Church and Clergy Tax Developments in 2003
(Part 1 of 4)

By Richard R. Hammar, J.D., LL.M., CPA

© Copyright 2004 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: m69 m94 c0104

Congress enacted a number of tax law changes that will impact the preparation of 2003 tax returns by ministers and lay church employees in 2003, and tax reporting by churches. In addition, a number of court decisions and IRS rulings provided clarification on a number of important tax issues. Nearly 70 of the most important changes and clarifications are summarized in this library.

Congress enacted major tax bills in 2001 and 2003 containing several provisions that will affect tax reporting by both churches and ministers for 2003 and future years.

• EGTRRA. On June 7, 2001, President Bush signed a massive new tax law known as the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"). This law made over 440 changes to the Internal Revenue Code. Some of these changes took effect in 2003, and those that have the greatest relevance to ministers and churches are summarized in this article.
  
• JGTRRA. On May 28, 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA"). Most of the provisions in this new law took effect in 2003, and those that have the greatest relevance to ministers and churches are summarized in this article.
  

Key point. An unprecedented feature of EGTRRA is a "sunset" provision that revokes all of the hundreds of tax law changes at the end of 2010 unless Congress votes to extend them. If Congress fails to take action, then the tax law in effect in 2001 will be reinstated. Because many taxpayers, in all income brackets, will increasingly rely on many of the tax law changes in the new law, it is inconceivable that Congress will allow all of the changes to expire at the end of 2010. It is reasonable to assume that many of the changes will be permanently adopted by Congress, but not necessarily all of them.

Individual Income Taxes

1. Reduction in income tax rates. Income taxes are computed by applying the applicable income tax rates to taxable income. EGTRRA created a new 10% income tax bracket effective for taxable years beginning in 2001. The 10% rate bracket applies to the first $6,000 of taxable income for single individuals, and $12,000 for married couples filing joint returns. The $6,000 and $12,000 amounts were scheduled to increase to $7,000 and $14,000 for 2008 and thereafter. However, JGTRRA accelerated these amounts to 2003 and 2004. Specifically, for 2003 and 2004, the taxable income level for the 10% tax rate bracket for unmarried individuals increases from $6,000 to $7,000 and for married individuals filing jointly from $12,000 to $14,000. The taxable income levels for the 10% regular income tax rate bracket will be adjusted annually for inflation for taxable years beginning after December 31, 2003.

For taxable years beginning after December 31, 2004, the taxable income levels for the 10% rate bracket will revert to the levels allowed under current law. Therefore, for 2005, 2006, and 2007, the levels will revert to $6,000 for unmarried individuals and $12,000 for married individuals filing jointly. In 2008, the taxable income levels for the 10% regular income tax rate brackets will be $7,000 for unmarried individuals and $14,000 for married individuals filing jointly. The taxable income levels for the 10% rate bracket will be adjusted annually for inflation for taxable years beginning after December 31, 2008.

Key point. A congressional conference committee report acknowledged that since the increase in the 10% tax bracket is retroactive to January 1, 2003, many taxpayers have had an excessive amount of income taxes withheld by their employer. Such taxpayers, the report concludes, "may obtain a refund of this overwithholding through the normal process of filing an income tax return, and not through the employer."

The 15% income tax bracket begins at the end of the 10% bracket. It is also adjusted in order to minimize the effect of the so-called "marriage penalty." This is addressed later in this article. Prior to EGTRRA, the regular income tax rates were 15%, 28%, 31%, 36%, and 39.6%. EGTRRA "phased down" the 28%, 31%, 36%, and 39.6% rates over six years to 25%, 28%, 33%, and 35%, effective after June 30, 2001. See Table 1.

Table 1: Income Tax Rate Reductions Established by EGTRRA

JGTRRA accelerates the reductions in the regular income tax rates in excess of the 15% regular income tax rate that is scheduled for 2004 and 2006. Therefore, for 2003 and thereafter, the regular income tax rates in excess of 15% are 25%, 28%, 33% and 35%.

Table 2: New Income Tax Rates for 2003 (Single Persons)

Table 3: New Income Tax Rates for 2003 (Married Persons Filing Jointly)

Example. Same facts as the previous example, except that the couple's taxable income is $80,000. Without the acceleration of the income tax rates, their income taxes would be $15,305. As a result of JGTRRA, their income taxes will be $13,620.

Key point. Note that tax savings under JGTRRA come from a variety of provisions in addition to the acceleration in the income tax rates. Many lower income employees (in the 10% and 15% tax brackets) will realize significant tax savings as a result of the increase in the child tax credit and the elimination of the marriage penalty.

Key point. The IRS has issued new withholding tables for 2003 that reflect changes made by JGTRRA. The new withholding tables are contained in IRS Publication 15-T. Churches should begin withholding using the new tables as soon as possible for wages paid in 2003. The fastest way to get a copy of the new withholding tables is on the IRS website, www.irs.gov.

2. Elimination of the "marriage penalty." When two persons are married, they often pay more taxes than if they had remained single and filed individually. There are two reasons. First, their combined income may put them in a higher tax bracket; and second, the standard deduction for a married couple is less than the standard deductions for two single persons. These two consequences are generally referred to as the "marriage penalty." JGTRRA reduces this penalty in the following two ways:

#1--income tax rates

The income tax rates prior to EGTRRA (15%, 28%, 31%, 36%, 39.6%) each applied to a specific range of taxable income, with higher amounts of income triggering higher tax rates. As a result, two wage-earners generally paid more in taxes if they were married than if they remained single since their income was combined for purposes of applying the tax rates. The tax code "penalized" them for marrying. JGTRRA minimizes the effect of the marriage penalty by increasing the 15% income tax rate for a married couple filing a joint return to twice the size of the corresponding rate for a single person filing a single return for 2003 and 2004.

#2--the standard deduction

EGTRRA increased the standard deduction for married persons filing jointly, beginning in 2005, to minimize the marriage penalty. Table 4 summarizes this change.

Table 4: Increase in the Standard Deduction

Key point. The attempt to reduce the impact of the marriage penalty by increasing the standard deduction for married couples does not help married couples who itemize their deductions instead of claiming the standard deduction.

Example. Larry and Laura have been dating for two years. In 2002 they each earned annual income of $25,000, filed their tax returns as single persons, and claimed the standard deduction ($4,700 each for 2002) instead of claiming itemized deductions. If they had married in 2002, their joint income would have been $50,000, and they would have been eligible for a standard deduction of only $7,850—or $650 less than their individual standard deductions when they were filing as single persons. Their taxable income would have increased, and they would have paid more taxes, simply because they chose to be married. JGTRRA partially corrects this "marriage penalty" by increasing the standard deduction for joint returns, for both 2003 and 2004, to twice the standard deduction for a single return.

3. Increase and expand the child tax credit. The child tax credit was introduced in 1998 as a maximum credit of $400 per qualifying child. JGTRRA accelerates a previously scheduled increase of the maximum credit to $1,000 per child, effective for 2003 and 2004. The child tax credit is a nonrefundable credit for each qualifying child. To qualify, a child must be under age 17, be a citizen or resident of the United States, be claimed as the taxpayer’s dependent, and be the taxpayer’s (a) child, stepchild, adopted child, or grandchild; (b) sibling, stepsibling, or a descendant of any of them, whom the taxpayer cared for as his or her own child, or (c) eligible foster child.

JGTRRA also provided immediate tax relief by directing the IRS to send the increase in the child tax credit to taxpayers in 2003. Eligible taxpayers received up to $400 for each child claimed on their 2002 returns as an advance payment of their 2003 child tax credit.

Key point. Taxpayers receiving an advance payment should keep the IRS notice of the advance payment amount in order to properly complete the 2003 tax return. They will subtract any advance payment already received from the total amount (up to $1,000 per child) when figuring the credit for the 2003 return.

There is also an "additional child tax credit" for individuals who get less than the full amount of the child tax credit because their tax is too low. The additional child tax credit (which is figured on Form 8812) may result in a refund even if the person does not owe any tax.

Example. Pastor Tom is a youth pastor at his church. He is married and has two young children ages 3 and 5. He will be eligible for a $2,000 child tax credit in 2003 as a result of JGTRRA. This is an increase of $800. The IRS mailed a check in the amount of $800 to Pastor Tom in August of 2003.

Example. Sherry is a single mother who is employed by a church child care center. She did not earn enough income to pay taxes in 2002, and does not expect to pay taxes this year. She will be eligible for an "additional child tax credit" in 2003 even though she does not pay taxes.

Example. Pastor Dave is the senior pastor of his church. He has two children, ages 15 and 17. His salary this year is $60,000. Pastor Dave received a check from the IRS in the amount of $800 in August of 2003. The credit is not reduced until a married couple's adjusted gross income exceeds $110,000.

Example. Pastor Jay is the youth pastor at his church. He and his wife have their first child in 2003. Pastor Jay and his wife will be eligible for a child tax credit in 2003, but they will not receive a $400 check from the IRS.

Tip. Some taxpayers may have changed their address after filing their 2002 tax return. If an advance payment check cannot be forwarded to the taxpayer (because the IRS has an old address), it will be returned to the IRS. Taxpayers who qualify for the advance payment, but who do not receive a check, may claim the full child tax credit amount of up to $1,000 per qualifying child on their 2003 tax returns.

After 2004, the amount of the child tax credit will revert to the amounts listed in Table 5.

Table 5: Increase in the Child Tax Credit

EGTRRA made the following changes in these rules, beginning in 2003

• It increased the maximum amount of eligible employment-related expenses from $2,400 to $3,000, if there is one qualifying individual (from $4,800 to $6,000, if there are two or more qualifying individuals).
  
• It increased the maximum credit from 30% to 35% (the maximum credit is $1,050 if there is one qualifying individual and $2,100, if there are two or more qualifying individuals).
  
• It modified the phase-down of the credit. The 35% credit rate is reduced, but not below 20%, by 1 percentage point for each $2,000 (or fraction thereof) of AGI above $15,000. Therefore, the credit percentage is reduced to 20% for taxpayers with AGI over $43,000.
  

5. Deduction for qualified higher education expenses. In general, taxpayers cannot deduct the education and training expenses of either themselves or their dependents. However, a deduction for education expenses is allowed if the education or training (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer’s employer, or requirements of applicable law or regulations, imposed as a condition of continued employment. Education expenses are not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses meet the above described criteria for deductibility under section 162 of the tax code and only to the extent that the expenses, along with other miscellaneous deductions, exceed 2% of the taxpayer’s AGI.

EGTRRA permits taxpayers an “above-the-line” (page 1 of Form 1040) deduction for qualified higher education expenses paid by the taxpayer during a taxable year. Qualified higher education expenses are defined in the same manner as for purposes of the HOPE credit. In 2002 and 2003, taxpayers with AGI that does not exceed $65,000 ($130,000 in the case of married couples filing joint returns) are entitled to a maximum deduction of $3,000 per year. Taxpayers with AGI above these thresholds would not be entitled to a deduction. In 2004 and 2005, taxpayers with AGI that does not exceed $65,000 ($130,000 in the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $4,000 and taxpayers with AGI that does not exceed $80,000 ($160,000 in the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $2,000. This provision expires at the end of 2005.

Estates and Gift Taxes

6. Phase-out and repeal of estate and generation-skipping transfer taxes.

EGTRRA made the following changes:

• Beginning in 2011, the estate and generation-skipping transfer taxes are repealed.
  
• After repeal, the "basis" of assets received from a decedent generally will equal the basis of the decedent (i.e., carryover basis) at death. However, a decedent’s estate is permitted to increase the basis of assets transferred by up to a total of $1.3 million. The basis of property transferred to a surviving spouse can be increased (i.e., stepped up) by an additional $3 million. As a result, the basis of property transferred to a surviving spouse can be increased (i.e., stepped up) by a total of $4.3 million. In no case can the basis of an asset be adjusted above its fair market value. For these purposes, the executor will determine which assets and to what extent each asset receives a basis increase. The $1.3 million and $3 million amounts are adjusted annually for inflation occurring after 2010.
  
• From 2002 and through 2010, the estate and gift tax rates are reduced, the unified credit amount is increased, and the generation-skipping transfer tax exemption amount is increased. The new rate structure is summarized in Table 6.
  

Table 6: Unified Credit Exemption; Highest Estate and Gift Tax Rates

IRAs and Retirement Plans

7. Individual retirement arrangements (“IRAs”). EGTRRA increased the maximum annual dollar contribution limit for IRA contributions to $3,000 for 2002 through 2004, $4,000 for 2005 through 2007, and $5,000 for 2008. After 2008, the limit is adjusted annually for inflation in $500 increments. In addition, individuals who have attained age 50 may make additional "catch-up" IRA contributions. The otherwise maximum contribution limit (before application of the AGI phase-out limits) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005, and $1,000 for 2006 and thereafter.

8. Increase in elective deferral limit. EGTRRA increased the dollar limit on annual elective deferrals an individual may make to a qualified cash or deferred arrangement (a “section 401(k) plan”), a tax-sheltered annuity (“section 403(b) annuity”) or a salary reduction simplified employee pension plan (“SEP”) to $11,000 in 2002. In 2003 and thereafter, the limits are increased in $1,000 annual increments until the limits reach $15,000 in 2006, with indexing in $500 increments thereafter.

9. Nonrefundable credit to certain individuals for elective deferrals and IRA contributions.

EGTRRA provides a temporary nonrefundable tax credit for contributions made by eligible taxpayers to a qualified retirement plan. The maximum annual contribution eligible for the credit is $2,000. The credit rate depends on the adjusted gross income (AGI) of the taxpayer. Only joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less, and single returns of $25,000 or less are eligible for the credit. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit offsets minimum tax liability as well as regular tax liability. The credit is available to individuals who are age 18 or over, other than individuals who are full-time students or claimed as a dependent on another taxpayer’s return.

The credit is available with respect to elective contributions to a section 401(k) plan, section 403(b) annuity, SIMPLE or SEP plans, and contributions to a traditional or Roth IRA. The rules governing such contributions continue to apply. The amount of any contribution eligible for the credit is reduced by taxable distributions received by the taxpayer and his or her spouse from any savings arrangement described above or any other qualified retirement plan during the taxable year for which the credit is claimed, the two taxable years prior to the year the credit is claimed, and during the period after the end of the taxable year and prior to the due date for filing the taxpayer’s return for the year. In the case of a distribution from a Roth IRA, this rule applies to any such distributions, whether or not taxable. The credit rates based on AGI are summarized in Table 7.

This provision is effective beginning in 2002. It expires at the end of 2007.

Table 7: Credit Rates Based on AGI

10. Additional salary reduction catch-up contributions. The limit on elective deferrals under a 403(b) annuity plan is increased for individuals who have attained age 50 by the end of the year. The catch-up contribution provision does not apply to after-tax employee contributions. Additional contributions may be made by an individual who has attained age 50 before the end of the plan year and with respect to whom no other elective deferrals may otherwise be made to the plan for the year because of the application of any limitation of the tax code (e.g., the annual limit on elective deferrals) or of the plan.

The additional amount of elective contributions that may be made by an eligible individual participating in such a plan is the lesser of (1) the applicable dollar amount, or (2) the participant’s compensation for the year reduced by any other elective deferrals of the participant for the year. The applicable dollar amount under a 403(b) annuity is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and thereafter. Catch-up contributions are not subject to any other contribution limits and are not taken into account in applying other contribution limits. In addition, such contributions are not subject to applicable nondiscrimination rules.