Article summary. Congress enacted two major tax laws in the closing days of 2004 that include several provisions of direct relevance to churches and church employees. Tax laws enacted in prior years also contain provisions that took effect in 2004. In addition, a number of court decisions and IRS rulings provided clarification on a number of important tax issues. Nearly 90 of the most important changes and clarifications are summarized in this feature article.

A. Tax Law Changes Made by the IRS and the Courts

1. The IRS assesses "intermediate sanctions" against a pastor. In a series of four rulings published in August of 2004 the IRS for the first time assessed "intermediate sanctions" against a pastor as a result of "excess benefits" paid to him (and members of his family) by his church. Intermediate sanctions are substantial excise taxes the IRS can impose on persons who receive "excess benefits" from a tax-exempt organization. The IRS concluded that a pastor's personal use of church assets (vehicles, homes, credit cards, computers, cell phones, etc.) and nonaccountable reimbursements (not supported by adequate documentation of business purpose) that a church pays its pastor, are "automatic excess benefits" resulting in intermediate sanctions, regardless of the amount involved, unless they are reported as taxable income by the church on the pastor's W-2, or by the pastor on Form 1040, for the year in which the benefits are provided. This is a stunning interpretation of the tax code and regulations that will directly affect the compensation practices of most churches, and expose some ministers and church board members to intermediate sanctions. IRS Letter Rulings 200435019, 200435020, 200435021, 200435022.

Key point. This important development was addressed fully in a feature article in the November-December 2004 edition of Church Law & Tax Report.

2. IRS addresses ministerial exemption from Social Security. Ministers may exempt themselves from self-employment (Social Security) taxes with regard to services they perform in the exercise of ministry if they file an exemption application (Form 4361) with the IRS by the due date of the federal tax return (Form 1040) for the second year in which they have at least $400 of self-employment earnings, any portion of which comes from ministerial services. The IRS chief counsel issued an opinion addressing the question of whether ministers can "requalify" for exemption from Social Security years after the "deadline" has expired if they change faiths, are "reordained" by their new faith, and thereafter acquire an opposition to accepting benefits from Social Security on the basis of their religious convictions. The chief counsel opinion breaks no new ground, but rather simply endorses the conclusion reached by a federal appeals court in 1994 in the Hall case. The chief counsel advice memorandum no more "opens the floodgates" for ministers to requalify for exemption from Social Security than the Hall case did a decade ago. For the vast majority of ministers who fail to file an exemption application by the deadline there is no second chance. They will never be able to exempt themselves from Social Security coverage. The chief counsel advice memorandum, like the court’s decision in the Hall case, is a narrow one and applies only to those few ministers who

• change their church affiliation
  
• are reordained
  
• develop an opposition, based on their new faith, to the acceptance of Social Security benefits, and
  
• submit an exemption application (Form 4361) by the due date of the federal tax return for the second year in which they have net self employment earnings of $400 or more, any part of which comes from the performance of ministerial services in their new faith
  

Few ministers will satisfy these requirements. The chief counsel advice memorandum will not apply to ministers who do not change their church affiliation or doctrine. Ministers who did not file an exemption application within the prescribed period, and who have served a local church for several years, are not given a second chance to opt out of Social Security by this ruling. Further, the chief counsel advice memorandum affirmed an earlier case denying an exemption from Social Security to a minister who changed his religious beliefs, was reordained, and then waited five years before submitting an exemption application. Ballinger v. Commissioner, 728 F.2d 1287 (10th Cir. 1984). Chief Counsel Advice 200404048, December 16, 2003.

3. IRS rejecting some ministers' applications for exemption from self-employment taxes. The IRS is rejecting some ministers' applications for exemption from self-employment taxes (Form 4361) because the applications were filed before the minister has worked at least two years in the ministry. Ministers may exempt themselves from self-employment (Social Security) taxes with regard to services they perform in the exercise of ministry if they file an exemption application (Form 4361) with the IRS by the due date of the federal tax return (Form 1040) for the second year in which they have at least $400 of self-employment earnings, any portion of which comes from ministerial services. The IRS apparently is interpreting this requirement, at least in some cases, to mean that ministers are not eligible to submit Form 4361 until they have worked at least two years. This is an incorrect interpretation of the tax code, which simply defines the deadline for filing Form 4361 and does not forbid ministers from filing the form until they have been engaged in ministry for at least two years. In fact, such an interpretation is absurd, since it means that ministers will have to file the form after the deadline has expired!

4. A federal appeals court issued a ruling suggesting that ministers who opt out of Social Security by filing a timely Form 4361 will not be able to claim years later that they qualify for Social Security retirement benefits on the ground that their exemption application was filed after the deadline expired and should never have been approved by the IRS. Section 1402(g) of the tax code permits self employed members (whether ministers or laypersons) of certain religious faiths to exempt themselves from Social Security coverage if the meet several conditions, including the following: (1) the member belongs to a recognized religious sect that is opposed to the acceptance of Social Security benefits; (2) the member adheres to the sect’s teachings relating to Social Security coverage; (3) the member files an exemption application (Form 4029); and (4) the member waives his right to all Social Security benefits.

A layman (Owen) applied for exemption from self-employment taxes by filing a Form 4029 with the IRS. His application was approved. Several years later, Owen sued the Social Security Administration (SSA), claiming that his application for exemption should never have been approved because it was not timely, and therefore he was entitled to Social Security retirement benefits. At the time Owen filed his application, the tax code mandated that such an application had to be submitted by the deadline for filing a tax return (Form 1040) for the first year that the individual had self-employment earnings.

Owen had worked in Social Security covered employment from 1950 to 1975, in 1977, and from 1986 to 1989. He also had income from self-employment beginning in 1973, when he became a member of the Conservative Mennonite Church. As a member of the Church, Owen was conscientiously opposed to Social Security benefits and so he filed with the IRS in 1981 an application for an exemption from paying self-employment tax. As part of this application, Owen agreed to waive all Social Security benefits. He stated on the application that he first became subject to self-employment tax in 1974. The IRS approved his application in 1981 and granted him the exemption to cover all years thereafter. Owen contends that the SSA was aware that the application was untimely because he did not apply for the exemption before the filing deadline for the first tax year in which he earned self-employment income.

After the IRS granted Owen the exemption he never again paid taxes on self-employment income. After he turned 65 in 1999, Owen applied for benefits with the SSA. The SSA denied his claim for benefits because he had been exempted from self-employment tax and had waived his right to Social Security benefits in his exemption application (Form 4029). Owen sued the SSA in an attempt to obtain his retirement benefits. He argued that his exemption (which included a waiver of all Social Security benefits) was invalid, and should not have been approved by the IRS, because he filed it after the deadline expired. A federal appeals court rejected Owen's claim. It noted that Owen "made a knowing waiver of his Social Security benefits in return for a tax exemption. . . . For over twenty years [he] did not pay self-employment tax and did not notify the IRS nor the SSA about the 'mistake' in granting his application. The government kept its part of the agreement, and Owen must keep his."

Key point. This case suggests that ministers who opt out of Social Security by filing a timely Form 4361 will not be able to claim years later that they qualify for Social Security retirement benefits on the ground that their exemption application was filed after the deadline expired and should never have been approved by the IRS. Yoder v. Barnhardt, 56 Fed. Appx. 728 (7th Cir. 2003).

5. 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. A 2001 tax law (EGTRRA) states that the term "earned income" includes only "amounts includible in gross income for the taxable year." However, the law 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 may appear, it seems to be what the law and the 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.

6. Social Security Protection Act of 2004. In 1996, Congress amended the tax code to clarify that retired ministers do not pay self-employment (Social Security) tax on housing allowances and the annual rental value of a parsonage. However, a corresponding change was not made to the Social Security Act. As a result, while these benefits are not subject to self-employment taxes they are used to earn insured status under Social Security and to compute benefits under the Social Security program. The Social Security Protection Act of 2004 amended the Social Security Act to conform it to the Internal Revenue Code, meaning that housing allowances and the annual rental value of parsonages provided to retired ministers are not considered in earning “insured status” or in computing the amount of Social Security benefits. The Act applies “to years beginning before, on, or after December 31, 1994.”

7. 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. The requirements are cumbersome, and many feel that the modest cost of cell phone charges does not warrant compliance with these rules. Two recent Tax Court cases demonstrate that such a view may not be acceptable to the IRS or the courts.

Case 1. An employee claimed an income tax deduction of $700 for costs associated with the business use of his cell phone. The IRS denied the deduction due to a lack of substantiation. The Tax Court agreed. It noted that the tax code imposes "stringent substantiation requirements" on "listed property" described in section 280F, including cell phones. For such expenses, "substantiation of the amounts claimed by adequate records or by other sufficient evidence corroborating the claimed expenses is required," and to meet the adequate records requirements a taxpayer "shall maintain an account book, diary, log, statement of expense, trip sheets, or similar record which, in combination, are sufficient to establish each element of an expenditure". The court noted that the taxpayer kept "no contemporaneously prepared records to document his employee-related uses of these devices." Instead, he presented a worksheet that simply listed his alleged expenses. This was inadequate, concluded the court, since a mere listing of expenses "does not suffice to satisfy the substantiation requirements for use of the cellular telephone." Jones v. United States, T.C. Summary Opinion 2004-76.

Case 2. A taxpayer claimed a business expense deduction of $1,250 on his tax return for the business use of his cell phone. The IRS denied the deduction due to a lack of substantiation. The Tax Court agreed. It noted that the tax code classifies cell phones as "listed property" under section 280F, and that "stringent substantiation requirements" apply to any deduction for the business use of such property (or the reimbursement of any expense by an employer under an accountable arrangement). These require documentary evidence proving the amount, date, place, and business nature of each expense. The court noted that the taxpayer made only "uncorroborated approximations" of his cell phone expenses, and this did not meet the strict requirements of the tax code. Woods v. Commissioner, TC Memo 2004-114.

8. IRS reminds taxpayers of adequate records requirement. In order to substantiate a business expense deduction on a tax return, or a reimbursement of an expense by an employer under an accountable arrangement, a taxpayer must have adequate records. In a recent ruling, the IRS clarified that a 1995 increase in the amount of a business expense for which a receipt is required (from $25 to $75) did not eliminate the other requirements for substantiating a business expense. The IRS concluded, "Even though a taxpayer does not need a receipt to establish the amount of certain expenditures of less than $75, the taxpayer must maintain adequate records to substantiate the amount, time, place, and business purpose of an expenditure such as through an account book or similar record prepared at or near the time of expenditure." IRS Letter Ruling 200343025.

9. 2004 standard mileage rate. The standard mileage rate for business miles driven during 2004 was 37.5 cents per mile for all business miles driven during the year (up from 36 cents per mile in 2003). The standard mileage rate can be used by taxpayers to compute a deduction for the business use of a vehicle. It also can be used by employers to reimburse workers' business miles under an accountable expense reimbursement arrangement. If your church has adopted an accountable reimbursement arrangement, be sure that your reimbursements for 2004 reflect the new rate. If the church reimburses business miles at a rate of more than 37.5 cents per mile, then the excess must be reported as taxable income to the employee on his or her W-2. In addition, payroll taxes must be withheld in the case of a nonminister employee or a minister who has elected voluntary tax withholding. If a church reimburses business miles at a rate less than the IRS-approved rate in 2004, then the "difference" represents an unreimbursed expense that may be claimed as a business expense deduction by the employee if certain conditions are met.

10. New tax form proposed for senior citizens. In 2004 the House of Representatives voted 418-0 to authorize a simplified tax form for taxpayers who are 65 years of age or older. The form will be in large type, and will be available regardless of income. Nearly 12 million Americans would qualify for the form. The proposal now moves to the Senate. It has the support of the American Association of Retired Persons (AARP).

11. IRS lists frivolous tax arguments. Here are some of the tax positions that the IRS considers frivolous: (1) The 16th amendment is invalid because it contradicts the Constitution. (2) A taxpayer can make a "claim of right" to exclude the cost of his labor from income. (3) Only income from a foreign source is taxable. (4) Citizens of states, such as New York, are citizens of a foreign country and therefore not subject to tax. (5) A taxpayer can escape income tax by putting assets in an offshore bank account. (6) A taxpayer can eliminate tax by establishing a corporation sole. (7) A taxpayer can place all of his assets in a trust to escape income tax while still retaining control over those assets. (8) Nothing in the tax code imposes a requirement to file a return. (9) Filing a tax return is voluntary. (10) Because taxes are voluntary, employers don't have to withhold income or employment taxes from employees. (11) A taxpayer can refuse to pay taxes if the taxpayer disagrees with the government's use of the taxes it collects. (12) A taxpayer can avoid tax by filing a return that reports zero income and zero tax liability. (13) A taxpayer can avoid tax by filing a return with an attachment that disclaims tax liability. (14) A taxpayer can deduct the amount of Social Security taxes that he paid and get a refund of those taxes. (15) A taxpayer may sell (or purchase) the right to use dependents in order to increase the amount of the earned income credit.

12. IRS warns against "offer in compromise" scams. The IRS issued a consumer alert in 2004 advising taxpayers to beware of promoters' claims that tax debts can be settled for "pennies on the dollar" through the offer in compromise program. Some promoters are inappropriately advising taxpayers to file an offer in compromise (OIC) application with the IRS. While the OIC program serves an important purpose for a select group of taxpayers, the IRS is "increasingly concerned about unscrupulous promoters charging excessive fees to taxpayers who have no chance of meeting the program's requirements," said IRS Commissioner Mark W. Everson. "We urge taxpayers not to be duped by high-priced promises." IRS News Release IR-2004-17.

13. IRS urges lower-income taxpayers to check their eligibility for the earned income credit. In 2004 the IRS urged working taxpayers with low incomes to review their eligibility for the earned income tax credit to see if they qualify. "This is an important program, and you should check to see if you qualify," said IRS Commissioner Mark W. Everson. "EITC rules can be complicated so you should carefully review the qualifications. Know, don't guess, if you are qualified. If in doubt, contact the IRS or its volunteer partners for help. If someone prepares your taxes, seek out a reputable professional who understands EITC rules and who will avoid common mistakes." The IRS is broadening its outreach to EITC claimants in an effort to maximize participation and minimize errors on tax returns. The IRS is taking several steps, including: (1) working with more than 180 community-based organizations nationwide to reach low-income workers who may be unaware of the EITC availability; (2) helping set up 14,000 volunteer centers that offer free tax preparation for low-income and elderly individuals (times and locations of these volunteer centers are publicized locally); and (3) coordinating with mayors' offices nationwide to help identify low-wage earners who may qualify for EITC. IRS News Release IR-2004-12.

14. Increase in earnings subject to the self employment tax. The self employment tax rate (15.3%) did not change in 2004. 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 2004, the maximum earnings subject to the OASDI portion of self employment taxes (the 12.4% amount) increased to $87,900—up from $87,000 in 2003. Stated differently, persons who received compensation in excess of $87,900 in 2004 paid the combined 15.3% tax rate for net self employment earnings up to $87,900, and only the HI tax rate of 2.9% on earnings above $87,900. 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.

Table 1: Social Security Changes

	2004	2005
tax rate-employees	7.65%	7.65%
tax rate-self-employed	7.65%	7.65%
maximum taxable earnings (Social Security tax only)	$87,900	$90,000
maximum taxable earnings (Medicare tax)	no limit	no limit
retirement earnings tax-exempt amounts (workers age 65 through 69)	no limit*	no limit*
retirement earnings tax-exempt amounts (workers under full retirement age)	$11,640	$12,000
maximum Social Security monthly benefit	$1,825	$1,939
average monthly benefit-retired workers	$930	$955
average monthly benefit-retired couple, both receiving benefits	$1,532	$1,574
average monthly benefit-widowed mother and two children	$1,927	$1,979
average monthly benefit-aged widow(er) alone	$896	$920
average monthly benefit-disabled worker, spouse and one or more children	$1,458	$1,497
average monthly benefit-all disabled workers	$871	$895

* A "modified" annual earnings test applies in the year a worker attains "full retirement age" (65 years and 4 months for those born in 1939). Social Security benefits are reduced by $1 for every $3 of earnings above $2,590 for each month prior to their full retirement age (this amount was $2,560 in 2003). Beginning with the month an individual attains full retirement age there is no reduction in Social Security retirement benefits no matter how much the person earns.

15. 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 2002 through 2005. 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.

16. Inflation adjustments. For 2004, 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 2004, the amount increased to $3,100 per person (up from $3,050 in 2003).

Standard deduction. The "standard deduction" (the amount you can deduct if you cannot itemize your deductions) increased to $9,700 in 2004 for married couples filing jointly—up from $9,500 in 2003. This is twice the amount of the standard deduction for single taxpayers ($4,850) for 2004. Single taxpayers who are 65 years of age or older, or blind, get a $1,200 increase in their standard deduction for 2004. Married taxpayers who are 65 years of age or older, or blind, get a $950 increase in their standard deduction for 2004.

17. Audit statistics. The General Accounting Office released a report in 2001 analyzing IRS audit rates. The results are summarized in Table 2.

Table 2: IRS Audit Rates for Individual Taxpayers 1996-2000 (in thousands)

	1996	1997	1998	1999	2000	% change
tax returns	116,000	118,000	120,000	122,000	124,000	8%
audits	1,941	1,512	1,192	1,100	617	-68%
overall audit rate	1.67%	1.28%	0.99%	0.90%	0.49%	-70%
income < $25,000	1.82%	1.39%	1.06%	1.18%	0.55%	-70%
income $25,000-$100,000	1.03%	0.73%	0.60%	0.36%	0.22%	-78%
income > $100,000	2.85%	2.27%	1.66%	1.14%	0.84%	-70%
Sch. C < $25,000	4.21%	3.19%	2.37%	2.69%	2.43%	-42%
Sch. C $25,000-$100,000	2.85%	2.57%	1.82%	1.30%	0.90%	-67%
Sch. C > $100,000	4.09%	4.13%	3.25%	2.40%	1.48%	-64%

The overall audit rate for 2001 was 0.58% (58 out of every 1,000 returns filed), which is up slightly from 0.49% in 2000. The overall audit rate for 2002 was 0.57%.

18. 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 2004 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.

19. 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 2004 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.

20. 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. For 2004 the deduction is limited to $102,000 for property placed in service in those years. The dollar limitations are indexed annually for inflation for taxable years before 2006.

21. "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 2004 limits are summarized in Table 3 along with the limits for 2003 for comparison purposes.

Table 3: “Luxury Car” Depreciation Limits

tax year	maximum depreciation deduction for cars first placed in service in 2003	maximum depreciation deduction for cars first placed in service in 2004
first	$3,060	$2,960
second	$4,900	$4,800
third	$2,950	$2,850
each succeeding year	$1,775	$1,675

In some cases, "bonus" depreciation of an additional $7,650 may be claimed in the first year a car is used for business purposes, which increases the first year limit to $10,610 for 2004. This bonus only applies to vehicles purchased after May 5, 2003 and before January 1, 2005.

For electric cars placed in service in 2004 these amounts are $8,800 for year one; $14,300 for year two; $8,550 for year three; and $5,125 each succeeding year in the recovery period.

22. Phase out of personal exemption for high income taxpayers. The personal exemption deduction (that you can claim for yourself and each dependent) increased to $3,100 in 2004 (up from $3,050 in 2003). In 2004 the personal exemption amounts are phased out for certain high income taxpayers. For married taxpayers filing jointly, the phase out begins when AGI exceeds $214,050. For single taxpayers, the phase out begins when AGI exceeds $142,700.

23. New per diem rates for substantiating the amount of travel expenses incurred in 2004. 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 4 summarizes the per diem rates for October 1, 2003 through September 30, 2004. The maximum per diem rates for the period October 1, 2004 through September 30, 2005 are $199 for high-cost localities, and $127 for all other localities.

Table 4: Per Diem Rates through September 30, 2004

locality (destination of overnight travel)	"lodging" per diem rate	"meals and incidental expense" per diem rate	maximum per diem rate
"high-cost" localities	$161	$46	$207
all other localities	$90	$36	$126

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.

24. Child and dependent care expenses. Beginning in 2003, the following changes were made to the child and dependent care credit: (1) The credit can be as much as 35% of your qualified expenses. (2) The maximum adjusted gross income amount that qualifies for the highest percentage (35% in 2004) is $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.

B. Tax Law Changes Made by Congress

Congress enacted major tax bills in 2001, 2003 and 2004 containing several provisions that will affect tax reporting by both churches and ministers for 2004 and future years.

• The American Jobs Creation Act of 2004. In October of 2004 Congress passed the American Jobs Creation Act of 2004. This comprehensive corporate tax law contains a number of provisions of direct relevance to churches and church staff, many of which are summarized in this article.

• The Working Families Taxpayer Relief Act of 2004. In September of 2004 Congress passed the Working Families Taxpayer Relief Act of 2004. The Act "extends" several tax benefits that were scheduled to expire, including the $1,000 child tax credit, reduced income tax rates, and marriage penalty relief, the charitable deduction for donations by corporations of computer equipment used for educational purposes, the tax deduction for certain expenses of elementary and secondary school teachers, and Archer medical savings accounts. These provisions are summarized in this article.

• JGTRRA. On May 28, 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA"). Some of the provisions in this new law took effect in 2004 or 2005, and those that have the greatest relevance to ministers and churches are summarized in this article. 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.

• 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 2004 or 2005, and those that have the greatest relevance to ministers and churches are summarized in this article.

Individual Income Taxes

25. 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 for taxable years beginning in 2001. The 10% rate bracket originally applied 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 for 2003 and 2004. Specifically, for 2003 and 2004, the taxable income level for the 10% tax rate bracket for unmarried individuals increased 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 are adjusted annually for inflation for taxable years beginning after 2003. The inflation-adjusted amounts for 2004 are $7,150 for single taxpayers and $14,300 for married taxpayers filing jointly.

Key point. Congress passed the Working Families Tax Relief Act in 2004. The Act extends the size of the 10% rate bracket through 2010. The 10% rate bracket for 2005 through 2010 is set at the 2003 level ($7,000 for single individuals and $14,000 for married individuals) with annual indexing from 2003.

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."

Prior to EGTRRA, the regular income tax rates were 15%, 28%, 31%, 36%, and 39.6%. EGTRRA "phased down" these rates over six years to 25%, 28%, 33%, and 35%, effective after June 30, 2001. See Table 5.

Table 5: Income Tax Rate Reductions Established by EGTRRA

calendar year	28% rate	31% rate	36% rate	39.6% rate
2001	27.5%	30.5%	35.5%	39.1%
2002-03	27%	30%	35%	38.6%
2004-05	26%	29%	34%	37.6%
after 2005	25%	28%	33%	35%

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

Table 6: New Income Tax Rates for 2004 (Single Persons)

taxable income		pay	plus this percent	of taxable income over
over	not over
$0	$7,150	$0	10%	$0
$7,150	$29,050	$715	15%	$7,150
$29,050	$70,350	$4,000	25%	$29,050
$70,350	$146,750	$14,325	28%	$70,350
$146,750	$319,100	$35,717	33%	$146,750
$319,100	$ ---	$92,592.50	35%	$319,100

Table 7: New Income Tax Rates for 2004 (Married Persons Filing Jointly)

taxable income		pay	plus this percent	of taxable income over
over	not over
$0	$14,300	$0	10%	$0
$14,300	$58,100	$1,430	15%	$14,300
$58,100	$117,250	$8,000	25%	$58,100
$117,250	$178,650	$22,787.50	28%	$117,250
$178,650	$319,100	$39,979.50	33%	$178,650
$319,100	$ ---	$86,328	35%	$319,100

Example. A pastor and his spouse are both employed, and file a joint tax return for 2004 reporting taxable income (after deductions, exemptions, and credits) of $50,000. Without the acceleration of the income tax rates, their income taxes would be $6,900. As a result of JGTRRA, their income taxes will be $6,785.

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 $13,475.

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.

26. 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 minimized 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.

Key point. Congress passed the Working Families Tax Relief Act in 2004. The Act increases the size of the 15% rate bracket for joint returns to twice the size of the corresponding rate bracket for single returns effective for 2005-2010.

#2--the standard deduction

EGTRRA increased the standard deduction for married persons filing jointly, beginning in 2005, to minimize the marriage penalty. Table 8 summarizes this change.

Table 8: Increase in the Standard Deduction

calendar year	standard deduction for joint returns as percentage of standard deduction for single returns
2005	174%
2006	184%
2007	187%
2008	190%
2009 and later	200%

JGTRRA increased the basic standard deduction amount for joint returns to twice the basic standard deduction amount for single returns effective for 2003 and 2004.

Key point. Congress passed the Working Families Tax Relief Act in 2004. The Act increases the basic standard deduction amount for joint returns to twice the basic standard deduction amount for single returns effective for 2005-2010.

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.

27. 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 accelerated 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.

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 2004 as a result of JGTRRA.

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 2004, and does not expect to pay taxes this year. She will be eligible for an "additional child tax credit" in 2004 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. The credit is not "phased out" until a married couple's adjusted gross income exceeds $110,000.

New in 2004. Congress passed the Working Families Tax Relief Act in 2004. The Act extends the $1,000 child tax credit through 2010, and accelerates to 2004 the increase in refundability of the credit to 15% of a taxpayer's earned income in excess of $10,750.

28. 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 2004 and 2005 married taxpayers filing a joint return with AGI of $130,000 or less are entitled to a maximum deduction of $4,000. This deduction is reduced to $2,000 for married taxpayers filing joint returns with AGI of more than $130,000 but not more than $160,000. There is no deduction for married taxpayers filing jointly whose AGI exceeds $160,000.

In 2004 and 2005 single taxpayers with AGI of $65,000 or less are entitled to a maximum deduction of $4,000. This deduction is reduced to $2,000 for single taxpayers with AGI of more than $65,000 but not more than $80,000. There is no deduction for single taxpayers whose AGI exceeds $80,000.

This deduction expires at the end of 2005.

Estates and Gift Taxes

29. 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 9.
  
• Beginning in 2011, the top gift tax rate will be 40%, and, except as provided in the tax regulations, a transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor’s spouse under the grantor trust provisions of the tax code.
  

Table 9: Unified Credit Exemption; Highest Estate and Gift Tax Rates

calendar year	estate and generation skipping tax deathtime transfer exemption	highest estate and gift tax rate
2002	$1 million	50%
2003	$1 million	49%
2004	$1.5 million	48%
2005	$1.5 million	47%
2006	$2 million	46%
2007	$2 million	45%
2008	$2 million	45%
2009	$3.5 million	45%
2010	taxes repealed	45%
2011	taxes repealed	top individual income rate under EGTRRA (gift tax only)

IRAs and Retirement Plans

30. 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.

31. 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.

32. 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 10.

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

Table 10: Credit Rates Based on AGI

joint returns	heads of household	all other filers	credit rate ($2,000 maximum)
$0-30,000	$0-22,500	$0-15,000	50%
$30,000-32,500	$22,500-24,376	$15,000-16,250	20%
$32,500-50,000	$24,375-37,500	$16,250-25,000	10%
over $50,000	over $37,500	over $25,000	0%

33. 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 $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.

The American Jobs Creation Act of 2004

On October 11, 2004, Congress passed the American Jobs Creation Act of 2004. The Act contains the following provisions of relevance to church leaders:

34. Substantiation of charitable contributions. The Act extends to all "C corporations" the present requirement, applicable to individuals, that a donor obtain a qualified appraisal of property donated to charity if the amount of the deduction exceeds $5,000. The Act also provides that if the amount of the contribution of property other than cash, inventory, or publicly traded securities exceeds $500,000, the qualified appraisal must be attached to the donor's tax return. For purposes of the dollar thresholds, property and all similar items of property donated to one or more charities are treated as one property. The Act specifies that a donor who fails to substantiate a charitable contribution of property, as required by the tax code and regulations, is denied a charitable contribution deduction (unless it is shown that such failure is due to reasonable cause and not to willful neglect).

These provisions are effective for contributions made after June 3, 2004.

35. Donation of vehicles. The Act imposes new requirements on charitable contributions of vehicles.

36. Sales tax deduction. The Act provides that, at the election of the taxpayer, an itemized deduction may be taken for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes. Taxpayers have two options with respect to the determination of the sales tax deduction amount. They can deduct the total amount of general state and local sales taxes paid by accumulating receipts showing general sales taxes paid. Or, they can use tables created by the IRS. The tables will be based on average consumption by taxpayers on a state-by-state basis taking into account filing status, number of dependents, adjusted gross income and rates of state and local general sales taxation. Taxpayers who use the tables may, in addition, deduct eligible general sales taxes paid with respect to the purchase of motor vehicles, boats and other items specified by the IRS. Sales taxes for items that may be added to the tables would not be reflected in the tables themselves.

This provision was added to address the "unequal" treatment of taxpayers in the nine states that have no income tax. Taxpayers in these states cannot take advantage of the itemized deduction for state income taxes. Allowing them to deduct sales taxes will help offset this disadvantage.

This provision is effective for taxable years beginning after December 31, 2003, and prior to January 1, 2006.

Key point. A conference committee report contains the following statement: "The IRS is currently in the process of finalizing tax forms for 2004. The tax code has not contained an itemized deduction for state and local sales taxes for a number of years. Developing the tables required by the Act will in general require a significant amount of time and effort. The conferees anticipate that IRS will do the best they can to reasonably and accurately implement this statutory provision in order to effectuate the deduction for the 2005 filing season." The IRS has announced that it will publish the new tables in Publication 600, which will be available on the IRS website prior to April 15, 2005.

37. Rabbi trusts. A "rabbi trust" is a trust or other fund established by the employer to hold assets from which nonqualified deferred compensation payments will be made. The trust is generally irrevocable and does not permit the employer to use the assets for purposes other than to provide nonqualified deferred compensation, except that the terms of the trust provide that the assets are subject to the claims of the employer's creditors in the case of insolvency or bankruptcy. Congress determined that legislation was needed to combat two problems that have arisen: (1) attempts to protect rabbi trust assets from creditors despite the terms of the trust to the contrary; and (2) attempts to allow deferred amounts to be available to individuals, while still purporting to meet the safe harbor requirements set forth by the IRS. The Act imposes several new limitations on rabbi trusts.

All of these provisions are effective for amounts deferred in taxable years beginning after December 31, 2004. However, earnings on amounts deferred before the effective date are subject to the Act to the extent the Act so provides.

38. Discrimination awards. The American Jobs Creation Act of 2004 specifies that the amount of monetary damages received on account of "unlawful discrimination" is reduced by the amount of the damages that are used to pay for attorneys' fees and court costs incurred in connection with the lawsuit. This rule applies to most forms of discrimination under state and federal law.

39. Partial payment installment agreements. Prior to 1998, the IRS often entered into "installment agreements" with taxpayers who were unable to pay their entire tax liability. However, in 1998, the IRS chief counsel issued an opinion barring the IRS from accepting installment agreements that did not call for the payment of a taxpayer's entire tax liability. The Act authorizes the IRS to enter into installment agreements with taxpayers for less than the full amount of their tax liability. The provision requires the IRS to review partial payment installment agreements at least every two years. The primary purpose of this review is to determine whether the financial condition of the taxpayer has significantly changed so as to warrant an increase in the value of the payments being made. This provision takes effect immediately. A conference committee report states that "some taxpayers are unable or unwilling to enter into a realistic offer-in-compromise. The committee believes that these taxpayers should be encouraged to make partial payments toward resolving their tax liability, and that providing for partial payment installment agreements will help facilitate this."

Miscellaneous changes

40. House committee kills political "safe harbor" for churches. The tax code prohibits churches from participating or intervening in any political campaign on behalf of or in opposition to any candidate for public office at the federal, state, or local level. This is often called the "campaign" limitation. A church that violates this limitation can lose its tax-exempt status. This limitation has rarely been enforced by the IRS because of constitutional concerns, and a lack of clarification in the law regarding the meaning of "participation" or "intervention" in a political campaign. Yet, it remains a threat that must be taken seriously by church leaders because of the serious consequences that could befall a church found to have violated the limitation. The recently proposed American Jobs Creation Act of 2004 (H.R. 4520), while primarily designed to create jobs, contained an amendment clarifying that churches are not engaged in campaign activities "solely by reason of a statement by a religious leader of such organization which is clearly identified as a statement made as a private citizen and not made on behalf of or in representation of such organization." The amendment also imposed an excise tax on churches that violate the campaign limitation. The House Ways and Means Committee unanimously voted to remove this amendment from the bill, citing concerns by church leaders that the provision would lead to excessive entanglement between church and state.

41. New Medicare law creates "Health Savings Accounts." Congress enacted a comprehensive Medicare reform bill in November. While the most publicized feature of the new law is prescription benefits, it also creates new "health savings accounts" with the following features: (1) Workers under the age of 65 will be allowed to accumulate tax-free savings for health care needs if they have qualified health plans. A qualified health plan has a minimum deductible of $1,000 with a $5,000 cap on out-of-pocket expenses for self-only policies. These amounts are doubled for family policies. (2) Individuals can make pre-tax contributions of up to 100% of the health plan deductible. (3) The maximum annual contribution is $2,600 for individuals with self-only policies and $5,150 for families (indexed annually for inflation). Pre-tax contributions can be made by individuals, their employers and family members. (4) Individuals age 55-65 can make additional pre-tax "catch-up" contributions of up to $1,000 annually (phased in). (5) Tax-free distributions are allowed for health care needs not covered by insurance. (6) The individual owns the account. The savings follow the individual from job to job and into retirement. (7) HSA savings can be drawn down to pay for retiree health care once an individual reaches Medicare eligibility age. (8) Tax-free distributions can be used to pay for retiree health insurance (with no minimum deductible requirements), Medicare expenses, prescription drugs, and long-term care services, among other retiree health care expenses. (7) Upon death, HSA ownership may be transferred to the spouse on a tax-free basis. HSAs become available in 2004. While patterned after the Archer Medical Savings Account, they are more generous and do not have "quotas" on the number of persons who can participate in them.

42. A proposal to consolidate tax-sheltered accounts. Current law provides multiple tax-preferred individual savings accounts to encourage savings for retirement, education, and health expenses. The accounts have overlapping goals but are subject to different sets of rules regulating eligibility, contribution limits, tax treatment, and withdrawal restrictions. Individual Retirement Accounts (IRAs), including traditional, Roth, and nondeductible IRAs, are primarily intended to encourage retirement saving, but can also be used for certain education, medical, and other non-retirement expenses. Each of the three types of IRAs is subject to a different set of rules regulating eligibility and tax treatment. Coverdell Education Savings Accounts (ESAs) and Section 529 Qualified Tuition Plans (QTPs) are both intended to encourage saving for education, but each is subject to different rules. Archer Medical Savings Accounts (MSAs) and Health Savings Accounts (HSAs) are intended to encourage saving for medical expenses.

The various individual savings accounts, each subject to different rules regarding eligibility, contributions, tax treatment, and withdrawal, creates complexity and redundancy in the tax code. A proposal by President Bush would consolidate the three types of IRAs into a single account: a Retirement Savings Account (RSA). RSAs would be dedicated solely to retirement savings. Instead of a list of exceptions for penalty-free early withdrawals, a new account, a Lifetime Savings Account (LSA) would be created that could be used for savings for any purpose, including augmenting retirement savings, health care, covering emergencies, and education.

Individuals could contribute up to $5,000 per year (or earnings includible in gross income, if less) to their RSA. As under current law IRAs, for an individual who is married filing a joint return, the compensation limitation will only be binding if the combined includible compensation of the spouses is less than $10,000. No income limits would apply to RSA contributions. Contributions would have to be in cash. Contributions would be nondeductible, but earnings would accumulate tax-free, and qualified distributions would be excluded from gross income. The RSA contribution limit would be indexed for inflation. Existing Roth IRAs would be renamed RSAs and be made subject to the new rules for RSAs.

Qualified distributions from the retirement account would be distributions made after age 58 or in the event of death or disability. Any other distribution would be a nonqualified distribution and, as with current non-qualified distributions from Roth IRAs, would be includible in income (to the extent it exceeds basis) and subject to a 10 percent additional tax.

In addition, individuals could contribute up to $5,000 per year to their LSA, regardless of income. No income limits would apply to LSA contributions. Contributions would have to be in cash. Contributions would be nondeductible, but earnings would accumulate tax-free, and all distributions would be excluded from gross income, regardless of the individual's age or use of the distribution. As with current law Roth IRAs, no minimum required distribution rules would apply to LSAs during the account owner's lifetime.

Contribution limits would apply to all accounts held in an individual's name, rather than to contributors. Thus, contributors could make annual contributions of up to $5,000 each to the accounts of other individuals, but the aggregate of all contributions to all accounts held in a given individual's name could not exceed $5,000. The LSA contribution limit would be indexed for inflation.

Both LSAs and RSAs would become effective beginning on January 1, 2005.

43. Senate committee considers new restrictions on charities following hearings addressing charitable abuses. The United States Senate conducted hearings in 2004 on abuses by public charities. One committee member stated that "while many charities are focused on doing good works and preserving the public trust, there have been a number of high-profile examples of problems in this expanding sector [including] inflated salaries paid to trustees and charity executives." Committee chairman Charles Grassley (R-IA) stated during the hearings that Congress should consider various reforms to address charitable abuses, including one or more of the following: (1) personal liability of a charity's board members for irresponsible management; (2) review of a charity's tax-exempt status every five years; (3) more financial disclosure; and (4) a charity's chief executive officer sign all tax returns filed by the charity.

44. Backup withholding. Recent tax legislation changed the backup withholding rate to 28% retroactive to January 1, 2003. If a self-employed worker performs services for your church (and earns at least $600 for the year), but fails to provide you with his or her Social Security number, then the church is required by law to withhold 28% of the amount of compensation as "backup withholding." The backup withholding is reported to the IRS on Form 945. Of course, a self-employed person can avoid backup withholding by providing the church with a correct Social Security number. The church will need the correct number to complete the worker's Form 1099-MISC. Churches can be penalized if the Social Security number they report on a Form 1099-MISC is incorrect, unless they have exercised "due diligence." A church will be deemed to have exercised due diligence if it has self-employed persons provide their Social Security numbers on IRS Form W-9. It is a good idea for churches to present self-employed workers (e.g., guest speakers, contract laborers) with a W-9 form, and then to "backup withhold" unless the worker completes and returns the form.

45. Congress considers charity relief legislation. In April of 2003 the United States Senate overwhelmingly passed the Charity Aid, Recovery, and Empowerment (CARE) Bill by a 95-5 vote. The House of Representatives passed a similar bill in 2003. The Senate bill authorized $1.3 billion in block grants to faith-based groups to provide specified social services. The House bill did not contain this provision. This difference stalled final passage of the legislation. In 2004, the Senate attached the legislation to a popular jobs bill, but it was later pulled due to disagreements over amendments. It is likely that some or all of the following provisions in the Senate and House bills will become law:

(1) Charitable contributions for nonitemizers. In the case of an individual taxpayer who does not itemize deductions, the bill allows a "direct charitable deduction" from adjusted gross income for charitable contributions paid in cash during the taxable year. This deduction is allowed in addition to the standard deduction. The deduction is available only for that portion of contributions actually made during the year that exceed $250 ($500 in the case of a joint return). The maximum deduction is $250 ($500 in the case of a joint return).

(2) Tax-free distributions from IRAs to charity. The bill provides an exclusion from gross income for IRA distributions from a traditional or a Roth IRA in the case of "qualified charitable distributions." A qualified charitable distribution is any distribution from an IRA that is made directly to (1) a church or other charity ("direct distributions"), or (2) a charitable remainder trust, a pooled income fund, or a charitable gift annuity ("split interest distributions"). Direct distributions are eligible for the exclusion only if made on or after the date the IRA owner attains age 70 1/2. Distributions to a split interest entity are eligible for the exclusion only if made on or after the date the IRA owner attains age 59 1/2.

(3) Contributions of food inventory. Taxpayers are eligible to claim an enhanced deduction for donations of food inventory to charity.

(4) Charitable mileage rate. The bill would make reimbursements by a church or other charity to a volunteer for the costs of using an automobile in connection with providing donated services excludable from the gross income of the volunteer, provided that (1) the reimbursement does not exceed the business standard mileage rate prescribed for business use (37.5 cents per mile in 2004), and (2) recordkeeping requirements applicable to deductible business expenses are satisfied.

(5) Annual IRS notices. Most charities are required to file an annual information return with the IRS (Form 990). This form, which is subject to public inspection, contains detailed information about a charity's finances and operation (including disclosure of compensation paid to officers). Some charities are exempt from filing this form, including churches, some other religious organizations, and charities that normally have gross annual income of not more than $25,000. The CARE bill would require charities that are exempt from filing Form 990 because they normally have annual income of less than $25,000 to provide the IRS with a "notice" each year containing specified information. Failure to file the notice for three years would result in revocation of a charity's tax exemption. This notice requirement would not apply to churches.

(6) IRS audits of churches. Under present law, the IRS may begin a church tax inquiry only if an appropriate high level Treasury official reasonably believes, on the basis of the facts and circumstances recorded in writing, that an organization (1) may not qualify for tax exemption as a church, (2) may be carrying on an unrelated trade or business, or (3) otherwise may be engaged in taxable activities. A church tax inquiry is any IRS inquiry to a church to determine if it qualifies for tax exemption as a church or whether it is carrying on an unrelated trade or business or otherwise is engaged in taxable activities. An inquiry is initiated when the IRS requests information or materials from a church contained in church records, other than routine requests for information or inquiries regarding matters that do not primarily concern the tax status or liability of the church itself. The CARE bill clarifies that the church tax inquiry procedures do not apply to contacts made by the IRS for the purpose of educating churches with respect to the federal income tax law governing tax-exempt organizations. For example, the IRS does not violate the church tax inquiry procedures when written materials are provided to churches for the purpose of educating them with respect to the types of activities that are not permissible under section 501(c)(3) of the tax code.

(7) Conventions and associations of churches. Under present law, an organization that qualifies as a "convention or association of churches" is not required to file an annual return (Form 990); is protected by the Church Audit Procedures Act; and is subject to certain other provisions generally applicable to churches. The tax code does not define the term "convention or association of churches." The CARE bill specifies that an organization that otherwise is a convention or association of churches does not fail to be so merely because the membership of the organization includes individuals as well as churches, or because individuals have voting rights in the organization.

46. Special first year "bonus" depreciation allowance. 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. The amount of the depreciation deduction for a taxable year is determined under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different types of property generally are assigned different "recovery periods" and depreciation methods. The recovery periods applicable to most tangible personal property range from 3 to 25 years. The tax code limits the annual depreciation deductions with respect to passenger automobiles to specified dollar amounts, indexed for inflation.

In lieu of depreciation, a taxpayer generally may elect to deduct up to $102,000 (for 2004) of the cost of qualifying property placed in service for the taxable year (the "section 179" deduction). In general, qualifying property is depreciable tangible personal property that is purchased for use in the active conduct of a trade or business.

JGTRRA provides taxpayers with an additional first year depreciation allowance in order to stimulate the economy by encouraging the purchase of goods and equipment. The first year depreciation deduction is equal to 50% of the adjusted basis of qualified property. Qualified property is defined as any property to which MACRS applies with an applicable recovery period of 20 years or less. In addition, the property must be acquired after May 5, 2003 and before January 1, 2005, and no binding written contract for the acquisition is in effect before May 6, 2003.

47. Increase in first year depreciation limit for automobiles used in business. 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 pre-JGTRRA limits are summarized in Table 11.

Table 11: Pre-JGTRRA “Luxury car” depreciation limits (2004)

tax year	maximum depreciation deduction for cars first placed in service in 2004
first	$2,960
second	$4,800
third	$2,850
each succeeding year	$1,675

JGTRRA increases the limitation on the amount of depreciation deductions allowed with respect to passenger automobiles in the first year by $7,650 for automobiles that qualify (assuming the taxpayer does not elect out of the increased first year deduction). The $7,650 increase is not indexed for inflation. This means that the total depreciation that can be claimed for the purchase of an automobile used in one's trade or business increased to $10,610 for 2004 (the pre-JGTRRA limit of $2,960 plus the bonus amount of $7,650).

48. Increase in section 179 expensing. For 2004 a taxpayer can elect to deduct up to $102,000 of the cost of qualifying property placed in service for the taxable year (the "section 179 deduction"). In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business. The $102,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $410,000. An election to expense these items generally is made on the taxpayer's tax return for the year in which the election is claimed. The dollar limitations are indexed annually for inflation for taxable years before 2006.

49. Reduction in capital gains rates. In general, gain or loss reflected in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of a capital asset, any gain generally is included in income. Any net capital gain of an individual is taxed at rates lower than the ordinary income tax rates. Net capital gain is the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain or loss is treated as long-term if the asset is held for more than one year.

Capital losses generally are deductible in full against capital gains. In addition, individual taxpayers may deduct capital losses against up to $3,000 of ordinary income in each year. Any remaining unused capital losses may be carried forward indefinitely to another taxable year.

A capital asset generally means any property, with certain exceptions (including depreciable business assets and business supplies).

Prior to JGTRRA, the maximum rate of tax on the adjusted net capital gain of an individual was 20%. In addition, any adjusted net capital gain that would be taxed at the 15% rate if it were ordinary income is taxed at a 10% rate.

JGTRRA reduces the 10% and 20% rates on the adjusted net capital gain to 5% and 15%, respectively. The lower rates apply to assets held more than one year, and sold after May 5, 2003. The 5% tax rate is reduced to zero for taxable years beginning after December 31, 2007. In some cases, other tax rates may apply. See IRS Publication 544 for details.