By Richard R. Hammar, J.D., LL.M., CPA
© 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: m71 c0100
TAX CHANGES OF INTEREST TO CHURCHES IN 1999
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 1999. 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%. 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 1999, the maximum wages subject to the "old-age, survivor and disability" (OASDI) portion of self-employment taxes (the 6.2% amount) increases to $72,600-up from $68,400 in 1998. Stated differently, employees who receive wages in excess of $72,600 in 1999 will pay the full 7.65% tax rate for wages up to $72,600, and the "HI" tax rate of 1.45% on all earnings above $72,600. Employers pay an identical amount.
2. Verifying social security numbers. The Social Security Administration (SSA) is urging employers to be sure that amounts reported on Form W-3 correspond to amounts reported on quarterly 941 forms. The SSA also noted that the main reason that W-2 forms are rejected is the use of incorrect social security numbers. Churches and other employers can verify the accuracy of social security numbers of up to 5 employees by calling the SSA at 1-800-772-1213. If you have more than 5 employees, you will need to contact your nearest SSA office for assistance in verifying names and social security numbers.
3. Due date for certain information returns. Employers are required to file an "information return" (Form W-3) by February 28 of each year reporting the amount of employee wages paid during the previous year. In addition, employers are required to file Form 1096 by February 28 of each year reporting the amount of nonemployee compensation paid during the previous year (to persons who received $600 or more). Under present law, the due date for filing information returns with the IRS is the same whether such returns are filed on paper, on magnetic media, or electronically. Congress enacted legislation in 1998 that provides an incentive to filers of information returns to use electronic filing by extending the due date for filing such returns from February 28 to March 31 of the year following the calendar year to which the return relates. This provision applies to information returns required to be filed after December 31, 1999.
The new law also requires the Treasury Department to issue a study evaluating the merits and disadvantages, if any, of extending the deadline for providing taxpayers with copies of information returns from January 31 to February 15 (Forms W-2 would still be required to be furnished by January 31).
4. Payroll deduction IRAs. Some ministers and lay church staff members are not eligible to participate in a church or denominational pension plan. This may be because the employing church has never established such a plan, and is not affiliated with a denomination that has done so. Perhaps your church does not offer a retirement plan to staff members, and no denominational plan is available, but you would like to do something to assist with retirement savings. A number of options are available. One was the subject of a recent IRS announcement-a payroll deduction IRA. In the Conference Report to the Taxpayer Relief Act of 1997, Congress indicated that "employers that choose not to sponsor a retirement plan should be encouraged to set up a payroll deduction system to help employees save for retirement by making payroll deduction contributions to their IRAs." Congress encouraged the IRS to "continue its efforts to publicize the availability of these payroll deduction IRAs." The IRS responded in a recent announcement in which it reminded employers "that are not currently in a position to sponsor a retirement plan" that they can allow employees to contribute to traditional or Roth IRAs by direct deposit though payroll deduction. In addition, the IRS noted that employees making direct deposits of deductible contributions to traditional IRAs may be able to adjust their federal income tax withholding on account of these contributions. By adjusting their withholding, employees may not have to wait until they file their tax return to get the benefit of the tax deduction for their contributions. The IRS concluded: "Many employers permit their employees to directly deposit all or a portion of their paychecks into checking or savings accounts maintained by financial institutions. Employers may also assist their employees in saving for retirement by means of direct deposit through payroll deduction to IRAs." IRS Announcement 99-2.
5. IRS modifies rules for electronic depositing of payroll taxes. Congress enacted legislation a number of years ago requiring the IRS to develop a system for the electronic filing of payroll taxes. Congress wanted a simple, "paperless" way for employers to deposit their payroll taxes. In response, the IRS came up with the Electronic Federal Tax Payment System (or EFTPS). Traditionally, employers have used a paper coupon and a check to make federal tax deposits (FTDs). EFTPS eliminates most of the paperwork in the old FTD coupon system. With EFTPS, deposits may be made by telephone or personal computer, or through the financial institution of the employer. The new electronic system is being phased in over a period of years by increasing the percentage of total taxes subject to the new EFTPS system each year. Congress mandated that 94 percent of employment taxes be collected electronically in 1999. The IRS previously assumed that this meant that employers with $50,000 or more in payroll tax deposits would have to deposit payroll taxes electronically. As a result, employers with $50,000 or more in payroll tax deposits for 1997 were required to begin depositing payroll taxes electronically by January 1, 1999. Recent experience has demonstrated that the 94 percent requirement can be met by increasing the $50,000 threshold to $200,000. As a result, the IRS has issued important new regulations that contain the following provisions that will be of interest to church treasurers:
(1) $200,000 threshold
Employers (including churches) do not need to deposit payroll taxes electronically unless they deposited payroll taxes of $200,000 or more in 1998. This is up from the $50,000 threshold that was scheduled to apply this year. Payroll taxes include withheld FICA and income taxes, as well as the employer's share of FICA taxes. Employers that exceed the $200,000 threshold in a future year will be required to deposit payroll taxes electronically following a one-year grace period. If an employer's deposits drop below $200,000 in a future year, it will not be allowed to revert back to making manual deposits at a local bank. The higher threshold will apply to deposits made on or after January 1, 2000. The IRS has announced that it will waive penalties for employers with $50,000 or more in payroll tax deposits that continue to deposit manually through the end of 1999. However, the IRS is reminding employers eligible for the penalty relief that deposits must still be made on time even when using paper coupons or they risk a late deposit penalty.
(2) a "fresh start"
Employers that have been making electronic deposits in anticipation of the $50,000 threshold will be allowed to revert to depositing payroll taxes manually at a bank if they do not meet the new $200,000 threshold for 1998. The IRS estimates that 65 percent of employers that would have met a $50,000 threshold will not meet the $200,000 threshold. The IRS estimates that 91 percent of all employers make less than $200,000 in payroll tax deposits. These are the employers that now can voluntarily deposit their payroll taxes electronically.
6. Church exemption from FICA taxes. Churches are allowed to exempt themselves from the employer's share of social security and Medicare taxes by filing a timely exemption application (Form 8274) with the IRS. To qualify for the exemption, a church must be opposed to paying the employer's share of these taxes on religious grounds. For churches with nonminister employees in 1984, the deadline for filing Form 8274 was October 30, 1984. The deadline for churches that hire their first nonminister employee after 1984 is the day before the due date for their first quarterly Form 941. The IRS recently rejected a church's application for exemption since the application was filed after the deadline. The church asked the IRS to waive the deadline, but the IRS refused. The IRS concluded: "The law setting forth the filing of elections for tax exemption was enacted by Congress, and there are no statutory provisions to permit an exception, for any reason, if the due date is missed. While we can sympathize with your situation, we have no authority to extend the period for filing the Form 8274, or to grant an exception to the timely filling requirement imposed by the law. Accordingly, you should continue to file Form 941." IRS Letter Ruling 199911025.
7. IRS ruling addresses backup withholding. A used car dealer made payments in excess of $600 during the year to various independent contractors for personal services provided to his business. For example, the dealer paid auto repair shops, auto body shops, and auto detail services for work performed on his dealership's cars. These independent contractors were paid by checks drawn on the dealer's business account. At the time the dealer made payments to the independent contractors, no taxpayer identification numbers were obtained, and the dealer did not issue a Form 1099 to any of the contractors. The dealer asked the IRS if he was required to engage in "backup withholding" on payments he made to these contractors. The IRS ruled that the dealer was required to engage in backup withholding at the time he made payments to the contractors, since he failed to obtain their taxpayer identification numbers. It stressed that an employer is required to withhold at a rate of 31 percent on any payment subject to the Form 1099 reporting requirement, at the time of the payment, if the employer has not received the contractor's taxpayer identification number. The IRS concluded that since the dealer failed to obtain the contractors' taxpayer identification numbers, his "obligation to backup withhold commenced with the entire amount of the payment that caused the total amount paid to an independent contractor to equal $600 or more for the calendar year."
It is important for church treasurers to recognize that if an independent contractor performs services for the church (and earns at least $600 for the year), but fails to provide you with his or her taxpayer identification number, then the church is required by law to withhold 31 percent of the amount of compensation as "backup withholding." Note that this must be done at the time of payment. There is no way to do it retroactively, since the compensation has been paid. IRS Letter Ruling 19990603.
8. Cancellation of debt creates taxable income. A teacher borrowed $130,000 from a bank to finance the purchase of a new home. A few years later, the bank foreclosed on the property after the teacher defaulted on his payment obligations. The property was sold for $93,000 by the county sheriff. At the time of the foreclosure sale, the teacher owed $160,000 in principal and accrued interest. After the sale, the bank discharged the balance due of $67,000. It issued the teacher a Form 1099-C (Cancellation of Debt), reflecting that he had received $67,000 in "discharge of indebtedness" income. The teacher did not report any of this amount on his income tax return. The IRS audited the teacher's tax return and added the $67,000 as income. The Tax Court agreed with the IRS. It noted that "generally, a taxpayer must include in gross income a discharge of indebtedness. The rationale for this principle is that, when a debt is forgiven, formerly encumbered assets of the borrower become freely available for his use and enjoyment. Since the loan does not have to be repaid, the newly freed assets constitute income." The court noted that the discharge of a debt does not constitute taxable income if it occurs in the course of bankruptcy, but this exception did not apply in this case since the teacher was not bankrupt.
Churches often "forgive" debts. To illustrate, many churches have made loans to youth pastors to assist with the down payment on a new home. A few years later the youth pastor accepts a position in another church. The loan is never paid. Eventually, the church board votes to forgive the debt (principal and accrued interest). The amount forgiven represents taxable income, and must be so reported by the youth pastor. Johnson v. Commissioner, 77 TCM 2005 (1999).
9. Tax Court addresses deductibility of a church member's contributions. A church member claimed a deduction on his tax return of $260 for cash gifts that he made to the church. The only support he had for this deduction was his claim that he attended church at least once each week and contributed $5 to $10 every Sunday. He also claimed a charitable contribution deduction of $500 for some old clothes that he donated to the Salvation Army. The Tax Court allowed a full deduction for the weekly cash contributions, finding the church member's testimony to be persuasive. It applied the so-called "Cohan rule," which allows taxpayers to estimate expenses if they can demonstrate that some deductible expenses were incurred. However, the court only allowed a deduction of $15 for the donation of old clothes. It noted that for a donation of noncash property, the donor "bears the burden of proving both the fact that the contribution was made and the fair market value of the contributed property." It noted that the donor in this case "offered only a general description of the articles of old clothing that he donated. While we believe that [he] actually did donate some old clothes [his] testimony that the value of the clothing was $500 was vague and unconvincing." Fontanilla v. Commissioner, 77 TCM 1977 (1999).
10. The IRS addressed the tax consequences of debt forgiveness. The IRS released an internal memorandum in 1999 (a "field service advisory") that addresses the tax consequences of debt forgiveness. A widow and mother of three adult children owned a partial interest in farm land. She suffered a stroke and was later determined by a court to be incompetent. A guardian was appointed to handle her financial affairs. The guardian sold the farm land to the children in exchange for non-interest bearing promissory notes signed by each child. The sales agreement called upon each child to pay the guardian $10,000 annually. However, the agreement contained a "cancellation" provision specifying that the payments owed by the children each year would be "forgiven" by the guardian. The children and guardian recognized that these annual cancellations of debt constituted gifts, but they had no tax impact since they were not more than the annual gift tax exclusion of $10,000 for each child. An IRS auditor determined that a completed gift had been made in the year the original sales agreement was signed, and not each year that the annual payments under the promissory notes were forgiven. As a result, the full amount of the notes represented a gift to the children in the year of the sale. Since these amounts were far more than $10,000, the children's attempt to purchase their mother's farm land without exceeding the annual gift tax exclusion failed. The IRS national office was asked to evaluate this arrangement. Specifically, it was asked whether a gift to the children occurred when the property was transferred in exchange for the non-interest bearing notes.
The IRS noted that the tax code imposes a "gift tax" on gifts, and that "the value of the property transferred, determined as of the date of the transfer, is the amount of the gift." Further the code specifies that if property is transferred for less than full value "the amount by which the value of the property exceeds the value [received] shall be deemed a gift." The IRS observed:
If an individual ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan. However, if there is no prearranged plan and the intent to forgive the debt arises at a later time, then the donor will have made a gift only at the time of the forgiveness. . . . Transactions within a family group are subject to special scrutiny, and the presumption is that a transfer between family members is a gift. Whether the transfer of property is a sale or a gift depends upon whether, as part of a prearranged or preconceived plan, the donor intended to forgive the notes that were received at the time of the transfer.
The IRS noted that the intent to forgive the notes was the determinative factor in this case, and that "a finding of a preconceived intent to forgive the notes relates to whether valuable consideration was received and thus to whether the transaction was in reality a bona fide sale or a disguised gift." The IRS pointed out that the children "did not execute separate notes" for each year, but rather "the indebtedness of each child . . . was represented by only one note." The children insisted that their arrangement represented a valid installment sale. The IRS disagreed: "It is difficult to conceive of this exchange as an installment sale where the intent of the [children] to make a gift to themselves . . . is so clearly evident at the time of the [sale agreement]. The [children] have not come forward with evidence to show that the notes represented an obligation portions of which could be forgiven annually . . . . The [IRS auditor] in this case has appropriately treated this entire transaction as a sham . . . . It is axiomatic that questions of taxation are to be determined with regard to substance rather than form. An examination of the objective facts of this case, therefore, can only lead to the conclusion that the children are entitled to a gift tax exclusion for [one year] only."
Many churches have advanced funds to a pastor to assist with the payment of a home. In some cases, there is no clear understanding as to the nature of the arrangement, and no documents are signed. It may not be until it is time for the church treasurer to issue the pastor a W-2 that the tax consequences of the transaction are addressed. If the amount advanced by the church is substantial, church leaders may attempt to characterize it as a "loan" to avoid reporting it as taxable compensation to the pastor. The IRS memorandum demonstrates that this may not be possible. FSA 9999-9999-170.
11. Reimbursing medical expenses without a formal plan. It is common for churches to pay some or all of the medical expenses of their ministers or lay employees. This can include direct payment of expenses, reimbursing employees for expenses they have incurred, and paying a "deductible" amount on an employee's medical insurance. The tax consequences of such payments and reimbursements are not well understood. Section 105 of the tax code permits employees to exclude from gross income amounts received under an employer-financed "accident and health plan" as payments for permanent injury or loss of bodily function, or as reimbursements of medical expenses. The payments can be made on behalf of a spouse or dependent of the employee. This exclusion assumes that the employer has established an "accident or health plan." Unfortunately, the requirements for such a plan are not specified in the tax code. The regulations simply state that "an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness." The regulations further specify that "an accident or health plan may be either insured or uninsured, and it is not necessary that the plan be in writing or that the employee's rights to benefits under the plan be enforceable." Of course, a written plan is preferable, since it generally will eliminate any doubt regarding the existence or date of a plan. The regulations do require that notice of a plan be "reasonably available" to employees (if employees' rights under the plan are not enforceable).
Employers may reimburse employee medical expenses under either a self-insured plan (e.g., reimbursements are paid out of the employer's own funds rather than through an insurance policy), or an insured plan. However, if reimbursements are made under a self-insured plan, then nondiscrimination rules apply. Generally, these rules require that the plan not discriminate in favor of highly compensated individuals with regard to either amount of benefits or eligibility to participate. If a self-insured plan is discriminatory, then highly compensated individuals ordinarily must report some or all of the amount of the employer's reimbursements as taxable income.
In 1999 the IRS released a policy that addresses this question: "Are employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan excludable from gross income by the employee under section 105(b) of the Internal Revenue Code?" The IRS policy concludes that "employer reimbursements under a self-insured accident and health plan for medical expenses incurred prior to the adoption of the plan are not excludable from gross income by the employee." The IRS noted that employers often adopt self-insured accident and health plans to cover medical expenses incurred prior to the date of the adoption of the plan but within the same taxable year. This is done in an attempt to allow employees to exclude these medical expense reimbursements from income. To illustrate, assume that a church employee experiences a severe illness. The church board agrees to pay the $2,500 "deductible" on the employee's health insurance policy. The board assumes that this amount is nontaxable because it was motivated by charity. Several weeks later, the board learns that the payment is nontaxable only if the church had a formal accident and health "plan" in place. The board hastily drafts a few paragraphs describing its "plan," and inserts the text in the minutes of a board meeting.
The IRS policy notes that "[code section] 105(b) states that gross income does not include amounts paid, directly or indirectly, to the employee to reimburse the employee for expenses incurred by him, his spouse or dependents for medical care. . . . However, section 105(b) does not apply unless the medical expense reimbursements are received under an accident or health plan." The IRS conceded that a plan "need not be enforceable and need not be in writing." However, in order for there to be a plan, the employer "must be committed to certain rules and regulations governing payment. These rules must be made known to employees as a definite policy and must be determinable before the employee's medical expenses are incurred." The IRS concluded that "payments for reimbursement of medical expenses incurred prior to the adoption of a plan are not paid or received under an accident or health plan for employees. Thus, these amounts are includible in the employee's gross income . . . and are not excludable under section 105(b) of the Code."
The relevance of the IRS policy to church treasurers is clear. Church leaders often distribute funds to ministers and lay employees to cover medical expenses without any serious consideration of the tax consequences. In most cases, they simply assume that these payments are nontaxable. The IRS policy suggests that such an assumption may be erroneous and lead to needless tax complications. In many cases a church not only is required to report the payments or reimbursements as taxable income and add them to the employee's W-2, but the employee will need to report them on his or her tax return and pay taxes on them. All of this can be avoided, the IRS concluded, if the church simply adopted an adequate "plan" in advance of making the medical payments. IRP ¶ 80,600 (1999).
12. Employer not liable for rejecting employee's fraudulent W-4 form. An employee submitted a W-4 form (withholding allowance certificate) to his employer on which he claimed 99 withholding allowances and "exempt" status from tax withholding. The employer submitted the W-4 to the IRS, and later received a letter from the IRS directing it to disregard the employee's W-4 and to treat him as a single person claiming zero allowances for tax withholding purposes. The employer complied with these directions, and it was sued by the employee who demanded a refund of all the taxes withheld from his wages. A federal court dismissed the employee's lawsuit, noting that the IRS has the authority to order employers to disregard an employee's W-4 form, and that the employer's actions "were in full compliance with federal regulations." Pesci v. Internal Revenue Service, 99-1 USTC ¶ 50,439 (D. Nev. 1999).
13. Social Security annual statements. On October 1, 1999, the Social Security Administration (SSA) launched the largest customized mailing ever undertaken by a federal agency when it began mailing an annual Social Security statement to 125 million workers. The 4-page statement is designed to help workers with financial planning by providing estimates of their retirement, disability and survivors' benefits. The statement will also provide workers an easy way to determine whether their earnings are accurately posted on their Social Security records. This is an important feature because Social Security benefits are based on an individual's career wage record-not on taxes actually paid. The SSA will send the annual statements to workers who are ages 25 and older and not receiving Social Security benefits. An annual statement will contain the following information: (1) an estimate of the monthly retirement benefit that the worker would receive at age 62, full retirement age, and age 70; (2) a projection of the amount of monthly disability benefit the worker could be entitled to should he or she become disabled; (3) an estimate of the monthly benefit that the worker's family could receive should the worker die; (4) an annual breakdown of the worker's earnings to date; and (4) a total of the Social Security taxes paid by the worker and his or her employer over the individual's working career.
Each annual statement will report a worker's lifetime earnings on an annual basis, along with total Social Security taxes paid each year by the worker and his or her employer. It is important for church workers to check the accuracy of the earnings reported on their statement, since this will determine the amount of Social Security benefits they will receive in the future. Workers who can prove that the earnings information reported on their statement is incorrect can contact their local Social Security office for assistance in correcting the record.
It is especially important for ministers to check their statements carefully, because their earnings history is vulnerable to error for two reasons. First, many ministers who report their income taxes as employees erroneously report their social security taxes as employees (the church withholds FICA taxes from their wages like any nonminister church employee). In fact, ministers always are self-employed for social security with regard to the exercise of their ministry. Some ministers who report their social security taxes as employees have reported errors in their earnings history. Second, ministers who continue to work after beginning to receive social security retirement benefits are assumed by the SSA to be receiving twice their reported income. This is because such ministers will report income as wages on Form 1040 (line 7) and also as self-employment earnings on Schedule SE (Form 1040). SSA computers assume that amounts reported in these two places reflect different sources of income. While this is true for most workers, it is not true of ministers. Again, the reason is that their income must be reported as self-employment earnings on Schedule SE even though the same income is reported as employee wages on Form 1040. What appears to be "two" different sources of income in fact is only one. The result is that the minister appears to be earning far more than the "annual earning test" (the amount that a retired person can earn between ages 62 and 70 without triggering a reduction in Social Security benefits). The bottom line is this-ministers should carefully review their yearly earnings history as reflected on their annual Social Security statement so they can correct errors.
14. An Indiana court ruled that a church-owned building was exempt from property taxation even though it was not currently being used for exempt purposes. A church purchased an adjacent building and parking lot for use as a community mental health center. While the building was structurally sound, it needed extensive interior renovations in order to be used as a mental health center. These renovations were in progress on the date the church filed an application to exempt the building and parking lot from property taxation. A state tax board granted an exemption for the parking lot, since it was being used by parishioners who attended the church. But the tax board denied the exemption for the building since it was "vacant and unoccupied" on the assessment date. The church appealed, and the state tax court ruled that the building was exempt. Indiana law exempts from taxation "all or part of a building [that is] owned, occupied, and used by a person for . . . religious or charitable purposes." The court acknowledged that exemption statutes are "strictly construed against the person claiming the exemption." But it insisted that "exemption provisions are not to be construed so narrowly that the legislature's purpose in enacting it is defeated or frustrated." The "proper focus," concluded the court, is "whether the use of the property furthers exempt purposes." Such an approach is "consistent with the legislative purpose of rewarding charities for providing a public benefit." The court noted that the building in question was undergoing extensive renovations on the tax assessment date (the date on which property tax exemptions are determined). The question to be decided "is whether preparing the building for future use in furtherance of exempt purposes qualifies the building for exemption."
The court agreed that "mere ownership alone is insufficient to support an exemption and that the intent to use the property for an exempt purpose must be more than a mere dream." It continued: "In this case, it is apparent that, on the assessment date [the church's] intent to use the building in furtherance of exempt purposes was more than a dream, and that it did more than merely own the building. [It] had taken concrete steps at great expense to prepare the building for use as a community mental health center. This is more than enough objective evidence to support [the church's] contention that, as of the assessment date, it held the building with an intention to use the building in the future for exempt purposes. It was therefore an abuse of discretion to deny [the building's] exemption." Trinity Episcopal Church v. Board of Tax Commissioners, 694 N.E.2d 816 (Ind. Tax 1998).
15. The IRS revokes a church's tax-exempt status because of political activities. In order to maintain their tax-exempt status for federal income tax purposes, churches and other religious organizations must comply with several requirements specified in section 501(c)(3) of the tax code. One of these requirements is that the organization must not participate or intervene in any political campaign on behalf of (or in opposition to) any candidate for public office. Many churches have violated this requirement in the past with no adverse consequences. However, the landscape is changing. In 1995 the IRS for the first time revoked the exempt status of a church for intervening in a political campaign. The church had published full-page ads in two national newspapers, warning Christians not to vote for candidate Bill Clinton in the 1992 presidential election. In 1999, a federal court upheld the IRS ruling. The court rejected the church's claim that the revocation of its tax-exempt status violated the first amendment, the Religious Freedom Restoration Act, and the Church Audit Procedures Act. The court also rejected the church's claim that the decision of the IRS to revoke its tax-exempt status was unconstitutionally motivated by the conservative political and religious beliefs of the church. The court concluded that the church had failed to establish that the revocation of its tax-exempt status substantially burdened its right to freely exercise its religion: "A substantial burden exists where the government puts substantial pressure on an adherent to modify his behavior and to violate his beliefs, or where the government forces an individual to choose between following the precepts of her religion and forfeiting benefits, on the one hand, and abandoning one of the precepts of her religion." The court stressed that the church had provided no evidence that the revocation of its exempt status by the IRS was in any way connected to its "refusal to violate its religious beliefs or abandon a precept of their religion." Instead, the revocation was undertaken "because of the church's involvement in partisan political activity."
The church claimed that the decision of the IRS to revoke its section 501(c)(3) status had imposed a number of burdens, including exposure to federal income taxation, and the likelihood that contributions will decrease since donors will not be eligible to deduct their contributions to the church. The court acknowledged that the church was "probably correct" in claiming that the revocation had imposed these burdens, but it insisted that the church had "failed to establish that the revocation has imposed a burden on their free exercise of religion." The court emphasized that the church had a choice-it "could engage in partisan political activity and forfeit its section 501(c)(3) status or it could refrain from partisan political activity and retain its section 501(c)(3) status." The court insisted that this choice was unconnected to the church's ability to freely exercise its religion. The court noted that the only way in which the revocation of section 501(c)(3) status had any effect on the church's exercise of religion was that the church had less operating money to spend on religious activities because it was now a taxable entity. But, the fact that the church had less money to spend on religious activities as a result of its participation in partisan political activity "is insufficient to establish a substantial burden on their free exercise of religion." Branch Ministries, Inc. v. Commissioner, 40 F. Supp.2d 15 (D.D.C. 1999).
16. A Colorado court ruled that two vacant lots owned by a church were exempt from property tax because they were used one day each year for religious purposes. This ruling will be of relevance to any church that is paying property taxes on vacant land. The church in question owned two vacant lots-one near the church, and the second some distance away. The church was the only user of the two lots, and used each lot one day each year for activities that it claimed were in furtherance of its religious mission. The church hoped to construct structures on each lot for church use, but it lacked the funds to do so. A local tax assessor ruled that the lots did not qualify for exemption because the quantity and extent of the church's use was insufficient. A board of tax appeals reversed the assessor's ruling, noting that the church actually used the lots "on a limited basis" and was "the only user" of the properties, and that the limited funding available to the church to improve the properties should not "keep the properties from being tax exempt." The tax assessor appealed, and a state appeals court upheld the exemption of the two lots. The court began its opinion by quoting the Colorado property tax exemption statute, which grants a property tax exemption to property "which is owned and used solely and exclusively for religious purposes." The court concluded:
Under [the exemption statute] the test for exemption depends upon the character of the use to which the property is put. . . . Further, property tax exemptions based on religious use should not be narrowly construed . . . . We note that property tax exemptions are determined on an annual basis . . . based on the use of the property in each tax year. Implicit in this scheme is the requirement that, in order for the property to qualify for tax exemption for that tax year, there be at least some actual use of the property for tax exempt purposes in that tax year. Apart from this minimal implicit requirement, however, we decline to hold . . . that any particular frequency or quantity of use religious in character is required to satisfy the foregoing . . . standards for exemption based on religious use.
The court noted that while the tax assessor considered the church's use of the lots just one day each year to be insufficient for exemption, he "was unable to quantify the frequency or amount of such use that would be considered sufficient." Pilgrim Rest Baptist Church v. PTA, 971 P.2d 270 (Colo. App. 1998).
17. Reimbursing business expenses through salary "restructuring." In a surprise development, the IRS issued a private letter ruling in 1999 suggesting that some salary "restructuring" arrangements may be used in connection with accountable business expense reimbursement arrangements. This is a very significant development for churches, since nearly 90 percent of churches now use accountable arrangements to reimburse staff members' business expenses, and many use some form of salary "restructuring" to pay for the reimbursements. The recent IRS ruling repudiates a 1993 ruling in which the IRS concluded that an employer could not use a salary "restructuring" arrangement to fund reimbursements under an accountable plan. The 1999 IRS ruling suggests that such arrangements can be accountable, if the following three conditions are met:
(1) Meet the three requirements of an accountable arrangement. These include the "business connection" requirement (an employer only reimburses legitimate business expenses); (2) the "substantiation" requirement (the employer only reimburses those business expenses that an employee substantiates within 60 days); and (3) the "return of excess reimbursements" requirement (the employee must return to the employer any reimbursements in excess of substantiated expenses).
(2) Meet the reimbursement requirement. Even if a reimbursement arrangement meets the three requirements of an accountable plan, it will not be accountable unless it meets the so-called reimbursement requirement. The regulations define this requirement as follows: "If [an employer] arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses . . . the arrangement does not satisfy [the reimbursement requirement] and all amounts paid under the arrangement are treated as paid under a nonaccountable plan." To meet this requirement, it is essential that a church or other employer not agree to pay an employee a specified amount of compensation out of which business expenses may or may not be reimbursed. Salary reduction arrangements are not accountable because of this requirement. Why? Because with such an arrangement the employer agrees to pay the employee a specified amount of compensation for the year whether or not the employee submits any business expenses for reimbursement. And, when expenses are reimbursed, the reimbursements come out of the employee's own compensation rather than out of church funds. This kind of arrangement is not really a "reimbursement" plan, since the church is not reimbursing anything. Rather, it is reducing the pastor's reportable compensation to pay for the expenses. Can a salary restructuring arrangement meet the reimbursement requirement? Possibly. In fact, this is the conclusion the IRS reached in its 1999 ruling. But this conclusion will not apply to any salary restructuring arrangement. There were several conditions present in the 1999 ruling that must be met for a salary restructuring arrangement to meet the reimbursement requirement.
(3) Meet the following essential conditions of the 1999 IRS ruling. The IRS concluded that a salary restructuring arrangement was "accountable" in its 1999 ruling. There were some factors present in that ruling that were essential to the conclusion reached by the IRS. These include the following: (1) Employees were reimbursed only for those business expenses that would be deductible as a business expense on their personal tax returns. (2) Prior to the start of each year, each employee's manager determines the amount, if any, to be excluded from the employee's commissions in the next year. (3) If an employee's expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the employee and will not be carried over from one calendar year to the next. (4) If an employee does not request reimbursement under the plan, he or she receives no additional compensation. To increase the likelihood that a salary restructuring arrangement will be deemed accountable, a church should consider designating a minister's salary and establishing a business expense reimbursement account as two separate actions of the board or compensation committee, without any indication that the reimbursement account is being funded out of what otherwise would be the minister's salary. These separate actions may be viewed as sufficiently unrelated to be consistent with an accountable reimbursement arrangement. Letter Ruling 99916011.
18. The Taxpayer Refund and Relief Act of 1999. By the slimmest of margins, Congress passed the Taxpayer Refund and Relief Act in August. The Act contains many provisions of interest to clergy and church leaders. While the President vetoed the Act, a review of its major provisions is still warranted since presidential candidate George W. Bush has stated that he would sign the bill into law if elected president. If governor Bush is elected president and the Republicans hold onto their majorities in the House and Senate, it is likely that most if not all of the provisions in the Act will become law in the future. As a result, church leaders should be familiar with those provisions that directly affect churches. These include the following: (1) Repeal of the estate and gift tax. This provision may result in a reduction in charitable contributions from wealthy individuals, since some are induced to make charitable contributions in order to minimize estate taxes. (2) The Act permits an exclusion from gross income for qualified charitable distributions from an IRA. To qualify, the distributions must be to a church or other charitable organization to which deductible contributions can be made. A qualified charitable distribution is any distribution from an IRA which is made after age 70-1/2, which qualifies as a charitable contribution, and which is made directly to the charitable organization. (3) Under current law, no charitable contribution deduction is allowed for a contribution of services. However, unreimbursed expenditures associated with providing donated services to a qualified charitable organization, such as out-of-pocket transportation expenses necessarily incurred in performing donated services, may constitute a deductible contribution. For purposes of computing the charitable contribution deduction for the use of a passenger automobile (including vans, pickups, and panel trucks) in connection with providing donated services to a qualified charitable organization, the standard mileage rate is 14 cents per mile. Volunteer drivers who are reimbursed for mileage expenses have taxable income to the extent the reimbursement exceeds 14 cents per mile. The Taxpayer Refund and Relief Act specifies that any reimbursement by church or other charity for the costs of using an automobile in connection with providing donated services is excludable from the gross income of the volunteer, provided that reimbursement does not exceed the standard mileage rate for business miles, and applicable recordkeeping requirements are satisfied. The expenditures for which a volunteer is reimbursed must be expenditures for which a deduction would otherwise be allowable as a charitable contribution. The Act does not permit a volunteer to exclude a reimbursement from income if the volunteer claims a deduction or credit with respect to his or her automobile transportation expenses incurred in connection with providing donated services. (4) Numerous changes were made to tax-sheltered annuities (403(b) plans), most of which are favorable to participants in these popular retirements plans.
19. An Illinois court ruled that a church's parking lots, a storage building, and a former sanctuary that had been badly damaged in a fire, were all exempt from property taxation. In 1992, a church sought a religious-use property tax exemption for various parcels of real estate in Chicago. A state agency denied the application, and the church requested a formal hearing to determine whether the parcels warranted exemption. At the hearing, the church requested exemption for the following properties: (1) a burned church building; (2) a private school located directly east of the burned church; (3) a large storage building; and (4) various parking lots. The burned church building had been damaged by a fire a few years earlier. The fire resulted in the relocation of worship services and other church activities to the school building. A judge determined that the school was exempt, as were the parking lots associated with it. However, the judge concluded that the burned church was not exempt even though the congregation intended to rebuild it when they received the proceeds from an insurance policy, since its condition prevented it from being used for religious purposes. Further, the storage building was "in a dilapidated condition that rendered it unsuitable for regular use" and therefore was not in exempt. The judge also noted that the church had failed to show how the storage facility furthered its exempt purpose and concluded that the storage building was not reasonably necessary to further the church's exempt operations. A state appeals court agreed that the school and associated parking lot were exempt, but it also ruled that the burned church building, the storage building, and the parking lots associated with these two buildings also were entitled to exemption. The court noted that Illinois law exempts from property taxation (1) "all property used exclusively for religious purposes, or used exclusively for school and religious purposes . . . and not leased or otherwise used with a view to profit" and (2) "parking areas, not leased or used for profit, when used as a part of a use for which an exemption is provided hereinbefore and owned by any . . . school or religious or charitable institution which meets the qualifications for exemption." The court noted that "to the extent that the burned church was used, it was used exclusively for a religious purpose." It referred to the testimony of a church leader who testified that "sometimes we would go there to pray." This satisfied the court that the building was used exclusively for religious purposes. It concluded: "[W]here a property already is devoted to a religious purpose as the site of a place of worship, and has been so devoted for numerous years, an incidental interruption of its actual use for that religious purpose due to fire will not destroy the exemption. We conclude that to hold otherwise would be unreasonable and improper." The court also noted that the church had established a building fund dedicated to rebuilding the burned church and was actively pursuing a legal remedy to obtain insurance proceeds following the fire.
The trial judge had denied exemption to all of the church's parking lots other than those associated directly with the school in which religious services were being conducted. The appeals court reversed this ruling, noting that the legislature "did not make the exemption of parking areas contingent upon location or proximity to exempt property. The plain language of the [law] requires that an applicant seeking an exemption for its parking area demonstrate three things: (1) ownership of the parking area by an exempt institution; (2) the fact that the parking area is not leased or used for profit; and (3) the fact that it is used as part of a use for which an exemption is provided . . . ." The court noted that the church had established its not-for-profit tax exempt status, its ownership of the parking areas, and the fact that the lots were not leased or used for profit. The only remaining question was whether the parking lots were used as part of a use for which an exemption is provided. The court concluded that they were. Once again, it relied on the testimony of a church leader who stated that the church used all of its parking facilities "not all of the time, but most of the time," and that church buses remained parked there when not in use. This testimony convinced the court that all the church's parking lots were used as part of an exempt use.
The court noted that property will be exempt from taxation if it is "primarily used for purposes which are reasonably necessary for the accomplishment and fulfillment of the [purposes], or efficient administration, of the particular institution." The court concluded that the storage building met this test: "[T]hough access to the building was limited, the building was used for storage, with certain persons going in and out to store and to retrieve items. Specifically, [the church] demonstrated that it used the storage building . . . for the purpose of storing desks, chairs, and air conditioners. . . . [S]o used, the storage building facilitated the congregation's efforts to keep its church services, activities, and community outreach programs ongoing after the fire. Therefore, we conclude that . . . [the church] established that the storage building was primarily used for purposes reasonably necessary for the accomplishment and fulfillment of the congregation's aims of worship and religious instruction, or the efficient administration of [the church]." Mount Calvary Baptist Church, Inc. v. Zehnder, 706 N.E.2d 1008 (Ill. App. 1998).