Annual “rental value” limit abolished – Warren v, Commissioner, 114 T.C. 23 (2000).
Editor’s Note: This case’s outcome became obsolete in 2002 when the US Congress passed the Clergy Housing Clarification Act of 2002.
Article summary. The housing allowance is the most significant benefit available to ministers. A recent Tax Court ruling makes it even more beneficial. The court abolished the annual “rental value” test which for nearly 30 years has limited the nontaxable portion of a housing allowance for ministers who own their homes to the annual rental value of their home. This test has prevented countless ministers from claiming a nontaxable housing allowance up to the full amount of their housing expenses. Ministers who have been hurt the most by the rental value test include those who have made a large down payment on a home, prepaid a significant amount of their mortgage loan, or incurred substantial repair or remodeling expenses. With the demise of the rental value test, ministers will be able to treat their church-designated housing allowance as nontaxable for federal income tax reporting purposes to the extent it is used to pay for housing-related expenses.
In one of the most significant clergy tax cases in recent years, the United States Tax Court ruled that a housing allowance is nontaxable for income tax reporting purposes so long as it is used to pay for housing-related expenses. The court threw out the annual “rental value” test that the IRS adopted in 1971, which limited nontaxable housing allowances for ministers who own their homes to the annual rental value of their home. The court’s decision will have a direct and immediate impact on many ministers. This article will summarize the facts of this important case, review the court’s decision, and assess the significance of the case to ministers and other church leaders.
Background
Section 107 of the Internal Revenue Code provides that “in the case of a minister of the gospel, gross income does not include … the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.” This language requires very little explanation. The portion of a minister’s church-designated housing allowance that is used to pay for housing-related expenses is nontaxable for federal income tax reporting purposes. Stated differently, ministers may exclude from taxable income the lesser of (1) the church-designated housing allowance, or (2) the actual amount of housing-related expenses paid during the year.
• Key point. There are certain technical requirements that must be met in order for a minister to qualify for a housing allowance exclusion. The allowance must be designated by official church action, and it must be designated in advance. Housing allowances cannot be declared retroactively. These and other requirements are reviewed fully in chapter 6 of Richard Hammar’s year 2000 Church and Clergy Tax Guide.
Unfortunately, in 1971 the IRS imposed an additional limitation on ministers who own their homes: the housing allowance exclusion may not exceed the annual rental value of the minister’s home (furnished) plus the cost of utilities. Revenue Ruling 71-280. Therefore, ministers who own their homes may only exclude actual housing expenses to the extent such expenses do not exceed either the church-designated allowance or the fair rental value of the home plus the cost of utilities.
In Publication 517, the IRS explains how to compute the nontaxable portion of a housing allowance as follows: “If you are a minister who owns your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the lowest of the following amounts: (1) the amount actually used to provide a home, (2) the amount officially designated as a rental allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.”
What has been the impact of the IRS-imposed “fair rental value” test? There are two points to note. First, the test has had little if any impact on ministers who have not incurred substantial housing expenses. Second, the test has had a substantial impact on ministers who have incurred extraordinary expenses. Consider the following examples.
• Example. Pastor B purchased a home in 1999. Pastor B’s housing expenses in 1999 were $12,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor B paid a $15,000 down payment on the home. The church board designated $30,000 of Pastor B’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor B’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor B could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $30,000, or that Pastor B incurred $27,000 in housing expenses (including the down payment), was irrelevant. This result had a direct and negative tax impact on Pastor B. Assuming that Pastor B is in the 15% tax bracket, the tax effect amounts to approximately $2,550 in additional taxes (15% multiplied times the excess of Pastor B’s actual housing expenses over the home’s annual rental value).
• Example. Pastor G owns his home. Pastor G’s housing expenses in 1999 were $12,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor G had to replace the roof on his home, at a cost of $5,000. The church board designated $20,000 of Pastor G’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor G’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor G could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $20,000, or that Pastor G incurred $17,000 in housing expenses (including the new roof), was irrelevant. This result had a direct and negative tax impact on Pastor G. Assuming that Pastor G is in the 15% tax bracket, the tax effect amounts to approximately $1,050 in additional taxes (15% multiplied times the excess of Pastor G’s actual housing expenses over the home’s annual rental value).
• Example. Pastor K owns his home. Pastor K’s housing expenses in 1999 were $15,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor K incurred $8,000 of expenses in remodeling the basement of his home. The church board designated $25,000 of Pastor K’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor K’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor K could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $25,000, or that Pastor K incurred $23,000 in housing expenses (including the remodeling job), was irrelevant. This result had a direct and negative tax impact on Pastor K. Assuming that Pastor K is in the 15% tax bracket, the tax effect amounts to approximately $1,950 in additional taxes (15% multiplied times the excess of Pastor K’s actual housing expenses over the home’s annual rental value).
• Example. Pastor M owns his home. Pastor M’s housing expenses in 1999 were $12,000 (mortgage payments, utilities, insurance, property taxes, etc.). In addition, Pastor M prepaid $10,000 of his remaining mortgage debt in order to “get out of debt” as soon as possible. The church board designated $25,000 of Pastor M’s 1999 compensation as a housing allowance in its last meeting of 1998. The annual rental value of Pastor M’s home is $10,000 (furnished, including utilities). Prior to the Tax Court’s recent ruling, a housing allowance was nontaxable only to the extent that it did not exceed either a minister’s actual housing expenses for the year, or the annual rental value of the minister’s home. Stated differently, a minister could exclude from taxable income the least of the following three amounts: (1) the properly designated housing allowance, (2) actual housing expenses, or (3) the annual rental value of the home. In this example, the lowest of these three amounts was the rental value of the home ($10,000), so Pastor M could not treat more than this amount of his housing allowance as nontaxable. The fact that the church designated a housing allowance of $25,000, or that Pastor M incurred $22,000 in housing expenses (including the mortgage prepayment), was irrelevant. This result had a direct and negative tax impact on Pastor M. Assuming that Pastor M is in the 15% tax bracket, the tax effect amounts to approximately $1,800 in additional taxes (15% multiplied times the excess of Pastor M’s actual housing expenses over the home’s annual rental value).
Facts
Let’s turn now to the facts of the recent Tax Court case. Rick Warren (the “pastor”) is an ordained Baptist minister with a master of divinity degree from Southwestern Theological Seminary and a doctor of ministry degree from Fuller Theological Seminary. In 1980, the pastor founded the Saddleback Valley Community Church (the “church”) in his home. Over the years the church used many different facilities to house the congregation, and the congregation has grown to more than 18,000 persons. The pastor also has authored best-selling books including The Purpose Driven Church, The Power to Change Your Life, and Answers to Life’s Difficult Questions, and he owns and operates a tape and book ministry called “The Encouraging Word.”
In 1992 the pastor bought a residence for $360,000. The annual fair market rental value of the residence was $58,061 in 1993, $58,004 in 1994, and $59,479 in 1995.
Each year the church’s trustees met to designate the amount of compensation to be paid to each of its ministers. The trustees also allocated these amounts between salary and housing allowances. The church paid the pastor compensation of $77,663 in 1993, $86,175 in 1994, and $100,000 in 1995. For 1993 and 1994 the trustees designated 100% of the pastor’s compensation as a housing allowance. In 1995, the trustees allocated $20,000 for salary and $80,000 for a housing allowance.
The pastor incurred housing expenses of $77,663 in 1993, $76,309 in 1994, and $84,278 in 1995 to provide a home for himself and his family. These amounts were used to pay for such housing-related expenses as mortgage payments, utilities, furnishings, landscaping, repairs, maintenance, real property taxes, and homeowner’s insurance premiums.
The pastor reported the following amounts as taxable income on his federal tax returns: 1993-none; 1994-$9,866; and 1995-$20,000. These amounts represented the amount of housing expenses in excess of compensation for the year. In other words, the pastor treated as nontaxable the lower of the following two amounts: his church-designated housing allowance for the year, or his actual housing expenses (columns C or D). He did not consider the annual rental value of his home in calculating the nontaxable amount. The following table summarizes this data:
ABCDEF
| year | compensation paid by the church | housing allowance designated by the church | housing expenses | annual rental value of the home | amount excluded from taxable income |
| 1993 | $77,663 | $77,663 (100% of income) | $77,663 | $58,061 | $77,663 |
| 1994 | $86,175 | $86,175 (100% of income) | $76,309 | $58,004 | $76,309 |
| 1995 | $100,000 | $80,000 | $84,278 | $59,479 | $80,000 |
The pastor also reported the following amounts of net income from his tape and book ministry during the years in question: 1993 – $183,635; 1994 – $217,770; and 1995 – $221,401.
The IRS audited the pastor’s tax returns for 1993-1995, and assessed $55,287 in “deficiencies” and penalties, as follows:
YearDeficiencyPenalty
| 1993 | $11,932 | $2,386 |
| 1994 | $18,061 | $3,612 |
| 1995 | $16,080 | $3,216 |
The IRS Position
The sole basis for the IRS position was that the nontaxable portion of the pastor’s housing allowance was limited to the least of the following three amounts: (1) the church-designated housing allowance, (2) actual housing expense, and (3) the annual rental value of the pastor’s home (furnished, including utilities). For each of the three years under examination, the IRS noted that the annual rental value was the lowest of the three limits, and therefore the pastor’s disregard of this limit resulted in an overstatement of the nontaxable amount of his housing allowances each year.
• Key point. The pastor claimed that the nontaxable portion of his housing allowance was the lesser of the amounts in columns C or D. The IRS insisted that the nontaxable amount was the least of the amounts in columns C, D, or E.
The IRS offered the following arguments to defend the annual rental value test: (1) the “rental value” language in section 106 supports the test; (2) the “part of compensation” language in section 107 supports the test; (3) the rental value test prevents ministers who own their homes from receiving a greater tax benefit than those who live in a church-provided parsonage; (4) the rental value test prevents ministers from acquiring expensive homes; and (5) the rental value test prevents ministers with other sources of income from acquiring more expensive homes by allocating a larger amount of their church compensation to a nontaxable housing allowance.
The pastor appealed the IRS decision to the United States Tax Court.
The court’s ruling
The Tax Court rejected each of the IRS’s arguments and invalidated the annual rental value test. The court’s response to each of the IRS’s arguments is summarized below.
#1 – The wording of section 107
The IRS claimed that the wording of section 107 of the Internal Revenue Code supported the rental value test. Here is the full text of section 107:
Section 107. Rental Value of Parsonages
In the case of a minister of the gospel, gross income does not include-
(1) the rental value of a home furnished to him as part of his compensation; or (2) the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.
The IRS insisted that allowing ministers to claim a nontaxable housing allowance in an amount exceeding the annual rental value of their home would be contrary to the “rental” language in section 107 and “to the concern for equality among ministers.” Specifically, the IRS pointed out that the title of section 107 (“Rental Value of Parsonages”) and the use of the word “rental” in both subsections 107(1) and 107(2) require use of the annual rental value limitation. The Tax Court disagreed. With regard to the significance of the title to section 107, the court noted that “it is well settled that the heading of a section does not limit the plain meaning of the text.” The court then addressed the significance of the word “rental” in the text of section 107:
Contrary to [the IRS’s] position, neither section 107(2), the regulations promulgated thereunder, nor the related legislative history, limits the amount that may be excluded from income as a parsonage allowance under section 107(2) to the fair market rental value of the residence occupied. A rental allowance excludable under section 107(2) may be used (1) to rent a home, (2) to purchase a home, and (3) to pay expenses directly related to providing a home. Section 107(1) limits the exclusion to the rental value of a home furnished as part of a minister’s compensation. In contrast, no fair rental value limit is stated in section 107(2) or the regulations issued thereunder ….
The trouble with [the IRS’s] analysis is that the Congress, faced with the “rental value” language of section 107(1), did not choose to use such language in section 107(2). Instead, the Congress provided that the exclusion applies to “the rental allowance paid … to the extent used by [the minister] to rent or provide a home.” Thus, the Congress clearly provided a different measure for the exclusion under section 107(2) than the measure provided under section 107(1). [The IRS] has failed to show us a policy problem so overwhelming as to force us to conclude that the Congress could not have meant what it said [quoting Reed v. Commissioner, 82 T.C. 208 (1984)] ….
[The IRS] contends that to not impose a fair rental value limit requires that we disregard the word “rental” in section 107(2). We disagree. Section 107(2) clearly is not limited to payment of rent; on the contrary, it expressly applies to a rental allowance “to the extent used … to rent or provide a home.” This includes home purchases ….
[We] believe our reading gives full effect to all of the words in section 107(2). First, section 107(2) specifically excludes not only the cost of renting a home, but also the cost of providing a home. Second, section 107(2) does not include language used in section 107(1) that limits the amount of the section 107(2) exclusion to the rental value of the residence; instead, section 107(2) requires that the amount excluded be a rental allowance paid as compensation to the minister and used by him or her to rent or provide a home.
#2 – “Part of compensation”
The IRS pointed out that section 107(2) refers to a rental allowance paid to a minister “as part of his compensation.” It insisted that this language demonstrated that Congress did not intend for churches to be able to designate all of a minister’s compensation as a housing allowance, as the church in this case had done for two of the three years under consideration. Once again, the court disagreed:
[The IRS’s] reading suggests that the “part of his compensation” language in section 107(2) requires that, to be excludable under section 107(2), any “part” of a minister’s compensation may be designated as a rental allowance so long as less than “all” is so designated. Under that interpretation, a taxpayer could qualify under section 107(2) if, for example, the amount designated as a rental allowance were $1.00 less than the minister’s total compensation. This reading is not specifically indicated by the legislative history or required by the regulations. It seems unlikely that such a tiny difference in amounts should control whether section 107(2) applies.
The “part of his compensation” language also appears in section 107(1). Thus, under [the IRS’s] reading, no exclusion would be available to a minister to whom a church provided a home but no other compensation because the home would be all of that minister’s compensation. We do not think Congress intended to require ministers living under those circumstances to pay tax on the value of their church-provided housing, and we do not believe the phrase “part of his compensation” in section 107(1) and section 107(2) has that effect. Instead, we give full meaning to the words of the statute when we read section 107(1) and section 107(2) to require simply that the source of the funds be the minister’s compensation.
The court concluded by noting that “where a statute plainly authorizes an exclusion from income, as here, we require unequivocal evidence of legislative purpose before construing the statute so as to override the plain meaning of the words used therein. Congress chose not to include the rental value limit in section 107(2). We do not read section 107(2) to provide otherwise.”
#3 – Unequal treatment
The IRS asserted that the annual rental value test prevents “unequal treatment” between ministers who live in a church-provided parsonage and those who receive a housing allowance with which they provide their own housing. Specifically, the IRS claimed that if ministers who own a home and receive a housing allowance could use the allowance to pay for housing expenses in excess of the annual rental value of their home, they would be in a “better” tax position than ministers who live in church-provided parsonages. The court rejected this argument on the basis of three considerations.
(1) No prior rulings. The court noted that it had never before ruled that ministers who provide their own home must never be treated more favorably than ministers living in a parsonage.
(2) The annual rental value test does not ensure equality. The court noted that the annual rental value test does not eliminate unequal treatment between ministers who live in a parsonage and those who provide their own home. In fact, in some cases, ministers who provide their own home will be treated less favorably than ministers who live in a church-provided parsonage. To illustrate, if the rental value of a minister’s home is more than his actual housing expenses, the nontaxable portion of his housing allowance is limited to actual expenses. Such a minister cannot treat the annual rental value as nontaxable. This minister is treated less favorably than ministers who live in a church-provided parsonage and who can exclude from taxable income the full annual rental value of the parsonage.
(3) Compliance burden. Finally, the court noted that if it retained the annual rental value test, then ministers who provide their own housing would face a “compliance burden” not imposed on ministers who live in a parsonage. Ministers who provide their own housing
could be required to obtain an estimate of the rental value of their home every year in order to know how much to exclude under section 107(2). This burden is not imposed on ministers for whom homes are provided, the rental value of which is excludable under section 107(1), because they may simply exclude the value of the home without any need to estimate the rental value. In the instant case, the parties stipulated the rental value for each year. However, the burden of obtaining valuation estimates could become onerous where rental value is in dispute. We decline to endorse this disparate treatment here by imposing potentially burdensome valuation obligations where neither the statute nor the legislative history so requires.
#4 – “Expensive” homes
The IRS suggested that without a rental value test, ministers would be free to acquire expensive homes and finance them through inflated housing allowances. In rejecting this argument, the court noted that “a more expensive home presumably would have a greater rental value which presumably would be excludable under [the IRS’s] approach.”
#5 – Other sources of income
The court acknowledged the IRS concern that a minister with additional income from another source could spend more for housing, and have a larger housing allowance exclusion. For example, assume that Pastor T is employed full-time as a public school teacher in addition to his duties as a part-time associate pastor at his church. For the year 2000, the church board agrees to pay him $10,000, all of which is designated as a housing allowance. Does this scenario discriminate against ministers who are employed full-time by their church and have no outside sources of income, and who are less able to apply their total church income to housing expenses? Perhaps. But the court concluded that “we are aware of no authority to justify our consideration of this point in construing section 107(2).”
The court acknowledged that the pastor’s substantial earnings from his tape and book ministry enabled him to spend more for housing. However, “the same financial flexibility would be available to a minister who has investment income or who is married to a spouse that earns a separate income …. Concern over those issues does not … justify our adding a fair rental value limit to sec. 107(2).”
The dissenting opinion
The court’s decision was endorsed by 14 Tax Court judges. Three judges dissented. Their reasoning is summarized below:
Extravagance
The dissenters began their opinion by noting that
the facts of this case present an archetypical example of the potential for abuse …. For the first 3 of its 4 fiscal periods here involved, the [church] designated 100 percent of [the pastor’s[ compensation as a housing allowance. Yet [the pastor], with other income (largely Schedule C income) near or in excess of $200,000 for each of the taxable years at issue, is nevertheless awarded an exclusion from tax of substantially all of [his] salary …. Moreover, with funds available from the above-mentioned alternative sources to cover living expenses otherwise necessary but unrelated to providing a home, [the pastor was] at liberty to, and did, spend nearly all compensation for the betterment of [his] residence …. I am satisfied that the rental allowance of section 107(2) was not intended to operate in this manner.
Of course, the simple answer to this concern is that it completely disregards the fact that the vast majority of pastors who will be helped by the court’s decision are not those with exorbitant incomes from outside sources, but rather lower to middle income pastors who pay a down payment in the year they acquire a home, who have to make emergency repairs to their home, or who decide to remodel. Consider the following examples.
• Example. Pastor C is paid a salary of $40,000 for year 2000. The church board designated $25,000 of this amount as a housing allowance. In February, Pastor C purchases a new home, and makes a down payment of $15,000. Assume that he has additional housing expenses of $7,000 for the year, and that the annual rental value of the home (furnished, including utilities) is $10,000. According to the dissenting opinion, Pastor C’s nontaxable housing allowance would be the least of the following three amounts: (1) the church-designated housing allowance ($25,000); (2) actual housing expenses ($22,000); or (3) the annual rental value of the home ($10,000). Since the annual rental value is the lowest amount, this is the amount of Pastor C’s housing allowance that is nontaxable. But why should this be so? Pastor C receives no substantial income from another vocation. Clearly, this scenario is far more common than the facts in the Tax Court’s case which the dissenting judges found to be so unfair. In their zeal to protect against rare cases of abuse, they defended a rule that would cause financial hardship and real “unfairness” to countless lower and middle income pastors. Fortunately, 14 of the Tax Court’s 17 judges rejected this result.
• Example. Pastor L’s roof collapses during a snowstorm during the Christmas season in 1999. Knowing that it would cost $5,000 to repair, and that he incurs about $10,000 of additional housing expenses per year, Pastor L has the church board designate $15,000 of his year 2000 salary of $40,000 as a housing allowance. Assume that the annual rental value of the home (furnished, including utilities) is $10,000. According to the dissenting opinion, Pastor L’s nontaxable housing allowance would be the least of the following three amounts: (1) the church-designated housing allowance ($15,000); (2) actual housing expenses ($15,000); or (3) the annual rental value of the home ($10,000). Since the annual rental value is the lowest amount, this is the amount of Pastor L’s housing allowance that is nontaxable. But why should this be so? Pastor L receives no substantial income from another vocation. Clearly, this scenario is far more common than the facts in the Tax Court’s case which the dissenting judges found to be so unfair. In their zeal to protect against rare cases of abuse, they defended a rule that would cause financial hardship and real “unfairness” to countless lower and middle income pastors. Fortunately, 14 of the Tax Court’s 17 judges rejected this result.
The dissenting judges’ reference to the court’s “open-handed generosity to the favored few” is clearly unjustified. A more apt description would be the dissenting judges’ attempt to salvage a rule that penalizes the vast majority of lower and middle income ministers.
The wording of section 107
The dissenting judges agreed with the IRS that the language of section 107, and its very title, supported the annual rental value test. The matter of the title (“Rental Value of Parsonages”) can be quickly addressed. The simple fact is that section 107(1) predated section 107(2) by several decades. Section 107(1), which provides that the rental value of a church-provided parsonage is nontaxable to a minister in computing federal income taxes, was appropriately entitled “Rental Value of Parsonages.” Unfortunately, this title was not changed when Congress added section 107(2), but this omission is of no consequence. It certainly does not provide support for the IRS’s annual rental value test.
The dissenting judges also noted that “the statute does not simply say that an allowance, or even a housing allowance or a residence allowance, used to provide a home may be excluded. Rather, the law states that gross income does not include a rental allowance so used. The majority’s interpretation effectively writes this term out of section 107(2).” Once again, the dissenting judges are misguided. Applying section 107(2) literally, as they apparently want to do, would not require recognition of the IRS-invented annual rental value limitation. Instead, it would limit the section 107(2) exclusion to ministers who use a church-designated housing allowance to rent a home. Ministers who own their home would receive no benefit. This result is so absurd that the dissenting judges did not embrace it. They opted instead for the view that the “rental” language in section 107 requires the nontaxable portion of a minister’s housing allowance to be limited to the annual rental value of the minister’s home. But as the court pointed out, there is no basis whatever in the text of section 107 to support such a view.
• Key point. Here’s a point that the dissenting judges completely ignored. Section 107(2) was enacted in 1954, and it was not until 1971 that the IRS “discovered” the annual rental value test. If the language (and title) of section 107 so clearly supports the annual rental value test, then why did it take the IRS 17 years to discover it?
Significance of the Case to Ministers and other Church Leaders
What is the relevance of the Tax Court’s ruling to other ministers and lay church leaders? Consider the following:
1. Significance of a “regular” Tax Court decision. The Tax Court’s opinion was a “regular” decision of the court. This means that it was a decision of the entire court. Such decisions serve as national precedents and may be relied on by taxpayers in all 50 states, unless reversed on appeal by either a federal appeals court or the United States Supreme Court. The IRS can appeal the Tax Court decision to the federal court of appeals for the ninth circuit, which has jurisdiction in the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. There are risks in doing so, however. The appeals court could reverse the Tax Court decision, which would eliminate the decision as a national precedent. On the other hand, the appeals court could affirm the decision, which would be a strong endorsement of the case and would leave the IRS with the option of appealing to the Supreme Court. It is very unlikely that the Supreme Court would hear such an appeal, which would make the appeals court’s decision final. The IRS could challenge the Tax Court decision in other states, and provoke appeals to other federal appeals courts.
• Key point. In our opinion, the federal appeals court would affirm the Tax Court’s decision if the IRS chooses to appeal. After all, it was a decision by 14 of the court’s 17 judges, which indicates overwhelming support for the pastor’s position. It is unusual for cases with such strong judicial support to be reversed by a federal appeals court. In the next issue of this newsletter we will let you know whether or not the IRS has appealed the case. If it does, we will be reporting all developments.
2. The status of the annual rental value test. For now, ministers can ignore the annual rental value test in computing the nontaxable amount of their housing allowance. The IRS is free to challenge ministers who ignore the annual rental value test, but ministers can rely on the Tax Court’s decision, which not only provides strong judicial support for their position but also protects them from penalties. If the IRS appeals the case, and the federal appeals court for the ninth circuit affirms the Tax Court’s decision, then the IRS cannot challenge ministers who ignore the annual rental value test in the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. Such a ruling would add even greater weight to the Tax Court’s decision, making it more likely that appeals courts in other federal circuits would reach the same conclusion.
3. The IRS audit guide for ministers. The IRS issued audit guidelines in 1995 for its agents to follow when auditing ministers. The audit guidelines assist IRS agents in the examination of ministers’ tax returns. They alert agents to the key questions to ask, and provide background information along with the IRS position on a number of issues. The guidelines provide agents with the following information regarding housing allowances:
Code section 107 provides an exclusion from gross income for a “parsonage allowance,” housing specifically provided to a minister of the gospel. This includes the rental value of a home furnished to him or her as part of compensation or a rental allowance, to the extent that the payment is used to rent or provide a home. The term “parsonage allowance” includes church provided parsonages, rental allowance with which the minister may rent a home and housing allowances with which the minister may purchase a home. A minister can receive a parsonage allowance for only one home ….
The amount of the parsonage allowance excludible from gross income is the least of (1) The amount actually used to provide a home, (2) the amount officially designated as a housing allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.
The IRS audit guidelines contain the following example:
• Example. B, an ordained minister, is vice president of academic affairs at Holy Bible Seminary. His compensation package includes a salary of $80,000 per year and a $30,000 housing allowance. His housing costs for the year included mortgage payments of $15,000, utilities of $3,000, and $3,600 for home maintenance and new furniture. The fair rental value of the home, as furnished, is $18,000 per year. The three amounts for comparison are: (a) Actual expenses of $21,600 ($15,000 mortgage payments + $3,000 utilities + $3,600 other costs); (b) designated housing allowance of $30,000; (c) fair rental value plus utilities of $21,000 ($18,000 + $3,000 utilities). B may exclude $21,000 from gross income but must include in income the other $9,000 of the housing allowance. The entire $30,000 will be considered in arriving at net self-employment income.
The IRS audit guidelines for ministers apply the annual rental value limit that was invalidated by the Tax Court in its recent decision. The IRS may choose to retain the rental value limit in the audit guidelines, which will mean that IRS agents will continue to apply it when auditing ministers. But, as noted above:
(1) Ministers who ignore the annual rental value test can rely on the Tax Court’s decision in support of their position if audited. Such ministers can immediately appeal the IRS position to the Tax Court, which of course will rule in favor of the minister on the basis of its recent decision. This will force the IRS to appeal to a federal appeals court.
(2) If a federal appeals court agrees with the Tax Court, then this eliminates any further IRS application of the annual rental value test in the states comprising that “circuit.” This assumes that the Supreme Court declines to accept an appeal of the case.
4. The “other” rental value test not affected. Section 107(1) of the tax code specifies that “in the case of a minister of the gospel, gross income does not include … the rental value of a home furnished to him as part of his compensation.” However, since this exclusion only applies to the computation of income taxes, ministers who live in a church-provided parsonage must include the annual rental value of the parsonage when computing their self-employment taxes (unless they have exempted themselves from such taxes).
• Example. Pastor E lives in a church-provided parsonage. For the year 2000, she receives a salary of $40,000. The annual rental value of the parsonage is $10,000. In computing her income taxes, Pastor E reports only $40,000 as church compensation. She does not include the annual rental value of the parsonage. However, in computing her self-employment taxes, Pastor E must include both her salary ($40,000) and the annual rental value of the parsonage ($10,000). This rule is not affected by the Tax Court’s decision.
5. How much of a minister’s compensation can be designated as housing allowance? The church in this case designated all of the pastor’s compensation as a housing allowance for two of the three years under consideration. The IRS insisted that section 107 prohibited designation of all of a minister’s compensation as a housing allowance. It relied on the language of section 107, which refers to a rental allowance paid to a minister “as part of his compensation.” It insisted that this language demonstrated that Congress did not intend for churches to be able to designate all of a minister’s compensation as a housing allowance, as the church in this case had done for two of the three years under consideration. The Tax Court rejected this argument:
[The IRS’s] reading suggests that the “part of his compensation” language in section 107(2) requires that, to be excludable under section 107(2), any “part” of a minister’s compensation may be designated as a rental allowance so long as less than “all” is so designated. Under that interpretation, a taxpayer could qualify under section 107(2) if, for example, the amount designated as a rental allowance were $1.00 less than the minister’s total compensation. This reading is not specifically indicated by the legislative history or required by the regulations. It seems unlikely that such a tiny difference in amounts should control whether section 107(2) applies.
There are many ministers who have most or all of their compensation designated as a housing allowance. Common examples would be bivocational pastors, pastors of small congregations or “missions” churches, and part-time associate pastors. Contrary to the position of the IRS and the dissenting judges, it is not “abusive” for churches to designate most or all of the income paid to these pastors as a housing allowance. The Tax Court’s decision will serve as strong legal support for the legitimacy of such housing allowances.
6. Retired ministers. Many denominational pension plans designate all of the pension distributions of retired pastors as a housing allowance. It should be noted that the Tax Court’s decision is strong legal support for such a practice. Had the Tax Court embraced the IRS position, denominational pension boards would have had to reassess the continuation of this practice.
7. Impact on church boards. In most churches, the church board designates housing allowances. In some churches, a “compensation committee” or the congregation itself designates housing allowances. In any case, church leaders should recognize the impact of the Tax Court’s ruling on the process of designating housing allowances. Most importantly, the case will permit churches to designate larger housing allowances than were permissible in the past.
• Example. A church board is considering the year 2001 compensation package for Pastor B. It decides on total compensation of $30,000. Pastor B informs the board that he will have ordinary housing expenses of $10,000, but that he also will be incurring remodeling expenses of an additional $10,000. The board is uncomfortable designating two-thirds of Pastor B’s total compensation as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate two-thirds of the pastor’s compensation as a housing allowance.
• Example. Pastor H is a part-time associate pastor at his church. The church board plans to pay him $10,000 for 2001. Pastor H asks the board to designate 100 percent of this amount as a housing allowance. The church treasurer is uncomfortable designating the entire amount as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor H’s compensation as a housing allowance.
• Example. A church board is considering the year 2001 compensation package for Pastor N. It decides on total compensation of $60,000. Pastor N asks the board to designate this entire amount as a housing allowance. He informs the board that he will have ordinary housing expenses of $15,000, but that he also will be purchasing a new home in 2001 and plans on making a large down payment (with the sale proceeds from his prior residence) of $45,000. Pastor N’s spouse is employed as a college professor, and the couple plans on using her salary for living expenses in 2001. The church board is uncomfortable designating the entire salary as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor N’s compensation as a housing allowance.
8. Social security. Ministers should recognize that a housing allowance is nontaxable only in computing federal income taxes. Housing allowances are included in a pastor’s income in computing the self-employment (social security) tax. The same is true for the annual rental value of a church-provided parsonage.
9. Examples. The tax effect of the Tax Court’s decision is summarized in the following table.
ABCDEFG
| case | salary | church designated housing allowance | actual housing expenses | annual rental value of home (furnished, including utilities) | non- taxable housing allowance the IRS position (lowest of columns C,D, and E) | non- taxable housing allowance applying the Tax Court’s decision (lower of columns C or D) |
| 1 | $25,000 | $10,000 | $12,000 | $15,000 | $10,000 | $10,000 |
| 2 | $50,000 | $25,000 | $25,000 | $15,000 | $15,000 | $25,000 |
| 3 | $40,000 | $10,000 | $25,000 | $15,000 | $10,000 | $10,000 |
| 4 | $60,000 | $60,000 | $60,000 | $20,000 | $20,000 | $60,000 |
| 5 | $10,000 | $10,000 | $10,000 | $12,000 | $10,000 | $10,000 |
| 6 | $30,000 | $0 | $12,000 | $15,000 | $0 | $0 |
| 7 | $40,000 | $20,000 | $10,000 | $12,000 | $10,000 | $10,000 |
| 8 | $40,000 | $20,000 | $12,000 | $10,000 | $10,000 | $12,000 |
| 9 | $75,000 | $40,000 | $35,000 | $20,000 | $20,000 | $35,000 |
| 10 | $40,000 | $15,000 | $5,000 | $10,000 | $5,000 | $5,000 |
© Copyright 2000 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided 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. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m96 m27 c0400
