Appeals court issues a surprising decision—Warren v. Commissioner, 2002 WL 338145 (9th Cir. 2002)
Article summary. A federal appeals court has issued a preliminary order in the Warren case, requiring the parties, and a law school professor, to submit briefs addressing the question of whether the housing allowance violates the first amendment’s nonestablishment of religion clause. This article summarizes the background of this important case, reviews the appeals court’s recent ruling, and reviews several possible outcomes.
In one of the most significant clergy tax cases in recent years, the United States Tax Court ruled in 2000 that a housing allowance is nontaxable for income tax reporting purposes so long as it is used to pay for housing-related expenses. Warren v. Commissioner, 114 T.C. 23 (2000). 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. This case is addressed fully in a feature article in the July-August 2000 edition of Church Law & Tax Report.
The IRS appealed the Tax Court’s ruling to a federal appeals court. On March 5, 2002, the appeals court issued a preliminary ruling. This article will summarize the background of the Warren case, review the appeals court’s decision, and evaluate the significance of the case to ministers.
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.
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. Therefore, ministers who own their homes may only exclude actual housing expenses to the extent such expenses do not exceed either the churchdesignated allowance or the fair rental value of the home plus the cost of utilities. Stated differently, the nontaxable portion of a pastor’s housing allowance is 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).
The IRS offered various arguments to defend the annual rental value test, including the following: 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; the rental value test prevents ministers from acquiring expensive homes; and, 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 Tax Court rejected each of these arguments, and threw out the annual rental test in its 2000 ruling. The IRS appealed the Tax Court ruling to a federal appeals court in California.
the appeals court’s ruling
On March 5, 2002, a three-judge panel of the federal appeals court for the ninth federal circuit issued a surprising decision in the Warren case. Two of the three judges issued an order asking the parties as well as Professor Erwin Chemerinsky of the University of Southern California Law School to submit additional briefs to the court addressing the following issues:
(1) Does the court have the authority to consider the constitutionality of Internal Revenue Code section 107(2) (the housing allowance exclusion)?
(2) If so, should the court exercise that authority?
(3) Is section 107(2) constitutional under the first amendment’s nonestablishment of religion clause?
The legal briefs are due within 45 days.
Section 107(2) of the tax code specifies 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.” Section 107(1) of the code provides that the annual rental value of a church-provided parsonage does not constitute taxable income to a minister. The court did not ask the parties to address the constitutionality of section 107(1), presumably because the pastor in this case did not live in a parsonage and so the court did not feel compelled to address this issue. It is also possible that the court assumed that section 107(1) is constitutional, since the benefit of tax-free housing is available to other taxpayers besides ministers.
In referring to the housing allowance the court observed that “it appears that no similar exemption is afforded any member of any other profession, whether serving a for-profit or non-profit institution.” This off-hand comment certainly suggests that the court has made up its mind that the housing allowance is unconstitutional. This conclusion is reinforced by the court’s reference to the following quotation from an earlier Supreme Court case,
When government directs a subsidy exclusively to religious organizations that is not required by the free exercise [of religion] clause and that either burdens non-beneficiaries markedly or cannot reasonably be seen as removing a significant state-imposed deterrent to the free exercise of religion … it provides unjustifiable awards of assistance to religious organizations and cannot but convey a message of endorsement to slighted members of the community. Texas Monthly, Inc. v. Bullock, 489 U.S. 1 (1989).
One of the court’s three judges passionately dissented from the court’s order, noting that neither the IRS nor the minister had raised the issue of the constitutionality of the housing allowance and therefore the court should not have done so on its own initiative. He observed,
The parties to this appeal have not questioned the constitutionality of the tax exclusion enacted by Congress and each party has advised the Court that they do not wish to do so …. Because the constitutional issue was not raised in the Tax Court, nor briefed or argued by the parties on appeal, and because it is unnecessarily and improvidently raised by my colleagues, I respectfully dissent from the order directing supplemental and court-appointed amicus briefing. This case can easily be decided without reaching the constitutionality of the statutory exclusion.
For now, the Tax Court’s decision in the Warren case stands. This means that the nontaxable portion of the housing allowance designated by a church for its pastor is not limited by the annual rental value of the pastor’s home. However, note that there are several possible outcomes to the Warren case, including the following:
1. Settlement. Settlement always is a possibility in any civil litigation. A settlement between Pastor Warren and the government would result in the dismissal of the case, depriving the federal appeals court of jurisdiction to render a decision addressing the constitutionality of the housing allowance.
2. Ruling. There are a number of possible rulings by the court if the case does not settle. It may rule that it has the authority to address the constitutionality of the housing allowance, and then decide that the housing allowance is unconstitutional. The court’s previous order certainly suggests that this is a likely result. On the other hand, the court may conclude that the housing allowance is constitutional, or that it cannot raise the constitutionality of a federal statute (the housing allowance) when this issue was not raised by either Pastor Warren or the government. There are arguments that can be made in defense of the constitutionality of the housing allowance.
3. Remand. Either party could ask the court to remand the case back to the Tax Court to address the issue of the constitutionality of the housing allowance. While this is up to the court’s discretion, it is not uncommon for cases to be sent back to a lower court when issues are addressed on appeal that were not fully developed during trial.
4. “En banc” review. If the three-judge panel of the ninth circuit court of appeals rules that it has the authority to address the constitutionality of the housing allowance, and finds the housing allowance to be unconstitutional, Pastor Warren can seek an “en banc” rehearing by all of the 24 active judges of the ninth circuit court of appeals (14 of whom were appointed by President Clinton). Such a rehearing is up to the court’s discretion, and may or may not be granted.
5. Supreme Court review. Pastor Warren can appeal to the United States Supreme Court any adverse decision by the three-judge panel (or an en banc decision by the entire ninth circuit court of appeals). The Supreme Court accepts only a small number of appeals each term, and there is no assurance that it would hear this case. However, the chances generally are better when a federal statute (such as section 107(2) of the tax code) has been declared unconstitutional.
6. Legislative options. A ruling that the housing allowance is unconstitutional cannot be “corrected” through legislation. Nevertheless, some church leaders are suggesting that Congress amend section 107(2) of the tax code to formally adopt the annual rental value limit as a matter of law. This effort would be futile if the court of appeals, or the Supreme Court, rules that the housing allowance is unconstitutional.
7. Other attacks on the constitutionality of the housing allowance. If the court of appeals or the Supreme Court rules that it is inappropriate to address the constitutionality of the housing allowance, or, if either court concludes that the housing allowance is constitutional, then it is possible that other groups may come forward to challenge the housing allowance. It is questionable, however, whether any taxpayer or group would have “standing” to litigate this question. “Standing” is a legal requirement for any litigation, and means that a party to a lawsuit must have a legal right to participate. According to decisions by the Supreme Court and other federal courts, it is questionable (though not certain) whether any group or individual would have standing to challenge the constitutionality of the housing allowance. Further, as noted above, there are arguments that can be made to support the constitutionality of the housing allowance even if standing is recognized.
8. Parsonages not affected. The court’s recent order does not question the constitutionality of the parsonage exclusion, which is set forth in section 107(1) of the tax code. Presumably this is because employer-provided housing is a tax-free fringe benefit to a wide variety of occupations besides clergy. The Supreme Court has ruled in a number of cases that a tax statute that benefits a wide range of occupations or organizations is not rendered unconstitutional by including clergy or churches on the list. To illustrate, the Supreme Court has ruled that state property tax laws that exempt property owned by several categories of non-religious charitable organizations are not rendered unconstitutional because churches are included on the list. The same principle would apply to the parsonage exclusion. While the benefit of tax-free employer-provided housing applies to clergy, it also applies to several other taxpayers.
© Copyright 2002 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 c0302