Article summary. Congress enacted two major tax laws in the closing days of 2005 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 2005. In addition, a number of court decisions and IRS rulings provided clarification on a number of important tax issues. The most important changes and clarifications are summarized in this feature article.

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

1. Tax Court applies "Deason rule" to minister's business expenses. Under the so-called "Deason rule" (named after a 1964 court case) ministers must reduce their business expense deduction for unreimbursed expenses as well as expenses reimbursed under a nonaccountable arrangement by the percentage of their total church income that consists of a tax-exempt housing allowance. For example, assume that Pastor Brad has total church income of $40,000, which includes a $10,000 housing allowance. He also incurs unreimbursed business expenses of $4,000. Since one-fourth of his church income is tax-exempt ($10,000 out of $40,000) he must reduce his business expense deduction by one-fourth. This means that only $3,000 of his expenses will be deductible. The Tax Court applied the Deason rule in a case in 2005. A pastor was paid compensation of $78,000 consisting of a salary of $36,000 and a housing allowance of $42,000. He also received self-employment earnings of $21,000 for the performance of miscellaneous religious services (including weddings, funerals, and guest speaking). The pastor also incurred business expenses of $25,000 that were not reimbursed by the church, including car expenses, books, office expenses, and business trips. The IRS audited the pastor's tax return, and claimed that his deduction for business expenses had to be reduced by the percentage of his total church income that consisted of a housing allowance. The pastor insisted that his business expense deduction should not be reduced by the percentage of his total income that was tax-exempt. On appeal, the Tax Court noted that section 265 of the tax code provides that "no deduction shall be allowed for any amount otherwise allowable as a deduction which is allocable to one or more classes of income wholly exempt from taxes." The court noted that the pastor "received both nonexempt income and a tax-exempt parsonage allowance for his ministry work. The ministry expenses he attempts to deduct were incurred while he was earning both nonexempt income and a tax-exempt parsonage allowance. This is precisely the situation section 265 targets. . . . The parsonage allowance is a class of income wholly exempt from tax and section 265 expressly disallows a deduction to the extent that the expenses are directly or indirectly allocable to his nontaxable ministry income."

The court noted that since the pastor "failed to provide evidence that would allow the court to determine which of his ministry activities generated which expenses, the court will allocate the expenses on a pro rata basis. The court concludes that the pastor's Schedule C ministry activities generated 22% of his total ministry income, and therefore allocates 22% of his ministry expenses to Schedule C, and the balance to Schedule A. Because 54% of his ministry salary was his parsonage allowance ($42,000/$78,000), 54% of his Schedule A deductions are rendered nondeductible because of section 265. The pastor may deduct (subject to the 2-percent floor) the balance as itemized miscellaneous deductions on Schedule A." Young v. Commissioner, T.C. Summary Opinion 2005-76.

2. IRS priorities for exempt organizations. IRS Commissioner Mark Everson has disclosed a list of 20 abuses by tax-exempt organizations that are receiving increased scrutiny. The list includes charitable donations, appraisals of donated property, and excessive compensation. Everson stressed that "the vast majority of charities are law-abiding, but we cannot let a few bad apples taint one of the pillars of our society."

Key point. According to IRS data there are over 1.8 million tax-exempt organizations under section 501(c)(3) of the tax code, not including churches and religious organizations. Between 1998 and 2002, the assets of tax-exempt organizations grew from $2 trillion to more than $3 trillion.

3. IRS publishes sales tax tables. The American Jobs Creation Act of 2004 allows taxpayers who claim itemized deductions on Schedule A (Form 1040) to choose between a deduction for state and local income or sales taxes. Taxpayers indicate by a checkbox on line 5 of Schedule A which type of deduction they are claiming. The law provides this choice for tax years 2004 and 2005 only. The IRS has issued Publication 600, which contains tables to assist taxpayers in computing a sales tax deduction for 2004 and 2005. This publication is available on the IRS website (www.irs.gov) and will be sent to all taxpayers who get a Form 1040 tax package. IRS Commissioner Mark Everson has suggested that taxpayers "check these tables to see if they're entitled to a larger sales tax deduction than a state income tax deduction." The tables give taxpayers a sales tax deduction amount as an alternative to saving their receipts throughout the year and tabulating the amount of sales taxes actually paid. Taxpayers use their income level and number of exemptions to find the sales tax amount for their state. The table instructions explain how to add an amount for local sales taxes if appropriate.

Tip. While the sales tax deduction will mainly benefit taxpayers with a state or local sales tax but no income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) it may give a larger deduction to any taxpayer who paid more in sales taxes than income taxes. For example, a person who purchases a new car in 2004 or 2005 may have sales taxes in excess of state income taxes.

4. 403(b) accounts off limits to bankruptcy creditors. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which was enacted in 2005 by Congress, protects tax-exempt retirement savings accounts, including 403(b) accounts, from bankruptcy creditors. The new law took effect October 17, 2005.

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. In the 2001 Economic Growth and Tax Relief Reconciliation Act (“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 2006 Church & Clergy Tax Guide.

6. IRS issues new Form 4361. The IRS issued a new Form 4361 in November of 2005. This is the form ministers use to apply for exemption from self-employment taxes.

7. 2005 standard mileage rates. The standard mileage rate for business miles driven during 2005 was 40.5 cents per mile for business miles driven during the first 8 months of the year, and 48.5 cents per mile for business miles driven during the final 4 months of the year (up from 37.5 cents per mile in 2004). The substantial increase during the final 4 months of 2005 was a response to the soaring price of gasoline. The standard mileage rate for 2006 had not been released by the IRS at the time of publication of this article.

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 2005 reflect the new rate. If the church reimbursed business miles at a rate of more than the standard mileage rate, 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 2005, then the “difference” represents an unreimbursed expense that may be claimed as a business expense deduction by the employee if certain conditions are met.

The standard mileage rate for computing deductible medical or moving expenses was 15 cents per mile for the first 8 months of 2005, and 22 cents a mile for the last 4 months of 2005. The medical and moving mileage rates for 2006 had not been released by the IRS at the time of publication of this article.

The rate for providing services for charitable organizations is set by statute, not the IRS, and remained at 14 cents a mile throughout 2005, with one exception. The Katrina Emergency Tax Relief Act of 2005 increases the charitable standard mileage rate for volunteers who use their personal vehicles to aid Hurricane Katrina victims to 70% of the standard business mileage rate (rounded to the next higher cent). In addition, volunteers who are reimbursed for the use of their personal vehicle do not have to pay income tax on the reimbursements. Both provisions are effective for miles driven from August 25, 2005 through December 31, 2006. The standard business mileage rate is 48.5 cents per mile for the September 1 to December 31, 2005 period. Therefore, the new mileage rate for charity work related to Hurricane Katrina is 29 cents per mile during the period of August 25, 2005, through August 31, 2005. The new mileage rate for charity work, therefore, is 34 cents per mile from September 1 to the end of the year. It will be adjusted for 2006 once the IRS releases the 2006 mileage rates.

8. 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.

9. Increase in earnings subject to the self employment tax. The self employment tax rate (15.3%) did not change in 2005. 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 2005, the maximum earnings subject to the OASDI portion of self employment taxes (the 12.4% amount) increased to $90,000—up from $87,900 in 2004. Stated differently, persons who received compensation in excess of $90,000 in 2005 paid the combined 15.3% tax rate for net self employment earnings up to $90,000, and only the HI tax rate of 2.9% on earnings above $90,000. 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.

Key point. The maximum earnings subject to the OASDI potion of self-employment taxes increases to $94,200 in 2006.

	2005	2006
tax rate-employees	7.65%	7.65%
tax rate-self-employed	7.65%	7.65%
maximum taxable earnings (Social Security tax only)	$90,000	$94,200
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)	$12,000	$12,480
maximum Social Security monthly benefit	$1,939	$2,053
average monthly benefit-retired workers	$963	$1,002
average monthly benefit-retired couple, both receiving benefits	$1,583	$1,648
average monthly benefit-widowed mother and two children	$1,992	$2,074
average monthly benefit-aged widow(er) alone	$929	$967
average monthly benefit-disabled worker, spouse and one or more children	$1,509	$1,571
average monthly benefit-all disabled workers	$902	$939

* A “modified” annual earnings test applies in the year a worker attains “full retirement age” (65 years and 8 months for those born in 1941). Social Security benefits are reduced by $1 for every $3 of earnings above a specified amount for each month prior to full retirement age (this amount was $2,650 in 2005, and is $2,770 for 2006). 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.

10. 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.

New in 2005. Congress passed the Working Families Tax Relief Act in 2004. The Act extends the deduction for educator expenses through 2005.

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.

11. Inflation adjustments. For 2005, 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 2005, the amount increased to $3,200 per person (up from $3,100 in 2004).

Standard deduction. The “standard deduction” (the amount you can deduct if you cannot itemize your deductions) increased to $10,000 in 2005 for married couples filing jointly—up from $9,700 in 2004. This is twice the amount of the standard deduction for single taxpayers ($5,000) for 2005. Single taxpayers who are 65 years of age or older, or blind, get a $1,200 increase in their standard deduction for 2005. Married taxpayers who are 65 years of age or older, or blind, get a $1,000 increase in their standard deduction for 2005.

12. 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 2005 a highly compensated employee was 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 $95,000, and, if an employer elects, was in the top 20% of employees by compensation.

The $95,000 amount is adjusted annually for inflation. It increases to $100,000 for 2006.

13. “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 2005 limits are summarized in a table along with the limits for 2005 for comparison purposes.

“Luxury Car” Depreciation Limits

tax year	maximum depreciation deduction for cars first placed in service in 2004	maximum depreciation deduction for cars first placed in service in 2005
first	$2,960	$2,960
second	$4,800	$4,700
third	$2,850	$2,850
each succeeding year	$1,675	$1,675

For electric cars placed in service in 2005 these amounts are $8,880 for year one; $14,200 for year two; $8,450 for year three; and $5,125 each succeeding year in the recovery period.

14. New per diem rates for substantiating the amount of travel expenses incurred in 2005. 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 12 summarizes the per diem rates for October 1, 2004 through September 30, 2005. The maximum per diem rates for the period October 1, 2005 through September 30, 2006 are $199 for high-cost localities, and $127 for all other localities.

Locality (destination of overnight travel)	Meals & incidental expense (M & IE) per diem rate	Maximum per diem rate (lodging and M & IE)
October 1, 2004 through September 30, 2005
high-cost localities*	$46	$199
all other localities	$36	$127
October 1, 2005 through September 30, 2006
high-cost localities*	$58	$226
all other localities	$45	$141
* high-cost localities for the M & IE rate are not the same as for the "lodging and M & IE" rate

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, and these are explained in chapter 7 of Richard Hammar's 2006 Church & Clergy Tax Guide.

B. Tax Law Changes Made by Congress

Congress enacted major tax bills in 2001, 2003, 2004, and 2005 containing several provisions that will affect tax reporting by both churches and ministers for 2005 and future years.

• Katrina Emergency Tax Relief Act of 2005. In September 2005 Congress passed the Katrina Emergency Tax Relief Act of 2005 by a unanimous vote. The legislation provides tax relief for individuals and families, along with incentives for charitable donations. The main provisions of this legislation are summarized later in this article.

• The Energy Policy Act of 2005. In 2005 Congress passed the Energy Tax Incentives Act in order to encourage energy efficiency and reduce our dependence on foreign oil. The Act contains a number of provisions of relevance to church employees that are addressed in this article.

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

• The Working Families Taxpayer Relief Act of 2004. In 2004 Congress passed the Working Families Taxpayer Relief Act. 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. The main provisions are summarized in this article.

• JGTRRA. In 2003 Congress passed the Jobs and Growth Tax Relief Reconciliation Act (“JGTRRA”). Some of the provisions in this new law took effect in 2004 and 2005, and those that have the greatest relevance to ministers and churches are summarized in this article.

• EGTRRA. In 2001 Congress passed a massive tax law known as the Economic Growth and Tax Relief Reconciliation Act (“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. An unprecedented feature is a “sunset” provision that revokes all of the hundreds of tax law changes at the end of 2010 unless Congress votes to extend them. If Congress fails to take action, then the tax law in effect in 2001 will be reinstated. Because many taxpayers, in all income brackets, will increasingly rely on many of the tax law changes in the new law, it is inconceivable that Congress will allow all of the changes to expire at the end of 2010. It is reasonable to assume that many of the changes will be permanently adopted by Congress, but not necessarily all of them.

Individual Income Taxes

15. 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 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 2005 are $7,300 for single taxpayers and $14,600 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.

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%, as illustrated in the following table.

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%

EGTRRA 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%.

New Income Tax Rates for 2005 (Single Persons)

taxable income		pay	plus this percent	of taxable income over
over	not over
$0	$7,300	$0	10%	$0
$7,300	$29,700	$730	15%	$7,300
$29,700	$71,950	$4,090	25%	$29,700
$71,950	$150,150	$14,652.50	28%	$71,950
$150,150	$326,450	$36,548.50	33%	$150,150
$326,450	$ ---	$94,727.50	35%	$326,450

New Income Tax Rates for 2005 (Married Persons Filing Jointly)

taxable income		pay	plus this percent	of taxable income over
over	not over
$0	$14,600	$0	10%	$0
$14,600	$59,400	$1,460	15%	$14,600
$59,400	$119,950	$8,180	25%	$59,400
$119,950	$182,800	$23,317.50	28%	$119,950
$182,800	$326,450	$40,915.50	33%	$182,800
$326,450	$ ---	$88,320	35%	$326,450

16. 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.” This penalty has been reduced in the following two ways:

#1--income tax rates

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

Congress increased the basic standard deduction amount for joint returns to twice the basic standard deduction amount for single returns.

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.

17. Increase and expand the child tax credit. 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.

The Working Families Tax Relief Act in 2004 extends the $1,000 child tax credit through 2010, and accelerates the increase in refundability of the credit to 15% of a taxpayer’s earned income in excess of $11,000 (in 2005).

18. 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 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 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

19. Phase-out and repeal of estate and generation-skipping transfer taxes. EGTRRA made the following changes:

1. Beginning in 2011, the estate and generation-skipping transfer taxes are repealed.
   
2. 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.
   
3. 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 the following table.
   

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)

4. 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.

New in 2005. The House of Representatives voted to permanently repeal the federal estate and gift tax. The Senate is considering a similar proposal, but no action has been taken as of the date of publication of this article. If the Senate declines to permanently repeal the estate and gift tax, it is possible that Congress will reach a compromise that would substantially boost the annual exemption.

New in 2006. The federal gift tax applies to the transfer by gift of any property. The general rule is that any gift is a taxable gift. However, there are many exceptions to this rule, including gifts to charity, gifts to a spouse, and gifts that are not more than the "annual exclusion" for the calendar year. A separate annual exclusion applies to each person to whom a taxpayer makes a gift. For 2005 the annual exclusion is $11,000. For 2006, this amount increases to $12,000. This means that taxpayers can give up to $12,000 each to any number of people in 2006 and none of the gifts will be taxable.

IRAs and Retirement Plans

20. 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.

21. 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.

22. 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 credit rates based on AGI are summarized in the following table.

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%

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

23. 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 $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

The American Jobs Creation Act of 2004 contains the following provisions of relevance to church leaders:

24. 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.

25. Donation of vehicles. The Act imposes new requirements on charitable contributions of vehicles. These requirements are addressed fully in chapter 8 of Richard Hammar's 2006 Church & Clergy Tax Guide.

New in 2005. The IRS provided guidance on the application of the new substantiation requirements for donations of used vehicles.

26. 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 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 (see IRS Publication 600). This provision is effective for taxable years beginning after December 31, 2003, and prior to January 1, 2006.

27. 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. It’s used as a retirement program for a small but growing number of churches, especially if they have a senior minister who “maxes out” on contributions to a 403(b) plan. 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. These limitations are addressed fully in chapter 10 of Richard Hammar's 2006 Church & Clergy Tax Guide.

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.

The Energy Policy Act of 2005

In 2005 Congress passed the Energy Tax Incentives Act in order to encourage energy efficiency and reduce our dependence on foreign oil. The Act contains a number of provisions of relevance to ministers and lay church employees including the following:

28. Energy efficient new homes. The Act provides a small credit ($1,000) to eligible contractors for energy-efficient property installed in a qualified new energy-efficient home during construction.

29. Credit for non-business energy property. The Act provides a credit for the purchase of qualified energy property. The allowable credit is (1) $50 for each advanced main air circulating fan or "Tier 1" natural gas, propane, or oil water heater, and (2) $300 for each "Tier 2" energy efficient property including water heaters and heat pumps which yield an energy savings above a specified level.

30. Highly efficient residences. The Act provides a credit for highly energy efficient principal residences. The credit is $2,000 if the principal residence achieves a 50% reduction in energy costs relative to the original condition of the building. In the case of a principal residence that achieves a reduction in energy costs between 20% and 50%, the allowable credit is $4,000 times the percentage reduction. No credit is allowed in the case of energy cost savings of less than 20%. Special "proration rules" apply in the case of jointly owned property and condominiums.

31. Solar energy. The Act provides a personal tax credit for the purchase of qualified photovoltaic property and qualified solar water heating property that is used exclusively for purposes other than heating swimming pools and hot tubs. The credit is equal to 30% of qualifying expenditures, with a maximum credit for each of these systems of property of $2,000.

32. Hybrid cars. From January 2006 through December 2009, the Act allows a tax credit of $1,700 to $3,000 on a one-time basis for the purchase of a hybrid vehicle. The amount of the credit is based on the estimated amount of fuel saved by the hybrid compared with a 2002 model of similar size class. The credit only applies to the first 60,000 hybrid cars sold by a given manufacturer. For 2005, a federal "clean-fuel vehicle" tax deduction of $2,000 can be claimed for personal and business hybrid vehicles the IRS has certified as eligible (model year 2005 Ford Hybrid Escape, Toyota Prius, Honda Civic Hybrid, Honda Insight, and Honda Accord Hybrid) purchased by December 31, 2005.

33. Daylight savings time. The Act extends Daylight Saving Time by four weeks (three weeks in the spring and one week in November) to reduce energy consumption by the equivalent of 100,000 barrels of oil for each day of the extension. The new times go into effect in 2007. Congress also directed the Department of Energy to conduct a study of possible energy savings. If the study does not report adequate savings, Congress has the option to return to the original Daylight Savings Time schedule. Studies indicate that the proposal to adopt Daylight Savings Time from the second Sunday in March to the first Sunday in November will also lower crime and traffic fatalities and allow for more recreation time and increased economic activity.

Miscellaneous changes

34. Backup withholding. 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.

The backup withholding rate for 2005 and 2006 is 28%.

35. 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 by a 408-13 vote. Supporters of the House and Senate bills have failed on nine occasions to form a conference committee to reconcile the two bills. 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 standard mileage rate allowed for business use, 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.

New in 2005. The Senate passed an amendment to the fiscal year 2006 budget resolution, expressing the sense of the Senate regarding the CARE bill.

36. 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.