useful life of computer equipment is 5 years); (3) the computer was purchased one year ago; and (4) the residual value of a one-year old computer is still significant. To avoid jeopardizing the church’s tax-exempt status as a result of prohibited inurement, the church has three options. First, it can ask Pastor D to return the computer. Second, it can let Pastor D keep the computer, but add the current value of the computer to Pastor D’s W-2. The computer’s current value can be obtained by calling local computer dealers, especially those dealing in used equipment. Third, the church can sell the computer to Pastor D for its current value.

Example 2. Inurement is a possibility according to the above criteria, since (1) the purchase price paid by the church was substantial; (2) some of the books still have a remaining “useful life” (according to IRS regulations, the useful life of books is 7 years); (3) while some of the books were purchased more than 7 years ago, many were purchased within the past 7 years; and (4) the residual value of books purchased within the past 7 years is still significant. To avoid jeopardizing the church’s tax-exempt status as a result of prohibited inurement, the church has three options. First, it can ask Pastor B to return books purchased within the past 7 years. Books purchased prior to that time are beyond their “useful life,” according to IRS regulations, and so their value is presumed to be insignificant. Second, it can let Pastor B keep the entire library, but add the current value of books purchased within the past 7 years to his W-2. The current value of these books can be obtained by calling a used book dealer. Third, the church can sell the books to Pastor B for their current value.

Example 3. See the analysis of example 2.

Example 4. Inurement is a possibility according to the above criteria, since (1) the purchase price paid by the church was substantial; (2) the CDs and software programs still have a remaining “useful life” (according to IRS regulations, the useful life of computer software is 36 months); (3) the CDs and software were purchased in the recent past (within the 36-month “useful life” specified by the IRS regulations); and (4) the residual value of the CDs and software is still significant. To avoid jeopardizing the church’s tax-exempt status as a result of prohibited inurement, the church has three options. First, it can ask Pastor T to return the CDs and software. Second, it can let Pastor T keep the CDs and software, but add the current value of these items to his W-2. The current value of CDs and software can be obtained from a local computer dealer, especially one that deals with used products. Third, the church can sell the CDs and software to Pastor T for their current value.

Example 5. Not applicable.

Example 6. Inurement is not a possibility according to the above criteria, since (1) the purchase price paid by the church was minimal; and (2) the current residual value of a dictation machine that cost $49 four years ago is negligible. IRS regulations specify that the useful life of such equipment is 7 years, and so the machine still has a remaining useful life. However, the age and minimal cost of the machine outweigh the significance of any remaining useful life.

Example 7. Inurement is not a possibility according to the above criteria, even though the original cost was substantial, since (1) the computer has outlived its useful life (according to IRS regulations, the useful life of computer equipment is 5 years); (2) the computer was purchased 7 years ago, and is essentially obsolete; and (3) the residual value of a 6-year-old computer is minimal.

Key point. This article has focused on the ownership of property purchased by a pastor or lay employee, when the purchase price is later reimbursed by the church under an accountable business expense reimbursement arrangement. The same analysis will apply, of course, if the church reimburses the purchase price under a nonaccountable arrangement. This article addresses accountable arrangements since the vast majority (93%, according to our surveys) of churches that reimburse business expenses claim to be doing so under an accountable arrangement.

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

The Discipline of Nonmembers

A Michigan court issues an important ruling-Smith v. Calvary Christian Church, 1998 WL 842259 (Mich. App. 1998) [Invasion of Privacy, Church Members,The Establishment Clause]

Richard R. Hammar, Attorney, CPA

Bio

Church Law and Tax1999-03-01

The Discipline of Nonmembers

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

A Michigan court issues an important ruling-Smith v. Calvary Christian Church, 1998WL842259(Mich. App. 1998) [Invasion of Privacy, Church Members, The Establishment Clause]

Article summary. A Michigan court addressed an important issue in a recent ruling-the authority of a church to discipline its members. The court concluded that the first amendment guaranty of religious freedom provides churches with substantial protection when disciplining members. This protection extends to statements made by a minister to the church during worship services or in church publications. But when a member resigns from the church prior to being disciplined, a more difficult question is presented. The Michigan court, like others before it, drew a distinction between the discipline of members and nonmembers. It concluded that churches have limited constitutional protection when disciplining nonmembers, meaning that such individuals are more likely to succeed in pursuing legal action against their former church.

Ministers often learn of personal struggles and failings in the course of counseling. In some cases, such disclosures may reveal conduct that violates the church’s teachings. In such cases ministers may feel that the person be disciplined. If so, they may feel compelled to share the confidential information with others, including the church board or the congregation itself. But any disclosure of confidential information, without consent, creates potential legal problems. Persons who share confidential information may feel betrayed, even outraged, by a public disclosure of the information shared in confidence with their minister. This may lead to a lawsuit seeking damages on the basis of breaching the duty of confidentiality, emotional distress, invasion of privacy, and possibly breach of contract. The church will insist that it has a constitutionally protected right to discipline its members. Obviously, these cases present the civil courts with a very difficult task. A Michigan court addressed such a lawsuit in a recent case. The court concluded that the liability of a church for a pastor’s public disclosures of information received in confidence will depend on whether or not the person who shared the information was a member of the church. This feature article will review the facts of the case, summarize the court’s ruling, and evaluate the relevance of the case to church leaders.

Facts

Can a pastor and church be liable for communicating information to the congregation that was shared with the pastor in confidence? This important question was addressed by a Michigan court in a recent ruling. A church member (the “plaintiff”) confessed to his pastor that he had previously committed adultery with prostitutes. The pastor decided to communicate this information to the entire congregation, including the member’s wife, family, and friends. The pastor insisted that he did not believe in confidential communications and that church doctrine required exposing sins to the congregation. The member claimed that the pastor had been motivated not by religious doctrine but by ill will and the intent to humiliate him and create dissension within his family.

The disgraced member sued his pastor and church, alleging that they breached their “duty of confidentiality” to him by disclosing personal, sensitive information to the church congregation. Moreover, the victim claimed that this intentional breach of confidentiality caused him to suffer psychological distress requiring treatment, as well as physical and mental pain. The trial court dismissed the case on the following grounds: (1) the clergy-penitent privilege is a “rule of evidence that did not create a cause of action for disclosure of private or privileged communications”; (2) the member and his pastor and church had not entered into “an express agreement regarding the confidentiality of the confessions” and therefore there had been no “breach of contract”; and (3) “whether the church required that clergy keep confidential a member’s personal disclosures was a matter of religious doctrine that the court could not determine according to civil law principles.” The member appealed.

The court’s ruling

The First Amendment

The appeals court began its opinion by observing:

Absent conduct that negatively impacts on the public interest in peace, safety and order, both federal and state courts are severely restricted by the [first amendment] in resolving disputes between a church and its members. Indeed, jurisdiction over these matters is limited to determining property rights that can be resolved by the application of civil law. When the court faces issues for their resolution requiring the application of religious doctrine or ecclesiastical polity, the court ceases to have jurisdiction. The United States Supreme Court has defined religious doctrine as ritual, liturgy of worship, and tenets of faith. Jones v. Wolf, 443 U.S. 595 (1979) .…

Here, the manner in which [the pastor and church] decide to discipline the church’s members and the religious doctrine that underlies the discipline are matters of ecclesiastical polity. In his affidavit [the pastor] stated that plaintiff’s discipline was consistent with … the church’s bylaws, entitled “Discipline,” which state that members willfully absent from services for an extended period of time or who are “under charges” are temporarily suspended from active voting membership pending investigation of the case. It also states that “[u]nscriptural conduct or doctrinal departure from the tenets of faith held by this assembly shall be considered sufficient grounds upon which any person may be disqualified as a member,” citing several biblical passages underlying these bylaws including Matthew 18:13-17; this biblical passage specifically states that the congregation should be told of the member’s sins if the sinner refuses to repent.

Despite the civil tort language that plaintiff applies to defendants’ actions, we cannot say that the facts in this case either permit or require judicial intervention into defendants’ decision to discipline its members because this exercise will necessarily involve interpreting religious doctrine.

The court concluded that the pastor’s statements to the congregation did not constitute a threat to public safety, peace, or order justifying state interference. It concluded that “disciplinary practices involving members of an ecclesiastical association, which do not pose a substantial threat to public safety, peace or order, are unquestionably among those hallowed first amendment rights with which the government cannot interfere.”

The effect of a member’s withdrawal on a church’s right to discipline-a review of three leading cases

The plaintiff insisted that the civil courts could resolve his claims since he resigned his church membership before the pastor shared the confidential information with the congregation. He insisted that he was not a church member on the date in question and that once he resigned his membership the pastor and church could not claim that the disclosure constituted church-imposed discipline against him. The court conceded that courts in a few other states have reached this conclusion, but it declined to do so because there was “conflicting evidence in the record regarding whether plaintiff was a member of church on that fateful day.” The court observed that courts in other states that have addressed the question of whether a church can discipline individuals without fear of judicial intervention “focus on whether the complaining individual was a member at the time of the disciplinary action.” Where the disciplined individual is a member of the church at the time of the church’s allegedly improper actions, and the person’s membership has not yet been severed, the church has authority to prescribe and follow disciplinary ordinances without fear of interference by the state.

The court referred extensively to two landmark decisions by the Oklahoma Supreme Court, and a Missouri court ruling.

(1) Guinn v. Church of Christ, 775 P.2d 766 (Okla. 1989)

In 1974, a single woman (the “parishioner”) moved with her minor children to Collinsville, Oklahoma, and soon became a member of a local Church of Christ congregation. The first few years of the parishioner’s association with the church were without incident. In 1980, however, three “elders” of the church confronted the parishioner with a rumor that she was having sexual relations with a local resident who was not a member of the congregation. According to the elders, they investigated the rumor because of the church’s teaching that church leaders are responsible to monitor the actions of church members and confront and discuss problems with anyone who is “having trouble.” The Church of Christ follows a literal interpretation of the Bible, which it considers to be the sole source of moral and religious guidance.

When confronted with the rumor, the parishioner admitted violating the Church of Christ prohibition against fornication. As a transgressor of the church’s code of ethics, the parishioner became subject to the disciplinary procedure set forth in Matthew 18:13-17. This procedure provides: “If thy brother shall trespass against thee, go and tell him his fault between thee and him alone; if he shall hear thee, thou has gained thy brother. But if he will not hear thee, then take with thee one or two more, that in the mouth of two or three witnesses every word may be established. And if he shall neglect to hear them, tell it unto the church; but if he neglect to hear the church, let him be unto thee as a heathen man and a publican.” Pursuant to this procedure, the church elders confronted the parishioner on three occasions over the course of a year. On each occasion, the elders requested that the parishioner repent of her fornication and discontinue seeing her companion. On September 21, 1981, a few days following the third encounter, the elders sent the parishioner a letter warning her that if she did not repent, the “withdrawal of fellowship” process would begin.

Withdrawal of fellowship is a disciplinary procedure that is based on Matthew 18 and carried out by the entire membership in a Church of Christ congregation. When a member violates the church’s code of ethics and refuses to repent, the elders read aloud to the congregation those Scripture passages which were violated. The congregation then withdraws its fellowship from the wayward member by refusing to acknowledge his or her presence. According to the elders, this process serves the dual purpose of encouraging transgressors to repent and return to fellowship with other members, and it maintains the purity and holiness of the church and its members. The parishioner had seen one incident of fellowship withdrawal, and was fully aware that such a process would result in the publication of her unscriptural conduct to the entire congregation. Accordingly, she contacted a lawyer who sent the elders a letter signed by the parishioner, and dated September 24, 1981, in which the parishioner clearly stated that she withdrew her membership. The attorney asked the elders not expose the parishioner’s private life to the congregation (which comprised about five percent of the town’s population).

On September 25, the parishioner wrote the elders another letter imploring them not to mention her name in church except to tell the congregation that she had withdrawn from membership. The elders ignored these requests, and on September 27 (during a scheduled service) they advised the congregation to encourage the parishioner to repent and return to the church. They also informed the congregation that unless the parishioner repented, the verses of Scripture that she had violated would be read aloud to the congregation at the next service and that the withdrawal of fellowship procedure would begin. The parishioner met with one of the elders during the following week, and she was informed that her attempt to withdraw from membership was not only doctrinally impossible, but could not halt the disciplinary process that would be carried out against her. The parishioner was publicly branded a fornicator when the scriptural standards she had violated were recited to the congregation at a service conducted on October 4. As part of the disciplinary process the same information regarding the parishioner’s transgressions was sent to four other area Church of Christ congregations to be read aloud during services.

The parishioner sued the three elders and local church, asserting that their actions both before and after her withdrawal from church membership on September 24, 1981 (the date of her letter to the church), invaded her privacy and caused her emotional distress. The invasion of privacy claim alleged that the elders and church had “intruded upon her seclusion,” and in addition, had “unreasonably publicized private facts about her life by communicating her transgressions to the [home church] and four other area Church of Christ congregations.” A jury ruled in favor of the parishioner, and awarded her $205,000 in actual damages, $185,000 in punitive damages, and $45,000 in interest. The decision was appealed to the Oklahoma Supreme Court.

The supreme court concluded that the discipline of church members is not always immune from civil court review. It ruled that the first amendment prevented the church and its elders from being sued for their actions prior to the parishioner’s withdrawal (which, according to the court, occurred on September 24 when the parishioner sent her letter of withdrawal to the church), but that the church and elders could be sued for actions occurring after the parishioner’s withdrawal. With regard to the parishioner’s claim for “pre-withdrawal” damages, the court noted that “under the first amendment people may freely consent to being spiritually governed by an established set of ecclesiastical tenets defined and carried out by those chosen to interpret and impose them.” The court continued: “Under the first amendment’s free exercise of religion clause, parishioner had the right to consent as a participant in the practices and beliefs of the Church of Christ without fear of governmental interference …. [H]er willing submission to the Church of Christ’s dogma, and the elders’ reliance on that submission, collectively shielded the church’s pre-withdrawal, religiously-motivated discipline from scrutiny through secular [courts].” As authority for this proposition, the court quoted from a decision of the United States Supreme Court:

The right to organize voluntary religious associations to assist in the expression and dissemination of any religious doctrine, and to create tribunals for the decision of controverted questions of faith within the association, and for the ecclesiastical government of all individual members, congregations, and officers within the general association, is unquestioned. All who unite themselves to such a body do so with an implied consent to this government, and are bound to submit to it. Watson v. Jones, 80 U.S. 879 (1972).

The court noted that “insofar as [the parishioner] seeks vindication for the actions taken by the elders before her membership withdrawal, her claims are to be dismissed.” It concluded that the parishioner’s September 24, 1981 letter was an effective withdrawal from church membership, and it agreed with the parishioner that the elders and church could be sued for their actions following her withdrawal. It observed:

The first amendment of the United States Constitution was designed to preserve freedom of worship by prohibiting the establishment or endorsement of any official religion. One of the fundamental purposes of the first amendment is to protect the people’s right to worship as they choose. Implicit in the right to choose freely one’s own form of worship is the right of unhindered and unimpeded withdrawal from the chosen form of worship …. [The local church], by denying the parishioner’s right to disassociate herself from a particular form of religious belief is threatening to curtail her freedom of worship according to her choice. Unless the parishioner waived the constitutional right to withdraw her initial consent to be bound by the Church of Christ discipline and its governing elders, her resignation was a constitutionally protected right.

The court concluded that the parishioner had not “waived” her constitutional right to withdraw from church membership. A waiver, observed the court, is a “voluntary and intentional relinquishment of a known right.” The parishioner testified that she had never been informed by the church of its teaching that membership constitutes an insoluble bond of lifetime commitment, and accordingly she was incapable of knowingly and intentionally “waiving” such a right.

The court rejected the elders’ claim that their statements to the congregations were protected by a “conditional privilege.” The court acknowledged that a statement is conditionally privileged if “the circumstances under which the information is published lead any one of several persons having a common interest in a particular subject matter correctly or reasonably to believe that there is information that another sharing the common interest is entitled to know.” The court concluded that the elders’ statements were not protected by a conditional privilege since the “parishioner was neither a present nor a prospective church member” at the time of the elders’ public statements, and accordingly that the “congregation did not share the sort of ‘common interest’ in parishioner’s behavior” that would render the elders’ statements privileged.

The court acknowledged that “communicating unproven allegations of a present or prospective member’s misconduct to the other members of a religious association is a privileged occasion because the members have a valid interest in and concern for the behavior of their fellow members and officers.” However, it concluded that the elders’ claim to a conditional privilege “as it pertains to their actions occurring after parishioner’s withdrawal from membership, is without merit.”

(2) Hadnot v. Shaw, 826 P.2d 978 (Okla. 1992 )

In 1992, the Oklahoma Supreme Court rendered a second landmark ruling on the discipline of church members. A church convened a disciplinary hearing to determine the membership status of two sisters accused of fornication. Neither sister attended, and neither sister withdrew her membership in the church. Following the hearing, both sisters received letters from the church informing them that their membership had been terminated. The sisters sued the church and its leaders, claiming that the church’s actions in delivering the termination letters and disclosing their contents “to the public” constituted defamation, intentional infliction of emotional distress, and invasion of privacy (public disclosure of private facts). A trial court dismissed the lawsuit, and the sisters appealed directly to the state supreme court, which upheld the dismissal of the case. The court began its opinion by rejecting the sisters’ claim that the contents of the termination letters had been disclosed improperly to the public. This allegation was based entirely on a conversation between a church board member and another member of the church. The member asked the board member why the board was “going after” the sisters, and the board member replied that it was on account of “fornication.” The court concluded that this comment did not constitute a disclosure of the contents of the letters “to the public,” and accordingly there had been no defamation of invasion of privacy. In rejecting the sisters’ allegation of emotional distress, the court noted that the evidence “does not suggest that the lay leader’s conduct was so extreme and outrageous as to justify submission of the claim to the jury.” The court then addressed the sisters’ claim that the manner in which the church notified them of the results of the disciplinary proceeding was inappropriate. In rejecting this claim, the court observed: “The church court had proper ecclesiastical cognizance when the letters were delivered. The [sisters] had not withdrawn their membership at the time they received notice of their expulsion. Under the first amendment, the procedural norms which govern the exercise of ecclesiastical cognizance are not subject to a secular court’s scrutiny. The [trial] court was hence without any authority to assess the propriety of the notice given.” The court then proceeded to announce an absolute constitutional protection for the membership determinations of religious organizations (assuming that the disciplined member has not effectively withdrawn his or her membership):

[The relationship between a church and its members] may be severed freely by a member’s positive act at any time. Until it is so terminated, the church has authority to prescribe and follow disciplinary ordinances without fear of interference by the state. The first amendment will protect and shield the religious body from liability for the activities carried on pursuant to the exercise of church discipline. Within the context of church discipline, churches enjoy an absolute privilege from scrutiny by the secular authority.

This absolute privilege also extends to the implementation of the decision of the church regarding the discipline of a member, even though the implementation occurs after the member has been dismissed. However, the absolute privilege only applies to disciplinary actions taken by the church before a member withdraws from membership. The court explained the effect of a member’s withdrawal from membership as follows:

At the point when the church-member relationship is severed through an affirmative act of either a parishioner’s withdrawal or excommunication by the ecclesiastical body, a different situation arises. In the event of withdrawal or of post-excommunication activity … the absolute privilege from tort liability no longer attaches.

However, the court cautioned that “until an affirmative notification of membership withdrawal is received the church need not reassess the course of its legitimate ecclesiastical interest.”

(3) Hester v. Barnett, 723 S.W.2d 544 (Mo. App. 1987)

A minister visited a family in their home and invited them to trust and confide in him and assured them that any communication with him as minister would be kept in strictest confidence and not be divulged to anyone outside the family. The husband and wife then confided in the minister that their three children had severe disciplinary and behavioral problems. The minister offered to counsel with the family. Despite his assurances of confidentiality, the minister divulged to deacons of the church and members of the community the confidential communications from the family, without their consent. The family claimed that the minister falsely informed others that they had abused their children, and that he instructed the children to lie to others about parental abuse.

The family sued the minister, claiming that he had defamed them from the pulpit and in letters, church bulletins and publications, by accusing the father of stealing, arson, cheating, and the physical and emotional abuse of his children. The family also claimed that the minister falsely reported the abuse to the child abuse hotline. The pastor insisted that the first amendment clothed him with an “absolute privilege” in the performance of his duties that prevented him from being used for defamation. A state appeals court rejected the pastor’s defense, and concluded that he could be sued for defamation-assuming that the family were not members of his church:

Our decision rests on the assumption that the [family] were not members of the church served by [the pastor]. The petition alleges only that [the pastor] presented himself to them as the minister of the [church] and invited [them] to confide in him. They responded with the confidences about the problems with the children. There is no intimation in the petition or answer that the [family] were members of the [church], or that they subjected themselves to the doctrine, religious practices or discipline of the church or its congregation. Among the defamations [alleged in the lawsuit] against the pastor were statements made in the course of sermons delivered from the pulpit. The [first amendment guaranty of religious freedom] forbids a court from any evaluation of the “correctness” of the content of religious sermons as expressions of belief or religious practice. The stricture of the free exercise clause is against “any governmental regulation of religious beliefs as such.” It is competent, therefore, for a court to inquire whether the sermon declarations that the [family] stole, committed arson and abused their children were expressions of actual creed and practice, held and exercised in good faith, or were merely the religious occasion for the wholly secular purpose of intentional defamation and injury to reputation of persons not even communicants of the church.

It may be that the statements from the pulpit, and the several others asserted against [the pastor] as defamations, were a form of chastening usual as to wayward members and conformable to the liturgy, discipline and ecclesiastical policy of the church and congregation. If so, and if the [family] were members of that religious body, they presumptively consented to religiously motivated discipline practiced in good faith …. A person who joins a church covenants expressly or impliedly that in consideration of the benefits which result from such a union he will submit to its control and be governed by its laws, usages and customs whether they are of an ecclesiastical or temporal character to which laws, usages, and customs he assents as to so many stipulations of a contract. The consent to submit to the discipline of the church, sect, or congregation is one of contract, therefore, between the member and the religious body. The discipline the religious body may impose, accordingly, must be within the terms of the consent. Damage incurred within the terms of consent is a nontortious consequence. It is a fundamental principle of the common law that to one who is willing no wrong is done.

The statements from the pulpit, and the others, moreover-if as to members and if as expressions of the religious practice of the church or congregation-are privileged as communications enjoined by duty [upon the pastor] to persons [church members] with a corresponding interest or duty. The privilege, however, is qualified, and is lost if the plaintiffs prove the defendant acted with the intention to injure the plaintiffs in reputation, feelings or profession. The use of the pulpit not as the pretext for the practice of religion, but as the occasion for intentional defamation, therefore, is neither justified by privilege nor protected by the free exercise clause.

In summary, if the family were members of the pastor’s church and the statements the pastor made from the pulpit were not only a form of chastening usual for wayward members but also consistent with the church’s liturgy, discipline, and ecclesiastical policy, then the family had no legal claim against either their pastor or church because they presumably consented to religious discipline.

The effect of a member’s withdrawal on a church’s right to discipline-the court’s conclusion

Having reviewed these three cases, the Michigan court turned to the facts of the present case, and concluded that it could not determine if the plaintiff had been a member of the church at the time of the pastor’s disclosures to the congregation. The evidence simply was not conclusive. However, the court left no doubt that this distinction was critical to the outcome of the case. If the plaintiff was a member of church on the date of the pastor’s disclosures to the congregation, then the court insisted that it was prevented by the first amendment guaranty of religious freedom from resolving the lawsuit. On the other hand, if the plaintiff was not a member on the date of the pastor’s disclosures, then “a closer look at plaintiff’s intentional tort claims is justified because once he removed himself from membership and withdrew his consent to obey church disciplinary policies [the pastor and church] lost their power to actively monitor plaintiff’s spiritual life or impose overt disciplinary actions on him.”

Potential Theories of Liability

The court sent the case back to the trial court to determine whether or not the plaintiff was a member of the church on the date of the pastor’s disclosures. If the plaintiff was not a member on that date, then the court concluded that the plaintiff was entitled to recover damages on the basis of intentional infliction of emotional distress and invasion of privacy.

(1) Intentional Infliction of Emotional Distress

The court noted that for the plaintiff to recover damages on the basis of intentional infliction of emotional distress, he had to prove (1) extreme and outrageous conduct, (2) performed intentionally or recklessly, (3) that caused severe emotional distress. The court added that “liability for such a claim has been found only where the conduct complained of has been 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.”

(2) Invasion of Privacy

The court noted that invasion of privacy may consist of a number of different offenses, including public disclosure of embarrassing private facts. In order for the plaintiff to prove this kind of invasion of privacy, he would have to establish (1) the disclosure of information, (2) that is highly offensive to a reasonable person, and (3) that is of no legitimate concern to the public. The court concluded that “a jury must determine whether a public disclosure involves embarrassing private facts.”

The court concluded:

[W]e believe that plaintiff has pleaded that [the pastor] disclosed to the congregation plaintiff’s previous contacts with prostitutes, that this information was of no legitimate concern to the public and was conveyed to the congregation with the intent to embarrass plaintiff and cause him severe emotional distress. Whether [the pastor’s] conduct was sufficiently outrageous or extreme is a question best left to the jury. Also, whether plaintiff’s previous disclosure of these facts to his wife impacts his ability to recover under either intentional tort is not a question for this court. We believe, however, that if the trial court determines that plaintiff was not a member of defendant church on [the date of the pastor’s disclosures] then plaintiff’s intentional tort claims should survive summary disposition.

The court affirmed the trial court’s dismissal of the plaintiff’s claims alleging breach of contract and a breach of a duty of confidentiality.

Relevance of the case to church leaders

What is the significance of this case to other churches? A decision by a Michigan state appeals court has limited effect. It is not binding in any other state, and is subject to reversal by the Michigan Supreme Court. Nevertheless, the case represents one of the few extended discussions of church discipline and the relevance of membership status. As a result, it may be given special consideration by other courts. For these reasons the case merits serious study by church leaders in every state. With these factors in mind, consider the following:

1. The discipline of church members is constitutionally protected. The discipline of church members (i.e., persons who have not withdrawn from membership) is a constitutionally protected right of churches. The court concluded that “disciplinary practices involving members of an ecclesiastical association, which do not pose a substantial threat to public safety, peace or order, are unquestionably among those hallowed first amendment rights with which the government cannot interfere.”

If discipline of church members is a possibility in your church, then you should adopt a disciplinary procedure that is based upon and refers to scriptural references. The procedure should specify the grounds for discipline, and describe the process that will be conducted. Avoid references to loaded phrases such as “due process,” which have no legal relevance in the context of church law and only create confusion.

2. No constitutional protection after a member resigns. Discipline of persons who have effectively withdrawn their church membership, or who were never members, is not a constitutionally protected activity, and churches that engage in such conduct can be sued under existing theories of tort law. The court in the Michigan case concluded that the church and pastor could be sued for emotional distress and invasion of privacy-if the trial court later determined that the plaintiff was not a member of the church on the day of the pastor’s disclosures.

3. No liability for breaching the “duty of confidentiality.” The court rejected the plaintiff’s argument that the pastor’s disclosures to the congregation amounted to a breach of the “duty of confidentiality.” The plaintiff insisted that the clergy-penitent privilege imposed upon clergy a “duty of confidentiality,” and that clergy who disclose confidences without permission may be sued for breaching this duty. The court disagreed, noting that the clergy-penitent privilege is a “rule of evidence that did not create a cause of action for disclosure of private or privileged communications.”

A few courts have found clergy liable for breaching a “duty of confidentiality.” But this case suggests that such a duty cannot be based on the clergy-penitent privilege. The effect of such a conclusion will be to make it more difficult to prove a duty of confidentiality. This case will be a useful precedent to clergy who are threatened with litigation over a disclosure of confidential information, to the extent that an alleged duty of confidentiality is based on the clergy-penitent privilege.

4. Breach of contract. The court rejected the plaintiff’s claim that he and his pastor and church had entered into “an express agreement regarding the confidentiality of the confessions” that was breached by the pastor’s public disclosures. The court concluded that no such agreement existed. Many churches have created “agreements” for persons to sign as a condition of receiving counseling services from a pastor or other church counselor. If your church has done so, you should carefully review your document for any assurances regarding confidentiality.

Example. A church requires persons to sign a document as a condition of counseling with the pastor. The document states that the counseling services provided by the church are religious in nature, rather than psychological; that statements shared in confidence with the pastor are protected by the clergy-penitent privilege; that statements shared in confidence with the pastor will be treated as confidential by the pastor, unless disclosure is legally mandated by the state child abuse reporting law. If the pastor discloses confidential information shared with him by a counselee, he (and the church) may be sued for breach of contract. Such a claim will be less likely to succeed, however, if the counselee was a member of the church at the time of the disclosure.

5. The importance of defining membership.The court in this case was unable to determine whether or not the plaintiff was a member of his church. Yet, this status was absolutely critical, since the ultimate outcome of the case depends entirely on this one issue. Unfortunately, the definition of “members” is ambiguous in many churches. For example, many churches have bylaws that limit the definition of members to those persons who regularly attend services and contribute to the support of the church. Such provisions are inherently ambiguous, and create uncertainty as to the definition of a “member”. Another example would be a church bylaw provision that limits membership to persons whose lives are consistent with the church’s moral and religious teachings. These provisions are worded in various ways, but the result is the same-the definition of “member” may be uncertain.

Church membership is an important status. Not only does it provide the church with substantial protection in disciplinary cases, but in most cases it also defines those persons who can vote at church membership meetings. It is a term that should be defined with precision.

Tip. Review the definition of “member” in your bylaws or other organizational documents. Is the definition ambiguous? If so, consider amending it.

6. Members have a right to resign. The Guinn case, referred to by the Michigan court, concluded that the right of a church member to withdraw from church membership is protected by the first amendment guaranty of religious freedom unless a member has waived that right. An effective waiver requires the voluntary relinquishment of a known right. In other words, a member can waive the right to resign by a voluntary and intentional act, but not through inadvertence or ignorance.

A church wishing to restrict the right of disciplined members to withdraw must obtain a voluntary and knowing waiver by present and prospective members of their constitutional right to withdraw. How can this be done? One approach would be for a church to adopt a provision in its bylaws preventing members from withdrawing if they are under discipline by the church. Obviously, the disciplinary procedure must be carefully specified in the church bylaws so there is no doubt whether the disciplinary process has been initiated with respect to a member. Most courts have held that members are “on notice” of all of the provisions in the church bylaws, and consent to be bound by them when they become members. As a result, the act of becoming a member of a church with such a provision in its bylaws may well constitute an effective waiver of a member’s right to withdraw (if the disciplinary process has begun). The problem in the Guinn case was that the church attempted to discipline the parishioner following her withdrawal. According to the court’s ruling, the church could have avoided liability by obtaining an effective waiver.

7. Communication of matters of “common interest” to members. While the Michigan court did not address the issue, other courts have ruled that church members have a right to know about matters in which they have a “common interest,” and that this right permits some disclosures to church members concerning the discipline or misconduct of current members. These courts generally conclude that statements by church leaders to church members concerning the discipline of current members are conditionally privileged-meaning that the disciplined member cannot successfully sue the church for making such disclosures unless the church acted maliciously (i.e., it either knew that the disclosures were false or made them with a reckless disregard as to their truthfulness). It must be emphasized that this privilege only protects disclosures made to church members about church members. Disclosures made to a congregation during a worship service in which non-members are present would not be protected. And, statements about former members are not protected (presumably, non-members would need to be removed from the sanctuary before statements regarding church discipline could be made).

Obviously, the safest course of action for a church board that has disciplined a member is to refrain from disclosing any information to the congregation. If the board decides that the congregation should be informed, then a general statement that the individual is “no longer a member” is the safest approach. If the board decides, for whatever reason, that it would like to share more details with the church, then it can reduce the risk of doing so in either of the following ways:

l. Letter to members. The church can send a letter to all active voting members informing them of the basis for the member’s discipline. The envelope, as well as the letter itself, should be marked “privileged and confidential.” The letter should inform members that the information is being shared only with members, and that the recipient should not disclose the information with anyone. The letter should only communicate factually verifiable information. The disadvantage of this approach is that it provides information to all members, including those with no interest in learning the basis for the discipline.

l. Membership meeting. The church board can call a membership meeting at which the basis for the member’s discipline is disclosed. This approach has the added benefit of being specifically mentioned in the disciplinary procedure set forth in Matthew 18, and so it is probably more insulated from judicial review. It is essential that procedures be established to ensure that only members are present at such a meeting. For example, the audience could all be seated on one side of the sanctuary, and as the membership roll is read each member moves to the other side. Nonmembers are excluded from the meeting. In addition, ushers should be posted to prevent nonmembers from entering the sanctuary after the meeting has begun, and no tape recording should be permitted. It would be desirable, though not essential, for the members to adopt a resolution agreeing to maintain the confidentiality of the information that will be shared. Such a resolution would be useful only if 100 percent of all members present vote to adopt it.

l. Specific response. The church could simply inform the congregation that the member has been disciplined, and that members wanting to learn more about the basis for the discipline are directed to the senior pastor for more information. The pastor can then ensure that persons coming to him for more information are members. This approach will result in the disclosure of the sensitive information to the fewest number of persons.

• Key point. A church should not disclose to its members any potentially damaging information about a disciplined member without first obtaining the counsel of a local attorney.

8. Arbitration. Churches wishing to reduce the risk of litigation by disciplined members (or any other members) should consider, in addition to the observations made above, the adoption of a binding arbitration policy. Such a policy, if adopted by the church membership at a congregational meeting as an amendment to the church’s bylaws, can force church members to resolve their disputes (with the church, pastor, board, or other members) within the church consistently with the pattern suggested by the apostle Paul in 1 Corinthians 6:1-8. While a discussion of arbitration policies is beyond the scope of this text, churches should recognize that arbitration is an increasingly popular means of resolving disputes in the secular world since it often avoids the excessive costs and delays associated with civil litigation and the uncertainty of jury verdicts. Of course, any arbitration policy should be reviewed by an attorney and the church’s liability insurer before being implemented. A legally effective and properly adopted arbitration policy can force disgruntled members to take their complaints to a panel of church representatives rather than create a costly and protracted spectacle in the secular courts. Such an approach, at a minimum, merits serious consideration by any church.

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

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How to handle the tax consequences of the return of excess funds.

Richard R. Hammar

Background. It occasionally happens. A church treasurer pays an employee more than the salary authorized by the church board. In most cases, this is due to an innocent mistake. But what happens if the treasurer and employee later discover the mistake, and attempt to correct it? Can the employee “give back” the excess to the church? And what if the mistake is discovered in the following year? How does a return of the excess affect the employee’s taxable income, and the church’s payroll reporting obligations? The IRS addressed these questions in a recent publication.

What the IRS said. Here are the tax consequences for employees who return to their employer in “year 2” excess salary received in “year 1”:

* The employer does not reduce the employee’s wages for FICA and federal income tax withholding purposes for year 2.

* The employer does not reduce the employee’s taxable income for year 1, or reduce the amount of income taxes withheld in that year.

* The repayment in year 2 of excess salary received in year 1 has no effect on the Form W-2 for year 2. The employer should furnish the employee a separate receipt acknowledging the repayment for the employee’s records.

* To the extent additional FICA taxes were paid in year 1 because of the erroneous salary payment, the repayment of the excess salary in year 2 creates an overpayment of FICA taxes in year 1, and credit may be claimed by the employer with respect to its FICA tax liability for that prior year.

* The employee may claim in year 2 a miscellaneous itemized deduction on Schedule A in the amount of the excess salary that was repaid.

* To the extent repayments in year 2 of erroneous salary paid in year 1 result in a reduced amount of social security (and Medicare) wages for year 1 and reduced amounts of employee social security (and Medicare) taxes paid for that year, the employer is required to furnish corrected Forms W-2 for year 1 showing the employee’s corrected “social security wages,” corrected “social security tax withheld,” corrected “Medicare wages and tips,” and corrected “Medicare tax withheld.” No changes should be made in the entries for “Wages, tips, other compensation” (Box 1 of Form W-2) or for “Federal income tax withheld” (Box 2 of Form W-2). SCA 1998-026.

This article originally appeared in Church Treasurer Alert, March 1999.

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

Works Made for Hire

Legal implications of works created by a church employee.

Richard R. Hammar, Attorney, CPA

Bio

Background. It is common for church employees to compose music or write books or articles in their church office during office hours. What is often not understood is that such persons do not necessarily own the copyright in the works they create. While the one who creates a work generally is its author and the initial owner of the copyright in the work, section 201(b) of the Copyright Act specifies that “[i]n the case of a work made for hire, the employer or other person for whom the work was prepared is considered the author … and, unless the parties have expressly agreed otherwise in a written instrument signed by them, owns all of the rights comprised in the copyright.”

The copyright law defines “work made for hire” as “a work prepared by an employee within the scope of his or her employment.” There are two requirements that must be met: (1) the person creating the work is an employee, and (2) the employee created the work within the scope of his or her employment. Whether or not one is an employee will depend on the same factors used in determining whether one is an employee or self-employed for federal income tax reporting purposes (see chapter 2 of Richard Hammar’s Church & Clergy Tax Guide). However, the courts have been very liberal in finding employee status in this context, so it is possible that a court would conclude that a work is a work made for hire even though the author reports his or her federal income taxes as a self-employed person.

The second requirement is that the work must have been created within the scope of employment. This requirement generally means that the work was created during regular working hours, on the employer’s premises, using the employer’s staff and equipment. This is often a difficult standard to apply. As a result, it is desirable for church employees to discuss this issue with the church leadership to avoid any potential misunderstandings. Section 201(a), quoted above, allows an employer and employee to agree in writing that copyright ownership in works created by the employee within the scope of employment belongs to the employee. This should be a matter for consideration by any church having a minister or other staff member who creates literary or musical works during office hours, on church premises, using church staff and church equipment (e.g., computers, printers, paper, library, secretaries, dictation equipment).

Example. Rev. B is senior minister of his church. He is in the process of writing a devotional book. Most of the writing is done during regular church office hours, in his office in the church, using church equipment and a church secretary. Rev. B’s contract of employment does not address the issue of copyright ownership in the book, and no written agreement has ever been executed by the church that addresses the matter. Under these facts, it is likely that the book is a “work made for hire.” The result is that the church is the “author” of the book, it is the copyright owner, and it has the sole legal right to assign or transfer the copyright in the book.

Example. Rev. T is minister of music at her church. She has composed several songs and choruses, all of which were written during regular office hours at the church, using church equipment (piano, paper, etc.). The church has never addressed the issue of copyright ownership in a signed writing. It is likely that the songs and choruses are “works made for hire.” The result is that the church is the “author” of these materials, it is the copyright owner, and it has the sole legal right to assign or transfer the copyright in these works.

Example. Same facts as the preceding example, except that Rev. T composes the music in the evening and on weekends in her home. While she is an employee, she did not compose the music “within the scope of her employment,” and therefore the music cannot be characterized as “works made for hire.” The legal effect of this conclusion is that Rev. W owns the copyright in the music, and is free to sell or transfer such works in any manner she chooses without church approval.

Example. Same facts as the previous example, except that Rev. T composes many of her works both at home and at the church office. Whether or not a particular work is a work made for hire is a difficult question under these circumstances. The answer will depend upon the following factors: (1) the portion of the work that is composed at the church office, compared to the portion composed at home; (2) the portion of the work created with church equipment, compared to the portion created with Rev. T’s personal equipment; (3) the portion of the work created during regular office hours, compared to the portion created after hours; and (4) the adequacy of Rev. T’s personal records to document each of these factors. Unfortunately, a staff member’s records may be inadequate. In such a case, work made for hire status will depend upon the staff member’s own testimony, and the testimony of other witnesses (such as other staff members).

A second concern—the church’s tax-exempt status. If a church transfers the copyright in a work made for hire to an employee, this may be viewed by the IRS as “private inurement” of the church’s resources to an individual. If so, this could jeopardize the church’s tax-exempt status. Neither the IRS nor any court has addressed the tax consequences of such an arrangement to a church. Here are some options:

1. The church transfers copyright ownership to the staff member. This may constitute private inurement. The IRS construes this requirement as follows:

An organization’s trustees, officers, members, founders, or contributors may not, by reason of their position, acquire any of its funds. They may, of course, receive reasonable compensation for goods or services or other expenditures in furtherance of exempt purposes. If funds are diverted from exempt purposes to private purposes, however, exemption is in jeopardy. The Code specifically forbids the inurement of earnings to the benefit of private shareholders or individuals …. The prohibition of inurement, in its simplest terms, means that a private shareholder or individual cannot pocket the organization’s funds except as reasonable payment for goods or services.

When a church employee writes a book during office hours at the church, using church equipment, supplies, and personnel, the copyright in the work belongs to the church. If the church chooses to renounce its legal rights in the book, and transfers the copyright back to the employee, then it is relinquishing a potentially valuable asset that may produce royalty income for several years. Few if any churches would attempt to “value” the copyright and report it as additional taxable compensation to the employee, and as a result it is hard to avoid the conclusion that such arrangements result in inurement of the church’s assets to a private individual. The legal effect is to jeopardize the church’s tax-exempt status. This risk must not be overstated, since only a few churches have had their exempt status revoked by the IRS in the last fifty years, and none because of a transfer of copyright to an employee who created a work made for hire. But the consequences would be so undesirable that the risk should be taken seriously.

2. The church retains the copyright. The risk of inurement can be minimized if not avoided if the church retains the copyright in works made for hire, and pays a “bonus” or some other form of compensation to the author.

Example. Rev. G is senior pastor of his church. He writes a devotional book in his office at the church during office hours and using church equipment. He reads an article about works made for hire, and is concerned about the legal implications. He discusses the matter with the church board. In order to eliminate any risk to the church’s tax-exempt status, the church board decides that the church will retain the copyright in Rev. G’s book. The publisher is contacted, and agrees to list the church as the copyright owner on the title page and to pay royalties from sales of the book directly to the church. The church board agrees to pay Rev. T a “bonus” in consideration of his additional services in writing the book. The bonus is added to Rev. T’s W-2 at the end of the year. This arrangement will not jeopardize the church’s tax-exempt status.

3. The church urges employees to do “outside work” at home. Do you have a writer or composer on staff at your church? If so, it is possible that this person is doing some writing or composing on church premises, using church equipment, during office hours. One way to avoid the problems associated with work made for hire status is to encourage staff members to do all their writing and composing at home. Tell staff members that (1) if they do any writing or composing at church during office hours, their works may be works made for hire; (2) the church owns the copyright in such works; and (3) the church can transfer copyright to the writer or composer, but this may constitute “inurement” of the church’s assets to a private individual, jeopardizing the church’s tax-exempt status. By urging staff members to do all their personal writing and composing at home, the church also will avoid the difficult question of whether works that are written partly at home and partly at the office are works made for hire.

4. Sermons. Are a minister’s sermons “works made for hire” that are owned by the employing church? To the extent that sermons are written in a church office, during regular church hours, using church secretaries and equipment, it is possible that sermons would be considered works made for hire. However, this issue has never been addressed directly by any court, and so it is difficult to predict how a court would rule. A professor’s lecture notes provide a comparable example. College professors often prepare their lecture notes in their office on campus, using campus equipment. Are these notes, and the lectures themselves, works made for hire? If so, the college owns the copyright in the notes and lectures, unless it has transferred the copyright back to the professor in a signed writing. One court has ruled that a professor’s lectures were not works made for hire, and did not belong to the university. Williams v. Weisser, 78 Cal. Rptr. 542 (1969). This case certainly can be used to support the position that a minister’s sermons are not works made for hire.

A third concern—excessive compensation. Staff members who retain ownership of a work made for hire because of a written transfer signed by the church may be subject to intermediate sanctions. Intermediate sanctions are excise taxes the IRS can assess against persons who receive excessive compensation from a church or other charity. The point is this—since the church is the legal owner of the copyright in a work made for hire, it is legally entitled to any income generated from sales of the work. By letting the writer or composer retain the copyright, and all rights to royalties, the church in effect is paying compensation to him or her in this amount. If the work generates substantial income, then this may trigger intermediate sanctions. This would expose the writer or composer to an initial excise tax of 25 percent of the amount of taxable compensation that exceeds what the IRS deems to be reasonable. There is an additional 200 percent tax that can be assessed against the writer or composer if he or she does not return the excess amount to the church. Board members who authorized a transfer of the copyright to the writer or composer may be collectively assessed a tax of 10 percent of the excessive compensation up to a maximum of $10,000.

Key point. Intermediate sanctions can be imposed only against “disqualified persons” and “managers.” IRS regulations define a disqualified person as any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the five-year period ending on the date of the transaction. While a senior pastor ordinarily will meet this definition, other staff members may not. As a result, in many churches the risk of intermediate sanctions will be limited to senior pastors who create works made for hire and are allowed by their church to retain the copyright.

Key point. Church board members are exposed to an excise tax if they authorize a transfer of copyright in a work made for hire to the employee who created it, if the work generates substantial income.

Checklist of important points. Here are the points to keep in mind:

a “work made for hire” is any book, article, or piece of music created by an employee in the course of employment
a work is created in the course of employment if it is written or composed during office hours, on church property, using church equipment
the employer owns the copyright in a work made for hire
an employer, by a signed writing, can transfer copyright in a work made for hire to the employee who created it
a church that transfers the copyright in a work made for hire to the employee who created it is jeopardizing its tax-exempt status, since this may constitute “inurement” of its assets to a private individual
a church that transfers the copyright in a work made for hire to the employee who created it may be exposing the employee to intermediate sanctions
sermons may not constitute a work made for hire, even if they are created in the course of employment

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

Payroll Deduction IRAs

An option for churches with no retirement plan.

Richard R. Hammar, Attorney, CPA

Bio

IRS Announcement 99-2

Some ministers and lay church staff members are not eligible to participate in a church or denominational pension plan. This may be because the employing church has never established such a plan, and is not affiliated with a denomination that has done so. Perhaps your church does not offer a retirement plan to staff members, and no denominational plan is available, but you would like to do something to assist with retirement savings. A number of options are available. One was the subject of a recent IRS announcement—a payroll deduction IRA.

In the Conference Report to the Taxpayer Relief Act of 1997, Congress indicated that “employers that choose not to sponsor a retirement plan should be encouraged to set up a payroll deduction system to help employees save for retirement by making payroll deduction contributions to their IRAs.” Congress encouraged the IRS to “continue its efforts to publicize the availability of these payroll deduction IRAs.”

The IRS responded in a recent announcement in which it reminded employers “that are not currently in a position to sponsor a retirement plan” that

the introduction of Roth IRAs in 1998 presents an additional opportunity to facilitate employee retirement savings. As with traditional IRAs, amounts accumulated under Roth IRAs are exempt from federal income tax, and contributions to Roth IRAs are subject to specific limitations. Unlike traditional IRAs, Roth IRA contributions cannot be deducted from gross income, but qualified distributions from Roth IRAs are excludable from gross income ….

The IRS further informed employers that they can allow employees to contribute to traditional or Roth IRAs by direct deposit though payroll deduction. In addition, the IRS noted that employees making direct deposits of deductible contributions to traditional IRAs may be able to adjust their federal income tax withholding on account of these contributions. By adjusting their withholding, employees may not have to wait until they file their tax return to get the benefit of the tax deduction for their contributions. Employees can review the instructions on IRS Form W-4 (Employee’s Withholding Allowance Certificate) and the worksheet on the back of that form to see if they are eligible for this withholding adjustment.

The IRS concluded: “Many employers permit their employees to directly deposit all or a portion of their paychecks into checking or savings accounts maintained by financial institutions. Employers may also assist their employees in saving for retirement by means of direct deposit through payroll deduction to IRAs.”

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

Giving the IRS a Check that Bounces

Recent case highlights legal implications of bouncing checks to the IRS.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

Giving the IRS a Check that Bounces

Recent case highlights legal implications of bouncing checks to the IRS.

Richard R. Hammar

Background. It can happen to anyone. You write a check to the IRS for your year-end tax liability, and your checking account does not have enough funds to cover the check. You may have intended to transfer funds to your checking account, but did not do so quickly enough. Or, you may have mistakenly believed there were sufficient funds to cover the check. What are the consequences in such a case? A recent Tax Court case provides the answer. The case involved a taxpayer who wrote a check to the IRS for a tax liability, but had the check returned due to insufficient funds. The IRS assessed the taxpayer a “dishonored check penalty.”

Section 6657 of the tax code gives the IRS the authority to assess a penalty against any taxpayer who issues the IRS a check that is not paid. For checks of $750 or more, the penalty is 2 percent of the amount of the check. For checks under $750, the penalty is the lesser of $15 or the amount of the check. The penalty can be waived if a taxpayer “tendered such check in good faith and with reasonable cause to believe that it would be duly paid.”

The taxpayer who issued the IRS the bad check was assessed a penalty of $10,000. He insisted that he was entitled to the “good faith” defense, on two grounds. First, while his checking account did not have enough funds to cover the check in question, his savings account did, and it was the bank’s responsibility to transfer funds from the savings account to cover the IRS check. Second, he claimed that his accountant assured him that it would take about 14 days for the check to the IRS to clear.

The taxpayer appealed the IRS-imposed penalty to a federal court. On appeal, the IRS noted that it was undisputed that the taxpayer did not have sufficient funds in his account when he wrote the check to the IRS, and therefore his actions could not be construed as reasonable. Waiting until the last minute to transfer sufficient funds to cover a check is not reasonable, the IRS insisted. The court agreed, noting that “writing checks out of accounts containing insufficient funds cannot be considered ordinary business care and prudence.”

The court rejected the taxpayer’s claim that the bank should have notified him that there were insufficient funds in his checking account to cover the IRS check. It noted that reliance upon a bank’s notification policy, especially when the taxpayer intends to wait until after notification to transfer funds to cover the check, “cannot be considered ordinary business care and prudence.”

The court also rejected the taxpayer’s claim that his reliance on his accountant’s advice (that checks to the IRS do not clear for about 14 days) qualified him for the “reasonable cause” defense to the dishonored check penalty. The court pointed out that the IRS did not deposit the check for 19 days, and that even at this late date the taxpayer’s accountant failed to contain sufficient funds. The court pointed out that “forgiveness of penalty assessments levied against taxpayers who write checks with insufficient funds planning to cover the checks at the last minute before the IRS deposits them, would only encourage this type of behavior in the future.”

What is the significance of this case to church leaders? Note the following:

1. You may be liable for a dishonored check penalty in the event that a check to the IRS is returned due to insufficient funds. This is in addition to interest and penalties that may also apply.

2. Do not assume that the penalty can be avoided because your bank failed to notify you that your checking account did not have sufficient funds to cover the check to the IRS, or failed to transfer funds from your savings account to cover the check. Neither may constitute “reasonable cause.”

3. A church that sends checks to the IRS to cover payroll or other tax liabilities is subject to the same penalties. Gregory v. United States, 97-2 USTC para. 50,741 (D. Mich. 1997).

This article originally appeared in Church Treasurer Alert, January 1999.

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

When Is Compensation Too Much? New IRS Regulations Address “Intermediate Sanctions”

The IRS has issued long-awaited regulations addressing “intermediate sanctions.”

Richard R. Hammar, Attorney, CPA

Bio

Church Law and Tax 1998-11-01

When Is Compensation Too Much?

New IRS Regulations Address “Intermediate Sanctions”

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

Article summary. The IRS has issued long—awaited regulations addressing “intermediate sanctions.” Intermediate sanctions refer to excise taxes that the IRS can assess against any officer or director of a tax—exempt organization (including churches and other religious organizations) who receives excessive compensation. It is very important for clergy and church board members to understand intermediate sanctions in order to avoid the substantial excise taxes that the IRS can impose upon the recipients of excessive compensation (and the board members who approved it). This article will review the background of these new sanctions, summarize the new regulations, and address the impact of intermediate sanctions on church leaders.

Background

The Taxpayer Bill of Rights 2 (TBOR2), enacted by Congress in 1996, contained a provision allowing the IRS to assess “intermediate sanctions” (an excise tax) against “disqualified persons” in lieu of outright revocation of an organization’s exempt status. The intermediate sanctions may be assessed only in cases of “excess benefit transactions,” meaning one or more transactions that provide unreasonable compensation to an officer or director of the exempt organization. An excess benefit transaction is defined as:

any transaction in which an economic benefit is provided to a “disqualified person” (someone in a position to exercise substantial influence over the affairs of the organization) if the value of the benefit exceeds the value of the services provided by the disqualified person, or

to the extent provided in IRS regulations, any transaction in which the amount of an economic benefit provided to a disqualified person is based on the revenues of the organization, if the transaction results in unreasonable compensation being paid

• Key point. Senior ministers ordinarily will be disqualified persons, since they are in a position to exercise substantial influence over the affairs of their church. This means that they are subject to intermediate sanctions if they receive excessive compensation.

The payment of personal expenses and benefits to or for the benefit of disqualified persons, and non—fair—market—value transactions benefiting such persons, would be treated as compensation only if it is clear that the organization intended and made the payments as compensation for services. In determining whether such payments or transactions are, in fact, compensation, the relevant factors include whether the appropriate decision—making body approved the transfer as compensation in accordance with established procedures and whether the organization and the recipient reported the transfer (except in the case of nontaxable fringe benefits) as compensation on the relevant forms (i.e., the organization’s Form 990, the Form W—2 or Form 1099 provided by the organization to the recipient, the recipient’s Form 1040, and other required returns).

The presumption of reasonableness

A committee report to TBOR2 clarified that the parties to a transaction are entitled to rely on a presumption of reasonableness with respect to a compensation arrangement with a disqualified person if such arrangement was approved by a board of directors (or committee of the board) that: (1) was composed entirely of individuals unrelated to and not subject to the control of the disqualified person involved in the arrangement; (2) obtained and relied upon objective “comparability” information, such as (a) compensation paid by similar organizations, both taxable and tax—exempt, for comparable positions, (b) independent compensation surveys by nationally recognized independent firms, or (c) actual written offers from similar institutions competing for the services of the disqualified person; and (3) adequately documented the basis for its decision.

• Key point. The new law creates a presumption that a minister’s compensation package is reasonable if approved by a church board that relied upon objective “comparability” information, including independent compensation surveys by nationally recognized independent firms. The most comprehensive compensation survey for church workers is the annual Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and available from the publisher of this newsletter.

A similar presumption arises with respect to the reasonableness of the valuation of property sold by an organization to a disqualified person if the sale is approved by an independent board that uses appropriate comparability data and adequately documents its determination.

Penalties

The intermediate sanctions that the IRS can impose, in lieu of revocation of a charity’ exempt status, include the following:

1. Tax on disqualified persons. A disqualified person who benefits from an excess benefit transaction is subject to a penalty tax equal to 25% of the amount of the “excess benefit” (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is paid by the disqualified person directly, not his or her employer.

2. Additional tax on disqualified persons. If the 25% excise tax is assessed against a disqualified person, and he or she fails to “correct” the excess benefit within the “taxable period,” the IRS can assess an additional tax of 200% of the excess benefit. The new law states that the disqualified person can “correct” the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The “correction” must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25% tax, or the date the 25% tax is actually assessed.

3. Tax on organization managers. If the IRS assesses the 25% tax against a disqualified person, it is permitted by the new law to impose an additional 10% tax on any “organization manager” (any officer, director, or trustee) who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.” This tax is limited to a maximum of $10,000 per manager.

• Key point. Intermediate sanctions apply to excess benefit transactions occurring on or after September 14, 1995.

• Key point. In 1997 the IRS provided the following clarification: (1) the IRS will impose intermediate sanctions only in extreme cases meeting a “front page test”; (2) the new sanctions were intended to change the behavior of nonprofit boards by encouraging them to take seriously the task of establishing compensation packages; (3) nonprofit boards are encouraged to maintain records documenting how they determined the compensation of higher paid employees; and (4) intermediate sanctions will result in an estimated $33 million of excise taxes over the next five years.

• Example. Many years ago, a church board adopted a resolution agreeing to pay its pastor “one—half of all revenues.” For the first several years, this formula resulted in modest compensation. But in recent years, the church has grown and the compensation paid to the pastor has increased dramatically. In 1997 the church received revenues of $500,000 and paid its pastor $250,000. How would the new law apply to this situation? Consider the following: (1) The level of compensation paid to the pastor is almost certainly unreasonable. As a result, it is possible that the IRS, if it learns of the amount of compensation paid by the church to its pastor, will revoke the church’s exempt status. This would have very negative consequences to the pastor, the church, and its membership. (2) Under the new law, the IRS has the option of applying “intermediate sanctions” against the church in lieu of outright revocation of its exempt status, if it establishes that the pastor is a “disqualified person” who was paid benefits in excess of the fair market value of his services. Sanctions available to the IRS include: (a) An excise tax of 25% of the amount of the pastor’s compensation that exceeds the fair market value of his services. If the IRS concludes that the maximum reasonable compensation under these circumstances would be $100,000, then the pastor was paid an “excess benefit” of $150,000, and the excise tax would be $37,500 for 1997 (25% x $150,000). This tax is paid by the pastor directly, not the church. (b) If the 25% excise tax is assessed against the pastor, and he fails to “correct” the excess benefit within the “taxable period,” the IRS can assess an additional tax of 200% of the excess benefit. In this case, this would amount to an additional $300,000! The new law states that the pastor can “correct” the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The “correction” must occur by the earlier of the date the IRS mails a notice informing the pastor that he owes the 25% tax, or the date the 25% tax is actually assessed. (3) If the IRS assesses the 25% tax against the pastor, it is permitted by the new law to impose an additional 10% tax on any “organization manager” (any officer, director, or trustee) who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.”

• Example. A small rural church with total income of $20,000 in 1998 pays its pastor “75% of gross income.” It is doubtful that this arrangement will trigger intermediate sanctions, even though compensation is based on a percentage of church income, since the resulting compensation paid to the pastor is minimal.

• Example. A pastor retires in 1998 after serving for 30 years in the same church. The church board authorizes a retirement gift of $100,000. Assume that the pastor also receives a salary of $50,000 for 1998. Assume that the IRS determines that the maximum “reasonable compensation” for this pastor for 1998 would be $100,000. This may expose the pastor to intermediate sanctions, beginning with a 25% excise tax applied to the amount of the pastor’s total compensation for 1998 that exceeds what the IRS has determined to be “reasonable.” This would yield a tax of $12,500 (25% x $50,000). If the excess compensation ($50,000) is not refunded to the church by the time the 25% tax is assessed, then the pastor can be assessed an additional excise tax of 200% times the amount of the excess compensation (for a total tax of $100,000). This is in addition to the 25% tax. In addition, members of the board may be assessed a tax in the amount of 10% times the excess compensation amount (or $5,000). The threat of intermediate sanctions could be reduced or eliminated under these circumstances if the board distributed the retirement gift over more than one year, so that the total compensation received by the pastor in any one year is reduced below what the IRS might consider to be unreasonable or excessive. Any such multi—year arrangement must avoid the “constructive receipt” rule, which is described in chapter 4 of Richard Hammar’s Church and Clergy Tax Guide.

• Example. A pastor lives in a church—owned parsonage for 25 years. The parsonage has a current value of $100,000, and is debt—free. The church board authorizes a gift of the parsonage to the pastor. This transaction may trigger intermediate sanctions. The analysis in the previous example should be reviewed.

The new IRS regulations

The new IRS regulations provide clarification on a number of important questions. Here is a run—down of the key provisions:

Application to churches

Can intermediate sanctions be applied to church employees and church “managers”? The regulations confirm that intermediate sanctions apply to churches. However, a special rule applies-the regulations specify that the procedures of the “Church Audit Procedures Act” will be used “in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and a disqualified person. The Church Audit Procedures Act imposes detailed limitations on IRS examinations of churches. The limitations can be summarized as follows:

Church tax inquiries

The IRS may begin a church tax inquiry only if

(a) an appropriate high—level Treasury official (defined as a regional IRS commissioner or higher official) reasonably believes on the basis of written evidence that an intermediate sanctions excise tax is due from a disqualified person with respect to a transaction involving a church, and

(b) the IRS sends the church a written inquiry notice that explains (1) the specific concerns which gave rise to the inquiry, (2) the general subject matter of the inquiry, and (3) the provisions of the Internal Revenue Code that authorize the inquiry and the applicable administrative and constitutional provisions, including the right to an informal conference with the IRS before any examination of church records, and the first amendment principle of separation of church and state.

Church tax examinations

The IRS may begin a church tax examination of the church records or religious activities of a church only under the following conditions:

(a) the requirements of a church tax inquiry have been met, and

(b) an examination notice is sent by the IRS to the church at least fifteen days after the day on which the inquiry notice was sent, and at least fifteen days before the beginning of such an examination, containing the following information: (1) a copy of the inquiry notice, (2) a specific description of the church records and religious activities which the IRS seeks to examine, (3) an offer to conduct an informal conference with the church to discuss and possibly resolve the concerns giving rise to the examination, and (4) a copy of all documents collected or prepared by the IRS for use in the examination and the disclosure of which is required by the Freedom of Information Act.

Church records

Church records (defined as all corporate and financial records regularly kept by a church, including corporate minute books and lists of members and contributors) may be examined only to the extent necessary to determine the liability for and amount of any income, employment, or excise tax (including the excise taxes associated with intermediate sanctions).

Deadline for completing church tax inquiries

Church tax inquiries not followed by an examination notice must be completed not later than ninety days after the inquiry notice date. Church tax inquiries and church tax examinations must be completed not later than two years after the examination notice date.

Written opinion of IRS legal counsel

The IRS can make a determination based on a church tax inquiry or church tax examination that an excise tax is owed only if the appropriate regional legal counsel of the IRS determines in writing that there has been substantial compliance with the limitations imposed by the Church Audit Procedures Act and approves in writing of such assessment of tax.

Statute of limitations

Church tax examinations involving the liability for any tax may be begun only for any one or more of the three most recent taxable years ending before the examination notice date.

Limitation on repeat inquiries and examinations

If any church tax inquiry or church tax examination is completed and does not result in an assessment of taxes, then no other church tax inquiry or church tax examination may begin with respect to that church during the five—year period beginning on the examination notice date (or the inquiry notice date if no examination notice was sent) unless such inquiry or examination is (a) approved in writing by the Assistant Commissioner of Employee Plans and Exempt Organizations of the IRS, or (b) does not involve the same or similar issues addressed in the prior inquiry or examination.

• Example. A local IRS office suspects that Rev. A is receiving excessive compensation from First Church. It sends the church an inquiry notice in which the only explanation of the concerns giving rise to the inquiry is a statement that “you may be involved in an excess benefit transaction.” This inquiry notice is defective since the Church Audit Procedures Act requires that such a notice explain (1) the specific concerns which gave rise to the inquiry, (2) the general subject matter of the inquiry, and (3) the provisions of the Internal Revenue Code that authorize the inquiry and the applicable administrative and constitutional provisions, including the right to an informal conference with the IRS before any examination of church records, and the first amendment principle of separation of church and state. Further, an inquiry notice may not be issued unless a regional IRS commissioner (or higher official) authorizes it.

• Example. The IRS receives a telephone tip from a disgruntled church member who claims that her church is paying excessive compensation to her senior pastor. A telephone tip cannot serve as the basis for a church tax inquiry since such an inquiry may commence only if an appropriate high—level Treasury official reasonably believes on the basis of written evidence that a church is not tax—exempt, is carrying on an unrelated trade or business, or otherwise is engaged in activities subject to taxation.

• Example. An IRS inquiry notice does not mention the possible application of the first amendment principle of separation of church and state to church tax inquiries. Such a notice is defective. However, a church’s only remedy is a stay of the inquiry until the IRS sends a valid inquiry notice.

• Example. In 1998, the IRS conducts an examination of the tax—exempt status of First Church. It concludes that the church was properly exempt from federal income taxation. In 1999, the IRS commences an examination of First Church to determine if its managers authorized the payment of excessive compensation to their senior pastor. Such an examination is not barred by the prohibition against repeated examinations within a five—year period, since it does not involve the same or similar issues.

• Need more information? The Church Audit Procedures Act is explained fully in Richard Hammar’s book, Pastor, Church & Law (2nd ed. 1992). While this text is currently out—of—print, the full text (along with all back issues of this newsletter) is available on our Online Legal and Tax Library. You may become a member directly online at www.iclonline.com. Select the link Become a library member under the Church Law & Tax Report heading on the home page.

“Correcting” an excess benefit transaction

The intermediate sanctions law specifies that a disqualified person who receives excess compensation is subject to an excise tax equal to 25% of the amount of compensation in excess of a reasonable amount. Further, if the excess benefit is not “corrected,” the disqualified person is liable for a tax of 200% of the excess benefit. The correction must occur before the earlier of (1) the date the IRS mailed a “notice of deficiency” for the 25% tax, or (2) the date on which the 25% tax is assessed.

How can a disqualified person “correct” an excess benefit transaction? The regulations answer this question as follows:

Correction means, with respect to any excess benefit transaction, undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards. Correction of the excess benefit occurs if the disqualified person repays the applicable tax—exempt organization an amount of money equal to the excess benefit, plus any additional amount needed to compensate the organization for the loss of the use of the money or other property during the period commencing on the date of the excess benefit transaction and ending on the date the excess benefit is corrected. Correction may also be accomplished, in certain circumstances, by returning property to the organization and taking any additional steps necessary to make the organization whole. If the excess benefit transaction consists of the payment of compensation for services under a contract that has not been completed, termination of the employment or independent contractor relationship between the organization and the disqualified person is not required in order to correct. However, the terms of any ongoing compensation arrangement may need to be modified to avoid future excess benefit transactions.

• Example. A church pays its pastor a salary that the board later determines to have resulted in an excess benefit of $100,000. The board persuades the pastor to “correct” the arrangement by returning the excess amount to the church. This is not enough to “correct” the excess benefit transaction, and so the pastor is exposed to the 200% excise tax ($200,000). The regulations clarify that a “correction” involves more than a return of the excess benefit. The recipient of the excess benefit must repay the church or other tax—exempt organization “an amount of money equal to the excess benefit, plus any additional amount needed to compensate the organization for the loss of the use of the money or other property during the period commencing on the date of the excess benefit transaction and ending on the date the excess benefit is corrected.” In this example, this means that the pastor must pay the church an amount sufficient to compensate it for the earnings it would have received on the excess amount had it not been paid to the pastor.

Tax on managers

“Managers” who approve an excess benefit transaction are subject to an excise tax equal to 10% of the amount of the excess benefit-up to a maximum of $10,000. The new regulations provide the following clarifications:

Manager defined

The regulations define a manager of a church or other tax—exempt organization as

any officer, director, or trustee of such organization, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization, regardless of title. A person shall be considered an officer of an organization if-(A) that person is specifically so designated under the certificate of incorporation, by—laws, or other constitutive documents of the organization; or (B) that person regularly exercises general authority to make administrative or policy decisions on behalf of the organization. Independent contractors, acting in a capacity as attorneys, accountants, and investment managers and advisors, are not officers. Any person who has authority merely to recommend particular administrative or policy decisions, but not to implement them without approval of a superior, is not an officer.

• Example. A church purchases land as the site of a future building. Before signing the contract of sale, the church obtained written assurance from the seller that there were no known environmental hazards on the property. In fact, the seller was aware that it had dumped hazardous materials on a portion of the property. The church sued the former owner for fraud and won a judgment of $1 million. The attorney retained by the church had taken the case on a “contingency fee” basis, meaning that her compensation was one—third of any amount she recovered. According to the regulations, the attorney is not a “manager” since she was an independent contractor acting on behalf of the church. And, as we will see later, she is not a disqualified person, and so she will not be subject to intermediate sanctions.

• Tip. Many church board members will meet the regulations’ definition of a manager.

Participation

A manager must participate in the decision to pay excessive compensation to a disqualified person in order to be subject to the 10% excise tax. What is participation? The new regulations specify that

participation includes silence or inaction on the part of an organization manager where the manager is under a duty to speak or act, as well as any affirmative action by such manager. However, an organization manager will not be considered to have participated in an excess benefit transaction where the manager has opposed such transaction in a manner consistent with the fulfillment of the manager’s responsibilities to the applicable tax—exempt organization.

Knowing

A manager’s participation in an excess benefit transaction must be “knowing” in order for the 10% excise tax to apply. The regulations specify that

a person participates in a transaction knowing that it is an excess benefit transaction only if the person-(A) has actual knowledge of sufficient facts so that, based solely upon such facts, such transaction would be an excess benefit transaction; (B) is aware that such an act under these circumstances may violate the provisions of federal tax law governing excess benefit transactions; and (C) negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction, or the person is in fact aware that it is such a transaction.

• Key point. The regulations clarify that “knowing” does not mean having reason to know. Actual knowledge is required. However, evidence tending to show that a person has reason to know of a particular fact or rule is relevant in determining whether the person had actual knowledge of the fact or rule. So, for example, evidence tending to show that a person has reason to know of an excess benefit transaction is relevant in determining whether the person has actual knowledge of it.

Willful

A manager’s participation in an excess benefit transaction must be “willful” in order for the 10% excise tax to apply. The regulations clarify that

participation by an organization manager is willful if it is voluntary, conscious, and intentional. No motive to avoid the restrictions of the law or the incurrence of any tax is necessary to make the participation willful. However, participation by an organization manager is not willful if the manager does not know that the transaction in which the manager is participating is an excess benefit transaction.

Advice of counsel

The regulations specify:

If a person, after full disclosure of the [facts] to legal counsel (including in—house counsel) relies on the advice of such counsel expressed in a reasoned written legal opinion that a transaction is not an excess benefit transaction, the person’s participation in such transaction will ordinarily not be considered knowing or willful … even if such transaction is subsequently held to be an excess benefit transaction …. [A] written legal opinion is reasoned so long as the opinion addresses itself to the facts and applicable law. However, a written legal opinion is not reasoned if it does nothing more than recite the facts and express a conclusion. The absence of advice of counsel with respect to an act shall not, by itself, however, give rise to any inference that a person participated in such act knowingly, willfully, or without reasonable cause.

Limit on manager liability

The new regulations clarify that the tax that must be paid by participating managers for any one excess benefit transaction cannot exceed $10,000.

• Example. A church board gives a retiring pastor the church parsonage (having a value of $150,000). The board members later learn about intermediate sanctions, and are concerned that they may each be liable for up to $10,000 as managers. The new regulations clarify that the board members will not individually be liable for the 10% excise tax (up to $10,000). Rather, they will collectively be liable for an excise tax (as managers) of 10% of the amount of the excess benefit up to a maximum tax of $10,000. The total tax assessed for this single transaction will be allocated to the board members who participated in the decision.

Who is a “disqualified person”?

Since intermediate sanctions apply only to disqualified persons (and managers of tax—exempt organizations that approve an excess benefit transaction), it is important for church leaders to be familiar with this term. The new regulations provide helpful guidance, as noted below.

General definition

The regulations define a disqualified person as

any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the five—year period ending on the date of the transaction.

Family members

The regulations clarify that some persons will be disqualified persons because of their relationship with a disqualified person. These include a spouse; brother or sister (by whole or half blood); a spouse of a brother or sister (by whole or half blood); an ancestor; child; grandchild; great grandchild; and a spouse of a child, grandchild, or great grandchild.

• Example. A church wants to make a large retirement gift to its retiring pastor, Rev. G. The board does not want to expose Rev. G to intermediate sanctions, so it makes the retirement gift to Rev. G’s spouse. This arrangement does not avoid intermediate sanctions. According to the new regulations. Rev. G’s spouse will be deemed to be a disqualified person if Rev. G meets that definition.

Persons having substantial influence

A disqualified person is someone who “was in a position to exercise substantial influence” over the affairs of the church or other charity. What is substantial influence? The regulations clarify this term by listing persons who are presumed to exercise substantial influence, as well as those who are not. The regulations then address persons fitting within either of these categories.

1. Persons who are presumed to exercise substantial influence. These include any individual who serves on the governing body of the organization who is entitled to vote on matters over which the governing body has authority as the president, chief executive officer, or chief operating officer of the organization as treasurer or chief financial officer of the organization.

• Key point. The regulations specify that “an individual serves as a treasurer or chief financial officer, regardless of title, if that individual has or shares ultimate responsibility for managing the organization’s financial assets and has or shares authority to sign drafts or direct the signing of drafts, or authorize electronic transfer of funds, from organization bank accounts.

2. Persons not having substantial influence. The new regulations specify that persons who do not meet the tax code’s definition of a highly compensated employee will not be deemed to exercise substantial influence over a charity and therefore will not meet the definition of a disqualified person. As a result, intermediate sanctions will not apply to them. The code defines a highly compensated employee as one who had compensation for the previous year in excess of $80,000 (and, if an employer elects, was in the top 20 percent of employees by compensation). The $80,000 amount is indexed annually for inflation.

Caution. Not all clergy earning annual compensation of less than $80,000 are exempt from the definition of a disqualified person. The new regulations specify that the exemption of persons earning less than this amount does not apply to (1) family members (as defined above) of a disqualified person, or (2) a board member, president, or treasurer of the church or charity.

• Example. Rev. T is senior pastor of a church, and serves as president of the corporation and a member of the board (with the right to vote). Rev. T’s church salary for the current year is $50,000. Since Rev. T serves as both president and a member of the board, he is not automatically exempted from the definition of a disqualified person even though he is not a highly compensated employee. As a result, he will be subject to intermediate sanctions if the church pays him excessive compensation. However, Rev. T’s current level of compensation is not excessive. In summary, while he is a disqualified person, he is not subject to intermediate sanctions because his compensation is reasonable.

• Example. Rev. C is an assistant pastor. He does not serve on the church board and is not an officer of the church. His church compensation for this year is $40,000. In addition, the church board is considering a gift of the parsonage to Rev. C. The parsonage has a current value of $75,000 (and is debt—free). The board is concerned that the gift of the parsonage to Rev. C will expose him to intermediate sanctions. They do not need to be concerned. It is true that Rev. C will be a highly compensated employee if the parsonage is given to him. But this in itself does not make him a disqualified person. The regulations require that he be in a position to exercise substantial influence over the affairs of the church. An assistant pastor who is neither an officer nor member of the board probably does not meet this test. Since Rev. C is not a disqualified person, he is not subject to intermediate sanctions.

• Example. Same facts as the previous example, except that Rev. C is a senior pastor who serves on the church board (with the right to vote). Under these circumstances, Rev. C will be deemed a disqualified person because of his status as a church board member. This will expose him to intermediate sanctions if the total amount of his church compensation for the current year is excessive.

• Example. Rev. N is a part—time assistant pastor. She does not serve on the church board and is not an officer of the church. Her church compensation for this year is $15,000. In addition, the church board is considering a gift of a new car to Rev. N. The car has a current value of $25,000. The board is concerned that the gift of the car to Rev. N will expose her to intermediate sanctions. They do not need to be concerned. First, her total compensation (including the gift of the car) would not make her a highly compensated employee, and so she is presumed not to exercise substantial influence over church affairs. Therefore, she cannot be a disqualified person and is not subject to intermediate sanctions.

3. Other cases. Some persons will not fit within either of the previous two categories. They do not serve as a board member, president, or treasurer of their church or charity; and, they satisfy the definition of a highly compensated employee. Whether or not such persons will be deemed disqualified persons depends on the circumstances.

The new regulations clarify that circumstances tending to show that a person has substantial influence over the affairs of a church or charity include, but are not limited to, any one or more of the following:

The person founded the organization.

The person is a “substantial contributor” (as defined in section 507(d)(2) of the code). This definition includes any person who contributed “an aggregate amount of more than $5,000” if such amount is more than 2 percent of the total contributions received by the church or charity before the close of the taxable year in which the contribution is received.

The person’s compensation is based on the revenues of the church or charity.

On the other hand, circumstances tending to show that a person does not have substantial influence over the affairs of a church or charity include but are not limited to, the following: (1) the person has taken a vow of poverty on behalf of a religious organization; or (2) the person is an independent contractor, such as an attorney, accountant, or investment manager or advisor, acting in that capacity-unless the person might economically benefit (aside from fees received for the professional services rendered).

• Key point. A compensation arrangement based on a percentage of a church’s revenue suggests that the recipient exercises substantial influence over church affairs and therefore is a disqualified person subject to intermediate sanctions. However, this rule will apply only if the recipient (1) is not a board member, president, or treasurer of the church; and (2) receives annual church compensation of $80,000 or more. Obviously, this rule will apply to very few ministers.

• Example. Rev. G is a pastor of a church and serves as president of the church corporation and a member of the board. The board agrees to pay him compensation equal to one—third of all church offerings. For 1998, the church receives offerings of $900,000, and Rev. G is paid $300,000. Rev. E is a disqualified person because he is president of the church and a member of the board, and as a result is presumed to exercise substantial influence over church affairs. The fact that the church pays him a percentage of revenue is another fact supporting his status as a disqualified person.

• Example. Same facts as the previous example, except that Rev. G is not an officer or director of the church. The fact that Rev. G is compensated on the basis of a percentage of church revenue is a fact that tends to show substantial influence over church affairs. As a result, it is likely that Rev. G will be deemed to be a disqualified person by the IRS.

• Example. B is a member of a local church. In 1998, B contributes $50,000 to the church. The church received contributions of $700,000 in 1998. B is a substantial contributor since she contributed more than $5,000 in 1998, and her contributions exceeded 2 percent of the church’s total contributions for the year. As a result, she may be deemed to exercise “substantial control” over church affairs, and this would make her a disqualified person. This exposes her to intermediate sanctions, in the event that the church pays her excessive compensation. However, since the church pays B no compensation, there is no exposure to intermediate sanctions.

What is an excess benefit transaction?

The IRS can assess intermediate sanctions against a disqualified person who is involved in an excess benefit transaction with a church or charity. Both conditions must be satisfied. The IRS cannot impose intermediate sanctions against someone who is not a disqualified person-even if he or she receives substantial compensation. Of course, such arrangements will be rare. And, the IRS cannot impose intermediate sanctions against a disqualified person who does not receive an excess benefit. We have defined the term “disqualified person” in the preceding pages. The remaining task is to define an excess benefit transaction. The new regulations provide the following definition:

An excess benefit transaction means any transaction in which an economic benefit is provided by an applicable tax—exempt organization directly or indirectly, to or for the use of, any disqualified person, and the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received by the organization for providing such benefit. An excess benefit transaction also includes certain revenue—sharing transactions ….

Certain economic benefits are disregarded

The regulations list a few economic benefits that are not considered in determining whether or not a disqualified person is paid excessive compensation. The most relevant exceptions are as follows:

1. Reimbursement of some expenses. A church’s payment of reasonable expenses for officers and directors to attend board meetings is not taken into account in applying intermediate sanctions. However, the new regulations warn that “reasonable expenses do not include luxury travel or spousal travel.”

2. A member of a charitable class. The new regulations specify that “an economic benefit provided to a disqualified person that the disqualified person receives solely as a member of a charitable class that the applicable tax—exempt organization intends to benefit as part of the accomplishment of the organization’s exempt purpose is generally disregarded” for purposes of assessing intermediate sanctions.

3. Insurance or indemnification of excise taxes. The payment of a premium for an insurance policy providing liability insurance to cover intermediate sanctions or indemnification of a disqualified person for such taxes will not constitute an excess benefit transaction if the premium or the indemnification is treated as compensation to the disqualified person when paid, and the total compensation paid to the disqualified person is reasonable.

• Example. Rev. L has served as senior pastor of his church for 30 years. The congregation has a membership of 200 and annual revenue of $300,000. The board sets Rev. L’s salary at $50,000 for 1999. In July of 1999, Rev. L informs the board and congregation that he will retire at the end of the year. The board votes to present Rev. L with the church parsonage as a retirement gift. The parsonage has a value of $150,000, and is debt—free. Will the church’s generous gift represent an excess benefit that will trigger intermediate sanctions? Possibly. The new regulations define an excess benefit transaction as any transaction in which the value of an economic benefit provided by a church or charity to a disqualified person “exceeds the value of the consideration (including the performance of services) received by the organization for providing such benefit.” The critical question is whether the value of the parsonage, when combined with Rev. L’s salary, exceeds the value of his services. Obviously, this is not an easy question to answer. But it is possible if not likely that the IRS would assert that the compensation paid to Rev. L is excessive. Consider the following: (1) The church previously agreed to pay Rev. L an annual salary of $50,000. This represented an “arm’s length” transaction that presumably reflected the “value” of Rev. L’s services. As a result, the gift of property valued at $150,000 represented additional compensation over and above what the church had already determined to be the value of Rev. L’s services for the year. (2) The total value of Rev. L’s compensation for 1999 ($200,000) is substantial, and is well beyond the upper end of clergy salary ranges for churches with a membership of 200 and annual revenue of $300,000. (3) The total value of Rev. L’s compensation for 1999 represents 67 percent of the church’s total income. As a result, the gift of the parsonage exposes Rev. L and the church board to intermediate sanctions. If the IRS determines that the maximum reasonable compensation for Rev. L in 1999 would be $100,000, then he has received an excess benefit of $100,000. He would be liable for an excise tax of $25,000 (25 percent of the excess), and an additional $200,000 (200 percent of the excess) if he did not “correct” the situation by returning the excess to the church. In addition, the church board would be subject to an excise tax of $10,000 (paid collectively, not individually). The church board should not have entered into this arrangement without seeking the advice of a tax attorney. It is possible that the church could have structured the gift in a way to “spread” it over more than one year, so that Rev. L’s annual compensation would never be excessive.

• Example. Same facts as the previous example, except that the church has 1,000 members and annual revenue of $1.5 million. It is less likely that Rev. L’s total compensation for 1999 would be excessive under these facts, since ministers serving congregations of this size have higher incomes. Nevertheless, because of the serious consequences associated with intermediate sanctions, prudence dictates that church boards seek the opinion of a tax attorney when considering a significant gift to a minister in order to minimize or eliminate the risk of sanctions.

What is reasonable compensation?

Compensation in excess of what is “reasonable” constitutes an excess benefit that will expose a disqualified person to intermediate sanctions. What, then, is reasonable compensation? The regulations simply note that “compensation for the performance of services is reasonable if it is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” The regulations clarify that compensation includes all items of compensation provided by a church or charity in exchange for the performance of services, including but not limited to:

All forms of cash and noncash compensation, including salary, fees, bonuses, and severance payments paid.

All forms of deferred compensation that is earned and vested, whether or not funded, and whether or not paid under a deferred compensation plan that is a qualified plan under section 401(a), but if deferred compensation for services performed in multiple prior years vests in a later year, then that compensation is attributed to the years in which the services were performed.

The amount of premiums paid for liability or any other insurance coverage, as well as any payment or reimbursement by the organization of charges, expenses, fees, or taxes not covered ultimately by the insurance coverage.

All other benefits, whether or not included in income for tax purposes, including payments to welfare benefit plans on behalf of the persons being compensated, such as plans providing medical, dental, life insurance, severance pay, and disability benefits, and both taxable and nontaxable fringe benefits … including expense allowances or reimbursements or foregone interest on loans that the recipient must report as income on his separate income tax return.

Compensation based on a percentage of revenue

The compensation of some ministers is based on a percentage of church income. In other cases, ministers receive a “bonus” if the church reaches a revenue goal. Do such arrangements result in “excess benefits” exposing the ministers to intermediate sanctions? Possibly, but not necessarily. The new regulations state that the answer depends on “all relevant facts and circumstances”. The regulations provide some clarification by noting that relevant facts and circumstances include, but are not limited to:

the relationship between the size of the benefit provided and the quality and quantity of the services provided, and

the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based

The new regulations contain the following additional clarification:

A revenue—sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.

The application of the new regulations to revenue—based pay is illustrated by the following examples.

• Example. Rev. C serves as an officer and director of his church. His annual compensation is one—half of all church income. In 1998, total church income was $60,000, and Rev. C was paid $30,000. The board is concerned that this compensation arrangement may trigger intermediate sanctions against Rev. C and the board members personally. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Rev. C’s compensation will not be excessive under these criteria. First, the size of his compensation is reasonably related to the quality and quantity of services performed (i.e., full—time professional services). And second, Rev. C has only limited ability to “control the activities” generating church revenue. Unlike many organizations, the amount of a church’s revenue is based on many variables that are beyond a minister’s control. Ultimately, church revenue is based largely on the theology and religious commitment of individual members concerning the importance of stewardship. It is doubtful that the IRS can even engage in intrusive inquiries into the motivation of church members in giving to their church. As a result, the second “fact and circumstance” cited in the new regulations will have limited application to local churches.

• Example. Same facts as the previous example, except that Rev. C is not an officer or director of his church. There is no possibility that the compensation arrangement will result in intermediate sanctions, since Rev. C is not a disqualified person.

• Example. Rev. C serves as an officer and director of his church. The congregation has 300 members. His annual compensation is one—half of all church income. In 1998, total church income was $600,000, and Rev. C was paid $300,000. The board is concerned that this compensation arrangement may trigger intermediate sanctions against Rev. C and the board members personally. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Rev. C’s compensation may be excessive under these criteria since the IRS may conclude that the amount of Rev. C’s compensation is not proportional to the quantity and quality of the services he provides. This is a difficult and somewhat subjective inquiry, but note the following: (1) It is highly irregular for the chief executive officer of any organization (nonprofit or for—profit) to receive half of all the organization’s revenue. While such an arrangement may be justifiable when the organization’s revenue is modest, it becomes increasingly irregular as the organization’s revenue increases. Being paid half of a church’s revenue probably is reasonable for a small congregation with revenues of $60,000 (see the previous example). But the same cannot be said of a church with revenue of $600,000. (2) It is likely the IRS will assert that Rec. C’s compensation is excessive in light of the quality and quantity of services performed. It is true that Rev. C is providing professional and valuable services. However, these services must be placed in perspective. How many ministers serving a congregation of 300 members receive annual compensation of $300,000? Few if any. As a result, Rev. C will have a difficult if not impossible task in convincing the IRS that his compensation is reasonably related to the value of his services. How can it be reasonable if few (if any) ministers serving congregations of similar size receive this level of compensation? This conclusion is reinforced by the annual Compensation Handbook for Church Staff, published annually by this newsletter. It is our recommendation that any doubt with regard to reasonableness of clergy compensation should be resolved on the side of caution-because of the enormity of the sanctions that can be assessed against disqualified persons who are paid excessive compensation. In this example, if the IRS determines that Rev. C’s “reasonable” compensation would be $100,000, then he has an excess benefit of $200,000. He will face an excise tax of $50,000 (25 percent of the excess), and an additional tax of $400,000 if he does not “correct” the overpayment by returning it to the church. In addition, the church board members who authorized this arrangement may be assessed a tax of $10,000 (collectively, not individually).

• Example. Same facts as the previous example, except that the congregation has more than 1,000 members and its revenue for 1998 was $1.5 million, resulting in compensation to Rev. C of $750,000. There is little if any doubt that Rev. C’s compensation will be deemed excessive by the IRS, and that Rev. C will be exposed to the 25 percent and 200 percent excise taxes discussed earlier in this article. In addition, the board is exposed to the 10 percent tax on managers.

• Example. A church with 200 members has annual revenue of $300,000. The board enters into a compensation arrangement with its pastor, Rev. E, under which Rev. E is paid an annual salary of $50,000 and in addition receives a “bonus” of $25,000 if membership or revenue increases by 10 percent in any year. Assuming that Rev. E is a disqualified person, it is doubtful that this arrangement will result in an excess benefit leading to intermediate sanctions. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. Rev. E’s compensation will not be excessive under these criteria. First, the size of his compensation is reasonably related to the quality and quantity of services performed (i.e., full—time professional services). Second, Rev. E has only limited ability to “control the activities” generating church revenue (see the previous examples). Third, the new regulations specify that “a revenue—sharing transaction may constitute an excess benefit transaction regardless of whether the economic benefit provided to the disqualified person exceeds the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization’s accomplishment of its exempt purpose.” However, an example in the new regulations clarifies that if additional compensation is based entirely on a “proportional benefit” to the charity, then the added pay is not an excess benefit. The example states that a manager of a charity’s investment portfolio, whose compensation consists of an annual salary plus a bonus equal to a percentage of any increase in the value of the charity’s portfolio, is not receiving an excess benefit. While the manager’s compensation (the bonus) is linked to the charity’s revenue, the arrangement gives the manager “an incentive to provide the highest quality service in order to maximize benefits.” Further, the manager “can increase his own compensation only if [the charity] also receives a proportional benefit. Under these facts and circumstances, the payment to [the manager] of the bonus described above does not constitute an excess benefit transaction.” It could be argued that Rev. E’s “bonus” is tied directly to a proportional benefit being received by the church (a 10 percent increase in membership or revenue), and therefore is not excessive.

• Example. Rev. N serves as her church’s minister of music, and is a member of the church board. Because she occasionally composes religious music in the course of her employment, she and the church enter into an agreement specifying that the church owns the copyright in such “works made for hire” but that Rev. N will receive half of all royalties the church earns from publication of the music. This is a “revenue—based” pay arrangement, since Rev. N’s compensation is based in part on the church’s royalty revenue. However, it will not result in an excess benefit to Rev. N. The new IRS regulations contain a similar example which contains the following conclusion (the names have been changed): “Rev. N receives the revenue—based compensation, i.e., the percentage of royalties, as an incentive and a reward for producing work of especially high quality. In addition, any time the church benefits by receiving royalties, Rev. N benefits as well and to a proportionate degree. Finally, because the copyright belongs to the church, Rev. N has no control over how the copyright is used nor the stream of revenue it generates. Under these facts and circumstances, the church’s payment of revenue—based compensation to Rev. N does not constitute an excess benefit transaction under the rules of this section.

• Example. A televangelist raises $10 million in annual revenue. The ministry’s board of directors adopts a compensation arrangement establishing the televangelist’s annual income at ten percent of the ministry’s total revenue. The televangelist engages in fundraising on every broadcast, and in addition conducts intensive fundraisers twice each year. The board is concerned that this compensation arrangement may trigger intermediate sanctions against the president and the board members personally. The new regulations clarify that not all “revenue—based” compensation arrangements result in an excess benefit leading to intermediate sanctions. Rather, all of the “relevant facts and circumstances” must be considered. The regulations state that “relevant facts and circumstances” include, but are not limited to (1) the relationship between the size of the benefit provided and the quality and quantity of the services provided, and (2) the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based. The televangelist’s compensation probably is excessive under these criteria since the IRS likely would conclude that the amount of the televangelist’s compensation is not proportional to the quantity and quality of the services he provides. This is a difficult and somewhat subjective inquiry, but note the following: (1) Annual compensation of $1 million for the chief executive of any charity is presumably excessive. This certainly is true for religious organizations. For example, the president of the United States receives annual compensation of $250,000, and members of Congress, state governors, and university presidents receive much less than this. (2) It is highly irregular for the chief executive officer of any organization (nonprofit or for—profit) to receive one—tenth of all the organization’s revenue. While such an arrangement may be justifiable when the organization’s revenue is modest, it becomes increasingly irregular as the organization’s revenue increases. (3) It is likely the IRS will assert that the televangelist’s compensation is excessive in light of the quality and quantity of services performed. (4) The new regulations specify that “the ability of the person receiving the compensation to control the activities generating the revenues on which the compensation is based” is one factor to be considered in evaluating the reasonableness of a revenue—based pay arrangement. The IRS likely would conclude that the televangelist has the ability to control the activities generating the revenues because of his central role in fundraising activities.

The rebuttable presumption of reasonableness

Disqualified persons (and “managers”) may benefit from a “rebuttable presumption” that compensation is reasonable. The new regulations describe this presumption as follows:

Payments under a compensation arrangement between [a church or charity] and a disqualified person shall be presumed to be reasonable, and a transfer of property, right to use property, or any other benefit or privilege between an applicable tax—exempt organization and a disqualified person shall be presumed to be at fair market value, if the following conditions are satisfied-(1) The compensation arrangement or terms of transfer are approved by the organization’s governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement or transaction; (2) The governing body, or committee thereof, obtained and relied upon appropriate data as to comparability prior to making its determination; and (3) The governing body or committee adequately documented the basis for its determination concurrently with making that determination.

1. Conflict of interest. The rebuttable presumption of reasonableness only arises if compensation is determined by a board or committee composed entirely of individuals not having a conflict of interest. If only one member of a board or committee has a conflict of interest, then the rebuttable presumption does not apply. The regulations state that a member of a board or committee has a conflict of interest if he or she

Is a disqualified person.

Is related to any disqualified person participating in or economically benefiting from the compensation arrangement or transaction. “Related” means a spouse; brother or sister (by whole or half blood); a spouse of a brother or sister (by whole or half blood); an ancestor; child; grandchild; great grandchild; and a spouse of a child, grandchild, or great grandchild.

Is in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement or transaction.

Is receiving compensation or other payments subject to approval by any disqualified person participating in or economically benefiting from the compensation arrangement or transaction.

Has no material financial interest affected by the compensation arrangement or transaction.

Does not approve a transaction providing economic benefits to any disqualified person participating in the compensation arrangement or transaction, who in turn has approved or will approve a transaction providing economic benefits to the member.

• Key point. The new regulations specify that “a person is not included on the governing body or committee when it is reviewing a transaction if that person meets with other members only to answer questions, and otherwise recuses himself from the meeting and is not present during debate and voting on the transaction or compensation arrangement.” What does this language mean? Unfortunately, it is not clear. It may mean that clergy who serve as a member of a church board will remain eligible for the rebuttable presumption of reasonableness if they recuse themselves from board meetings where their compensation is addressed. This interpretation is reasonable, but not certain.

• Example. A parachurch ministry’s board includes the president. If the IRS later asserts that the president was paid excessive compensation, the president will not be able to rely on the presumption of reasonableness because of his presence on the board. However, if he recuses himself from the board meeting in which his compensation is discussed (and so is not present for the debate and voting on the compensation arrangement), he may not have a “conflict of interest” that would preclude the presumption of reasonableness.

• Example. Same facts as the previous example. The president does not serve on the board, but his wife does. The president recuses himself from the board meeting in which his compensation is determined, but his wife does not. The president will not be able to rely on the presumption of reasonableness, because one board member (the wife) is related to the president, and she did not recuse herself from the meeting that addressed her husband’s compensation.

2. “Comparability data”. The rebuttable presumption of reasonableness only arises if the governing board “obtained and relied upon appropriate data as to comparability prior to making its determination”. The new regulations specify that a board “has appropriate data as to comparability” if it “has information sufficient to determine whether … a compensation arrangement will result in the payment of reasonable compensation or a transaction will be for fair market value.” The regulations clarify that relevant information includes, but is not be limited to:

Compensation levels paid by similarly situated organizations, both taxable and tax—exempt, for “functionally comparable positions”

the availability of similar services in the same geographic area

independent compensation surveys compiled by independent firms

actual written offers from similar institutions competing for the services of the disqualified person

independent appraisals of the value of property that the organization intends to purchase from, or sell or provide to, the disqualified person

• Example. A church with 500 members and an annual budget of $1 million pays its senior pastor compensation of $200,000 in 1998. The pastor participated in the board meeting in which his compensation was determined. The church board is concerned that the pastor’s compensation may be excessive. They begin doing “salary comparisons” of other churches and businesses in the area with a similar membership or budget. Such efforts will serve no purpose if the board is attempting to qualify the pastor for the rebuttable presumption of reasonableness. The pastor’s presence on the board, and his participation in the meeting in which his compensation was determined, disqualify him for the presumption of reasonableness. However, salary surveys will be relevant in determining whether or not the pastor’s compensation is excessive.

• Example. Same facts as the previous example, except that the pastor recused himself from the board meeting in which his compensation was determined. The board’s efforts to obtain “salary comparisons” may be helpful. If the board determines that “similarly situated organizations, both taxable and tax—exempt”, are paying persons in a “functionally equivalent position” a similar amount of compensation, then this may establish a rebuttable presumption that the pastor’s compensation is reasonable. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any “conflict of interest”.

• Example. Same facts as the previous example. Assume that the board learns that the average annual compensation paid to senior pastors by 20 “similarly situated” churches in the same area is $75,000. The board also determines that the average annual compensation paid by 10 local businesses with annual revenue of $1 million is $100,000. The results of the board’s salary surveys clearly will not support the rebuttable presumption of reasonableness.

• Example. A church pays its senior pastor annual compensation of $75,000 for 1998. The pastor serves as a member of the church’s governing board. In 1998 the church board also provides the pastor with a new car (with a value of $25,000) in recognition of 30 years of service. The pastor recused himself from the board meetings in which his salary and the gift were approved. The gift of the car is fully taxable, and so the pastor’s total compensation for 1998 will be $100,000. The board obtains a copy of the Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and determines that senior pastors in “similarly situated” churches are paid an average of $85,000 per year. This information may be used to support a rebuttable presumption of reasonableness, since the pastor’s compensation (including the gift of the car) is not substantially above the average. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any “conflict of interest”.

Tip. The intermediate sanctions law creates a presumption that a minister’s compensation package is reasonable if approved by a church board that relied upon objective “comparability” information, including independent compensation surveys by nationally recognized independent firms. The most comprehensive compensation survey for church workers is the annual Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and available from the publisher of this newsletter.

3. Special rule for compensation paid by small organizations. The new regulations specify that for organizations with annual gross revenue of less than $1 million, the governing board will be considered to have appropriate comparability data if it has data on compensation paid “by five comparable organizations in the same or similar communities for similar services.” The regulations also clarify that a rolling average based on the three prior years may be used to calculate annual gross revenue of an organization.

4. Rebutting the presumption. The regulations specify that the presumption “may be rebutted by additional information showing that the compensation was not reasonable or that the transfer was not at fair market value.”

5. Adequate documentation. In order to qualify for the rebuttable presumption of reasonableness, the governing board must “adequately document” the basis for its decision at the same time that it makes the decision. The new regulations specify that for a decision to be documented adequately, the “written or electronic records” of the board must note:

the terms of the transaction that was approved and the date it was approved;
the members of the governing body or committee who were present during debate on the transaction or arrangement that was approved and those who voted on it
the comparability data obtained and relied upon by the committee and how the data was obtained, and
the actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the governing body or committee but who had a conflict of interest with respect to the transaction or arrangement

• Key point. For a decision to be documented concurrently, records must be prepared by the next meeting of the board occurring after the final action is taken. Records must be reviewed and approved by the governing body “within a reasonable time period thereafter”.

Effect on tax—exempt status

The new regulations caution that the ability of the IRS to assess intermediate sanctions “does not affect the substantive statutory standards for tax exemption under sections 501(c)(3) …. Organizations are described in [that section] only if no part of their net earnings inure to the benefit of any private shareholder or individual.” In other words, churches and other charities are still exposed to loss of their tax—exempt status if they pay excessive compensation. The fact that such compensation arrangements may trigger intermediate sanctions does not necessarily protect the organization’s tax—exempt status from attack.

© Copyright 1998 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m71 m24 ,c0698

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

Foreign Travel Expenses

The Tax Court issues a helpful decision.

Richard R. Hammar, Attorney, CPA

Bio

Fast v. Commissioner, T.C. Memo. 1998-272 (1998)

Background. Many ministers have traveled to foreign countries. In some cases, the trip is primarily for church-related activities. In others, it is primarily a vacation. In many cases, there are elements of both “business” and pleasure. How should church treasurers report the church’s reimbursement of travel expenses incurred by a minister under these circumstances?

A recent case. A nurse attended an international health conference in China at which she had been invited to present a paper. The participants in the conference were public health professionals from around the world. The nurse spent 2 days attending the formal conference proceedings that included panel sessions and the presentation of papers (including hers). On 7 of the remaining 11 days, the conference participants, including the nurse, made conference-sponsored trips to medical facilities and met with local health officials, for either half of the day or for the entire day. Two days were fully devoted to sightseeing. The nurse deducted all of the costs of her trip (meals, food, lodging, transportation) as a business travel expense. The IRS audited her tax return, and disallowed any deduction for her travel expenses. It concluded that the trip was not primarily for business. The nurse appealed to the Tax Court.

The Court’s ruling. The Court ruled that the nurse could deduct all of her travel expenses incurred during the trip to China. It observed:

The regulations provide that travel expenses are deductible only if the trip is related primarily to the taxpayer’s business. One of the important factors in deciding whether a trip is primarily business or personal is the amount of time spent on each activity. In an example in the regulations, if 1 week is spent on business and 5 are spent on vacation, the trip is primarily personal. Thus, if one-sixth of the time is spent on business and the rest is personal, the trip is primarily personal. Further, the regulations provide that expenses paid or incurred in attending a convention may be ordinary and necessary depending on the facts and circumstances of each case.

Based on our review of the record, we believe that [the attempt by the IRS] to portray [the nurse’s] trip to China as a personal sightseeing junket are unavailing. While it is true that she spent a certain amount of time touring the Great Wall and other sites of interest, a far greater proportion of her time was spent visiting hospitals and medical clinics accompanied by Chinese health officials or participating in the formal presentation of papers. Visiting medical facilities is not personal recreation. On the contrary, we believe it bears a direct relation to her work as an educator in the public health field and is accordingly an ordinary and necessary business activity with respect to petitioner. Consequently, her travel to China and participation in the conference activities were primarily for business reasons within the meaning of the regulations.

The Court allowed the nurse to claim the following “ordinary and necessary” travel expenses: airfare to China, the conference fee, visa fee, books regarding China, travel insurance, slides for presentations, tips, breakfast, taxi, customs fees, parking, and meals. However, the court also noted that the nurse claimed several additional expenses with respect to the China trip that were purely personal or living expenses which were not deductible.

The Court did not allow the nurse to deduct travel expenses incurred within China, because she lacked adequate substantiation. The income tax regulations provide the following explanation of the substantiation required for travel expenses incurred while away from home:

[The] amount of each separate expenditure for traveling away from home, such as cost of transportation or lodging, except that the daily cost of the traveler’s own breakfast, lunch, and dinner and of expenditures incidental to such travel may be aggregated, if set forth in reasonable categories, such as for meals, for gasoline and oil, and for taxi fares.

The Court concluded that the nurse failed to meet this standard with respect to travel expenses incurred while in China, since the meals, lodging, and travel expenses were not separately accounted for, as required by the regulations.

The tax code and regulations. The tax code and regulations directly address foreign business trips. Here is a summary of the rules:

1. Foreign travel entirely for business. If your trip to a foreign country is entirely for business, then all of your travel expenses are deductible (and reimbursable under an accountable arrangement). Travel expenses include such items as transportation, meals, and lodging.

2. “Safe harbors”. Some foreign trips are treated as if they were entirely for business, even though they were not. As a result, all travel expenses are deductible (and reimbursable under an accountable arrangement). Here are the four safe harbors recognized by the tax code and regulations:

• No substantial control. A foreign trip is considered entirely for business if you did not have substantial control over arranging the trip. You do not have substantial control merely because you had control over the timing of the trip. But you will be considered to have substantial control over a trip if you were reimbursed or paid a travel expense allowance for a trip, and you are not a “managing executive”. A “managing executive” is an employee who has the authority and responsibility, without being subject to the veto of another, to decide on the need for the business travel.

Tip. Clergy who report their federal income taxes as self-employed are more likely to have substantial control over arranging business trips. This means that it is less likely that they will qualify for this rule.

• Trips of less than one week. A trip is considered entirely for business if it involves travel outside the United States for a week or less—even if the trip combines both business and nonbusiness activities. One week means seven consecutive days. In counting the days, do not count the day of departure, but do count the day of return to the United States.

• Less than 25% of time on personal activities. A trip is considered entirely for business if you were outside the United States for more than a week, but you spent less than 25% of the total time you were outside the United States on nonbusiness activities. For this purpose, count both the day your trip began and the day it ended.

• Vacation not a major consideration. Your trip is considered entirely for business if you can establish that a personal vacation was not a major consideration, even if you have substantial control over arranging the trip.

Tip. If you do not meet any of the above exceptions, you may still be able to deduct some of your expenses.

3. Travel Primarily for Business. If you travel outside the United States primarily for business purposes but spend some of your time on nonbusiness activities, you generally cannot deduct all of your travel expenses—unless you qualify for one of the four exceptions summarized above. You can only deduct the business portion of your cost of getting to and from your destination. You must allocate the costs between your business and nonbusiness activities to determine your deductible amount. How do you make this allocation? In general, if your trip outside the United States was primarily for business, you must allocate your travel time on a day-to-day basis between business days and nonbusiness days. The days you depart from and return to the United States are both counted as days outside the United States. To figure the deductible amount of your round-trip travel expenses, multiply your expenses by the following fraction: The numerator (top number) is the total number of business days outside the United States; the denominator (bottom number) is the total number of travel days outside the United States.

Your business days include transportation days, days your presence was required, days you spent on business, and certain weekends and holidays. Count as a business day any day your presence is required at a particular place for a specific business purpose. Count it as a business day even if you spend most of the day on nonbusiness activities. Also, count as a business day any day you are prevented from working because of circumstances beyond your control. Count weekends, holidays, and other necessary “standby days” as business days if they fall between business days. But if they follow your business meetings or activity and you remain at your business destination for nonbusiness or personal reasons, do not count them as business days.

4. Travel primarily for vacation. If you travel outside the United States primarily for vacation, the entire cost of the trip is a nondeductible personal expense. This is true even if you spend some time attending brief professional seminars or a continuing education program. You can, however, deduct your registration fees and any other expenses incurred that were directly related to your business.

Caution. If you travel by ocean liner, cruise ship, or other form of luxury water transportation for the purpose of carrying on your trade or business, there is a limit on the amount you can deduct. You cannot deduct more than twice the federal “per diem” rate allowable at the time of your travel. For purposes of this limit, the federal per diem is the highest amount allowed as a daily allowance for living expenses to employees of the executive branch of the federal government while they are away from home but in the United States.

5. Conventions held outside North America. You cannot deduct expenses for attending a convention, seminar, or similar meeting held outside North America unless the meeting is directly related to your trade or business. Also, it must be as reasonable to hold the meeting outside North America as in it. If the meeting meets these requirements, you also must satisfy the rules for deducting expenses for business trips in general, discussed above. The following factors must be considered in deciding if it was reasonable to hold the meeting outside North America: (1) the purpose of the meeting and the activities taking place at the meeting; (2) the purposes and activities of the sponsoring organizations or groups; and (3) the homes of the active members of the sponsoring organizations and the places at which other meetings of the sponsoring organizations or groups have been or will be held.

Relevance to church treasurers. The following examples illustrate many of the rules summarized above. They are based on examples contained in the regulations:

Example. A church board authorizes Rev. G to travel to Mexico City to conduct religious services on three consecutive days. He leaves on a Saturday, conducts services on Sunday through Tuesday, goes sightseeing on Wednesday and Thursday, and returns home on Friday. Since Rev. G’s business trip outside the United States lasted for less than 7 days, his travel expenses for the entire trip are treated as business expenses. This means that he can deduct them on his tax return, or the church can reimburse them fully. If the church has an accountable reimbursement arrangement, its reimbursement of these expenses is not reported as taxable compensation on Rev. G’s W-2 or 1099.

Example. Same facts as the previous example, except that Rev. G goes sightseeing for an entire week. Rev. G will only be able to treat a portion of his travel expenses as a deductible business expense. He multiplies his total travel expenses times a fraction whose numerator is the total number business days (3) and whose denominator is the total number of travel days (12). This is the amount that Rev. G can deduct, or that the church can reimburse. If the church has an accountable reimbursement arrangement, its partial reimbursement of these expenses is not reported as taxable compensation on Rev. G’s W-2 or 1099.

Example. Rev. N goes on a 10-day tour of Israel. He has no business functions or activities, other than the enrichment of his ministry. This trip is primarily for vacation, and so Rev. N’s travel expenses are not tax-deductible. Any reimbursement of his expenses by the church must be reported on his W-2 or 1099 as taxable compensation.

Example. Rev. C traveled to Brussels primarily for business. He left Denver on Tuesday and flew to New York. On Wednesday, he flew from New York to Brussels, arriving the next morning. On Thursday and Friday, he was engaged in business activities, and from Saturday until Tuesday, he was sightseeing. He flew back to New York, arriving Wednesday afternoon. On Thursday, he flew back to Denver. Although he was away from his home in Denver for more than a week, he was not outside the United States for more than a week. This is because the day he departed does not count as a day outside the United States. He can deduct the cost of the round-trip flight between Denver and Brussels. He can also deduct the cost of his stay in Brussels for Thursday and Friday while he conducted business. However, he cannot deduct the cost of his stay in Brussels from Saturday through Tuesday because those days were spent on nonbusiness activities. The church can reimburse the portion of Rev. C’s travel expenses that are tax-deductible. If the church has an accountable reimbursement arrangement, its partial reimbursement of these expenses is not reported as taxable compensation on Rev. C’s W-2 or 1099.

Example. Rev. J travels from Seattle to Taiwan, where he spends 14 days on a preaching and teaching mission and 5 days on personal matters. He then flew back to Seattle. He spent one day flying in each direction. Because only 5/21 (less than 25%) of his total time abroad was for nonbusiness activities, he can deduct as travel expenses what it would have cost him to make the trip if he had not engaged in any personal activity. The amount he can deduct is the cost of the round-trip plane fare and 16 days of meals (subject to the 50% limit), lodging, and other related expenses. Alternatively, the church can reimburse Rev. J’s travel expenses. If the church has an accountable reimbursement arrangement, its reimbursement of these expenses is not reported as taxable compensation on Rev. J’s W-2 or 1099.

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

Reclassifying Self-Employed Workers as Employees

Such a reclassification usually has tax implications.

Richard R. Hammar, Attorney, CPA

Bio

When the IRS reclassifies a self-employed worker as an employee, there usually are tax consequences—an increase in income taxes and a decrease in social security taxes. Income taxes are increased because self-employed taxpayers can claim a number of “above the line” deductions on their income tax return that are not available to employees. These include deductions for half of a taxpayer’s self-employment tax, a portion of the taxpayer’s health insurance premiums, and contribution to a “Keogh” retirement plan. Income taxes also will be increased if the taxpayer has business expenses that are either unreimbursed, or reimbursed under a “nonaccountable” arrangement. Such expenses are fully deductible by self-employed persons, but only partially (if at all) by employees. On the other hand, social security taxes are slashed when a self-employed worker is reclassified as an employee, since the social security and Medicare tax rate for employees is 7.65 percent compared to the “self-employment tax” rate of 15.3 percent.

When the IRS reclassifies a self-employed worker as an employee, can it “offset” a “refund” of excess social security taxes by the additional income tax liability? Or, must it refund the entire overpayment of social security taxes, and charge the taxpayer for the additional income tax liability? In a recently published internal memorandum, the IRS said that it will offset the refund by the additional income tax liability. FSA 1992-116.1.

Example. Assume that a church treats its full-time custodian as self-employed. It does not withhold taxes from his pay and issues him a 1099 form at the end of each year. The IRS reclassifies the custodian as an employee. The custodian will be entitled to a refund of the excess social security taxes he paid as a self-employed person, but the IRS can offset this refund by the amount of the custodian’s additional income tax liability.

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

Are Gifts of Blank Checks Tax-Deductible?

No, the tax court rules.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

Are Gifts of Blank Checks Tax-Deductible?

No, the tax court rules.

Richard R. Hammar

Background. A blank check is a check that is complete in all respects except for the designation of a payee. The person issuing the check specifies the date and an amount, and signs the check, but does not identify a payee. Occasionally a church will receive a blank check in the offering or in the mail. This can occur for a number of reasons. Some elderly church members may simply forget to complete the check. Others may assume that the church will insert (or “stamp”) its name as payee, so why bother.

Can church members claim a charitable contribution deduction for a blank check? No, said the United States Tax Court in a recent case.

The court’s ruling. A husband and wife claimed a charitable contribution of $16,000 to their church in 1991, and an additional $18,000 in 1992. The IRS audited the couple’s tax returns, and questioned the contributions to their church. The couple attempted to substantiate their deductions with canceled checks and carbon copies of checks from their two personal checking accounts on which they left the payee lines blank. The Tax Court ruled that “because these canceled blank checks fail to list [the church] as the donee, these checks to not establish” that the couple made tax-deductible charitable contributions to the church.

This case involved tax years prior to the overhaul of the charitable contribution substantiation requirements that occurred in 1994. Prior to those changes, taxpayers could rely on canceled checks to substantiate charitable contributions. Today, canceled checks may still be used to substantiate charitable contributions, but only for contributions of less than $250. As a result, this case is of continuing relevance, especially in light of the fact that the vast majority of checks issued by donors to churches are for less than $250.

Relevance to church treasurers. This case suggests the following actions: (1) From time to time churches should inform members that while checks can still be used to substantiate contributions of $250 or less, this rule may not apply to blank checks. Churches can share this information in church bulletins or newsletters, or in a note enclosed with contribution receipts. (2) Church treasurers should consider returning blank checks to donors, and asking them to reissue their checks with the name of a payee (generally, the church). Dorris v. Commissioner, T.C. Memo. 1998-324.

This article originally appeared in Church Treasurer Alert, November 1998.

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