Tax Changes of Interest to Ministers in 2000

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: m27 c0101

1. Revoking an exemption from self-employment (social security) taxes. It's official-ministers can revoke an exemption from social security. Many ministers who opted out of social security by filing a Form 4361 with the IRS have wanted to rejoin the program-often to qualify for Medicare benefits. In the past, ministers have not been permitted to revoke an exemption. The tax code specifies that such exemptions are irrevocable. In December of 1999, President Clinton signed the "Ticket to Work Act" into law. The Act contains a provision allowing ministers to revoke an exemption from self-employment taxes by filing Form 2031 with the IRS by April 15, 2002. Ministers who file the form must begin paying self-employment taxes as of either January 1, 2000, or January 1, 2001. In order to avoid paying several quarters of back taxes, ministers wanting to revoke an exemption should file the revocation form (1) in January of 2000 and elect to begin paying taxes as of January 1, 2000, or (2) in December of 2000 or January of 2001, and elect to begin paying taxes as of January 1, 2001. One exception to these recommendations would be ministers who want to accumulate additional quarters of coverage to become eligible for retirement or Medicare benefits. These ministers may prefer to elect coverage retroactive to January 1, 2000. While they will have some back taxes to pay when they revoke their exemption, this is the price they will have to pay for the additional quarters of coverage. Ministers wanting to revoke an exemption from social security can obtain a copy of Form 2031 by calling the IRS toll-free forms hotline at 1-800-TAX-FORM, or by downloading a copy from the IRS website (www.irs.gov).

2. 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. 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. 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. 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, or (3) the annual rental value of the pastor's home (furnished, including utilities). The IRS offered the following arguments to defend the annual rental value test: the "rental value" language in the tax code supports the test; 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. This means that ministers may now compute the nontaxable portion of their church-designated housing allowance without reference to the annual rental value test. There are a few additional points to note:

(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.

(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 audit guidelines for ministers apply the annual rental value limit that was invalidated by the Tax Court in this 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, ministers who ignore the annual rental value test can rely on the Tax Court's decision in support of their position if audited.

(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).

(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. The Tax Court rejected this argument. 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, 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. Warren v. Commissioner, 114 T.C. 23 (2000).

3. The Tax Court ruled that a minister was not exempt from social security because his exemption application was filed too late. In order to be exempt from social security (self-employment) taxes, a minister must meet several requirements. One of these requirements is the submission of a timely exemption application (Form 4361) to the IRS. In order to be timely, the application must be filed by the due date of the federal tax return (Form 1040) for the second year in which the minister had net self-employment earnings of $400 or more, any portion of which derived from ministerial services. While enrolled in college, a student (John) was licensed as a "student local pastor" for the United Methodist Church (the Church) and served in a local church in 1983 and 1984. His earnings exceeded $400 each year. John thereafter attended seminary, and during this time he was licensed and served as the local pastor of a church from 1985 to 1987. In 1987, he was ordained a deacon in the Church. In 1990 he was ordained an elder. The ordained ministry of the Church consists of deacons and elders. In 1989, John filed an application for exemption from social security (self-employment) taxes by filing a Form 4361 with the IRS. He noted on the form that he had been "ordained" in 1987, when he was ordained a deacon. Therefore, the form was filed prior to the deadline. The Tax Court ruled that John's application for exemption had been filed too late since the duties he performed as a "licensed" pastor in 1983 and 1984 were the performance of services as a minister. The court noted that as a licensed local pastor in 1983 and 1984 John was authorized to preside over the ministration of sacerdotal functions, such as baptism, communion, and marriage, and he conducted religious worship. Therefore, "for those years [John] acted in a manner consistent with the performance of service by a duly ordained, commissioned, or licensed minister within the meaning of [the tax code]." The court conceded that as a licensed pastor John had no "voice or vote" on official matters of his denomination. However, it noted that "to perform services in the control, conduct, and maintenance of the church or organizations within the church, the minister need only have some participation in the conduct, control, and maintenance of the local church or denomination." It concluded that during 1983 and 1984, as a licensed local pastor, John served "in the control, conduct, and maintenance" of his local church even though as a licensed local pastor he might not have done so with respect to his national denomination. Since John had net earnings of at least $400 derived for the performance of services as a minister in 1983 and 1984, his application for exemption from self-employment tax should have been filed prior to the due date of his 1984 federal income tax return (April 15, 1985). Because it was not, it was filed too late and was not effective. Brannon v. Commissioner, T.C. Memo. 1999-370 (1999).

4. The IRS ruled that a minister who was employed as a guidance counselor and teacher by a church-affiliated school was eligible for a housing allowance. A minister was employed as a guidance counselor by a school that was sponsored by six congregations. The IRS ruled that the minister was eligible for a housing allowance. It noted that the income tax regulations specify that "if a minister is performing service for an organization which is operated as an integral agency of a religious organization under the authority of a religious body constituting a church or church denomination, all service performed by the minister in the conduct of religious worship, in the ministration of sacerdotal functions, or in the control, conduct, and maintenance of such organization is in the exercise of his ministry." The IRS concluded that the school in this case was an integral agency of the sponsoring churches, and therefore the services performed by the minister on behalf of the school were in the exercise of his ministry and qualified for a housing allowance. The IRS based this conclusion on a 1972 ruling in which it listed 8 criteria to consider in deciding whether or not a church-related institution is an integral agency of the church. Revenue Ruling 72-606. These criteria include (1) whether the religious institution incorporated the agency; (2) whether the corporate name of the agency indicates a church relationship; (3) whether the religious organization continuously controls, manages, and maintains the agency; (4) whether the trustees or directors of the agency are approved or must be approved by the religious organization or church; (5) whether trustees or directors may be removed by the religious organization or church; (6) whether annual reports of finances and general operations are required to be made to the religious organization or church; (7) whether the religious organization or church contributes to the support of the agency; and (8) whether, in the event of the dissolution of the agency, its assets would be turned over to the religious organization or church. The IRS stressed that "the absence of one or more of these characteristics will not necessarily be determinative in a particular case." The IRS concluded that the school was an integral agency of the sponsoring churches: "Each of the six sponsoring congregations appoint [sic] two of their members to serve on the school board, and each is free to remove and/or replace its own representatives at will. The sponsoring congregations, through their respectively appointed board members, establish school policies, purchase equipment and supplies, maintain facilities, as well as approve and sign teacher contracts. The school board elects its own trustees and officers from among the board members appointed by the congregations. Each member of the school's staff is required to sign a 'Statement of Faith' embracing church doctrine. The treasurer of the school board presents monthly financial statements to the school board, and it is the responsibility of the members to report the financial operations of the school back to their respective congregations. The six sponsoring congregations provide annual cash contributions to the school. Additionally, four of the sponsoring congregations house branches of the school in their church facilities. In the event of dissolution of the school, its assets would become the sole property of the sponsoring congregations. . . ." As a result, the minister was eligible for a housing allowance. IRS Letter Ruling 200002040.

5. The Tax Court ruled that an ordained minister who worked for an evangelical ministry was eligible for a housing allowance. An evangelical ministry conducted crusades, produced religious television broadcasts, and published religious literature. It also provided a minister with a housing allowance. The IRS claimed that the minister was not eligible for a housing allowance. The income tax regulations specify that a housing allowance must be provided as compensation for ministerial services, and they define ministerial services to include the performance of sacerdotal functions; the conduct of religious worship; and "the control, conduct, and maintenance of religious organizations, under the authority of a religious body constituting a church." The IRS claimed that the minister was not eligible for a housing allowance since his employer was not a "church," and therefore he was not a minister performing services under the authority of a church. The Tax Court disagreed. It defined a church as follows: "To classify a religious organization as a church under the Internal Revenue Code, we should look to its religious purposes and, particularly, the means by which its religious purposes are accomplished. . . . At a minimum, a church includes a body of believers or communicants that assembles regularly in order to worship. When bringing people together for worship is only an incidental part of the activities of a religious organization, those limited activities are insufficient to label the entire organization a church." The court concluded that the evangelistic ministry in this case met this definition: "[It] has a far-ranging ministry that reaches its members through television and radio broadcasts, written publications, and crusades. It has loyal followers, some who attended worship services . . . and attended crusades held regularly in various cities. Many . . . were not associated with any other religious organization or denomination. In essence, [it] had the requisite body of believers, and, therefore, [the minister] performed services under the authority of a church. In addition, [he] was 'authorized to administer the sacraments, preach, and conduct services of worship' and was an ordained minister of the gospel." Whittington v. Commissioner, T.C. Memo. 2000-296 (2000).

6. Annual earnings test is repealed. President Clinton signed a bill into law in 2000 that repeals the "annual earnings test" for workers who are 65 to 70 years of age. The repeal is retroactive to January 1, 2000. As a result of this repeal, persons who are 65 to 70 years of age, and who continue to work, will not have their social security benefits reduced by earning income over a specified amount. Prior to the repeal, workers who were between 65 and 70 years of age, and who were receiving social security benefits, could earn up to $17,000 (for year 2000) without any reduction in their social security benefits. However, for every $3 of earned income over this amount, a worker's social security benefits were reduced by $1. The annual earnings test for workers who elect to begin receiving social security benefits at ages 62 to 65 is not affected. For every $2 of earned income over $10,060, their social security benefits are reduced by $1 (in year 2000). Workers can earn any amount beginning at age 70 without a reduction in social security benefits.

. Example. Pastor T is a retired minister who is hired by a church as its minister of visitation. Pastor T is 66 years old and is receiving social security benefits. The church paid him $26,000 of taxable compensation for year 2000. If Congress had not repealed the annual earnings test, Pastor T's social security benefits would have been reduced by $1 for every $3 of earned income over $17,000. Since Pastor T has earned income of $9,000 in excess of $17,000, his social security benefits would have been reduced by $3,000. However, because the annual earnings test has been repealed, Pastor T's social security benefits are not affected. His benefits are not reduced by $3,000. The repeal of the earnings test means that Pastor T will have an additional $3,000 of income in 2000.

. Example. Same facts, except that Pastor T is 63 years old. There are no plans to repeal the annual earnings test for workers who are age 62 to 65. Therefore, Pastor T's social security benefits would be reduced by $1 for every $2 of earned income over $10,060 in 2000. Since Pastor T earned income of $15,940 in excess of $10,060, his social security benefits would be reduced by a whopping $7,970.

7. IRS simplifies the offer in compromise program. The offer in compromise program's purpose is to settle tax debts for the maximum amount that a taxpayer can pay. In many cases the taxpayer can more easily pay back the debt by paying it off over a period of time. The IRS has announced two changes to the program. First, taxpayers can elect a fixed monthly payment option, ending uncertainty about converting offer amounts into monthly payments. In the past taxpayers were not eligible to pay offers in compromise in installments. They still are not eligible for ordinary installment agreements, but they will be eligible for the new, fixed monthly payment option. Second, the IRS is eliminating Form 656-A and combining it with the standard Form 656 that is used to submit an offer in compromise to the IRS. Taxpayers will now only have to complete one form in order to submit an offer in compromise. IRS News Release IR-1999-105.

• Key point. Many church members have been overwhelmed by huge tax bills that they cannot afford to pay. Church treasurers may want to suggest to such persons that they submit an offer in compromise to the IRS. If accepted, not only will the tax liability be reduced, but the taxpayer may be able to pay it back over an extended period.

8. Offer in compromise program expanded. The IRS has begun accepting applications for a new type of offer in compromise plan designed to help some taxpayers facing severe or unusual economic hardships. For the first time, the IRS will be able to consider economic hardship factors in cases where taxpayers try to settle unpaid tax debts through the offer in compromise program. The change expands the offer in compromise program, which allows the IRS to negotiate a settlement with people unable to pay their entire tax bill. Previously, the IRS could accept the taxpayer's offer in compromise only when there was doubt about whether the tax debt could ever be collected or whether it was owed. Taxpayers may be eligible for this new provision if collection of the entire tax liability would create economic hardship, or exceptional circumstances exist where collection of the entire tax liability would be detrimental to voluntary compliance. To qualify, taxpayers must have a history of paying and filing their taxes. Internal Revenue News Release, IR-1999-76.

9. Social Security average benefits for 2000. The maximum social security benefit for workers retiring at age 65 on January 1, 2000 increased to $1,373 per month ($16,476 per year). The average benefit is $780 per month ($9,360 per year) for all retired workers; $1,310 per month ($15,720 per year) for a retired couple who each receive benefits; $1,554 per month ($18,684 per year) for a widowed mother with two minor children; and $733 per month ($8,796 per year) for a disabled worker. See the table for more details on changes in the Social Security program that took effect in 2000.

Year 2000 Social Security Changes

10. IRS assesses intermediate sanctions. A few years ago, Congress gave the IRS the authority to impose "intermediate sanctions" on certain officers of tax-exempt organizations who receive excessive compensation for their services. These sanctions can be severe-up to 200% of the amount of compensation that is deemed to be excessive. The IRS has now imposed the first round of these sanctions. While none of the early cases involves a religious organization, we will be monitoring these cases closely for any developments that may be relevant to religious organizations and clergy.

11. Tax statistics. The IRS just released the following data on tax returns filed in 1997: (1) Adjusted gross income (AGI) reported on individual income tax returns for 1997 was slightly less than $5 trillion, a 10% increase over 1996. (2) The average AGI for 1997 was $40,597, compared to $37,690 for 1996. The largest source of income, salaries and wages, was 7% higher than the previous year, the largest percentage increase since 1988. (3) Total itemized and standard deductions increased only 6%. (4) Charitable contribution deductions increased 15%, to $99.2 billion. (5) There were 19.4 million lower-income taxpayers who claimed the earned income credit. The total amount claimed in 1997 was $30.4 billion, compared to $28.8 billion for 1996. IR-2000-2.

12. IRS defines "last known address." The IRS generally has three years from the date a federal tax return is filed (or the due date for the return if the return is filed early) to audit the return and assess additional taxes and penalties. However, the IRS may not assess additional taxes and penalties unless it mails a "notice of deficiency" to the taxpayer giving the taxpayer an opportunity to challenge the IRS position before the United States Tax Court. An IRS notice of deficiency must be mailed to the taxpayer's "last known address," even if it is not received by the taxpayer. In the past, the term "last known address" was not defined by the tax code or regulations. The IRS has released regulations defining this important term. There are two key points to note. First, the regulations define "last known address" as the address that appears on a taxpayer's most recently filed federal tax return, unless the IRS is given clear and concise notification of a different address. Second, while the tax code does not require the IRS to check with the United States Postal Service concerning a change in a taxpayer's address, the new regulations provide that beginning in May 2000 (and every November thereafter), the IRS will refer to the Postal Service's National Change of Address (NCOA) database to obtain a taxpayer's address for purposes of determining the taxpayer's last known address. Any citizen can update his or her residential address with the Postal Service by submitting a Form 3575 containing a new address, and the new address is thereafter maintained in the NCOA database. Beginning in May of 2000, before sending correspondence to a taxpayer, the IRS reviews the NCOA database to see if the taxpayer has submitted a Form 3575 to the Postal Service with a more recent address. If so, the following will occur: (1) the correspondence will be mailed to the address obtained from the NCOA database, and (2) the IRS will use the new address from the NCOA database to update the automated master file. This updated address will be the taxpayer's last known address. A new NCOA address will be the taxpayer's last known address, unless the IRS is given clear and concise notification of a different address.

Using the NCOA database will increase customer service by allowing faster delivery of IRS correspondence to a taxpayer. Rather than mailing correspondence to an address which is no longer a taxpayer's address and relying on the Postal Service to forward mail to the taxpayer's most recent address, the IRS will mail the correspondence directly to the taxpayer's most recent address. In addition, by updating the automated master file with the most recent address, future IRS correspondence will be mailed to the taxpayer's most recent address. Since the IRS will review the NCOA database only once each year, it is still possible if not likely that many IRS notices of deficiency will be mailed to the wrong address. Taxpayers can avoid this possibility by completing and submitting to the IRS a Form 8822. This form is used to notify the IRS of a change in address.

13. The tax consequences of reclassifying an employee as self-employed. A company treated one of its workers ("John") as self-employed for 1995, and as a result did not withhold income taxes or FICA taxes from his wages. It assumed that John would pay his own income taxes and self-employment (social security) taxes using the quarterly estimated tax procedure. In fact, John did not pay the full amount of his income taxes. The IRS later audited John, and determined that he was an employee and not self-employed in 1995. The question then was who was legally responsible for the underpayment of John's income tax? John claimed that his employer was responsible for his income tax liability for 1995 because it failed to withhold these taxes from his wages when they were earned. He relied on IRS Publication 15 ("Circular E"), which states: "You [meaning the employer] will be liable for Social Security and Medicare taxes and withheld income tax if you do not deduct and withhold them because you treat an employee as a nonemployee." The Court rejected John's argument, noting that "IRS publications are not authoritative sources of federal tax law." It noted that section 3509 of the tax code specifies that an employer who fails to withhold income tax from an employee's wages (because it misclassified the employee as self-employed) is subject to a penalty equal to 1.5 percent of the employee's wages (3 percent if no 1099 was issued). However, the Court also noted that section 3509 "specifically provides that the employee's liability for income tax shall not be affected by the assessment or collection of any tax determined against the employer under section 3509. In other words, the employee remains fully liable for income tax arising from the receipt of gross wages." Therefore, even though the company misclassified John as self-employed and failed to withhold income taxes, he remained liable for his own income taxes for the year. The court concluded: "It is unfortunate that [the company] did not ask [John] to complete a Form W-4 for the year in issue and did not withhold income tax from [his] wages. If it had done so, there might not have been any deficiency in income tax in respect of such wages. However, [it] never withheld, and [John] was paid his gross wages without any reduction for withheld income tax. As a consequence, there is a deficiency in income tax for which [John] is liable." Lucas v. Commissioner, T.C. Memo. 2000-14 (2000).

• Key point. This case demonstrates that workers who are incorrectly treated as self-employed by their employer remain liable for paying their own income taxes. However, the failure by an employer (including a church) to withhold payroll taxes from a self-employed worker who the IRS later reclassifies as an employee has the following potential consequences: (1) the employer is liable for an "income tax" penalty of 1.5 percent of the employee's wages (3 percent if no 1099 was filed); (2) the employer is liable for a "FICA" penalty of 20 percent of the employee's share of FICA taxes (40 percent if no 1099 was filed); (3) the employer is liable for the full employer's share of FICA taxes; and (4) the employer is liable for the full amount of the employee's taxes if it intentionally disregards the withholding rules.

14. When travel expenses are deductible business expenses. A worker traveled 200 miles each week to perform a temporary job in another town. He returned home each weekend to his family. While the worker was told that the job could be terminated at any time, he ended up working for 27 months. Each year, the worker deducted his travel expenses (mileage, lodging, food) as a business expense. The IRS audited him, and denied the deductions. The Tax Court conceded that a taxpayer can deduct traveling expenses incurred while away from home, if the following 3 conditions are met: (1) The expense must be reasonable and necessary; (2) it must be incurred while away from home; and (3) it must be incurred in the pursuit of a trade or business. The tax code specifies, however, that a taxpayer "shall not be treated as being away from home during any period of employment if such period exceeds 1 year." IRC 162(a). The IRS argued that the worker was not "away from home" while he was working in the other town. The court agreed. It noted that a taxpayer's home generally is "the vicinity of his principal place of employment, not where his personal residence is located. However, if a taxpayer's principal place of employment is temporary rather than indefinite, the taxpayer's residence may be considered the taxpayer's home, and the taxpayer may deduct the expenses associated with traveling to and living at a job site." The worker claimed that even though his employment in the other town lasted 2 years, it was "temporary" since he was subject to termination at any time. The court dismissed this argument, noting that "in that sense, all employment is temporary in that employees generally serve at the will of the employer." The court concluded by noting that the tax code "specifically states that employment in excess of 1 year is not temporary, and [the worker's] employment exceeded this limitation." Saric v. Commissioner, T.C. Memo. 2000-8 (2000).

15. House votes to abolish tax code. The House of Representatives voted (229-187) on April 13, 2000 to abolish the current federal tax code on December 31, 2004. While the President has promised to veto the legislation if it is passed by the Senate, the House's action is still quite noteworthy if not astonishing. Clearly, there is widespread dissatisfaction with the complexity of the tax code. While this may not lead to an outright dismantling of the code, it probably indicates that "tax simplification" proposals will be on the way.

16. Allowing nonitemizers to deduct their contributions. Consider the following two facts: (1) More than 84 million Americans cannot deduct any of their charitable contributions because they do not itemize deductions on Schedule A (Form 1040); and (2) non-itemizers earning less than $30,000 give the highest percentage of their household income to charity. A bill (S. 2077) introduced in the United States Senate by Senators Santorum and Coverdell would permit nonitemizers to deduct 50% of their charitable giving in excess of $500 per year.

• Key point. President Clinton's fiscal year 2001 budget includes a provision which would allow nonitemizers who file joint returns to deduct 50% of their charitable contributions in excess of $2,000 per year. The president's proposal would eventually lower the threshold to $500 in 2006.

17. Substantiating business use of a car. A taxpayer claimed a deduction for the business use of her car in the amount of $4,300, which she computed by multiplying the standard mileage rate times the number of miles she drove her car for business during the year. The IRS denied any deduction because of a lack of substantiation, and the taxpayer appealed. The Tax Court noted that the tax code imposes "stringent substantiation requirements for claimed deductions relating to the use of a [car]." The information that must be substantiated to claim a deduction for the business use of a car includes the following: "(1) The amount of the expenditure; (2) the mileage for each business use of the automobile and the total mileage for all use of the automobile during the taxable period; (3) the date of the business use; and (4) the business purpose of the use of the automobile." The taxpayer testified that she carried a calendar with her in her car and filled it out each day, recording any business activity she conducted. She further testified that she carried a "business miles log" on all of her business trips and made notes about these trips shortly after completing each trip. The court conceded that the entries in the log and the notations on the calendar generally indicated the miles that were driven for business purposes. However, the court concluded that the taxpayer had failed to meet the substantiation requirements quoted above, and it agreed with the IRS that she was not entitled to a deduction. It noted that she "had not substantiated all the required elements of her automobile use, her records are not reliable, and her testimony lacks credibility." The court observed: "Although [the taxpayer's] records purport to provide the dates of business use of her automobile, miles driven for each business use, and evidence of business purpose, she has not provided the total mileage for all use of her automobile during the year. Thus, she has not substantiated all the elements required by the regulations . . . When questioned about the pristine condition of the log and the fact that all entries in the log appear to have been made with the same pen, the taxpayer explained that she carried the log in a case with a pen. We also question the reliability of the information recorded in the taxpayer's records. Despite her testimony, we find it unlikely that the records were made contemporaneously with the activities recorded given the condition of the mileage log, the appearance of the entries in the log, and the mistakes in the log." Aldea v. Commissioner, T.C. Memo. 2000-136 (2000).

• Key point. The court's skepticism about the reliability of the taxpayer's records may seem unreasonable, but it illustrates the importance of the court's observation that "stringent substantiation requirements" apply to any deduction for the business use of a car. This is a point that church treasurers should note well. When it comes to deciding whether or not staff members have substantiated the business use of a car sufficiently to be reimbursed under an accountable plan, church treasurers should understand that the requirements are both real and strict.
• Key point. The court's analysis of the "reliability" of the taxpayer's records will be relevant to church treasurers in evaluating the adequacy of records submitted by church staff to substantiate a reimbursement of their business expenses by the church under an accountable plan.

18. No dependency deduction for a child without a social security number. So ruled the Tax Court in a recent case. A married couple filed a joint tax return on which they claimed dependency exemption deductions for their 10 children. They wrote "NA" in the section provided for listing the Social Security numbers (SSN's) of dependents. None of the children had social security numbers. The IRS denied a dependency exemption for each of the 10 children, and the couple appealed. The Tax Court agreed with the IRS on the basis of tax code section 151(e) which states: "No exemption shall be allowed under this section with respect to any individual unless the [taxpayer identification number] of such individual is included on the return claiming the exemption." Kocher v. Commissioner, T.C. Memo. 2000-238 (2000).

19. IRS to issue final regulations explaining cafeteria plans. The new regulations are due out by the end of the year, and will be of interest to any church that operates this kind of fringe benefit plan. We will provide you with the details.

20. Tax rate adjustments. For 2000, the income tax rates for married couples filing jointly are 15% for the first $43,850 of taxable income, 28% for taxable income from $43,850 to $105,950, 31% for taxable income from $105,950 to $161,450, 36% on taxable income from $161,450 to $288,350, and 39.6% on taxable income in excess of $288,350. For 2000, the income tax rates for single individuals are 15% for the first $26,250 of taxable income, 28% for taxable income from $26,250 to $63,550, 31% for taxable income from $63,550 to $132,600, 36% on taxable income between $132,600 and $288,350, and 39.6% on taxable income in excess of $288,350. The new income tax rate structure is summarized in the following two tables.

Table 1 - 2000 Income Tax Rates
Married Persons Filing Jointly

Table 2 - 2000 Income Tax Rates
Single Persons

. Example. Rev. B is married, and for 2000 he and his wife report gross income of $50,000 on their income tax return. Their taxable income, after deducting itemized deductions, personal exemptions, and a housing allowance, is $35,000. According to Table 1, they will pay an income tax rate of 15% on their entire taxable income, since it is below $43,850.

. Example. Same facts as the previous example, except that Rev. B and his wife report gross income of $75,000, and taxable income of $50,000. According to Table 1, some of this taxable income will be subject to the higher 28% tax rate. The couple computes their income taxes as follows: (1) $6,557 in taxes on the first $43,850 of taxable income (taxed at 15%); and (2) a 28% tax on taxable income above $43,850 (and below $105,950), or $1,722 ($50,000 - $43,850 x 28%). The combination of these amounts is $8,299. This is in addition to Rev. B's self-employment tax, which is an additional 15.3% multiplied times his net earnings from self employment (note that this amount will include his housing allowance).

21. Increase in earnings subject to the self-employment tax. The self-employment tax rate (15.3%) did not change in 2000. However, the amount of earnings subject to tax increased. The 15.3% tax rate consists of two components: (1) a Medicare hospital insurance (HI) tax of 2.9%, and (2) an "old-age, survivor and disability" (OASDI) tax of 12.4%. There is no maximum amount of self-employment earnings subject to the Medicare hospital insurance (the 2.9% "HI" tax rate). The tax is imposed on all net earnings regardless of amount. For 2000, the maximum earnings subject to the "old-age, survivor and disability" (OASDI) portion of self-employment taxes (the 12.4% amount) increases to $76,200-up from $72,600 in 1999. Stated differently, persons who receive compensation in excess of $76,200 in 2000 will pay the 15.3% tax rate for net self-employment earnings up to $76,200, and the "HI" tax rate of 2.9% on all earnings above $76,200. These rules directly impact ministers, who always are considered self-employed for social security purposes with respect to their ministerial services. Ministers should take these rules into account in computing their quarterly estimated tax payments.

. Example. Rev. L has net earnings from self-employment for 2000 of $76,200 (the maximum amount subject to the self-employment tax). His self-employment tax will be $11,659. Note that the housing allowance is included when computing this tax. If Rev. L earned $80,000, he would pay the 12.4% "old-age, survivor and disability" (OASDI) tax up to the limit of $76,200, and the 2.9% Medicare tax on his entire taxable earnings.

22. The standard mileage rate for business miles was 32.5 cents per mile for 2000. The standard mileage rate can be used to compute the cost associated with the business use of a car, provided that it is used in the first year the car is used for business purposes. In addition, employers can use the standard mileage rate to reimburse clergy and church workers for their business use of a car. Of course, ministers and other church staff members are free to deduct the actual costs associated with the business use of a car, but most do not because computing actual costs is much more time-consuming and inconvenient. The new standard mileage rate applied to all business miles driven in 2000.

23. Inflation adjustments. For 2000, the following three "inflation adjustments" took effect:

Tax rates. The amounts of income you need to earn to boost you to a higher tax rate were adjusted for inflation. The new rates are explained earlier in this section. This means that additional income you earn due to inflation will not automatically put you in a higher tax rate bracket. To illustrate, married persons filing jointly do not move from the 15% to the 28% tax rate in computing their 2000 taxes until they have at least $43,850 of taxable income (up from $43,050 in 1999). Single persons do not move from the 15% to the 28% tax rate until they have $26,250 of taxable income (up from $25,750 in 1999). As noted previously, additional tax rates apply to higher income taxpayers in 2000.

Personal exemptions. The "personal exemption amount" (the amount you can deduct for yourself, your spouse, and each dependent) was adjusted for inflation. For 2000, the amount increased to $2,800 per person (up from $2,750 in 1999).

Standard deduction. The "standard deduction" (the amount you can deduct if you cannot itemize your deductions) increased to $7,350 for married couples filing jointly-up from $7,200 in 1999. It increased to $4,400 for single taxpayers-up from $4,300 in 1999. Single taxpayers who are 65 years of age or older, or blind, get a $1,100 increase in their standard deduction for 2000. Married taxpayers who are 65 years of age or older, or blind, get an $850 increase in their standard deduction for 2000.

24. IRS audit statistics. In 1999 the IRS released its "Data Book" for fiscal year 1997 (the most recent version available). The publication contains a number of interesting facts about IRS audits. Here are some of the highlights:

(1) Geographic areas with highest audit rates. The IRS Western Region had the most audits for 1997-more than twice the audit rate in the Midstates and Southeast regions.

(2) Tax Court results. What are your chances if you appeal an adverse IRS audit decision to the United States Tax Court? In 1997, cases disputing some $3.5 billion in taxes were resolved by the Tax Court. Of this amount, the Court ruled that $1 billion in taxes were owed.

(3) Tax revenues. Individual income taxes comprised 48% of the $1.6 trillion in taxes collected by the IRS in 1997. The remaining taxes were mostly payroll taxes (35%) and corporate taxes (12%).

(4) Electronic filing. More than 19 million taxpayers filed their income tax returns electronically in 1997 (including 4.6 million TeleFile returns).

(5) IRS telephone support. The IRS received 104 million telephone inquiries in 1997. The IRS estimates that callers received "accurate" responses 96% of the time. The General Accounting Office gives a much lower figure.

IRS Audit Rates by Region for 1997

(Source: 1997 Internal Revenue Service Data Book, Publication 55B, Tables 7 and 13.)

25. Health insurance deduction for the self-employed. Self-employed persons can deduct health insurance costs for themselves (and their spouse and children) as follows: 60 percent in 1999 through 2001; 70 percent in 2002; and 100 percent in 2003 and thereafter. This deduction is not allowed in any year in which the self-employed person is eligible to participate in a subsidized health plan maintained by an employer of either the self-employed person or his or her spouse.

26. Foreign earned income credit. United States citizens generally are subject to federal income tax on all their income, whether derived in the United States or in a foreign country. However, citizens working in foreign countries may be eligible to exclude from their income for federal income tax purposes certain foreign earned income and housing costs. To qualify for these exclusions, the individual must either (1) be a resident of the foreign country for an uninterrupted period that includes the entire tax year, or (2) be present overseas for 330 days out of any 12 consecutive month period. The maximum exclusion for foreign earned income for 2000 was $76,000. This amount increases by $2,000 each year until it reaches a maximum of $80,000 in the year 2002. In addition, the credit will be indexed for inflation beginning in 2008. This credit is claimed by many American missionaries serving in foreign countries.

27. Estimated tax requirements. A taxpayer is subject to a penalty for underpayments of estimated taxes. For 2000 tax returns the penalty is avoided if a taxpayer made timely estimated tax payments at least equal to (1) 100 percent of the previous year's tax liability, or (2) 90 percent of the current year's tax liability. For individuals with adjusted gross income of more than $150,000 for the previous year, the "100 percent of last year's tax liability" rule is changed to 110 percent of the previous year's tax liability in 2000, 112 percent of the previous year's tax liability in 2001, and 110 percent of the previous year's tax liability in 2002 and thereafter.

28. Simplified definition of "highly compensated employee." A number of tax-favored rules do not apply if there is discrimination in favor of "highly compensated employees." These include (1) simplified employee pensions (SEPs); (2) 403(b) tax-sheltered annuities (churches and qualified church-controlled organizations are exempt from this nondiscrimination rule); (3) qualified employee discounts; (4) cafeteria plans; (5) flexible spending arrangements; (6) qualified tuition reductions; (7) employer-provided educational assistance; and (8) dependent care assistance. Unfortunately, the definition of a "highly compensated employee" has been complex, and has often led to absurd results. Congress enacted legislation in 1996 making the definition of the term "highly compensated employee" much simpler and fairer. Beginning in 1997, a highly compensated employee is one who (1) was a 5 percent owner of the employer at any time during the current or prior year (this definition will not apply to churches), or (2) had compensation for the previous year in excess of $80,000, and, if an employer elects, was in the top 20 percent of employees by compensation. The new definition repeals the previous rule requiring the highest paid officer to be treated as highly compensated, no matter how little he or she was paid. The $80,000 amount is adjusted annually for inflation. It increased to $85,000 in 2000. IRS Notice 99-55.

29. Increase in "section 179" deduction. It is a basic principle of tax law that if a product is purchased for business use and has a useful life of more than one year, the full cost may not be deducted in the year of purchase but rather must be allocated over the useful life of the product and an annual "depreciation" deduction claimed each year. Section 179 of the Code, however, permits taxpayers to elect to deduct most if not all of the cost of business property in the year of purchase if certain conditions are satisfied. In 2000 and future years, the deduction is limited to the following amounts:

• Key point. As this newsletter was going to press, Congress was considering a bill that would increase the section 179 deduction to $35,000.

30. Extend the phaseout of the luxury tax on automobiles. An excise tax is imposed on the sale of a "luxury automobile" whose price exceeds a threshold amount ($38,000 in 2000). The excise tax for 2000 is 5 percent of the purchase price in excess of this threshold amount.

31. "Luxury car" limits adjusted for inflation. Ministers who use the "actual expense" method of computing their car expenses can claim a deduction for depreciation. There are limits on the amount of depreciation that you can claim in any given year. These limits are known as the "luxury car" limits. The 2000 limits are summarized in the table below, along with the limits for 1999 (for comparison purposes).

"Luxury car" depreciation limits

32. The IRS continues to target "self-employed" taxpayers. The IRS continues to target self-employed taxpayers for audits. Particularly vulnerable are persons who receive only one or two 1099 forms each year. Why all the attention on self-employed persons? A joint IRS and General Accounting Office study concluded that most taxpayers who report as self-employed, but who receive only one or two 1099 forms each year, are actually employees. Reclassifying self-employed persons as employees results in higher tax revenues for the IRS, since employees are subject to tax withholding and they often are not allowed to deduct their business expenses (unless their employer has adopted an accountable reimbursement plan). Also, the employer of a self-employed person who is reclassified as an employee by the IRS is subject to a special penalty under the tax code. Clergy who report their income taxes as self-employed are "prime targets" for IRS examination, since most of them will "fit the profile" of receiving only one or two 1099 forms. Our recommendation-most clergy should report their income taxes as employees, not self-employed. This is one very good reason.

33. Phase-out of personal exemption for high-income taxpayers. As noted elsewhere in this summary, the personal exemption deduction (that you can claim for yourself and each dependent) increased to $2,800 in 2000 (up from $2,750 in 1999). In 2000, the personal exemption amounts are phased out for certain high-income taxpayers. For married taxpayers filing jointly, the phase-out begins when adjusted gross income exceeds $193,400. For single taxpayers, the phase-out begins when adjusted gross income exceeds $128,950.

34. New per diem rates for substantiating the amount of travel expenses incurred in 2000. The IRS allows taxpayers to substantiate the amount of their business expenses by using "per diem" (daily) rates. Taxpayers still must have records substantiating the date, place, and business purpose of each expense. There are separate rates for meals and lodging, and separate rates for "high-cost localities" and all other communities. The rates for 2000 are summarized in the table below.

Per Diem Rates for 2000

In some cases, using the per diem rates will simplify the substantiation of meals and lodging expenses incurred while engaged in business travel. However, a number of restrictions apply.

35. The IRS has issued a private letter ruling creating two limited exceptions to the general rule that business trips in excess of one year are "indefinite" in nature and therefore the travel expenses incurred during such trips cannot be treated as business expenses. Travel expenses are your ordinary and necessary expenses while traveling away from home for your work or business. It is important to determine where your tax home is, since you may deduct travel expenses only to the extent that they are incurred while you are traveling away from your home. Generally, your tax home is your main place of employment or work. If you regularly work in two or more areas, your tax home is the general area where your main place of work is located. Although you regularly work within the city or general area of your tax home, you occasionally may have to work or conduct business at another location. It may not be practical to return home from this other location at the end of each day's work. You will be considered away from home, and your travel expenses (including meals and lodging) will constitute travel expenses, if you are away from home on a temporary rather than on an indefinite basis. Your assignment or job away from your regular place of work is temporary if it lasts 1 year or less. In such a case, your tax home does not change and accordingly your travel expenses are incurred while away from home. On the other hand, if your assignment or job away from home lasts more than 1 year, then you will be deemed to be away from home on an indefinite rather than a temporary basis. If your work at the new location is indefinite, then that location becomes your new tax home. A consequence of this change in tax home is that you cannot deduct your travel, meals, and lodging expenses while there (since they are not travel expenses incurred while "away from home"). Any reimbursements or advances you receive from an employer must be included in your income even if they are called travel allowances. The IRS issued a private ruling in 2000 that creates two important exceptions to the definition of "temporary."

(1) Breaks in service. The IRS concluded, "While there is no general guidance on what is considered a significant break, we believe that a break of 3 weeks or less is not significant and will not 'stop the clock' in applying the 1-year limitation. On the other hand, for employers administering transportation expense reimbursements under an accountable plan, we believe that it is reasonable to treat a break of at least 7 months as significant, thereby treating two work segments separated by a 7-month break as separate periods of employment for applying the 1-year limitation."

(2) Infrequent work locations. The IRS concluded, "For employers administering transportation expense reimbursements under an accountable plan, we believe that, if there is an initial realistic expectation that an employee will perform services at a work location for a period exceeding 1 year, but for no more than 35 workdays (or partial workdays) during each of the calendar years within that period, then employment at that location may be treated as temporary (rather than nontemporary) for a calendar year in which the employee actually works no more than 35 workdays (or partial workdays) at that location."IRS Letter Ruling 200026025.