Background. Congress enacted four major tax laws in August. It is essential for church treasurers to be familiar with a number of key provisions in these laws that will have a direct impact on church finances and reporting. This article contains a summary of the eight provisions of most importance to church treasurers.
#1—Liability of board members for noncompliance with payroll tax requirements. The IRS can assess a 100 percent penalty against corporate officers who willfully fail to withhold federal taxes from employees’ wages or who fail to pay over withheld taxes to the government. This law has been applied to church board members and treasurers. A new law clarifies that this penalty is not to be imposed on volunteer, unpaid members of any board of a tax-exempt organization to the extent such members are solely serving in an honorary capacity, do not participate in the day-to-day or financial activities of the organization, and do not have actual knowledge of the failure. However, this provision cannot operate in such a way as to eliminate all responsible persons from responsibility.
The new law also requires the IRS to develop materials to better inform board members of tax-exempt organizations (including voluntary or honorary members) that they may be subject to this penalty. The IRS is required to make such materials routinely available to tax-exempt organizations.
Example. Bill serves as treasurer of his church. Due to financial difficulties, a decision is made by the pastor to use withheld payroll taxes to pay other debts. The IRS later asserts that the church owes $25,000 in unpaid payroll taxes. The church has no means of paying this debt. The IRS later insists that Bill and the other members of the church board are personally liable for the debt. It is likely that Bill is a responsible person who may be liable for the 100 percent penalty since he has authority over the day-to-day financial activities of the church. The new law will not protect him. However, the new law will protect those members of the church board who (1) are volunteer, unpaid members; (2) serve solely in an honorary capacity; (3) do not participate in the day-to-day or financial activities of the organization; and (4) do not have actual knowledge of the failure to pay over withheld taxes to the government.
Example. A church board votes to use withheld taxes to pay other debts of the church. Over a three year period the church fails to deposit $100,000 in withheld taxes. The IRS claims that the board members are personally liable for the 100 percent penalty for failing to deposit withheld taxes. All of the members of the board claim they are protected by the provisions of the new law. They are not correct, since the new law specifies that its provisions cannot operate in such a way as to eliminate all responsible persons from responsibility.
#2—Interim sanctions. The so-called “Taxpayer Bill of Rights 2,” signed into law by the president in August of 1996, contains a provision allowing the IRS to assess “intermediate sanctions” (an excise tax) against exempt organizations in lieu of outright revocation of exempt status. The intermediate sanctions may be assessed only in cases of “excess benefit transactions,” meaning one or more transactions that provide unreasonable compensation to an officer or director of the exempt organization. An excess benefit transaction is defined as:
- any transaction in which an economic benefit is provided to a “disqualified person” (someone in a position to exercise substantial influence over the affairs of the organization) if the value of the benefit exceeds the value of the services provided by the disqualified person, or
- to the extent provided in IRS regulations (to be released later), any transaction in which the amount of an economic benefit provided to a disqualified person is based on the revenues of the organization, if the transaction results in unreasonable compensation being paid
A committee report to the new law clarifies that the parties to a transaction are entitled to rely on a presumption of reasonableness with respect to a compensation arrangement with a disqualified person if such arrangement was approved by a board of directors (or committee of the board) that: (1) was composed entirely of individuals unrelated to and not subject to the control of the disqualified person involved in the arrangement; (2) obtained and relied upon objective “comparability” information, such as (a) compensation paid by similar organizations, both taxable and tax-exempt, for comparable positions, (b) independent compensation surveys by nationally recognized independent firms, or (c) actual written offers from similar institutions competing for the services of the disqualified person; and (3) adequately documented the basis for its decision.
Key point. A disqualified person who benefits from an excess benefit transaction is subject to a penalty tax equal to 25 percent of the amount of the excess benefit. An exempt organization’s managers who participate in an excess benefit transaction knowing that it is an improper transaction are subject to a penalty tax of 10 percent of the amount of the excess benefit (up to a maximum penalty of $10,000). It is possible that the IRS will assess this penalty against church board members who participate in an excess benefit transaction involving a pastor or other church employee.
This provision generally applies to excess benefit transactions occurring on or after September 14, 1995.
#3—Including telephone numbers on 1099 forms. All 1099 forms issued after December 31, 1996, must contain the name, address, and telephone number of a “contact person” who can answer questions the recipient may have about the form. The purpose of this new requirement is to give recipients of 1099 forms the ability to contact a person who was responsible for preparing the form and who presumably has the ability to answer any questions the recipient may have.
Key point. For many churches, the “contact person” will be the church treasurer. This means that all 1099 forms issued by the church must contain the name, address, and telephone number of the treasurer. In other churches, the contact person will be a business administrator.
#4—Increase in the federal minimum wage. The minimum wage increased to $4.75 on October 1, 1996, and increases to $5.15 on October 1, 1997. Church treasurers often ask if the minimum wage law applies to churches. That depends. Any worker employed in an “enterprise engaged in commerce” must be paid the minimum wage, with certain exceptions. The law specifically includes schools and preschools in the definition of an enterprise engaged in commerce, and so a worker employed by a church-operated school or preschool should be paid the minimum wage. It is also likely that the government would claim that churches engaged in commercial or business activities, or that engage in significant interstate sales or purchases, must pay the minimum wage.
Key point. Employers are not required to pay the minimum wage to “any employee employed in a bona fide executive, administrative, or professional capacity” if income tests are met. The definitions of these terms are complex, and should not be relied upon without the assistance of legal counsel.
Example. A church operates a preschool, and employs a director and nine workers. The church must pay the nine workers the minimum wage (currently $4.75 per hour). It is possible that the director would qualify as a professional employee. If so, the church would not be required to pay the minimum wage to this person.
#5—Treating workers as self-employed. Churches, like any employer, face substantial penalties if they classify workers as “self-employed” and the IRS later reclassifies those workers as employees.
Example. A church employs three part-time custodians. Each custodian works twenty hours per week. For the past ten years the church has treated these workers as self-employed, and as a result does not withhold taxes from their pay and issues them a 1099 each year. The IRS reclassifies these workers as employees. The church is now subject to a number of possible penalties, including: (1) liability for the full amount of income taxes and FICA taxes not withheld from these workers’ wages; (2) an additional penalty of 1.5% of each worker’s wages, for failure to withhold income taxes; and (3) an additional penalty of 20% of each worker’s share of FICA taxes, for failure to withhold FICA taxes. The cumulative effect of these penalties can be substantial.
Imposing penalties on employers for improperly classifying workers as self-employed is viewed by many as unfair, since the definitions of the terms “employee” and “self-employed” are so vague. In 1978, Congress agreed and enacted a law exempting employers from penalties associated with the classification of workers as self-employed if they have a reasonable basis for doing so based on (1) published IRS rulings or court decisions; (2) past IRS audit practice with respect to the employer; (3) a long-standing recognized practice of a significant segment of the industry in which the worker is engaged; or (4) any other reasonable basis for treating a worker as self-employed. Over the years, the IRS interpreted this provision very narrowly, causing many employers to be ineligible for the relief from penalties that Congress so clearly intended. One of the tax laws enacted by Congress this past summer reaffirms the protections of the 1978 law, and adds a number of provisions making it more likely that employers will receive the relief intended. Here are some of the key provisions:
- The new law clarifies that a “long-standing recognized practice” shall not be construed “as requiring the practice to have continued for more than ten years.” The IRS had said that the practice must have existed for at least ten years.
- The new law clarifies that “in no event shall the significant segment requirement … be construed to require a reasonable showing of the practice of more than 25 percent of the industry.” The IRS had said that at least 50 percent was required.
- The new law specifies that if an employer establishes a “prima facie case” that it was reasonable to treat a worker as self-employed on the basis of precedent (IRS or court rulings), prior audit practice, or a long-standing practice of a significant industry segment, then the burden of proof shifts to the IRS to prove that the worker is an employee.
- If an employer changes its treatment of workers from self-employed to employees for employment tax purposes, such a change cannot be considered in evaluating whether or not the workers were employees or self-employed for prior years.
- The IRS must, at or before the commencement of an audit involving worker classification issues, provide the employer with written notice of the protections of the 1978 law.
Example. Same facts as the previous example. How will the new law help protect the church from penalties the IRS may attempt to impose as a result of the church’s improper classification of the custodians as self-employed? The church can argue that it is exempt from any penalties because it had a “reasonable basis” for treating its custodians as self-employed. One way for the church to establish a reasonable basis is to prove that its treatment of the custodians as self-employed was based on a “long-standing recognized practice” of a “significant segment of the industry” in which the custodians are engaged. Under the new law, it will be easier for the church to prove these elements. Since it has treated the custodians as self-employed for ten years, it meets the “long-standing recognized practice” requirement. And, in meeting the “significant segment of the industry” test the church will not be required to establish that more than 25 percent of churches (not 50 percent, as had been required by the IRS) treat part-time custodians as self-employed. Note that the 25 percent rule is the maximum, and that a church could argue that the treatment of part-time custodians as self-employed represents the practice of a significant industry segment even if less than 25 percent of churches treat part-time custodians as self-employed. The church should also insist that it has met the “prima facie case” requirement under the new law, which shifts the “burden of proof” to the IRS to prove that the custodians are not self-employed.
Key point. The law requires that all tax forms filed by the employer (1099, 941, etc.) since 1978 must be consistent with self-employed status of the worker. In other words, if a church has treated a worker as self-employed, then it must have issued the worker 1099 forms rather than W-2 forms since 1978 (or since the worker was employed, if later).
#6—New definition of “highly compensated employee.” One of the new tax laws enacted by Congress simplifies the definition of the term “highly compensated employee.” This is a very important provision for church treasurers, because it will determine whether certain fringe benefits provided to church employees are taxable or tax-free. Church treasurers need to know this in order to correctly complete W-2 and 941 forms. The key point is this—certain fringe benefits that “discriminate” in favor of a highly compensated employee are taxable to that employee, even if they otherwise would be nontaxable. The most common examples of these fringe benefits for church workers include cafeteria plans, flexible spending arrangements, qualified tuition reductions, employer-provided educational assistance, and dependent care assistance.
For the past several years there have been two problems associated with the definition of the term “highly compensated employee.” First, the definition has been so complicated that many church treasurers had difficulty applying it. Second, and perhaps even more importantly, the definition included the highest paid officer of a church or other employer no matter how little this person was paid. The new definition responds directly to both of these problems. First, it adopts a simple definition of a highly compensated employee—beginning in 1997 a highly compensated church employee is one who had compensation for the previous year in excess of $80,000 (and, if an employer elects, was in the top 20 percent of employees by compensation). The $80,000 figure will be adjusted each year for inflation.
Example. A church operates a private school, and charges annual tuition of $2,000. In 1996, the senior pastor (who also serves as the president of the school) is allowed to send his daughter to the school without charge. The senior pastor’s total compensation for 1996 is $35,000. The church provides no tuition reductions to other school or church employees. The “tuition reduction” granted to the senior pastor ($2,000) is discriminatory, and so the entire amount must be reported as income on the pastor’s W-2. This is because the benefit discriminates in favor of the pastor, who meets the definition of a highly compensated employee (even though he earns only $35,000 for the year) because he is the highest paid officer of the school.
Example. Same facts as the previous example, except that the year is 1997. The new definition of a highly compensated employee takes effect in 1997, and under this definition the pastor is not a highly compensated employee since he earns less than $80,000. The fact that he is the highest paid officer (regardless of the amount of his compensation) no longer makes him a highly compensated employee.
#7—Delay in implementing electronic deposit of payroll taxes. Some church treasurers are still not aware that they soon may be required to deposit payroll taxes electronically. Under the Electronic Federal Tax Payment System (EFTPS), employers that deposited at least $50,000 in payroll taxes in 1995 must enroll with a private contractor hired by the IRS and begin making deposits of payroll taxes either by telephone or by computer beginning on January 1, 1997. One of the tax laws recently enacted by Congress postpones the January 1, 1997 deadline for six months. As a result, churches and other employers have until July 1, 1997 to begin depositing payroll taxes electronically—if they made payroll tax deposits of at least $50,000 in 1995.
Example. A church had 6 employees in 1995, with a total payroll of $130,000, and deposited $23,000 in payroll taxes. It is not required to deposit payroll taxes electronically in 1997.
Example. A church had 15 employees in 1995, with a total payroll of $320,000, and deposited $62,000 in payroll taxes. It is required to begin depositing payroll taxes electronically in 1997 as of July 1 of that year.
Example. A church had 6 employees in 1995, with a total payroll of $130,000, and deposited $23,000 in payroll taxes. In 1997 it has 10 employees and expects to deposit more than $50,000 in payroll taxes. It is not required to deposit payroll taxes electronically in 1997 since it did not deposit more than $50,000 in payroll taxes in 1995.
Key point. Future issues of this newsletter will discuss the new electronic filing requirements in more detail.
#8—Medical savings accounts (MSAs). Beginning in 1997, some workers will be allowed to open medical savings accounts (MSAs) as a means of paying for certain health expenses. An MSA will look a lot like an IRA—a worker will be able to make tax-deductible contributions to his or her account, an employer can make nontaxable contributions, and any interest earned by the account is tax-deferred. Funds can be distributed tax-free from an MSA only to pay medical expenses.
MSAs will not be available to everyone. There were many in Congress who were opposed to the idea of “incentivizing” taxpayers to reduce medical spending by allowing them to pay for some medical expenses out of their own funds. A compromise was reached that allows MSAs only during a trial period (from 1997 to 2000); allows no more than 750,000 MSAs; and restricts MSAs to workers who are covered under an employer-sponsored “high deductible” medical plan of a “small employer” (having fewer than 50 employees during either of the two preceding years), or who are self-employed. A “high deductible” plan is a health insurance plan with a deductible of at least $1,500 in the case of single coverage and $3,000 in the case of coverage of more than one individual.
There are limits on the amounts that employees and employers can contribute to an MSA. The maximum annual contribution that can be made to an MSA is 65 percent of the deductible under the high deductible plan in the case of individual coverage and 75 percent of the deductible in the case of family coverage. Contributions for a year can be made until the due date for the individual’s tax return for the year (determined without regard to extensions).
As MSAs receive more attention in early 1997, it is likely that many church employees will be asking their church treasurer for information concerning these accounts and their availability to church workers.
Example. A church has 8 employees, and offers a health insurance plan provided through commercial insurance with a deductible of $500 in the case of single coverage and $1,000 in the case of family coverage. None of the church employees is eligible for an MSA. While they are employed by a small employer (fewer than 50 employees), they are not participating in a “high deductible health plan.”
This article originally appeared in Church Treasurer Alert, October 1996.