Background. Most churches will receive gifts of noncash property during 1998. If a donor claims a charitable contribution deduction of more than $5,000 for such a gift, he or she must comply with specific substantiation rules. These rules were adopted for one reason—to make it harder for donors to inflate the value of donated property and claim an excessive charitable contribution deduction.
Donors who contribute property valued at more than $5,000 to a church or other charity must satisfy each of the following requirements in order to claim a charitable contribution deduction:
(1) obtain a qualified appraisal
A donor’s first obligation is to obtain a qualified appraisal. The income tax regulations define a qualified appraisal as an appraisal made by a “qualified appraiser” no earlier than sixty days prior to the date of a contribution, and containing the following information: (1) a description of the donated property; (2) the physical condition of the property; (3) the date of the contribution; (4) the terms of any agreement regarding the use of the donated property; (5) the name, address, and social security number of the qualified appraiser; (6) the qualifications of the qualified appraiser; (7) a statement that the appraisal was prepared for income tax purposes; (8) the date of the appraisal; (9) the appraised fair market value of the property on the date (or expected date) of the contribution; (10) the method used to determine the fair market value; and (11) the fee arrangement between the donor and appraiser.
Only a “qualified appraiser” can perform a qualified appraisal. A qualified appraiser is anyone who: (1) holds himself or herself out to the public as an appraiser; (2) is qualified to perform appraisals because of his or her education, experience, background, and membership, if any, in professional appraisal associations; (3) is not the donor, the person from whom the donor obtained the property, the donee, any person employed by one of the foregoing persons, or any person whose relationship with any of the foregoing persons would cause a reasonable person to question his or her independence; and (4) understands that a false or fraudulent overvaluation of property may subject the appraiser to civil penalties. The income tax regulations also provide that qualified appraisers cannot base their fee on a percentage of the appraised value.
The qualified appraisal must be received by the donor before the due date (including extensions) of the federal income tax return on which the deduction is claimed. A qualified appraisal must be obtained for each item of contributed property valued by the donor in excess of $5,000.
(2) prepare a qualified appraisal summary
A donor must also complete an appraisal summary and enclose it with the tax return on which the charitable contribution deduction is claimed. The appraisal summary is a summary of the qualified appraisal and is made on Section B (side 2) of IRS Form 8283. Section A (side 1) of Form 8283 is completed by donors who contribute property valued between $500 and $5,000.
Section B of Form 8283 contains four parts. Part I is completed by the donor or appraiser, and sets forth information from the qualified appraisal regarding the donated property, including its appraised value. Part II is completed by the donor and identifies individual items in groups of similar items having an appraised value of not more than $500. Part III contains the appraiser’s certification that he or she satisfies the definition of a qualified appraiser. Part IV is a donee acknowledgment, which must be completed by the church. The church simply indicates the date on which it received the contribution, and agrees to file an information return (Form 8282) with the IRS if it disposes of the donated property within two years. The regulations specify that the church’s acknowledgment “does not represent concurrence in the appraised value of the contributed property. Rather, it represents acknowledgment of receipt of the property described in the appraisal summary on the date specified in the appraisal summary ….”
The instructions to Form 8283 permit a church to complete part IV before the qualified appraisal is completed. They instruct the donor to “complete at least your name, identification number, and description of the donated property,” along with Part II if applicable, before submitting the Form 8283 to the church (or other donee). In other words, the donor should fill in his or her name and social security number on the lines provided at the top of page 1 of the form, and also complete line 5(a) of Section B, Part I (on the back page of the form), before submitting the form to the church. After completing Section B, Part IV, the church returns the form to the donor, who then completes the remaining information required in Part I. The donor should also arrange to have the qualified appraiser complete Part III at this time.
(3) maintain records
The donor’s third obligation is to maintain records containing the following information: (1) the name and address of the church; (2) the date and location of the contribution; (3) a description of the property; (4) the fair market value of the property at the time of the contribution, including a description of how the value was determined; (5) the cost or other basis of the property; (6) if less than the donor’s entire interest in the property was given, an explanation of the total amount claimed as a deduction in the current year; and (7) the terms of any agreement regarding the use of the property. Most of these items will be contained in the qualified appraisal, which should be retained by the donor.
Key point. Publicly traded stock is not subject to these requirements since its value is readily ascertainable. Contributions of nonpublicly traded stock (i.e., stock held by most small, family owned corporations) are subject to these requirements but only if the value claimed by the donor exceeds $10,000.
A recent case. In 1990 and 1991 a taxpayer donated noncash property to his church and claimed substantial charitable contribution deductions on his tax returns for each year. In 1991, his deduction was $40,000. No appraisal summary (Part B, Form 8283) was attached to the tax return, since the taxpayer did not obtain a qualified appraisal. Rather, he valued the contributions on the basis of their fair market value on the dates of the contributions. The IRS conceded that the taxpayer made the contributions and that the amounts of the deductions fairly represented the value of the donated property. However, it disallowed the charitable contribution deductions for the sole reason that the taxpayer failed to obtain qualified appraisals and attach qualified appraisal summaries to his tax returns. The taxpayer insisted that the qualified appraisal, and Form 8283, were technicalities that should not bar a charitable contribution deduction if there is no doubt (1) that the contribution was made, and (2) that a deduction was claimed for the fair value of the donated property.
The Tax Court rejected the taxpayer’s argument, and disallowed any deduction for his charitable contributions of noncash property. The Court noted that the income tax regulations require that a qualified appraisal be obtained prior to the filing of the tax return on which the deduction is claimed and that an appraisal summary be submitted with that return. It concluded:
For donations of property as to which the donor appraisal requirements apply, the donor must obtain and retain a qualified written appraisal by a qualified appraiser for the property contributed and must attach a signed appraisal summary to the return on which the deduction is first claimed (with such other information as prescribed by regulations). [The taxpayer in this case] furnished practically none of the information required by either the statute or the regulations ….
Moreover, it is clear that the principal objective of [the qualified appraisal requirement] was to provide a mechanism whereby [the IRS] would obtain sufficient return information in support of the claimed valuation of charitable contributions of property to enable [it] to deal more effectively with the prevalent use of overvaluations. Such need exists even though in a particular case, such as this, it turns out that the taxpayer’s deduction was in fact based on the fair market value of the property. This happenstance is insufficient to constitute substantial compliance with a statutory condition to obtaining the claimed deduction. As we see it, what [the taxpayer] is seeking is not the application of the substantial compliance principle but an exemption from the clear requirement of the statute and regulations in a situation where there is no overvaluation of the charitable contribution. We are not prepared to follow that path to decision.
A limited exception. In another case the Tax Court ruled that a taxpayer was entitled to a deduction for a contribution of noncash property even though he failed to obtain a qualified appraisal. However, the Court pointed out that the taxpayer had a qualified appraiser complete a Form 8283 which was attached to the taxpayer’s tax return, and the Form 8283 contained most of the information that would have appeared in a qualified appraisal. Under these circumstances the Court concluded that the taxpayer had “substantially complied with the requirements of the statute and the regulations even though a separate appraisal had not been obtained and the qualifications of the appraiser were omitted from the appraisal summary attached to the return.” The Court concluded that the substantiation requirements for contributions of noncash property valued at more than $5,000 “could be met by substantial, rather than strict, compliance.” Bond v. Commissioner, 100 T.C. 32 (1993).
However, the Tax Court ruled that this exception did not apply in the present case, since there was not “substantial compliance” with the substantiation requirements.
Relevance to church treasurers. The lesson is clear—persons who claim a charitable contribution deduction of more than $5,000 for contributions of noncash property risk losing their deduction if they do not obtain a qualified appraisal and attach a qualified appraisal summary (Form 8283) to their tax return. To reduce this risk, consider the following steps:
4 Do not assume that donors are familiar with the substantiation rules that apply to gifts of noncash property. We recommend that church treasurers obtain several copies of Form 8283 each January to give to persons who donate noncash property to the church during the year. Many donors will not be familiar with these requirements, and so you will be doing them a big favor. You can order these forms by calling the IRS forms hotline at 1-800-TAX-FORM.
4 Make a note to contact the donor by the end of the year to be sure that a qualified appraisal has been obtained—if you believe the donor may claim a charitable contribution deduction of more than $5,000. Make a written record of your contact, or send the donor a letter and keep a copy for the church’s files.
Remember, these rules do not apply to gifts of publicly traded stock. And, for gifts of nonpublicly traded stock, the qualified appraisal requirement only applies to gifts of more than $10,000.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Avoiding Double Payments on Construction Projects
Make sure your church does not make this unnecessary and costly misstep.
Make sure your church does not make this unnecessary and costly misstep.
Richard R. Hammar
Background. In most states, a company that supplies building materials for a construction project can claim a “materialman’s lien” against the property in the event it is not paid. If the property owner pays a general contractor for the materials, and the general contractor fails to pay the supplier, then the owner must pay the supplier in order to avoid the sale of its property to enforce the lien. In other words, the property owner ends up paying twice for the same materials. Of course the owner can sue the general contractor, but in some cases this person cannot be found or is insolvent.
A recent case. A company provided materials for a church construction project. Before delivering the materials the company wrote the church a letter warning it that if the general contractor failed to pay for the materials, the company could claim a lien against the church’s property. When the company failed to receive payment from the general contractor, it sued to enforce its lien. The company sought not only payment in full for the materials it had supplied, but also finance charges and attorney fees. A court ruled that a materialman’s lien only allows a supplier to collect the full price of materials that were supplied. The supplier is not entitled to an additional amount, whether for finance charges or attorney fees, unless the contract between the parties specifically provides for it.
Relevance to church treasurers. It is important for church treasurers to be familiar with the concept of materialman’s liens. Whenever your church hires a contractor to perform a construction or remodeling job, the last thing you want to do is pay twice for the same materials. This not only can create a substantial financial hardship, but it also can be embarrassing. There are a various ways to avoid such a situation. Here are some recommendations: (1) Only deal with reputable contractors who have been in business in your community for several years and who have an excellent reputation. Many churches use a contractor who is a member of their congregation. (2) Require the contractor to provide you with “lien waivers” from all suppliers and workers before making payments for the job. (3) Hold back a portion of the contract price until you are assured that all suppliers and workers have been paid. (4) Ask the contractor to submit bills from suppliers and workers directly to the church, and inform the contractor that the church will pay these bills directly. (5) If you sign a contract, you may want to address some of these options in the contract. The services of an attorney are essential. Sherman v. Greater Mt. Olive Baptist Church, 678 So.2d 156 (Ala. App. 1996).
This article originally appeared in Church Treasurer Alert, January 1998.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
A recent case addresses legal concerns- Mennen v. Easter Stores, 951 F. Supp. 838 (N.D. Iowa 1997)
Article summary. Churches occasionally recommend that employees take a polygraph test as a means of resolving accusations of misconduct. A federal law enacted by Congress in 1988 protects many employees from employer requests to take such tests. A recent federal case addresses the application of this law. While the case involved a secular business, it has direct relevance to churches. This feature article reviews this case and its relevance to church leaders
Have you ever considered the use of a polygraph test to resolve an internal church problem? If so, you are not alone. A number of churches have used such tests in the past, and each year many other churches consider doing so. Consider the following examples:
• Example. Church offerings are much higher when the church’s bookkeeper is on vacation. The pastor and church board suspect that the bookkeeper has embezzled funds. The board confronts the bookkeeper, who vigorously denies any wrongdoing. The board is considering asking the bookkeeper to take a polygraph examination.
• Example. A 10—year—old child informs her mother that a Sunday School teacher improperly touched her. The mother informs her pastor, who confronts the teacher. The teacher denies any wrongdoing. The church board is not sure how to proceed. One member suggests that the teacher be asked to take a polygraph exam.
• Example. A former member sues a church, alleging that the pastor seduced her in the course of a counseling relationship a few years ago. The pastor adamantly denies any wrongdoing. The woman’s attorney has her submit to a polygraph exam, which indicates that the woman is telling the truth. The woman’s attorney says that she will drop the lawsuit if the pastor is tested by the same polygraph examiner and is found to be telling the truth. The pastor refuses to do so, insisting that he does not need a test to prove that he is telling the truth. The church board urges the pastor to reconsider, and to take the exam.
• Example. A church adopts an employee handbook that prohibits various kinds of conduct, including use of alcoholic beverages. Over the past several months, a number of members inform the pastor that they have seen a church employee consuming alcoholic beverages. The employee is confronted, and she denies the allegations. The pastor suggests that she take a polygraph exam.
Many church leaders are unaware that a federal law enacted by Congress in 1988 may limit their ability to require or even suggest that employees take a polygraph exam. Church leaders should never suggest, recommend, or require that an employee take a polygraph exam without ensuring that they are in compliance with the law. A recent federal court decision provides helpful guidance on the application of this law. This article will review the facts of the case, summarize the court’s ruling, and evaluate the relevance of the case to churches.
Facts
In 1992, during regular business hours, a thief stole $261 in cash from a grocery store. The money was taken from a cash register, and the store’s manager as well as the police believed that the person who stole the money was a store employee with access to that register. On the date of the theft, there were only two employees who had access to the cash register in question-the grocery manager and a young female cashier. The police later asked these two employees if they would submit to a polygraph exam. The grocery manager was advised that he did not have to take the exam, but he consented because he believed that it was the only way to “clear his name.” The cashier also consented to the exam. The store manager decided to refrain from taking any action against either employee until he received the results of the exams. The results of the grocery manager’s polygraph exam indicated that he exhibited emotional distress and “deception” and as a result did not pass the exam. On the other hand, the cashier’s polygraph results demonstrated that she told the truth to the best of her knowledge and belief.
A detective informed the store manager of the polygraph results. The detective stated that he believed that the grocery manager was guilty but that the police had decided not to prosecute because they did not believe they could establish guilt beyond a reasonable doubt. The store manager responded to this information by reassigning the grocery manager to a “stocker” position, thereby barring him from any cash handling and managerial duties. However, neither his wages nor hours were reduced. While he was not directly threatened with termination, he was told that his honesty and integrity would always be in question, and that he should begin “looking for other employment”. Distraught over his demotion and feeling that his future with the store was gone and that he would never be promoted or transferred to another store, the former grocery manager resigned. He later sued his former employer for violating his rights under the federal Employee Polygraph Protection Act and the Iowa Polygraph Act. He claimed that he was demoted based upon the polygraph examination results released to his employer. The store responded by asserting that it merely cooperated with police authorities who requested that the grocery manager take a polygraph examination. In addition, the store insisted that it did not base its decision to demote the grocery manager solely on the basis of his polygraph examination. Rather, it had already lost confidence in his work and planned to alter his employment status with the store regardless of the results of the polygraph exam.
The court’s decision
What is a polygraph? The court answered this question as follows:
The polygraph is a machine that simultaneously measures a series of physiological responses to a series of relevant and irrelevant questions. The basic theory underlying the polygraph is that a subject’s honesty, dishonesty, or guilty knowledge can be judged from those physical responses that are scientifically related to emotional upset. The reason for attributing relevance to those responses is based upon the scientific understanding that guilt is a learned response that causes inner conflict and emotional upset. The tension associated with the inner conflict of choosing between willful dishonesty and truthfulness is presumed to be measurable by recording changes in inherent body functions. The polygraph does not directly measure whether the subject is either lying or telling the truth. Rather it merely records the physiological changes that occur as the subject responds to a series of questions requiring simple “yes” or “no” answers.
historical background
The court provided the following review of the history of the polygraph exam:
Since its invention in the late 1920s, the polygraph has been the subject of debate …. As the use of this machine increased in various legal and business sectors, the debate intensified, not only over the accuracy of the results of polygraph examinations, but over the use and abuse of these tests in the private employment sector. Initially developed as an adjunct to criminal investigations within the law enforcement community, polygraphs rapidly became part of routine testing and screening in the workplace, and employers, particularly those confronted with losses from employee theft, quickly adopted lie detectors as an expedient and inexpensive solution. Thus, the explosive growth in polygraph tests, coupled with the rampant, unregulated use of these tests in the private employment sector, prompted Congress to address the need for federal regulation of polygraph testing in the workplace …. [A congressional committee] found many employers and polygraph examiners abused and manipulated the testing process and “frequently used inaccurate or unfounded results to justify employment decisions which otherwise would be suspect.” While noting that this abuse was not true of all employers or examiners, the committee found that it was “sufficiently widespread to warrant congressional action.”
In the ongoing or apparently ceaseless conflict between the employee’s right to privacy and the employer’s right to protect its business, Congress, as opposed to the state legislatures and courts, became the principal battleground for the fierce debate regarding the use of polygraph testing in the workplace …. In discussing the potential parameters of federal regulation of polygraph use in the private employment sector, Congress considered arguments from representative warriors from each side of the battlefield. Proponents of polygraph use in the workplace cited the polygraph as a valuable tool necessary to ensure an honest, dependable workforce. These advocates claim that the threat of the polygraph examination acts as a deterrent to employees, that it is no less accurate than the methods used in many subjective employment decisions, and that the test can also be an avenue for innocent employees seeking to exonerate themselves from wrongful accusations. On the other hand, those who advocate the employee’s right to privacy contend that the probing of someone’s body for the purpose of determining whether he or she is telling the truth is “inherently offensive to civil rights.” After weighing these competing interests and conducting various hearings on this issue, Congress ultimately passed the Employee Polygraph Protection Act in 1988.
The Employee Polygraph Protection Act-what it says
The Employee Polygraph Protection Act (EPPA), which was enacted by Congress in 1988, prohibits any “employer” (defined as an employer “engaged in or affecting commerce”) from doing any one of the following three acts:
(1) directly or indirectly, to require, request, suggest, or cause any employee or prospective employee to take or submit to any lie detector test
(2) to use, accept, refer to, or inquire concerning the results of any lie detector test of any employee or prospective employee
(3) to discharge, discipline, discriminate against in any manner, or deny employment or promotion to, or threaten to take any such action against-(A) any employee or prospective employee who refuses, declines, or fails to take or submit to any lie detector test, or (B) any employee or prospective employee on the basis of the results of any lie detector test ….
A church is subject to the Act if it is “engaged in or affecting commerce.” There is no requirement that an employer have a minimum number of employees. There is no doubt that many churches are engaged in or affect commerce. Examples include churches that (1) sell tapes, books, or other products across state lines; (2) engage in radio or television broadcasts; (3) make substantial purchases from out—of—state vendors. Some courts have suggested that the operation of a “web page” on the internet may implicate a church or other employer in commerce. In summary, the test of “engaged in or affecting commerce” is complex and in some cases uncertain. If there is reasonable doubt, churches should “play it safe” and assume that they meet the test.
An important exception-for “ongoing investigations” into employee theft
The Act contains a few narrow exceptions. Of most relevance to church leaders is one that permits employers to ask employees to submit to a polygraph exam if they are suspected of theft and there is an ongoing investigation. Here are the details of this exception:
[This Act] shall not prohibit an employer from requesting an employee to submit to a polygraph test if-
(1) the test is administered in connection with an ongoing investigation involving economic loss or injury to the employer’s business, such as theft, embezzlement, misappropriation, or an act of unlawful industrial espionage or sabotage;
Blockquote
(2) the employee had access to the property that is the subject of the investigation;
(3) the employer had a reasonable suspicion that the employee was involved in the incident or activity under investigation; and
(4) the employer executes a statement, provided to the examinee before the test, that-(A) sets forth with particularity the specific incident or activity being investigated and the basis for testing particular employees, (B) is signed by a person (other than a polygraph examiner) authorized to legally bind the employer, (C) is retained by the employer for at least 3 years, and (D) contains at a minimum-(i) an identification of the specific economic loss or injury to the business of the employer, (ii) a statement indicating that the employee had access to the property that is the subject of the investigation, and (iii) a statement describing the basis of the employer’s reasonable suspicion that the employee was involved in the incident or activity under investigation.
The employer did not improperly request the employee take the exam
The court concluded that the employer had not violated the Employee Polygraph Protection Act, because it did not “require, request, suggest, or cause” the grocery manager to take the exam. Rather, the court pointed out that the police administered the exam and shared their findings with the store. The court noted that the store’s “passive cooperation” with the police did not amount to a violation of the Act. It conceded that an employer can violate the Act if its cooperation with the police in administering a polygraph exam is “active.”
• Key point. Department of Labor regulations specify that “allowing a test on the employer’s premises, releasing an employee during working hours to take a test at police headquarters, and other similar types of cooperation” with the police are not the kinds of “active cooperation” that violate the Act.
The employer “used” the polygraph exam
The Act not only forbids employers from “requiring, requesting, suggesting, or causing” an employee to take a polygraph exam, but it also forbids employers from using exam results. The court concluded that the store violated this standard since it based its decision to demote the grocery manager, at least in part, on the polygraph exam results.
The store argued that it could have relied on the “ongoing investigation” exception (summarized above), and so it should not be found to be in violation of the Act by using the exam results. The court disagreed. It conceded that the ongoing investigation exception was available to the store, but it stressed that the store failed to comply with the specific requirements of that exception: “The court is not willing to circumvent the explicit requirements of the statute to provide [the store] with the protection it could have had in the first place had it followed the law.”
The store could have dismissed the employee prior to the exam
The court acknowledged that the grocery manager may have committed the theft, and that the store could have fired him on the basis of its mere suspicion that he was guilty:
The irony of this case is that [the grocery manager] may well have committed the theft … Perhaps even more ironic is that [the store] could have discharged [him] prior to any polygraph examination simply based upon a mere suspicion that he committed the theft, and the court would have deferred to [its] decision ….
However, instead of exercising its business judgment to discharge [him] when it suspected him of the theft, [the store] did nothing until it received the polygraph results. [It] overlooked two opportunities to discharge or discipline [him] legally: first, by failing to discharge him upon its initial suspicion after the theft but before the request for the polygraph examination was made, and second, by failing to follow the guidelines set forth in the ongoing theft exemption under [the Act].
The court acknowledged that the store waited until it received the exam results to discipline the grocery manager so that its decision would be based on more than mere suspicion. But it concluded that “this is a choice Congress clearly foreclosed when it passed the EPPA.”
Significance of the case to churches-a helpful checklist
If an employee in your church is suspected of misconduct, do not suggest or even mention a polygraph exam without first considering the following:
1. Does the Employee Polygraph Protection Act apply to our church? The Act applies to any employer that is “engaged in or affecting commerce.” No minimum number of employees is required. If your church satisfies any one or more of the following, you should assume you are engaged in commerce:
operate a private school
significant purchases of supplies, literature, and equipment from out—of—state vendors
sell products (such as literature or tapes) to persons or other churches in other states
several persons from other states attend your church
operate a “web page” on the internet
operate an unrelated trade or business
engage in television or radio broadcasts
• Key point. Even if your church does not satisfy any of these factors, it still may be deemed to be engaged in commerce and therefore subject to the EPPA.
2. Know what the law forbids. If you determine that your church is subject to the Employee Polygraph Protection Act, then the following prohibitions apply:
You cannot “require, request, suggest, or cause any employee or prospective employee to take a polygraph exam.
You cannot “actively participate” with the police in administering a polygraph exam to an employee. You can engage in “passive cooperation.” This includes allowing the police to conduct an exam on your premises, or releasing an employee during working hours to take a test at a police station.
You cannot “use, accept, refer to, or inquire concerning the results” of a polygraph exam.
You cannot discharge, discipline, discriminate against, or deny employment or promotion to an employee or applicant for employment on the basis of (1) a refusal to take a polygraph exam, or (2) the results of a polygraph exam. Nor can you threaten to do so.
3. Know the details of the “ongoing investigation” exception. Under very limited circumstances, you can request that an employee take a polygraph exam if you suspect the employee of theft and you are conducting an ongoing investigation. Do not rely on this exception without fully complying with all of the requirements quoted above. Also, consult with legal counsel to be sure the exception is available to you.
• Example. A church board suspects the church’s volunteer treasurer of embezzling several thousands of dollars of church funds. The treasurer is called into a board meeting, and is told “you can clear your name if you submit to a polygraph exam.” Does this conduct violate the Employee Polygraph Protection Act? Possibly not. The Act only protects “employees,” and so a volunteer treasurer presumably would not be covered. However, if the treasurer receives any compensation whatever for her services, or is a “prospective employee,” then the Act would apply. Because of the possibility that volunteer workers may in some cases be deemed “employees,” we recommend that you not suggest or request that they take a polygraph exam without the advice of legal counsel.
• Example. Same facts as the previous example, except that the church suspects a full—time secretary. Can it suggest that the secretary take a polygraph exam? Only if all the requirements of the “ongoing investigation” exception apply. These include: (1) the test is administered in connection with an ongoing investigation involving economic loss or injury to the employer’s business, such as theft or embezzlement; (2) the employee had access to the property that is the subject of the investigation; (3) the employer had a reasonable suspicion that the employee was involved in the incident or activity under investigation; and (4) the employer executes a statement, provided to the examinee before the test, that-(A) sets forth with particularity the specific incident or activity being investigated and the basis for testing particular employees, (B) is signed by a person (other than a polygraph examiner) authorized to legally bind the employer, (C) is retained by the employer for at least 3 years, and (D) contains at a minimum-(i) an identification of the specific economic loss or injury to the business of the employer, (ii) a statement indicating that the employee had access to the property that is the subject of the investigation, and (iii) a statement describing the basis of the employer’s reasonable suspicion that the employee was involved in the incident or activity under investigation.
4. Know the consequences of violating the Act. The EPPA provides that an employer that violates the Act is liable to the employee or prospective employee for “such relief as may be appropriate, including, but not limited to, employment, reinstatement, promotion, and the payment of lost wages and benefits.” A court may also award damages based on “emotional distress,” and punitive damages.
• Key point. Damages awarded for violating the Employee Polygraph Protection Act may not be covered under a church’s liability insurance policy. This is another reason for church leaders to assume that the Act applies to their church, and to interpret its provisions prudently.
Article summary. In August the President signed into law two major tax bills-the Taxpayer Relief Act and the Balanced Budget Act. These new laws contain a number of provisions that will be of interest to ministers and churches. The more important provisions are summarized in this feature article, with several examples and a review of all effective dates.
Once again Congress has enacted sweeping tax changes that will impact every taxpayer. This article will review those provisions of greatest relevance to ministers and churches.
• Key point. The Taxpayer Relief Act was passed by huge majorities in Congress (389—43 in the House, and 92—8 in the Senate). It contains over 800 amendments to the Internal Revenue Code, and adds more than 300 new sections.
Individuals
1. Child tax credit. One of the key provisions of the Taxpayer Relief Act is the creation of a new child tax credit. Here is how it works. If you have one or more children under 17 years of age, and you earn less than a specified amount of income, then you will be able to claim a $400 credit on your 1998 tax return for each child. The credit increases to $500 in 1999. Here are some key considerations to note:
! Qualifying child. To qualify for the credit, you must have a child who (1) is under 17 years of age; (2) is your child, descendent, stepson or stepdaughter, or foster child; and (3) is claimed by you as a dependent on your tax return.
! Phaseout for high—income taxpayers. The child care credit is reduced by $50 for each $1,000 of adjusted gross income in excess of $110,000 for married couples filing jointly. For single persons, the credit is reduced by $50 for each $1,000 of adjusted gross income in excess of $75,000. These amounts are not adjusted for inflation.
! Refundable child care credit. Some lower income families will be eligible to receive a supplemental credit. To qualify, a family must be eligible to receive the earned income tax credit. Unfortunately, the amount of this credit is so difficult to compute that few eligible families will be able to claim it. Congress anticipated this problem, and has instructed the IRS to determine “whether a simplified method of calculating the credit can be achieved.” We will report any progress in future issues of this newsletter. For now, here is a “ballpark test” that can be used-the supplemental credit will not be available unless you (1) qualify for the earned income credit, and (2) your earned income credit exceeds your share of FICA or self—employment taxes.
• Key point. The child tax credit is in addition to the personal exemption amount ($2,650 for 1997) that can be claimed for each dependent child.
• Key point. The child tax credit is in addition to the dependent care credit you can claim if you pay someone to care for your dependent child who is under 13 (or a disabled dependent) so that you can work. This credit is 30% of the amount you pay for dependent care. You can only count expenses of up to $2,400 for one child, or $4,800 for two or more children. The credit is phased out for persons earning above a specified amount.
• Key point. Tax credits benefit taxpayers far more than deductions or exclusions, since they represent a dollar—for—dollar reduction in taxes.
• Key point. The new law introduces the HOPE credit, lifetime learning credit, and education IRA. Each of these provisions will be of direct relevance to churches that operate schools or that have scholarship funds for students, or whose members contribute to the postsecondary educational expenses of their children.
2. Home office expenses. Many ministers and church staff members maintain an office in their home and perform some of their duties in their home office. Are expenses associated with the home office deductible as a business expense? Unfortunately, it has become much more difficult in recent years to claim a home office deduction. The Taxpayer Relief Act makes it a little easier. Consider the following:
! Background. Prior to 1976, home office expenses were deductible whenever they were “appropriate and helpful” to the taxpayer’s business. In 1976 Congress narrowed the home office deduction by making it available only when the office is used regularly and exclusively as a principal place of business, or as a place of business used to meet clients in the normal course of business. In 1993, the United States Supreme Court announced a very narrow interpretation of a taxpayer’s “principal place of business.” Commissioner v. Soliman, 113 S. Ct. 701 (1993). The Court concluded that a physician did not qualify for a home office deduction even though he used his home office regularly and exclusively for business, because the “essence of his professional service” was performed in hospitals. It focused on the place where the primary income—generating functions are performed, and the amount of time spent at each location. Under this analysis, the only possible conclusion was that the physician’s principal place of business was at the hospitals where he worked, and not his home office where he performed largely administrative tasks.
! The new law. The Taxpayer Relief Act repeals the Soliman decision and recognizes that some taxpayers will be eligible for a home office deduction if they use their home office for largely administrative tasks-even if their income—generating activities occur at another location. This is a major break for taxpayers with home offices. The new law provides that a home office qualifies as a principal place of business if:
(1) the office is used by the taxpayer to conduct administrative or management activities related to a trade or business, and
(2) there is no other fixed location where the taxpayer conducts substantial administrative and management activities of the trade or business
As before, the home office must be used regularly and exclusively for business purposes.
Taxpayers who meet these new requirements are eligible for a home office deduction even if they conduct some administrative and management activities at a fixed location of their business outside their home-so long as those activities are not substantial. For example, a taxpayer occasionally does minimal paperwork at another fixed location of the business. Further, taxpayers can claim a home office deduction even though they conduct substantial non—administrative or non—management business activities at a fixed location of their business outside their home. For example, a taxpayer meets with or provides services to customers or clients at a fixed location that is away from home. It is this rule that overturns the Soliman decision, and makes the home office deduction available to many more persons.
! Effect of an office in the church. What if a minister has a home office, but an office is also available at the church? Is a home office deduction ever available under these circumstances? In the past, the answer has been “no,” at least for ministers who are employees for federal income tax reporting purposes. For an employee to qualify for a home office deduction, the use of a home office must not only be regular and exclusive, but it also must be for the “convenience of the employer.” This has meant that the home office must be essential for the employee to perform his or her work. This is simply not the case when an office is available in the church. The courts and the IRS have ruled that if an employer provides employees access to an office on its premises for the performance of their duties, and an employee elects to conduct these duties at home as matter of personal preference, then the employee’s use of the home office is not for the “convenience of the employer” and there is no deduction allowed.
In summary, if a self—employed taxpayer in fact does not perform substantial administrative or management activities at any fixed location of the business away from home, then the second part of the new test is met whether or not the taxpayer elected not to use an office away from home that was available. However, for employees, the fact that they elect not to use an office on their employer’s premises that is available to them for administrative activities will still be relevant in deciding whether or not they meet the “convenience of the employer” requirement.
• Example. Rev. V reports his income taxes as an employee. He has an office at his church, but also maintains an office in his home where he occasionally does research and other work—related activities. He also uses his home office to monitor investments, and assist his children with their homework. Rev. V is not eligible for a home office deduction for two reasons. First, his home office is not used exclusively for business purposes. And second, his home office is not for the convenience of his employer since an office is available at the church where Rev. V can perform all of his work—related duties.
• Example. Rev. H is pastor of a small congregation. He reports his income taxes as an employee. The church does not maintain an office for Rev. H, and so he performs all of his work—related administrative tasks at a home office that he uses regularly and exclusively in performing his duties. While H performs all of his non—administrative duties (preaching, sacraments) at the church, all of his administrative tasks (sermon preparation, business planning) are performed at his home office. While Rev. H might not have qualified for a home office deduction under the Soliman ruling, he clearly qualifies under the new rules that take effect in 1999.
• Example. Rev. K has an office at the church, but she also has a home office which she uses regularly and exclusively to counsel with church members. Does she qualify for a home office deduction? While she uses her home office as a place for meeting with clients in the normal course of her activities, the home office still must be used for the convenience of her employer. This means that it is essential to use her home office to perform her duties. This is very unlikely if not impossible when an office is maintained in the church.
• Key point. Taxpayers who qualify for a home office deduction get an additional tax break-travel between their home and church (or other business location) is not commuting since they are not traveling between home and work. Rather, they are traveling between two business locations. In many cases this will convert nondeductible “commuting” expenses into a deductible business expense.
3. Health insurance deduction for the self—employed. Under current law, self—employed persons can deduct health insurance costs for themselves (and their spouse and children) as follows: 40 percent in 1997; 45 percent in 1998 through 2002; 50 percent in 2003; 60 percent in 2004; 70 percent in 2005; and 80 percent in 2006 and thereafter. This deduction is not allowed in any year in which the self—employed person is eligible to participate in a subsidized health plan maintained by an employer of either the self—employed person or his or her spouse.
The Taxpayer Relief Act accelerates the health insurance deduction for self—employed workers as follows: 40 percent in 1997; 45 percent in 1998 and 1999; 50 percent in 2000 and 2001; 60 percent in 2002; 80 percent in 2003 through 2005; 90 percent in 2006; and 100 percent in 2007 and thereafter.
4. Real estate reporting requirements. Under current law, persons who close real estate transactions are required to file an information return (Form 1099S) with the IRS. This return reports the details of the transaction, and is designed to disclose persons who may owe capital gains tax. The Taxpayer Relief Act exempts sales of personal residences with a gross sales price of $500,000 or less ($250,000 or less for single taxpayers) from this reporting requirement, beginning after May 6, 1997. The purpose of this change is to relieve taxpayers of the reporting requirement on transactions that will be exempt from the capital gains tax under new rules (explained below) that took effect after May 6, 1997.
• Key point. To qualify for this exemption, a home seller must provide the buyer with written assurance that no capital gain tax will be payable on the transaction. The IRS will issue further guidance on this requirement.
5. “Continuous levy” authority of the IRS extends to social security payments. Under current law, taxpayers who do not pay a tax within 10 days of notice and demand by the IRS are subject to “levy.” A levy is a procedure the IRS uses to collect the tax deficiency. It permits the IRS to seize property owned by the taxpayer. Generally, a levy does not apply to property acquired after the date of the levy-with one exception. A levy on wages is “continuous” from the date it is first made until the debt is paid in full.
The Taxpayer Relief Act permits the IRS to impose a continuous levy on federal payments for which eligibility is not based on the income or assets of the taxpayer. To illustrate, the IRS will now be able to treat social security checks like wages. This means that a levy against such payments will “continue” until the tax deficiency is paid. The new law specifies that such levies can attach up to 15 percent of any payment due the taxpayer.
This provision took effect on August 6, 1997.
6. Earned income credit modifications. Certain low—income workers are entitled to claim a refundable earned income credit (EIC) on their tax return. A refundable credit is a credit that not only reduces income taxes, but allows a refund to taxpayers whose credit exceeds their tax liability. The amount of the credit depends on the number of children the taxpayer has, and it is phased out for taxpayers with adjusted gross income above certain limits. The Taxpayer Relief Act makes certain changes to the earned income credit, including the following:
! Fraud or recklessness. A taxpayer who fraudulently claims an EIC is ineligible to claim the EIC for the next 10 years. A taxpayer who erroneously claims the EIC due to reckless or intentional disregard of the law is ineligible to claim the credit for the next 2 years. This provision took effect January 1, 1997.
! Definition of adjusted gross income. The EIC is phased out for taxpayers with adjusted gross income above specified levels. The new law provides that tax—exempt interest and nontaxable distributions from pensions, annuities, and IRAs (if not rolled over into similar tax—favored products) are not counted in computing adjusted gross income for purposes of determining eligibility for the EIC. This provision takes effect in 1998.
7. Foreign earned income credit. United States citizens generally are subject to federal income tax on all their income, whether derived in the United States or in a foreign country. However, citizens working in foreign countries may be eligible to exclude from their income for federal income tax purposes certain foreign earned income and housing costs. To qualify for these exclusions, the individual must either (1) be a resident of the foreign country for an uninterrupted period that includes the entire tax year, or (2) be present overseas for 330 days out of any 12 consecutive month period. The maximum exclusion for foreign earned income under current law is $70,000 per year.
The Taxpayer Relief Act increases the $70,000 annual foreign earned income exclusion by $2,000 per year beginning in 1998, until it reaches a maximum of $80,000 in the year 2002. In addition, the credit will be indexed for inflation beginning in 2008. This credit is claimed by many American missionaries serving in foreign countries.
8. Increase in standard deduction of dependents. Under current law, the standard deduction of a taxpayer who is claimed as a dependent on another’s tax return cannot exceed the lesser of (1) the standard deduction for an individual (projected to be $4,250 for 1998), or (2) the greater of $500 (indexed for inflation) or the dependent’s earned income. In other words, a minor child who works outside the home, and who is claimed as a dependent on his parents’ tax return, is eligible for a reduced standard deduction based on this formula.
The Taxpayer Relief Act increases the standard deduction for a taxpayer who is claimed as a dependent on another’s tax return to the lesser of (1) the standard deduction for individuals, or (2) the greater of (a) $500 (indexed for inflation), or (b) the individual’s earned income plus $250. The $250 amount will be indexed for inflation after 1998. The new standard deduction rules take effect in 1998.
• Example. Rev. L’s daughter is 17 years old and works part—time in a local restaurant. Assuming that she earns $2,000 in 1997, and is claimed as a dependent on her parents’ tax return, her standard deduction under current law is the lesser of (1) the standard deduction for an individual ($4,000 for 1997), or (2) the greater of $500 or the dependent’s earned income ($2,000). This formula permits the daughter to claim a standard deduction on her own tax return in the amount of $2,000.
• Example. Same facts as the previous example, except that the year is 1998. Under the new rules, the daughter’s standard deduction is the lesser of (1) the standard deduction for individuals (projected to be $4,250 in 1998), or (2) the greater of (a) $500, or (b) the dependent’s earned income ($2,000) plus $250. This formula permits the daughter to claim a standard deduction on her own tax return in the amount of $2,250-an increase of $250 over the 1997 deduction.
9. Estimated tax penalties. Taxpayers are subject to an “addition to tax” for any underpayment of estimated taxes. This penalty is not assessed if the total tax liability for the year (reduced by any withheld tax and estimated tax payments) is less than $500. The Taxpayer Relief Act increases this amount to $1,000, beginning in 1998.
• Key point. This provision is relevant to ministers, who always pay estimated taxes because their wages are exempt from tax withholding (unless they elect voluntary tax withholding).
10. Estimated tax requirements. Under current law, a taxpayer is subject to a penalty for underpayments of estimated taxes. The penalty is avoided if a taxpayer makes timely estimated tax payments at least equal to (1) 100 percent of the previous year’s tax liability, or (2) 90 percent of the current year’s tax liability. The 100 percent of last year’s tax liability exception is increased to 110 percent for individuals with adjusted gross income of more than $150,000 for the previous year.
The Taxpayer Relief Act changes the 110 percent of last year’s tax liability rule to 100 percent of the previous year’s tax liability in 1998; 105 percent of the previous year’s tax liability in 1999, 2000, and 2001; and 112 percent of the previous year’s tax liability in 2002.
Education
1. HOPE scholarship tax credit. The Taxpayer Relief Act provides welcome relief to families with children in college or vocational training. Beginning in 1998, taxpayers can claim a “HOPE” credit against federal income taxes of up to $1,500 per student per year for 50 percent of qualified tuition and related expenses (not including room, board, and books) paid during the first two years of the student’s postsecondary, undergraduate education in a degree or certificate program. Here are some of the key provisions:
! Effective date. HOPE scholarship credits are available for tuition expenses and academic fees paid after December 31, 1997, for education furnished in academic periods beginning after such date.
! Eligible taxpayers. Who qualifies for the HOPE scholarship credit? The law provides that the credit is available for tuition expenses incurred by a taxpayer, or the taxpayer’s spouse or dependent child.
• Example. A church member would like to claim a HOPE tax credit for monies he pays for scholarships on behalf of members of his church who are attending college. He is not eligible for the credit with respect to any student who is not his spouse or dependent.
• Example. A student attending a church—related college incurs $9,000 in tuition expenses for 1997. The student’s mother pays this entire amount. She is not eligible for a HOPE credit, even if she claims her son as a dependent, since the credit is not available until 1998.
• Example. Same facts as the previous problem, except the year is 1998. The parent would be eligible for a HOPE credit in the amount of $1,500-assuming that she meets the conditions summarized below.
• Example. A parent pays $10,000 in tuition fees incurred by his son during 1998 while attending seminary as a full—time student. The parent is not eligible for a HOPE credit, since the tuition was not incurred during the first two years of postsecondary, undergraduate education.
• Example. A parent pays the full $5,000 tuition for 1998 on behalf of his daughter who attends a church—operated high school. The parent is not eligible for the HOPE credit, since the credit is limited to the first two years of postsecondary, undergraduate education.
! First two years of college. The HOPE credit applies only to tuition incurred during the first two years of a college or vocational program leading to a degree or certificate.
! Amount of credit. The credit is 100 percent of the first $1,000 of tuition and fees, and 50 percent on the next $1,000 of tuition and fees-for a total available credit of $1,500. Remember that a credit is a direct dollar—for—dollar reduction in income taxes. It is far more beneficial than a tax deduction which merely reduces taxable income.
• Example. A student who incurs tuition of $1,000 is eligible for a $1,000 HOPE credit. A student who incurs tuition of $2,000 or more is eligible for a $1,500 HOPE credit.
• Key point. The amount of the HOPE credit is indexed for inflation after the year 2000.
! Eligible students. To be eligible for a HOPE credit, a student must be enrolled at least half—time in a degree or certificate program leading to a recognized educational credential at an eligible educational institution.
! What expenses are eligible for the credit? The credit is available with respect to amounts paid for tuition and academic fees. It is not available with respect to amounts paid for books, meals, lodging, student activities, athletics, insurance, transportation, and similar personal expenses.
! Phaseout for high—income taxpayers. The HOPE credit is phased out for single taxpayers with adjusted gross income between $40,000 and $50,000. The credit is phased out for married taxpayers who file jointly with adjusted gross income between $80,000 and $100,000. These amounts will be indexed for inflation after 1999, although the first year when an adjustment can be made is 2001.
• Example. A student incurs $5,000 in tuition expenses during her first semester of college in 1998. Her parents pay this entire amount. They have adjusted gross income of $50,000 for 1998. They are eligible to claim a HOPE credit of $1,500.
• Example. Same facts as the previous example, except that the parents have adjusted gross income of $100,000. They are not eligible for a HOPE credit because their income is too high.
! Which year is the credit claimed? The HOPE credit is available in the year the tuition expenses are paid-so long as the education begins or continues during that year or during the first three months of the next year.
• Key point. Congress gave the IRS authority to issue regulations providing that the HOPE credit will be “recaptured” if a student receives a refund of tuition for which a credit was previously claimed.
! What about loans? Qualified tuition expenses paid with the proceeds of a loan are eligible for a HOPE credit. The credit is not applied to the repayment of the loan itself.
! Reporting requirements. The new law specifies that parents cannot claim the HOPE credit unless their tax return reports the name and social security number of the eligible student. Tax returns for 1998 and future years will allow parents to provide this information.
2. Lifetime learning credit. Here’s another break for parents with children in college-taxpayers are allowed a “lifetime learning credit” against federal income taxes equal to 20 percent of tuition and academic fees incurred during a year on behalf of the taxpayer, or the taxpayer’s spouse or dependent child. Here are some of the details:
! Effective date. This credit applies to tuition expenses incurred after June 30, 1998, for education furnished in academic periods beginning after such date.
! Eligible taxpayers. The credit is available for tuition expenses incurred by a taxpayer, or the taxpayer’s spouse or dependent child.
! Amount of credit. The credit is 20 percent of the first $5,000 of tuition and academic fees. This means that the maximum credit will be $1,000 per year. However, for expenses paid after December 31, 2002, up to $10,000 of tuition and academic fees will be eligible for the 20 percent lifetime learning credit. This means that the maximum credit will increase to $2,000 per year.
! No two—year limitation. Unlike HOPE credits, the lifetime learning credit is not limited to the first two years of postsecondary, undergraduate education. It can be claimed for an unlimited number of years.
! Multiple children. The lifetime learning credit can be claimed in any one year on behalf of any number of eligible students.
• Example. A church member has three dependent children who are attending college (one church—related college and two public universities). The parent may claim a credit of $1,000 for each of these three students, assuming that they each incur tuition expenses of at least $5,000 per year and all other conditions are met.
• Key point. The amount of the lifetime learning credit is indexed for inflation after the year 2000.
! Eligible students. The lifetime learning credit is available to students at both undergraduate and graduate educational institutions (and postsecondary vocational schools). In addition, students need not be enrolled half—time or full—time.
• Key point. There are important differences between students who qualify for HOPE credits and the lifetime learning credit. Consider the following:
! HOPE credits are available only with respect to postsecondary, undergraduate education. Lifetime learning credits are available for both undergraduate and graduate education.
! HOPE credits are available only for the first two years of undergraduate education. There is no limit on how often lifetime learning credits can be claimed.
! HOPE credits cannot be claimed for more than two years for the same student. Lifetime learning credits are not subject to this limitation.
! Like HOPE credits, lifetime learning credits are available with respect to education that is at least half—time. But unlike HOPE credits, lifetime learning credits also are available with respect to “any course of instruction at an eligible educational institution to acquire or improve job skills of the individual.” In other words, many continuing education courses and professional seminars would qualify for the lifetime learning credit-if offered by an eligible educational institution.
• Example. A parent incurs tuition expenses of $10,000 in 1998 for a child who attends seminary. The parent is eligible for a lifetime learning credit of $1,000 (unless phased out because of the parent’s adjusted gross income).
What expenses are eligible for the credit? Same as for HOPE credits (see above).
! Phaseout for high—income taxpayers. Same as for HOPE credits (see above).
! Which year is the credit claimed? Same as for HOPE credits (see above).
! What about loans? Same as for HOPE credits (see above).
! Choice of credit. If a taxpayer claims a HOPE credit with respect to a student then the lifetime learning credit will not be available with respect to that same student for the year, although the lifetime learning credit may be available with respect to that student for other years. Also, taxpayers who claim an exclusion for distributions from an “education IRA” (explained later in this article) with respect to a student will not be able to claim a lifetime learning credit for that student during the same year.
3. Education IRAs. Taxpayers are given yet another break for education expenses under the new law-they can contribute up to $500 each year to an “education IRA.” Here is how it works. A taxpayer establishes an education IRA and designates a “beneficiary” (usually, the taxpayer’s child). The taxpayer contributes up to $500 each year into the account, up until the beneficiary’s 18th birthday. Earnings on an education IRA generally accumulate tax—free-provided they are distributed for the post—secondary educational expenses of the beneficiary. Here are some more specifics:
! Effective date. Parents can begin contributing to education IRAs on or after January 1, 1998.
! Annual contribution limit. Parents can contribute a maximum of $500 each year to an education IRA. This amount is phased out for higher income taxpayers. The phaseout begins at $95,000 of adjusted gross income for single parents, and is phased out completely at $110,000. The phaseout begins at $150,000 of adjusted gross income for married couples filing jointly, and is phased out completely at $160,000.
! Qualified expenses. Earnings must be distributed for “qualified expenses” in order to accumulate tax—free. Such expenses include post—secondary tuition, fees, books, supplies, equipment, and certain room and board expenses. Room and board expenses qualify only if the beneficiary is enrolled on at least a half—time basis. Further, “room and board expenses” are defined to mean the minimum room and board allowance as determined by the college or other academic institution in computing costs of attendance for federal financial aid programs.
• Key point. Expenses for elementary and secondary school expenses do not qualify.
! Termination of education IRAs. Any balance remaining in an education IRA when a beneficiary attains 30 years of age must be distributed, and the earnings portion of such a distribution will be included in the beneficiary’s taxable income and subject to an additional ten percent penalty tax because the distribution was not for educational purposes.
• Key point. However, prior to a beneficiary reaching age 30, the balance in the education IRA may be “rolled over” (without penalty or tax) to another education IRA benefiting a different beneficiary-if the new beneficiary is a member of the family of the original beneficiary.
! Interaction with HOPE credits and lifetime learning credits. In any year in which an exclusion is claimed for a distribution from an education IRA, neither a HOPE credit nor a lifetime learning credit may be claimed with respect to educational expenses incurred during that year on behalf of the same student. The HOPE credit and lifetime learning credit may be available in other years with respect to that beneficiary.
! Qualified educational institutions. Education IRAs can be distributed for the qualified educational expenses incurred by beneficiaries attending post—secondary undergraduate or graduate educational institutions. Some vocational institutions also qualify.
! Tax treatment of distributions. An education IRA will consist of two components-all annual contributions made to the account plus accumulated earnings. Distributions from the account likewise will consist of both contributions and earnings. The portion of an annual distribution that comes from annual contributions is always tax—free to the beneficiary, but the portion that comes from earnings may not be. Here are two rules to keep in mind:
(1) Qualified education expenses equal or exceed the annual distribution from an education IRA. The full amount of the distribution is tax—free to the beneficiary.
• Example. A college student is the beneficiary of an education IRA established by her parents. The parents have made annual contributions of $500 for eight years (for a total of $4,000), and the account has accumulated an additional $1,000 in earnings, for a total account balance of $5,000. During one year the student incurs $10,000 of educational expenses, and $1,000 is distributed from the education IRA for these expenses. This distribution represents $800 of contributions and $200 of earnings. These amounts are computed on the basis of the ratio of total contributions ($4,000) to the total account balance ($5,000, representing contributions and earnings). Since the qualified educational expenses exceed the amount of the distribution, the full amount of the distribution is tax—free.
(2) Qualified education expenses are less than the annual distribution from an education IRA. This scenario will be far less common, especially for the next several years. However, it may apply to students who are taking only a few courses. The earnings component of a distribution (see the previous example) will be partially tax—free and partially taxable. You compute these amounts by multiplying the earnings component of the distribution times the ratio of educational expenses to the total amount of the distribution.
• Example. Same facts as the previous example, except that the student’s educational expenses are only $600 for the year in question. Since her education expenses are less than the amount of the distribution, a portion of the distribution allocated to earnings will be tax—free and a portion will be taxable. The tax—free portion is computed by the ratio of educational expenses ($600) divided by the total distribution ($1,000)-or 60 percent. Taking 60 percent of the earnings component of the distribution ($200, as computed in the previous example) yields a tax—free earnings distribution of $120. This leaves a taxable portion of $80, which should be included in the beneficiary’s taxable income.
! Technical requirements. Parents cannot treat an existing IRA as an education IRA. You must establish a separate IRA that you specifically designate as an education IRA.
4. Penalty—free withdrawals from an existing IRA to pay for educational expenses. Beginning in 1998, the 10 percent penalty that applies to early distributions from an IRA will not apply to amounts used for qualified higher education expenses (including graduate courses) of the taxpayer or the taxpayer’s spouse, child, or grandchild. The penalty—free withdrawal is available for “qualified higher education expenses,” meaning tuition, fees, books, supplies, equipment required for enrollment, and room and board. All expenses must be incurred at a post—secondary educational institution, including a graduate program.
5. Extension of employer—provided educational assistance exclusion. In the past, an employee’s taxable income did not include amounts paid by an employer for educational assistance if such amounts were paid pursuant to an educational assistance program that met certain requirements. This exclusion was limited to $5,250 of educational assistance per employee during a calendar year, and applied whether or not the education was job related. The exclusion expired for graduate education beginning after June 30, 1996, and for undergraduate education beginning after June 30, 1997. The Taxpayer Relief Act extends this exclusion for undergraduate education for courses beginning before June 1, 2000. The exclusion does not apply to graduate—level courses.
Retirement
1. Increase IRA phaseout limits. Under current law, if an individual (or his or her spouse) is an active participant in an employer—sponsored retirement plan, the $2,000 IRA deduction limit is phased out over the following levels of adjusted gross income: (1) $25,000 to $35,000 for single persons; and (2) $40,000 to $50,000 for married persons filing jointly. The Taxpayer Relief Act contains two important modifications in these rules, effective in 1998:
(1) Spouse’s participation not considered. An individual will not be considered to be an active participant in an employer—sponsored retirement plan merely because his or her spouse is an active participant in such a plan. However, the maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, is phased out for taxpayers with adjusted gross income between $150,000 and $160,000.
(2) Phaseout limits increased. The deductible IRA phaseout ranges are increased as follows:
Joint Returns
tax year phaseout range (adjusted gross income)
1998 $50,000—$60,000
1999 $51,000—$61,000
2000 $52,000—$62,000
2001 $53,000—$63,000
2002 $54,000—$64,000
2003 $60,000—$70,000
2004 $65,000—$75,000
2005 $70,000—$80,000
2006 $75,000—$85,000
2007 and thereafter $80,000—$100,000
Single Taxpayers
tax year phase out range (adjusted gross income)
1998 $30,000—$40,000
1999 $31,000—$41,000
2000 $32,000—$42,000
2001 $33,000—$43,000
2002 $34,000—$44,000
2003 $40,000—$50,000
2004 $45,000—$55,000
2005 and thereafter $50,000—$60,000
• Example. Rev. B is not a participant in an employer—sponsored retirement plan. Rev. B’s spouse works for a secular employer, and is a participant in an employer—sponsored retirement plan. The combined adjusted gross income of the couple is $80,000. Neither can make a deductible contribution to an IRA during 1997.
• Example. Same facts as the previous example, except that the year is 1998. Rev. B is eligible to make a deductible $2,000 to an IRA. The fact that Rev. B’s spouse is an active participant in an employer—sponsored retirement plan does not affect Rev. B’s eligibility.
2. “Roth” (“backloaded”) IRAs. Another new IRA that debuts in 1998 is the so—called “Roth” or “backloaded” IRA. It is named in honor of Senator William Roth (R—Del.), its chief advocate. Here is how it works. Taxpayers can make annual nondeductible contributions of up to $2,000 to a Roth IRA, and distributions from such an IRA are not taxed if they are made after a five year holding period, and are made as a result of the account holder’s: (1) attaining age 59 and 1/2 or older, (2) death, (3) disability, or (4) purchase of a first home. Further, earnings on Roth IRAs accumulate tax—free. Here are some more details:
! Phaseout for higher income taxpayers. Roth IRAs are phased out for single taxpayers with adjusted gross income of $95,000 to $110,000, and for married taxpayers filing jointly with adjusted gross income of $150,000 to $160,000.
! Rollovers. A regular IRA may be rolled over to a Roth IRA. Only taxpayers with adjusted gross income of less than $100,000 are eligible for this provision.
• Caution. If you roll over your regular IRA into a Roth IRA prior to 1999, the amount that would have been included in taxable income had the funds been withdrawn are included in your taxable income over a four—year period. The ten percent penalty on early withdrawals from an IRA does not apply.
• Key point. If you expect your income tax rate to drop when you retire, it ordinarily will not be advantageous to roll over your existing IRA into a Roth IRA. But if you are younger and a disciplined saver and investor, and expect your tax rate to increase when you retire, then a rollover should be considered. Discuss the specifics of your situation with a financial planner or CPA.
! Maximum IRA contribution. Persons who cannot (or do not) make contributions to a deductible IRA or a Roth IRA can continue to make contributions to a nondeductible IRA, as under prior law. However, the new law clarifies that in no case may contributions to all of a taxpayer’s IRAs for the same year exceed $2,000.
! No age limit on contributions. Unlike a regular IRA, taxpayers can make contributions to a Roth IRA after they reach age 70 and 1/2.
! Technical requirements. A Roth IRA must be separately established, and it must be designated as a Roth IRA when it is created.
• Example. Rev. G opens a Roth IRA. Contributions made by Rev. G each year are not tax—deductible. However, following a five—year holding period Rev. G may make tax—free distributions from the Roth IRA on account of any one or more of the following conditions: (1) attaining age 59 and 1/2 or older, (2) death, (3) disability, or (4) purchase of a first home.
• Key point. In summary, the advantage of a Roth IRA is that it is “backloaded.” This means that annual contributions to the IRA are not tax—deductible, but that earnings and distributions are nontaxable if they meet the requirements mentioned above. This will be a major tax break for many taxpayers, and will make Roth IRAs preferable in some cases to ordinary IRAs.
• Key point. In general, a Roth IRA will be preferable to a regular IRA if your tax rate remains the same or increases during retirement. If your total effective tax rate drops during your retirement years, a regular IRA may be more attractive (though not significantly).
Comparing Regular and Roth IRAs
Regular IRARoth IRA
annual contribution limit
$2,000
$2,000
both spouses can contribute
yes
yes
tax treatment of annual contributions
tax—deductible (phaseout rules apply to higher income taxpayers)
not tax—deductible
earnings
accumulate tax—free, but are taxed at distribution
accumulate tax free, and are not taxed at distribution (if on account of age, death, disability, or first—time homebuyer expenses)
distributions
taxed as ordinary income
not taxed (if on account of age, death, disability, or first—time homebuyer expenses)
how long can contributions be made
until age 70 and 1/2 (for deductible IRAs)
no limit
3. No penalty for early IRA withdrawals by first—time homebuyers. Under current law, a 10 percent “additional tax” applies to distributions from an IRA prior to age 59 and 1/2. Beginning in 1998, the Taxpayer Relief Act permits taxpayers to withdraw funds from their IRA prior to age 59 and 1/2 for “first—time homebuyer expenses” without triggering the 10 percent penalty (up to $10,000). The expenses must be incurred to buy or build a principal residence for yourself, or a child or grandchild.
• Caution. To avoid the 10 percent tax on premature IRA distributions, you must use the distribution within 120 days to build or buy a first—time home.
• Caution. To be considered a “first—time homebuyer,” you must not have had an ownership interest in a principal residence during the 2—year period ending on the date of acquisition of the principal residence.
4. Repeal of 15 percent tax on excess distributions from a retirement plan. Under current law, a 15 percent tax is imposed on excess distributions from most types of retirement plans (including IRAs and tax—sheltered annuities). Excess distributions generally are those in excess of $160,000 for 1997, or $800,000 in the case of a lump—sum distribution. Congress suspended this tax for the years 1997 through 1999. The Taxpayer Relief Act repeals it permanently. The new law also repeals the assessment of the 15 percent penalty to “excess accumulations” of funds within a retirement account.
5. Modification of section 403(b) exclusion allowance. Under current law, annual contributions to a 403(b) annuity cannot exceed the “exclusion allowance.” In general, the exclusion allowance is the excess (if any) of (1) 20 percent of the employee’s “includible compensation” multiplied times his or her years of service, over (2) the total employer contributions for an annuity excluded for prior years. The Taxpayer Relief Act provides that the term “includible compensation” shall not include elective deferrals (by salary reduction agreement) into a 403(b) annuity or a cafeteria plan. The effect of this change, which took effect on January 1, 1998, will be to increase the amount that some employees can contribute to their 403(b) annuity.
• Key point. Congress enacted legislation in 1996 removing salary reduction contributions to both 403(b) annuities and cafeteria plans from the definition of “compensation” for computing the limits on employer contributions to 403(b) annuities and other defined contribution retirement plans under Code section 415. The Taxpayer Relief Act applies this same definition of compensation in the context of the exclusion allowance.
Capital gains
1. Capital gains tax rate reduction. Under current law, gain or loss in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of a “capital asset,” the “capital gain” is taxed at ordinary income tax rates, except that individuals are subject to a maximum rate of 28 percent on the net capital gain. A capital asset generally means any property, with some exceptions (including depreciable real estate used in a taxpayer’s trade or business, and property held for sale to customers). Common examples include real personal residences and investments.
The Taxpayer Relief Act contains the following modifications:
! Reduction in rate of tax. The maximum rate of tax on net capital gain of individuals is reduced from 28 percent to 20 percent. This means that taxpayers who are in the 28 percent (or higher) income tax bracket will pay a capital gains tax of 20 percent. Lower—income taxpayers whose ordinary income is taxed at the 15 percent rate will pay a capital gains tax of 10 percent.
• Key point. The lower capital gains tax rates apply to sales and exchanges of capital assets after July 28, 1997. For the lower tax rates to apply, the capital asset must have been held by the taxpayer for more than 18 months.
• Key point. For capital assets held for more than 1 year but not more than 18 months, the maximum capital gains tax rate is 28 percent.
• Key point. The capital gains rate on depreciable real estate used in a taxpayer’s trade or business is reduced to 25 percent.
! Additional tax rate reduction in 2001. Beginning in the year 2001, the maximum capital gains rates for assets which are held for more than 5 years are 18 percent (for persons in the 28 percent or higher ordinary income tax bracket) and 8 percent (for persons in the 15 percent ordinary income tax bracket). The 18 percent rate applies only to assets that are acquired on or after January 1, 2001.
• Example. Rev. C is in the 28 percent ordinary income tax bracket. Rev. C sells securities in December of 1997 resulting in a capital gain of $10,000. The securities were purchased in 1995. The capital gains will be taxed at 28 percent ($2,800) since they were not held for more than 18 months beginning after July 28, 1997.
• Example. Same facts as the previous example, except that Rev. C waits until March of 1999 to sell the securities. If the gain remains $10,000, it will be taxed at the lower 20 percent rate ($2,000) since the securities were held for more than 18 months after July 28, 1997. If Rev. C waits until the year 2006 to sell the securities, the lower 18 percent tax rate will apply. Of course, by waiting for the lower capital gains tax rates to take effect, Rev. C assumes the risk that the value of the securities will decrease.
• Key point. Securities with growth potential as opposed to high income (dividends and interest) are favored by the lower capital gains tax rates.
2. Sales of personal residences. Under current law, no gain is recognized on the sale of a principal residence if (1) a new residence is purchased that is at least equal in cost to the sales price of the old residence, and (2) the new residence is used as a principal residence of the taxpayer at some point within a “replacement period” that begins two years prior to the sale of the old residence and ends two years after the sale. Also, under present law an individual can exclude on a one—time basis up to $125,000 of gains from the sale of a principal residence if the taxpayer (1) has attained age 55 before the sale, and (2) has owned the property and used it as a principal residence for 3 or more of the 5 years preceding the sale.
The Taxpayer Relief Act eliminates these rules for sales of principal residences occurring after May 6, 1997. The new rules are much more liberal, and will greatly benefit many taxpayers. Here is breakdown of the new rules:
! Higher nontaxable amounts. Most importantly, after May 6, 1997 a married couple (who file a joint return) can exclude up to $500,000 of gain from the sale or exchange of a principal residence. Single taxpayers can exclude up to $250,000.
! Holding period. To qualify for the full exclusion, a taxpayer must have owned and occupied the residence as a principal residence for at least 2 of the 5 years prior to the date of sale or exchange. But, unlike the former law, the tax benefit may not be lost completely if this “holding period” is not satisfied. Taxpayers who sell a home without meeting this requirement get a partial benefit if they had to sell their home on account of a change of place of employment, health, or other unforeseen circumstances. The partial benefit is the fraction of $500,000 (or $250,000 for single taxpayers) equal to the fraction of 2 years that the home was owned and occupied as a principal residence.
A special rule applies to persons who become physically or mentally incapable of self—care and who move into a licensed facility (including a nursing home). If they owned and occupied a residence for at least 1 year before moving into such a facility, the 2—year “holding period” rule will not apply to them.
! Multiple sales allowed. The old rule that permitted only one exclusion of up to $125,000 for taxpayers at least 55 years of age is out the window. Taxpayers can claim the $500,000 exclusion every two years, and there is no minimum age requirement!
! Remarriages. Assume that John is a single taxpayer who has never excluded gain from the sale of a home under the new rules. He marries Jane, who has used the exclusion within 2 years prior to their marriage. John can still claim up to a $250,000 exclusion of gain from the sale of residence. Once two years have passed since the last exclusion was allowed to either of them, they can exclude up to $500,000 of gain on a joint return.
• Example. Rev. T is 60 years old, and is considering moving into a smaller and less expensive home. The new law permits Rev. T to do so without being concerned about whether this is the right time to exercise the once in a lifetime exclusion of up to $125,000 in gains from the sale of a residence. The gains Rev. T realizes from selling his current home and buying a less expensive home will be nontaxable gain under the new law-assuming that he lived in the old home for at least 2 years. And, if he later decides to relocate to another home (and at least 2 years have elapsed), he again can exclude the gain from tax.
• Example. Rev. R accepts a position at a church and purchases a new residence. One year later she accepts a position in another church in another state. She sells her former home and purchases a less expensive home resulting in a capital gain of $50,000. Since Rev. R owned and occupied her former home for less than 2 years on account of a change in employment location, she is eligible for a partial exclusion in capital gains. The exclusion is the same fraction as the fraction of 2 years that she owned and occupied her former home. Since she owned and occupied the former home for 1 year, the fraction is one—half. This means that she will pay capital gains tax on only half of her $50,000 gain.
• Example. Rev. G is a widower. In December of 1997 he sells his home and purchases a less expensive home. He excludes the capital gains from tax under the new rules. He remarries in 1998, and his wife sells her home after the marriage. She has never excluded gain from the sale of a residence under the new rules. They can claim an exclusion of up to $250,000 on their 1998 joint tax return.
• Key point. The new law does not “force” taxpayers to replace a current residence with a residence of equal or greater cost in order to avoid capital gains tax.
Estate taxes
1. Estate tax relief. Some people unexpectedly find themselves subject to federal estate taxes because of insurance proceeds, successful investments, and inheritances. The estate tax is substantial-it begins at a 37 percent rate. Fortunately, there are ways to reduce it. Under current law, estates of less than $600,000 are exempt from tax (unchanged since 1987). This amount is increased under the new law as follows:
year ;&nbs p;effective exemption
1997 $600,000
1998 $625,000
1999 $650,000
2000 $675,000
2001 $675,000
2002 $700,000
2003 $700,000
2004 $850,000
2005 $950,000
2006 and thereafter $1 million
These rates are not indexed for inflation.
• Key point. A common technique for reducing estate taxes is through a credit shelter trust. A married couple can double their effective exemption through such a trust, meaning that in the year 2006 and thereafter a married couple can pass up to $2 million tax—free with such a trust. Without it, the estate tax would be avoided completely at the death of the first spouse, but the surviving spouse could then shelter only $1 million from tax.
• Key point. Some estates that include a family—owned business are eligible for a $1.3 million exemption amount beginning in 1998.
2. Annual gift exclusion. Under current law, a taxpayer can exclude up to $10,000 in gifts made to each donee during a calendar year without affecting the $600,000 lifetime exemption from estate taxes described above. Gifts of more than this amount reduce the $600,000 estate exemption. For married couples, the exclusion is available to each spouse. To illustrate, a couple with three children can give up to $60,000 each year ($20,000 to each child), without affecting their exemption from estate taxes. Many couples have used this technique to reduce estate taxes by reducing the size of their estate that will be distributed at death. The $10,000 annual gift exclusion has remained unchanged for several years, meaning that its real value has been steadily eroded by inflation. The Taxpayer Relief Act provides that the $10,000 annual gift exclusion will be indexed for inflation beginning in 1999 (rounded to the next lowest multiple of $1,000).
Employment taxes
1. Delay in penalty for failure to deposit payroll taxes electronically. Current law requires a “phase in” of the electronic deposit of payroll taxes under the Electronic Federal Tax Payment System (EFTPS). Employers that deposited payroll taxes of more than $50,000 in 1995 were required to begin depositing such taxes electronically not later than January 1, 1997. The Small Business Jobs Protection Act of 1996 postponed this deadline until July 1, 1997. The IRS announced in June of 1997 that it would not impose penalties for failure to comply through the end of 1997-for employers that make timely deposits using paper forms while converting over to the EFTPS system. The Taxpayer Relief Act provides that no penalties will be assessed for failure to use the EFTPS system to deposit payroll taxes prior to July 1, 1998.
Tax—exempt organizations
1. Increase in charitable mileage rate. Under current law, taxpayers can deduct out—of—pocket expenses incurred in performing services on behalf of a church or other charity. Since 1984, taxpayers have been permitted to value the use of a car while performing charitable services at a “standard charitable mileage rate” of 12 cents per mile. The Taxpayer Relief Act increases this rate to 14 cents per mile for miles driven on or after January 1, 1998. The new rate is not indexed for inflation.
2. Corporate sponsorship payments. While this provision will not be directly relevant to most churches, it will be relevant to a number of other religious organizations (including parachurch ministries, broadcasters, denominational agencies, and schools). The Taxpayer Relief Act specifies that “qualified sponsorship payments” received by a tax—exempt organization will not be subject to the unrelated business income tax (UBIT). A qualified sponsorship payment is defined as a payment made by a business to a charity in exchange for the use of the business’s name or logo by the charity.
The new law cautions that this exception will not apply to:
(1) Advertising of a company’s products or services “including messages containing qualitative or comparative language, price information, or other indications of savings or value, an endorsement, or an inducement to purchase, sell, or use such products or services.”
(2) Any payment which entitles a company to advertise its name or logo “in regularly scheduled and printed material” published by the charity-unless “related to and primarily distributed in connection with a specific event conducted by” the charity.
(3) Any payment made in connection with any qualified convention or trade show activity.
• Key point. This provision applies to payments made or received on or after January 1, 1998.
• Example. A charity agrees to run ads in a monthly publication for any company that contributes $10,000. Payments received under this arrangement are subject to UBIT. The new law specifies that if a portion of a lump sum payment, if made separately, would be a qualified sponsorship payment, then such portion will be treated as a separate payment. To illustrate, if the company in this example was provided ads and an acknowledgment in exchange for its financial contribution, then the contribution can be divided into two parts-the portion allocated to the ad (which is not a qualified sponsorship payment) and the portion allocated to the acknowledgement (which is a qualified sponsorship payment). The portion allocated to the acknowledgement is that portion that exceeds the fair market value of the advertising provided to the company. It is not subject to UBIT.
• Example. A church is planning a pictorial directory of its membership. It informs the congregation that any business that contributes $1,000 to the project will have its name listed as a sponsor at the end of the directory. This acknowledgement does not subject the financial support to UBIT.
• Example. Same facts as the previous example, except that the congregation is informed that any business contributing at least $1,000 to the project will be able to publish an ad at the end of the directory. Income received by the church under this arrangement probably will be subject to UBIT, since the ads will not be “related to and primarily distributed in connection with a specific event conducted by” the church.
• Example. A church is planning a public concert with a famous musician. To raise funds for the event, it allows local businesses to pay a fee in return for an ad in the printed program that will be distributed to each person attending the concert. The church receives payments from three local music companies. Income received by the church under this arrangement probably will not be subject to UBIT, since the ads are “related to and primarily distributed in connection with a specific event conducted by” the church.
3. Eliminate gift tax filing requirements for gifts to charity. Persons who donate more than $10,000 to any one person or organization in the same year are required to file a federal gift tax return with the IRS. Gifts to churches and other charities are exempted from this requirement. The Taxpayer Relief Act clarifies that this exemption applies only to gifts of a donor’s entire interest in property to the church or charity. It does not apply to a gift of a partial interest in property. This provision applies to gifts made after August 5, 1997.
• Example. John contributes $15,000 in cash to his church in 1997. He is not required to file a gift tax return with the IRS, because he has made a gift of his entire interest in the funds to his church.
• Example. Joan gives her home to her church in December of 1997. She is not required to file a gift tax return with the IRS, even though the home is worth more than $10,000, because she gave her entire interest in the property to the church.
• Example. Same facts as the previous example, except that Joan reserved a “life estate” in the home, which permits her to remain in the home for the rest of her life. Joan must file a gift tax return with the IRS, since she made only a partial gift of her property to the church.
• Example. Jack gives ten acres of land to a church in 1998. The deed provides that if the property ever ceases to be used for church purposes, then title will revert back to Jack or his heirs. Jack has retained a partial interest in the property since title may revert to him or his heirs in the future. As a result, he must file a gift tax return with the IRS. Jack’s interest is known as a “possibility of reverter.”
• Key point. It is common for churches to receive gifts of partial interests in property. Church treasurers should be ready to advise these donors of their obligation to file a federal gift tax return. The form can be obtained by calling the IRS at 1—800—TAX—FORM.
Provisions addressing churches and ministers
1. Contributions on behalf of self—employed ministers to church retirement plans. The Taxpayer Relief Act provides that in the case of contributions made on behalf of a minister who is self—employed to a church plan, the contribution is nontaxable to the extent that it would be if the minister were an employee of a church and the contribution were made to the plan. This provision takes effect in 1998.
2. Church plan exception to group health coverage. Under the Health Insurance Portability and Accountability Act (enacted in 1996), group health plans may not condition participation on an employee’s health or medical condition. The Taxpayer Relief Act provides that certain church plans do not violate this nondiscrimination requirement merely because the plan requires evidence of good health in order for an individual to enroll in the plan, for individuals (1) who are employees of an employer with 10 or fewer employees, or self—employed, or (2) who enroll after the first 90 days of eligibility under the plan. This provision applies to a church for a particular year if the plan required evidence of good health as of July 15, 1997, and at all times thereafter.
3. Religious schools exempt from federal unemployment tax. The Balanced Budget Act contained a provision exempting from federal unemployment tax any work performed in an elementary or secondary school that is operated primarily for religious purposes. The exemption is available even though a religious school is not operated, supervised, controlled, or principally supported by a church or a convention or association of churches. This provision took effect as of August 7, 1997.
First Born Church of the Living God v. Bank South, 472 S.E.2d 469 (Ga. App. 1996).
Background. Is a bank required to honor a change in signature authority on church accounts if the change failed to comply with the church’s constitution? That was the issue facing a Georgia court in a recent case. A church’s bank accounts stated that all checks and withdrawals had to be approved by the senior pastor. A dispute arose in the church, and the congregation was divided over the issue of whether or not to retain their pastor. The church board held an “emergency meeting” at which it removed the pastor and replaced him with another pastor. The board also amended its bank accounts to require that all checks and withdrawals be approved by the new pastor. The former pastor claimed that the board’s actions were invalid because they violated the church constitution. The constitution required that the senior pastor approve any actions adopted by the board. The former pastor claimed that he had not been asked to approve the board’s attempt to change the church bank accounts, and therefore the board’s action was legally invalid. The bank asked a court to determine who controlled the church’s accounts.
The board’s actions were invalid. The court ruled that the board failed to follow the church constitution in attempting to change the bank accounts. The effect of this failure? The board’s attempt to substitute the new pastor on the bank accounts failed. Such a substitution required the former pastor’s approval—according to the church constitution.
The court concluded that it was not barred by the first amendment’s guaranty of religious freedom from resolving this lawsuit. It observed that “the sole issue is not of a religious nature but is secular—whether the board at its emergency meeting duly complied with the provisions of the written constitution. The court’s involvement does not call for the resolution of any ecclesiastical or theological dispute.”
Moral.Every church with a bank account has completed a card or resolution identifying those persons with signature authority. If such a person is removed from office in a manner that violates the church’s constitution or bylaws, then a bank may question the validity of such an action. This can result in unfortunate delays in accessing church funds, which may result in delays in meeting payroll obligations or in paying church debts. This is one of the consequences of attempting to take action in violation of the church’s constitution or bylaws.
Key point. Any attempt by a church to remove a person from office who has signature authority over church bank accounts must be in strict compliance with the church’s constitution or bylaws.
Checklist. Now is a good time to review your records to see who has signature authority over your church bank accounts. Here is a checklist of questions you should ask:
(1) In which banks does the church maintain accounts?
(2) Which persons have signature authority to write checks or make withdrawals?
(3) Are the persons with authority to write checks and make withdrawals the persons duly authorized by the church’s constitution, bylaws, or pertinent board or congregational resolution? If not, this discrepancy should be addressed immediately.
(4) Does your church require the signature of two persons on all checks and withdrawals? If not, this is a serious weakness in your church’s internal control that should be addressed immediately.
This article originally appeared in Church Treasurer Alert, November 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. Every church has received contributions designating a specific project or use. It is important for church treasurers to understand the tax implications of such gifts. Are they tax-deductible? Should the church issue the donor a receipt acknowledging the contribution? Can the donor claim a tax deduction on his or her tax return? A recent IRS ruling addresses this important topic. While the case involved a university, it is directly relevant to churches.
Facts. A university owned several fraternity houses. Over the past several years, the physical condition of the fraternity houses declined to such an extent that student safety was jeopardized. As a result, university officials launched a fund-raising drive to help finance the cost of reconstructing and remodeling the fraternity houses. Donors were encouraged to contribute for the renovation of a specific fraternity house, and the university assured donors that it would “attempt” to honor their designations. However, the university made it clear to donors that it accepted their designated gifts with the understanding that the designations would not restrict or limit the university’s full control over the contributions, and that the university could use the designated contributions for any purpose.
What the IRS said. The IRS cautioned that for a designated gift to be a tax-deductible charitable contribution, it
must be in reality a gift to the college and not a gift to the fraternity by using the college as a conduit. The college must have the attributes of ownership in respect of the donated property, and its rights as an owner must not, as a condition of the gift, be limited by conditions or restrictions which in effect make a private group the beneficiary of the donated property. In addition … the college should, as an owner, be free to use the property acquired with the gift as its future policy suggests or requires ….
[The] university will accept gifts designated for the benefit of a particular fraternity only with the understanding that such designation will not restrict or limit university’s full ownership rights in either the donated property or property acquired by use of the donated property.
Accordingly, we conclude that contributions made to university for the purpose of reconstructing and remodeling fraternity housing will qualify for a charitable contribution deduction ….
Relevance to church treasurers. There are two major types of designated contributions—those that designate a person as the intended recipient, and those that designate a project. This ruling addresses only the second type of designated contribution. It illustrates an important point—a contribution to a church that specifies a particular project qualifies as a charitable contribution so long as
(1) the church has the “attributes of ownership” with respect to the contribution, and
(2) the church’s rights as owner of the contributed property are not “limited by conditions or restrictions which in effect make a private group the beneficiary of the donated property.”
Examples. Let’s illustrate the IRS ruling with a few examples.
Example. A church establishes a “new building” fund. Bob donates $500 to his church, with the stipulation that the money be placed in the “new building” fund. This is a valid charitable contribution, and may be treated as such by the church treasurer.
Example. Barb would like to help her church’s music director buy a new home. She contributes $10,000 to her church, with the stipulation that it be used “for a new home for our music director.” Neither the church board nor congregation has ever agreed to assist the music director in obtaining a home. Barb’s gift is not a charitable contribution. As a result, the church treasurer should not accept it. Barb should be advised to make her gift directly to the music director. Of course, such a gift will not be tax-deductible by Barb. On the other hand, the music director may be able to treat it as a tax-free gift.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Alston v. City of Camden, 471 S.E.2d 174 (S.C. 1996)
Background. Many churches have policies or handbooks that describe employee “fringe benefits.” Common examples include vacation leave, sick leave, medical and life insurance, and retirement plans.What happens when a church decides that it cannot maintain fringe benefits at current levels? Does it have a legal right to reduce these benefits? This is a complex and controversial question that was addressed in a recent ruling.
Facts. A city issued a new employee handbook that replaced its old one. All employees were notified of the change and were informed of reductions in certain fringe benefits. These included (1) a reduction in the maximum accrual of annual leave from 60 days to 45 days; (2) discontinuance of a policy that had permitted employees to “redeem” accrued sick leave for cash; and (3) a reduction in the amount contributed by the city for employees’ health insurance. When employees learned of these reductions in fringe benefits under the new employment handbook, they sued the city claiming that their contractual rights under the old handbook had been violated.
A court rejects the employees’ claim. The South Carolina Supreme Court rejected the employees’ claim. It observed:
The contracts (if any) created by the original employee handbook did not give rise to any legitimate expectation that the fringe benefits provided for therein would continue for any specific amount of time. Recent rulings by this court make clear that contractual rights created by employee handbooks are subject to unilateral modification at any time, provided the employees received actual notice of the modifications. This rule rests on the recognition that the employer-employee relationship is not static. Employers must have a mechanism which allows them to alter the employee handbook to meet the changing needs of both [the employer] and employees. This is especially true where, as here, employees concede their “at will” status.
The court added that any other conclusion would “cripple the efficient operation” of employers.
Relevance to church treasurers. This case illustrates that in some cases it may be legally permissible for a church to reduce fringe benefits offered to employees. The court concluded that modifications in employee handbooks that reduce fringe benefits are legally permissible so long as the employees receive actual notice of the changes, and the changes do not operate retroactively.
This is a controversial area of law. The importance of this case is that it demonstrates that some courts liberally permit employers to modify and reduce fringe benefits. Of course, a church should not consider reducing fringe benefits without the assistance of legal counsel.
Checklist. In general, reductions in fringe benefits are more likely to be upheld by the courts if the following conditions are met:
(1) The employee handbook contains a conspicuous disclaimer on the title page (in bold, capital letters) informing employees that it is not a contract, and no provision, benefit, or policy shall be deemed to be contractual in nature.
(2) The employee handbook specifically permits the employer to modify any provision, including increases or reductions in any employee benefit. Such a statement should be conspicuous, and appear on the title page.
(3) At the time of hire, all new employees should sign a statement confirming receipt of the employee handbook, and acknowledging their understanding and agreement that the handbook is not contractual in nature and is subject to unilateral modification by the employer (including reductions in employee benefits).
(4) At the time of any modification in an employee handbook, or the replacement of employee handbook with an updated version, all employees should sign a statement acknowledging that the employer fully explained the new provisions to them, and that they understand and accept them.
This article originally appeared in Church Treasurer Alert, November 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
What Church Treasurers Need to Know About the Recent Tax Legislation
Important changes in payroll taxes, unemployment taxes, charitable mileage rate, and more.
What Church Treasurers Need to Know About the Recent Tax Legislation
Important changes in payroll taxes, unemployment taxes, charitable mileage rate, and more.
Richard R. Hammar
Background. Congress enacted two major tax laws in August—the Taxpayer Relief Act and the Balanced Budget Act. Together, these laws amend over 800 sections of the Internal Revenue Code (our federal tax law), and add more than 300 new sections. We have fully reviewed the new laws, and are summarizing in this article those provisions of most relevance to church treasurers.
1. Delay in penalty for failure to deposit payroll taxes electronically. In 1993 Congress enacted legislation 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). The new electronic system is phased in over a period of years by increasing the percentage of total taxes subject to the new EFTPS system each year. For 1997, the target percentage was to be achieved by requiring all employers that deposited more than $50,000 in payroll taxes in 1995 to begin using EFTPS by January 1, 1997. Congress later postponed this deadline until July 1, 1997, and the IRS announced earlier this year that it would not impose penalties for noncompliance through the end of 1997—for employers that make timely deposits using paper forms while converting over to the EFTPS system. The recent Taxpayer Relief Act provides that no penalties will be assessed for failure to use the EFTPS system to deposit payroll taxes prior to July 1, 1998.
Key point. If you had a federal payroll tax obligation of more than $50,000 for 1995, you must use the EFTPS system to deposit payroll taxes not later than July 1, 1998. There are no exceptions for churches or other religious or charitable organizations. Failure to comply may result in a 10 percent penalty.
Example. A church had 2 ministers and 4 nonminister employees in 1995. The ministers were treated as employees, but did not elect voluntary withholding of their federal income taxes. The church had a federal payroll tax obligation of $20,000. It does not have to begin using the EFTPS system to deposit payroll taxes in 1998.
Example. A church had 3 ministers and 8 nonminister employees in 1995. The ministers were treated as employees, and elected voluntary withholding of payroll taxes. The church had a federal payroll tax obligation of $55,000. It must begin using the EFTPS program to deposit payroll taxes no later than July 1, 1998.
Key point. For further information on how to comply with the EFTPS requirements, see the May 1997 issue of this newsletter.
2. Increase in charitable mileage rate. Church members often ask if they can deduct transportation expenses incurred in performing services on behalf of the church. For example, a church member uses her car to visit other members in the hospital. Or, a member uses his car to visit new members. Are these expenses deductible as a charitable contribution, and if so, how is the contribution computed? Church treasurers should be able to respond to such questions.
The income tax regulations specify that “out-of-pocket transportation expenses necessarily incurred in performing donated services are deductible” as charitable contributions. The IRS permits taxpayers to deduct either their actual transportation costs incurred in performing charitable work, or a standard mileage rate that has been 12 cents per mile since 1984.
The Taxpayer Relief Act increases the charitable standard mileage rate to 14 cents per mile for miles driven on or after January 1, 1998. The new rate is not indexed for inflation.
Key point. Church members can continue to deduct the actual cost of using a vehicle to perform charitable services instead of using the charitable standard mileage rate. IRS Publication 526 (“Charitable Contributions”) states that “you may deduct unreimbursed out of pocket expenses, such as the cost of gas and oil, that are directly related to the use of your car in giving services to a charitable organization. You may not deduct general repair and maintenance expenses, depreciation, or insurance …. You may deduct parking fees and tolls, whether you use your actual expenses or the standard rate.”
3. Corporate sponsorship payments. Many churches produce pictorial directories of members, and sponsor concerts or other events. In some cases, churches seek financing for these projects from local businesses. For a fee, a business can have its name appear as a sponsor in the pictorial directory, or in a printed program distributed at the concert or other event. Are these fees subject to the federal unrelated business income tax (UBIT)? The recent Taxpayer Relief Act addresses this issue directly. Here are the new rules:
“Qualified sponsorship payments” received by a church or other charity will not be subject to UBIT. A qualified sponsorship payment is defined as a payment made by a business to a charity in exchange for the use of the business’s name or logo by the charity.
This exception will not apply to any payment which entitles a company to advertise its name or logo “in regularly scheduled and printed material” published by the charity—unless “related to and primarily distributed in connection with a specific event conducted by” the charity.
Key point. This provision applies to payments made or received on or after January 1, 1998.
Example. A church is planning a pictorial directory of its membership. It informs the congregation that any business that contributes $1,000 to the project will have its name listed as a sponsor at the end of the directory. This acknowledgement does not subject the financial support to UBIT.
Example. Same facts as the previous example, except that the congregation is informed that any business contributing at least $1,000 to the project will be able to publish an ad at the end of the directory. Income received by the church under this arrangement probably will be subject to UBIT, since the ads will not be “related to and primarily distributed in connection with a specific event conducted by” the church.
Example. A church is planning a public concert with a famous musician. To raise funds for the event, it allows local businesses to pay a fee in return for an ad in the printed program that will be distributed to each person attending the concert. The church receives payments from three local music companies. Income received by the church under this arrangement probably will not be subject to UBIT, since the ads are “related to and primarily distributed in connection with a specific event conducted by” the church.
4. Eliminate gift tax filing requirements for gifts to charity. Persons who donate more than $10,000 to any one person or organization in the same year are required to file a federal gift tax return with the IRS. Gifts to churches and other charities are exempted from this requirement. The Taxpayer Relief Act clarifies that this exemption applies only to gifts of a donor’s entire interest in property to the church or charity. It does not apply to a gift of a partial interest in property. This provision applies to gifts made after August 5, 1997.
Example. John contributes $15,000 in cash to his church in 1997. He is not required to file a gift tax return with the IRS, because he has made a gift of his entire interest in the funds to his church.
Example. Joan gives her home to her church in December of 1997. She is not required to file a gift tax return with the IRS, even though the home is worth more than $10,000, because she gave her entire interest in the property to the church.
Example. Same facts as the previous example, except that Joan reserved a “life estate” in the home, which permits her to remain in the home for the rest of her life. Joan must file a gift tax return with the IRS, since she made only a partial gift of her property to the church.
Example. Jack gives ten acres of land to a church in 1998. The deed provides that if the property ever ceases to be used for church purposes, then title will revert back to Jack or his heirs. Jack has retained a partial interest in the property (since title may revert to him or his heirs in the future). Jack’s interest is known as a “possibility of reverter.”
Key point. It is common for churches to receive gifts of partial interests in property. Church treasurers should be ready to advise these donors of their obligation to file a federal gift tax return. The form can be obtained by calling the IRS at 1-800-TAX-FORM.
5. Contributions on behalf of self-employed ministers to church retirement plans. The Taxpayer Relief Act provides that in the case of contributions made on behalf of a minister who is self-employed to a church plan, the contribution is nontaxable to the extent that it would be if the minister were an employee of a church and the contribution were made to the plan. This provision takes effect in 1998.
6. Church plan exception to group health coverage. Legislation enacted in 1996 prohibits group health plans from excluding an employee on account of his or her health or medical condition. The Taxpayer Relief Act provides that church plans do not violate this nondiscrimination requirement merely because the plan requires evidence of good health in order for an individual to enroll in the plan. However, this exception only applies with respect to individuals (1) who are employees of an employer with 10 or fewer employees, or self-employed, or (2) who enroll after the first 90 days of eligibility under the plan. Further, this exception applies to a church for a particular year only if the health plan required evidence of good health as of July 15, 1997, and at all times thereafter.
7. Religious schools exempt from federal unemployment tax. Since 1970, all work performed for nonprofit organizations is subject to federal unemployment tax and must be covered by state unemployment law, unless specifically exempted by law. Exemptions have included work performed for a church (or convention or association of churches), or an organization “which is operated primarily for religious purposes and which is operated, supervised, controlled, or principally supported by a church or convention or association of churches.” The recent Balanced Budget Act expands this list of exceptions to include work performed in an elementary or secondary school that is operated primarily for religious purposes, even if it is not operated, supervised, controlled, or principally supported by a church or a convention or association of churches.
Key point. Some churches that operate private schools have separately incorporated them in order to reduce the church’s risk of liability. Unfortunately, separate incorporation will have little effect on the church’s liability for the obligations of the school—unless the church relinquishes control of the school. If a church is willing to relinquish control, then the school becomes largely independent. This has a number of consequences, including the following: (1) liability of the church is reduced; and (2) employees of the school are not covered by federal or state unemployment law in most states.
8. New W-4s. The recent Taxpayer Relief Act does what its title suggests—it provides significant tax relief to many taxpayers. The biggest winners are lower and middle income taxpayers. As a result, many church staff members will be paying less taxes in 1998. Church treasurers should encourage all staff members to consider filing new and updated W-4 forms for 1998—to reduce their income tax withholdings.
Key point. This is especially true for staff members with more than one minor child. These employees will be eligible for a $400 per child tax credit in 1998 ($500 in 1999). The effect of a credit is a dollar-for-dollar reduction in income taxes—which is far more advantageous than a deduction or exclusion. These employees will see a significant reduction in their income tax liability.
This article originally appeared in Church Treasurer Alert, October 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Background. Church treasurers occasionally are asked to return a charitable contribution. In some cases, the request comes directly from the donor. In other cases, the request comes from a bankruptcy trustee. This article will review both kinds of requests, and provide church treasurers with guidance on how to respond.
Key point. Church treasurers must not treat donors’ requests for a return of their contributions as simply a “public relations” matter. There are legal and tax issues that must be addressed in addition to any desire to “keep donors happy.”
Requests from donors. Have you ever had a donor ask you to return a contribution? Many church treasurers have had this experience, and have not known how to respond. You should be familiar with the following rules:
(1) undesignated contributions
Most charitable contributions are undesignated, meaning that the donor does not specify how the contribution is to be spent. An example would be a church member’s weekly contributions to a church’s general fund. Undesignated contributions are unconditional gifts. This means that they are an irrevocable transfer of a donor’s entire interest in the donated funds. Since the donor’s entire interest in the donated property is transferred, the church has absolutely no legal obligation to return undesignated contributions to a donor under any circumstances. In fact, there are a number of problems associated with the return of undesignated contributions to a donor. These include:
Amended tax returns. Donors who receive a “refund” of their contributions would have to be informed that they will need to file amended federal tax returns if they previously claimed a charitable contribution deduction for their “contributions”. This would mean that donors would have to file a Form 1040X with the IRS. In most states, donors also would have to file amended state income tax returns.
1099s. Any donor who receives back contributions of $600 or more should be issued a 1099-MISC form from the church. Why? Because failure to do so may expose the church to penalties for aiding and abetting in the understatement of income—if some donors fail to file amended tax returns.
Tip. Most donors who ask for a refund of their contributions for a prior year will change their minds when informed that they will need to file an amended tax return for the year in question, and that the church will be issuing them a 1099 reporting the full amount of the returned contributions.
“Refund department”. Compliance with a donor’s demand for the return of a contribution would morally compel a church to honor the demands of anyone wanting a return of a contribution. This would establish a terrible precedent.
Tip. Churches should resist appeals from donors to return their undesignated contributions. There is no legal basis for doing so, even in “emergencies”. Honoring such requests can create serious problems, as noted above. Our recommendation—do not honor such requests without the recommendation of an attorney.
(2) designated contributions
Many donors make “designated” contributions to a church. That is, the donor designates how the contribution is to be spent. For example, a donor contributes a check in the amount of $500 and specifies that it be used for missions, or the building fund, or some other specific project. It is very important for church treasurers to understand that designated contributions are held by the church “in trust” for the designated purpose.
So long as the church honors the donor’s designation, or plans to do so in the foreseeable future, it has no legal obligation to return such a contribution if asked to do so. Quite to the contrary, returning a donor’s designated contribution under these circumstances would create the same problems associated with the return of undesignated contributions (summarized above).
What if a donor contributes money to a church’s building fund and the church later abandons its plans to construct a new facility? Such contributions are conditioned on the church pursuing its building program. When the condition fails, the contribution is revocable at the option of the donor. Should the church refund designated contributions to donors under these circumstances? There are a number of possibilities, including the following:
Donors can be identified. If donors can be identified, they should be asked if they want their contributions returned or retained by the church and used for some other purpose. Ideally, donors should communicate their decision in writing to avoid any misunderstandings. Churches must provide donors with this option in order to avoid violating their legal duty to use “trust funds” only for the purposes specified.
Tip. Churches should advise such donors that they will need to file amended tax returns if they claimed a charitable contribution deduction for their contributions in a prior year. And, the church should advise donors who request a refund of at least $600 in prior year contributions that it will need to issue them a 1099-MISC form reporting the returned contributions.
Key point. Often, donors prefer to let the church retain their designated contributions rather than go through the inconvenience of filing an amended tax return and being issued a 1099 form.
Donors cannot be identified. A church may not be able to identify all donors who contributed to the building fund. This is often true of donors who contributed small amounts, or donors who made anonymous cash offerings to the building fund. In some cases, designated contributions were made many years before the church abandoned its building plans, and there are no records that identify donors. Under these circumstances the church has a variety of options.
One option would be to address the matter in a meeting of church members. Inform the membership of the amount of designated contributions in the church building fund that cannot be associated with individual donors, and ask the church members to take an official action with regard to the disposition of the building fund. In most cases, the church membership will authorize the transfer of the funds to the general fund. Note that this procedure is appropriate only for that portion of the building fund that cannot be traced to specific donors.
Other options are available. Churches should be sure to consult with a local attorney when deciding how to dispose of designated funds if the specified purpose has been abandoned.
Key point. This article has focused on building funds. The same analysis is relevant to contributions that designate any other specific purpose or activity. Other examples include contributions designating a new organ, a missions activity, or a new vehicle.
Requests by bankruptcy trustees. Some bankruptcy trustees have asked churches to return contributions made by a bankrupt donor. Perhaps this has happened in your church. It is important for church treasurers to know how to respond to such requests. Federal law gives bankruptcy trustees the power to “set aside” transfers by bankrupt debtors for less than fair value during the twelve months preceding the filing of a bankruptcy petition.
Example. A bankruptcy trustee contacts a church and demands that it return all contributions made by a bankrupt member during the twelve months preceding the filing of a bankruptcy petition. The trustee claims that contributions made by the church were transfers for less than fair value, and so they can be recovered by the bankruptcy court.
Must the church return the contributions? What about the constitutional guaranty of religious freedom? Does it protect the church? Note the following:
A federal appeals court ruled in 1996 that the first amendment guaranty of religious freedom did not prevent bankruptcy trustees from recovering contributions made by bankrupt donors to a church. However, the court ruled that allowing trustees to recover contributions would violate the Religious Freedom Restoration Act with respect to those donors for whom giving to their church was an important religious practice. In re Young, 82 F.3d 1407 (8th Cir. 1996).
In 1997, the Supreme Court struck down the Religious Freedom Restoration Act on the ground that Congress exceeded its authority in enacting the law. This decision has the effect of repealing the Young case discussed in the previous paragraph. Contributions made by church members to their church within a year before filing a bankruptcy petition are now subject to recovery by a bankruptcy court.
Example. Same facts as the previous example. The church claims that turning over the member’s contributions would violate the member’s first amendment right to freely exercise his religion. The church will lose. The Supreme Court has ruled that “neutral laws of general applicability,” like the bankruptcy law, are valid even if they impose a burden on religious practices or beliefs.
In summary, there is little chance that a church or donor could successfully challenge a bankruptcy trustee’s efforts to recover contributions made by the donor within one year of filing a bankruptcy petition.
This article originally appeared in Church Treasurer Alert, September 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Abandoning Rental Property
When is a church legally allowed to abandon a rented building?
Background. Many churches rent property. What if the property becomes uninhabitable because of defective conditions on the premises? Under what circumstances is a church legally justified in abandoning rented premises? That was the issue addressed by a Texas court in a recent case.
Facts. A church leased a facility in which it conducted religious services. When the church moved on the leased property one air conditioner was not working, and the property’s two other air conditioners needed servicing. The pastor also discovered there was no insulation in the building and that one restroom did not work properly. To make matters worse, the roof leaked every time it rained. This caused offensive odors, a stained and rotting floor, and soaked ceiling tiles. The church abandoned the premises, and was promptly sued by the property owner for breach of contract.
The court’s ruling. The court ruled that state law recognizes an “implied warranty” in any commercial lease that the premises are suitable for their intended purpose. Factors to be considered when determining whether there has been a breach of this warranty are:
(1) the nature of the defect, (2) its effect on the tenant’s use of the premises, (3) the length of time the defect persisted, (4) the age of the structure, (5) the amount of rent, (6) the area in which the premises are located, (7) whether the tenant waived the defects, and (8) whether the defect resulted from any unusual or abnormal use by the tenant.
The court concluded that there was sufficient evidence that the property was uninhabitable for its intended purpose, and that the church was justified in abandoning it. The court noted that “the evidence establishes the nature of the defects on the property, the defects’ effect on [the church’s] use of the property and the persistent nature of the defects. In addition, there is evidence to support the findings that [the church] neither waived the defects nor caused the defects through abnormal use of the premises.”
Relevance to church treasurers. This case illustrates an important legal principle—tenants are not required to honor a lease if the premises become uninhabitable. However, the court cautioned that a tenant can waive a right to abandon such premises. This can happen if a tenant does not object to conditions that exist at the time of the lease. Obviously, an inspection of any rental property is essential prior to signing a lease agreement. If there are defective conditions, the landlord’s responsibility for correcting them should be addressed in the lease. Of course, a church should not make a decision to abandon leased property without the advice of a local attorney who is familiar with real estate law. Also, note that this case will be relevant to churches that rent their own property. To illustrate, many churches own residential properties that were acquired for future expansion, and these properties often are rented. Tenants may have a legal right to abandon such leases with the church on the same grounds addressed by the Texas court. Ruiz v. Hilley, 1996 WL 580940 (Tex. App. 1996).
This article originally appeared in Church Treasurer Alert, September 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Rental Income Not Taxable, Says IRS
Though only if certain conditions are met, IRS notes.
Though only if certain conditions are met, IRS notes.
Richard R. Hammar
A charity rented a portion of its premises to another charity with similar purposes. The IRS ruled that the rental income was not subject to the “unrelated business income tax” (UBIT), even though the property was “debt-financed,” since the rental arrangement was “substantially related” to the charity’s exempt purposes. The IRS noted that rental income received by a charity from “debt-financed” property generally is subject to UBIT. However, an exception applies to rental agreements that are substantially related to the charity’s exempt purposes. The IRS noted that “an organization’s leasing of its property to others may be substantially related to the performance of its exempt function.” This test was met, the IRS concluded, because the rental agreement “will contribute importantly to the accomplishment of [the charity’s] purposes” and will help further its “charitable goals.”
The IRS noted that a rental agreement will be “substantially related” to a charity’s exempt purposes if it meets any one or more of the following conditions:
(1) it has a “causal relationship to the achievement of exempt purposes (other than through the production of income)”
(2) it contributes importantly to the accomplishment of those purposes
(3) the entire property is devoted to the charity’s exempt purposes at least 85 percent of the time, or
(4) at least 85 percent of the property (in terms of physical area) is used for the charity’s exempt purposes. IRS Letter Ruling 9726005.
Key point. Church treasurers should apply these same considerations in evaluating whether or not rental income from debt-financed property is taxable.
Key point. Rental income from debt-free property is not subject to UBIT.
This article originally appeared in Church Treasurer Alert, September 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Supreme Court Strikes Down Religious Freedom Restoration Act
Article summary. The Supreme Court struck down the Religious Freedom Restoration Act on the ground that Congress exceeded its authority in enacting the law. The Court’s decision will impact virtually every religious organization in America. Some of those impacts are predictable, but others are not. This article explores the practical significance of the Court’s decision to churches and other religious organizations.
In 1993 Congress (by an extraordinary unanimous vote) enacted the Religious Freedom Restoration Act (RFRA). The purpose of RFRA was to reverse a 1990 Supreme Court ruling that greatly limited the first amendment guaranty of religious freedom. The Court’s decision will make it much more difficult for churches and religious adherents to challenge a government law or action that infringes upon a religious belief or practice. The Court’s decision impacts most if not all churches and religious organizations. This article will summarize the background and facts of the case, review the Court’s ruling, and evaluate the significance of the case to churches.
Background
pre—1990 law-government needs a compelling interest to restrict the free exercise of religion
The first amendment to the United States Constitution protects a number of fundamental rights, including the free exercise of religion. The first amendment specifies that “Congress shall make no law … prohibiting the free exercise of religion.” For many years, the United States Supreme Court interpreted this language to mean that the government could not impose substantial burdens on the exercise of sincerely—held religious beliefs unless its actions were justified by a “compelling state interest” that could not be served through less restrictive means. In a 1990 ruling, the Supreme Court revised its understanding of the “free exercise” clause. Employment Division v. Smith, 494 U.S. 872 (1990).
The Smith case-no compelling interest needed for “neutral laws of general applicability”
Oregon law prohibits the intentional possession of a “controlled substance,” including the drug peyote. Two employees of a private drug rehabilitation organization were fired from their jobs because they consumed peyote for “sacramental purposes” at a ceremony of the Native American Church. The two individuals applied for unemployment benefits under Oregon law, but their application was denied on the grounds that benefits are not payable to employees who are discharged for “misconduct.” The two former employees claimed that the denial of benefits violated their constitutional right to freely exercise their religion. The Supreme Court ruled that (1) the constitutional guaranty of religious freedom did not prohibit a state from criminalizing the sacramental use of a narcotic drug, and (2) the state of Oregon could deny unemployment benefits to individuals who were fired from their jobs for consuming peyote.
The Court began its opinion by noting that “we have never held that an individual’s religious beliefs excuse him from compliance with an otherwise valid law prohibiting conduct that the state is free to regulate.” On the contrary, the constitutional guaranty of religious freedom “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 [prohibits] conduct that his religion prescribes.”
• Key point. The Court did not throw out the “compelling state interest” requirement in all cases involving governmental restrictions on religious freedom. Rather, the Court stated that this requirement does not apply to restrictions caused by a “neutral law of general applicability.” A law or other government act that targets or singles out religious organizations must be supported by a compelling state interest. Further, as noted below, the compelling state interest requirement applies if a second constitutional right is burdened by a law or other government act.
The real significance of the Court’s ruling was its refusal to apply the “compelling state interest” test as requested by the discharged employees. As noted above, the Supreme Court previously had interpreted the constitutional guaranty of religious freedom to mean that the government could not impose substantial burdens on the exercise of sincerely—held religious beliefs unless its actions were justified by a “compelling state interest” that could not be served through less restrictive means. The former employees argued that the Oregon law’s denial of unemployment benefits to persons using peyote for sacramental purposes was not supported by a “compelling state interest” and accordingly could not be applied without violating the constitution.
The Court justified its refusal to apply the “compelling state interest” test by noting that
it had not applied the test in a number of its recent decisions
it had never found a state law limiting religious practices invalid on the ground that it was not supported by a compelling state interest, and
the compelling state interest test should never be applied “to require exemptions from a generally applicable criminal law”
The Court rejected the former employees’ suggestion that the “compelling state interest” test be applied only in cases involving religiously—motivated conduct that is “central” to an individual’s religion. This would require the courts to make judgments on the importance of religious practices-and this the civil courts may never do. The only options are to apply the “compelling state interest” test to all attempts by government to regulate religious practices, or to not apply the test at all. Applying the test in all cases involving governmental attempts to regulate religious practices would lead to “anarchy,” since it would render “presumptively invalid” every law that regulates conduct allegedly based on religious belief. This would open the floodgates of claims of religious exemption “from civic obligations of almost every conceivable kind-ranging from compulsory military service to the payment of taxes, to health and safety regulation such as manslaughter and child neglect laws, compulsory vaccination laws, drug laws; to social welfare legislation such as minimum wage laws, child labor laws, animal cruelty laws, environmental protection laws, and laws providing for equality of opportunity for the races. The first amendment’s protection of religious liberty does not require this.”
The Court’s ruling represents a clear departure from its previously well—established understanding of the constitutional guaranty of religious freedom. No longer will a state need to demonstrate that a “compelling state interest” supports a law that prohibits or restricts religious practices. This is unfortunate, and will tend to make it more difficult to prove that a state’s interference with religious practices violates the guaranty of religious freedom. Four of the Court’s nine justices disagreed with the Court’s analysis, and with the virtual elimination of the “compelling state interest” test. The minority asserted that the Court’s ruling diminished the guaranty of religious liberty by making it more difficult for persons to prove a violation of this fundamental constitutional guaranty. One of the dissenting Justices lamented that the Court’s decision tilts the scales “in the state’s favor,” and “effectuates a wholesale overturning of settled law concerning the religion clauses of our Constitution. One hopes that the Court is aware of the consequences ….”
Congress responds – the Religious Freedom Restoration Act
The consequences of the Supreme Court’s reinterpretation of the first amendment guaranty of religious freedom were predictable. Scores of lower federal courts and state courts upheld laws and other government actions 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 in an extraordinary way-by enacting the Religious Freedom Restoration Act by a unanimous vote of both houses. RFRA was signed into law by President Clinton in 1993.
In the Senate, RFRA was introduced by Senators Kennedy and Hatch along with several other Senators. Senator Kennedy, in introducing the Act, made the following remarks:
The Supreme Court’s 1990 decision in Employment Division v. Smith sharply limited the first amendment’s guarantee of freedom of religion. Until then, government actions that interfered with individuals’ ability to practice their religion were prohibited, unless the restriction met a strict two—part test. It must be necessary to achieve a compelling governmental interest, and there must be no less burdensome way to achieve the goal.
The compelling interest test had been the constitutional standard for nearly 30 years. Yet, in 1990, the Court abruptly abandoned it. Under the new standard, there is no special constitutional protection for religious liberty, as long as governmental restrictions are neutral on their face as to religion and have general application.
The bill we are reintroducing today restores the compelling interest test by statute. Not every free exercise claim will prevail. The previous standard had worked well for many years, and it deserves to be reinstated. Few issues are more fundamental to our country. America was founded as a land of religious freedom and a haven from religious persecution. Two centuries later, that founding principle has been endangered. Religious liberty is damaged each day the Smith decision stands. Since Smith , more than 50 cases have been decided against religious claimants, and harmful rulings are likely to continue.
As a result of the Smith decision, it has been suggested that government could regulate the selection of priests and ministers, dry communities could ban the use of wine in communion services, government meat inspectors could require changes in the preparation of kosher food, and school boards could force children to attend sex education classes contrary to their faith. Because of this threat to religious freedom, organizations with widely divergent views strongly support this legislation, including the National Council of Churches, the National Association of Evangelicals, the United States Catholic Conference, the American Jewish Committee, the American Muslim Council, the Southern Baptist Convention, the Baptist Joint Committee, the Episcopal Church, the Christian Legal Society, the Church of Jesus Christ of Latter—day Saints, the American Civil Liberties Union, People for the American Way, Coalitions for America, Concerned Women for America, and the House School Legal Defense Association.
Similarly, Senator Hatch observed:
I am pleased today to introduce, along with Senator Kennedy and others, the Religious Freedom Restoration Act of 1993. This legislation responds to the Supreme Court’s April 17, 1990, decision in Employment Division v. Smith, 494 U.S. 892 (1990). In the Smith case, the Supreme Court abandoned the compelling state interest standard of review for government practices burdening an individual’s exercise of religion where the government action involves a “valid and neutral law of general applicability.”
In my view, the standard outlined by the Court in Smith does not sufficiently protect an individual’s first amendment right to the “free exercise” of religion. Freedom of religion is the first freedom in the Bill of Rights, guaranteed to every individual, not just those who practice their faith in a majority religion. I do not believe the framers of the first amendment envisioned that the religious minority would remain at a relative disadvantage in our society as an unavoidable consequence of our democratic government, as the Court suggests. In my view, it was exactly this relative disadvantage a religious minority might suffer that the authors of the first amendment specifically sought to avoid and protect against. The free exercise of religion is not a luxury afforded our citizenry, but a well conceived and fundamental right …. Supporters of this legislation include over 55 groups, representing an extremely broad and diverse coalition of religious and civil liberties organizations, including the U.S. Catholic Conference.
It is clear to me a legislative response is critical to the preservation of the full range of religious freedoms the first amendment guarantees to the American people, particularly those whose religious beliefs and practices differ from the religious majority in our country. This bill will serve to reestablish those rights guaranteed in the first amendment by imposing the “compelling state interest” standard for judicial review of governmental action which burdens an individual’s free exercise of religion. It is imperative Congress act expeditiously in response to the Smith decision.
RFRA begins by reciting the following “congressional findings”:
(1) the framers of the Constitution, recognizing free exercise of religion as an unalienable right, secured its protection in the first amendment to the Constitution;
(2) laws “neutral” toward religion may burden religious exercise as surely as laws intended to interfere with religious exercise;
(3) governments should not burden religious exercise without compelling justification;
(4) in Employment Division v. Smith, 494 U.S. 872 (1990) the Supreme Court virtually eliminated the requirement that the government justify burdens on religious exercise imposed by laws neutral toward religion; and
(5) the compelling interest test as set forth in prior federal court rulings is a workable test for striking sensible balances between religious liberty and competing prior governmental interests.
RFRA next states its purposes as follows: “(1) to restore the compelling interest test … and to guarantee its application in all cases where free exercise of religion is burdened; and (2) to provide a claim or defense to persons whose religious exercise is burdened by government.”
The key provision of RFRA is section 3, which specifies:
(a) IN GENERAL. Government shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability, except as provided in subsection (b) ….
(b) EXCEPTION. Government may substantially burden a person’s exercise of religion only if 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.
(c) JUDICIAL RELIEF. A person whose religious exercise has been burdened in violation of this section may assert that violation as a claim or defense in a judicial proceeding and obtain appropriate relief against the government. Standing to assert a claim or defense under this section shall be governed by the general rules of standing under article III of the Constitution.
In practical terms, how did the enactment of RFRA affect local churches and other religious organizations? There is little doubt that it provided significant protections to the exercise of religion. Any law or government practice (whether at the local, state, or federal level) that “burdened” the exercise of religion was legally permissible only if the law or practice (1) was in furtherance of a compelling governmental interest, and (2) was the least restrictive means of furthering that compelling governmental interest. These were difficult standards to meet. As the Supreme Court itself observed in 1993, the concept of a “compelling governmental interest” is a very difficult standard for the government to satisfy:
A law burdening religious practice that is not neutral or not of general application must undergo the most rigorous of scrutiny. To satisfy the commands of the first amendment, a law restrictive of religious practice must advance interests of the highest order and must be narrowly tailored in pursuit of those interests. The compelling interest standard that we apply once a law fails to meet the Smith requirements is not “watered … down” but “really means what it says.” A law that targets religious conduct for distinctive treatment or advances legitimate governmental interests only against conduct with a religious motivation will survive strict scrutiny only in rare cases …. Church of the Lukumi Babaluaye, Inc. v. City of Hialeah, 1993 WL 195255 (1993).
As noted below, in the years following the enactment of RFRA a number of government attempts to regulate or interfere with religious practices were struck down by the courts on the basis of the Act.
The Supreme Court’s recent decision
facts of the case
Situated on a hill in the city of Boerne, Texas, some 28 miles northwest of San Antonio, is St. Peter Catholic Church. Built in 1923, the church’s structure reflects the mission style of the region’s earlier history. The church seats about 230 worshippers, a number too small for its growing parish. Some 40 to 60 parishioners cannot be accommodated at some Sunday services. In order to meet the needs of the congregation the Archbishop of San Antonio gave permission to the parish to plan alterations to enlarge the building.
A few months later, the Boerne City Council passed an ordinance authorizing the city’s Historic Landmark Commission to prepare a preservation plan with proposed historic landmarks and districts. Under the ordinance, the Commission must pre—approve construction affecting historic landmarks or buildings in a historic district.
Soon afterwards the Archbishop applied for a building permit so construction to enlarge the church could proceed. City authorities, relying on the ordinance and the designation of a historic district (which, they claimed, included the church), denied the application. The Archbishop filed a lawsuit challenging the city’s denial of the permit. The lawsuit relied upon RFRA as one basis for relief from the refusal to issue the permit. A federal district court concluded that by enacting RFRA Congress exceeded the scope of its authority. A federal appeals court reversed this decision, and upheld the constitutionality of RFRA. The city appealed to the United States Supreme Court. The appeal addressed the question of the constitutional validity of RFRA.
the Court’s ruling
The Supreme Court ruled that RFRA was unconstitutional since Congress did not have the authority to enact it. 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 first amendment specifies that “Congress” cannot enact legislation “prohibiting the free exercise” of religion. Of course, “Congress” refers to the federal legislature, and so the first amendment guaranty of religious freedom, as originally worded, was not a limitation on the power of state or local governments. In 1868, the fourteenth amendment to the Constitution was ratified, which prohibits any state from depriving “any person of life, liberty, or property without due process of law.” Then, in 1940, the Supreme Court ruled that the “liberty” protected by the fourteenth amendment against state interference included the first amendment guaranty of religious freedom. For the first time, this limitation upon the power of Congress to prohibit the free exercise of religion now applied to state and local governments as well. The fourteenth amendment contained a section (section 5) which gave Congress “power to enforce, by appropriate legislation, the provisions of this [amendment].” Congress pointed to this section as the source of its authority to enact RFRA. Members of Congress insisted that they were only protecting by legislation one of the liberties guaranteed by the fourteenth amendment that had been diminished by the Supreme Court’s ruling in Smith.
The Supreme Court ruled that section 5 of the fourteenth amendment did not authorize Congress to enact RFRA. It acknowledged that section 5 authorizes Congress to “enforce” the fourteenth amendment, and therefore Congress can enact legislation “enforcing the constitutional right to the free exercise of religion.” However, the Court then observed:
Congress’ power under section 5, however, extends only to enforcing the provisions of the fourteenth amendment …. The design of the amendment and the text of section 5 are inconsistent with the suggestion that Congress has the power to decree the substance of the fourteenth amendment’s restrictions on the states. Legislation 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. It has been given the power “to enforce,” not the power to determine what constitutes a constitutional violation. Were it not so, what Congress would be enforcing would no longer be, in any meaningful sense, the “provisions of [the fourteenth amendment] ….”
If Congress could define its own powers by altering the fourteenth amendment’s meaning, no longer would the Constitution be “superior paramount law, unchangeable by ordinary means.” It would be “on a level with ordinary legislative acts, and, like other acts … alterable when the legislature shall please to alter it.” Under this approach, it is difficult to conceive of a principle that would limit congressional power. Shifting legislative majorities could change the Constitution and effectively circumvent the difficult and detailed amendment process contained [therein].
The Court conceded that it is not always clear whether Congress is “enforcing” the fourteenth amendment or making unauthorized substantive changes in the Constitution. However, it insisted that there must be a “proportionality between the injury to be prevented or remedied and the means adopted to that end.” The Court concluded that this test was not met in this case, since RFRA was not a “proportional” response to the “injury to be prevented or remedied.” Rather, RFRA was an expansive law that was enacted to address minimal threats to religious freedom. The Court noted that
sweeping coverage ensures [RFRA’s] intrusion at every level of government, displacing laws and prohibiting official actions of almost every description and regardless of subject matter. RFRA’s restrictions apply to every agency and official of the federal, state, and local governments. RFRA applies to all federal and state law, statutory or otherwise, whether adopted before or after its enactment. RFRA has no termination date or termination mechanism. Any law is subject to challenge at any time by any individual who alleges a substantial burden on his or her free exercise of religion.
Further, this massive response was not warranted by any significant threat to religious freedom:
RFRA’s legislative record lacks examples of modern instances of generally applicable laws passed because of religious bigotry. The history of persecution in this country detailed in the [congressional] hearings mentions no episodes occurring in the past 40 years …. The absence of more recent episodes stems from the fact that, as one witness testified, “deliberate persecution is not the usual problem in this country.” Rather, the emphasis of the [congressional] hearings was on laws of general applicability which place incidental burdens on religion. Much of the discussion centered upon anecdotal evidence of autopsies performed on Jewish individuals and Hmong immigrants in violation of their religious beliefs … and on zoning regulations and historic preservation laws (like the one at issue here), which as an incident of their normal operation, have adverse effects on churches and synagogues …. It is difficult to maintain that they are examples of legislation enacted or enforced due to animus or hostility to the burdened religious practices or that they indicate some widespread pattern of religious discrimination in this country. Congress’ concern was with the incidental burdens imposed, not the object or purpose of the legislation.
The stringent test RFRA demands of state laws reflects a lack of proportionality or congruence between the means adopted and the legitimate end to be achieved. If an objector can show a substantial burden on his free exercise, the State must demonstrate a compelling governmental interest and show that the law is the least restrictive means of furthering its interest. Claims that a law substantially burdens someone’s exercise of religion will often be difficult to contest. Requiring a state to demonstrate a compelling interest and show that it has adopted the least restrictive means of achieving that interest is the most demanding test known to constitutional law. If “compelling interest” really means what it says … many laws will not meet the test …. [The test] would open the prospect of constitutionally required religious exemptions from civic obligations of almost every conceivable kind.” Laws valid under Smith would fall under RFRA without regard to whether they had the object of stifling or punishing free exercise …. [RFRA] would require searching judicial scrutiny of state law with the attendant likelihood of invalidation. This is a considerable congressional intrusion into the states’ traditional prerogatives and general authority to regulate for the health and welfare of their citizens.
The substantial costs RFRA exacts, both in practical terms of imposing a heavy litigation burden on the states and in terms of curtailing their traditional general regulatory power, far exceed any pattern or practice of unconstitutional conduct under the free exercise clause as interpreted in Smith. Simply put, RFRA is not designed to identify and counteract state laws likely to be unconstitutional because of their treatment of religion. In most cases, the state laws to which RFRA applies are not ones which will have been motivated by religious bigotry ….
It is a reality of the modern regulatory state that numerous state laws, such as the zoning regulations at issue here, impose a substantial burden on a large class of individuals. When the exercise of religion has been burdened in an incidental way by a law of general application, it does not follow that the persons affected have been burdened any more than other citizens, let alone burdened because of their religious beliefs. (emphasis added)
Significance of the Court’s ruling to churches and other religious organizations
How will the Supreme Court’s ruling impact churches? It is important for church leaders to understand that the Court’s ruling does not eliminate all constitutional protection of religious freedom. The following rules summarize the current status of the first amendment guaranty of religious freedom, in light of the recent Supreme Court decision and other relevant precedent.
Rule #1: It will be difficult for religious organizations to challenge neutral laws of general applicability that burden religious practices or beliefs, because such laws are presumably valid whether or not supported by a compelling government interest.
Rule #1 is based on the Supreme Court’s decisions in the Smith and City of Boerne cases. RFRA’s attempt to establish a “compelling government interest” requirement in order to justify governmental infringements upon religion was declared unconstitutional by the Court in the City of Boerne ruling.
Rule #2: Laws that are not “neutral” towards religion, or that are not of “general applicability,” will violate the first amendment guaranty of religious freedom unless supported by a compelling government interest.
The Court’s repeal of the “compelling state interest” requirement in the Smith case applied only in the context of neutral laws of general applicability. In 1993, the Court clarified the meaning of these important terms. Church of the Lukumi Babaluaye, Inc. v. City of Hialeah, 1993 WL 195255 (1993). It also clarified the meaning of a “compelling state interest.”
neutrality
The Court ruled that a law that is not neutral “must be justified by a compelling governmental interest and must be narrowly tailored to advance that interest.” It is very important to define neutrality. The Court made the following clarifications:
If the object of a law is to infringe upon or restrict practices because of their religious motivation, the law is not neutral. The Court added:
There are, of course, many ways of demonstrating that the object or purpose of a law is the suppression of religion or religious conduct. To determine the object of a law, we must begin with its text, for the minimum requirement of neutrality is that a law not discriminate on its face. A law lacks facial neutrality if it refers to a religious practice without a secular meaning discernible from the language or context.
A law may not be neutral even though it is neutral “on its face.” The Court observed:
The free exercise clause … “forbids subtle departures from neutrality,” and “covert suppression of particular religious beliefs.” Official action that targets religious conduct for distinctive treatment cannot be shielded by mere compliance with the requirement of facial neutrality. The free exercise clause protects against governmental hostility which is masked, as well as overt. The Court must survey meticulously the circumstances of governmental categories to eliminate, as it were, religious gerrymanders.
In evaluating the neutrality of a government action, the courts should consider “the historical background of the decision under challenge, the specific series of events leading to the enactment or official policy in question, as well as the legislative or administrative history, including contemporaneous statements made by members of the decisionmaking body,” to determine if the intent was to single out religious organizations or believers for unfavorable treatment.
general applicability
The Court ruled that a law that is not of general applicability “must be justified by a compelling governmental interest and must be narrowly tailored to advance that interest.” This is so even if the law is neutral. Neutrality and general applicability are separate considerations. If a law fails either, then it must be supported by a compelling governmental interest in order to justify a negative impact on religious practices. With regard to the concept of “general applicability,” the Court made the following clarification:
All laws are selective to some extent, but categories of selection are of paramount concern when a law has the incidental effect of burdening religious practice. The free exercise clause “protects religious observers against unequal treatment,” and inequality results when a legislature decides that the governmental interests it seeks to advance are worthy of being pursued only against conduct with a religious motivation. The principle that government, in pursuit of legitimate interests, cannot in a selective manner impose burdens only on conduct motivated by religious belief is essential to the protection of the rights guaranteed by the free exercise clause.
The court further observed that “in circumstances in which individualized exemptions from a general requirement are available, the government may not refuse to extend that system to cases of religious hardship without compelling reason.” In other words, if a law of general applicability contains some non—religious exceptions, it cannot deny an exemption to religious institutions (in cases of religious hardship) without a compelling reason.
compelling state interest
The Court emphasized the high standard that a law or governmental practice must satisfy that burdens religious practice and that is either not neutral or not generally applicable:
A law burdening religious practice that is not neutral or not of general application must undergo the most rigorous of scrutiny. To satisfy the commands of the first amendment, a law restrictive of religious practice must advance interests of the highest order and must be narrowly tailored in pursuit of those interests. The compelling interest standard that we apply once a law fails to meet the Smith requirements is not “watered … down” but “really means what it says.” A law that targets religious conduct for distinctive treatment or advances legitimate governmental interests only against conduct with a religious motivation will survive strict scrutiny only in rare cases.
The Court then proceeded to give one of its most detailed interpretations of the concept of a “compelling governmental interest”:
Where government restricts only conduct protected by the first amendment and fails to enact feasible measures to restrict other conduct producing substantial harm or alleged harm of the same sort, the interest given in justification of the restriction is not compelling. It is established in our strict scrutiny jurisprudence that “a law cannot be regarded as protecting an interest of the highest order … when it leaves appreciable damage to that supposedly vital interest unprohibited.”
Rule #3: Neutral laws of general applicability that infringe upon a second constitutional right (in addition to religious freedom) will be unconstitutional unless supported by a compelling government interest.
In the Smith case the Supreme Court observed that the compelling government interest test is triggered if a neutral and generally applicable law burdens not only the exercise of religion, but some other first amendment right (such as speech, press, or assembly) as well. The Court observed: “The only decisions in which we have held that the first amendment bars application of a neutral, generally applicable law to religiously motivated action have involved not the free exercise clause alone, but the free exercise clause in conjunction with other constitutional protections, such as freedom of speech and of the press ….” In other words, if a neutral and generally applicable law or governmental practice burdens the exercise of religion, then the compelling governmental interest standard can be triggered if the religious institution or adherent can point to some other first amendment interest that is being violated. In many cases, this will not be hard to do. For example, the first amendment guaranty of free speech often will be implicated when a law or governmental practice burdens the exercise of religion. The same is true of the first amendment guarantees of free press and assembly.
• Key point. Those who represent religious institutions and adherents must keep this important point in mind. It can make the difference between winning and losing a religious freedom case.
Rule #4: The government may not refuse to extend a system of exemptions to cases of religious hardship without compelling reason.
In the Smith case the Supreme Court observed: “[O]ur decisions in the unemployment cases stand for the proposition that where the state has in place a system of individual exemptions, it may not refuse to extend that system to cases of `religious hardship’ without compelling reason.”
Rule #5: Every state constitution has some form of protection for religious freedom. In some cases, these protections are more comprehensive than under the federal Constitution. State constitutional protections in some cases may provide religious organizations with additional protections.
Churches and religious adherents whose first amendment right to the free exercise of religion is not violated by a neutral law of general applicability may claim that their state constitution’s guaranty of religious freedom has been violated.
These four rules are illustrated by the following examples.
• Example. A state law prohibits the issuance of securities by any organization unless the securities are registered with the state securities commissioner. One of the purposes of the law is to prevent fraud. A church would like to sell promissory notes to raise funds for a new sanctuary. When it learns that it cannot do so without registering its securities, it insists that the application of such a law to churches violates the first amendment’s free exercise of religion clause. The church will lose. The securities law is neutral and of general applicability, and accordingly rule #1 controls. The law is presumably valid without the need to prove a compelling governmental interest.
• Example. A number of common church practices may violate copyright law. Does the application of copyright law to churches violate the first amendment’s free exercise of religion clause? No. The copyright law is neutral and of general applicability, and accordingly rule #1 controls. The law is presumably valid without the need to prove a compelling governmental interest.
• Example. A city enacts a civil rights ordinance that bans any employer (including churches) from discriminating on the basis of sexual orientation in any employment decision. A church argues that applying such a law to a church that is opposed on the basis of religious doctrine to hiring homosexuals will violate its constitutional right to freely exercise its religion. Under the Supreme Court’s ruling in the Smith case, it is doubtful that the church would prevail. The civil rights law in question clearly is neutral and of general applicability, and accordingly rule #1 applies. This means that the law is presumably valid without the need to prove a compelling governmental interest. However, a number of federal courts (prior to Smith) concluded that the clergy—church relationship is unique and is beyond governmental regulation. Accordingly, it is doubtful that such an ordinance could be applied to clergy. This of course assumes that the Supreme Court, after Smith, would agree with these previous rulings.
• Example. A religious denomination does not ordain women. A female church member sues the denomination, claiming that its ban on female clergy violates a state civil rights law banning discrimination in employment on the basis of gender. Is the denomination’s practice legally permissible as a result of the first amendment’s free exercise of religion clause? See the preceding example.
• Example. A city council receives several complaints from downtown business owners concerning homeless shelters that are operated by churches. In response to these complaints, the city council enacts an ordinance banning any church from operating a homeless shelter. This ordinance is neither neutral nor of general applicability, and so rule #2 applies. This means that the city will need to demonstrate that the ordinance is supported by a compelling government interest. It is doubtful that it will be able to do so. First, the law is “underinclusive,” meaning that it singles out churches to further its purposes. Further, as the Supreme Court observed in the Hialeah case (discussed above), “[a] law that targets religious conduct for distinctive treatment or advances legitimate governmental interests only against conduct with a religious motivation will survive strict scrutiny only in rare cases.”
• Example. Same facts as the previous example, except that the ordinance bans any homeless shelter in the downtown area, whether or not operated by a church. A downtown church sues the city, claiming that the ordinance violates its first amendment right to freely exercise its religion. The church will lose. The ordinance in this example is a neutral law of general applicability, and so rule #1 controls. This means that the ordinance is presumably valid without the need for demonstrating that it is based on a compelling government interest.
• Example. A state legislature enacts a law that requires teachers at all public and private elementary and secondary schools, including those operated by churches, to be state—certified. A church challenges this law on the basis of the first amendment guaranty of the free exercise of religion. The church probably will lose. The law in question clearly is neutral and of general applicability, and so rule #1 controls. This means that the law is presumably valid without the need to prove a compelling governmental interest.
• Example. A state legislature enacts a law imposing a sales tax on purchases made by most organizations, including churches. A church challenges this law on the ground that it violates the first amendment guaranty of the free exercise of religion. It is doubtful that the church will prevail. The law in question clearly is neutral and of general applicability, and so rule #1 controls. This means that the law is presumably valid without the need to prove a compelling governmental interest.
• Example. A city enacts an ordinance establishing a “landmark commission.” The commission is authorized to designate any building as an historic landmark. Any building so designated cannot be modified or demolished without the commission’s approval. A church is designated as an historic landmark. A few years later, the church asks the commission for permission to enlarge is facility in order to accommodate its growing congregation. The commission rejects this request, despite proof that several persons are “turned away” each Sunday because of a lack of room in the current church facility. These were the facts in the City of Boerne case. If the church relies solely on a violation of its first amendment right to religious freedom, it will lose because the ordinance is neutral and of general applicability, and so rule #1 controls. This means that the law is presumably valid without the need to prove a compelling governmental interest. However, note that the first amendment also guarantees the rights of assembly and association, and a strong case can be made that these rights are violated by the commission’s action since the right of some members to engage in religious services (assembly and association) is being curtailed. By asserting that these first amendment rights are being violated in addition to the free exercise of religion, the church invokes rule #3. This will force the city to demonstrate a compelling government interest supporting its decision to deny the church permission to expand its facilities. It is doubtful that the city could meet this requirement.
• Example. A church is located on a major highway. It constructs a billboard on its property that contains religious messages. The city enacts an ordinance prohibiting any billboards along the highway. Since the ordinance is a “neutral law of general applicability” (it applies equally to all property owners and does not single out religious organizations), it is legally valid though it interferes with the church’s first amendment right to freely exercise its religion. There is no need for the city to demonstrate a compelling government interest. However, if the church asserts that its first amendment right to free speech is being violated by the city ordinance (in addition to its right to freely exercise its religion), then rule #3 is invoked. This will force the city to demonstrate a compelling government interest supporting the ordinance. As noted above, this is a difficult (though not impossible) test to meet. Note, however, that if the church can force the city to demonstrate that the ordinance is based on a compelling government interest, then it has obtained the same legal protection that it would have had under RFRA.
• Example. Federal tax law forbids most tax—exempt organizations from intervening or participating in political campaigns on behalf of or in opposition to any candidate for public office. A church publicly supports a particular candidate during a campaign, and the IRS revokes its exempt status. The church claims that the law violates its first amendment right to the free exercise of religion. If this is the church’s only argument, it will lose since the law is a neutral law of general applicability and therefore need not be supported by a compelling government interest. However, if the church argues that its first amendment rights to speech and press are also violated by the ban on political participation, then rule #3 is invoked. This will force the government to prove a compelling government interest to justify the law. As noted above, this is a difficult (though not impossible) test to meet. Note, however, that if the church can force the government to demonstrate that the law is based on a compelling government interest, then it has obtained the same legal protection that it would have had under RFRA.
• Example. Federal law gives bankruptcy trustees the power to “set aside” transfers by bankrupt debtors for less than “reasonably equivalent value” during the twelve months preceding the filing of a bankruptcy petition. A bankruptcy trustee contacts a church and demands that it return all contributions made by a bankrupt member during the twelve months preceding the filing of a bankruptcy petition. The trustee claims that contributions made by the church were transfers for less than reasonably equivalent value, and accordingly they can be recovered by the bankruptcy court. The church claims that turning over the member’s contributions would violate the member’s first amendment right to freely exercise his religion. The church will lose. The bankruptcy law is a neutral law of general applicability, and so rule #1 controls. The law is presumably valid without the need to prove a compelling governmental interest. A federal court ruled in 1995 that RFRA prevented bankruptcy courts from recovering contributions by bankrupt debtors to their churches-if making contributions was an important religious practice. In re Young, 82 F.3d 1407 (8th Cir. 1996) (discussed in the November—December 1996 issue of this newsletter). The Supreme Court’s recent decision declaring RFRA unconstitutional has the effect of repealing this case. Contributions made by church members to their church within a year before filing a bankruptcy petition are now subject to recovery by a bankruptcy court.
• Example. A public school adopts a policy prohibiting any outside group to rent or use its facilities for any purpose. A church asks for permission to rent the school gymnasium for a special religious service. The school denies this request. The church claims that its first amendment right to the free exercise of religion has been violated by the school’s policy. Since the policy is a neutral law of general applicability, rule #1 controls. The law is presumably valid without the need to prove a compelling governmental interest. However, if the church asserts that its first amendment rights to free speech, assembly, and association are violated by the school policy (in addition to its right to freely exercise its religion), then rule #3 is invoked. This will force the school to demonstrate a compelling government interest supporting its policy. Other decisions by the Supreme Court suggest that the school will be able to demonstrate a compelling government interest-avoiding the “establishment” of religion (by singling out religious groups for special or favored treatment).
• Key point. RFRA was invoked most often by prison inmates seeking special treatment based on their alleged religious beliefs. The Supreme Court’s decision declaring RFRA unconstitutional will be welcome news for prison officials, for now it will be much more difficult for inmates to demand special treatment based on their religious beliefs.
• Key point. Since RFRA was enacted by unanimous vote of both houses of Congress, it is likely that efforts will now be launched to draft a constitutional amendment. Such an amendment would need the approval of two—thirds of each house of Congress, and would then need to be ratified by three—fourths of the states.
A pastor visits an elderly church member in her hospital room prior to major surgery. The member delivers several items of jewelry to the pastor and informs him that “I want the church to have these items if I don’t survive.” The woman does not survive the surgery. Does the church own the jewelry? What if her heirs claim ownership of the jewelry? How would a court rule? The answer to these questions depends on the legal principle of gift causa mortis. A recent case illustrates the application of this principle.
Facts of the case. A woman was taken to a hospital emergency room after suffering a massive heart attack. She was informed that she needed immediate open heart surgery. As she was being taken to the surgery room, with her pastor and niece by her side, she was told that she would have to remove her rings. She removed the rings and, in the presence of her pastor, handed them to her niece. She stated that she wanted her niece to have the rings if she died during surgery. The woman died during open heart surgery, and a dispute arose as to the legal ownership of the rings (which were valued at $5,000).
The court’s ruling. A court ruled that the niece owned the rings. It based its decision on the legal principle of gift causa mortis, which it defined as follows:
A gift causa mortis is a gift of personal property made in the immediate apprehension of death, subject to the conditions … that if the donor should not die, as expected, or if … the donor should revoke the gift before death, the gift should be void …. It is essential to the validity of the gift causa mortis that the property be delivered to the donee ….
The court concluded that this definition was met, and so a valid gift of the rings to the niece had occurred. It noted that the donor knew that she was about to undergo open heart surgery and that there was a serious risk of death.
Relevance to church treasurers. It is common for pastors to be present with church members who are about to undergo surgery or who are suffering from a terminal condition. Sometimes such persons will hand the pastor an item of jewelry or something else of value, with instructions as to its disposition in the event of their death. In some cases donors designate the church as the recipient, while in others an individual is named. It is only after the person dies that the pastor confronts the legal consequences of the transaction. Who owns the property? Were the donor’s “deathbed” instructions legally binding? This case will help pastors, church treasurers, and other church leaders understand the legal principles that apply in answering these important questions.
Key point. In some cases the donor’s heirs will challenge a gift causa mortis, particularly if a pastor claims that the donor wanted the property to be distributed to his or her church. Heirs may view the pastor’s testimony as self-serving and possibly false. It is very important in such cases for the pastor to have at least one witness who can testify regarding the donor’s wishes. So, if a person facing major surgery delivers property to a pastor with instructions as to its disposition in the event of his or her death, the pastor should immediately find someone who can witness the transaction and hear the donor’s instructions. This will make it much easier to uphold the legal validity of the transaction if it is later challenged.
This article originally appeared in Church Treasurer Alert, August 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
IRS Issues New Business Expense Substantiation Rules
IRS Issues New Business Expense Substantiation Rules
What churches and their employees should know.
Richard R. Hammar
Background. In March the IRS released amended regulations addressing the substantiation of business expenses under an employer’s expense reimbursement arrangement. The amended regulations contain a number of provisions that will affect the way churches reimburse business expenses. It is important for church treasurers to be familiar with the new rules. This article will summarize the amended regulations, and illustrate them with several examples.
Receipts. For many years the income tax regulations required that taxpayers substantiate the amount of any business expense of $25 or more with a receipt. In 1995 the IRS announced that it was increasing this “receipt threshold” to $75. The amended regulations make official the action taken by the IRS in 1995.
Key point. The $75 receipt requirement applies both to the deductibility of a business expense, and to the substantiation of a business expense under an employer’s accountable expense reimbursement arrangement.
Example. A church has adopted an accountable business expense reimbursement arrangement for its two pastors and three staff members. This means that the church only reimburses those employee business expenses that are properly substantiated. In order to properly substantiate a business expense of $75 or more, an employee must produce a receipt.
Example. Rev. G is not reimbursed for business expenses that he incurs. In order to claim a business expense deduction on his tax return he will need to produce a receipt for each separate expense of $75 or more.
Retaining documentary evidence. The income tax regulations specify that a reimbursement arrangement will not satisfy the requirements of an accountable arrangement
to the extent that the employer … does not require an adequate accounting from its employees or does not maintain such substantiation. To the extent an employer fails to maintain adequate accounting procedures he will thereby obligate his employees to separately substantiate their expense account information.
According to this regulation, churches and other employers are required to keep the receipts and other records submitted by employees to substantiate their business expenses under an accountable expense reimbursement arrangement. In a 1963 ruling, the IRS observed that it was “studying the problems presented to employers regarding warehousing and retention of documentary evidence.” It promised to “issue a ruling on this matter in the near future.” For more than 30 years employers have waited for the promised ruling, and the expected relief from the requirement that they retain records and receipts submitted by employees to substantiate their business expenses under an accountable arrangement.
The amended income tax regulations address this issue directly—in response to numerous comments the IRS has received to provide employers with relief from the records retention requirement. Federal agencies and private employers alike asked the IRS to provide relief from the administrative burden and cost of storing large quantities of paper receipts. Some employers asked the IRS to adopt a rule allowing employers to dispose of documentary evidence after an employee has made an adequate accounting—or return the documentary evidence to the employee for retention. Other employers asked the IRS to consider modifying the rules for accountable expense reimbursement arrangements to permit employees to substantiate their business expenses by submitting an expense voucher or summary without any receipts of documentary evidence.
The IRS responded to these concerns in the following two ways:
It noted that with the increase in the receipt requirement to business expenses of $75 or more “the necessity for storing large quantities of paper records is significantly reduced.”
It amended the above-quoted regulation that in the past has required employers to retain records and receipts submitted by employees to substantiate their expenses under an accountable arrangement. The new, amended regulation provides:
The [IRS] Commissioner may, in his discretion, prescribe rules under which an employee may make an adequate accounting to his employer by submitting an account book, log, diary, etc., alone, without submitting documentary evidence.
This language is very important. It is saying that the IRS can issue new rules modifying the substantiation requirements for an adequate accounting by an employee to an employer under an accountable arrangement. The IRS explained this amendment as follows:
Under the amendment, the [IRS] could publish rules defining the circumstances (including the use of specified internal controls) under which an employee may make an adequate accounting to his employer by submitting an expense account alone, without the necessity of submitting documentary evidence (such as receipts). This change is expected to reduce the recordkeeping burden for employers and employees.
Key point. Why may the IRS issue rules allowing expense accounts (without supporting receipts or documentary evidence) to substantiate business expenses under an accountable arrangement? To relieve employers of the burden and cost of maintaining receipts and other documentary evidence supporting an employee’s business expenses.
Key point. The IRS has not yet issued rules permitting employees to substantiate business expenses under an accountable arrangement by submitting an expense account without any supporting receipts or documentary evidence. As soon as these rules are published, we will be addressing them in this newsletter. Until they are issued, churches should continue to rely on the old rules.
Key point. The IRS has warned that any relaxation in the substantiation requirements for accountable plans will not affect the deductibility of unreimbursed business expenses (or expenses reimbursed under a nonaccountable arrangement).
The importance of this proposed change cannot be overstated. In the future, churches may be able to maintain an accountable business expense reimbursement arrangement by having employees submit an expense account or summary without any supporting receipts or other documentary evidence. This is a major development that we will be following closely.
Example. A church reimburses its pastor’s business expenses upon receipt of an account book or log, without any receipts of other supporting documentary evidence. For 1996, the church reimbursed $4,000 of business expenses under this arrangement. Under present law, this arrangement is nonaccountable since it does not provide receipts for expenses of $75 or more. This means that the church should have reported the $4,000 as income on the pastor’s W-2 for 1996. However, under the amended income tax regulations, the IRS may relax the requirements for an accountable plan. Depending on what (if anything) the IRS announces later this year, the church may be able to treat its reimbursement arrangement as accountable—meaning that reimbursed expenses would not be reported as income on the pastor’s W-2. If the IRS does relax the rules for accountable plans, it likely will do so only if certain conditions are satisfied.
Example. Same facts as the previous example, except that the church only reimburses those business expenses for which the pastor submits adequate documentation substantiating the amount, date, place, and business purpose of each expense. The church also requires receipts to support any individual expense of $75 or more. The pastor must substantiate expenses not later than two months after they are incurred. This is an accountable arrangement under present law, meaning that the church’s reimbursements are not reported as income on the pastor’s W-2. However, under the amended income tax regulations, the IRS may relax the requirements for accountable plans. Depending on what (if anything) the IRS announces later this year, the church may be able to continue to treat its reimbursement arrangement as accountable while requiring less substantiation of expenses. If the IRS does relax the rules for accountable plans, it likely will do so only if certain conditions are satisfied.
Maintaining records in electronic form. Some employers urged the IRS to relieve their recordkeeping burden by permitting them to maintain records substantiating business expenses under an accountable arrangement in electronic form (on a computer). The new regulations do not address this issue. However, in commenting on the new regulations, the IRS noted that there is no requirement that records substantiating reimbursements of business expenses under an accountable arrangement be in paper or “hardcopy” form. It referred to a previous ruling in which it permitted retention of some records in electronic form.
Key point. Many church treasurers are unaware that some kinds of tax records can be kept in electronic form. Storing records electronically can result in a significant reduction in paperwork and storage facilities. Further, documents that are stored electronically often are far easier to access and research. There are several requirements that must be met in order to store records electronically. These include (1) documentation describing the electronic recordkeeping system; (2) specific documentation for retained files; (3) documentation of any change in the electronic recordkeeping system; (4) specific rules on how long such records must be kept, and where; (5) appropriate labeling of electronic records; and (6) periodic testing to identify data loss. These requirements will be addressed in a future issue of Church Treasurer Alert.
Credit card charges. Some employers asked the IRS to include a provision in the new regulations allowing employees to substantiate lodging expenses with a credit card statement alone. The IRS rejected this request. It noted that current law requires that documentary evidence of lodging must show separate amounts for charges such as lodging, meals, and telephone calls. The IRS concluded:
A credit card statement or record of charge, unlike a hotel bill, normally will not segregate lodging and other expenses, such as meals and entertainment … or personal expenses (such as personal phone calls or gift purchases) that may not be deducted. Therefore, such a credit card statement or record of charge alone will not constitute acceptable documentary evidence of a lodging expense …. The temporary regulations make no change to the current documentary evidence requirements for lodging expenses. Because of the large number of expenses that can be charged to hotel bills, and extensive variation from traveler to traveler in the types of expenses charged to hotel bills, any attempt to establish percentages for allocating hotel bills to lodging and other fully deductible business expenses, meals and entertainment, and personal expenses is considered impracticable.
Oral substantiation. Some employers asked the IRS to include a provision in the new regulations allowing employees to “orally”: substantiate the “business purpose” of their business expenses. The IRS responded by noting that “the current regulations do not preclude an initial oral substantiation of business purpose which is reduced to writing no later than the time of the employee’s final accounting to the employer.”
Employer verification procedures. Some employers asked the IRS to include a provision in the new regulations allowing employers to conduct a review of only a statistical sampling as opposed to 100 percent of employees’ expense vouchers. The IRS responded to this request as follows:
[Current regulations] state that an employee who makes an adequate accounting to his employer will not again be required to substantiate such expenses, unless the employer’s accounting procedures are not adequate or it cannot be determined that such procedures are adequate. The [IRS] will determine whether the employer’s accounting procedures are adequate by considering all the facts and circumstances, including the employer’s use of internal controls. The employer’s accounting procedures should include a requirement that an expense account be verified and approved by a reasonable person other than the person incurring the expense. To the extent the employer fails to maintain adequate accounting procedures, the [IRS] may require the employee to separately substantiate his expense account information.
[Current regulations] cite post-expenditure review of employees’ expense accounts as an internal control that should normally be employed. However, whether the employer’s post-expenditure review procedures are appropriate is a matter within the discretion of the [IRS], based on a review of all the facts and circumstances.
“De minimis” exception to substantiation requirements. Some employers asked the IRS to include a provision in the new regulations that would exempt employees who receive $1000 or less per year in reimbursed expenses from the need to substantiate the amount, date, and place of business expenses. Such a provision, these employers claimed, would reduce the paperwork burden imposed on employers that administer an accountable expense reimbursement arrangement. The IRS declined to adopt such an exception, noting that “in view of the other changes made by the temporary regulations that will lessen a taxpayer’s recordkeeping burden, such as the increase in the receipt threshold, the temporary regulations do not incorporate this suggestion.”
Increase in limit on deduction for gifts. Some employers asked the IRS to include a provision in the new regulations increasing the $25 limit on the deduction for business gifts to $75. The IRS refused to do so, noting simply that it had “no discretion to raise this statutory limit.”
Use of full federal per diem method to substantiate travel for deduction purposes. Some employers asked the IRS to include a provision in the new regulations allowing self-employed persons and unreimbursed employees to substantiate lodging expenses for deduction purposes by means of the “high-low” per diem method. The IRS declined to adopt this suggestion, noting that existing law “permits this substantiation method for employee reimbursements only” and that “this suggestion is outside the scope of this revision to the temporary regulations.”
When do the new rules take effect? The new rules were released in March of 1997, and apply to business expenses paid or incurred after September 30, 1995.
Need additional clarification? The new regulations were written by Donna Crisalli, Office of the IRS Assistant Chief Counsel (Income Tax & Accounting). For further information concerning the new regulations you can contact her at 1-202-622-4920.
This article originally appeared in Church Treasurer Alert, July 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Liability for Giving Positive References
Churches can be held liable for recommending someone with a history of misconduct.
Article summary. Church staff members occasionally are asked to provide a reference on a former employee or volunteer. Sometimes these references are provided over the telephone while in other cases they are provided in writing. Two recent state supreme court rulings address an important question-can persons who provide such references incur any legal liability for doing so? The courts reached the same conclusion-persons who know of information about a former worker that makes him or her a risk of harm to others may be liable for giving an unqualified “positive” reference that omits any information regarding the workers prior misconduct or potential risk of harm. This feature article fully reviews these historic cases, and evaluates their relevance to churches.
In two historic cases that will be of direct relevance to churches, the supreme courts of Texas and California have ruled that individuals and their employers face potential legal liability for providing positive and unqualified references on former workers who they know pose a risk of harm to others. In both cases, positive references were provided on individuals with a known background of sexual misconduct involving minors. The molesters were hired on the basis of these references, and they later molested other minors in the course of their new duties. Both courts ruled that persons who provide positive references under these circumstances, without any disclosure of the negative information, are legally responsible for the harm the worker inflicts on others. It is essential for church leaders to be familiar with both of these rulings. While they apply only in the states of Texas and California, it is likely they will be followed in other states. This article summarizes the facts of both cases, reviews the courts’ rulings, and evaluates the impact and relevance of both cases to other churches and ministries.
Case #1 – Golden Spread Council, Inc. v. Akins, 926 S.W.2d 287 (Tex. 1996)
Facts
In the summer of 1987, a 6th—grade boy (the victim) began spending the night at his best friend’s home. The friend’s parents were experiencing marital difficulties, and were not living together. When the victim spent the night with his friend, only the father was present. On at least four occasions the father sexually molested the victim. The victim later discontinued seeing his friend, and the acts of molestation ceased.
A few months later the boy began attending meetings of a local Boy Scout troop and discovered that the molester was an assistant scoutmaster and that his friend was a member of the troop. Shortly after joining this troop, the victim informed other scouts about the details of his molestation by the assistant scoutmaster. Some of the other scouts disclosed that the assistant scoutmaster had “tried the same thing with them.” The victim did not tell the head scoutmaster about the molestation, but the scoutmaster could tell that something was wrong. The scoutmaster shared his concerns with a Boy Scout official, informing him that “they had heard there was some kind of situation between [the assistant scoutmaster] and … some of the boys.” The official could not recall later whether or not the scoutmaster mentioned sexual molestation. The official prepared a written report of this conversation that he shared with his superior (a Boy Scout executive with a regional council). The report stated that the scoutmaster “had heard a boy say that [the molester] was messing with some boys.”
A few months later a district scout commission recommended the molester as a potential head scoutmaster for a new troop that a church wished to sponsor. The scout official who was informed of the problems involving the victim did not make the district commission aware of what he knew about the molester because (1) at least some of the members of the commission already knew or the allegations, and (2) he considered the matter to be based on unfounded rumors. The new troop was established a short time later and the troop committee selected the molester as head scoutmaster. No one informed the church of the rumors about the molester. A few months later, the molester persuaded the victim to join the new troop. The molester immediately resumed his efforts to molest the victim. On one occasion, he informed the victim that a physical examination would be needed to attend summer camp, and he took the victim to a restroom where he “demonstrated” what would happen during the examination. On another occasion, the molester invited the victim to his home to discuss summer camp, and again molested him. The molester was later charged with several counts of molestation. He was found guilty and sentenced to 25 years in prison.
The lawsuit
The victim’s mother sued the national Boy Scouts organization (BSA) as well as the local council. She alleged that both the BSA and local council were responsible for her son’s injuries on the basis of their negligent failure to properly screen, train, and supervise the molester and for their failure to remove the molester from his position as a scoutmaster. A trial court dismissed the lawsuit, but a state appeals court reversed this ruling. The case was then appealed to the state supreme court.
The state supreme court’s ruling
BSA
The Texas Supreme Court concluded that the national BSA organization was not liable for the scoutmaster’s acts of child molestation. The court observed:
Here it is undisputed that BSA had no knowledge of any allegations of sexual abuse by [the molester] before his selection as scoutmaster [of the new troop]. BSA keeps a list of people reported to them as unfit for leadership, and BSA will refuse to commission a person on the list as a troop leader. [The molester] however was not on BSAs unfit list, and BSA had no way of knowing of [his] past history with [the victim] or any other boys. Thus [his] actions were not foreseeable to BSA. In addition, to place a duty on BSA to screen adult volunteers about whom it had no knowledge and over whom it has little or no control would be a tremendous burden. There are about 130,000 units nationwide run by approximately 1,300,000 adult volunteers. Therefore, under these facts, we hold that the BSA had no duty to screen an adult volunteer about whom it had no knowledge and over whom it had no right of control.
The court also rejected the victims claim that BSA was liable for the local councils negligent selection and supervision of the molester. It noted that the local council was a “separate corporate entity from BSA” and that “BSA has no right to control [the councils] activities.” The court acknowledged that “to carry out its programs in certain geographical areas, BSA charters local councils … to have jurisdiction over a set area.” However, “each local council is a separate nonprofit corporation with its own articles of incorporation, bylaws, and board of directors. Thus, as a practical matter, BSA has no direct control over [the local councils] day—to—day activities.”
The local council
The court ruled that the local council could not be responsible for the victims injuries on the basis of negligent hiring, since it did not hire the scoutmaster. But it dropped a bombshell by concluding that if the council knew or should have known that the molester was “peculiarly likely to molest boys,” it had a duty not to recommend him as a scout master. By recommending him, the council could be liable for the injuries he caused. The court noted that the local council was aware of complaints that the molester was “messing with” some boy scouts and was concerned that they might be serious. Only a few months later, a local church asked an employee of the local council to recommend a scoutmaster for a new troop that was forming in a church. The employee, with full knowledge of the prior allegations, recommended the molester to the church. He did not disclose the concerns the council had concerning the molesters suitability for working with minors.
The court considered several factors in deciding that the council had a legal duty not to recommend someone whom it knew (or should have known) would pose a risk of harm to children. These included the following:
(1) Foreseeability. By recommending the molester as a new scoutmaster, the council and its employee should have foreseen that they were creating an unreasonable risk of harm to others. Such foreseeability “weighs heavily” in favor of imposing a duty on the council.
(2) Likelihood of harm. The court concluded that the “risk and likelihood of injury are high in this case.” It noted that the Boy Scout Handbook informs all scouts that their troop leader carries out his duties because “he likes boys and wants to help them become real men” and that a troop leader is “a friend to whom you can always turn for advice.” The court concluded that “by introducing a person about whom doubts had been raised to a church knowing that the church would likely put that person in a position of trust with young boys, [the council] could be found to have actually increased the risk and likelihood of injury in this case.”
(3) Social utility of the councils conduct. The court conceded that the “social utility” (i.e., public benefit) of the Boy Scouts is high.
(4) Magnitude and consequences of imposing a duty. The court concluded that the magnitude of any burden on the local council to refrain from recommending unsuitable leaders was minimal. It noted that the council was
not obligated to investigate [the molester] on its own, or to risk liability for defamation by publishing the information it had received [concerning the molester]. If [the council] should have known from the information it received … that there was an unreasonable risk that [the molester] would molest boys, [it] simply should not have recommended [him] to the church sponsor of [the new troop].
(5) Child abuse reporting law. The court noted that the Texas legislature has “voiced a strong policy to protect children from abuse” by requiring the reporting of incidents of child abuse.
(6) Superior knowledge and a right to control. Other factors the court considered in imposing a duty on the council not to recommend an unsuitable leader were “whether one party has superior knowledge of the risk or a right to control the actor whose conduct caused the harm.” The court concluded that both of these factors supported the imposition of a duty in this case: “Although [the council] did not control the everyday activities of its chartered organizations and scoutmasters, it certainly was not obligated to recommend [the molester] …. [The council] might well have prevented [the molester] from being scoutmaster simply by not recommending him to the church.”
Viewing all of these factors together, the court concluded that the council owed a legal duty to the church that sought a recommendation concerning a new scoutmaster, and that this duty extended to the children and parents associated with the troop who relied on the council in selecting a scoutmaster who was fit to serve. Further, the local councils “affirmative act of recommending [the molester] as a potential scoutmaster to the church created a duty on the part of [the council] to use reasonable care in light of the information it had received.” It continued: “[W]e hold that if [the local council] knew or should have known that [the molester] was peculiarly likely to molest boys, it had a duty not to recommend him as a scoutmaster.”
• Key point. The central aspect of the court’s ruling was its conclusion that if the local council knew or should have known that the molester was peculiarly likely to molest boys, it had a duty not to recommend him as a scoutmaster.
The court cautioned that it was imposing no other duty on the council, and that the council “had no duty to investigate [the molester] on its own or to divulge to the church … or others the information it had received [concerning the molester]. [The councils] only duty was to exercise reasonable care, based on the information it received, in recommending scoutmasters.”
The court concluded:
[W]e recognize that there is no way to ensure that this type of conduct will never happen, despite an organizations best efforts. However [the local council] and similar organizations deal with children. The public has a strong interest in protecting children from abuse, and parents put their trust in such organizations. Having undertaken to recommend a potential scoutmaster for the church, [the council] had a duty to use reasonable care in doing so to prevent an unreasonable risk of harm to [the victim] and others who would be affected. [The council] breached that duty if it knew or should have known that [the molester] was peculiarly likely to molest boys. On this record, this is the issue determinative of [the councils] liability.
The court sent the case back to the trial court to determine whether or not the council in fact “knew or should have known” that the molester was “peculiarly likely to molest boys.” If the trial court determines that the council had such knowledge on the basis of the rumors it had hears about the molester, then it may be found legally responsible for providing an unqualified reference without disclosing the molesters potential risks.
Significance of the case to church leaders
What is the significance of this case to other churches? Obviously, the decision by the Texas Supreme Court has limited effect. It will not be binding on any court outside of the State of Texas. Nevertheless, the decision represents an extended discussion of the liability of charities for making unqualified recommendations of persons whom they know (or should know) pose a risk of harm to others, and accordingly it may be given special consideration by other courts. For this reason, the case merits serious study by church leaders in every state. With these factors in mind, consider the following:
1. The duty not to recommend. The most important aspect of the court’s opinion was its conclusion that if the local Boy Scouts council knew or should have known that the molester was peculiarly likely to molest boys, it had a duty not to recommend him as a scoutmaster. The important point for church leaders to note is that this same principle could easily apply to them. Churches, like the Boy Scouts, work extensively with children, and it is common for churches to be asked for a reference on a former worker. Sometimes, the church knows of information suggesting that a former worker would be unsuitable for working with children. If so, this case suggests that the church may be liable for recommending the worker to another church.
• Example. G worked as a volunteer childrens worker at First Church. After parents complained to the senior pastor about Gs inappropriate touching of a number of children, G is removed from his position. A few months later G leaves First Church and begins attending Second Church. When he applies as a childrens worker, Second Church contacts First Church for a reference. First Church sends a letter containing a strong and unqualified recommendation of G. Nothing is disclosed regarding Gs inappropriate touching of several children. G later molests a child at Second Church. When the childs parents learn of First Churchs recommendation, they sue the church. In Texas, or in any state that follows the Texas Supreme Court’s decision discussed in this article, First Church may be legally responsible for Gs acts of molestation occurring at Second Church. It knew that G was “peculiarly likely” to molest minors and therefore had a duty not to recommend him.
• Example. Same facts as the previous example, except that First Church refused to respond to Second Churchs request for a reference regarding G. The Texas Supreme Court ruled that there can be no liability under these circumstances, since First Church has not “recommended” G.
2. No duty to investigate. The court emphasized that the local council had no duty to investigate the suitability of the molester for working as a scoutmaster. Its duty was simply not to recommend him if it knew (or should have known) of information suggesting that he would not be suitable for working with children. The court noted that the council “had no duty to investigate [the molester] on its own.” There is a paradox here. A duty not to recommend someone arises if a church knew or should have known that the individual was likely to harm others. But how can a church know if it “should have known” an individual poses a risk of harm to others without conducting some form of investigation? The court simply noted that the local Boy Scouts councils “only duty was to exercise reasonable care based on the information it received in recommending scoutmasters.” Presumably, this means that there is no duty to independently investigate a person for whom a reference is requested, though a church has a duty not to recommend the person if it knows (or if it should have known on the basis of information available to it without an independent investigation) that the person presents a risk of harm to others.
• Example. B, a former member of First Church, has attended Second Church for a few years and recently applied to work in the church nursery. Second Church asks First Church for a letter of recommendation. The staff at First Church is aware of no information regarding B that would indicate she would be unsuitable for working with minors, and so it sends a letter of recommendation. It does no investigation. B later is accused of abusing a child in the nursery at Second Church. The Texas Supreme Court’s ruling would not make First Church legally responsible for Bs actions under these circumstances. While it recommended her, it had no knowledge indicating that she posed a risk of harm to others. According to the court’s decision, First Church had no independent duty to investigate B on its own.
• Example. Same facts as the previous example, except that the staff at First Church was aware that B had been accused of child molestation on two different occasions, but it did not believe that the accusations were credible and so ignored them when preparing its letter of recommendation. Under these circumstances, it is possible that a court would conclude that First Church should have known, on the basis of information available to it without an independent investigation, that B posed a risk of harm to children. As a result, it had a duty not to recommend her. In Texas, or in any state following the Texas Supreme Court’s decision discussed in this article, First Church may be liable for acts of abuse committed by B at Second Church.
3. No duty to disclose negative information. The court stressed that while the local council had a duty not to recommend the molester as a scoutmaster, it did not have to risk liability for defamation by disclosing the basis for its refusal not to recommend him. It noted that the council “had no duty … to divulge to the church sponsor of [the troop] or others the information it had received [about the molester].” Further, the court insisted that the council “was not obligated … to risk liability for defamation by publishing the information it had received.”
4. The relevance of rumors. One of the more troubling aspects of this case is that the local council did not have actual knowledge that the molester posed a risk of harm when it recommended him as a scoutmaster of the new troop. What evidence did the council actually have regarding the molester? Lets review the evidence:
(1) The victim confided in other scouts that the scoutmaster had molested him.
(2) One of these other scouts told his father, who was a scout leader, who in turn informed a council employee that there were allegations that the scoutmaster had been “messing with some boys.” The council employee was not informed that the allegations concerned sexual molestation.
(3) The council employee informed his superior of the allegations, and he was instructed to investigate further. The employee later informed his superior that the family of the boy who allegedly overheard the victims accusations regarding the scoutmaster was involved in a “family feud” with the scoutmasters family. He also informed his superior that the boy who overheard the victims accusations referred to the victim as a “known liar.”
Based on this evidence, the council determined that the allegations regarding the scoutmaster were unfounded, and no further investigation was conducted.
At best, this evidence is highly questionable. The council was aware of vague accusations against the scoutmaster without any mention of sexual molestation, and it determined that these accusations came from a boy who was a “known liar” and whose family was engaged in a “feud” with the scoutmasters family. Yet, the Texas Supreme Court concluded that this evidence was sufficient to place the council on notice that the scoutmaster was “peculiarly likely to molest boys” and therefore it had a duty not to recommend him. As one justice pointed out in a dissenting opinion, “spreading rumors about child molestation can result in the undeserved destruction of an individuals reputation.” Yet, the court’s decision “virtually mandates the dissemination of unconfirmed reports of child molestation.”
5. Incidents of child molestation cannot be eliminated. The court acknowledged that “there is no way to ensure that this type of conduct will never happen, despite an organizations best efforts.” This is a candid and realistic appraisal. However, the court went on to conclude that organizations that recommend persons to work with minors have a duty to use reasonable care in doing so to prevent an unreasonable risk of harm to others. This duty is breached if the organization knew or should have known that the person it recommends “is peculiarly likely to molest boys.”
6. Negligent hiring. The court refused to find the local council liable for negligent hiring since it did not hire the molester. Rather, it simply recommended him as a scoutmaster to a church that was organizing a new troop.
7. Liability for the acts and obligations of affiliated organizations or ministries. The court concluded that the national BSA organization was not liable for its local councils activities. The court based this conclusion on the following considerations:
• BSA had no knowledge of any allegations of sexual abuse by the molester before his selection as scoutmaster.
• BSA keeps a list of people reported to it as unfit for leadership, and BSA will refuse to commission a person on the list as a troop leader. The molester was not on BSAs unfit list, and BSA had no way of knowing of his past history with the victim or any other boys. As a result, his actions were not foreseeable to BSA.
• Placing a duty on BSA to screen adult volunteers about whom it has no knowledge and over whom it has little or no control would be a tremendous burden. There are about 130,000 units nationwide run by approximately 1,300,000 adult volunteers.
• The local council was a “separate corporate entity from BSA” and BSA “has no right to control [the councils] activities.” The court acknowledged that “to carry out its programs in certain geographical areas, BSA charters local councils … to have jurisdiction over a set area.” However, “each local council is a separate nonprofit corporation with its own articles of incorporation, bylaws, and board of directors. Thus, as a practical matter, BSA has no direct control over [the local councils] day—to—day activities.
This aspect of the court’s decision will be useful to denominational agencies that conduct scouting programs and other ministries.
8. Concurring opinion. One judge filed a concurring opinion that deserves comment. This justice would have ruled that the Texas child abuse reporting statute, which makes any person a mandatory reporter who has “cause to believe” that a child has been abused, should be interpreted to impose civil liability on any person who fails to report child abuse (for those injuries occurring after a failure to report). The court did not respond to this opinion.
Case #2 – Randi W. v. Muroc Joint Unified School District, 60 Cal. Rptr.2d 263 (Cal. 1997)
• Key point. In a decision of extraordinary significance to churches, the California Supreme Court ruled that the former employers of a teacher who molested an adolescent girl were liable for his actions because they provided his current employer with positive references despite their knowledge of his previous misconduct.
Facts
A teacher was employed by a public school based in part on the glowing letters of recommendation from the principals of three schools in which he had previously been employed. Unfortunately, the teacher sexually molested a 13—year—old girl (the victim). The victim later sued the three prior schools and their principals, claiming that they were responsible for her injuries because they were aware of prior incidents of sexual misconduct involving the teacher but failed to disclose this information in their letters of recommendation.
The first school. School officials in the first school (a junior high school) were aware that the teacher hugged female students, placed his arms around female students, kept female students alone with him in his classroom after school, had been involved in “sexual situations” with more than one female student, gave back massages to female students while he was alone with them in the teachers lounge, and made sexual remarks to female students. Despite this knowledge, the principal of the school provided the teacher with a letter of recommendation that said in part: “I am privileged to write a letter of recommendation on behalf of [the teacher]. He is dedicated, hard—working, dependable, reliable, and more importantly, he possesses a strong desire to excel …. [His] biggest asset, however, is the genuine concern towards the students …. He is enthusiastic, energetic and has outstanding rapport with everyone …. I wouldn’t hesitate to recommend [him] for any position!” The letter contained no reference to sexual misconduct.
• The second school. School officials in the second school (a high school) were aware that the parents of some students had complained that the teacher made sexual overtures and remarks to students, and that his actions toward students had “sexual overtones.” School officials forced the teacher to resign on account of these charges. Nevertheless, in his letter of recommendation, the principal noted: “[The teacher’s] enthusiasm, organization and pleasant personality consistently generated a student waiting list …. [He] sets high standards and has the ability to achieve them …. I would recommend him for almost any administrative position he wishes to pursue.” The letter contained no reference to sexual misconduct.
• The third school. School officials in the third school were aware that the teacher had been asked to resign following charges of sexual harassment of female students and allegations regarding offensive and sexual touching of female students and sexually suggestive remarks. Despite this knowledge, the principal’s letter of recommendation on behalf of the teacher stated: “[The teacher] is an upbeat, enthusiastic administrator who relates well to the students …. Due in large part to [his] efforts, our campus is a safe, orderly and clean environment for students and staff …. I recommend [him] without reservation.” The letter contained no reference to sexual misconduct.
A state appeals court ruled that the three prior schools and their principals were responsible for the victim’s injuries as a result of their “negligent misrepresentation” in failing to disclose the prior incidents of sexual misconduct in their letters of recommendation. The schools appealed the case to the state supreme court.
The state supreme court’s ruling
The supreme court concluded that the three principals and their schools could be legally responsible for the victims injuries on the basis of fraud or negligent misrepresentation if
(1) the principals and schools owed the victim a “duty of care”
(2) the principals and schools breached this duty by making misrepresentations or giving false information in their letters of recommendation concerning the teacher, and
(3) the employing schools reliance on these letters caused the victims injuries
The court concluded that all three conditions were met. Its reasoning is summarized below.
Duty of care
The court concluded that the three principals and their schools owed the victim a duty of care. It based this conclusion on the following considerations.
(1) Foreseeability of harm. The court concluded that the three principals should have foreseen that a child could have been molested as a result of their unqualified endorsements of the teacher. Specifically, they should have foreseen that school officials would rely on their letters of recommendation in hiring the teacher; that had they not given the school an unqualified endorsement of the teacher he would not have been hired; and, that after being hired, he might molest a student.
(2) Moral blame associated with the principals conduct. Another factor the court considered in deciding whether or not the principals (and their schools) owed the victim a duty of care was the “moral blame” associated with their conduct. The court concluded that “their unreserved recommendations of [the teacher] together with their failure to disclose facts reasonably necessary to avoid or minimize the risk of further child molestations or abuse, could be characterized as morally blameworthy.”
(3) Availability of insurance. A third factor the court considered in deciding whether or not the principals (and their schools) owed the victim a duty of care was the availability of insurance. The court concluded that that schools standard business liability policies covered incidents of negligent misrepresentation.
(4) Alternative courses of conduct. A fourth factor the court considered in deciding whether or not the principals (and their schools) owed the victim a duty of care was whether there were “alternative courses of conduct” available to them. The court concluded that the principals had at least two alternatives besides giving the teacher an unqualified endorsement, and that both would have eliminated any legal liability:
• a “full disclosure” letter revealing all relevant facts regarding the teachers background, or
• a “no comment” letter omitting any affirmative representations regarding the teachers qualifications, or merely verifying basic employment dates and details
The court noted that the victim cited no case or other legal precedent
suggesting that a former employer has an affirmative duty of disclosure that would preclude such a “no comment” letter. As we have previously indicated, liability may not be imposed for mere nondisclosure or other failure to act, at least in the absence of some special relationship not alleged here.
(5) Public policy considerations. A fifth factor the court considered in deciding whether or not the principals (and their schools) owed the victim a duty of care was whether or not there was a public policy supporting liability for persons who engage in negligent misrepresentation when providing letters of recommendation to prospective employers. The principals (and their schools) insisted that there was no such public policy, since “a rule imposing liability on writers of recommendation letters could have one very predictable consequence-employers would seldom write such letters, even in praise of exceptionally qualified employees.” The principals pointed out few persons will provide “full disclosure” of all negative information in reference letters since doing so would expose them to liability for defamation or invasion of privacy. This threat of liability will “inhibit employers from freely providing reference information,” and this in turn will restrict the flow of information prospective employers need and impede job applicants in finding new employment. The court referred to a number of articles in professional publications deploring the obstruction in the free flow of information that results from more and more employers using “no comment” letters in response to a request for a reference on a former employee.
On the other hand, the victim insisted that employers providing references on former employees are protected under California law by a “qualified privilege.” The qualified privilege renders employers immune from liability for their communications pertaining to a former employees “job performance or qualifications” so long as they do not act maliciously and provide the information “to, and upon request of, the prospective employer.”
The court concluded that this qualified privilege greatly reduces the concerns expressed by the principals (and their schools). The court went so far as to observe that the qualified privilege ordinarily would prevent liability in a case such as this involving negligent misrepresentations made by employers about a former employee. However, the court noted that the qualified privilege did not help the principals in this case since it applies only to communications made “upon request of” a prospective employer. The principals “do not claim that they wrote [their letters of recommendation] in response to [the schools] request, and, accordingly, the privilege is inapplicable.”
• Key point. The court announced the following two rules:
(1) “The writer of a letter of recommendation owes to prospective employers and third persons a duty not to misrepresent the facts in describing the qualifications and character of a former employee, if making these misrepresentations would present a substantial, foreseeable risk of physical injury to the prospective employer or third persons.”
(2) “In the absence, however, of resulting physical injury, or some special relationship between the parties, the writer of a letter of recommendation should have no duty of care extending to third persons for misrepresentations made concerning former employees. In those cases, the policy favoring free and open communication with prospective employers should prevail.”
Negligent misrepresentation
Having concluded that the principals (and their schools) owed the victim a duty of care, the court addressed the question of whether or not they breached this duty by making misrepresentations or giving false information in their letters of recommendation concerning the teacher. The court conceded that there is no liability for “nondisclosure,” meaning that an employer cannot be legally responsible for a victims injuries on the basis of its refusal to disclose information about a former worker. However, the court concluded that this case presented an exception to this general rule. It noted that the principal who wrote one of the letters of recommendation “extolled” the teachers “genuine concern” for and “outstanding rapport” with students, and recommended him for “any position” though he knew that the teacher had engaged in inappropriate physical contact with students. The second principal stated in his letter of recommendation that he would recommend the teacher for “any administrative position,” despite his knowledge that the teacher had resigned under pressure due to allegations of sexual misconduct. The third principal stated in his letter of recommendation that he recommended the teacher “without reservation,” and described the teacher as an “enthusiastic administrator who relates well with students,” despite his knowledge that the teacher was forced to resign as a result of sexual harassment charges involving students.
The court concluded:
[T]hese letters, essentially recommending [the teacher] for any position without reservation or qualification, constituted affirmative representations that strongly implied [the teacher] was fit to interact appropriately and safely with female students. These representations were false and misleading in light of [the principals] alleged knowledge of charges of [the teachers] repeated sexual improprieties. We also conclude that [the victims] complaint adequately alleged misleading half—truths that could invoke an exception to the general rule excluding liability for mere nondisclosure or other failure to act.
Reliance
Lastly, the court concluded that the principals letters of recommendation were relied upon by the school that hired the teacher. The court rejected the principals argument that the victim herself must have relied upon their letters of recommendation:
In a case involving false or fraudulent letters of recommendation sent to prospective employers regarding a potentially dangerous employee, it would be unusual for the person ultimately injured by the employee actually to “rely” on such letters, much less even be aware of them.
Conclusion
The court summarized its ruling as follows:
[W]e conclude that [the principals] letters of recommendation, containing unreserved and unconditional praise for [a former teacher] despite [their] alleged knowledge of complaints or charges of his sexual misconduct with students, constituted misleading statements that could form the basis for … liability for fraud or negligent misrepresentation. Although policy considerations dictate that ordinarily a recommending employer should not be held accountable for failing to disclose negative information regarding a former employee, nonetheless liability may be imposed if, as alleged here, the recommendation letter amounts to an affirmative misrepresentation presenting a foreseeable and substantial risk of physical harm to a prospective employer or third person.
Significance of the case to church leaders
What is the significance of this case to churches? Obviously, the decision by the California Supreme Court has limited effect. It will not be binding on any court outside of the State of California. Nevertheless, the decision represents an extended discussion of the liability of charities for making unqualified recommendations of persons whom they know (or should know) pose a risk of harm to others, and accordingly it may be given special consideration by other courts. For this reason, the case merits serious study by church leaders in every state. With these factors in mind, consider the following:
1. Liability for giving references. The court ruled that persons or organizations can be legally responsible for injuries occurring as a result of references they give if (1) they owe the victim a “duty of care”; (2) they breach this duty by making misrepresentations or giving false information in their letters of recommendation; and (3) the prospective employers reliance on the reference results in the victims injuries.
• Key point. The court considered the following factors in deciding that the principals (and their schools) owed the victim a duty of care: (1) the victims injuries were foreseeable given the negligent misrepresentations set forth in the principals letters of recommendation; (2) the principals behavior in providing such misleading letters was morally blameworthy; (3) the schools insurance policies provided coverage for negligent misrepresentations; (4) other options were available to the principals besides providing reference letters containing negligent misrepresentations, including either a “full disclosure” letter or a “no comment” letter; (5) public policy supported the recognition of a duty.
• Key point. There is no question that church leaders may face liability under this same test for giving unqualified recommendations of workers they know may pose a risk of harm.
2. Other options. The California Supreme Court stressed that the principals had “alternative courses of conduct” available to them. In other words, they did not have to provide unqualified recommendations about the former teacher. The court noted that there are three options available to a person who is asked for a reference or recommendation on a former worker whom is known to have engaged in sexual or some other form of misconduct:
• option #1-negligent misrepresentation. Provide a positive and unqualified recommendation of the person, without any disclosure of the information you have indicating that he or she poses a risk of harm to others. This option may result in liability based on negligent misrepresentation if the worker is hired in part because of the recommendation and injures someone as a result of the same kind of misconduct.
• option #2-full disclosure. Provide a recommendation revealing all of the relevant facts regarding the workers background. While this option will avoid liability based on negligent misrepresentation, it may result in liability on the basis of other theories (including defamation, invasion of privacy, infliction of emotional distress, or breach of the duty of confidentiality). This is the very reason why employers often provide little if any information in response to a request for a reference on a former worker, and ironically it probably explains why the three principals in this case provided such positive recommendations concerning the teacher-they wanted to avoid liability for sharing negative information. The California Supreme Court addressed this concern directly, acknowledging that employers fear of being sued for providing negative (though true) references causes them to share little or no information about former workers, thereby impeding the free flow of information and allowing dangerous individuals to be hired without knowledge of the risk they pose. The court insisted that the state legislature addressed this concern by enacting legislation in 1994 providing employers with a “qualified privilege” for references they share. This legislation specifies that employers who share communications with other employers about a current or former employees job performance or qualifications for employment are protected from liability for what they share on the basis of a “qualified privilege” so long as: (1) they base their communications on credible evidence; (2) their communication is made without malice; and (3) the communication is provided “to, and upon request of, the prospective employer.” The court expressed the hope that this new law would “encourage more open disclosure of relevant information regarding former employees.”
• Key Point. The “qualified privilege” law mentioned by the court applies to communications made by employers about former employees. It may not apply to communications made about volunteer workers.
• Key point. The California Supreme court conceded that the state qualified privilege law extends beyond liability based on defamation, and may provide employers with a defense to negligent misrepresentation lawsuits such as the one involved in this case. That is, the three principals and their schools may have been insulated from liability on the basis of the qualified privilege law, which immunizes employers form liability for their nonmalicious communications regarding a former employees qualifications. The court refused to reach this conclusion, however, on the basis of an important technicality-the qualified privilege law only applies to communications made by employers “upon request of” a prospective employer. The court concluded that there was no evidence in this case that the principals provided their recommendations “upon request of” the school that hired the teacher. Rather, the references were provided to the teachers college placement service which in turn forwarded them on to the school that hired him.
• Key point. In order to take full advantage of the state qualified privilege law, churches in California should insist upon receiving a written request by a prospective employer for a reference or recommendation on a current or former employee. Do not respond to oral requests. Insist that the request be put in writing, so that you can later demonstrate that your reference was made in response to a request by the prospective employer. Keep such written requests indefinitely!
There is another way for a church to reduce its risk of liability when sharing negative information about a former worker-inform the prospective employer that you will provide a reference only if you receive a release form signed by the former worker releasing your church (and anyone providing a reference) from liability for any reference you provide. This form also should consent to you providing the reference, and give the former worker the option of either waiving or not waiving the right to see the reference you provide.
• option #3-no comment. Provide the prospective employer with a “no comment” letter that either refrains from making any comment about the worker in question, or simply verifies basic employment dates and details. Many church leaders follow this course of action out of a fear of being sued if they choose any other option. This raises an interesting question-can a church be legally responsible for a persons injuries if it refuses to provide a reference on a former worker who it knew would pose a risk of harm to others? The California Supreme Court said “no”:
The parties cite no case or [statutory] provision suggesting that a former employer has an affirmative duty of disclosure that would preclude such a no comment letter. As we have previously indicated, liability may not be imposed for mere nondisclosure or other failure to act, at least in the absence of some special relationship not alleged here.
While a “no comment” letter eliminates the risk of liability for negligent misrepresentation, many church leaders feel strongly that they have a moral obligation to share information about a former worker who may pose a risk of harm to others. Fortunately, as noted above, the “second option” often can be used in a way that reduces risk.
• Key point. Before sharing negative information about a current or former worker with a prospective employer, be sure to consult with a local attorney for guidance.
3. Child abuse reporting. A state appeals court had ruled that the principals were responsible for the victims injuries on the basis of their failure to comply with their reporting duties under the state child abuse reporting law. The state supreme court disagreed with this conclusion. It noted that the duty to report extends to “child care custodians” (including school personnel) who have knowledge of or who observe a child “whom he or she knows or reasonably suspects has been the victim of child abuse.” The court observed:
Reasonably construed, the [child abuse reporting] act was intended to protect only those children in the custodial care of the person charged with reporting the abuse, and not all children who may at some future time be abused by the same offender. [The victim] fails to allege that she was ever in [the three principals] custodial care, or even that [they] were aware that [the teacher] had molested her.
To adopt [the victims] contrary argument would impose a broader reporting obligation than the legislature intended. Under [the victims] interpretation of the reporting act, a child care custodian that fails to report suspected child abuse affecting one child in its care or custody could be held liable, perhaps years later, to any other children abused by the same person, whether or not those children were within its custodial protection. Neither legislative intent nor public policy would support such a broad extension of liability.
The problem. Sarah is a church employee who leaves her job to accept other employment. Before leaving, she asks the church treasurer if she will be paid for any portion of the unused sick leave that she has accumulated on the job. How should the treasurer respond? As more and more churches provide employees with sick leave, this question is being asked with increasing frequency. A recent court ruling in Texas addressed this question.
A recent case. A county employee worked for five years before resigning to accept other employment. The county had a personnel manual specifying that employees with at least five years of service would be paid, upon termination of their employment, the value of one-half day’s wages for each day of accrued but unused sick leave. However, the county amended its personnel manual a year before the employee resigned. Under the revised manual the right to be paid for unused sick leave was restricted to employees who retired.
On the date of his resignation the employee would have received $4,000 under the original sick leave policy. But, since he resigned rather than retired, he was paid nothing under the terms of the revised policy. The employee sued the county. He insisted that his rights to sick leave were to be determined by the original policy that existed on the date he was hired.
The court’s decision. A state appeals court rejected the employee’s claim. The court based its ruling on the following considerations:
An employee manual does not constitute a binding contract with regard to any of its policies or fringe benefits unless it uses language clearly indicating an intent to do so.
The county’s personnel manual contained no language indicating an intent to make its policies and fringe benefits contractually binding. Quite to the contrary, the manual states that it can be unilaterally changed by the county. Such a provision “does not clearly express an intent to vest contractual or property rights,” the court concluded.
There is no applicable state law that creates a legal entitlement to fringe benefits described in a personnel manual.
The court concluded:
In an employment-at-will relationship [one in which an employee is hired for an indefinite term] either party may modify the employment terms as a condition of continued employment. When the employer notifies an employee of changes in employment terms, the employee must accept the new terms or quit. If the employee continues working with knowledge of the changes, he accepts the modified terms as a matter of law and gives up any right to claim anything other than that provided by the new terms. [The employee in this case] continued working for the county after the personnel manual had been changed to eliminate the right to payment for unused sick leave. He therefore gave up any right to claim benefits under the [earlier] manual.
Relevance to church treasurers. Many church treasurers have wondered if they are obligated to pay employees for any unused sick leave upon their termination. This case provides some helpful guidance in answering that question. Here are some points to consider: (1) Does your church have a personnel or policy manual? (2) If so, does it provide for the payment to terminating employees of the value of their unused sick leave? (3) If so, does the manual contain language indicating that its terms are contractual in nature? Or, does it contain language disclaiming any contractual significance, and permitting the church to modify the manual at will? (4) Is there a statue in your state that confers upon terminating employees any legal right to unused sick leave? (5) If you have a personnel or policy manual, have you modified those provisions addressing unused sick leave? If so, were the changes communicated to your employees? Can you document that they were communicated? Of course, before making a final decision regarding the payment of unused sick leave to terminating employees, we recommend that you consult with a local attorney. Gamble v. Gregg County, 932 S.W.2d 253 (Tex. App. 1996).
This article originally appeared in Church Treasurer Alert, June 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Use of Church Vehicles by Staff Members’ Children
Check your insurance policy to avoid a costly denial of coverage.
Does your church have a vehicle that is made available to pastors or other church staff members for both business and personal use? If so, have you considered whether your church insurance policy would cover an accident involving the vehicle while it was being driven by a child of the pastor or staff member? A New York court addressed this important question in a recent case. A company owned a vehicle that it provided to an employee for business and personal use. It was insured under a “business auto policy” that provided coverage to anyone using the vehicle with the company’s permission. The company adopted a corporate policy specifying that the vehicle was to be driven only by the employee and his wife. However, the employee permitted his teenage son to drive the car, and the son caused an accident that seriously injured a father and his infant daughter. The company was sued, and its insurance company refused to provide a defense or assume any liability for the accident on the ground that there was no insurance coverage under the policy unless the vehicle was being driven by the employee or his wife. A court agreed with the insurance company. It noted that the company “was within its rights to limit the use of its company cars to its employees and their spouses” and that the insurance company provided coverage “for that limited risk.” Since the teenage son’s use of the car was not permitted by company policy, the insurance company was free to deny coverage.
What is the significance of this case to church treasurers? It illustrates the importance of being familiar with any limitations in your church insurance policy pertaining to church-owned vehicles. Now is a good time to review your church’s insurance policy to see what limitations apply to accidents involving church-owned vehicles. If coverage is limited to “authorized users” of a vehicle, has the church adopted a policy defining which persons are authorized to use each vehicle? If so, it is essential that unauthorized persons not be allowed to drive a vehicle. Any exceptions, however well-intentioned, could lead to the terrible result that happened in this case—catastrophic injuries with no insurance coverage. Jasper Corporation v. Dunikowski, 645 N.Y.S.2d 88 (A.D. 1996).
This article originally appeared in Church Treasurer Alert, June 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
The Pitfalls of Borrowing Funds from Church Members
The Pitfalls of Borrowing Funds from Church Members
A Tennessee court issues a helpful ruling.
Richard R. Hammar
Whitehaven Community Baptist Church v. Halloway, 1997 WL 147529 (Tenn. App. 1997)
Background. A church purchased vacant land as the site of a new building. The church signed a $120,000 note, which was secured by a first mortgage on the land. When the church was unable to obtain a commercial loan to finance construction of the new building, it borrowed $100,000 from two of its members. The church signed a promissory note agreeing to pay the members in full within seven months, at ten percent interest. To secure this loan the church conveyed title to this property to the two members, subject to the first mortgage. With the financing in hand, construction of the new facility began. Unfortunately, the church defaulted on both loans. To protect against a foreclosure (and loss of its security) the two members paid off the church’s debt under the first mortgage. By now the members had invested more than $200,000 in the project. A court later ruled that the two members were entitled to exclusive possession of the church property. The church appealed. A state appeals court agreed with the trial court’s eviction of the church from the property.
Relevance to church treasurers. There are a couple of important points to note. First, churches that seek to raise funds by borrowing from their own members may be creating a significant problem. Church leaders sometimes assume that borrowing from members is an attractive option because it is convenient and members will be more “forgiving” than a bank if the church is late with a payment or defaults. As this case illustrates, borrowing from church members can create unforeseen legal complications. Some members cannot afford to be “forgiving” when the church fails to repay them their loans. This case illustrates another important point—failure to pay promissory notes ultimately may lead to a congregation’s eviction from church property. Promissory notes that are secured by mortgages on church property must be honored in order to avoid foreclosure.
This article originally appeared in Church Treasurer Alert, June 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
Depositing Payroll Taxes Electronically
What church treasurers need to know about the new EFTPS system.
Background. Beginning on July 1, 1997, some churches must begin depositing their federal payroll taxes electronically. Failure to do so may result in penalties. This article will help church treasurers understand the new rules, and determine whether or not they will apply to their church.
Depositing payroll taxes—how often? If your church has at least one nonminister employee (or a minister who has elected voluntary withholding), then you should be accumulating three kinds of federal payroll taxes:
income taxes withheld from employees’ wages
employees’ share of FICA taxes (withheld from employees’ wages), and
the employer’s share of FICA taxes.
Most churches deposit withheld payroll taxes on a monthly or semiweekly basis, depending on the amount of taxes reported in a four quarter “lookback” period. For 1997 the lookback period is July 1, 1995 through June 30, 1996. Churches that reported payroll taxes of $50,000 or less in the lookback period deposit their withheld taxes for 1997 on a monthly basis. This means that payroll taxes withheld during each calendar month, along with the employer’s share of FICA taxes, must be deposited by the 15th day of the following month. Churches that reported payroll taxes of more than $50,000 in the lookback period must deposit their withheld taxes on a semiweekly basis. This means that for paydays falling on Wednesday, Thursday, or Friday, the payroll taxes must be deposited on or by the following Wednesday. For all other paydays, the payroll taxes must be deposited on the Friday following the payday.
Key point. Churches accumulating less than $500 in withheld payroll taxes during a calendar quarter may skip the deposit requirements altogether and send the taxes in to the IRS with their quarterly 941 forms.
Depositing payroll taxes—how and with whom? Churches use Form 8109 (Tax Deposit Coupon) to deposit employment taxes. The taxes may be deposited at any financial institution qualified to act as a depository for federal taxes or to the federal reserve bank serving your geographical area. Checks are made payable to the depository where you make the deposit. Deposits are timely if delivered on or before the deadline, or mailed on or before the second day before the due date.
Depositing payroll taxes—the new rules. In 1993 Congress enacted legislation 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). The new electronic system is phased in over a period of years by increasing the percentage of total taxes subject to the new EFTPS system each year. For 1994, 3 percent of all payroll taxes were required to be made by electronic fund transfer. This percentage increased to 20 percent for 1996, and 58 percent for 1997. Implementation began with the largest depositors of employment taxes. For 1997, the target percentage will be achieved by requiring all employers that deposited more than $50,000 in payroll taxes in 1995 to begin using EFTPS by July 1, 1997.
Key point. If you had a federal payroll tax obligation of more than $50,000 for 1995, you must use the EFTPS system to deposit payroll taxes not later than July 1, 1997. There are no exceptions for churches or other religious or charitable organizations.
Example. A church had 2 ministers and 4 nonminister employees in 1995. The ministers were treated as employees, but did not elect voluntary withholding of their federal income taxes. The church had a federal payroll tax obligation of $20,000. It does not have to begin using the EFTPS system to deposit payroll taxes in 1997.
Example. A church had 3 ministers and 8 nonminister employees in 1995. The ministers were treated as employees, and elected voluntary withholding of payroll taxes. The church had a federal payroll tax obligation of $55,000. It must begin using the EFTPS program to deposit payroll taxes no later than July 1, 1997.
Payroll taxes are deposited electronically with a government account maintained by either First National Bank of Chicago or NationsBank. It is not necessary for a church to open an account with either bank. The banks never receive a church’s deposit. Rather, all deposits flow directly from the church’s bank account to the federal government’s account with either of these two banks. The IRS selected these banks to enroll employers with the EFTPS program, provide customer service, direct deposits to the government’s account, and provide tax payment information to the IRS.
How the EFTPS system works. How does a church deposit its payroll taxes using the EFTPS program? Simply follow these steps:
Order IRS Form 9770. If the IRS did not mail you an enrollment form (Form 9770), you can order one by calling either First National Bank of Chicago (1-800-945-8400) or NationsBank (1-800-555-4477).
Complete and submit Form 9770. Complete Form 9779 and mail it to the address provided in the form’s instructions.
It will take 2-10 weeks to process an enrollment application. So if your church is required to begin using the EFTPS program by July 1, 1997, be sure to submit your enrollment form as soon as possible.
Need more help? Call either bank and ask for the customer service department.
Using the “ACH debit option” to transfer your payroll taxes. Once you have established an account with either First National Bank of Chicago or NationsBank, you transfer payroll taxes from your own bank account to the government’s account at either bank that you select. You can do this in any one of the following three ways:
call the customer service department of First National Bank of Chicago or NationsBank
use an automated touchstone telephone system offered by both banks
use your own personal computer (call either bank to obtain Windows-based software to enable you to use this option)
Whichever option you select, you are using what is called the “ACH debit option” to deposit your taxes. “ACH” refers to the Automated Clearing House. It is a financial network run by the Federal Reserve Board to transfer funds electronically. ACH is widely used by banks to deposit wages and social security payments in personal bank accounts.
Be sure to transfer the correct amount. You must transfer the same amount of payroll taxes that you would have deposited with a bank under the prior rules. In other words, you compute your payroll tax obligations the same way. You are simply using a different method of depositing them. You must be able to establish that you had sufficient funds in your bank account to cover the transfer of payroll taxes to the government’s account. If you can’t, you may have to pay a penalty.
Tips for church treasurers. If your church had a federal payroll tax obligation of more than $50,000 in 1995, you will have to begin using the EFTPS program to deposit your payroll taxes by July 1, 1997. If your church deposited payroll taxes of less than this amount in 1995, you will continue to physically deposit your taxes with a bank using Form 8109.
Key point. No fees will be charged by the IRS, or either First Bank of Chicago or NationsBank, for using the EFTPS program. However, your local bank may charge a fee.
Key point. Most employers are not covered by the new rules. The IRS estimates that only 1.2 million employers out of a total of 5.2 million employers with federal payroll tax obligations will be required to use the EFTPS program.
This article originally appeared in Church Treasurer Alert, May 1997.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
The Tax Court issues an important decision—Greene v. Commissioner, T.C. Memo. 1996-531 (1996)
Article summary. Ministers have a “dual” tax status. For social security purposes they always are self-employed with respect to services performed in the exercise of ministry. However, for federal income tax reporting purposes most ministers are employees. There are exceptions to this rule, as a recent decision by the Tax Court illustrates. The Court ruled that an Assemblies of God foreign missionary was self-employed for income tax reporting purposes. The Court’s decision will be a helpful precedent not just to foreign missionaries, but to pastoral ministers as well. The Court’s ruling is fully analyzed in this feature article.
Are ministers employees or self-employed for federal income tax reporting purposes? This is an important question. In fact, the “audit guidelines for ministers” released by the IRS in 1995 inform agents that “the first issue that must be determined is whether the minister is an employee or an independent contractor.” A recent Tax Court decision provides useful guidance in resolving this important issue. The Tax Court ruled that an Assemblies of God foreign missionary was self-employed rather than an employee for federal income tax reporting purposes. The Court’s conclusion and analysis will be helpful to other missionaries and pastors in evaluating their own tax reporting status. This feature article will review the facts of the case, summarize the court’s ruling, and evaluate the significance of the case to other missionaries and pastors.
facts
An Assemblies of God foreign missionary in Bangladesh reported his income taxes as self-employed. He was audited by the IRS and informed that he was in fact an employee. The IRS transferred his business expenses from Schedule C to Schedule A, resulting in additional taxes of $1,000. The missionary appealed to the Tax Court, which ruled that he was self-employed.
the court’s ruling-an 8 factor test
The Tax Court listed eight factors to be considered in deciding whether a worker is an employee or self-employed for federal income tax reporting purposes:
(1) the degree of control exercised by the [employer] over the details of the work; (2) which party invests in the facilities used in the work; (3) the taxpayer’s opportunity for profit or loss; (4) the permanency of the relationship; (5) the [employer’s] right of discharge; (6) whether the work performed is an integral part of the [employer’s] business; (7) what relationship the parties believe they are creating; and (8) the provision of benefits typical of those provided to employees. No one factor is determinative; rather, all the incidents of the relationship must be weighed and assessed.
The court concluded that the missionary was self-employed on the basis of these eight factors. Its conclusions are summarized below:
#1 – degree of control
The court noted that an employer’s right to control the manner in which a person’s work is performed “is ordinarily the single most important factor” in determining whether that person is an employee. The more control, the more likely the worker is an employee. The court mentioned three additional factors to be considered in applying this test: (1) A sufficient degree of control for employee status does not require the employer to “stand over the taxpayer and direct every move made by that person.” (2) “The degree of control necessary to find employee status varies according to the nature of the services provided.” (3) “[W]e must consider not only what actual control is exercised, but also what right of control exists as a practical matter.”
Facts indicating control. The IRS insisted that the following facts demonstrated a sufficient degree of control for the missionary to be considered an employee:
Missionaries qualify as professionals who require little supervision and therefore the absence of actual control should not be confused with an absence of the right to control.
The Assemblies of God Division of Foreign Missions (DFM) maintained control over the missionary through its missions manual that dictated the manner in which he was to conduct his “deputational” and foreign ministry. Deputational ministry refers to the practice of Assemblies of God of missionaries raising their own financial support by visiting local churches.
The national Assemblies of God organization (the “National Church”) exercised control, or had the right to exercise control, over the missionary’s ministerial credentials to such a degree that he was an employee. For example, the National Church: (1) maintains specific requirements for ministerial licensing and ordination; (2) has the authority to discipline ministers based on their behavior and conduct; and (3) has the authority to withdraw ministerial credentials.
Facts indicating a lack of control. The court pointed to the following facts in concluding that there was no sufficient control exercised over the missionary to treat him as an employee:
Neither the National Church nor DFM provided any type of professional training for the missionary.
The DFM did not assign the missionary to minister in a particular country. The missionary himself selected Bangladesh, despite some reservations expressed by the DFM.
The DFM did not direct the missionary to work on a particular project in Bangladesh. Rather, the missionary independently chose to become involved in student ministry. He decided to expand his foreign ministry to include a drug-rehabilitation program. He was able to make this decision without seeking permission from the DFM. In fact, it appears that the DFM was not even aware of the missionary’s plans to initiate a drug-rehabilitation clinic in Bangladesh.
The missionary determined his own work days and hours.
The missionary used vacation and sick leave without notifying or seeking permission from the DFM.
The missionary decided to return from his foreign ministry after only three years in the foreign field. He made this decision considering the needs of his school-aged children and the schedules of the other missionaries in his area. It appears that the DFM played little or no role in his field departure date.
The missionary decided when his “personal allowance” (a monthly distribution for living expenses) would begin, and he had the power to designate the amount of his personal allowance up to the limit imposed by the DFM.
The missionary was required to attend only one meeting every five years.
Apart from filing periodic expense and activity reports, the missionary and the DFM did not communicate regularly. Specifically, the DFM did not contact him at all during his year of “deputational ministry” (when he visited churches in the United States raising support). Likewise, the DFM communicated with the missionary infrequently while he served in the foreign field.
The missionary was not directly supervised or evaluated by anyone.
The court acknowledged that the DFM missions manual contains extensive information with respect to foreign ministry. However, it concluded that “the missions manual was intended by the DFM to be an informational reference for missionaries, not a set of rules controlling their day-to-day conduct.”
The court concluded that the IRS’s emphasis on the National Church’s control of the missionary’s ministerial credentials was misplaced for two reasons. First, although the missionary was an ordained Assemblies of God minister, he worked as a missionary. The court observed that “the National Church’s requirements for ministerial licensing and ordination, as well as its authority to discipline [the missionary] and withdraw his ministerial credentials, have little or no bearing as to the details and means by which [he] performed his duties as a missionary.” Second, the court concluded that the “control test” is not satisfied “where the manner in which a service is performed is controlled by the threat of the loss of professional credentials. Carried to its logical extreme, this argument would serve to classify all ordained ministers as employees of the National Church, regardless of the type of service performed.”
The IRS pointed to a recent federal district court ruling in Arkansas in which an Assemblies of God pastor was found to be an employee for federal income tax reporting purposes. The Tax Court simply noted that the missionary’s circumstances in this case “are very different” from those of a pastor of a local church:
[The taxpayer in this case] was employed as a foreign missionary, not a pastor. We think that the National Church’s authority over the manner in which a pastor performs his or her duties is not highly probative in analyzing the National Church’s control over the daily activities of a foreign missionary. This is because pastoring a local church and engaging in foreign mission work are two different jobs involving different qualifications, duties, and bodies of authority. Pastors are subject to the controls of a local church whereas missionaries are subject to the authority of the DFM. As previously discussed, the DFM exerted very little control over petitioner.
The court concluded:
In summary, the DFM lacked the control and lacked the right to control the manner and means by which [the taxpayer] performed his duties as a foreign missionary. Rather, the DFM facilitates foreign ministry by processing a missionary’s collections and pledges and providing useful information to missionaries through the missions manual and a proposed foreign living budget. In other words, we view the DFM as a service provider relieving endorsed missionaries from the administrative burdens of collecting and processing their pledges and obtaining information regarding their country of service.
#2 – investment in facilities and equipment
The second factor in the Tax Court’s eight factor test is “which party invests in the facilities used in the work”? If the employer invests in the facilities, it is more likely that the worker is an employee. The court observed:
[The taxpayer’s] sole compensation as a missionary was in the form of a “personal allowance” secured from funds that he raised during his deputational ministry. In this regard, we observe that if a donor fails to remit a pledged amount, the DFM makes no effort to contact the donor, much less obtain the donation. Additionally, the National Church does not guarantee missionaries minimum compensation or support. [The taxpayer] used his personal car and telephone to raise funds during his deputational ministry. [He] occasionally hired assistants at his own discretion and accepted responsibility for paying those assistants.
The IRS pointed out that the missionary was reimbursed for his expenses when he withheld costs from the offerings remitted to the DFM. The court did not find this relevant: “Even if [he] were regarded as receiving reimbursement for his expenses, this matter is more than outweighed by other evidence probative of his being an independent contractor, e.g., petitioner’s efforts in securing the funding for his foreign ministry and his investment in his automobile and telephone.” The court concluded that the second factor supported self-employed status.
#3 – opportunity for profit or loss
The third factor in the Tax Court’s eight factor test is “the taxpayer’s opportunity for profit or loss.” The court noted that the National Church does not guarantee missionaries minimum compensation. Rather, compensation received by missionaries is in the form of a personal allowance, the amount of which depends on the total amount of funding that missionaries are able to secure during their deputational ministry. Additionally, upon resignation, missionaries forfeit any account balance they may have with the DFM and must reallocate their funds to another ministry. The court concluded that the third factor supported self-employed status.
#4 – permanency of the relationship
The fourth factor in the Tax Court’s eight factor test is the permanency of the relationship. The more permanent the relationship, the more likely the individual is an employee. The taxpayer conceded that missionary service is a lifetime career. Therefore, the court concluded that the fourth factor supported employee status.
#5 – DFM’s right of discharge
The fifth factor in the Tax Court’s eight factor test is whether or not the employer has the right to discharge the worker. If such a right exists, it is more likely that the worker is an employee. The court noted that the DFM did not have the power to prevent the taxpayer from serving as an Assemblies of God missionary in Bangladesh:
The DFM’s most extreme form of discipline is the withdrawal of a missionary’s endorsement. For a missionary, the practical consequence of losing the DFM’s endorsement is one of administrative inconvenience, namely, that the missionary must collect and process pledges without the assistance of the DFM. In any event, unendorsed Assemblies of God missionaries can and do serve in the foreign field.
The IRS insisted that because the missionary is an Assemblies of God minister, the National Church has the right to revoke his ministerial credentials, and therefore the National Church can effectively discharge him. The court disagreed:
Indeed, the credentials committee [of the National Church] has the authority to withdraw the approval and recommend the recall of ministerial credentials. Although [the taxpayer] is an Assemblies of God minister subject to the disciplinary proceedings in the constitution and bylaws, he presently serves in the capacity of a foreign missionary. Thus, we think the more appropriate analysis considers the DFM’s right to discharge [him] in his capacity as a missionary, rather than the National Church’s right to recall [his] ministerial credentials.
The court concluded that the fifth factor supported self-employed status.
#6 – integral part of business
The sixth factor in the Tax Court’s eight factor test is whether or not the work performed is an integral part of the employer’s business. The court noted that the DFM’s primary mission is world evangelism and that the taxpayer’s work as an Assemblies of God missionary was directly related to the accomplishment of that mission. Therefore the court concluded that the sixth factor supported employee status.
#7 – relationship the parties believe they have created
The seventh factor in the Tax Court’s eight factor test is the relationship the parties believe they have created. That is, did the DFM and its missionaries believe that their relationship was that of employer and employee, or did they believe that their relationship was that of an employer and self-employed workers? The court concluded that the parties believed that missionaries were self-employed, based on the following factors: (1) the financial comptroller of the DFM testified that the DFM considered its missionaries to be self-employed; (2) the National Church issued the taxpayer a 1099 form each year reflecting nonemployee compensation for services rendered; (3) federal income tax was not withheld from the missionary’s compensation (the court apparently was unaware of the fact that the compensation of ministers and missionaries is exempt from federal income tax withholding whether they report their income taxes as employees or as self-employed); and (4) the taxpayer thought he was self-employed as evidenced by the fact that he reported his foreign ministry income and expenses on Schedule C. The court concluded that the seventh factor supported self-employed status.
#8 – employee-type benefits
The eighth factor in the Tax Court’s eight factor test is whether or not the employer provides “employee-type benefits” to the worker. The court noted that the DFM provided its missionaries with the following fringe benefits: (1) access to the National Church’s retirement plan, and (2) access to the National Church’s health insurance plan. On the other hand, the DFM has no policy regarding sick leave and does not maintain records reflecting either vacation or sick leave taken by missionaries. The court concluded that “although the matter is not free from doubt, we think that these facts support a finding that [the taxpayer] was an employee, not [self-employed].”
The court concluded its analysis of the eight factors by observing:
Some aspects of the relationship between [the missionary] and the National Church indicate that [he] was an employee, whereas other aspects of the relationship indicate that he was [self-employed]. After weighing the above factors, giving particular weight to the lack of control and the lack of the right to control that the National Church and the DFM had over endorsed missionaries, we conclude that [the taxpayer] was [self-employed], and not an employee ….
As a result, the court concluded that the missionary’s business expenses could be deducted on Schedule C and “need not be relegated to Schedule A.”
Relevance to other missionaries and ministers
What is the significance of this important ruling to other ministers? Consider the following:
1. “Dual tax status”. Most of the confusion associated with clergy tax preparation is based on the fact that clergy have a “dual tax status”. For federal income tax reporting purposes most clergy are employees, but for social security purposes all clergy are self-employed (with respect to services performed in the exercise of ministry). Many church treasurers assume that ministers who are treated as employees for income tax purposes must be treated as employees for social security purposes. They accordingly withhold FICA taxes from the wages of their ministers just as they would for a nonminister church employee. While common, this approach is incorrect. All ministers are self-employed for social security purposes with respect to their ministerial services. As a result, they pay the self-employment tax, not FICA taxes. This is so even if the ministers are employees for income tax reporting purposes.
2. The court’s 8-factor test. The Tax Court applied the same test that it used in two decisions in 1994 addressing the correct reporting status of ministers for federal income tax reporting purposes. In the first case the court applied a 7-factor test in concluding that a Methodist minister was an employee. Weber v. Commissioner, 103 T.C. 378 (1994). In the second case, the court applied the same 7-factor test and ruled that a Pentecostal Holiness minister was self-employed. Shelley v. Commissioner, T.C. Memo. 1994-432 (1994). The Tax Court applied the same 7-factor test in this case, but treated the seventh factor as two separate factors. In the Weber and Shelley cases, the seventh factor in the court’s 7-factor test was the relationship the parties themselves thought they had established. However, in addressing this factor, the court looked to the kinds of fringe benefits provided to the minister. The court separated this analysis in its new 8-factor test. Under the new 8-factor test, consideration must be given to the following factors in evaluating a person’s correct reporting status for income tax reporting purposes:
(1) the degree of control exercised by the employer over the details of the work
(2) which party invests in the facilities used in the work
(3) the opportunity of the individual for profit or loss
(4) the permanency of the relationship
(5) whether the employer has the right to discharge the individual
(6) whether the work is part of the employer’s regular business
(7) the relationship the parties believe they are creating
(8) whether benefits provided to the worker are typical of those provided to employees
There are three additional points the court made that should be considered in applying this test:
• A sufficient degree of control for employee status does not require the employer to “stand over the taxpayer and direct every move made by that person.”
• The degree of control necessary to find employee status varies according to the nature of the services provided. For example, the level of control necessary to find employee status is generally lower when applied to professional services than when applied to nonprofessional services.
• A court must consider not only what actual control is exercised, but also what right of control exists as a practical matter.
• Key point. The Tax Court did not refer to the 20-criteria test announced by the IRS in 1987. Ministers who report their income taxes as self-employed probably will have a higher chance of prevailing under the 8-factor test than under the more restrictive 20-factor test.
3. Ministers who may be self-employed for income tax reporting purposes. The Greene case demonstrates that there will be some ministers who will be self-employed for federal income tax reporting purposes. In addition to missionaries who are substantially similar to the missionary in the Greene case, there are a number of other situations in which a minister is likely to be self-employed for federal income tax reporting purposes. These include:
• Itinerant evangelists. Itinerant evangelists, who conduct services in several different churches during the course of a year, ordinarily would be considered self-employed for purposes of both income taxes and social security taxes. They ordinarily would not be considered employees under either the Tax Court’s 8-factor test or the IRS 20-criteria test.
• Guest speaking. Many ministers are called upon to conduct worship services in other churches on an occasional basis. To illustrate, Rev. D, who serves as senior minister at First Church, is invited to conduct a service at a church in another community. Clergy generally will be considered to be self-employed with respect to such occasional guest speaking commitments.
• Supply pastors. Many ministers serve temporary assignments in local churches until a permanent minister can be selected. In some cases, these ministers will be self-employed with respect to such an assignment. This will depend on an application of the Tax Court’s 8-factor test (or the IRS 20-criteria test). In general, the shorter the assignment the more likely that the minister will be considered self-employed.
• Direct services. IRS Publication 517 recognizes that it is possible for ministers who are employees of their churches for income tax reporting purposes to be self-employed for certain services (such as baptisms, marriages, and funerals) that are performed directly for individual members who in turn pay a fee or honorarium to the minister.
• Church polity. In some cases a church’s polity may suggest that ministers are self-employed rather than employees for income tax reporting purposes. For example, ministers who are not associated with a regional or national religious body that exercises control over their activities will find it easier in some cases to argue that they are self-employed for income tax reporting purposes.
• Key point. The Tax Court ended the Weber case with the following comment: “We recognize that there may be differences with respect to ministers in other churches or denominations, and the particular facts and circumstances must be considered in each case.”
4. The bottom line. Some missionaries and ministers will find it easier to defend self-employed status under the Tax Court’s 8-factor test. However, this should not necessarily cause those missionaries and ministers who presently report their income taxes as employees to change their status, nor should it keep self-employed ministers from changing to employee status. The simple fact is that in the vast majority of cases missionaries and ministers will be far better off for federal tax purposes by reporting as employees rather than as self-employed. The advantages of employee status include: (1) the value of various fringe benefits will be excludable, including the oftentimes significant cost of employer-paid health insurance premiums on the life of the minister and his or her dependents, (2) the risk of an IRS audit is substantially lower, and (3) as an employee, a minister avoids the additional taxes and penalties that often apply to self-employed clergy who are audited by the IRS and reclassified as employees.
The only “advantages” of self-employed status are that business expenses are deductible whether or not the minister is able to itemize deductions on Schedule C, and these expenses are not subject to the 2% “floor” that applies to employee business expenses (deductible only to the extent they exceed 2% of adjusted gross income). However, employees can realize the same benefits by having their employing church adopt an accountable business expense reimbursement policy.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
