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.