Tax Changes of Interest to Churches

Changes churches should know.

1. Increase in wages subject to FICA tax. The FICA tax rate (7.65% for both employers and employees, or a combined tax of 15.3%) did not change in 1995. However, the amount of earnings subject to tax increased. The 7.65% tax rate is comprised of two components: (1) a Medicare hospital insurance (HI) tax of 1.45%, and (2) an “old—age, survivor and disability” (OASDI) tax of 6.2%. For 1995 and future years there is no maximum amount of wages subject to the Medicare hospital insurance (the 1.45% “HI” tax rate). The tax is imposed on all wages regardless of amount. For 1995, the maximum wages subject to the “old—age, survivor and disability” (OASDI) portion of self—employment taxes (the 6.2% amount) increases to $61,200—up from $61,200 in 1994. Stated differently, employees who receive wages in excess of $61,200 in 1995 will pay the full 7.65% tax rate for wages up to $61,200, and the “HI” tax rate of 1.45% on all earnings above $60,000. Employers pay an identical amount. The new rule will impact churches and other religious organizations that have nonminister employees receiving wages in excess of $61,200. Such employers must be certain to properly withhold the Medicare tax in order to avoid any penalties.

2. IRS issues regulations clarifying the new charitable contribution substantiation rules. The IRS issued regulations in 1995 that clarify a few questions that have arisen in applying the new charitable contribution substantiation rules. The new regulations address the following matters:

Out—of—pocket expenses. Let’s say that Greg, a member of First Church, participates in a short—term missions project and in the process incurs $300 of unreimbursed out—of—pocket travel expenses. The IRS has long acknowledged that such expenses are deductible as a charitable contribution. But what about the new rules for substantiating charitable contributions of $250 or more? Do they apply to this kind of contribution? Is the church responsible for keeping track of Greg’s travel expenses in order to determine if they are $250 or more? The proposed regulations address this common problem. The IRS acknowledged that a charity “typically has no knowledge of the amount of out—of—pocket expenditures incurred by a taxpayer, and therefore, would have difficulty providing taxpayers with substantiation of unreimbursed expenditures.” To address this concern, the proposed regulations provide that where a taxpayer incurs unreimbursed expenses in the course of performing services for a charitable organization, the expenses may be substantiated by the donor’s normal records and an “abbreviated written acknowledgment” provided by the charitable organization. This “abbreviated written acknowledgment” from the charity must contain (1) a description of the services provided by the donor, (2) the date the services were provided, (3) whether or not the donee organization provided any goods or services in return and, (4) if the donee organization provided any goods or services, a description and good faith estimate of the fair market value of those goods or services.

In addition, the abbreviated written acknowledgment must be received by the taxpayer before the earlier of (1) the date he or she files a tax return claiming the contribution deduction, or (2) the due date (including extensions) for the tax return for that year.

Good faith estimate of value. To substantiate a individual charitable contribution of $250 or more, a donor must obtain a receipt from the charity that satisfies a number of requirements. One requirement is that the receipt state whether or not the charity provided any goods or services in exchange for a contribution of $250 or more (other than intangible religious benefits), and if so, a description and good faith estimate of the value of those goods and services. The regulations define a good faith estimate as an estimate of the fair market value of the goods or services provided by a charity in consideration of a donor’s contribution. The fair market value of goods or services may differ from their cost to the charity. The charity may use any reasonable method that it applies in good faith in making the good faith estimate. However, a taxpayer is not required to determine how the charity made the estimate.

Reliance on a charity’s estimate of value. The proposed regulations specify that a taxpayer generally may treat an estimate of the value of goods or services as the fair market value for purposes of computing a charitable contribution deduction if the estimate is in a receipt issued by the charity. For example, if a charity provides a book in exchange for a $100 payment, and the book is sold at retail prices ranging from $18 to $25, the taxpayer may rely on any estimate of the charity that is within the $18 to $25 range (the charitable contribution deduction is limited to the amount by which the $100 donation exceeds the fair market value of the book that is provided to the donor). However, a taxpayer may not treat an estimate as the fair market value of the goods or services if the taxpayer knows, or has reason to know, that such treatment is unreasonable. For example, if the taxpayer is a dealer in the type of goods or services it receives from a charity or if the goods or services are readily valued, it is unreasonable for the taxpayer to treat the charity’s estimate as the fair market value of the goods or services if that estimate is in error and the taxpayer knows, or has reason to know, the fair market value of the goods or services.

Intangible religious benefits. The regulations clarify that if a charity provides not goods or services to a donor in consideration for a contribution of $250 or more, other than intangible religious benefits, the receipt it issues to the donor must contain a statement that effect. This is an important point for church leaders to comprehend. Most churches will provide donors (of individual contributions of $250 or more) with no goods or services other than intangible religious benefits. The regulations remind religious organization’s that the receipts they issue to donors who make one or more individual contributions of $250 must state that no goods or services were provided to the donor other than intangible religious benefits.

Membership benefits. Under current law, a taxpayer who receives membership benefits in return for a payment to a charitable organization may not claim a charitable contribution deduction for more than the amount by which the payment exceeds the fair market value of the membership benefits. Accordingly, taxpayers and donee organizations must determine the fair market value of any membership benefits the charity provides to its donors. It is often difficult to value membership benefits, especially rights or privileges that are not limited as to use, such as free or discounted admission or parking, and gift shop discounts. In the new regulations the IRS recognized the difficulty charities often have in valuing benefits provided to members, and concluded that it is appropriate to provide limited relief with respect to certain types of customary membership Benefits. The regulations provide that both the charity and the donor may disregard membership benefits provided in return for a payment to the organization in calculating the value of a charitable contribution, if the benefits meet either of the following 2 tests:

(1) The benefits have an insubstantial value under existing IRS guidelines. Insubstantial value means that the benefits provided by the charity consist of low cost articles (items costing $6.60 or less for 1995), newsletters that are not commercial quality publications, and benefits worth 2% or less of a payment, up to a maximum of $66 for 1995.

(2) The benefits are given as part of an annual membership offered in return for a payment of $75 or less and fall into one of the following two categories: (i) Admission to events that are open only to members and for which the charity reasonably projects that the cost per person (excluding allocable overhead) for each event will be less than or equal to $6.60 in 1995. An example is a modest reception where light refreshments are served to members of a charity before an event. (ii) Rights or privileges that members can exercise frequently during the membership period. An example is free admission to a museum.

3. IRS provides some relief in complying with the new charitable contribution substantiation rules. Under a new law that took effect in 1994, donors must substantiate individual contributions of $250 or more with a receipt that satisfies a number of new requirements (discussed fully in chapter 8). Unfortunately, many charities have failed to provide receipts for 1994 contributions that comply fully with the new requirements. The result—the deductibility of millions of dollars in donations has been jeopardized. The IRS recently responded to this crisis by issuing a public notice informing taxpayers that they can still claim deductions for charitable contributions of $250 or more on their 1994 returns if they make a “good faith effort” on or before October 16, 1995 to obtain the required written receipt from the charity. The IRS noted that a “good faith effort” would include sending a letter to the charity requesting a receipt that complies with the new rules.

4. The IRS expresses concern over widespread failure by donors to properly substantiate their contributions of noncash property to charity. The IRS continues to express concern over the widespread lack of compliance with the substantiation requirements that apply to charitable contributions of noncash property valued by the donor at $500 or more (note that these rules are in addition to the new substantiation rules that took effect on January 1, 1994, as noted above). Any donor who contributes noncash property (i.e., homes, land, vehicles, equipment, jewelry) to a church or other charity, and who claims a deduction of $500 or more, must complete IRS Form 8283 and enclose it with the Form 1040 on which the deduction is claimed. If property valued at more than $5,000 is donated, then additional requirements apply. The donor must obtain a qualified appraisal and enclose an appraisal summary with the Form 1040 on which the deduction is claimed. These important requirements are discussed fully in chapter 8. Church treasurers should be familiar with these rules.

5. The Tax Court ruled that a taxpayer who sent contributions to a mosque in his family’s home town in Iran was not entitled to a charitable contribution deduction. Federal law specifies that a charitable contribution, to be tax—deductible, must go to an organization “created or organized in the United States or in any possession thereof.” In addition, the organization must be organized and operated exclusively for religious or other charitable purposes. This means that contributions made directly by church members to a foreign church or ministry are not tax—deductible in this country. Alisobhani v. Commissioner, T.C. Memo. 1994—629 (1994).

6. The IRS ruled that persons who give property to charity are eligible for a charitable contribution deduction even though their “gift” may revert back to them under specified conditions. A deceased person left a will giving $50,000 to a school to establish a scholarship fund for needy students attending the school (to be selected by the school). The will specified that in the event the school “ceases to exist as a school or ceases to be accredited by the state” the balance in the fund would revert to the deceased’s heirs. The question was whether the deceased’s estate could claim a charitable contribution deduction for the scholarship gift despite the possibility that the fund could one day revert to the donor’s heirs. The IRS ruled that the estate was entitled to a charitable contribution deduction—because the likelihood that the school would “cease to exist” was so remote as to be negligible. The IRS noted that the tax regulations specify that “if an interest passes to charity at the time of a decedent’s death and the interest would be defeated by … some act or the happening of some event, the possibility of occurrence of which appears at the time of the decedent’s death to be so remote as to be negligible, the deduction is allowable.” The IRS also noted that the tax regulations contain an example in which a decedent dies leaving a will which donates land to a city government “for as long as the land is used by the city for a public park.” The example concludes that “a deduction is allowable if, on the date of the decedent’s death, the possibility that the city will not use the land for a public park is so remote as to be negligible.”

7. IRS software to address worker status. One of the most difficult and confusing tasks church treasurers face is classifying workers are either employees or self—employed. The correct classification is essential, for it determines whether the church should (1) withhold taxes; (2) issue the worker a W—2 or 1099 form; and (3) include the worker’s wages and taxes withheld on the church’s quarterly 941 forms. In addition, this classification will determine the availability of a number of tax—free fringe benefits (such as employer—paid medical insurance premiums and cafeteria plans, which are taxable fringe benefits to self—employed workers). Unfortunately, it is often difficult to classify some kinds of church workers. Examples include part—time child care workers, musicians, custodians, and yard maintenance workers. Help may soon be on the way. The IRS has announced that it soon will be releasing computer software to assist employers in classifying a worker as either an employee or self—employed. The software (which the IRS calls the “SS—8 Determiner”) is based on the IRS 20—factor test. [See also Clergy Status—Employee or Self-employed.]

8. 403(b) retirement plans receive more scrutiny. One of the more popular retirement programs for employees of nonprofit organizations (including many churches) is the tax—sheltered annuity authorized by section 403(b) of the federal tax law. The IRS has expressed concern in recent months over the failure of many of these programs to comply with complex legal requirements. One IRS spokesman said recently that “we have made no secret of the fact that the IRS has yet to find a 403(b) plan fully in compliance,”and that the overall noncompliance rate may be as high as 90%! The IRS will be announcing a “voluntary correction program” in the near future under which nonprofit organizations can pay reduced fines in return for voluntarily correcting certain errors in their plans. One of the main areas of noncompliance for churches is excessive contributions (a church contributes more to a 403(b) on behalf of a pastor or other church employee than is permitted by law). Another problem—churches that permit self—employed workers to participate. These plans are available only to employees.

9. IRS says relief to specific bomb victims not deductible. The IRS has issued a public notice in response to many questions it has received concerning relief for the victims of the Oklahoma City bombing. Contributions to exempt organizations that are “earmarked for Oklahoma City federal building bomb attack relief” are tax—deductible. Not so for contributions that are “earmarked for relief of any particular individual or family.” What’s the difference? To be tax—deductible, a contribution must go to a charity and not directly to an individual. Contributions to a charity that “earmark” a specific person or family ordinarily are deemed to be gifts to the individuals and not to the charity. IRS Notice 95—33.

10. 1099 forms and church fund—raising programs. Many churches conduct sales of merchandise to raise funds for various programs and activities. Examples include bake sales, auctions, and bazaars. Should a church issue a 1099—MISC form to persons who purchase items at such events? No, said the IRS in a recent ruling. Charities that sell items in the course of fund—raising events need not issue 1099 forms to purchasers since no compensation is being paid to them. Form 1099—MISC is issued to non—employees who are paid compensation of $600 or more during the year. IRS Letter Ruling 9517010.

11. Tax Court denies charitable contribution deduction to church member for unsubstantiated contributions. A taxpayer claimed cash contributions of $3,500 to her church. She was audited and the IRS denied any deduction for these contributions. The IRS claimed that the woman had insufficient evidence to substantiate the contributions. The taxpayer claimed that these contributions were all made in cash, and so she had no canceled checks to substantiate them. She also claimed that she kept no records or receipts to prove her contributions. The only evidence she had was a letter from her church stating that the taxpayer made contributions of $3,500 to the church during the year in question “through tithes, offerings, and love donations.” No church representative testified during the woman’s trial. The Tax Court agreed with the IRS that the woman had failed to substantiate the $3,500 in charitable contributions to her church. It dismissed the church’s letter by noting that “the letter from the church is very general and provides no information as to how and when [her] contributions were made. The evidence presented does not satisfy the court that [she] made the contributions to the church in the amount claimed.” The court was satisfied that the woman made some contributions to the church, and allowed her a deduction in the amount of $450. Generic letters that merely report the total amount of contributions given by a donor during the year will not be enough to substantiate the donor’s individual cash contributions of less than $250. The letter, or receipt, must list church’s name and the dates and amounts of each contribution. Additional rules apply to the substantiation of individual contributions of $250 or more. Witherspoon v. Commissioner, T.C. Memo. 1994—593.

12. Impact of tax simplification. A number of sweeping proposals for tax reform are being discussed in Congress. Some “flat tax” proposals would eliminate most deductions, including a deduction for charitable contributions, in exchange for a flat income tax rate. How would such a tax impact churches and other charities? Would donations decline because of the loss of a contribution deduction? Two factors suggest that they would not. First—71% of all taxpayers can’t deduct their contributions under present law, because they cannot itemize deductions on Schedule A. A “flat tax” that eliminated charitable contribution deductions would only affect the remaining 29% of taxpayers that currently can deduct their contributions. Second—when the partial deduction of charitable contributions by nonitemizers expired in 1986, there was no decrease in charitable giving. We will be closely following the debate in Congress over tax reform. If any new laws emerge, we will let you know the details in future editions of this text.

13. IRS rules that a religious organization’s sales of books by its founder did not generate unrelated business income. The IRS noted that the books offered for sale provided information on the doctrine and principles constituting the basis for the religious beliefs of the organization’s members. The IRS further noted that the federal tax on unrelated business income does not apply to income generated from activities that are substantially related to an exempt organization’s exempt purposes. It concluded: “You will offer for sale books written by your founder. The books offered for sale are intended to provide additional information about your religious doctrine and principles. The books will be used to educate your members and prospective members about the tenets of your religion. Therefore, the sale of books written by your founder will be substantially related to the accomplishment of your religious purposes … Accordingly, this activity will not constitute an unrelated trade or business.” IRS Letter Ruling 9535050. [ Tax on Unrelated Business Income]

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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