Background. It is a fairly common practice for a congregation to set aside a sum of money in a "discretionary fund" and give a minister the sole authority to distribute the money in the fund. In some cases, the minister has no instructions regarding permissible distributions. In other cases, the congregation establishes some guidelines, but these often are oral and ambiguous. Consider the following examples.
Example. A congregation at an annual business meeting authorizes the creation of a "pastor's fund" in the amount of $10,000, with the understanding that Rev. T, the congregation's senior minister, will have the authority to distribute the fund for any purpose. Rev. T is not required to account to the congregation or church board for any distribution, and he is not prohibited from making distributions to himself. During 1994, Rev. T distributes the entire fund to members of the congregation who were in need. He did not distribute any portion of the fund to himself or to any family member.
Example. Same facts as the previous example, except that Rev. T distributed $5,000 to himself in 1994.
Example. The governing board of First Church sets aside $5,000 in a discretionary fund, and authorizes Rev. D, its senior minister, to distribute the funds for "benevolent purposes." Rev. D is required to account to the church board for all distributions and is prohibited from making any distributions to himself or to any family member.
Many church treasurers are unaware of the potential tax consequences of these arrangements. The tax consequences of some of the more common arrangements are summarized in this article.
Situation 1. The congregation (or governing board) establishes a discretionary fund and gives a cleric full and unfettered discretion to distribute it.
To the extent the minister has the authority to distribute any portion of the discretionary fund for any purpose, including a distribution to him or herself, without any oversight or control by the governing board, then the following consequences ensue:
• The entire fund must be reported as taxable income to the minister in the year it is funded. This is so even if the minister in fact does not personally benefit from the fund. The mere fact that the minister could personally benefit from the fund is enough for the fund to constitute taxable income. The basis for this result is the "constructive receipt" rule, which is set forth in income tax regulation 1.451 2(a):
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. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.
For a discretionary fund to constitute taxable income to a minister, it is essential that the minister have the authority to "draw upon it at any time" for his or her own personal use. This means that the fund was established without any express prohibition against personal distributions.
• Donations by members of the congregation to the fund would not be tax-deductible as charitable contributions since the fund is not subject to the full control of the congregation or its governing board. For a charitable contribution to be tax-deductible, it must be subject to the full control of the church or other charity. The IRS stated the rule as follows in an important ruling: "The test in each case is whether the organization has full control of the donated funds, and discretion as to their use, so as to insure that they will be used to carry out its functions and purposes." If a church sets up a discretionary fund and authorizes a minister to make distributions from the fund for any purpose without any oversight or control by the church, this fundamental test is not met.
Situation 2.The congregation establishes a discretionary fund and gives a minister the discretion to distribute it for any purpose, but the congregation's governing board retains administrative control over the fund.
Under this scenario the fund would still constitute taxable income to the minister, but the donations of congregational members to the fund probably would be tax-deductible as charitable contributions since the congregational board exercises control over the funds. Board "control" could be established if the board simply reviewed all distributions to ensure consistency with the congregation's exempt purposes.
Situation 3.The congregation establishes a discretionary fund and gives a minister the discretion to distribute it only for specified purposes (such as relief of the needy) that are consistent with the congregation's exempt purposes. The minister does not qualify for distributions and in fact is prohibited from making distributions to him or herself. The congregation's governing board retains administrative control over the fund.
If a discretionary fund is set up by a resolution of a congregation's governing board that absolutely prohibits any distribution of the fund for the minister's personal use, then the constructive receipt rule is avoided and no portion of the fund represents taxable income to the minister. In the words of the income tax regulations, "income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions." Accordingly, in order to avoid the reporting of the entire discretionary fund as taxable income to the minister, it is essential that the fund be established by means of a congregational or board resolution that absolutely prohibits any use of the fund by the minister for personal purposes.
In order to provide a reasonable basis for assuring donors that their contributions to the fund are deductible, the following steps should be taken: (1) The board resolution should specify that the fund may be distributed by the minister only for needs or projects that are consistent with the congregation's exempt purposes (as set forth in the congregation's charter); and (2) the congregational board must exercise control over the funds. As noted above, board "control" could be established if the board simply reviewed all distributions to ensure consistency with the congregation's exempt purposes.
Planning tip. Ministers can avoid the constructive receipt of taxable income and donors can be given reasonable assurance of the deductibility of their contributions if a discretionary fund:
- Gives a minister the discretion to distribute the fund only for specified purposes (such as relief of the needy) that are consistent with the congregation's exempt purposes.
- Prohibits (in writing) the minister from distributing any portion of the fund for him or herself or any family member.
- The congregation or its governing board retains administrative control over the fund to ensure that all distributions further the church's exempt purposes.
What is "charity"? Ministers who are authorized to distribute discretionary funds for benevolent purposes must recognize that the IRS interprets the term "charity" very strictly. More is required than a temporary financial setback or difficulty paying bills. Ministers should keep this important point in mind when making distributions from a discretionary fund. And, the church board should carefully scrutinize every distribution to ensure that this strict test is satisfied.
Should recipients receive a 1099? In general, a 1099-MISC form is issued only to self-employed workers who are paid compensation. Since most recipients of a minister's discretionary fund do not perform any services for their distribution, no 1099-MISC is required.
This article originally appeared in Church Treasurer Alert, August 1994.