Occasionally, a church that has failed to do any pastoral retirement planning will begin making payments directly to the pastor after his or her retirement (and in some cases to the pastor’s spouse if he or she survives the pastor).
For example, assume Pastor T was employed by a church for 30 years preceding his retirement in 2023, and that the church never established a retirement program for him.
Embarrassed by the lack of provision for the pastor’s retirement, the church board enacts a resolution to pay him $5,000 per month until he dies.
However, there are several important legal and tax issues that church leaders should address before finalizing such an arrangement, and the assistance of a tax attorney or CPA is recommended.
Editor’s note: In this article, “informal retirement agreement” refers to an unenforceable agreement by a church to make a lump sum or monthly payments to a retired minister
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1. Are informal retirement plans legally enforceable?
Key point. Financial commitments made by a church to a staff member are legally enforceable only if the church receives something of value (“consideration”) in return.
Many informal retirement agreements are legally unenforceable for one or both of the following reasons:
Consideration
Consideration is a legal requirement for any contract. Without it, a purported contract is not legally enforceable.
What, then, is consideration, and why is it important?
First of all, consideration is a fundamental requirement in any contract.
It means that for a contract to be legally enforceable, each party agrees to do something and must receive something of value in exchange.
That “something of value” is called consideration. There is no enforceable contract without it.
The issue of consideration often arises in evaluating the enforceability of commitments by churches to make distributions of cash or other benefits to retired ministers or their spouses.
Consider an actual case:
Pastor Dave served as senior pastor at a Baptist church in Tennessee (the “church”) from 1981 until he died in 1995.
In return for his services, the church paid Pastor Dave a salary and various fringe benefits, including cell phone services, lawn services, and vehicle maintenance.
At Pastor Dave’s request, the church orally agreed to provide most of these benefits directly to his wife, Darla. Before his death, Pastor Dave spoke to several deacons of the church and asked the church to provide for his wife if the church was able to do so.
The church entered into an agreement with Darla to provide her with $785 on the first and third Sunday of every month until 2010. The church also agreed to provide lawn services for her residence.
Pursuant to the agreement, these benefits would continue until one of two terminating events occurred: (1) her death; or (2) she remarried. However, if she remarried within five years of the inception of the contract, she would continue to receive these benefits for five years. If she remarried five years or more after the inception of the contract, she would no longer receive any benefits.
The church discontinued making payments to Darla in 1996.
Darla sued the church and the board of deacons for breach of contract.
A trial court dismissed all of Darla’s claims on the ground that the church’s obligations under the “contract” were unenforceable because it had not received anything of value (i.e., “consideration”) from Darla for its substantial commitments under the contract. This meant the church was legally justified in terminating its payments to Darla.
A state appeals court affirmed the trial court’s ruling.
This case illustrates an important legal principle. Commitments made by churches to current or former employees, or their spouses, may not be legally enforceable if the church receives nothing of value (consideration) in return for its commitments. There are some exceptions to this rule, such as the doctrine of promissory estoppel, but these will not be available in all cases.
Cochran v. Robinwood Lane Baptist Church, 2005 WL 3527627 (Tenn. App. 2005).
Statute of frauds
The statute of frauds requires certain contracts to be in writing in order to be enforceable.
Every state, by statute or court decision, has adopted the statute of frauds, with slight variations.
Under the statute of frauds, an alleged contract that cannot be fully performed within one year is void if its central terms are not in writing.
The purpose of the statute of frauds is to prevent fraud in commercial transactions.
However, there is no exemption for churches.
Church leaders, therefore, should carefully consider the potential application of the statute of frauds to any legal agreement that is not in writing.
In other words, a church’s agreement to provide a monthly retirement stipend to a pastor, or a pastor’s spouse, generally must be in writing if it cannot be fully performed within one year. An unwritten commitment by a church to pay a retirement stipend is therefore unenforceable. A church can honor its unenforceable commitment, but if it discontinues doing so for any reason, the pastor (or spouse) has no legal recourse.
Authority of signatory to bind the church
In some cases, a church’s written agreement to pay a monthly retirement stipend is signed by a board member or corporate officer having no legal authority to do so.
Under these circumstances, the “agreement” is unenforceable.
2. Taxable income or a tax-free gift?
It is common for churches to present a retiring minister with a retirement gift in the form of a substantial lump sum payment, or a series of annual installments to the minister, and in some cases to a surviving spouse.
Such “informal retirement agreements” often are prompted by the church’s failure to provide adequately for a pastor’s retirement.
Such gifts can be very generous, which raises the question of their tax status.
Should the church report them as taxable compensation and include them on the recipient’s Form W-2? Or can the church treat them as nontaxable gifts?
This question has vexed church boards for many years.
In a series of cases, four federal appeals courts concluded that certain retirement gifts to ministers were tax-free gifts rather than taxable compensation.
(1) Schall v. Commissioner, 174 F.2d 893 (5th Cir. 1949)
A federal appeals court ruled that a church’s retirement gift to its pastor represented a tax-free gift rather than taxable compensation. The pastor was forced to retire on the advice of his physician as a result of a long illness. He made no request of the congregation that any amount be paid to him after his resignation, and he had no knowledge that the church would agree to do so. He did not agree to render any services in exchange for the gift and did not do so.
The court concluded:
We are of opinion the Tax Court clearly erred in holding that the payments to [the pastor] were taxable income. Where, as here, all the facts and circumstances surrounding the adoption of the [gift] clearly prove an intent to make a gift, the mere use of the terms “salary” and “honorarium” do not convert the gift into a payment for services. Moreover, “a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient. . . .” Manifestly, these payments to [the pastor] were non-taxable gifts, within the orbit of the rule defining same, as enunciated by this court in [another case]: “That only is a gift which is purely such, not intended as a return of value or made because of any intent to repay another what is his due, but bestowed only because of personal affection or regard or pity, or from general motives of philanthropy or charity.”
(2) Mutch v. Commissioner, 209 F.2d 390 (3rd Cir. 1954)
A federal appeals court ruled that monthly retirement gifts made by a church to its retired pastor were tax-free gifts rather than taxable compensation.
The court noted that the church’s action in providing for the monthly honoraria “was motivated solely and sincerely by the congregation’s love and affection for [the pastor].” The court described the church’s action as a “free gift of a friendly, well-to-do group who as long as they were able and because they were, wished their old minister to live in a manner comparable to that which he had enjoyed while actively associated with them.”
The court also observed:
[The pastor] had been adequately compensated as far as money could for his services in the past. He was not being tied into any promise of services in the future. The installment gift, while it could be stopped or changed at any time by the trustees, had no conditions attached to its acceptance. The court concluded that no other ruling “justifies the taxing of this bona fide gift given [the pastor] with love and affection by his old congregation.”
(3) Kavanagh v. Hershman, 210 F.2d 654 (6th Cir. 1954)
A federal appeals court, in a one-paragraph opinion, ruled that a distribution of funds to a minister was a tax-free gift rather than taxable compensation. The court based its decision on the Mutch decision (summarized above).
(4) Abernathy v. Commissioner, 211 F.2d 651 (D.C. Cir. 1954)
The Abernathy case was a one-paragraph decision issued by a federal appeals court in 1954.
The ruling addressed the question of whether a $2,400 retirement gift paid by a church to its pastor “as a token of its gratitude and appreciation” and “in appreciation of his long and faithful service” represented taxable income or a tax-free gift.
The federal court concluded that the transfer was a tax-free gift. It cited (without explanation) the Schall, Mutch, and Kavanagh decisions (summarized above) along with Bogardus v. Commissioner, 302 U.S. 34 (1936) (discussed below).
The IRS in 1955 endorsed the four cases summarized above because of the following facts in each case:
- “the payments were not made in accordance with any enforceable agreement, established plan, or past practice”;
- the minister “did not undertake to perform any further services for the congregation and was not expected to do so” following his retirement;
- “there was a far closer personal relationship between the [minister] and the congregation than is found in lay employment relationships”; and
- “the available evidence indicated that the amount paid was determined in light of the financial position of the congregation and the needs of the recipient, who had been adequately compensated for his past services.”
(Revenue Ruling 55-422)
Given the age of the four federal appeals court rulings addressing retirement gifts to ministers, what is their status?
Note the following:
First, the IRS has never revoked, modified, declared obsolete, or distinguished Revenue Ruling 55-422.
Second, the ruling was quoted with approval as recently as 1995 by the United States Tax Court. Osborne v. Commissioner, 69 T.C.M. 1895 (1995).
Third, IRS Audit Guidelines for Ministers (2009) contain the following statement: “There are numerous court cases that ruled the organized authorization of funds to be paid to a retired minister at or near the time of retirement were gifts and not compensation for past services. Revenue Ruling 55-422 discusses the fact pattern of those cases which would render the payments as gifts and not compensation.” This appears to be an explicit recognition that Revenue Ruling 55-422 continues to accurately reflect the law.
Fourth, other federal courts have affirmed the tax-free status of retirement gifts made to ministers.
To illustrate, in Brimm v. Commissioner, 27 T.C.M. 1148 (1968), the United States Tax Court ruled that a severance gift made by a church-affiliated school to a professor was a nontaxable gift rather than taxable compensation. The professor (the “taxpayer”) was employed by a church-related, two-year graduate school supported by the Southern Baptist Convention. It became apparent that, because of low enrollment and the high cost of operations, the school would have to be closed. Before the school’s dissolution, its board of trustees adopted a resolution authorizing “a gift equivalent to one year’s salary to each faculty member and staff member upon termination of his or her services with the school.” Pursuant to this policy, the taxpayer received a “gift” of $8,600 in two annual installments bearing the notation “severance gift.” The taxpayer did not report the two installments as taxable income on his tax returns because he regarded them to be a tax-free gift rather than taxable compensation for services rendered.
The IRS audited the taxpayer’s tax returns and determined that the severance gifts constituted taxable income.
On appeal, the Tax Court concluded that the severance payments were, in fact, nontaxable gifts:
It is clear from the evidence that the board of trustees of the school took their action in declaring and making a severance gift to the taxpayer, as well as to other members of the small staff, because they were grateful and appreciative of the past faithful and dedicated service rendered to the school.” The court noted that the presence of affection, respect, admiration, and a deep sense of appreciation in the minds of trustees was demonstrated by the testimony of a member of the board who testified that the severance gifts were not intended to represent additional compensation but were authorized solely as a means of showing appreciation to the faculty and that there was no expectation of additional services being performed in return for the severance gifts.
The court concluded:
There is no doubt that the school’s trustees were motivated by gratitude for the taxpayer’s past faithful services, but, as the Supreme Court said in [the Bogardus case] “a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient.” Indeed, long and faithful service may create the atmosphere of goodwill and kindliness toward the recipient which tends to support a finding that a gift rather than additional compensation was intended. . . . We hold that the school intended to make, and did make, a gift which was made gratuitously and in exchange for nothing.
Key takeaway: Taxpayers generally are not liable for penalties if they rely on a published court decision in support of a tax position. Since the four 1950s cases summarized above have never been overruled, they probably would prevent a minister from being assessed penalties as a result of treating a retirement gift as nontaxable. However, the IRS likely will insist that the entire value of the retirement gift represents taxable income, forcing the minister to still pay taxes on it.
Other cases addressing retirement gifts
(1) Commissioner v. Duberstein, 363 U.S. 278 (1960)
The United States Supreme Court weighed in on a case involving a $20,000 retirement gift made by a church to a retiring lay officer. The church’s board approved the gift, characterizing it as “gratuity” and specifiying it was given “in appreciation for services rendered.” The Supreme Court freely admitted the difficulty of distinguishing between tax-free gifts and taxable compensation. But it noted “a gift in the statutory sense . . . proceeds from a detached and disinterested generosity . . . out of affection, respect, admiration, charity, or like impulses. . . . The most critical consideration . . . is the transferor’s intention.”
The Court also observed an objective inquiry must be made to decide “whether what is called a gift amounts to it in reality.”
(2) Bogardus v. Commissioner, 302 U.S. 34 (1936)
The Supreme Court noted:
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.
(3) Perkins v. Commissioner, 34 T.C. 117 (1960)
The Tax Court ruled that pension payments made by the United Methodist Church to retired ministers constituted taxable compensation rather than tax-free gifts. The court concluded that the pension payments could not be characterized as tax-free gifts, since they did not satisfy all of the conditions specified by the IRS in Revenue Ruling 55-422 (discussed above).
(4) Joyce v. Commissioner, 25 T.C.M. 914 (1966)
The Tax Court ruled that retirement payments made by the General Conference of Seventh-Day Adventists to the widow of a former minister represented taxable income and not tax-free gifts. The General Conference issued the widow Forms 1099-MISC reporting the payments as taxable income. However, in reporting her taxes, the widow treated the payments as nontaxable gifts. The court noted that “the ultimate criterion” in resolving such cases is “the basic or dominant reason that explains the action of the transferor.” How is this “basis or dominant reason” to be determined?
The court listed the following considerations:
- To constitute a gift the benefits paid must proceed from a “detached and disinterested generosity” or “out of affection, respect, admiration, and charity or like impulses.”
- “The absence of a legal or moral obligation to make such payments . . . or the fact that payments are voluntary . . . do not [necessarily] establish that a gift was intended. However, payments which do proceed from a legal or moral obligation are not gifts.”
- “Additional factors, which militate against a determination that gifts were intended, have been findings: (1) that a plan or past practice of payment was in existence; (2) that the needs of the widow were neither the prerequisite for, nor the measure of payment; and (3) that the transferor considered the payment as compensation, including the withholding of income tax.”
The court acknowledged that “in determining that certain payments constituted gifts, courts have seized upon the following: that payments were made directly to the widow rather than to the estate; that the widow performed no services for the transferor; that full compensation had been paid for the services of the deceased husband; and that the transferor derived no benefit from the payment.”
The court concluded that the payments made to the widow in this case represented taxable income.
- The benefits paid were fixed according to a computation based on length of service–a formal plan.
- There was no inquiry into her financial condition.
- The payments were “based on a computation which ignores financial condition” without considering the widow’s financial status.
- The General Conference itself treated the payments as taxable income by issuing the widow Forms 1099-MISC.
- And, the church “recognized a moral obligation to make such payments to those employees, and their widows, who have loyally rendered service to the church. This fact alone has been held sufficient to prevent payments from constituting gifts.”
The court also acknowledged that the payments were made directly to the widow and that she did not perform any services for the church. It rejected the widow’s argument that this factor required the payments to be treated as gifts to her, since she had otherwise failed to overcome all of the other factors supporting the court’s decision that the payments were taxable.
Caution: Church leaders should not treat retirement gifts to clergy as nontaxable distributions on the basis of the precedent cited above without first obtaining the assistance of a tax professional.
3. Nonqualified deferred compensation
Section 409A of the tax code imposes strict requirements on most “nonqualified deferred compensation plans” (NQDCs).
The IRS’s final regulations interpreting 409A include any plan that provides for the deferral of compensation, with some exceptions.
This definition is broad enough to include rabbi trusts and many other kinds of church compensation arrangements.
Any church or other organization that is considering a rabbi trust (or any other arrangement that defers compensation to a future year) should ask a tax attorney or CPA to review the arrangement for compliance with both section 409A and the final regulations.
Doing this will protect against the substantial penalties the IRS can assess for noncompliance.
It also will help clarify whether a deferred compensation arrangement is a viable option in light of the limitations imposed by section 409A and the final regulations.
NQDC plans are rarely used by churches because so few ministers are able to contribute the maximum amount each year to a 403(b) or other qualified plan.
For example, in 2024, ministers who are 50 years old or older can contribute up to $30,500 to a 403(b) plan.
This amount, and any gains realized, are tax-deferred.
Only for those few ministers who are able to contribute more than this amount does an NQDC plan make sense.
Key point: The “limit on annual additions” (the combination of all employer contributions and employee elective salary deferrals to all 403(b) accounts) generally is the lesser of: (1) $69,000 in 2024, or (2) 100-percent of includible compensation for the employee’s most recent year of service. Generally, includible compensation is the amount of taxable wages and benefits the employee received in the employee’s most recent full year of service.
4. More on Section 409A
Section 409A of the tax code governs NQDC arrangements.
More specifically, section 409A provides that all amounts deferred under an NQDC plan for all taxable years are currently includible in gross income (to the extent the amounts are not subject to a substantial risk of forfeiture and were not previously included in gross income) unless certain requirements are satisfied.
All plans must be in compliance with 409A regulations, both in form and operation.
If section 409A requires an amount to be included in taxable income, the tax code imposes a substantial additional tax assessed against the employee, and not the employer recipient.
Employers must withhold income tax on any amount includible in gross income under section 409A, with the possible exception of NQDC plans established for ministers, since ministers’ church compensation is exempt from withholding.
Section 409A also provides that “failed deferrals” under an NQDC plan (deferrals that become includible in the employee’s income due to a violation of section 409A) must be reported separately on Form W-2 (box 12, code Z).
So, what requirements does section 409A of the tax code impose on NQDC plans?
There are several, and they are highly complex.
Church leaders contemplating the deferral of compensation that an employee earns in the current year to a future year should address the following four points:
- If your church is considering the deferral of compensation for an employee beyond the current year, such as in a severance agreement, rabbi trust, or informal retirement plan, you need to understand that complex rules now apply to such arrangements (nonqualified deferred compensation plans), and the employee may be subject to significant penalties (including back taxes plus a 20-percent tax) if the requirements spelled out in section 409A are not met.
- Penalties may be avoided if a deferral arrangement meets the requirements of section 409A.
- Any church contemplating the deferral of an employee’s compensation to a future year should first consult with a tax professional for assistance in complying with the section 409A requirements.
- Section 409A contains some exemptions that may apply, depending on the facts and circumstances. A tax professional can assist in evaluating the possible application of these exemptions.
Key point: Any church or other organization that has entered into a rabbi trust or any other informal retirement arrangement that defers compensation to a future year should contact an attorney to have the trust or other arrangement reviewed. Doing this will protect against substantial penalties. It also will help clarify whether a rabbi trust or other deferred compensation arrangement remains a viable option in light of section 409A and the IRS regulations.
5. Section 403(b) tax-sheltered annuities
One of the most popular retirement plans for church employees is the 403(b) plan (sometimes called a tax-sheltered annuity).
Such plans permit employees of churches and other public charities to make nontaxable contributions to their 403(b) retirement account up to the allowable limits prescribed by law. In addition, earnings and gains on 403(b) accounts are tax-deferred, meaning that they are not taxed until distributed.
A 403(b) plan has several tax advantages:
- You do not pay tax on contributions to your 403(b) plan in the year they are made.
- Earnings and gains on your 403(b) plan are not taxed until you withdraw them, usually after you retire. Earnings and gains on amounts in a Roth 403(b) contribution program are not taxed if your withdrawals are qualified distributions.
- You may be eligible to claim a “qualified retirement savings” tax credit (the “saver’s credit”) for contributions to your 403(b) plan made by salary reduction.
- Churches and church pension boards that offer 403(b) plans can designate a portion of a retired minister’s distributions as a housing allowance.
Key point: The amount that can be invested in a 403(b) account is so generous that there is little justification for utilizing alternatives that may expose a church to liability if conditions are not met. Such alternatives, some of which are addressed in this article, should not be considered if a church’s contributions to an informal retirement plan are less than the 403(b) plan limits.
As noted above, NQDC plans are rarely used by churches because so few ministers are able to contribute the maximum amount each year to a 403(b) or other qualified plan. To illustrate, for 2024, ministers who are 50 years of age or older can contribute up to $30,500 to a 403(b) plan. This amount, and any gains realized, are tax-deferred. Only for those few ministers who are able to contribute more than this amount does an NQDC plan make sense.
6. Excess benefit transactions
Section 4958 of the tax code authorizes the IRS to impose an excise tax against a “disqualified person” (an officer or director of a tax-exempt charity or a relative of such a person) if the church pays excessive compensation to them.
(Excise taxes can also be imposed against individual board members, in some cases.)
These taxes are substantial—up to 225 percent of the amount of compensation the IRS determines to be in excess of reasonable compensation.
As it pertains to churches, most senior pastors are disqualified persons. .
Therefore, governing boards or other bodies responsible for setting clergy compensation should be prepared to document any amount that may be viewed by the IRS as excessive. This includes salary, fringe benefits, and special-occasion gifts.
When in doubt, consult a tax attorney.
For example, a church board establishes an informal plan calling for the payment of $25,000 per year to the pastor upon his retirement.
The church treasurer assumes that these payments are non-taxable and doesnot report them as taxable compensation. However, if the IRS determines that these payments are taxable, they constitute automatic excess benefits. And this exposes the pastor, and possibly members of the church board, to substantial excise taxes.
Important note: The IRS deems any taxable fringe benefit provided to a disqualified person, such as no additional discounts for the pastor’s kids to attend church camp or church bookstore discounts, to be an “automatic excess benefit” that may trigger the excise tax on excess benefit transactions, regardless of the amount of the benefit, unless the benefit was timely reported as taxable income by either the recipient or the employer.
7. Housing allowances
Can a church that adopts an informal retirement plan for a retired pastor designate some or all of the payments made under the plan as a housing allowance?
This question is addressed in Revenue Ruling 72-249. The IRS concluded that payments made to a retired minister under an informal retirement agreement are nontaxable.
However, payments made by the church to the pastor’s widow following his death, were taxable.
The background:
Shortly before a pastor retired, the governing body of the church he pastored authorized a monthly payment upon his retirement. These payments were to continue until his death, with survivor benefits for his wife. The authorization designated a portion of the payment as a rental allowance.
The wife was not a minister of the gospel, and she did not perform any services for the church.
The IRS concluded:
Until his death, and to the extent used to provide a home, the rental allowance paid to the retired minister was excludable from his gross income since it was paid as part of his compensation for past services and it was paid pursuant to official action of his church.
However, the rental allowance exclusion does not apply to amounts paid to his widow since it does not represent compensation for services performed by her as a minister of the gospel.
This ruling suggests that local churches can designate housing allowances out of retirement distributions paid to a retired minister under a church-sponsored plan.
But a church cannot designate a housing allowance out of funds distributed to a deceased pastor’s widow unless he or she is a minister and the distributions constitute payment for ministerial services.
Housing allowances are always a hot topic for those visiting Church Law & Tax! Give this Recommended Reading list a scan for more on housing allowance basics.
