IRS Issues Ruling on Car Expense Reimbursements

Helpful guidance for church treasurers.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

IRS Issues Ruling on Car Expense Reimbursements

Helpful guidance for church treasurers.

Richard R. Hammar

Private Letter Ruling 9547001

Background. The IRS has issued a ruling that addresses the correct tax treatment of employer reimbursements of employee car expenses using the “standard mileage rate.” The ruling provides excellent guidance to church treasurers.

Facts. An employer adopted two approaches for reimbursing its employees’ business use of their privately-owned cars. “Non-supervisory employees” were required to supply odometer readings to document all business miles for purposes of calculating their reimbursable business mileage. Employees were reimbursed under this arrangement at the standard mileage rate specified by the IRS (30 cents per mile in 1995). “Supervisory employees” were reimbursed at a specified “per diem” (daily) rate or the standard mileage rate, whichever was greater. Odometer readings were not required on supervisory employees’ claim forms. The integrity of the claim was the responsibility of the employee. If the employer for any reason questioned a particular claim, the employee had to provide evidence supporting the claim of distance traveled.

What the IRS ruled. The IRS concluded that the employer’s method of reimbursing the business travel expenses of non-supervisory employees was “accountable,” and so the employer’s reimbursements did not represent taxable income to the employees. The IRS concluded that these reimbursements satisfied the three requirements of an “accountable” arrangement: (1) the expenses were for a legitimate business purpose, (2) the reimbursed expenses were adequately substantiated, and (3) any reimbursements in excess of substantiated expenses were returned to the employer. The IRS observed:

[E]mployees … who occupy non-supervisory positions are reimbursed for official use of their privately-owned vehicles at the applicable cents-per-mile rate. The … arrangement requires substantiation of the business use of privately-owned vehicles with mileage records and, thus, satisfies the substantiation requirement of … the regulations. Because non-supervisory employees are reimbursed at the applicable cents-per-mile rate, the return of excess requirement is deemed to be satisfied.

However, the IRS ruled that the supervisory employees were not reimbursed under an accountable arrangement. As a result, all of the employer’s reimbursements of these expenses had to be reported as additional income on the employees’ W-2 forms. The IRS observed:

The supervisors auto arrangement does not require supervisory employees to submit mileage records or return amounts in excess of substantiated expenses. This arrangement also establishes a different rate of reimbursement for supervisory employees. Reimbursements are calculated at [a daily rate] or the applicable cents-per-mile rate, whichever is greater.

To meet the substantiation requirement … of the regulations for passenger automobiles, an arrangement must require the submission of information sufficient to [demonstrate the amount, date, and business purpose of each reimbursed expense]. The supervisors auto arrangement does not require the submission of mileage records and, thus, does not meet the applicable substantiation requirements. In addition, the automobile arrangement provides for reimbursements at the rate of the greater of [a daily rate] or the applicable cents-per-mile rate without requiring the return of amounts in excess of actual or deemed substantiated expenses. Accordingly, the supervisors auto arrangement does not meet the substantiation or return of excess requirements of … the regulations. Therefore, the supervisors auto arrangement is a nonaccountable plan.

Importance to church treasurers. Many churches reimburse the business use of a privately-owned car by a pastor or other staff member using the standard mileage rate. Church treasurers must recognize that the use of the standard mileage rate to reimburse these expenses can be either “accountable” or “nonaccountable,” and that the differences between these two approaches is significant.

Accountable. Under an accountable arrangement, the church multiplies the standard mileage rate times the number of business miles that a pastor or other staff member substantiates (through a log book, diary, trip sheet, or odometer readings). To satisfy the substantiation requirement the records produced by the minister or other staff member must demonstrate the number of miles driven for business purposes along with the dates of travel. The substantiation and reimbursement should occur no less often than every two months. The church does not include any of the reimbursements as income on the employee’s W-2, and there are no business expenses to deduct.
Nonaccountable. This ruling illustrates that the use of the standard mileage rate to reimburse business use of a privately-owned car can be “nonaccountable” if the worker is not required to substantiate the business miles that are being reimbursed. In this case the “supervisory employees” were reimbursed for the business miles they claimed without any documentation. The fact that they were required to produce documentation to the employer upon request was not sufficient to make the arrangement accountable.

Tip. If your church uses the standard mileage rate to reimburse an employee’s business use of a privately-owned car, be sure you (1) only reimburse those miles for which the dates of travel and business purpose are adequately substantiated, and (2) reimburse substantiated business miles within 60 days.

Tip. Churches, like other employers, are free to use a rate different from the IRS “standard mileage rate” to reimburse an employee’s business use of a privately-owned car under an otherwise accountable arrangement. If the church uses a rate lower than the IRS approved rate, then the arrangement can be accountable up to the rate used by the church. The employee can treat the difference between the church approved rate and the IRS approved rate as an unreimbursed business expense. If the church uses a rate in excess of the IRS approved rate, then the arrangement can be accountable up to the IRS approved rate and all reimbursements in excess of this amount are then reported as taxable income to the employee on his or her W-2 at year end (assuming the employee is not required to return the excess to the church).

This article originally appeared in Church Treasurer Alert, March 1996.

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

For Whom the Bell Tolls

What to do when the sound of church bells is not music to a neighborhood’s ears.

Richard R. Hammar, Attorney, CPA

Bio

Background. Many churches broadcast chimes and carillon music to their neighborhoods through bells in a steeple or electronic equipment. These broadcasts are inspiring and uplifting to many. But some neighbors may find the noise disturbing or even offensive. Do these neighbors have a legal right to stop the music? That was the issue addressed by a New York court.

Facts. A Presbyterian church played hourly chimes and in addition played carillon music at noon and 6 o’clock in the evening. A neighbor asked a court to stop the church from broadcasting the chimes and carillon music on the ground that it was “a complete disruption of her family life, prevents a child from sleeping, invades the privacy of her residence, and creates unnecessary stress.” The neighbor claimed that the chimes and music were a “private nuisance.”

The court’s ruling. The court began its opinion by observing that “what may be music to the ears of some can, in certain circumstances, be a nuisance to the ears of others.” It noted that a “private nuisance” is a use of one’s property in a way that causes an unreasonable and “substantial interference” with a neighbor’s enjoyment of his or her property. Did the church’s daily performance of chimes and carillon music create an unreasonable and substantial interference with the neighbor’s property? No, said the court. It pointed to an affidavit (submitted by the church) from an expert in noise management showing that the sound levels caused by the chimes and carillon music were “no greater than the sound from a passing automobile, of which some 6,500 passed [the neighbor’s] property each day.” The court also pointed to affidavits from 15 other neighbors who found the bells and chimes to be pleasant and inspirational.

Importance to church treasurers. If your church broadcasts chimes or carillon music to your neighborhood, and neighbors complain about the noise and threaten to take legal action if it does not stop, follow the lead of the church in this case by: (1) obtaining the opinion of a noise engineer who can compare the noise levels of your chimes or carillon music to other commonly accepted noises; and (2) obtaining the affidavits of several neighbors who find the bells and chimes pleasant and inspiring. These actions will reduce the likelihood that the complaining neighbors will be able to prove that the bells and chimes create an unreasonable and substantial interference to neighbors’ use and enjoyment of their properties. Langan v. Bellinger, 611 N.Y.S.2d 59 (A.D. 3 Dept. 1994).

This article originally appeared in Church Treasurer Alert, February 1996.

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

Notifying Your Insurer of a Loss

Failure to promptly notify can result in loss of coverage.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

Notifying Your Insurer of a Loss

Failure to promptly notify can result in loss of coverage.

Richard R. Hammar

Shaw Temple v. Mount Vernon Fire Insurance Company, 605 N.Y.S.2d 370 (A.D. 2 Dept. 1994)

Background. Church insurance policies generally require that the church notify the insurance company in writing and within a specified period of time concerning any property damage or personal injury that occurs. Failure to do so can relieve the insurance company of any duty to defend the church in a lawsuit or pay a settlement or jury verdict as a result of the damage or injury. One church learned this lesson the hard way in a recent case.

Facts. A church member was injured when he fell on church property during a funeral. At the time of the injury the church had a general liability insurance policy that required the church to give the insurance company written notice of any accident “as soon as practicable.” Immediately following the accident the pastor instructed the chairman of the board of trustees to notify the church’s insurance broker about the accident. The chairman did so by calling the insurance broker’s office. An employee of the broker assured the chairman that the insurance company would be duly notified. In fact, the insurance company was not notified.

Nine months later the church received a letter from an attorney for the injured member threatening to sue the church unless it paid the member a large amount of money. The church immediately turned this letter over to its insurance broker, who in turn forwarded it to the church’s insurance company. The insurance company refused to provide the church with a defense of the lawsuit or pay any amount of money based on the accident since the church had failed to provide it with written notice of the accident “as soon as practicable” as required by the insurance policy.

The church responded by suing its insurance company. It sought a court order requiring the insurance company to defend the church under the terms of the policy and to pay for any damages awarded by a jury. A trial court ruled in favor of the church, and the insurance company appealed.

The court’s ruling. A state appeals court reversed the trial court’s decision and ruled that the insurance company had no legal duty to defend the church or pay for any jury verdict since the church had failed to notify it of the accident “as soon as practicable.”

First, the court concluded that when the church gave notice of the accident to its insurance broker it was not giving notice to its insurance company as required by the policy. Why? Because brokers are not necessarily “agents” of the insurance companies they represent. Rather, they are agents of the persons and organizations they insure. So, when the church gave notice to its broker it was not giving notice to its insurance company since the broker was not an agent of the insurance company.
Second, the court stressed that the insurance policy required that the church provide the insurance company with written notice of any accident. Even if the broker were an agent of the insurance company the church still failed to comply with the terms of the insurance policy since it provided the broker with oral rather than written notice of the accident.
Finally, the court concluded that the church’s nine-month delay in providing the insurance company with written notice of the accident was not “as soon as practicable” as required by the policy and as a result the insurance company had no legal duty to defend the church or pay any jury verdict based on the church’s negligence.

Importance to church treasurers. It is very important for church treasurers to be familiar with this case, for it illustrates three fundamental points:

1. Notifying your broker may not be enough. Many churches purchase their insurance through a local broker. Sometimes this person is a member of the congregation. Church leaders naturally assume that in the event of an accident or injury they can simply call this individual and everything will be “taken care of.” This case illustrates that such a conclusion may not always be correct. A broker may not be deemed to be an “agent” of the insurance companies he or she represents, and accordingly when a church provides its insurance broker with notice of an accident or loss it is not necessarily notifying its insurance company.

Tip. If you notify your insurance broker of a loss, insist on a written assurance that he or she will notify the insurance company in writing within the period of time specified in the insurance policy. If you do not hear back within a week or so, contact the broker again to follow up. Better yet, the church itself should notify both its broker and insurance company. The insurance company’s address will be listed on your insurance policy. Ask the insurance company to provide you with written confirmation of receipt of your notice.

2. Written rather than oral notice. If your insurance policy requires written notice, then be sure you provide written rather than oral notice of a loss.

Tip. Church treasurers should be familiar with the insurance policy’s provisions regarding notification of the insurance company. Is written notice required? If so, how soon after a loss? It is essential that these provisions be scrupulously followed in order to prevent a loss of coverage.

Tip. If you change insurance companies, be sure to review the new insurance policy. Do not assume that it will contain the same “notice” provisions as your previous policy.

3. A reasonable time. How soon does your church insurance policy require that notice be submitted to the insurance company following an accident or loss? Be sure you know, and that this requirement is followed whenever there is an accident, personal injury, or other kind of loss.

Tip. The duty to inform your insurance company of an accident or loss arises when the injury occurs, and not when a lawsuit is filed. The purpose of the notice requirement is to give your insurance company sufficient time to investigate the incident and provide a defense.

Example. On February 15, 1996 the church board at First Church is informed by a parent that her minor child was molested by a church volunteer. The volunteer is questioned, and admits having molested the child. This incident represents a potential “loss” under the church’s insurance policy, triggering a duty to inform the church’s insurance company of the loss within the period of time specified in the insurance policy. The church should inform its insurance company immediately. It is very important that it not wait until a lawsuit is filed to notify its insurance company. Such a delay not only hinders the insurance company’s ability to investigate the incident and defend the case, but it also may result in loss of coverage under the policy. This could have disastrous consequences to the church.

This article originally appeared in Church Treasurer Alert, February 1996.

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

Tax Changes of Interest to Churches

Changes churches should know.

Richard R. Hammar, Attorney, CPA

Bio

1. Increase in wages subject to FICA tax. The FICA tax rate (7.65% for both employers and employees, or a combined tax of 15.3%) did not change in 1995. However, the amount of earnings subject to tax increased. The 7.65% tax rate is comprised of two components: (1) a Medicare hospital insurance (HI) tax of 1.45%, and (2) an “old—age, survivor and disability” (OASDI) tax of 6.2%. For 1995 and future years there is no maximum amount of wages subject to the Medicare hospital insurance (the 1.45% “HI” tax rate). The tax is imposed on all wages regardless of amount. For 1995, the maximum wages subject to the “old—age, survivor and disability” (OASDI) portion of self—employment taxes (the 6.2% amount) increases to $61,200—up from $61,200 in 1994. Stated differently, employees who receive wages in excess of $61,200 in 1995 will pay the full 7.65% tax rate for wages up to $61,200, and the “HI” tax rate of 1.45% on all earnings above $60,000. Employers pay an identical amount. The new rule will impact churches and other religious organizations that have nonminister employees receiving wages in excess of $61,200. Such employers must be certain to properly withhold the Medicare tax in order to avoid any penalties.

2. IRS issues regulations clarifying the new charitable contribution substantiation rules. The IRS issued regulations in 1995 that clarify a few questions that have arisen in applying the new charitable contribution substantiation rules. The new regulations address the following matters:

Out—of—pocket expenses. Let’s say that Greg, a member of First Church, participates in a short—term missions project and in the process incurs $300 of unreimbursed out—of—pocket travel expenses. The IRS has long acknowledged that such expenses are deductible as a charitable contribution. But what about the new rules for substantiating charitable contributions of $250 or more? Do they apply to this kind of contribution? Is the church responsible for keeping track of Greg’s travel expenses in order to determine if they are $250 or more? The proposed regulations address this common problem. The IRS acknowledged that a charity “typically has no knowledge of the amount of out—of—pocket expenditures incurred by a taxpayer, and therefore, would have difficulty providing taxpayers with substantiation of unreimbursed expenditures.” To address this concern, the proposed regulations provide that where a taxpayer incurs unreimbursed expenses in the course of performing services for a charitable organization, the expenses may be substantiated by the donor’s normal records and an “abbreviated written acknowledgment” provided by the charitable organization. This “abbreviated written acknowledgment” from the charity must contain (1) a description of the services provided by the donor, (2) the date the services were provided, (3) whether or not the donee organization provided any goods or services in return and, (4) if the donee organization provided any goods or services, a description and good faith estimate of the fair market value of those goods or services.

In addition, the abbreviated written acknowledgment must be received by the taxpayer before the earlier of (1) the date he or she files a tax return claiming the contribution deduction, or (2) the due date (including extensions) for the tax return for that year.

Good faith estimate of value. To substantiate a individual charitable contribution of $250 or more, a donor must obtain a receipt from the charity that satisfies a number of requirements. One requirement is that the receipt state whether or not the charity provided any goods or services in exchange for a contribution of $250 or more (other than intangible religious benefits), and if so, a description and good faith estimate of the value of those goods and services. The regulations define a good faith estimate as an estimate of the fair market value of the goods or services provided by a charity in consideration of a donor’s contribution. The fair market value of goods or services may differ from their cost to the charity. The charity may use any reasonable method that it applies in good faith in making the good faith estimate. However, a taxpayer is not required to determine how the charity made the estimate.

Reliance on a charity’s estimate of value. The proposed regulations specify that a taxpayer generally may treat an estimate of the value of goods or services as the fair market value for purposes of computing a charitable contribution deduction if the estimate is in a receipt issued by the charity. For example, if a charity provides a book in exchange for a $100 payment, and the book is sold at retail prices ranging from $18 to $25, the taxpayer may rely on any estimate of the charity that is within the $18 to $25 range (the charitable contribution deduction is limited to the amount by which the $100 donation exceeds the fair market value of the book that is provided to the donor). However, a taxpayer may not treat an estimate as the fair market value of the goods or services if the taxpayer knows, or has reason to know, that such treatment is unreasonable. For example, if the taxpayer is a dealer in the type of goods or services it receives from a charity or if the goods or services are readily valued, it is unreasonable for the taxpayer to treat the charity’s estimate as the fair market value of the goods or services if that estimate is in error and the taxpayer knows, or has reason to know, the fair market value of the goods or services.

Intangible religious benefits. The regulations clarify that if a charity provides not goods or services to a donor in consideration for a contribution of $250 or more, other than intangible religious benefits, the receipt it issues to the donor must contain a statement that effect. This is an important point for church leaders to comprehend. Most churches will provide donors (of individual contributions of $250 or more) with no goods or services other than intangible religious benefits. The regulations remind religious organization’s that the receipts they issue to donors who make one or more individual contributions of $250 must state that no goods or services were provided to the donor other than intangible religious benefits.

Membership benefits. Under current law, a taxpayer who receives membership benefits in return for a payment to a charitable organization may not claim a charitable contribution deduction for more than the amount by which the payment exceeds the fair market value of the membership benefits. Accordingly, taxpayers and donee organizations must determine the fair market value of any membership benefits the charity provides to its donors. It is often difficult to value membership benefits, especially rights or privileges that are not limited as to use, such as free or discounted admission or parking, and gift shop discounts. In the new regulations the IRS recognized the difficulty charities often have in valuing benefits provided to members, and concluded that it is appropriate to provide limited relief with respect to certain types of customary membership Benefits. The regulations provide that both the charity and the donor may disregard membership benefits provided in return for a payment to the organization in calculating the value of a charitable contribution, if the benefits meet either of the following 2 tests:

(1) The benefits have an insubstantial value under existing IRS guidelines. Insubstantial value means that the benefits provided by the charity consist of low cost articles (items costing $6.60 or less for 1995), newsletters that are not commercial quality publications, and benefits worth 2% or less of a payment, up to a maximum of $66 for 1995.

(2) The benefits are given as part of an annual membership offered in return for a payment of $75 or less and fall into one of the following two categories: (i) Admission to events that are open only to members and for which the charity reasonably projects that the cost per person (excluding allocable overhead) for each event will be less than or equal to $6.60 in 1995. An example is a modest reception where light refreshments are served to members of a charity before an event. (ii) Rights or privileges that members can exercise frequently during the membership period. An example is free admission to a museum.

3. IRS provides some relief in complying with the new charitable contribution substantiation rules. Under a new law that took effect in 1994, donors must substantiate individual contributions of $250 or more with a receipt that satisfies a number of new requirements (discussed fully in chapter 8). Unfortunately, many charities have failed to provide receipts for 1994 contributions that comply fully with the new requirements. The result—the deductibility of millions of dollars in donations has been jeopardized. The IRS recently responded to this crisis by issuing a public notice informing taxpayers that they can still claim deductions for charitable contributions of $250 or more on their 1994 returns if they make a “good faith effort” on or before October 16, 1995 to obtain the required written receipt from the charity. The IRS noted that a “good faith effort” would include sending a letter to the charity requesting a receipt that complies with the new rules.

4. The IRS expresses concern over widespread failure by donors to properly substantiate their contributions of noncash property to charity. The IRS continues to express concern over the widespread lack of compliance with the substantiation requirements that apply to charitable contributions of noncash property valued by the donor at $500 or more (note that these rules are in addition to the new substantiation rules that took effect on January 1, 1994, as noted above). Any donor who contributes noncash property (i.e., homes, land, vehicles, equipment, jewelry) to a church or other charity, and who claims a deduction of $500 or more, must complete IRS Form 8283 and enclose it with the Form 1040 on which the deduction is claimed. If property valued at more than $5,000 is donated, then additional requirements apply. The donor must obtain a qualified appraisal and enclose an appraisal summary with the Form 1040 on which the deduction is claimed. These important requirements are discussed fully in chapter 8. Church treasurers should be familiar with these rules.

5. The Tax Court ruled that a taxpayer who sent contributions to a mosque in his family’s home town in Iran was not entitled to a charitable contribution deduction. Federal law specifies that a charitable contribution, to be tax—deductible, must go to an organization “created or organized in the United States or in any possession thereof.” In addition, the organization must be organized and operated exclusively for religious or other charitable purposes. This means that contributions made directly by church members to a foreign church or ministry are not tax—deductible in this country. Alisobhani v. Commissioner, T.C. Memo. 1994—629 (1994).

6. The IRS ruled that persons who give property to charity are eligible for a charitable contribution deduction even though their “gift” may revert back to them under specified conditions. A deceased person left a will giving $50,000 to a school to establish a scholarship fund for needy students attending the school (to be selected by the school). The will specified that in the event the school “ceases to exist as a school or ceases to be accredited by the state” the balance in the fund would revert to the deceased’s heirs. The question was whether the deceased’s estate could claim a charitable contribution deduction for the scholarship gift despite the possibility that the fund could one day revert to the donor’s heirs. The IRS ruled that the estate was entitled to a charitable contribution deduction—because the likelihood that the school would “cease to exist” was so remote as to be negligible. The IRS noted that the tax regulations specify that “if an interest passes to charity at the time of a decedent’s death and the interest would be defeated by … some act or the happening of some event, the possibility of occurrence of which appears at the time of the decedent’s death to be so remote as to be negligible, the deduction is allowable.” The IRS also noted that the tax regulations contain an example in which a decedent dies leaving a will which donates land to a city government “for as long as the land is used by the city for a public park.” The example concludes that “a deduction is allowable if, on the date of the decedent’s death, the possibility that the city will not use the land for a public park is so remote as to be negligible.”

7. IRS software to address worker status. One of the most difficult and confusing tasks church treasurers face is classifying workers are either employees or self—employed. The correct classification is essential, for it determines whether the church should (1) withhold taxes; (2) issue the worker a W—2 or 1099 form; and (3) include the worker’s wages and taxes withheld on the church’s quarterly 941 forms. In addition, this classification will determine the availability of a number of tax—free fringe benefits (such as employer—paid medical insurance premiums and cafeteria plans, which are taxable fringe benefits to self—employed workers). Unfortunately, it is often difficult to classify some kinds of church workers. Examples include part—time child care workers, musicians, custodians, and yard maintenance workers. Help may soon be on the way. The IRS has announced that it soon will be releasing computer software to assist employers in classifying a worker as either an employee or self—employed. The software (which the IRS calls the “SS—8 Determiner”) is based on the IRS 20—factor test. [See also Clergy Status—Employee or Self-employed.]

8. 403(b) retirement plans receive more scrutiny. One of the more popular retirement programs for employees of nonprofit organizations (including many churches) is the tax—sheltered annuity authorized by section 403(b) of the federal tax law. The IRS has expressed concern in recent months over the failure of many of these programs to comply with complex legal requirements. One IRS spokesman said recently that “we have made no secret of the fact that the IRS has yet to find a 403(b) plan fully in compliance,”and that the overall noncompliance rate may be as high as 90%! The IRS will be announcing a “voluntary correction program” in the near future under which nonprofit organizations can pay reduced fines in return for voluntarily correcting certain errors in their plans. One of the main areas of noncompliance for churches is excessive contributions (a church contributes more to a 403(b) on behalf of a pastor or other church employee than is permitted by law). Another problem—churches that permit self—employed workers to participate. These plans are available only to employees.

9. IRS says relief to specific bomb victims not deductible. The IRS has issued a public notice in response to many questions it has received concerning relief for the victims of the Oklahoma City bombing. Contributions to exempt organizations that are “earmarked for Oklahoma City federal building bomb attack relief” are tax—deductible. Not so for contributions that are “earmarked for relief of any particular individual or family.” What’s the difference? To be tax—deductible, a contribution must go to a charity and not directly to an individual. Contributions to a charity that “earmark” a specific person or family ordinarily are deemed to be gifts to the individuals and not to the charity. IRS Notice 95—33.

10. 1099 forms and church fund—raising programs. Many churches conduct sales of merchandise to raise funds for various programs and activities. Examples include bake sales, auctions, and bazaars. Should a church issue a 1099—MISC form to persons who purchase items at such events? No, said the IRS in a recent ruling. Charities that sell items in the course of fund—raising events need not issue 1099 forms to purchasers since no compensation is being paid to them. Form 1099—MISC is issued to non—employees who are paid compensation of $600 or more during the year. IRS Letter Ruling 9517010.

11. Tax Court denies charitable contribution deduction to church member for unsubstantiated contributions. A taxpayer claimed cash contributions of $3,500 to her church. She was audited and the IRS denied any deduction for these contributions. The IRS claimed that the woman had insufficient evidence to substantiate the contributions. The taxpayer claimed that these contributions were all made in cash, and so she had no canceled checks to substantiate them. She also claimed that she kept no records or receipts to prove her contributions. The only evidence she had was a letter from her church stating that the taxpayer made contributions of $3,500 to the church during the year in question “through tithes, offerings, and love donations.” No church representative testified during the woman’s trial. The Tax Court agreed with the IRS that the woman had failed to substantiate the $3,500 in charitable contributions to her church. It dismissed the church’s letter by noting that “the letter from the church is very general and provides no information as to how and when [her] contributions were made. The evidence presented does not satisfy the court that [she] made the contributions to the church in the amount claimed.” The court was satisfied that the woman made some contributions to the church, and allowed her a deduction in the amount of $450. Generic letters that merely report the total amount of contributions given by a donor during the year will not be enough to substantiate the donor’s individual cash contributions of less than $250. The letter, or receipt, must list church’s name and the dates and amounts of each contribution. Additional rules apply to the substantiation of individual contributions of $250 or more. Witherspoon v. Commissioner, T.C. Memo. 1994—593.

12. Impact of tax simplification. A number of sweeping proposals for tax reform are being discussed in Congress. Some “flat tax” proposals would eliminate most deductions, including a deduction for charitable contributions, in exchange for a flat income tax rate. How would such a tax impact churches and other charities? Would donations decline because of the loss of a contribution deduction? Two factors suggest that they would not. First—71% of all taxpayers can’t deduct their contributions under present law, because they cannot itemize deductions on Schedule A. A “flat tax” that eliminated charitable contribution deductions would only affect the remaining 29% of taxpayers that currently can deduct their contributions. Second—when the partial deduction of charitable contributions by nonitemizers expired in 1986, there was no decrease in charitable giving. We will be closely following the debate in Congress over tax reform. If any new laws emerge, we will let you know the details in future editions of this text.

13. IRS rules that a religious organization’s sales of books by its founder did not generate unrelated business income. The IRS noted that the books offered for sale provided information on the doctrine and principles constituting the basis for the religious beliefs of the organization’s members. The IRS further noted that the federal tax on unrelated business income does not apply to income generated from activities that are substantially related to an exempt organization’s exempt purposes. It concluded: “You will offer for sale books written by your founder. The books offered for sale are intended to provide additional information about your religious doctrine and principles. The books will be used to educate your members and prospective members about the tenets of your religion. Therefore, the sale of books written by your founder will be substantially related to the accomplishment of your religious purposes … Accordingly, this activity will not constitute an unrelated trade or business.” IRS Letter Ruling 9535050. [ Tax on Unrelated Business Income]

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

Often Overlooked Sources of Taxable Income to Ministers

Clarifying what income is taxable and what is not.

Richard R. Hammar, Attorney, CPA

Bio

Background. It is important for church treasurers to know how much taxable income the church is paying a minister so that the correct amount can be reported on the W-2 or 1099 the church issues to the minister. Unfortunately, the concept of “taxable income” is complex and confusing. Church treasurers often issue W-2 or 1099 forms that do not fully reflect all income received by a minister.

Key point. This article focuses on items of taxable income received by ministers that often are overlooked by church treasurers when completing the minister’s W-2 or 1099 form. Many of the items summarized below apply equally to non-minister staff members as well.

Assignments of income. Sometimes a minister or other staff member will refuse to accept payment for services rendered. Consider two examples:

• Rev. G conducts services for two weeks at another church whose pastor is on vacation. The church wants to pay Rev. G income of $750 for these services, but Rev. G declines and requests that the money be applied to the church’s building fund.

• Rev. T declines to accept a Christmas gift or anniversary gift of $500 from the congregation. Instead, Rev. T asks the church treasurer to transfer the amount to the church’s benevolence fund.

Clearly, both ministers believe they have avoided the receipt of taxable income by assigning these amounts to the church. Are they correct? Should a church treasurer report these amounts as taxable income on each minister’s W-2 form? Unfortunately, the answer is yes. The United States Supreme Court addressed this issue in a landmark ruling in 1940, in which it ruled that “[t]he power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.” Helvering v. Horst, 311 U.S. 112 (1940).

Example. A taxpayer earned an honorarium of $2,500 for speaking at a convention. He requested that the honorarium be distributed to a college. This request was honored, and the taxpayer assumed that he did not have to report the $2,500 as taxable income since he never received it. The IRS ruled that the taxpayer should have reported the $2,500 as taxable income. It noted that “the amount of the honorarium transferred to the educational institution at the taxpayer’s request … is includible in the taxpayer’s gross income [for tax purposes]. However, the taxpayer is entitled to a charitable contribution deduction ….” The IRS further noted that “the Supreme Court of the United States has held that a taxpayer who assigns or transfers compensation for personal services to another individual or entity fails to be relieved of federal income tax liability, regardless of the motivation behind the transfer” (citing the Helvering case discussed above). Revenue Ruling 79-121.

Example. A church member signed a real estate contract agreeing to sell a rental property that he owned. At the real estate closing the member insisted that 8% of the sales price be paid to his church for a building project. The Tax Court ruled that the member had to report the full amount of the sale price as taxable gain and that the attempt to “assign” 8% of the gain to the church did not reduce the member’s taxable gain. It observed that “the payment of part of the sales proceeds to the church was an anticipatory assignment of income which does not protect [the member] from taxation on the full amount of the gain realized on the sale.” The court stressed that the member could claim a charitable contribution deduction for the amount he paid to the church, but he had to report the full amount of the sales price as taxable gain. Ankeny v. Commissioner, 53 T.C.M. 827 (1987).

Key point. No taxable income is incurred when a taxpayer performs purely gratuitous and volunteer services with no expectation of compensation. To illustrate, the IRS ruled that a professional entertainer who gratuitously rendered professional services as a featured performer at a fund-raising event for a charity did not receive taxable income since he “was not entitled to, and received no payment for these services.” Revenue Ruling 68 503.

Refusals to accept full salary. Occasionally a minister or other staff member will decline to accept the full amount of a church-approved salary. Should a church treasurer report the full amount of the church-approved salary as income on the individual’s W-2 form? Church treasurers need to be familiar with the so-called “constructive receipt doctrine,” which is defined by the income tax regulations as follows:

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.

A number of courts have ruled that this principle requires employees to include in their taxable income any portion of their stated salary that they refuse to accept.

On the other hand, some courts have reached an opposite conclusion. Perhaps the most notable case is Giannini v. Commissioner, 129 F.2d 638 (9th Cir. 1942). This case involved a corporate president whose annual compensation was 5 percent of the company’s profits. In the middle of one year, the president informed members of his company’s board of directors that he would not accept any further compensation for the year and suggested that the company “do something worthwhile” with the money. The company never credited to the president any further compensation for the year nor did it set any part of it aside for his use. The amount of salary refused by the president was nearly $1.5 million, and no part of this amount was reported by the president as taxable income in the year in question. The IRS audited the president and insisted that the $1.5 million should have been reported as taxable income. The taxpayer appealed, and a federal appeals court rejected the IRS position:

[T]he taxpayer did not receive the money, and … did not direct its disposition. What he did was unqualifiedly refuse to accept any further compensation for his services with the suggestion that the money be used for some worthwhile purpose. So far as the taxpayer was concerned, the corporation could have kept the money …. In these circumstances we cannot say as a matter of law that the money was beneficially received by the taxpayer and therefore subject to the income tax provisions ….

The court acknowledged that the United States Supreme Court has observed: “[O]ne who is entitled to receive, at a future date, interest or compensation for services and who makes a gift of it by an anticipatory assignment, realizes taxable income quite as much as if he had collected the income and paid it over to the object of his bounty.” Helvering v. Schaffner, 312 U. S. 579 (1941). However, the court distinguished this language by observing that “the dominance over the fund and taxpayer’s direction show that he beneficially received the money by exercising his right to divert it to a use.” This was not true of the corporate president in the present case, the court concluded.

In summary, there is a reasonable basis for not treating as taxable income that portion of an employee’s stated salary that is refused, particularly where the employee does not assign the income to a specified use but rather is content to leave the unpaid salary with the employer. Church treasurers should seek the advice of a CPA or tax attorney before adopting this position in a particular case.

Forgiveness of debt. Churches often make loans to their ministers, often at no interest. Sadly, in some cases a minister never repays the debt. Church treasurers often are unsure of their obligations under these circumstances. Consider the following example:

First Church hires Rev. B as a youth pastor. Rev. B is young and was recently married, and is in need of housing. Rev. B would like to buy a home but lacks the $10,000 needed for a down payment. The church board votes to loan Rev. B $10,000. Rev. B signs a no-interest $10,000 promissory note agreeing to pay the church back the $10,000 in 60 monthly installments of $166.67. Rev. B pays all of the monthly installments for the first year, but in the second and third year he pays only half of the required installments. He accepts another position and leaves First Church at the end of the third year. The balance due on his note is now $6,000. Over the next several months the church treasurer at First Church writes Rev. B on 3 occasions and requests that the note be paid in full. Rev. B does not respond to any of these requests. The church board eventually decides to forgive the debt and makes no further contact with Rev. B.

What should a church treasurer do under these circumstances? Does the forgiven debt of $6,000 represent taxable income? The forgiveness of debt ordinarily represents taxable income to the debtor. As a result, if a church makes a loan to a minister or other staff member and the debt is later forgiven by the church, the church should report the forgiven debt as income. Here are the rules to follow, using the same facts as in the example:

• If the church has not yet issued a W-2 or 1099 to Rev. B for his last year of employment, then reflect the forgiven debt on the W-2 or 1099.

• If the church already has issued a W-2 or 1099 to Rev. B for the last year of employment, then issue a corrected W-2 or 1099. A corrected W-2 is prepared on Form W-2c. Be sure to note the year of the Form W-2 that is being corrected. There is no separate form for a corrected 1099—simply fill out a new 1099 and check the box at the top of the form indicating that it is a “corrected” version.

• In addition to the forgiven debt ($6,000) Rev. B received income because no interest was charged by the church on the loan. In essence, this additional “income” consists of the amount of interest Rev. B would have paid the church had the prevailing commercial interest rate been charged by the church on the loan. A below market term loan of less than $10,000 is not subject to these rules (assuming one of its principal purposes is not the avoidance of tax). Check with a CPA or tax attorney for assistance in making this calculation. Different rules apply for “demand loans.”

Example. An employer paid the moving expenses of newly hired employees to relocate them to the employer’s city. Employees were required to reimburse the employer for a portion of the moving expenses paid by the employer if they terminated their employment within 1 year after being hired. An employee voluntarily terminated her employment within 1 year of being hired, and the employer was unsuccessful in collecting $5,000 in moving expenses from the employee. The employer eventually wrote this amount off as uncollectible. The IRS ruled that the employer had to report the forgiven debt as taxable income to the former employee. It observed: “It is well settled that where an employee’s debt to his employer is satisfied by canceling such debt, income is realized by the employee. Therefore, the employee must include in gross income the total amount of the debt that was canceled by [the employer]. The income realized upon cancellation of indebtedness arose as a result of an employment relationship. Accordingly, Form W 2 should be used to report the amount of indebtedness canceled. This form should be used even if the debt is canceled in a year subsequent to the year of employment.” IRS Letter Ruling 8315021.

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

End of Year Contributions

How to address donations dated the previous year.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

End of Year Contributions

How to address donations dated the previous year.

Richard R. Hammar

The first Sunday in January often presents problems for church treasurers regarding the correct receipting of charitable contributions. For example, the first Sunday in January of 1996 falls on January 7th. Can a member who contributes a personal check to your church on Sunday, January 7th, deduct the check on his or her 1995 federal tax return if the check is backdated to read “December 31, 1995”? Many churches advise their congregations during worship services conducted on the first Sunday in January that checks contributed on that day can be credited to the previous year if they are dated December 31st of the previous year. Is this true? Unfortunately, the answer is no. The income tax regulations specify that “ordinarily, a contribution is made at the time delivery is effected. The unconditional delivery or mailing of a check which subsequently clears in due course will constitute an effective contribution on the date of delivery or mailing.” According to this language, a check dated December 31, 1995 but physically delivered in January of 1996 is deductible only on the donor’s 1996 federal tax return. This is so whether a donor “predated” a check to read “December 31, 1995” during church services conducted in January of 1996, or in fact completed and dated the check on December 31, 1995 but deposited it on or after January 1, 1996. The only exception to this rule is in the case of a check that is dated and mailed (and postmarked) in December of 1995. The fact that the church does not receive the check until January of 1996 does not prevent the donor from deducting it on his or her 1995 federal tax return. The rules are summarized in the table accompanying this article. Type of contributionChurch treasurer reports as a 1995 contributionChurch treasurer reports as a 1996 contribution

Checks written in December 1995 and deposited in church offering in January 1996.		X
Checks written and deposited in church offering in January 1996 but “back dated” to December 1995.		X
Checks written and deposited in church offering in December 1995 but “post dated” to January 1996.	X
Checks written in December 1995 and deposited in the mail and postmarked in December 1995, but not received by the church until January 1996.	X
Checks written in December 1995 and deposited in the mail in December 1995 but not postmarked until January 1996, and not received by the church until January 1996.		X

This article originally appeared in Church Treasurer Alert, December 1995.

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

Additional Sources of Income to Ministers

Clarifying what income is taxable and what is not.

Richard R. Hammar, Attorney, CPA

Bio

Key point. This article focuses on items of taxable income received by ministers that often are overlooked by church treasurers when completing the minister’s W-2 or 1099 form. Many of the items summarized in this article apply equally to non-minister staff members as well.

Bonuses. Any “bonus” paid by a church to a minister represents taxable income, and must be reported on the minister’s W-2 or 1099.

“Love gifts.” Churches often pay ministers a “love gift” on special occasions such as Christmas, birthdays, or anniversaries. Many church treasurers are not sure how to report these “gifts.” Are they nontaxable gifts, or do the represent taxable compensation for services rendered? Here is the basic test: If the purpose of a “gift” is to more fully compensate a minister for faithful services rendered on behalf of the church, the amount represents taxable compensation for services rendered and is not a nontaxable gift. It must be included on a minister’s W-2 or 1099. This is so even though the amount is called a “love gift.”

Key point. The United States Supreme Court has observed: “What controls is the intention with which payment, however voluntary, has been made. Has it been made with the intention that services rendered in the past shall be requited more completely, though full acquittance has been given? If so, it bears a tax. Has it been made to show good will, esteem, or kindliness toward persons who happen to have served, but who are paid without thought to make requital for the service? If so, it is exempt.” Bogardus v. Commissioner, 302 U.S. 34, 45 (1936).

Here’s another important point—since 1987 federal law has specified that the term gift does not include “any amount transferred by or for an employer to, or for the benefit of, an employee.” An exception is a traditional employer holiday gift of low fair market value (such as a turkey, fruitcake, etc.). These items are nontaxable.

Note the following general principles:

Special occasion gifts made to a minister by the church out of the general fund should be reported as taxable compensation and included on the minister’s W 2 or 1099.
Members are free to make personal gifts directly to their minister, such as a card at Christmas accompanied by a check or cash. Such payments normally are tax free gifts to the minister (though they are not deductible by the donor).
Special occasion “gifts” to a minister funded through members’ contributions to the church (i.e., the contributions are entered or recorded in the church’s books as cash received and the members are given charitable contribution credit), should be reported as taxable compensation and included on the minister’s W 2 or 1099.
Members who contribute to special occasion offerings may deduct their contributions if (1) the contributions are to the church and are entered or recorded in the church’s books as cash received, and (2) they are able to itemize deductions on Schedule A (Form 1040).
Some churches collect an all cash special occasion offering with the understanding that the entire proceeds will be paid directly to the minister and that no contributions will be tax deductible. Whether or not these amounts represent taxable income to the minister will depend on the following factors: (1) the intent of the donors who contribute to the offering (e.g., if they are simply wanting to provide additional compensation to their minister in recognition of services rendered, then the transfer will be taxable compensation rather than a tax free gift); (2) whether or not a church adjusts the minister’s compensation on the basis of the special occasion offerings collected on his or her behalf; and (3) whether the contributions were spontaneous and voluntary as opposed to fixed amounts established under a “highly structured program” for transferring money to the minister on a regular basis. One court ruled that such “gifts” represented taxable compensation to a minister in part because “[t]he transfers were initiated, sponsored, collected and distributed by the congregation.”

Key point. An aggressive argument can be made that in some cases a Christmas offering collected by a congregation for its minister represents a nontaxable gift rather than taxable compensation if the following factors are present: (1) The members are not receipted for their contributions. (2) Members are informed that they are giving directly to the pastor. (3) Members do not deduct their contributions. (4) The church acts merely as an intermediary. The gifts in reality are made by individual members directly to their pastor. (5) The church’s minimal involvement in the arrangement (collecting and turning over the offering) does not amount to sufficient church involvement to prevent the offering from being characterized as several individual gifts from members directly to their pastor. (6) Only 1 special occasion offering is collected each year. (7) Members are not pressured or coerced into making contributions. Participating in the offering is entirely voluntary. (8) The pastor is adequately compensated through salary and fringe benefits mutually agreed to between the pastor and church board. (9) Most members contribute to such an offering out of sincere affection, respect, and admiration, and not out of a desire to compensate the pastor more fully for services rendered. Pastors and churches should not select the “aggressive approach” without the advice of a tax professional.

Retirement gifts. Most churches present retiring ministers with some form of “gift.” Are these “gifts” nontaxable, or should church treasurers treat them as taxable compensation and add them to the minister’s W-2 or 1099? In the vast majority of cases, retirement gifts represent taxable compensation. This is because federal law (since 1987) has specified that the term gift does not include “any amount transferred by or for an employer to, or for the benefit of, an employee.”

Key point. Prior to 1987 a number of courts (and the IRS itself) ruled that retirement gifts to ministers in some cases could represent nontaxable income. These rulings were all overruled by the tax law change that took effect in 1987 prohibiting employers from making tax-free gifts to employees.

Key point. The 1987 tax law change only applies to employees. It does not apply to self-employed workers. As a result, ministers who in fact are self-employed for income tax reporting purposes are not absolutely barred from receiving tax-free retirement gifts. But note—(1) it will be very difficult for most ministers to demonstrate that they are self-employed for income tax reporting purposes, and (2) self-employed ministers still must demonstrate that (a) the retirement gift was not intended to more fully compensate a minister for faithful services rendered on behalf of the church, and (b) the gift satisfied the legal definition of a gift as a transfer that “proceeds from a detached and disinterested generosity … out of affection, respect, admiration, charity, or like impulses.”

Key point. Ministers who receive retirement gifts directly from members may be able to treat them as tax free gifts. Of course, the members receive no charitable contribution deduction since their contributions went directly to an individual. See the above discussion on special occasion gifts.

Property purchased from the church at a discount. Sometimes a church will sell property to a minister at less than fair market value. For example, a church sells its parsonage (with a fair market value of $100,000) to its minister for $25,000. In these cases the church treasurer ordinarily must include in the minister’s W-2 or 1099 the excess of the property’s fair market value over the bargain sale price.

Social Security paid by the church. Ministers are always treated as self-employed for social security purposes with respect to services they perform in the exercise of their ministry. This means that they pay the full “self-employment tax” (15.3 percent) rather than FICA taxes. Some churches agree to pay a portion (or all) of this tax liability. Any amount paid to a minister to help him or her pay the higher self employment tax must be reported as additional compensation on the minister’s W 2 or 1099 form. The amount paid by the church must be reported as compensation for social security purposes as well.

Moving expenses paid by the church. Since 1994, employer reimbursements of an employee’s moving expenses are treated as a tax-free fringe benefit if (1) the moving expenses would be deductible by the employee if paid directly by the employee; (2) the employee did not deduct the expenses in a prior year; and (3) the employer only reimburses those moving expenses that are properly substantiated by the employee (under rules similar to an accountable expense reimbursement arrangement). Employer reimbursements that satisfy these requirements are not reported in box 1 of the W-2 form, but must be reported in box 13. Code “P” is used to identify these nontaxable reimbursements in box 13. Any moving expense reimbursements that do not satisfy the three requirements summarized above represent a taxable fringe benefit and must be reported as taxable income on the minister’s W-2 or 1099.

Personal use of a church-provided car. The important point to note is this—if a church provides a car to its minister, the minister’s personal use of the car is a taxable noncash fringe benefit. The church must determine the actual value of this fringe benefit so that it can be included in the minister’s income and reported on his or her W 2 or 1099 form. There are four ways to compute the taxable value of the personal use of a church-provided car—a general valuation rule and three special valuation rules. These rules are explained fully in chapter 4 of Richard Hammar’s 1996 Church and Clergy Tax Guide.

Below market interest loans. It is common for churches to make below market interest loans to ministers, often to assist the minister in obtaining a home. Church treasurers often are unaware that these loans may generate taxable income that must be reported on the minister’s W-2 or 1099. Here are the basic rules:

Demand loans. A demand loan is a loan payable in full at any time upon the church’s demand. For example, a church loans $20,000 to Rev. B with no indication of when it is to be repaid. If the church charges less than the prevailing interest rate then Rev. B is treated as having received additional compensation from the church in an amount equal to the “foregone interest.” These additional transfers of compensation are deemed to occur annually, generally on December 31. The “lender” (church) must report this amount as interest income to the “borrower” (minister). Foregone interest for any period is the amount of interest that would be payable for that period if interest occurred at the applicable federal rate, over and above any interest actually payable on the loan for the same period. The applicable federal rate is established by the IRS each month in a revenue ruling. You can get this rate from any IRS office.

Term loans. A term loan is a loan that is not a demand loan. These loans are payable over a specified period of time. For example, a church loans Rev. C $15,000 over a 10-year term at no interest. Rev. C is treated as having received an additional payment of compensation on the date the loan was made. The amount of compensation is the excess of the amount of the loan over the present value of all payments due under the loan. You can easily compute this amount with a financial calculator.

Key point. A below market demand or term loan of less than $10,000 is not subject to these rules (assuming one of its primary purposes was not the avoidance of tax)

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

Inflating the Value of Donated Property

Donors face significant risks if they claim too high a value on donations.

Richard R. Hammar, Attorney, CPA

Bio

Background. Persons who donate property to charity want to claim the highest possible value to increase their charitable contribution deduction. Sometimes they claim too high an amount, and this can result in problems. Taxpayers who understate their income taxes in any year by $5,000 or more because they overstated the value of donated property on their tax return are subject to a penalty. The penalty only applies if the overstated value is at least 200% of its actual value. The penalty is computed by multiplying 20% times the amount of the underpayment of income taxes (the penalty rate increases to 40% if the overstated value is at least 400% of its actual value).

A common example of valuation overstatements involves overvaluations of properties donated to charity. Such overvaluations result in inflated charitable contribution deductions and a corresponding understatement of income taxes.

A recent case. A property owner purchased 250 acres of inaccessible mountain property in Alaska for $30,000. Two years later, after an unsuccessful attempt to sell the property, he donated it to charity and claimed a charitable contribution deduction of $2.75 million. The IRS audited the taxpayer, and claimed that the property was worth only $28,000. This meant that the taxpayer overstated the value of the donated property by 98 times! The Tax Court agreed with the IRS, and denied the donor’s inflated charitable contribution deduction. It also upheld the following penalties:

• Overvaluation of donated property. The Court ruled that the taxpayer was subject to the penalty for overvaluation of donated property (summarized above). The Court noted: “Here, [the taxpayer] attempted to claim a charitable contribution deduction for approximately 98 times the amount paid for the property 2 years prior to donation. [He] grossly overstated the value of the donated property.”

• Additional interest. Federal law provides for an interest rate of 120 percent if there is a “substantial underpayment” (an underpayment in excess of $1,000) in a taxable year “attributable to one or more tax-motivated transactions.” Tax-motivated transactions include inflated valuations of donated property. The Court ruled that the taxpayer could be assessed additional interest since he made “blatant misuse of the charitable donation provisions” and “participated in a scheme to generate egregious charitable contribution deductions through the gross overvaluation of the items donated.”

• Negligence. The Court also concluded that the taxpayer could be assessed an additional penalty for negligence. The Court noted that negligence is “the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.” The Court acknowledged that the taxpayer relied on the opinion of an appraiser that the donated property was worth $2.75 million. However, it cautioned that

mere reliance on an appraiser or expert in a matter does not automatically shield a taxpayer from the negligence addition; a taxpayer must affirmatively establish that his reliance was reasonable, prudent, and in good faith …. We cannot agree that [the taxpayer’s] reliance was reasonable, prudent, and in good faith …. [He] should have known the [appraiser] grossly overstated the fair market value of the donated property. [He] should have been aware that nothing had occurred to substantially increase the value of the property between the time [he] purchased the property and the time it was donated …. Common sense should have come into play …. It was unreasonable for petitioners to expect that property purchased for $30,174 would increase to a value of $2,750,000 just 2 years later, generating such enormous charitable contribution deductions.

Effect of a qualified appraisal. Donors who contribute property valued at more than $5,000 must obtain a qualified appraisal of the property and attach a qualified appraisal summary (IRS Form 8283) to the tax return on which the charitable contribution is claimed. The taxpayer in this case obtained a qualified appraisal, but this did not affect the Court’s conclusion that he was subject to the penalties described above. The tax code specifies that taxpayers who comply with the qualified appraisal requirements are not subject to this penalty even if there is an overvaluation, but only if the taxpayer “in addition to obtaining such appraisal … made a good faith investigation of the value of the contributed property.” The taxpayer in this case did not satisfy this requirement, so the qualified appraisal did not protect him from penalties.

Relevance to church treasurers. Church treasurers who receive donated property that may be worth more than $5,000 should advise the donor of the qualified appraisal requirement. It would be a good practice to have sample copies of IRS Form 8283 (with instructions) to distribute to these donors. You can obtain them by calling the IRS forms hotline at 1-800-TAX-FORM. Be sure you have current copies. This case suggests that you also may want to advise these donors that they have an obligation under the tax code to make their own “good faith investigation of the value of the contributed property” in order to avoid penalties associated with an inflated valuation.

This article originally appeared in Church Treasurer Alert, November 1995.

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

Tax Implications of Severance Pay

How to determine when an employee’s severance pay is taxable.

Richard R. Hammar, Attorney, CPA

Bio

Background. Many churches have entered into severance pay arrangements with a pastor or other staff member. Such arrangements can occur when a pastor or staff member is dismissed, retires, or voluntarily resigns. Consider the following examples:

Example 1. Rev. G is hired for a 3-year term at an annual salary of $45,000. After 2 years, the church membership votes to dismiss Rev. G. The church agrees to pay Rev. G “severance pay” in the amount of $45,000 (the full amount of the third year’s salary).

Example 2. Rev. C is called by a church for an indefinite term. After 10 years, Rev. C resigns to accept another position. The church board agrees to pay Rev. C “severance pay” of $20,000.

Example 3. Rev. T accepts a call as a pastor of a local church. After 1 year, she is dismissed and is replaced by a male pastor. Rev. T believes that the church was guilty of sex discrimination. The church and Rev. T enter into a severance agreement in which Rev. T agrees to waive any claims she has against the church under state and federal law in exchange for its agreement to pay her “severance pay” of $40,000 (representing one year’s salary).

Example 4. K has served as bookkeeper of her church for 20 years. She is 68 years old. The church board decides that it is time for K to retire so that a younger person can take over her job. When the board learns that K has visited with an attorney, they offer her a severance pay of one year’s full salary ($25,000).

Is severance pay taxable income? Is severance pay paid by a church taxable income to the recipient? In most cases, the answer is yes. The tax code imposes the income tax on “all income from whatever source derived,” unless a specific exclusion applies. The severance pay described in examples 1 and 2 (above) would be taxable under this general rule. There is one “exclusion” that will apply in some cases. Section 104 of the tax code excludes from taxable income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.” What does this language mean? Simply this—severance pay that is intended to settle personal injury claims may be nontaxable. The words “personal injuries” are defined broadly by the IRS and the courts, and include potential or threatened lawsuits based on discrimination and harassment. The severance pay described in examples 3 and 4 (above) may be nontaxable based on this section of the tax code.

Key point. The Tax Court has noted that “payments for terminating and canceling employment contracts are not payments for personal injuries.” Matray v. Commissioner, 56 T.C.M. 1107 (1989).

The IRS and the courts have addressed the section 104 exclusion of severance pay based on personal injuries in several rulings. Here are a few examples.

Case 1. A company asked a female manager to resign because it was not satisfied with her management style. The employee retained an attorney who threatened to sue the company for sex discrimination. The employee’s attorney worked out a severance agreement with the company in which the employee agreed to resign and release the company from all legal claims in exchange for a full year’s salary plus other benefits. The employee assumed that the continuation of her salary for one year represented “damages received … on account of personal injuries” under section 104 of the code and accordingly was not taxable. The Tax Court disagreed, based on the following considerations: (1) the company paid the employee an additional year’s salary “to reward her for her past services and to make her severance as amicable as possible”; (2) the severance agreement “contained no express reference to a sex discrimination claim, stating instead that the payment arose from the company’s dissatisfaction with the employee’s managerial style; (3) the company withheld taxes from the severance payments and issued the employee a W-2 reporting these payments as taxable income; (4) the company continued a number of employee benefits, including health insurance, for an additional year; and (5) the severance agreement was similar to other severance agreements the company executed with other officers who were asked to resign. Based on these considerations the Tax Court concluded that the severance pay that was paid to the former employee did not represent damages payable on account of a sex discrimination or other personal injury claim. Britell v. Commissioner, T.C Memo. 1995-264.

Case 2. An employee was dismissed by a company, and later threatened to sue the company for the emotional distress he had suffered. To avoid a lawsuit, the company entered into a severance agreement with the employee in which the employee released all legal claims against the company in exchange for its promise to pay him a cash settlement. The agreement stated the company “intends to treat all payments made hereunder as wages for purposes of any withholding obligation the company may have in order to avoid any penalties and interest which might otherwise accrue.” The Tax Court ruled that the severance pay was taxable income to the employee and not nontaxable damages payable as a result of personal injuries. The court noted that an employee’s belief that he has “certain claims relating to personal injuries … does not establish that the [severance] payments were made on account of personal injuries.” Further, the court pointed out that the company withheld taxes on the payments, and that such withholding “is a significant factor” in classifying the payments as taxable income. Nagourney v. Commissioner, 57 T.C.M. 954 (1989).

Case 3. A company offered older workers an “early retirement” option. Under this option, older workers signed a severance agreement in which they agreed to resign and to release the company from any age discrimination claims in exchange for a continuation of their salary for one year and continued medical insurance. The IRS ruled that the amounts paid to workers who accepted the early retirement option were not excludable from taxable income as a settlement of a personal injury claim. The IRS based this decision on the following considerations: (1) Section 1.61-2(a)(1) of the income tax regulations specifies that severance pay “is income to the recipient unless excluded by law.” (2) “Provisions that exempt income from taxation are to be construed narrowly.” (3) “The burden of proof is on the taxpayer to show that the requirements imposed by the Code are met in order to be entitled to an exclusion from [taxable income].” (4) The existence of a severance agreement in which an employee waives any discrimination claims that he or she has against an employer does not by itself establish that amounts payable under the agreement represent nontaxable damages to settle a personal injury claim. The IRS pointed out that the employee “never filed a lawsuit or any other type of claim against [the employer] alleging age discrimination. A payment cannot be characterized as damages for personal injuries where there is no indication that personal injuries actually exist.” IRS Letter Ruling 9331007.

Key point. The Tax Court has ruled that “damages are not excludable under section 104 if … the damages were received upon the prosecution of economic rights arising out of a contract.” Guidry v. Commissioner, 67 T.C.M. 2507 (1994).

Tips for church treasurers. Here are some factors, based on the above cases, to assist in deciding whether a severance payment made to a former worker represents taxable compensation or nontaxable damages in settlement of a personal injury claim:

Purpose of the payment. An amount paid to a former employee “to reward her for her past services and to make her severance as amicable as possible” is taxable compensation.
Reference to a discrimination claim. An amount paid to a former employee under a severance agreement that contains no reference to a specific discrimination or other personal injury claim is taxable compensation.
Did the church issue a W-2? If an employer pays a former employee severance pay, and reports the severance pay on a W-2 (or 1099), this is strong evidence that the amount represents taxable compensation.
Continuation of employee benefits. If an employer continues one or more employee benefits (such as health insurance) as part of a severance agreement, this suggests that any amount payable under the agreement represents taxable compensation.
Similar to other agreements. If a severance agreement is similar to other severance agreements an employer entered into with other employees, this suggests that amounts payable under the agreements represent taxable income.
Were taxes withheld? If an employer withholds taxes from amounts paid under a severance agreement, this “is a significant factor” in classifying the payments as taxable income. Of course, this factor will not be relevant in the case of ministers whose wages are not subject to withholding (unless they elect voluntary withholding).
What is the payment called? Referring to a payment as “severance pay” indicates that it is taxable compensation rather than nontaxable damages in settlement of a personal injury claim. Remember, section 1.61-2(a)(1) of the income tax regulations specifies that severance pay “is income to the recipient unless excluded by law.”
Exclusions are narrowly interpreted. The Supreme Court has ruled that “provisions that exempt income from taxation are to be narrowly construed.” United States v. Centennial Savings Bank, 111 S. Ct/ 1510 (1001). Any reasonable doubts about the correct classification of a particular payment should be resolved in favor of taxation rather than exclusion. Also remember this—the “burden of proof” is on the one claiming an exclusion.
Was severance pay based on salary? Severance pay based on a former employee’s salary (such as one year’s salary) are more likely to be viewed as taxable compensation rather than nontaxable damages in settlement of a personal injury claim. As the IRS has noted, “where payments made by an employer to its employees are excludable from the employee’s taxable income as damages for personal injury under section 104 of the Code, those payments are not remuneration for services performed by an employee for an employer, and therefore are not considered wages for purposes of the Code.” IRS Letter Ruling 9331007.
An actual personal injury claim must exist. To be nontaxable, severance pay must represent “damages” received in settlement of a personal injury claim. The income tax regulations defines the term “damages received” as “an amount received (other than workmen’s compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1(c). The IRS has noted that this language requires more than a settlement agreement in which a former employee “waives” any discrimination or other personal injury claims he or she may have against an employer. If the employee “never filed a lawsuit or any other type of claim against [the employer] … the payment cannot be characterized as damages for personal injuries” since “there is no indication that personal injuries actually exist.” IRS Letter Ruling 9331007.

Caution. Church treasurers must determine whether severance pay is taxable so that it can be properly reported (on a W-2 and the church’s 941 forms). Also, taxes must be withheld from severance pay that is paid to nonminister employees (and ministers who have elected voluntary withholding). Failure to properly report severance pay can result in substantial penalties for both a church and the recipient.

What about a housing allowance? A related question is whether a church can designate any portion of severance pay as a housing allowance. This question has never been addressed by either the IRS or any court. However, an argument can be made that a church can designate a portion of severance pay as a housing allowance if the severance pay is treated as taxable compensation rather than as damages in settlement of a personal injury claim. If the severance pay represents taxable income, as the IRS will almost certainly insist in most cases, it is because the amount paid represents compensation based on services rendered. Since a housing allowance must be designated out of compensation paid to a minister for services rendered in the exercise of ministry, a reasonable case can be made that a housing allowance can be designated with respect to taxable severance pay.

Of course, a housing allowance can only be designated for ministers. And, the designation of a housing allowance will be of little value if the minister transfers immediately to another church that designates a timely housing allowance. But a designation of a housing allowance will be useful in the case of a minister who is not immediately employed by another church or religious organization. Note that there is no guaranty that this position will be accepted by either the IRS or the courts. All that can be said is that in many cases this position will have a reasonable basis and therefore no penalties will be assessed in the event the position is not allowed in an audit.

Also, note this—housing allowances are not reduced by the portion of a minister’s compensation that represents vacation pay, even though the minister ordinarily is not performing services in the exercise of ministry during vacation. The same principle supports the availability of a housing allowance designated out of a minister’s severance pay.

Key point. The Older Workers Benefit Protection Act of 1991, which applies to any employer with 20 or more employees that is engaged in interstate commerce, prohibits employees at least 40 years of age from “waiving” their rights under federal age discrimination law unless the waiver meets several specific requirements, including the following: (1) the waiver is in simple language; (2) the waiver specifically refers to rights arising under the federal Age Discrimination in Employment Act; (3) the employee does not waive rights or claims that may arise after the date the waiver is executed; (4) the employee must receive some benefit for signing the waiver in addition to salary; (5) the individual is advised in writing to consult with an attorney prior to executing the agreement; (6) the individual is given a period of at least 21 days within which to consider the agreement; and (7) the agreement provides that for a period of at least 7 days following the execution of such agreement, the individual may revoke the agreement. This law will not apply to most local churches, since they have fewer than 20 employees. Even churches with 20 or more employees are not subject to these requirements unless they are engaged in interstate commerce.

This article originally appeared in Church Treasurer Alert, October 1995.

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

IRS Issues New Charitable Contribution Regulations

Regulations clarify questions about contribution substantiation requirements.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

IRS Issues New Charitable Contribution Regulations

Regulations clarify questions about contribution substantiation requirements.

Richard R. Hammar

The IRS issued regulations in August that clarify a few questions that have arisen in applying the new charitable contribution substantiation rules. Perhaps the most relevant provision for church treasurers is the substantiation of “out-of-pocket” expenses incurred by a person who performs volunteer services on behalf of a charity.

To illustrate, let’s say that Greg, a member of First Church, participates in a short-term missions project and in the process incurs $300 of unreimbursed out-of-pocket travel expenses. The IRS has long acknowledged that such expenses are deductible as a charitable contribution. But what about the new rules for substantiating charitable contributions of $250 or more? Do they apply to this kind of contribution? Is the church responsible for keeping track of Greg’s travel expenses in order to determine if they are $250 or more?

The proposed regulations address this common problem. The IRS acknowledged that a charity “typically has no knowledge of the amount of out-of-pocket expenditures incurred by a taxpayer, and therefore, would have difficulty providing taxpayers with substantiation of unreimbursed expenditures.” To address this concern, the proposed regulations provide that where a taxpayer incurs unreimbursed expenses in the course of performing services for a charitable organization, the expenses may be substantiated by the donor’s normal records and an “abbreviated written acknowledgment” provided by the charitable organization.

This abbreviated written acknowledgment from the charity must contain the following information:

a description of the services provided by the donor
the date the services were provided
whether or not the charity provided any goods or services in return, and
if the charity provided any goods or services, a description and good faith estimate of the fair market value of those goods or services

Here is an example of an abbreviated written acknowledgement that complies with the new regulations: “Greg Jones participated on a missions trip sponsored by First Church from July 1-10, 1995, in the nation of Panama. His services included working in a medical clinic. The church provided no goods or services in return for these services.” The church should be sure that Greg receives this receipt before the earlier of (1) the date he files a tax return claiming the contribution deduction, or (2) the due date (including extensions) for the tax return for that year.

This article originally appeared in Church Treasurer Alert, October 1995.

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

IRS Issues Audit Guidelines for Ministers

What church treasurers and ministers should know.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

IRS Issues Audit Guidelines for Ministers

What church treasurers and ministers should know.

Richard R. Hammar

On July 28, 1995, the IRS issued its audit guidelines for ministers under its “market segment specialization program” (MSSP). These guidelines will be used by IRS agents who audit ministers. Most of the information contained in the audit guidelines is a restatement of existing law. Here are some of the key provisions that will be interest to church treasurers:

Ministers “are generally considered employees” for income tax reporting purposes (although they are self-employed for social security with respect to their ministerial income).
The guidelines do not provide specific guidance in answering the sometimes troublesome question of who is a “minister” for federal tax purposes. Rather, they summarize some of the leading court decisions that have addressed this issue. Significantly, these cases include the Tax Court’s decision in Knight v. Commissioner, a case that has perhaps the most liberal definition of the term “minister.” See chapter 2 of Richard Hammar’s Church and Clergy Tax Guide for a full discussion of the Knight case.
“Special gifts” received by ministers from their employing church are includable in gross income for tax purposes.
“If the church or church agency pays amounts in addition to salary to cover the minister’s self-employment tax or income tax, these are also includable in gross income.”
“An accountable plan is an arrangement that meets all the [following] requirements: business connection, substantiation within a reasonable period of time, and return of amounts in excess of substantiated expenses within a reasonable period of time …. If an arrangement meets all the requirements for an accountable plan, the amounts paid under the arrangement are excluded from the minister’s gross income and are not required to be reported on his or her Form W 2. If, however, the arrangement does not meet one or more of the requirements, all payments under the arrangement are included in the minister’s gross income and are reported as wages on the Form W 2, even though no withholding at the source is required.”
If the church has a salary reduction arrangement which “reimburses” the minister for employee business expenses by reducing his or her salary, the arrangement will be treated as a nonaccountable plan because it does not meet the reimbursement requirement …. This is the result regardless of whether a specific portion of the minister’s compensation is designated for employee expenses or whether the portion of the compensation to be treated as the expense allowance varies from pay period to pay period depending on the minister’s expenses. As long as the minister is entitled to receive the full amount of annual compensation, regardless of whether or not any employee business expenses are incurred during the taxable year, the arrangement does not meet the reimbursement requirement.”
Ministers often pay a small annual renewal fee to maintain their credentials, which constitutes a deductible expense. However, ministers’ contributions to the church are not deductible as business expenses. They may argue that they are expected to donate generously to the church as part of their employment. This is not sufficient to convert charitable contributions to business expenses.”

Key point. The audit guidelines rely heavily on Richard Hammar’s annual Church and Clergy Tax Guide.

This article originally appeared in Church Treasurer Alert, September 1995.

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

Forgiving Our Debtors May Jeopardize Tax-Exempt Status

What a church should know before forgiving its debtors.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

“Forgiving Our Debtors” May Jeopardize Tax-Exempt Status

What a church should know before forgiving its debtors.

Richard R. Hammar

Background. Churches and other organizations that are exempt from federal income taxes must comply with several requirements in order to maintain their exempt status. One of these requirements is that none of the exempt organization’s resources “inures” to the benefit of a private individual—other than as reasonable compensation for services rendered or in direct furtherance of the organization’s exempt functions. Does an exempt organization’s forgiveness of a bad debt constitute prohibited “inurement”? That was the issue presented to a federal court in a recent case. While the case involved a non-religious charity, it has implications for churches and other religious organizations.

Facts. The founder of a tax-exempt charity also created a for-profit corporation. The for-profit corporation leased property from the charity, but did not pay rent in a timely manner and eventually accumulated hundreds of thousands of dollars in rental debt. The charity also “forgave” nearly $34,000 in interest owed by the for-profit corporation. The charity claimed that the interest was “forgiven” “because of the unlikelihood of repayment.” The IRS audited the charity and revoked its tax-exempt status. It concluded that the charity’s forgiveness of interest and failure to collect back rent from the for-profit corporation controlled by the charity’s founder amounted to prohibited “inurement” of the charity’s resources to the benefit of the founder. The charity appealed this ruling.

The court’s ruling. A federal court agreed with the IRS and upheld the revocation of the charity’s tax-exempt status. It noted a charity can lose its exempt status if it does not “operate exclusively” for exempt purposes, and if any part of its resources “inures” to the benefit of a private individual. The court observed:

First, the organization must “operate exclusively” for tax-exempt purposes. An organization’s tax-exempt status will not be revoked for providing “incidental” benefits while serving an exempt purpose. But a single substantial non-exempt purpose served by the organization does nullify the organization’s tax exemption regardless of the quantity or substance of its tax-exempt purposes. An organization does not operate exclusively for tax-exempt purposes if it serves a private rather than a public interest. This requirement applies to the organization’s actual, not purported, purposes.

Second, “no part of the net earnings” of the organization may “inure to the benefit of any private shareholder or individual.” “Private shareholder or individual” has been construed broadly by the courts as any person “having a personal or private interest in the activities of the organization,” including the organization’s founder and family.

These two requirements, “though separate, frequently overlap.” Failure to satisfy either requirement results in revocation of the organization’s tax-exempt status. The burden is on the organization to establish that it meets the statutory requirements for tax-exempt status.

The court concluded that the charity’s “forgiveness of the accrued interest is an example of how [its] earnings inured to private benefit,” namely to the benefit of a for-profit corporation owned by the charity’s founder.

Relevance to church treasurers. This ruling is directly relevant to any church treasurer whose church is considering the forgiveness of a debt owed to the church by anyone with a “a personal or private interest in the activities of the organization.” At a minimum this would include debts owed to the church by pastors or board members, and probably by church members as well. Often, these debts are in the form of a loan.

Key point. Churches often make loans to clergy in order to assist in the purchase of a home. In some cases the minister fails to pay the loan in full. Church treasurers and board members often do not know how to respond in such cases. This case illustrates an important point—delinquent loans should not be forgiven without careful consideration of the possible consequences to the church. In order to minimize jeopardizing the church’s exempt status, a church should not forgive a delinquent loan without, at a minimum, taking the following steps: (1) exhaust all reasonable means of collection, and (2) report the bad debt (principal and accrued interest) as income to the debtor. If the debtor is a current employee, the forgiven debt can be reported as income on the employee’s W-2. If the debtor is not an employee, use a Form 1099-MISC.

This article originally appeared in Church Treasurer Alert, August 1995.

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

The New Social Security Reporting Procedures

What church treasurers should know.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

The New Social Security Reporting Procedures

What church treasurers should know.

Richard R. Hammar

Background. For many years the Social Security Administration has sent a “personal earnings and benefit estimate statement” (PEBES) to any person who requested one. This statement displays the person’s earnings based on either self-employment income or information provided by employers on W-2 forms. The statement also provides an estimate of benefits that the person may be eligible for both now and in the future.

Unfortunately, few workers ever request this information and this has led to many undetected problems. Here are some common examples:

A nonminister church employee’s social security benefits are reduced because the church failed to report one or more taxable fringe benefits on the employee’s W-2 forms. To illustrate, a church fails to report the value of the personal use of a church-provided car as income on an employee’s W-2. By understating the employee’s wages subject to social security (FICA) taxes, the church is reducing the employee’s social security benefits which are based on those earnings.
A nonminister church employee’s social security benefits are reduced because the church underreported the wages paid to the employee on the W-2 forms it issued. To illustrate, a church pays an employee $20,000 in 1995, but it inadvertently reports $18,000 as wages on the employee’s W-2. This clerical error will cause a reduction in the earnings reported to the Social Security Administration and this in turn may cause a reduction in the employee’s social security benefits.
A church incorrectly reports an employee’s social security number on a W-2 form. This will prevent wages from being credited to the employee’s record. Uncredited earnings can affect the employee’s future benefits.
A church incorrectly reports an employee’s name on a W-2 form. To illustrate, a female employee is married and the church begins reporting her wage information (on Form W-2) under her new name. If the employee has not reported her name change to the Social Security Administration, then this can prevent wages from being credited to the employee’s record. Uncredited earnings can affect the employee’s future benefits.

Tip. Church employees should be encouraged to immediately report to the Social Security Administration any change in their name. This will ensure that all wages are properly credited to the employee’s record. Reporting a name change is easy. The employee simply submits a Form SS-5 (application for social security card) to the Social Security Administration. Church treasurers may want to keep some of these forms on hand, and give them to employees who have a name change. You can order a supply by calling 1-800-772-1213.

Observation. Many employees incorrectly assume that notifying their employer of a name change is all they need to do. Notifying an employer does not change the records of the Social Security Administration, and mismatches will occur until the government is notified.

A minister fails to include the fair rental value of a parsonage as earnings subject to the self-employment tax. Remember that all ministers are self-employed for social security purposes with respect to their ministerial income. As a result they pay the self-employment tax (the social security tax for self-employed workers) rather than FICA taxes (the social security tax for employers and employees).
A minister fails to include a housing allowance as earnings subject to the self-employment tax.

Unfortunately, these kinds of errors are common, and they can disqualify workers from social security coverage or cause a needless reduction in benefits. Often, retired workers are not even aware that their benefits have been reduced because of one or more of these errors. Obviously, the solution to these problems is easy. The government should recognize that few workers ever take the time to obtain and review a PEBES statement from the Social Security Administration. The Social Security Administration should simply begin sending these statements automatically to all workers and encourage them to review the information for accuracy. This is exactly what Congress has required the Social Security Administration to do! Church treasurers need to be aware of the new rules, and be prepared for the questions they may soon receive.

The new reporting procedures. Here are the new reporting procedures in a nutshell:

February 1995. Between February and September of 1995 the Social Security Administration will mail a PEBES statement to nearly 9 million people age 60 or older who (1) have earnings credited to their social security number, and (2) are not currently receiving social security benefits.
October 1995. Beginning in October of 1995 and each year thereafter the Social Security Administration will send a PEBES statement to persons who reach age 60 during the year.
January 2000. By January of the year 2000, some 123 million eligible workers age 25 and older will receive PEBES statements each year.

Each PEBES statement provides a year-by-year display of a worker’s earnings as either a self-employed person or an employee, provides the worker with an estimate of future benefits, and asks the worker to carefully inspect the statement for errors. While many workers will contact the Social Security Administration directly if they have questions, many will be contacting their employers directly.

How church treasurers should respond. What steps can church treasurers take in response to the new reporting procedures? Consider the following:

Step 1: education. Church treasurers should inform any worker who will reach 60 years of age during 1995 that he or she will be receiving a PEBES statement from the Social Security Administration. The same will be true in the years 1996 through 1999 for workers who reach age 60 in those years. Beginning in the year 2000, any worker who is 25 years of age or older will receive a PEBES statement. One way to inform workers is to provide them with an appropriate letter. Here is a sample letter prepared by the Social Security Administration:

[Employer’s name] matches your Social Security and Medicare taxes dollar-for-dollar. This investment serves as a base for your retirement planning when you combine it with savings, in individual retirement account, or investments. To help you plan for your financial future, the Social Security Administration (SSA) can provide you with a Personal Earnings and Benefit Estimate Statement (PEBES) showing the earnings recorded under your Social Security number (SSN). The statement also provides an estimate of the Social Security benefits you and your family may qualify for now and in the future.

If you are age 60 or older and are not already receiving Social Security benefits, SSA will automatically send you a PEBES sometime between February 1995 and September 1995. Beginning in October 1995, and each year thereafter, eligible people who turn 60 in that year will also automatically receive a PEBES. By the year 2000, 123 million eligible individuals age 25 and older will receive an earnings statement each year.

Once you receive a statement, please carefully check the earnings to make sure they match your records. You don’t need to do anything unless you believe the earnings information is incorrect. If the error involves recent earnings at your current job, report the discrepancy to Social Security’s toll-free number, 1-800-772-1213. When you call, be sure to have your records of the correct earnings handy—such as W-2s, pay stubs, and tax returns. You should also call the toll-free number to report an SSA from properly crediting your earnings record which could affect future Social Security benefits payable to you and your family.

Step 2: corrections. Church workers who receive the PEBES statements may have questions for their church treasurers. In some cases errors will be detected. If it is clear that an error has occurred, church treasurers should do the following:

incorrect earnings. If the church issued a W-2 form for a prior year that failed to report the correct amount of wages subject to social security taxes, then the church should file a Form W-2c (a corrected W-2) with the Social Security Administration. The Form W-2c reports the correct amounts of wages and social security taxes.
missing earnings. If an employee was not issued a W-2 in a prior year, then a Form W-2 (original Copy A) should be filed for the missing year.
Key point. A church that files a W-2c form to correct a W-2 form that underreported an employee’s earnings for a prior year may be responsible for paying back taxes plus interest.
- miscellaneous. Here are some helpful hints when preparing correcting W-2 or W-2c forms: (1) Send W-2 and W-2c forms (with an accompanying W-3 or W-3c form) to the Social Security Administration, Data Operations Center, Wilkes-Barre, Pennsylvania 18769. (2) Never use a W-2 form to correct a previously submitted W-2 form. Use a Form W-2c instead—with a separate form for each year needing correction. (3) If the only correction needed is to an employee’s name or social security number, file only Form W-2c (not a W-3c) and have the employee contact the Social Security Administration to obtain an SS-5 form to change his or her name on the government’s records. However, if you need to correct the money amounts on a previous Form W-2 then a Form W-3c must be filed along with a Form W-2c. (4) If incorrect information reported on prior W-2 forms was also incorrectly reported on the church’s 941 forms submitted to the IRS, then you may have to correct the corresponding 941 forms by filing a Form 941c with the IRS. (5) Be sure the church’s employer identification number reported on your W-2c and W-3c forms (and 941c if applicable) is correct, and that you reported the same number on all of these forms.
Step 3: precautions. There are a number of steps that church treasurers can take to reduce the chance of reporting incorrect information on an employee’s W-2 forms. Consider the following:
review social security cards. Review the social security cards of new workers and be sure that church payroll records correctly report each worker’s name and social security number.
reconcile W-2 and 941 forms. Add up the total wages reported on your quarterly 941 forms for the year and compare this amount to the wages reported on all of the W-2 forms issued by the church.
the correct treatment of clergy. Remember that clergy are self-employed for social security purposes with respect to their ministerial income. As a result, they pay self-employment taxes rather than FICA taxes—even though they may report their income taxes as employees. This rule has important applications that some church treasurers miss. For example, it means that no amount should be reported in boxes 3 (social security wages), 4 (social security tax withheld), 5 (Medicare wages and tips), and 6 (Medicare tax withheld) on a minister’s Form W-2. A similar rule applies to nonminister employees who are employed by churches that have exempted themselves from the employer’s share of FICA taxes by filing a timely Form 8274 with the IRS. Such employees, like clergy, are treated as self-employed with regard to their church compensation.
name changes. Encourage workers who change their names to promptly notify the Social Security Administration. Provide them with an SS-5 form to simplify the process.
annual check of payroll records. Each year have employees check the accuracy of their names and social security numbers on the church’s payroll records.
Key point. For more information on a church’s reporting requirements, see chapter 10 in Richard Hammar’s annual Church and Clergy Tax Guide.
This article originally appeared in Church Treasurer Alert, August 1995.

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

IRS Will Issue Regulations Explaining New Contribution Rules

Goal is to help reduce widespread noncompliance.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

IRS Will Issue Regulations Explaining New Contribution Rules

Goal is to help reduce widespread noncompliance.

Richard R. Hammar

The IRS is working on comprehensive regulations that will provide churches and other nonprofit organizations with guidance on complying with the charitable contribution substantiation rules that took effect in 1994. The regulations are being released in response to widespread noncompliance with the new rules. The IRS believes that most charities want to comply, but simply do not understand the new rules. When will the regulations be released? By the end of the year, says an IRS spokeswoman.

Key point. Among other issues, the regulations will address a common church question—how to treat a volunteer’s travel expenses incurred on a short-term missions trip on behalf of a local church. Such expenses often are deductible as a charitable contribution. But what if a volunteer’s expenses are $250 or more? Do the new substantiation rules apply, and if so, how? Many times the volunteer pays the expenses directly, and the church does not know how much they are and so cannot report them on the volunteer’s contribution receipt. Your author asked the IRS to address this issue in the regulations, and the IRS has confirmed that it will. We will give you the details as soon as the regulations are issued, probably by the end of the year.

Key point. Another issue the regulations will address—how does a charity value the goods or services that it provides in exchange for a donation? A common example—church bazaars and auctions. An IRS spokesman says the new regulations will suggest a number of ways a charity can value such goods or services.

This article originally appeared in Church Treasurer Alert, July 1995.

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

Checking Workers’ Withholding

Employees may be able to pay less tax throughout the year if forms are corrected.

Richard R. Hammar, Attorney, CPA

Bio

The average tax refund last year was $1,066. A person receiving this amount could have received an extra $20.50 each week throughout the year instead. How? By reducing withheld taxes to more closely match their actual tax.

Tip. Church employees who receive large tax refunds should be encouraged to provide the church treasurer with a new Form W-4 (withholding allowance certificate). Often, large refunds are caused by the use of old W-4 forms that fail to take into account new information (such as additional dependents). You can order new W-4 forms, along with IRS Publication 919 (“Is My Withholding Correct?”) by calling the IRS toll-free number, 1-800-829-3676.

Tip. Many church members end up receiving large tax refunds because the information reported on their W-4 form is no longer accurate. Church treasurers may want to print the following brief notice in the church bulletin or newsletter: “Did you receive a tax refund this year? If so, this may indicate that the information on the W-4 form you submitted to your employer is either inaccurate or obsolete. You may want to provide your employer with an updated W-4. This can result in less taxes being withheld from your pay throughout the year.”

This article originally appeared in Church Treasurer Alert, June 1995.

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

Keeping Church Records (Part 2)

When to keep and when to toss your church’s records.

Richard R. Hammar, Attorney, CPA

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Church Finance Today

Keeping Church Records (Part 2)

When to keep and when to toss your church’s records.

Richard R. Hammar

The February 1994 issue of Church Treasurer Alert! contained the first in a series of articles on recordkeeping requirements for church records. That article addressed corporate and tax records. This article addresses personnel records. Future articles will address recordkeeping recommendations for several other categories of church records including insurance, correspondence, contracts, property, financial, vehicles, members, investments, and legal.

The problem. Most churches have no policy addressing the retention and disposal of church records. As a result, churches often go through the following phases:

Phase 1—Don’t throw out anything. Church records are kept indefinitely out of a fear that they may be needed in the future.

Phase 2—Frustration. Phase 1 creates frustration as the volume of records and “clutter” expands out of control.

Phase 3—Get rid of the clutter. Church workers go on “search and destroy” missions, aggressively discarding records to “get control” of the situation.

Phase 4—Anxiety. Church leaders wonder, “What did we throw out that we shouldn’t have?” This results in a return to phase 1, and the cycle begins again.

The solution. What is needed is a records retention policy based on applicable legal considerations and your church’s needs that will make records retention and disposal decisions systematic and rational. The “guesswork” and arbitrary nature of record retention decisions must be replaced with a sound and consistent policy. The table reproduced in this newsletter will assist you in developing such a policy with regard to personnel. A similar table in the February 1994 issue of this newsletter addressed the retention and disposal of corporate and tax records.

Key point. It is possible to keep some records too long—well beyond what is required by law. In some cases this can result in the retention of records that might be harmful in future litigation. On the other hand, disposing of records too soon can lead to unanticipated problems—both with various state and federal government agencies and in future lawsuits.

Tip: You can use the chart as a quick glossary of commonly used terms.

Tip: In establishing a records retention policy you should consider a number of factors in addition to how long to keep records. These include: (1) when to make copies of records, (2) maintaining the security of records (especially records you plan to keep permanently), including backups of computer records, and (3) developing a record retention schedule (a document that summarizes records, lists how long you plan to keep them, and indicates where they are kept).

Here are some additional factors to consider in developing a records retention policy for your church:

Make an inventory of existing records.
The church board should develop and approve your records retention policy.
Your records retention policy should be reviewed by a local attorney (who can check local and state requirements), a CPA, and your insurance agent.
There are many reasons to keep church records. These include legal requirements, potential relevance in future litigation, the needs of the organization, and historical importance. The table reproduced in this article suggests minimum periods of time for retaining various church records. Some of the suggested retention periods are based on legal requirements, while others are based on practical considerations. You may want to keep some records longer than the table suggests.
Some organizations maintain a “destruction of records journal”. When the period of time for keeping a record has expired, the record is described in the journal before being destroyed.
Do not destroy records, even when the period for keeping them has expired, if they may be relevant in pending or threatened litigation or in pending or threatened government (including IRS) investigations.

Personnel records. Every church keeps personnel records. In small churches that employ only the pastor, these records may include an application for employment, reference checks, a job description, and annual W-2 or 1099 forms. In larger churches that employ one or more nonminister employees, the list of personnel records can be long (including many of the forms listed in the table). The table lists most of the kinds of personnel forms that a church will use, along with a description of each form and a minimum time to keep each record.

Key point. Some of the recordkeeping requirements summarized in the table are based on federal laws that apply only to employers that are engaged in “interstate commerce.” Most local churches are not engaged in interstate commerce, unless they have substantial commercial transactions across state lines. For example, a church that sells tapes of its weekly services to individuals in other states may be engaged in interstate commerce. If in doubt, church leaders should assume that their church is engaged in interstate commerce.

Key point. The rules listed in the table are based on federal law requirements. Most states have their own requirements which may apply to churches. A local attorney should be consulted to determine the application of state law.

Key point. The rules summarized in the table are designed for the typical local church. Additional requirements may apply to large churches, denominational agencies, and parachurch ministries. To illustrate, the federal Family and Medical Leave Act imposes additional recordkeeping requirements on employers engaged in interstate commerce and employing 50 or more employees. The Civil Rights Act of 1964 imposes additional recordkeeping requirements on employers engaged in interstate commerce and employing 100 or more employees.

Key point. The recordkeeping rules for corporate and tax records were addressed in a table appearing in the February 1994 edition of Church Treasurer Alert! This table included some personnel records, including W-2 forms, W-4 forms, 1099 forms, receipts substantiating business expense reimbursements, and housing allowance designations.

CHURCH RECORDS—HOW LONG TO KEEP THEM

PERSONNEL RECORDS

Note. The recordkeeping periods are minimums. Do not destroy any record that may be relevant in pending or threatened litigation or a government investigation, that has historical value, or that otherwise may be useful or relevant.

document	description	how long to keep (choose the relevant rule or rules)
applications for employment (hired)	churches often have prospective employees complete an application for employment that asks question about an applicant’s background, education, and prior work experience	RULE 1. Employers subject to Title VII of the Civil Rights Act of 1964 (15 or more employees, and engaged in interstate commerce) must retain “any personnel or employment record” for at least 1 year after the record was made, or until the disposition of a discrimination charge. 29 CFR 1602.14. RULE 2. Employers subject to the Americans with Disabilities Act (15 or more employees, and engaged in interstate commerce) must retain such records for at least 1 year after the record was made, or until the disposition of a discrimination charge. RULE 3. Employers subject to the Age Discrimination in Employment Act (20 or more employees, and engaged in interstate commerce) must retain such records for at least 1 year from the date of the personnel action to which the document relates. 29 CFR 1627.3. RULE 4. If an employment application includes screening questions to determine an applicant’s fitness and suitability, or a statement authorizing the employer to obtain references (and releasing the references from liability) the application form should be retained permanently. If the employee later assaults or molests an adult or minor, this evidence will be helpful in proving that the church was not negligent in hiring the person.
applications for employment (not hired)	churches often have prospective employees complete an application for employment that asks question about an applicant’s background, education, and prior work experience	RULE 1 (above).
screening forms	used to determine the suitability of an individual to work with children (whether a paid employee or volunteer); includes background information on the individual’s criminal convictions, prior church membership, and prior involvement with youth activities	RULE 5. Permanently. If the employee or volunteer later assaults or molests a minor, this evidence will be helpful in proving that the church was not negligent in hiring the person. Because of liberalized statutes of limitation in many states, lawsuits can be filed long after an alleged offender leaves the church.
reference forms—general	forms or letters completed by current or former churches, employers, schools, friends, or relatives, addressing the suitability of an applicant for employment	RULE 6. Permanently—if the employee counsels adults (or works with minors—see below). If the employee or volunteer later assaults or molests a counselee, this evidence will be helpful in proving that the church was not negligent in hiring the person. Because of liberalized statutes of limitation in many states, lawsuits can be filed long after an alleged offender leaves the church.
reference forms—for youth workers	forms or letters completed by current or former churches, employers, and youth organizations addressing the suitability of an applicant for youth work (paid or volunteer)	RULE 7. Permanently. If the employee or volunteer later assaults or molests a minor, this evidence will be helpful in proving that the church was not negligent in hiring the person. Because of liberalized statutes of limitation in many states, lawsuits can be filed long after an alleged offender leaves the church.
job descriptions	a summary of the duties the employer expects an employee to perform	RULE 1 (above). RULE 8. Retain for the duration of the employee’s employment. If the employee is dismissed (or resigns) under circumstances making a lawsuit against the employer reasonably foreseeable, then retain for the applicable statute of limitations period (for the foreseeable theory of liability, including breach of contract, discrimination, or personal injury) following the date of dismissal or resignation.
employee manuals or handbooks	documents prepared by some employers setting forth the terms and conditions of employment, a summary of fringe benefits, and the grounds and procedures for discipline or dismissal	RULE 9. Permanently. Be sure to retain copies of all editions or versions, and be able to demonstrate which manual or handbook applied to any given period of time.
employee statement	a statement, signed by an employee, acknowledging that he or she understands the terms and conditions of employment (including grounds for discipline or dismissal) and agrees to them	RULE 8 (above).
payroll records	the following records for each employee: name, address, date of birth (if under 19), gender, occupation, rate of pay, hours worked each workday and week, compensation earned each week	RULE 10. Employers subject to the Fair Labor Standards Act (any church-operated school or preschool, or a church engaged in interstate commerce regardless of the number of employees) must keep such records for 3 years “from the last date of entry.” 29 CFR 516.5. RULE 11. Employers subject to the Age Discrimination in Employment Act (20 or more employees, and engaged in interstate commerce) must retain such records for at least 3 years after the record was made. 29 CFR 1627.3. RULE 12. Employers subject to FICA (social security) taxes must retain these records for 4 years after the due date of the tax for the return period to which the records relate, or the date such tax is paid, whichever is later.
contracts of employment	an agreement setting forth the terms and conditions of employment between a church and an employee	RULE 10 (above).
performance evaluations	periodic (i.e., annual) evaluations of several criteria of employee performance, including efficiency, ability, initiative, and attitude	RULE 1 (above). RULE 8 (above).
dismissal records	documents explaining the basis for an employee’s dismissal	RULE 1 (above). RULE 8 (above).
testing records	tests administered to employees or prospective employees to measure intelligence or various job skills	RULE 1 (above). RULE 3 (above).
reports of work-related injuries and illnesses	reports noting the dates and circumstances of work-related injuries or illnesses of any employee, and completed within 6 working days of the injury or illness (OSHA Form No. 200 can be used)	RULE 13. Employers subject to the Occupational Safety and Health Act (any employer with 1 or more employees, that is engaged in interstate commerce) must keep such records for “5 years following the end of the year to which they relate.” 29 CFR 1904.6.
fringe benefit plans	employer-sponsored plans addressing the terms and conditions of “specified fringe benefit plans” described in section 6039D of the Internal Revenue Code, including employer paid group life insurance premiums, accident and health plans, employer paid medical insurance premiums, employer-provided group legal services, cafeteria plans, employer-provided educational assistance, and employer-provided dependent care	RULE 14. Employers maintaining a “specified fringe benefit plan” for any year must keep such records as may be necessary to establish that the requirements for maintaining such a plan have been met—for 7 years following the end of the year the documents were created.
Form I-9	immigration form completed by employers and new hires, demonstrating an employee’s identity and eligibility to work	Rule 15. All employers regardless of size must retain such records for 3 years after the date of hire or 1 year after an employee’s termination, whichever is later.

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

Donor Restrictions on Gifts of Property

IRS clarifies eligibility of restricted gifts for tax deductions.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

Donor Restrictions on Gifts of Property

IRS clarifies eligibility of restricted gifts for tax deductions.

Richard R. Hammar

IRS Letter Ruling 9443004

Background. Many churches are given some or all of the land upon which they build their facilities. In some cases, donors impose restrictions on such gifts. For example, some donors specify that the contributed property “reverts” to them (or their heirs) in the event the property ever ceases to be used for church purposes. There are two important issues here:

Can churches that own property subject to such a reverter clause inadvertently lose their property if they later sell it? Unfortunately, the answer to this question can be yes.

Key point. This is one reason why it is important to be familiar with the wording of your church deed. Does it contain a reverter clause? If so, what triggers it?

Can a donor who gives property to a charity with this kind of “reverter clause” claim a charitable contribution deduction? This second issue was addressed recently by the IRS in a private ruling.

Facts of the case. A deceased person left a will giving $50,000 to a school to establish a scholarship fund for needy students attending the school (to be selected by the school). The will specified that in the event the school “ceases to exist as a school or ceases to be accredited by the state” the balance in the fund would revert to the deceased’s heirs. The question was whether the deceased’s estate could claim a charitable contribution deduction for the scholarship gift despite the possibility that the fund could one day revert to the donor’s heirs.

What the IRS said. The IRS ruled that the estate was entitled to a charitable contribution deduction—because the likelihood that the school would “cease to exist” was so remote as to be negligible. The IRS noted that “[the tax regulations specify] that if an interest passes to charity at the time of a decedent’s death and the interest would be defeated by … some act or the happening of some event, the possibility of occurrence of which appears at the time of the decedent’s death to be so remote as to be negligible, the deduction is allowable.”

The IRS also noted that the tax regulations contain an example in which a decedent dies leaving a will which donates land to a city government “for as long as the land is used by the city for a public park.” The example concludes that “a deduction is allowable if, on the date of the decedent’s death, the possibility that the city will not use the land for a public park is so remote as to be negligible.”

Recommendation. Check the deed or deeds to your church property to determine if any conditions exist. If they do, it is possible in some cases to have them “released” by the previous owner (if he or she is willing to do so). Often this is done by having the previous owner execute a quitclaim deed. If the previous owner is no longer living (a fairly common circumstance) then the condition can be released only by all of the legal heirs of the deceased owner. This can be a very cumbersome process.

This article originally appeared in Church Treasurer Alert, April 1995.

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

Must Churches Pay the Minimum Wage to Child Care Workers?

A federal court issues an important clarification.

Richard R. Hammar, Attorney, CPA

Bio

Reich v. Miss Paula’s Day Care Center, Inc., 37 F.3d 1191 (6th Cir. 1994)

Background. Many churches operate child care centers during the week, and nearly every church has some form of child care during worship services. Must churches pay the minimum wage to persons who work in either capacity? A related question is whether or not churches must pay “overtime” compensation (“time and a half”) to employees who work more than 40 hours per week. If churches must pay the minimum wage and overtime pay, are there any exceptions? What about volunteer workers and self-employed individuals? Is there a difference between preschool and child care? These are questions that church treasurers often ask. A recent federal appeals court ruling directly addresses many of these questions.

Facts of the case. A child care center in Ohio provides custodial care for very young children. It has 12 employees and has grown to care for more than 60 children. Children attending the center range in age from “infants and toddlers” to those between ages three and six. Many of the children’s parents are low-income, working mothers or college students who are hard-pressed to pay for child care. Unlike pure babysitting services, the center provides the children with daily activities designed to produce mental stimulation and enrichment. The center has been able to remain affordable by paying its staff less than the federal minimum wage.

The federal Department of Labor notified the center that it was a “preschool” subject to the federal minimum wage law, and ordered it to pay $18,000 in back wages to employees who had been receiving salaries below the minimum wage.

The federal minimum wage and overtime law (the “Fair Labor Standards Act”) applies to workers employed by “an enterprise engaged in commerce or in the production of goods for commerce.” Federal law defines this term to include a “preschool, elementary or secondary school … (regardless of whether or not such … institution or school is public or private or operated for profit or not for profit).” The child care center argued that it was not a “preschool” but rather was a child care institution, since its program was primarily custodial in nature rather than educational.

The court’s decision. The court ruled that workers at the child care center were covered by the minimum wage law. It referred to a publication of the Department of Labor that defined the term preschool as follows:

A preschool is any enterprise … which provides for the care and protection of infants or preschool children outside their own homes during any portion of a 24-hour day. The term “preschool” includes any establishment or institution which accepts for enrollment children of preschool age for purposes of providing custodial, educational, or developmental services designed to prepare the children for school in the years before they enter the elementary school grades. This includes day care centers, nursery schools, kindergartens, head start programs and any similar facility primarily engaged in the care and protection of preschool children. Publication 1364.

In other words, there is no distinction between a preschool and a child care center. Both are included within the definition of the term “preschool,” even child care centers that provide custodial services and little if any education. The court also noted that the child care center in this case provided far more than custodial services.

The court made the following additional observations:

Other court rulings. It referred to two other federal appeals court decisions addressing the same issue. One court found that child care centers came within the definition of a preschool and were subject to the minimum wage law, while the other court reached the opposite conclusion.

Key point. In fact, a number of other federal courts have addressed this issue, and most have concluded that child care centers are preschools and their workers are entitled to the minimum wage. For more details, see the Special Report entitled “Must Churches Pay the Minimum Wage?” which is available from Church Law & Tax Report.

Professional babysitting services. The court pointed out that even if it agreed that a purely “custodial” child care center is not a “preschool,” this would not relieve the center from the minimum wage requirements since it would then meet the definition of a “professional babysitting service” which is covered by the minimum wage law.
Professional worker exception. The court suggested that the center’s best defense against coverage under the minimum wage law might be to stress its educational mission and then argue that its workers are “professional” employees who are exempted from the minimum wage requirements. The court observed that “we have not been asked to decide whether the quality of preschool learning experiences that [the center’s] staff members provide rises to a level that could bring those employees under the [law’s] exemption for those who work in a professional capacity. We therefore leave that question for another day.”

Key point. Department of Labor Publication 1364 states: “Employees employed in a bona fide executive, administrative, or professional capacity (including any employee employed in the capacity of academic administrative personnel or teacher in elementary or secondary schools) … are exempt from the minimum wage and hours provisions of the Act. While preschools engage in some educational activities for the children, employees whose primary duty is to care for the physical needs of the children would not ordinarily meet the requirements for exemption as teachers. This is true even though the term “kindergarten” may be applied to the ordinary day care center. However, bona fide teachers in a kindergarten which is part of an elementary school system are still considered exempt under the same conditions as a teacher in an elementary school.”

999 points of light. The court conceded that the center was on a tight budget, and that forcing it to pay minimum wage (and $18,000 in back pay) would probably put it out of business. It dismissed this result by noting: “It frequently is the effect, and even the underlying purpose, of a statutory scheme like [the minimum wage] to destroy low-wage operations that are brought within its coverage. If that is the government’s intended social policy, this court is not authorized to stand in its way.”

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

1. Preschools. The Act specifies that church-operated preschools are enterprises engaged in commerce. Accordingly, they are subject to the minimum wage and overtime compensation requirements.

Key point. The courts have rejected the claim that subjecting church-operated preschools to these requirements violates the constitutional guaranty or religious freedom. However, all of these cases occurred prior to passage of the Religious Freedom Restoration Act. For more details, see the Special Report entitled “The Religious Freedom Restoration Act,” which is available from Church Law & Tax Report.

While a few federal courts have concluded that the term preschool does not include child care facilities that are primarily custodial rather than educational in nature (and that are not regulated or licensed by state law), other courts have rejected this interpretation of the law. It is the position of the Department of Labor that the term preschool includes child care facilities that are primarily custodial in nature. Accordingly, churches that operate preschools or child care facilities should recognize that the federal government will consider the employees of such facilities to be covered by the minimum wage and overtime pay requirements of the Fair Labor Standards Act. Prudence would dictate that churches follow these requirements with respect to such employees.

2. Uncompensated nursery workers and Sunday School teachers. What about workers in a church nursery that is open during worship services, or workers in a church’s Sunday School? Many churches operate a nursery for a few hours one day each week or month as an accommodation to mothers (often called “mothers day out”). Must churches pay workers in these programs the minimum wage? Clearly, if the workers are volunteers who work a few hours each week or month with no expectation of compensation, they are volunteers who are not covered by the federal minimum wage law. The Supreme Court has noted that while the definition of an employee is broad, it does have limits. For example, “an individual who, without promise or expectation of compensation, but solely for his personal purpose or pleasure, works in activities carried on by other persons either for their pleasure or profit, is outside the sweep of the [minimum wage law].” Further, Department of Labor Publication 1364 specifies that “[i]ndividuals who volunteer their services, usually on a part-time basis, to a preschool not as employees or in contemplation of pay are not considered employees within the meaning of the Act.” A Department of Labor attorney confirmed this understanding in a telephone conversation with your editor. The same rule would apply to volunteer Sunday School teachers.

3. Compensated nursery workers. Many churches pay their nursery attendants a fee for their services. It would be difficult to argue that such persons are not employees, and accordingly they would be entitled to the minimum wage if they perform services for an enterprise that is engaged in commerce. Is a church such an enterprise? No court has addressed this question. Remember, however, that the definition of an enterprise engaged in commerce includes church-operated preschools. Further, the Department of Labor in its Publication 1364 sets forth a very broad definition of preschool. Whether this definition is broad enough to cover church nursery workers is not clear at this time. A Department of Labor attorney informed your editor that compensated church nursery workers are covered by the federal minimum wage law. Until the federal courts provide clarification, churches must recognize that nursery workers who are compensated for their services may be covered by the federal minimum wage and overtime pay requirements. This apparently is the position of the Department of Labor. Future clarification of this issue of course will be published in this newsletter.

4. Elementary and secondary schools. The law specifies that church-operated schools are enterprises engaged in commerce. Accordingly, they are subject to the minimum wage and overtime pay requirements. The courts have rejected the claim that subjecting church-operated schools to these requirements violates the constitutional guaranty or religious freedom.

5. Adjustments. Preschools and churches that are covered by the minimum wage and overtime pay requirements can adjust their liability in a variety of ways. For example, they can reduce the number of hours worked each week; prohibit all unauthorized overtime work (however, they must also ensure that workers in fact do not work overtime, since an employer who “prohibits” overtime will be required to pay overtime compensation to employees that it “allows” to work more than 40 hours each week); reduce hourly compensation (but not below the minimum wage); reduce fringe benefits; or take credit for all indirect and noncash payments made on behalf of employees.

6. Required records. All employers having employees covered by the federal minimum wage and overtime pay requirements must maintain records documenting covered employees’ wages, hours, and the other conditions and practices of employment. Included are payroll records, employment contracts, pension plans and other employee benefits, and worktime schedules. If an employer intends to claim credit for noncash payments, it must maintain records documenting the value of such payments.

7. State law. Church treasurers must recognize that many states have enacted their own versions of the Fair Labor Standards Act. It is imperative to review the potential application of state minimum wage and overtime compensation laws to church workers.

8. Penalties. Penalties may be imposed for violations of the federal minimum wage law. Employers who violate the minimum wage or overtime pay requirements are liable to their employees for the amount of the unpaid minimum wage or the unpaid overtime pay, and “an additional equal amount as liquidated damages.” In addition, employees who are not paid minimum wage or overtime compensation can collect the reasonable cost of their attorney’s fees in suing the employer. Employers who “willfully” violate the minimum wage or overtime pay requirements of the Act are subject to a fine of up to $10,000 for each violation. A 2-year statute of limitations applies to the recovery of back wages except in the case of willful violations, in which case a 3-year statute of limitations applies.

This article originally appeared in Church Treasurer Alert, March 1995.

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

Tax Court Rules Contribution to Foreign Charity Was Not Deductible

Contributions must go to U.S. charity organizations.

Richard R. Hammar, Attorney, CPA

Bio

Church Finance Today

Tax Court Rules Contribution to Foreign Charity Was Not Deductible

Contributions must go to U.S. charity organizations.

Richard R. Hammar

Alisobhani v. Commissioner, T.C. Memo. 1994-629 (1994)

Background. Church members sometimes make contributions directly to religious organizations or ministries overseas. Or, they make contributions to a United States religious organization for distribution to a foreign organization. Are these contributions tax-deductible? That was the issue addressed by the Tax Court in a recent ruling.

The Tax Court ruled that a taxpayer who sent contributions to a mosque in his family’s home town in Iran was not entitled to a charitable contribution deduction. The Court noted that to be deductible a charitable contribution must go to a charity organized in the United States.

Importance to church treasurers. Federal law specifies that a charitable contribution, to be tax-deductible, must go to an organization “created or organized in the United States or in any possession thereof.” In addition, the organization must be organized and operated exclusively for religious or other charitable purposes. This means that contributions made directly by church members to a foreign church or ministry are not tax-deductible in this country.

A related question, not addressed by the Court but addressed by the IRS in a 1963 ruling, is whether a donor can make a tax-deductible contribution to an American charity with the stipulation that it be transferred directly to a foreign charity. The IRS ruled that such a contribution is not deductible since it in effect is directly to the foreign charity. Revenue Ruling 63-252.

Key point. In its 1963 ruling, the IRS did concede that contributions to a United States charity are deductible even though they are earmarked for distribution to a foreign charity, so long as the foreign charity “was formed for purposes of administrative convenience and the [United States charity] controls every facet of its operations.” The IRS concluded: “Since the foreign organization is merely an administrative arm of the [United States] organization, the fact that contributions are ultimately paid over to the foreign organization does not require a conclusion that the [United States] organization is not the real recipient of those contributions.”

This article originally appeared in Church Treasurer Alert, March 1995.

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

Tax Court Denies Charitable Contribution

Donor did not meet new substantiation requirements, court ruled.

Richard R. Hammar, Attorney, CPA

Bio

New rules took effect in 1994 for the substantiation of individual charitable contributions of $250 or more. However, the rules for substantiating cash contributions of less than $250 remain the same. Donors making individual cash contributions of less than $250 must be able to substantiate such contributions with one of the following:

canceled checks,
a receipt or letter from the church showing the church’s name and the amounts and dates of the contributions, or
any other reliable written record showing the name of the church and the amounts and dates of the contributions.
Background
In the case Witherspoon v. Commissioner, T.C. Memo. 1994-593, a taxpayer claimed cash contributions of $3,500 to her church. She was audited and the IRS denied any deduction for these contributions. The IRS claimed that the woman had insufficient evidence to substantiate the contributions. The taxpayer claimed that these contributions were all made in cash, and so she had no canceled checks to substantiate them.
She also claimed that she kept no records or receipts to prove her contributions. The only evidence she had was a letter from her church stating that the taxpayer made contributions of $3,500 to the church during the year in question “through tithes, offerings, and love donations.” No church representative testified during the woman’s trial.
The court’s ruling
The court agreed with the IRS that the woman had failed to substantiate the $3,500 in charitable contributions to her church. It dismissed the church’s letter by noting that “the letter from the church is very general and provides no information as to how and when [her] contributions were made. The evidence presented does not satisfy the court that [she] made the contributions to the church in the amount claimed.” The court was satisfied that the woman made some contributions to the church, and allowed her a deduction in the amount of $450.
What this means to churches?
As noted above, donors making individual cash contributions of less than $250 must be able to substantiate such contributions with one of the following:
canceled checks
a receipt or letter from the church showing the church’s name and the amounts and dates of the contributions, or
any other reliable written record showing the name of the church and the amounts and dates of the contributions
The taxpayer did not keep canceled checks, and she had no other records to substantiate her contributions—other than the general letter from the church stating that she had contributed $3,500 during the year in question. Such a letter is not enough to substantiate contributions of less than $250, because it “provides no information as to how and when [the] contributions were made.” The woman would have been entitled to deduct her church contributions if the church’s letter had reported the “amounts and dates” of her contributions.
Tip. Generic letters that merely report the total amount of contributions given by a donor during the year will not be enough to substantiate the donor’s individual cash contributions of less than $250. The letter, or receipt, must list church’s name and the dates and amounts of each contribution. Additional rules apply to the substantiation of individual contributions of $250 or more.
Witherspoon v. Commissioner, T.C. Memo. 1994-593

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