Church and Clergy Tax Developments in 2003
(Part 3 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.

Other Tax Law Developments of Interest to Ministers and Lay Church Employees

18. Housing allowances and the earned income credit. An unanswered question is whether a housing allowance (or annual rental value of a parsonage) should be treated as "earned income" when computing the earned income credit. If so, then earned income will be higher, making it more likely that a minister will not qualify for the earned income credit. In the 2001 tax law (EGTRRA) Congress clarified that the term "earned income" includes only "amounts includible in gross income for the taxable year." However, Congress added that earned income also includes "net earnings from self-employment." The problem is that ministers are always "self-employed" for purposes of Social Security with respect to their ministerial services, and so their entire church compensation constitutes "net earnings from self-employment" unless they filed a timely exemption application (Form 4361) that was approved by the IRS. Logically, then, housing allowances should be treated as earned income for those ministers who have not exempted themselves from self-employment taxes by filing Form 4361. On the other hand, ministers who have exempted themselves from self-employment taxes should not treat their housing allowance as earned income in computing the earned income credit. As illogical as this result may seem, it is exactly what the IRS instructions to Form 1040 require, and for now the IRS national office is taking the position that there is nothing it can do to change the law as enacted by Congress. So, for now, whether or not a minister’s housing allowance (or annual rental value of a parsonage) is included within the definition of "earned income" for purposes of the earned income credit depends on whether the minister is exempt or not exempt from paying self-employment taxes. This issue is discussed fully in chapter 7 of Richard Hammar's 2004 Church & Clergy Tax Guide.

19. The Tax Court ruled that a minister could not deduct the cost of courses he took at a local university to complete his undergraduate degree, even though he took the courses to enhance his ministerial skills. In 1986, George decided to pursue a career in the ministry of the United Methodist Church (UMC). In 1992, George became a "certified candidate." This level requires graduation from an accredited high school or receipt of a certificate of equivalency. From 1993 to 1996, George was a part-time "local pastor." A local pastor may be a student or a part-time or full-time position. This level requires attendance at a 2-week licensing school or completion of one-third of the work necessary for a master of divinity degree. Local pastors are appointed annually, and continue in the course of study for ordained ministry until they have completed the educational requirements for associate or probationary membership. After completion of the educational requirements for an associate membership, however, an individual may choose to remain a local pastor. A local pastor may lead the sacraments (i.e., baptism, communion) at the appointed parish. Prior to entering the candidacy for ministry, George had accumulated over 60 undergraduate semester hours from various schools, which met the minimum undergraduate educational requirements to become an associate member. In 1994, he decided that he needed to improve his ministry skills, and so he enrolled in various courses at a local university (including Introduction to Counseling, Internship in Ministry Practice, Death and Dying as a Life Cycle, Modern Social Problems, The Family, Community, Ethics in Human Services, Symphonic Choir, Basic Writing, and Writing Strategies). These courses were not required for him to continue as a local pastor. In 1995, he earned a bachelor's degree in human services.

On his 1994 tax return, George claimed a deduction of $9,698 for "Continuing Education" on Schedule C. The amount claimed represented tuition, books, and course-related fees incurred for the courses taken at the university. The IRS audited George's 1994 tax return, and disallowed the deduction, stating: "Since you did not establish that the business expense shown on your tax return was paid or incurred during the taxable year and that the expense was ordinary and necessary to your business, we have disallowed the amount shown." George appealed.

The United States Tax Court agreed with the IRS determination that George's educational expenses were not deductible. The Court acknowledged that education expenses are deductible as business expenses if the education "maintains or improves skills required by the taxpayer in his employment or meets the express requirements of an employer imposed as a condition for the taxpayer's continued employment." However, education expenses are not deductible if they are "made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business." This is so even if the courses meet the express requirements of the employer. It is "immaterial whether the individual undertaking the education intends to or does in fact become employed in a new trade or business." Whether the education qualifies a taxpayer for a new trade or business depends upon the "tasks and activities which he was qualified to perform before the education and those which he is qualified to perform afterwards." The Court noted that it has "repeatedly disallowed education expenses where the education qualifies the taxpayer to perform significantly different tasks and activities. Further, the taxpayer's subjective purpose in pursuing the education is irrelevant, and the question of deductibility is not satisfied by a showing that the taxpayer did not in fact carry on or did not intend to carry on a new trade or business."

The IRS argued that the courses George took qualified him for a new trade or business, and that the expenses of a college education are almost always nondeductible personal expenses. The Court agreed, "We conclude that the courses, which ultimately led to George's bachelor's degree, qualified him in a new trade or business. The courses provided him with a background in a variety of social issues that could have prepared him for employment with several public agencies and private non-profit organizations outside of the ministry. Whether or not he remains in the ministry is irrelevant; what is important under the regulations is that the degree 'will lead' him to qualify for a new trade or business." The Court noted that it is "all but impossible" for taxpayers to establish that a bachelor's degree program does not qualify them for a new trade or business. Warren v. Commissioner, T.C. Memo. 2003-175 (2003).

20. Cell phone expenses. The tax code imposes strict substantiation requirements on the business use of certain kinds of "listed property" including cell phones. These requirements must be met in order to claim a business expense deduction, or for a church to reimburse these expenses under an accountable arrangement. They are explained fully in chapter 7 of Richard Hammar's 2004 Church & Clergy Tax Guide. These requirements are cumbersome, and many feel that the modest cost of cell phone charges does not warrant compliance with these rules. A recent federal appeals court case demonstrates that such a view may not be acceptable to the IRS or the courts. The case involved a taxpayer who claimed a business expense deduction of $750 for the use of a cell phone. The court denied a deduction for any of these expenses since the taxpayer did not comply with the strict substantiation requirements that apply to cell phones. The court concluded, "Cellular telephones are 'listed property' subject to the substantiation requirements of [the tax code]. The taxpayer failed to submit any documentation to establish the business use of his cellular telephone, the amount he paid for the service, or even the identity of the telephone company." Vaksman v. Commissioner, 2003-1 USTC 50,126 (5th Cir. 2002).

21. Court rejects claim that ministers' income is tax-free. A federal court rejected a couple's claim that they were entitled to an exemption from federal income tax because they "labor for the ministry." The court concluded, "Income received by ministers whether from the church itself or from other private employers or sources is not exempt from income tax. The income received by taxpayers must be included in gross income required to be reported for income tax purposes according to the Internal Revenue Code." The court acknowledged that ministers' income (from the exercise of ministry) is exempt from federal income tax withholding, but noted that "while certain income of ministers may be exempt from withholding of income tax, the income received by ministers, even from religious activities . . . is not exempt from payment of income tax." Further, "the fact that a church itself may be exempt from payment of income taxes does not mean that the income received by ministers is exempt." Pomeroy v. Commissioner, 2003-2 USTC 50,568 (D. Nev. 2003).

22. Deduction for educator expenses. If you are an eligible educator, you can deduct as an adjustment to income up to $250 in qualified expenses. You can deduct these expenses even if you do not itemize deductions on Schedule A (Form 1040). This adjustment to income is for expenses paid or incurred in tax years beginning during 2002 or 2003. Previously, these expenses were deductible only as a miscellaneous itemized deduction subject to the 2% of AGI limit.

You are an eligible educator if, for the tax year, you meet the following requirements: (1) you are a kindergarten through grade 12: (a) teacher; (b) instructor; (c) counselor; (d) principal; or (e) aide. (2) You work at least 900 hours during a school year in a school that provides elementary or secondary education, as determined under state law.

Qualified expenses are unreimbursed expenses you paid or incurred for books, supplies, computer equipment (including related software and services), other equipment, and supplementary materials that you use in the classroom. For courses in health and physical education, expenses for supplies are qualified expenses only if they are related to athletics.

To be deductible as an adjustment to income, the qualified expenses must be more than the following amounts for the tax year: (1) The interest on qualified U.S. savings bonds that you excluded from income because you paid qualified higher education expenses; (2) any distribution from a qualified tuition program that you excluded from income; or (3) any tax-free withdrawals from your Coverdell education savings account.

23. Social Security average benefits for 2003. The maximum Social Security benefit for workers retiring at age 65 on January 1, 2003 increased to $1,660 per month ($19,920 per year). The average benefit is $874 per month ($10,488 per year) for all retired workers; $1,454 per month ($17,448 per year) for a retired couple who each receive benefits); $1,764 per month ($21,168 per year) for a widowed mother with two minor children; and $815 per month ($9,780 per year) for a disabled worker. See Table 10 for more details on changes in the Social Security program that took effect in 2003.

Table 10: Social Security Changes

24. Increase in earnings subject to the self employment tax. The self employment tax rate (15.3%) did not change in 2003. 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 2003, the maximum earnings subject to the OASDI portion of self employment taxes (the 12.4% amount) increases to $87,000—up from $84,900 in 2002. Stated differently, persons who received compensation in excess of $87,000 in 2003 will pay the combined 15.3% tax rate for net self employment earnings up to $87,000, and only the HI tax rate of 2.9% on earnings above $87,000. 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.
* A "modified" annual earnings test applies in the year a worker attains age 65. For every $3 earned in excess of a specified monthly rate for months prior to a worker's 65th birthday his or her Social Security benefits will be reduced by $1. The monthly rate for 2001 was $2,084. For 2002, the rate was $2,500.
25. The standard mileage rate for business miles was 36 cents per mile for 2003. 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 36 cents per mile rate applied to all business miles driven in 2003. The standard mileage rate in 2002 was 36.5 cents per mile. It increases to 37.5 cents per mile in 2004.

26. Inflation adjustments. For 2003, 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.
  
• Personal exemptions. The “personal exemption amount” (the amount you can deduct for yourself, your spouse, and each dependent) was adjusted for inflation. For 2003, the amount increased to $3,050 per person (up from $3,000 in 2002).
  
• Standard deduction. The "standard deduction" (the amount you can deduct if you cannot itemize your deductions) increased to $9,500 for married couples filing jointly—up from $7,850 in 2002. This is twice the amount of the standard deduction for single taxpayers ($4,750) for 2003. Single taxpayers who are 65 years of age or older, or blind, get a $1,150 increase in their standard deduction for 2003. Married taxpayers who are 65 years of age or older, or blind, get a $950 increase in their standard deduction for 2003.

27. Audit statistics. The General Accounting Office released a report in 2001 analyzing IRS audit rates. The results are summarized in Table 11.

Table 11: IRS Audit Rates for Individual Taxpayers 1996-2000 (in thousands)

28. Health insurance deduction for the self-employed. Self-employed persons can deduct 100% of the health insurance costs they incur for themselves and their spouse and children in 2003 (up from 70% in 2002). 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.

29. Foreign earned income exclusion. 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 2003 was $80,000. This amount remains at $80,000 through 2007. In addition, the credit will be indexed for inflation beginning in 2008. This credit is claimed by many American missionaries serving in foreign countries.

30. Estimated tax requirements. For estimated tax payments for tax years beginning in 2003, the estimated tax safe harbor for higher income individuals has been modified. If your 2002 adjusted gross income is more than $150,000 ($75,000 if you are married filing a separate return for 2003), you must deposit the smaller of 90% of your tax for 2003 or 110% of the tax shown on your 2002 return to avoid an estimated tax penalty.

31. 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.

For 2003 a highly compensated employee is one who (1) was a 5% 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 $90,000, and, if an employer elects, was in the top 20% of employees by compensation. The $90,000 amount is adjusted annually for inflation.

32. 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 tax 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 2003, 2004, and 2005 the deduction is limited to $100,000 for property placed in service in those years. The dollar limitations are indexed annually for inflation for taxable years beginning after 2002 and before 2006.

33. 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 ($40,000 in 2002). The excise tax for 2002 is 3% of the purchase price in excess of this threshold amount.

34. "Luxury car" limits adjusted for inflation. Ministers and lay church employees 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 2003 limits are summarized in Table 12 along with the limits for 2002 (for comparison purposes).

Table 12: “Luxury Car” Depreciation Limits

35. Phase out of personal exemption for high income taxpayers. The personal exemption deduction (that you can claim for yourself and each dependent) increased to $3,050 in 2003 (up from $3,000 in 2002). In 2003 the personal exemption amounts are phased out for certain high income taxpayers. For married taxpayers filing jointly, the phase out begins when AGI exceeds $209,250. For single taxpayers, the phase out begins when AGI exceeds $139,500.

36. New per diem rates for substantiating the amount of travel expenses incurred in 2003. 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 (see IRS Publication 1542 for a complete list). The IRS uses the federal "fiscal year" (October 1 – September 30) in computing per diem rates instead of the calendar year. Table 13 summarizes the per diem rates for October 1, 2002 through September 30, 2003. The per diem rates for the period October 1, 2003 through September 30, 2004 were not available at the time of publication of this text.

Table 13: Per Diem Rates through September 30, 2003

37. Child and dependent care expenses. Beginning in 2003, the following changes will be made to the child and dependent care credit: (1) The credit can be as much as 35% (increased from 30% in 2002) of your qualified expenses. (2) The maximum adjusted gross income amount that qualifies for the highest percentage (35% in 2003) will increase to $15,000. (3) The dollar limit on the amount of qualifying expenses will increase to $3,000 for one qualifying individual and $6,000 for two or more qualifying individuals. (4) The amount of earned income your spouse (who is either a full-time student or not able to care for himself or herself is treated as having "earned") will increase. This amount will increase to $250 a month if there is one qualifying person and to $500 a month if there are two or more qualifying persons.