Swaringer v. Commissioner, T.C. Summary Opinion 2001-37 (2001)
Background. A recent Tax Court decision addresses the correct reporting of minister compensation as well as the substantiation requirements for business expenses. There is much in this decision that will be instructive for church treasurers. This article will review the facts of the case, summarize the court’s ruling, and then address the relevance of the case to church treasurers.
Facts. A pastor reported $28,000 as income from his church in 1995. The IRS audited the pastor’s tax return and concluded that he understated his taxable income by $24,000 and overstated several business expense deductions. The pastor insisted that the $24,000 of unreported income came from voluntary “gifts” or offerings from members of the congregation, which were not taxable. The IRS rejected this argument, and the pastor appealed to the Tax Court.
The Court’s ruling. The court’s ruling is summarized below.
Understatement of income
The pastor reported $28,000 of income from his church on Schedule C. The IRS claimed that the pastor in fact earned an additional $24,000 from the church. It came up with this amount by performing a “bank deposits analysis” to verify the pastor’s church income. This analysis showed that the pastor made bank deposits of $94,000 in 1995. After subtracting the pastor’s reported church income ($28,000), his wife’s salary, and various other known sources of income, there was a remaining balance of $24,000 that could not be accounted for. The IRS claimed that this entire amount represented additional but unreported income the pastor had received from his church.
The pastor insisted that the $24,000 in unexplained bank deposits reflected nontaxable gifts from parishioners of the church. According to the pastor, on occasions such as his birthday, Father’s Day, and Christmas, parishioners would give him money as gifts.
The court agreed with the IRS that these “gifts” represented taxable income to the pastor. It observed, that section 102(a) of the tax code specifies that taxable income does not include “the value of property acquired by gift.” However, the court noted that neither the tax code nor the regulations define a gift for the purposes of section 102.
The court quoted from a landmark decision by the United States Supreme Court addressing the issue of whether a large amount of money given to a retiring church treasurer was taxable compensation for services rendered, or a tax-free gift:
A gift in the statutory sense … proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses. And in this regard, the most critical consideration … is the transferor’s intention …. The donor’s characterization of his action is not determinative—there must be an objective inquiry as to whether what is called a gift amounts to it in reality. It scarcely needs adding that the parties’ expectations or hopes as to the tax treatment of their conduct … [has] nothing to do with the matter …. The proper criterion … is one that inquires what the basic reason for … [the donor’s] conduct was in fact—the dominant reason that explains his action in making the transfer.
The court stressed that the pastor had the burden of proving that the amounts given to him by members of his congregation were nontaxable gifts rather than additional compensation for services rendered. The court concluded that the pastor failed to do so. It concluded,
The fundamental problem with [the pastor’s] case is that we have no evidence as to the dominant reason for the transfers. Instead, all we have is his characterization of the transfers as gifts, which in itself has little or no evidentiary value. On the other hand, the evidence that we do have strongly suggests that the transfers were not gifts within the meaning of section 102(a). The transfers arose out of the pastor’s relationship with the members of his congregation presumably because they believed he was a good minister and they wanted to reward him. Furthermore, the pastor testified that without the gifts his activity as a minister was essentially a money losing activity. In short, as the pastor recognized, the so-called gifts were a part of the compensation he received for being a minister. As such, the transfers are not excludable from income under section 102(a).
Overstated business expenses
The IRS claimed that the pastor overstated his business expense deductions by $19,000. The Tax Court agreed. It noted that (1) the tax code allows deductions for ordinary and necessary expenses paid or incurred in carrying on a trade or business; (2) taxpayers have the burden of establishing that such expenses were paid or incurred; and (3) taxpayers must maintain specific records concerning certain types of expenses. With these principles in mind the court addressed the pastor’s business expenses.
(1) Car expenses
The pastor claimed a deduction of $9,300 for car expenses. The IRS disallowed $8,000 of this amount. The pastor claimed that the deduction was based on the number of miles he drove in connection with the ministry. The court pointed out that to properly substantiate a deduction for the business use of a car, a taxpayer must have records to prove “the amount of the business use and total use of the automobile, the time of the use of the automobile, and the business purpose for the use. [Taxpayers] must maintain adequate records such as a log, diary, or trip sheet.”
The pastor’s records consisted of a document prepared by his secretary after the end of the year that contained headings as to the date of travel, the place of travel, the general purpose of the travel, and the mileage. But the court concluded that there were several “problems” with the information contained in this document:
It contains [the pastor’s] transportation to and from his residence and his place of business which represents personal commuting and not deductible expenses. It also contains a trip to Los Angeles, California, that the pastor admits was erroneous. There are trips listed for which the stated mileage is obviously wrong. Furthermore, the reasons stated for the travel lack any specificity. In short, we do not find that the pastor’s records satisfy the [substantiation] requirements ….
The court noted that the pastor’s records stated that the reason for many of his trips was to attend a “conference” without any description of the nature of the conference.
(2) Travel and meals
The pastor claimed deductions of $2,100 for travel and $1,500 for meals. The IRS allowed only $650 for travel and $500 for meals. The court noted that the tax code requires that travel expenses be substantiated “by evidence establishing the amount of the expense, the business purpose for the travel, and the time and place of the travel.” It concluded that the pastor “introduced no receipts or other evidence to show the amounts paid or the business purpose of the travel. With respect to the meals, he contends that he is entitled to use the so-called per diem substantiation. But, to use the per diem method in lieu of strict substantiation, a taxpayer still must substantiate the elements of time, place, and business purpose of the travel expenses …. As we have noted, [the pastor has] not satisfied this requirement.”
The pastor claimed a deduction of $2,000 for utilities which the IRS disallowed in full. The court agreed, “As we understand, the deduction claimed was for telephone expenses incurred on [the pastor’s] home telephone. He has no records substantiating these expenditures as expenses incurred in his trade or business. He apparently did not keep the monthly telephone statements. He could have, but did not, obtain copies of statements from the telephone company. In addition, the cost of basic local telephone service with respect to the first telephone line is a personal expense and is not deductible. We sustain [the IRS’s] disallowance of the deduction.”
(4) Robes and dry cleaning
The pastor claimed a deduction of $4,900 for robes and dry cleaning. He insisted that he was required to wear business suits that he would not otherwise have worn because of the nature of his employment. The IRS disallowed this deduction, and the court agreed. It concluded, “But, even if this were correct, the cost of clothing is only deductible if the clothing is of a type specifically required as a condition of employment and is not adaptable as ordinary clothing. This rule also applies to the maintenance of such clothing. There is no indication in the record that the amounts disallowed were for clothing that could not be worn in an ordinary way.”
Section 6662 of the tax code permits the IRS to assess a penalty against a taxpayer whose underpayment of taxes is due to negligence or a disregard of tax law. This penalty is computed by multiplying 20 percent times the amount of the underpayment of taxes that is due to negligence or disregard. “Negligence” includes (1) a failure to make a reasonable attempt to comply with the tax law; (2) a failure to exercise reasonable care in the preparation of a tax return; or (3) a failure to keep adequate records or to substantiate items properly. The term “disregard” includes any careless, reckless, or intentional disregard of federal tax law. The IRS assessed this penalty against the pastor on the ground that omitting the church members’ “gifts” from his income, and the excessive deductions he claimed, were both negligent. The Tax Court agreed that the penalty was appropriate,
Negligence is a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances. The question then is whether [the pastor’s] conduct meets the reasonably prudent person standard. We do not believe that the pastor’s conduct meets this standard. The law surrounding the disputed items is not complex. With respect to the claimed deductions, the pastor was required to maintain records, which he failed to do. Furthermore, there is no indication that he sought the advice of a qualified tax advisor concerning any of the disputed items.
Relevance to church treasurers
There are many aspects of this case that are directly relevant to church treasurers. Consider the following:
1. “Love gifts” usually are taxable. This case demonstrates that “love gifts” made by members of the congregation to their pastor usually will constitute taxable income to the pastor. Of course, direct “person-to-person” gifts made privately by church members directly to their pastor ordinarily will be nontaxable, especially if they are small. For example, a $20 bill that a family encloses with a Christmas card sent to their pastor would be a nontaxable gift. But when the church becomes involved, it is far more difficult to treat members’ “gifts” to a pastor as nontaxable. In this case, the court concluded that the members’ gifts (on special occasions, such as the pastor’s birthday, Father’s Day, and Christmas) amounted to taxable compensation for services rendered rather than tax-free gifts, since (1) the transfers arose out of the pastor’s relationship with the members of his congregation, and were presumably made by members who believed he was a good minister and who wanted to “reward” him for a job well done; (2) without the gifts the pastor’s ministry at the church “was essentially a money losing activity.” That is, the pastor’s church salary was so low that church leaders must have regarded members’ “gifts” as additional compensation for his services.
Key point. Since the members’ “gifts” were taxable income to the pastor, it is possible that they could claim their gifts as charitable contributions.
2. Substantiating the business use of a car. The Tax Court agreed that the pastor could deduct only $1,300 of the $9,300 in car expenses that he deducted on his tax return. The court concluded that the pastor failed to properly substantiate the remaining $8,000 of car expenses that he claimed. In order for ministers or other church staff to use the standard mileage rate to claim a deduction for the business use of their car, they must maintain records showing “the amount of the business use and total use of the automobile, the time of the use of the automobile, and the business purpose for the use. [Taxpayers] must maintain adequate records such as a log, diary, or trip sheet.” The pastor’s records did not meet these requirements for the following reasons: (1) commuting miles were treated as business miles (commuting miles always are considered “personal” rather than business-related by the IRS); (2) mileage for some business trips was obviously wrong; and (3) some trips lacked a sufficient description of their business purpose.
Key point. The court concluded that references to “conferences” as the purpose for a trip did not provide sufficient information to treat the miles as a business expense. Church treasurers who reimburse their pastor’s business use of a car should keep this in mind. There must be sufficient specificity in the pastor’s log, diary, or trip sheet to demonstrate the business purpose of each trip. Not much is needed to satisfy this test, but a single word such as “conference” may not be enough.
Key point. Most churches have adopted an accountable business expense reimbursement arrangement. Under such an arrangement, churches only reimburse those employee business expenses that are adequately substantiated. If you have an accountable reimbursement arrangement, take time to educate staff members who use their cars in the performance of their duties about the degree of specificity required to obtain a reimbursement of car expenses.
3. Per diem expenses. Some churches use “per diem” (daily) rates to reimburse staff members’ travel expenses on out-of-town, overnight trips. As the court pointed out, the per diem rates only can be used to substantiate the amount of travel expenses. Staff members must substantiate the date, place, and business purpose of each expense.
4. Clothing. The court ruled that the pastor could not deduct the cost of purchasing or cleaning the clothing he wore in performing his ministerial duties. Pastors can deduct the cost of clothing (including cleaning expenses) used in their ministry only if the clothing (1) is of a type specifically required as a condition of employment, and (2) is not adaptable to general use (it could take the place of ordinary clothing). The ordinary business suits that the pastor wore in this case were perfectly adaptable to general use, and therefore could not be claimed as a business expense.
5. Penalty. The court imposed a negligence penalty on the pastor on the ground that the tax issues in this case were “not complex.”
6. Self-employed. The IRS “conceded” that the pastor was self-employed for income tax reporting purposes. While most ministers are employees for income tax reporting purposes, cases such as this demonstrate that this is not true in all cases.
7. Summary opinion. The court’s decision was a “summary opinion,” meaning that it could not be appealed and cannot serve as precedent in other cases. Despite these limitations, most tax professionals view such cases as reflecting the position of the Tax Court.
This content originally appeared in Church Treasurer Alert, May 2001.