On June 7, 2001, President Bush signed a massive new tax law known as the Economic Growth and Tax Relief Reconciliation Act of 2001. The Act’s most publicized feature is a $1.35 trillion package of tax cuts. However, the Act also contains more than 440 other tax law changes, some of which are of special relevance to church treasurers. We have carefully reviewed the entire text of the new law, and are summarizing in this feature article those provisions that are of most relevance to church treasurers.
Key point. All of the changes summarized in this article, along with many more, are addressed in the 2002 edition of the Church and Clergy Tax Guide. The fully updated 2002 edition contains indispensable and up-to-date information for church treasurers.
Key point. An unprecedented feature of the new law is a “sunset” provision that revokes all of the hundreds of tax law changes at the end of 2010 unless Congress votes to extend them. If Congress fails to take action, then the tax law in effect in 2001 will be reinstated. Because many taxpayers, in all income brackets, will increasingly rely on many of the tax law changes in the new law, it is inconceivable that Congress will allow all of the changes to expire at the end of 2010. It is reasonable to assume that many of the changes will be permanently adopted by Congress, but not necessarily all of them.
1. Reduction in income tax rates. The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRA”) creates a new 10% income tax bracket for a portion of taxable income that is currently taxed at 15%, effective for taxable years beginning after December 31, 2000. The 10% rate bracket applies to the first $6,000 of taxable income for single individuals, and $12,000 for married couples filing joint returns. This $6,000 amount increases to $7,000 and the $12,000 increases to $14,000 for 2008 and thereafter. The 15% income tax bracket is modified to begin at the end of the new 10% income tax bracket. The pre-EGTRA income tax rates of 28%, 31%, 36%, and 39.6% are phased down over six years to 25%, 28%, 33%, and 35%, effective after June 30, 2001. Since the tax rate changes do not take effect until July 1, 2001, rate reductions for 2001 will come in the form of a “blended” tax rate.
Key point. The IRS recently released Publication 15-T, “New Withholding Tables for 2001.” The new withholding tables reflect changes in the income tax rates on individuals beginning July 1, 2001 under the new tax law. Churches should begin withholding using the new tables as soon as possible for wages paid after June 30, 2001. The new tables are a supplement to Publications 15, 15-A, and 51 and should be used instead of the tables in those publications. You can obtain Publication 15-T by calling the IRS at 1-800-TAX-FORM, or by visiting the IRS web site at www.irs.gov.
Tip. Many donors will realize a greater tax benefit by making charitable contributions in 2001 rather than in future years since their contributions reduce taxes at the current higher rates. But high income donors may be better off deferring some contributions to future years when the current reduction in charitable contribution deductions for high income taxpayers is phased out. Under current law, itemized deductions for charitable contributions are reduced by 3% of the amount of the donor’s adjusted gross income in excess of $132,950 (but contributions cannot be reduced by more than 80%).
2. Simplification of the earned income credit. Eligible lower-income workers are able to claim a refundable earned income credit. The amount of the credit an eligible taxpayer may claim depends upon the taxpayer’s earned income and the number of dependent children. EGTRA simplifies the definition of earned income by excluding nontaxable employee compensation from the definition of earned income for earned income credit purposes. As a result, earned income includes wages, salaries, tips, and other employee compensation, if includible in gross income for the taxable year, plus net earnings from self employment.
Key point. Housing allowances, and the annual rental value of church-provided parsonages, are examples of “nontaxable employee compensation” that in the past was included in the computation of “earned income” in calculating the earned income credit. The effect was to increase earned income and either disqualify many ministers for the earned income credit (because their earned income was too high), or reduce the value of the credit. By eliminating housing allowances and the annual rental value of parsonages from the definition of earned income, EGTRA will make the earned income credit available to many more ministers, and will result in a larger credit for those who qualify for the credit.
Key point. Other examples of nontaxable employee compensation that no longer will be included in the definition of earned income when computing the earned income credit include contributions (by salary reduction) to either a cafeteria plan or 403(b) annuity.
Example. Pastor Bob is the youth pastor at his church. He is married and has 3 minor children. In 2001, Pastor Bob is paid a salary of $25,000 and in addition receives a housing allowance of $8,000. Prior to EGTRA, Pastor Bob would not have qualified for the earned income credit, since his salary plus nontaxable employee compensation (the housing allowance) exceed the amount above which married taxpayers with minor children no longer are eligible for an earned income credit ($32,121). However, EGTRA eliminates nontaxable employee compensation from the definition of earned income, and therefore Pastor Bob qualifies for the credit since his earned income is his salary of $25,000 and does not include his housing allowance. He will receive a tax credit of $1,500, computed as follows: maximum allowable credit ($4,008) less the excess of earned income over the “phase-out threshold” ($25,000 – $13,090 = $11,910) times the phase-out rate of 21.06% ($2,508) = a credit of $1,500. This means that because of EGTRA’s modification of the definition of earned income, Pastor Bob will qualify for a tax credit of $1,500. Note that a credit reduces actual taxes and therefore is more beneficial than deductions or exclusions which merely reduce taxable income. This change in the law will benefit many younger ministers with dependent children.
3. Modifications to education IRAs. Current law allows taxpayers to create “education IRAs” for the purpose of paying the qualified higher education expenses of designated beneficiaries. Annual contributions to education IRAs may not exceed $500 per beneficiary and may not be made after the designated beneficiary reaches age 18. EGTRA makes a number of changes to educational IRAs, effective in 2002. Some of these changes are of direct relevance to churches that operate a private elementary or secondary school. They include the following:
- The annual limit on contributions to education IRAs is increased from $500 to $2,000.
- The definition of “qualified education expenses” for which tax-free distributions from an education IRA may be made is expanded to include “qualified elementary and secondary school expenses,” meaning expenses for (1) tuition, fees, academic tutoring, special need services, books, supplies, computer equipment (including related software and services), and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under state law, and (2) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary.
Key point. Allowing education IRAs to fund private elementary school education will provide little financial benefit to parents, especially if they plan on applying the earnings to tuition for one of the early elementary grades.
Example. A couple begins contributing $2,000 annually to an education IRA in the year their daughter is born, and they earn 7% per year on their account. They will generate nontaxable earnings of only $1,943 by the time their daughter starts kindergarten at a church school 5 years later. And this leaves no tax-free earnings for any future year. Had the couple waited until their daughter started 10th grade (at age 16), their tax-free earnings at an annualized rate of 7% would have accumulated to $26,609. Had they waited until their daughter started college at age 18, their tax-free earnings would have accumulated to $35,622.
Key point. Computer software involving sports, games, or hobbies is not considered a qualified elementary and secondary school expense unless the software is predominantly educational in nature.
4. Exclusion for employer-provided educational assistance. Employer-paid educational expenses are excludable from the gross income and wages of an employee if provided under a “section 127” educational assistance plan. Section 127 provides an exclusion of $5,250 annually for employer-provided educational assistance. The exclusion does not apply to graduate courses beginning after June 30, 1996. The exclusion for employer-provided educational assistance for undergraduate courses expires with respect to courses beginning after December 31, 2001. In order for the exclusion to apply, certain requirements must be satisfied. The educational assistance must be provided pursuant to a separate written plan of the employer and the educational assistance program must not discriminate in favor of highly compensated employees.
EGTRA extends the exclusion for employer-provided educational assistance to graduate education and makes the exclusion (as applied to both undergraduate and graduate education) permanent. This provision is effective with respect to courses beginning after December 31, 2001.
Example. Pastor Ed is taking graduate-level counseling courses at a local seminary. His church pays his tuition, which amounts to $5,000 in 2001. The exclusion of employer provided educational assistance was not available in 2001 for graduate level courses. However, because of EGTRA, the church’s payment of Pastor Ed’s tuition in 2002 may be nontaxable employer provided educational assistance since this benefit no longer is limited to undergraduate education.
Key point. Educational expenses that do not qualify for the section 127 exclusion may be excludable from income as a working condition fringe benefit. In general, education qualifies as a working condition fringe benefit if the employee could have deducted the education expenses under section 162 of the tax code if the employee paid for the education. In general, education expenses are deductible by an individual under section 162 if the education (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer’s employer, applicable law or regulations imposed as a condition of continued employment. However, education expenses are generally not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business.
5. Phase-out and repeal of estate taxes. From 2002 through 2010, estate taxes are reduced. They are eliminated beginning in 2011. After repeal, the “basis” of assets received from a decedent generally will equal the basis of the decedent (i.e., carryover basis) at death. The “basis” of property inherited from a decedent is an important amount, since taxable gain on a future sale of the property generally is computed by subtracting the basis from the property’s sale price. The new carryover basis rule means that heirs often will end up paying more taxes on the sale of inherited property since the property’s basis is the same basis that the decedent had (generally, what the decedent paid for the property, often years ago). In the past, inherited property had a “stepped up” basis, meaning that the basis was adjusted to the value of the property on the date of the decedent’s death. This stepped up basis greatly reduced taxes on the sale of inherited property. The elimination of the stepped up basis was the cost Congress exacted for repealing the estate tax.
Note, however, that the new carryover basis requirement is softened by a couple of new rules. First, a decedent’s estate is permitted to increase the basis of assets transferred by up to a total of $1.3 million. And second, the basis of property transferred to a surviving spouse can be increased (i.e., stepped up) by an additional $3 million. As a result, the basis of property transferred to a surviving spouse can be increased (i.e., stepped up) by a total of $4.3 million. In no case can the basis of an asset be adjusted above its fair market value. For these purposes, the executor will determine which assets and to what extent each asset receives a basis increase. The $1.3 million and $3 million amounts are adjusted annually for inflation occurring after 2010.
Tip. Charitable remainder trusts will become an even more attractive option for donors once the estate tax is repealed. Following repeal of the estate tax, gifts of property made at death will have a “carryover basis,” meaning that when an heir later sells the property any gain will be computed on the basis of what the decedent paid for the property, however long ago. This means that heirs will be stuck with paying tax on the appreciation or gain in the value of the property that occurred during the decedent’s lifetime, which in many cases will be substantial. In the past, persons receiving gifts of property by inheritance generally had a “stepped up” basis equal to the property’s market value at the date of the donor’s death. This meant that any appreciation or “gain” realized by the donor was not taxed. However, note that this harsh rule can be minimized or even avoided if donors transfer appreciated property to a charitable remainder trust. Here’s how it works. A donor creates a charitable remainder trust and then transfers appreciated, income-generating property to the trust. The trust makes annual (or more frequent) distributions to the donor or one or more family members for a term of years (ordinarily not more than 20), with an irrevocable remainder interest to a designated charity. In other words, property is given to a trust with income from the property being paid to the donor or the donor’s family for a period of years, and with a designated charity ultimately receiving the property. It is an excellent tool in tax planning for larger estates, as well as for persons with greatly appreciated property.
6. Individual retirement arrangements (“IRAs”). EGTRA increases the maximum annual dollar contribution limit for IRA contributions from $2,000 to $3,000 for 2002 through 2004, $4,000 for 2005 through 2007, and $5,000 for 2008. After 2008, the limit is adjusted annually for inflation in $500 increments. In addition, individuals who have attained age 50 may make additional “catch-up” IRA contributions. The otherwise maximum contribution limit (before application of the AGI phase-out limits) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005, and $1,000 for 2006 and thereafter.
Example. A church has a senior pastor who is 52 years old, and a youth pastor who is 30 years old. The church does not participate in a retirement program for its staff. In 2001, the senior pastor and youth pastor can each contribute $2,000 to an IRA account. In 2002, however, the senior pastor will be able to contribute $3,500 (maximum annual contribution of $3,000 plus a “catch-up” contribution of $500), and the youth pastor will be able to contribute $3,000. In 2008, the senior pastor will be able to contribute $6,000 (maximum annual contribution of $5,000 plus a “catch-up” contribution of $1,000), and the youth pastor will be able to contribute $5,000.
7. Increase in contribution limits. The amount that employees can contribute (through salary reduction) to a 403(b) retirement plan is limited to $10,500 in 2001. This amount will increase to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006 at which time the amount will be indexed for inflation annually in $500 increments.
8. “Roth contributions” to 403(b) plans. EGTRA allows a 403(b) annuity plan to include a “Roth contribution program” that permits a participant to elect to have all or a portion of his or her elective deferrals under the plan treated as Roth contributions. Roth contributions are elective deferrals that the participant designates (at such time and in such manner as the IRS prescribes) as not excludable from the participant’s gross income. A qualified distribution from a participant’s Roth contribution account is not includible in the participant’s gross income. This provision takes effect in 2006.
Key point. Some churches have established their own 403(b) plans for their employees. Maintaining such plans in the future will become increasingly difficult because of a number of changes made by EGTRA, including the following: (1) Every 403(b) plan is required to establish a separate account, and maintain separate recordkeeping, for each participant’s Roth contributions (and earnings). This requirement will impose a heavy administrative burden on some churches. Some churches may attempt to avoid this burden by not allowing employees to make Roth contributions, but this will be a short-sighted solution since it is probable that many employees not only will be aware of the option of Roth contributions but will demand it. (2) EGTRA requires the IRS to require administrators of any 403(b) plan that allows Roth contributions to “make such returns and reports regarding Roth contributions to the [IRS], plan participants and beneficiaries, and other persons that the IRS may designate.” This is yet another administrative burden that will make the administration of a 403(b) plan by a local church undesirable. (3) The new law permits “rollovers” between Roth IRAs and Roth contributions to a 403(b) plan. Plan administrators need to be prepared for requests to roll funds in and out of Roth 403(b) accounts. Also, the new law appears to allow rollovers between Roth 403(b) accounts and Roth 401(k) accounts.
Tip. Ministers and lay church employees who currently are participating in a 403(b) retirement plan should carefully consider whether or not they want to make designated Roth contributions when this option becomes available in 2006. For many taxpayers, the dual advantages of no taxes on gains or distributions are compelling and outweigh the loss of any deduction for annual contributions to their account.
9. Backup withholding. Employers are required to engage in “backup withholding” at a rate of 31% for payments made to self-employed workers who do not disclose their social security number. The 31% is reported on the church’s 941 forms. Employers need the correct social security number to complete the worker’s Form 1099 MISC. EGTRA decreases the backup withholding rate from 31% to 30.5% for amounts paid to self-employed persons after August 6, 2001. For amounts paid after December 31, 2001, the backup withholding rate is equal to the fourth lowest income tax rate (for single persons). As a result, the backup withholding rates will be 30% in 2002 and 2003, 29% in 2004 and 2005, and 28% in 2006 and thereafter.
Key point. The backup withholding rate shown in the December 2000 edition of Form W-9 is incorrect for amounts paid after August 6, 2001. Form W-9 (and instructions) will be revised in December 2001 to reflect the new backup withholding rate for amounts paid after December 31, 2001. In addition, the backup withholding rate shown in the 2001 version of Form 1099 is incorrect for amounts paid after August 6, 2001. The 2002 version of this form (and instructions) will show the new backup withholding rate for amounts paid after December 31, 2001.
Example. A church invites a visiting pastor to conduct services for one week in September of 2001, and agrees to pay him $1,000. The visiting pastor declines to disclose his social security number. As a result, the church must withhold $305 from his compensation as backup withholding (30.5% of total compensation).
This content originally appeared in Church Treasurer Alert, October 2001.
