Sometimes churches, having failed to establish a formal retirement plan, attempt to support a retiring pastor by making direct payments.
While well-intentioned, this practice—known as an informal retirement agreement—raises significant legal and tax issues that must be handled carefully.
What Is an Informal Retirement Agreement?
An informal retirement agreement is an unenforceable promise by a church to make lump sum or periodic payments to a retired minister (or their surviving spouse) without a formal plan in place.
Key Topics Covered
Jump ahead to a topic:
1. Are Informal Retirement Plans Legally Enforceable?
Consideration Requirement
Contracts require consideration—something of value exchanged between parties.
Without it, agreements (including informal retirement promises) are not legally enforceable.
Example:
In Cochran v. Robinwood Lane Baptist Church, 2005 WL 3527627 (Tenn. App. 2005), a widow sued when the church stopped retirement payments.
The court ruled the agreement was unenforceable due to a lack of consideration.
Statute of Frauds
- Contracts that cannot be performed within one year must be in writing to be enforceable.
- Verbal retirement promises extending beyond a year are unenforceable under this law.
Authority of Signatories
- Even a written agreement may be invalid if signed by someone without legal authority to bind the church.
2. Taxable Income or a Tax-Free Gift?
Churches sometimes present retirement gifts as lump sums or annual payments.
But are they taxable compensation or tax-free gifts?
Historic Cases Favoring Tax-Free Treatment
Courts have ruled in favor of tax-free gifts when:
- No enforceable agreement existed.
- The pastor was not required to render further services.
- The payment was motivated by gratitude and affection.
Notable cases:
- Schall v. Commissioner (1949)
- Mutch v. Commissioner (1954)
- Kavanagh v. Hershman (1954)
- Abernathy v. Commissioner (1954)
(See also IRS Revenue Ruling 55-422.)
IRS Current Position
- The IRS still recognizes these cases but may argue retirement gifts are taxable compensation unless all conditions of Revenue Ruling 55-422 are met.
Caution:
Churches should consult a tax professional before treating retirement gifts as non-taxable.
3. Nonqualified Deferred Compensation (NQDC)
Section 409A of the tax code governs NQDC plans, including many informal retirement arrangements.
Key points:
- Plans must meet complex IRS requirements to avoid penalties.
- Violations result in immediate taxation and a 20% penalty on employees.
- Compliance must be both “in form and operation.”
Tip:
Always seek legal or tax advice before deferring compensation beyond the current year.
4. More on Section 409A
NQDC arrangements must comply with Section 409A regulations, which include:
- Strict rules on timing of elections and payments
- Reporting failed deferrals separately (Form W-2, Box 12, Code Z)
- Substantial penalties for noncompliance
Important:
Even minor errors can trigger tax penalties and back taxes for employees.
5. Section 403(b) Tax-Sheltered Annuities
A 403(b) plan offers major retirement savings advantages:
- Contributions and gains are tax-deferred.
- Churches can designate part of distributions as housing allowances for retired ministers.
- Eligible ministers aged 50+ can contribute up to $30,500 in 2024.
Key takeaway:
Because of 403(b)’s benefits and flexibility, churches should prioritize these plans over informal retirement arrangements whenever possible.
6. Excess Benefit Transactions
Under Section 4958, if a church pays excessive compensation to a disqualified person (like a pastor):
- The individual may face excise taxes up to 225% of the excess amount.
- Board members may also be penalized.
Warning:
Unreported retirement payments can trigger automatic excess benefit penalties unless properly reported as taxable income.
7. Housing Allowances
Can informal retirement payments qualify as housing allowances?
According to Revenue Ruling 72-249:
- Payments to a retired minister can be designated as a housing allowance, if made under official church action.
- Payments made to a surviving spouse are taxable, unless the spouse is also a minister.
Conclusion
Supporting retired pastors is honorable, but informal retirement payments are fraught with legal and tax risks.
To protect your church:
- Put all agreements in writing.
- Ensure consideration is present.
- Consult legal and tax professionals before finalizing any retirement arrangements.
- Understand the rules around taxable income, deferred compensation, excess benefits, and housing allowances.
