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 for churches are summarized in this feature article.

37. Forgiven loans constitute taxable income. A company loaned an employee a substantial amount of money. The employee later resigned his position. At the time of his resignation, he still owed $300,000 on the loan. The employer contacted the former employee frequently in the months following his resignation, requesting that he resume payments on the loan. These efforts proved fruitless. The employer later "forgave" the remaining debt as part of a severance agreement in which the former employee agreed to drop any legal claims he had against the employer. The employer was not aware that the forgiveness of a debt constituted taxable income, and did not report it on the employee's W-2 form. The IRS audited the employee's tax return, and classified the forgiven debt as taxable income. The Tax Court agreed, noting that the tax code's definition of taxable income includes "income from the discharge of indebtedness." The court concluded, "The employee was relieved of his obligation to pay the remaining $300,000 due on his promissory note to [his employer] and, therefore, realized income from the forgiveness of debt." Corrigan v. Commissioner, T.C. Memo. 2005-119 (2005).

Tip. Many churches have made loans to staff members that they later forgive. Church treasurers should understand that debt forgiveness usually results in taxable income to the debtor.

38. A Maryland court ruled that a church did not necessarily act improperly in paying off the home mortgage loans of the church's pastor and his son. A church congregation voted to sell the church property to another church for $900,000 in a duly called special business meeting. The congregation later convened another meeting to determine how to use the sales proceeds. A majority voted to use $400,000 to pay off mortgage loans on homes owned by the pastor and his son. Some of the church's members filed a lawsuit contesting the use of the sales proceeds to pay off mortgage loans on the two homes. The church insisted that its payment of the mortgage loans represented compensation for past services for which the pastor and his son had not been adequately paid, and therefore constituted reasonable "deferred" compensation. A state appeals court agreed. It observed, "A religious or charitable corporation may take past services into consideration . . . in compensating an employee, as may a court when that compensation is challenged." In support of its conclusion, the court noted that the tax code permits the IRS to assess substantial excise taxes (called "intermediate sanctions") against the officers of a tax-exempt organization who benefit from an "excess benefit transaction," and pointed out that the tax regulations specify that "services performed in prior years may be taken into account" in determining reasonable compensation in the current year. However, the court concluded that the church members had established a "prima facie case" of unreasonable compensation "through the substantial sums paid for the benefit of the church's pastor and a member of his family." As a result, it sent the case back to the trial court to further address the question of what was fair and reasonable compensation for all of the services of the pastor and his son, including past services, in light of the purposes of the church. First Baptist Church v. Beeson, 841 A.2d 347 (Md. App. 2004).

39. IRS audit guidelines target executive pay. The IRS has issued new audit guidelines for corporate executives. The guidelines are instructive in evaluating the compensation packages provided to senior pastors and other church employees. Here are some of the instructions provided to IRS agents when examining executive pay:

• Bonuses. The employer may utilize a number of methods to provide compensation for services rendered by the executives. Additional attention must be given to executive payment arrangements and plans used to determine bonuses and or awards. Generally, all payments in whatever form, are payments in the nature of compensation if they arise out of an employment relationship or are associated with the performance of services. Payments in the nature of compensation include (but are not limited to) wages, salary, bonuses, severance pay, fringe benefits, pension benefits, and other deferred compensation. Awards or bonuses paid to executives should be carefully reviewed to determine if they should be included as remuneration.

• Club memberships. No deduction is permitted for club dues. This includes all types of clubs, including social, athletic, sporting, luncheon clubs, airline and hotel clubs, and "business" clubs. The purposes and activities of a club, and not its name, determine whether it is covered under the disallowance.

• Corporate credit card. Many employers provide corporate credit cards to executives and other employees. The difference between the rank and file credit card accounts and those maintained for executives is generally the method of reimbursement. Top level executives are permitted to use the card at will. A monthly statement may be mailed directly to the employer and the account may be paid in full without the submission of a business expense report. Lower level executives are generally required to submit an expense report and are reimbursed for business related expenses. Personal expenses paid on behalf of executives are taxable fringe benefits that should be included in wages. The determination of whether the corporation has an accountable plan should be made at the beginning of the examination. If executives are not required to substantiate that the expenses charged to the corporate credit card were for business expenses, the reimbursement is considered to have been made under a nonaccountable plan and the entire reimbursement is taxable to the executive, and constitutes wages for employment tax purposes.

• Loans. A number of employers have made loans or extended credit to their executives. These loans have either been at no cost or low cost. In some instances, the terms have been such that the loan is really disguised compensation. Factors that are indicative of a bona fide loan are (1) existence of a promissory note, (2) cash payments according to a specified repayment schedule, (3) interest is charged, and (4) there is security for the loan. Loans to executives should be reviewed to determine if they are bona fide and to determine if the terms are being followed. Is there a written document detailing the terms of the loan, payment over a certain number of years or is payment on demand; is the interest rate at market or at a below market rate of interest; is the loan listed on the company's balance sheet as a receivable? Are the terms of the loan being followed (payments are to be made monthly and the executive is not making payments, etc.)? The loan terms could include forgiveness of part of the entire loan if the executive remains with the company for a certain number of years, etc. Code section 7872 deals with the treatment of loans with below market interest rates; it specifically applies to what it terms compensation-related loans, which include below market loans directly or indirectly between an employer and an employee. In general, section 7872 operates to impute interest and applicable taxes on below market loans.

• Transportation. If an employer provides a car or other road vehicle for an executive's use, the amount excludable as a working condition fringe benefit is the amount that would be allowable as a deductible business expense if the executive paid for its use. The executive's personal use of the vehicle is taxable. The value is generally determined by reference to fair market value unless one of the special valuation methods is used. The three special valuation rules for automobiles are the automobile lease valuation rule, the vehicle cents-per-miles rule, and the commuting valuation rule. There are specific requirements that must be met in order to use these special valuation rules. For example, the employer must provide the employee with a vehicle for commuting for bona fide noncompensatory business reasons in order to use the commuting valuation rule.

• Transfer of property. Remuneration may take the form of property. Property may include real and personal property. Property other than cash may be represented in a number of forms. It may include stock or personal property including real estate, furniture, equipment, personal computers, or cellular phones.

• Employee use of listed property. Special recordkeeping rules apply to computers except for those used exclusively at the business establishment and owned or leased by the person operating the business. Detailed records are required to establish business use of computers that can be taken home or are kept at home by the executives. There are no record keeping exceptions like "no personal use" available for computers. Similar recordkeeping problems arise for cellular and car phones. This requires documentation of business usage in order for the purchase and operational cost to be an allowable deduction and not included as income to the executive.

• Employer-paid vacations. The value of employer-provided vacations generally is includable in gross income and wages. The value of a vacation is generally not excludable as a working condition fringe benefit because vacation expenses are personal expenses. A working condition fringe is any property or service provided to an employee of an employer to the extent that, if the employee paid for the property or service, the amount paid would be allowable as a deduction. However, special rules exist for air travel provided in connection with trips that are part business and part personal.

• Spousal or dependent travel. No deduction is allowed for travel expenses paid or incurred for a spouse, dependent, or other individual accompanying the executive on business travel unless (1) the spouse, dependent, or other individual is an employee of the taxpayer; (2) the travel of the spouse, dependent, or other individual is for a bona fide business purpose; and (3) such expenses would otherwise be deductible by the spouse, dependent, or other individual.

40. IRS amends "use it or lose it" rule for flex plans. Many churches have adopted flexible spending arrangements (FSAs, or "flex plans") as a way to allow employees to pay for medical expenses with "before tax" salary reductions. The law specifies that any salary reductions not used to pay for medical expenses by December 31 are forfeited. This rule is often referred to as the "use it or lose it" rule. It's a real hardship for many employees, and some members of Congress have been pressuring the IRS to relax this rule. In May, the IRS agreed to do so. In a published notice, the IRS stated:

A cafeteria plan document may, at the employer's option, be amended to provide for a grace period immediately following the end of each plan year. The grace period must apply to all participants in the cafeteria plan. Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year. The grace period must not extend beyond the fifteenth day of the third calendar month after the end of the immediately preceding plan year to which it relates (i.e., "the 2 and 1/2 month rule"). If a cafeteria plan document is amended to include a grace period, a participant who has unused benefits or contributions relating to a particular qualified benefit from the immediately preceding plan year, and who incurs expenses for that same qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that the participant may have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are "forfeited" under the "use-it-or-lose-it" rule.

The IRS cautioned that during the grace period a cafeteria plan may not permit unused contributions to be cashed-out or converted to any other taxable or nontaxable benefit. Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit. For example, unused amounts elected to pay or reimburse medical expenses in a health flexible spending arrangement (FSA) may not be used to pay or reimburse dependent care or other expenses incurred during the grace period. IRS Notice 2005-42.

Example 1. An employer with a flex plan year ending on December 31, 2005, amended the plan document before the end of the plan year to permit a grace period that allows all employees to apply unused contributions remaining at the end of the plan year to medical expenses incurred during the grace period immediately following that plan year. The grace period adopted by the employer ends on the fifteenth day of the third calendar month after the end of the plan year (March 15, 2006 for the plan year ending December 31, 2005). Employee X timely elected salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2005. As of December 31, 2005, X has $200 remaining unused in his health FSA. X timely elected salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2006. During the grace period from January 1 through March 15, 2006, X incurs $300 of unreimbursed medical expenses. The unused $200 from the plan year ending December 31, 2005, is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for the plan year ending December 31, 2005. The remaining $100 of medical expenses incurred between January 1 and March 15, 2006 is paid or reimbursed from X's health FSA for the plan year ending December 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2006.

Example 2. Same facts as the previous example, except that X incurs $150 of medical expenses during the grace period (January 1 through March 15, 2006). As of March 16, 2006, X has $50 of unused benefits or contributions remaining for the plan year ending December 31, 2005. The unused $50 cannot be cashed-out, converted to any other taxable or nontaxable benefit, or used in any other plan year (including the plan year ending December 31, 2006). The unused $50 is subject to the "use-it-or-lose-it" rule and is "forfeited." As of March 16, 2006, X has the entire $1,500 elected in the health FSA for the plan year ending December 31, 2006.

41. Proposed law addresses use of personal vehicles for charity. Under current law, when volunteers use their cars for charitable purposes, they may be reimbursed up to 14 cents per mile for their donated services without the reimbursement constituting taxable income. If the charity reimburses any more than that, the volunteers must include the amount over 14 cents per mile in their taxable income (and the charity must report the excess to the IRS on a Form 1099 if over $600 for the year). By contrast, the mileage reimbursement rate allowed for businesses was 40.5 cents for the first 8 months of 2005 and 48.5 cents for the final 4 months. A bill introduced in the United States Senate (S.315), if enacted into law, would allow charities to use the standard business mileage rate to reimburse volunteers for the use of their personal vehicles in performing donated labor. Any reimbursement up to but not exceeding the standard business mileage rate would be nontaxable. Similar proposals have been made in previous sessions of Congress without final action.

42. The Indian Ocean Tsunami Relief Act. Congress enacted the Indian Ocean Tsunami Relief Act in January of 2005. The Act permits taxpayers who made donations in January 2005 to nonprofit organizations (including churches) aiding the victims of the Indian Ocean tsunami to claim those donations as deductions on their 2004 tax returns. Under prior law, any charitable contributions made in 2005 would have been deductible (for taxpayers who itemize) on their 2005 tax return, which could not be filed until after the close of the 2005 tax year. The new law allows taxpayers to claim those deductions and receive the benefit when they file their 2004 tax return. Taxpayers may choose whether to treat a contribution made in January 2005 as made on December 31, 2004, or as made in January of 2005. However, the deduction may be claimed only with respect to one taxable year.

43. Church members denied full deduction for donations to their church. A married couple claimed a charitable contribution deduction of $4,100 on their federal tax return for contributions they made to their church. The only proof they had for their alleged donations was a photocopy of a "contribution receipt" from their church dated December 30 of the year in question, showing contributions during the year of $3,660. The receipt was generated by a computer word processing program and was not printed on an official letterhead of the church. The photocopy had the signature of the pastor and contained the stamped seal of the church. The IRS audited the couple's return and allowed a deduction of only $450 due to a lack of substantiation. The couple appealed to the Tax Court. The court began its opinion by noting, "For contributions of money, taxpayers must maintain canceled checks, receipts from the donee organizations showing the date and amounts of the contribution, or other reliable written records showing the name of the donee, date, and amount of the contribution. Taxpayers bear the burden of proving they are entitled to deductions claimed."

The court acknowledged that "in some cases where a taxpayer's records are inadequate to substantiate a claimed deduction, we may estimate the amount." But, "in order for the court to make an estimate, we must have some basis in fact upon which an estimate can be made." The court concluded, "While we have some doubt about the reliability of the contribution receipt and the amount of the couple's contributions, we find that they attended church and made some contributions to the church in [the year in question]. Bearing in mind that they have the burden to prove that they are entitled to the claimed deduction, we hold that they are entitled to an additional deduction of $800 for donations to the church. Thus, they are entitled to a total charitable contribution deduction of $1,250 (including the $450 previously conceded by the IRS)." Kellum v. Commissioner, T.C. Summary Op. 2005-29 (2005).

44. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005. The new law represents the most comprehensive revision of federal bankruptcy law in a quarter century. It does not amend the following two provisions pertaining to charitable contributions:

(1) Bankruptcy trustees cannot recover contributions made by debtors to a religious or charitable organization within a year of filing for bankruptcy protection if (1) the amount of the contribution does not exceed 15% of the debtor’s annual income for the year in which the contribution was made, or (2) the contribution exceeded 15% of the debtor’s gross annual income, but “was consistent with the practices of the debtor in making charitable contributions."

(2) Bankruptcy trustees cannot reject a debtor's bankruptcy plan on the ground that it proposes to make charitable contributions, so long as the contributions are not more than 15% of the debtor's annual income, or a greater amount if consistent with the debtor's customary practice in making charitable contributions.

The Bankruptcy Abuse Prevention and Consumer Protection Act does not affect either of these valuable protections.

45. Tax Court denies deduction for donation of computer equipment to a church. A taxpayer accumulated a "garage full" of obsolete computer equipment over several years. In order to eliminate this clutter, he donated all the equipment to a church. He claimed a charitable contribution deduction on his tax return in the amount of $15,320 for this transaction. The IRS audited his tax return, and requested substantiation of the contribution. The taxpayer provided a copy of a receipt, purportedly from the church, for $15,320. The IRS disallowed the entire contribution, and the taxpayer appealed to the Tax Court. The court concluded that the church's "receipt" was inadequate substantiation for three reasons:

• The taxpayer failed to prove that the church was a qualified public charity to which deductible contributions could be made. In particular, the court noted that the church had never applied for recognition of exempt status with the IRS.

• Even if the church was a qualified charity, its receipt did not contain the necessary information to adequately substantiate the contribution. The receipt "purported to substantiate a contribution and did not indicate that any noncash contribution had been made. If the taxpayer had made a noncash contribution as he testified, the receipt should have described the location of the contributions and the property contributed. The receipt also should have stated whether the donee provided goods or services as a quid pro quo. The receipt did not provide any of the information necessary to substantiate the contribution that the taxpayer testified he made."

• Since the taxpayer claimed a contribution deduction in excess of $5,000 for the donated equipment, he was required to obtain a qualified appraisal and attach an appraisal summary (Form 8283, Section B) to his tax return. Since he failed to file an appraisal summary with his tax return, no deduction was permissible.

This case provides church treasurers with a useful review of the substantiation requirements that apply to gifts of noncash property. Note the following points in particular. First, be sure that any receipt issued by the church complies with the requirements listed in the tax code. A failure to do so can deprive a donor of a charitable contribution deduction. Second, note that contributions of noncash property for which a donor claims a charitable contribution deduction of more than $5,000 must comply with special substantiation requirements. The donor must obtain a qualified appraisal of the donated property from a qualified appraiser, and attach an appraisal summary to the tax return on which the deduction is claimed (this is done on IRS Form 8283, Section B). As the donor in this case learned, a failure to comply with this requirement may lead to the loss of a charitable contribution deduction. Third, the qualified appraisal requirement applies to a donation of any single item of noncash property for which a charitable contribution deduction in excess of $5,000 is claimed, or to a donation of similar items of property with a combined value in excess of $5,000. Castleton v. Commissioner, T.C. Memo. 2005-58 (2005).

Key point. Stock is a special case. No qualified appraisal is required for donations of publicly-traded stock, and a qualified appraisal is required for privately-held stock only if the claimed value exceeds $10,000.

46. Are pledges legally enforceable? A synagogue’s members were assessed annual “dues” payable in three equal installments. A member of the congregation submitted a letter to the rabbi stating that he was resigning as a member. A month later, the synagogue’s finance chairman sent him a letter requesting that he remit the remaining $1,200 of membership dues that he owed for the balance of the year. The letter explained, “As a temple, we budgeted our expenses based upon your membership. While you benefited from our services when you were a member, your resignation did not relieve you of your financial obligation. We are in need of the balance of your membership dues.” The dispute ended up in court, and the court ruled that "the trend of judicial decision during the last century has been towards the enforcement of charitable pledges almost as a matter of public policy.” The court conceded that pledges, like any promise, generally are not legally enforceable unless the person making the pledge receives something of value (called “consideration”) in return. But there are exceptions to this requirement, and one of them is “detrimental reliance.” According to this exception, if a charity relies to its detriment upon the pledges of members, then those pledges are enforceable even though not supported by consideration in a traditional sense. The court applied this principle to pledges made to the synagogue.

The court also suggested that members of the congregation did receive valuable consideration in exchange for their pledges, such as worship services, and this constituted “consideration” making the members’ pledges legally enforceable. Temple Beth Am v. Tanenbaum, 789 N.Y.S.2d 658 (Dist. Ct. 2004).

47. Why church leaders should be familiar with Form 1098-C. The American Jobs Creation Act of 2004 changed the rules for claiming a charitable contribution deduction for donations of used vehicles to charity. The new rules took effect this year. It is important for church treasurers to be familiar with the new rules for two reasons. First, churches have reporting requirements that must be followed; and second, church treasurers need to be ready to explain the rules to members who indicate an interest in donating a car to the church.

Sale with no significant use or material improvement

Beginning in 2005, if the claimed value of a donated car exceeds $500 and the car is sold by the charity, the donor's charitable contribution deduction is limited to the gross proceeds from the sale. Prior to 2005 taxpayers could deduct the fair market value of a donated car. Under the new rules, the charity must:

(1) provide the donor with a "contemporaneous written acknowledgement" within 30 days of the sale listing the information specified by the tax code (the donor's name and Social Security number, the vehicle identification number, date of sale, a certification that the vehicle was sold in an arm's length transaction, and the gross proceeds from the sale), and

(2) submit the same information to the IRS by February 28 of the following year.

A church must use IRS Form 1098-C (Contributions of Motor Vehicles, Boats, and Airplanes) to provide the required information to the IRS. It may use the same form to provide a "contemporaneous written acknowledgment" to the donor.

Significant use or material alteration

Beginning in 2005, if the claimed value of a donated car exceeds $500 and the charity "significantly uses or materially improves" the car, the donor may be able to deduct the car's market value. In addition, the church has the following reporting requirements:

(1) provide the donor with a "contemporaneous written acknowledgement" within 30 days of the date of the contribution listing the information specified by the tax code (the donor's name and Social Security number, the vehicle identification number, date of sale, a certification that the vehicle was sold in an arm's length transaction, and the gross proceeds from the sale), and

(2) submit the same information to the IRS by February 28 of the following year.

A church must use IRS Form 1098-C (Contributions of Motor Vehicles, Boats, and Airplanes) to provide the required information to the IRS. It may use the same form to provide a "contemporaneous written acknowledgment" to the donor.

Key point. The IRS released Form 1098-C in 2005, which charities can use to provide a contemporaneous written acknowledgment to a person who donates a used car. Charities must use this form to report the same information to the IRS. File Copy A of this form with the IRS by February 28, 2006, for vehicle donations made during 2005.

48. IRS addresses deductibility of designated contributions. A charity began construction of a cultural center, and solicited contributions for this project. It asked the IRS for a ruling affirming that contributions toward the project would be deductible even if donors requested that their donations be applied to the project and the charity "provides no more than assurances to such donors that it will attempt in good faith to honor such preferences." The IRS provided an exhaustive analysis of the deductibility of designated contributions, and made the following observations:

• An important consideration is the charity's control over the donated funds. The donor must show that the charity retained control over the funds. To have control over donated funds is to have discretion as to their use. In instances where a donor designates a gift to benefit a particular individual, and the individual does benefit from the gift, the determination of whether the gift is deductible depends upon whether the charity has full control of the donated funds and discretion as to their use. Such control and discretion ensures the funds will be used to carry out the organization's functions and purposes.

• If contributions to a fund are earmarked by the donor for a particular individual, and the charity exercises no control or discretion over their use, they are treated as gifts to the designated individual and are not deductible as charitable contributions.

• A charitable contribution may be permitted where preferences expressed at the time of contribution are precatory rather than mandatory, or where preference is given to relatives who otherwise qualify as charitable beneficiaries. . . . In addition, retention by the donor, or his family members, of the right to determine which individuals actually receive benefits does not preclude a charitable deduction.

• The charity must ensure that it maintains its discretion and control over all contributions. Accordingly, the charity may endeavor to honor donors' wishes that designate the use of donated funds. The charity, though, must maintain control over the ultimate determination of how all donated funds are allocated. Donors should be made aware that, although the charity will make every effort to honor their contribution designation, contributions become the property of the charity, and the charity has the discretion to determine how best to use all contributions to carry out its functions and purposes.

The IRS concluded, based on this precedent, that charitable contributions to the charity would be deductible even if the donors requested that their donations be used to cover costs and expenses relating to the cultural center, and the charity provided no more than assurances to the donors that it would attempt in good faith to honor such preferences. IRS Letter Ruling 200530016 (2005).

49. New W-2 codes for rabbi trusts. The IRS has added "code Z" for use in box 12 on the 2005 Form W-2. Churches and denominational agencies that offer rabbi trusts should take note of the change. Similar reporting is required on Form 1099-MISC for nonemployees. This code, and other reporting, will be used to identify income recognized due to participation in a nonqualified deferred compensation plan that fails to meet the requirements of tax code section 409A (enacted in 2004 as part of the American Jobs Creation Act). In addition, income deferrals under a nonqualified deferred compensation plan must be reported to the IRS using code Y in box 12 of Form W-2 (or in box 15a of Form 1099-MISC for nonemployees). Report deferrals in box 12 even if the payee must recognize income under section 409A during the same year. IRS Announcement 2005-05.

50. New IRS regulations address 403(b) plans. For the first time in a half century, the IRS has issued regulations addressing the use and administration of 403(b) plans. The application of the new regulations to church retirement plans is addressed in chapter 10 of Richard Hammar's 2006 Church & Clergy Tax Guide.

51. IRS issues guidance on nonqualified deferred compensation plans. The American Jobs Creation Act of 2004 added section 409A to the tax code. Section 409A provides that amounts deferred under a nonqualified deferred compensation plan are includible in taxable income to the extent they are not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements set forth in section 409A are met. These requirements will apply to rabbi trusts and some other forms of retirement plans maintained by churches. In 2005 the IRS released a notice containing 38 common questions regarding the section 409A requirements, along with the IRS answers. Many of these questions and answers are addressed in chapter 10 of Richard Hammar's 2006 Church & Clergy Tax Guide.

52. IRS introduces new Form 944. The IRS will be unveiling a new Form 944 in 2006, which will replace Form 941 (Employer's Quarterly Tax Return) for eligible small employers. The purpose of new Form 944 is to reduce burden on the smallest employers by allowing them to file their employment tax returns annually, and in most cases pay the employment tax due with their return. A small employer will file the annual Form 944 (Employer's Annual Federal Tax Return) to report wages paid, federal income tax withheld, Social Security and Medicare taxes withheld, the employer's share of Social Security and Medicare taxes, and advance earned income credit payments. Form 944 is targeted for employers that owe $1,000 or less in total employment tax per year. The first returns will be due January 31, 2007 (for 2006).

Key point. IRS research has disclosed that approximately 1 million small employers of the approximately 6 million total Form 941 filers (17%) will be eligible to file Form 944, at the proposed $1,000 tax liability threshold.

53. IRS addresses Form W-4 rules. New tax regulations issued by the Treasury Department eliminate the requirement that employers send copies of potentially questionable Forms W-4 (Employee’s Withholding Allowance Certificate) to the IRS. The new regulations took effect on April 14, 2005. In the past, employers had to send to the IRS any Form W-4 claiming more than 10 allowances or claiming complete exemption from withholding if $200 or more in weekly wages was expected. Forms W-4 are still subject to review by the IRS. However, employers will no longer have to submit them to the IRS unless directed to do so in a written notice to the employer or pursuant to specified criteria set forth in future published guidance from the IRS. This change follows a comprehensive review of the withholding compliance program conducted recently by the IRS, which found that withholding noncompliance remains a problem with some employees. The IRS has developed a process to use information already reported on W-2 forms to more effectively identify workers with withholding compliance problems. In some cases where a serious under-withholding problem is found to exist for a particular employee, the IRS will notify the employer to withhold income tax from that employee at a more appropriate rate. IRS News Release IR-2005-45.

Tip. The "withholding calculator" found on the IRS website (www.IRS.gov) can help your employees determine the proper amount of federal income tax withholding. Another useful resource, Publication 919 (How Do I Adjust My Tax Withholding?), is available on the IRS website.

54. Department of Treasury says church political inquiries by IRS not biased. The tax code prohibits churches from participating in political campaigns on behalf of or in opposition to any candidate for public office. Responding to public criticism that it audits churches for political activity based on political ideology, the IRS asked the Treasurer Inspector General for Tax Administration (TIGTA) to examine its selection procedures. The TIGTA examined IRS procedures, and concluded that there is no evidence that the IRS uses political ideology in deciding which churches to examine for prohibited campaign intervention. The TIGTA randomly selected 60 IRS cases of suspected church political activity, and found that there was no evidence of ideological bias since 26 of the cases involved pro-conservative churches (43%), 16 involved pro-liberal churches (26%) and in the remaining cases the churches had no known ideological preference. The TIGTA concluded, "We did not identify any indications that the IRS inappropriately handled the [churches] we reviewed," and that the IRS "followed a consistent process when reviewing [churches] regardless of the source of the allegation or the nature of the alleged political activity."

55. IRS rules that gains from the sale of a charity's property were not taxable. Many churches have realized a gain from the sale of property. Are these gains taxable to the church? That was the issue addressed by the IRS in a recent private letter ruling. A charity owned several acres that it had purchased many years before, and a decision was made to sell some of this property to raise funds for the charity's purposes. The charity asked the IRS if gains from the sale would be taxable as "unrelated business taxable income." The IRS said "no." It noted that the tax code imposes a tax on the "unrelated business income" generated by a tax-exempt organization from a "trade or business" that is "regularly carried on." But, this tax did not apply to the charity's sale of property because the sale was not a trade or business that was "regularly carried on." Instead, it was an isolated transaction. IRS Letter Ruling 200510029.

56. Court ruled that churches are exempt from city water assessments. A city's department of environmental protection attempted to collect water and sewer charges from a church. The church's request for an exemption was denied because the church property contained apartments for three staff members (the pastor, church business administrator, and a full-time teacher at a church-operated school). The pastor wrote the city, claiming that "we are a religious organization, providing this community with a vital service. Our only income are gifts that come from the members of this community. We cannot pay these charges, moreover, we are entitled to exemption." The city disagreed, and assessed $12,000 in back charges against the church and imposed a "tax lien" on the church's property. The church appealed. It asked a court to grant its exemption from the water and sewer charges, reverse the city's assessments and penalties against it, and remove the tax lien.

A city ordinance contained the following exemption: "The real estate owned by any religious corporation . . . actually dedicated and used exclusively as a place of public worship [is] hereby exempt from the payment of any sum of money, whatsoever to said city, for the use of water taken by same from said city." A similar exemption applies to sewer charges.

The appeals court ruled that the exemption of religious corporations from water and sewer charges "should be interpreted as applying to all property used in furtherance of the corporation's purpose," and in this case "that would include the housing provided its pastor, teacher and administrator staff promoting the primary purpose of the institution."

The court added that even if the staff members who were provided housing were not promoting the purposes of the church, the city should have granted a "partial exemption" for all of the church's property less the three apartments. The city's denial of any exemption was "legally wrong, arbitrary and capricious." Bathelite Community Church v. Department of Environmental Protection, 797 N.Y.S.2d 707 (N.Y. Sup. Ct. 2004).

57. The IRS issued a ruling in which it addressed a number of important issues including (1) the impact an accumulation of assets has on a church's tax-exempt status; (2) the prohibition of political campaign intervention by churches and church leaders; and (3) the definition of the term "church" for federal tax purposes. A church conducted three or four weekly worship services on its premises for a number of years. These services were attended by up to 350 persons. Over time, the church stopped conducting regular worship services and embarked upon radio and publishing activities and occasional regional seminars where the church's founder disseminated his religious views, counseled the audience, and raised funds. These ventures proved successful, and the church accumulated large sums of money and acquired substantial real estate properties. On a couple of its radio broadcasts, the founder urged listeners not to vote for a particular candidate in a presidential election. The IRS reviewed the church's status, and its political activities, and reached the following conclusions:

Accumulation of assets

The first issue was whether the church's accumulation of substantial assets, including commercial properties, affected its tax-exempt status. The IRS noted that a tax-exempt organization can justify a significant accumulation of assets only if it can demonstrate that the assets are necessary for its reasonably anticipated needs. To do this, the organization "must demonstrate a need warranting such accumulation and the existence, as of the end of the relevant taxable year, of specific, definite and feasible plans to use the accumulation within a reasonable time to meet this need." The IRS concluded, "While this case is close, we think that the church has provided sufficient information as to its needs and reasonably anticipated needs for its accumulations." The IRS pointed out that for several years the church operated its tax-exempt programs at substantial deficits, and the income from the investment real estate was available to cover the deficits.

The IRS noted that the church's board consisted of its founder, his wife, and a son. It then remarked:

Small, closely controlled exempt organizations—and especially those that are closely controlled by members of one family—with related business entities require thorough examination to insure that the arrangements serve charitable purposes rather than private interests. Qualifying for exemption is a facts and circumstances test. There is nothing that precludes an organization that is closely controlled or has related for-profit organizations from qualifying, or continuing to qualify, for exemption. However, the lack of institutional protections, that is, a board of directors comprised of active, disinterested persons, and the potential for such organizations to be abused requires IRS to closely examine actual operations to analyze whether they continue to serve exclusively charitable purposes. Further, the fact that the IRS has concluded that a closely held organization has operated so as to continue to qualify for exemption does not guarantee that it will continue to do so in the future.

Political activities

Section 501(c)(3) of the tax code exempts from federal income taxes a church or other religious organization that is organized and operated exclusively for exempt purposes, and “no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation, and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.”

Note that there are two limitations. First, churches may not engage in substantial efforts to influence legislation. Second, churches may not participate or intervene in any political campaign, even to an insubstantial degree, on behalf of or in opposition to any candidate for public office. Violation of the second limitation (often called the "campaign" limitation) may result in revocation of exempt status and the imposition of excise taxes.

During one of its radio broadcasts, the church's founder told the audience that they should not vote for a particular candidate for president in the general election. On a second occasion, the founder again told listeners that the named candidate should not be elected president of the United States. The founder offered no disclaimer indicating that the views were his own and not those of his church. He insisted that his statements did not constitute intervention by the church in a political campaign on behalf of, or in opposition to, a candidate for public office since (1) his statements were taken out of context; (2) the statements reflected his personal views and not those of the church; and (3) the political activity, even if a technical violation, was "insubstantial" given the overall volume of statements made by the founder and disseminated through books, pamphlets, audio and videotapes.

The IRS rejected each of these claims, and concluded that the church had violated section 501(c)(3)'s ban on campaign intervention. First, it noted that the founder had stated during his radio broadcasts that it would be “dangerous to be an American” and that he would likely “go into exile" if a particular candidate were elected. These were "clear statements in opposition to a candidate" made on behalf of the church that were "clearly and unequivocally intended to influence listeners on how to vote in the presidential election."

Second, the IRS rejected the founder's claim that his statements were his own and should not be imputed to his church. It observed:

Where an official publication or [broadcast] of an organization contains the organization's opposition to a candidate, the statement of opposition should be imputed to the organization, particularly when the statement is represented to reflect the views of its minister. A religious organization's publications and the acts of the minister at official functions of the organization are the principal means by which an organization communicates its official views to its members. It is, therefore, evident that the statements made by the minister on the organization's official broadcast should be imputed to the organization. The only exception would be where the organization has clearly informed the members prior to the act that the publication or broadcast does not speak for the organization and the organization does not utilize either the minister or the publication to generally represent the views of the organization. Thus, the founder's opposition to [a presidential candidate] should be imputed to the church since he was a minister of the church, and the statement of opposition (and implied endorsement of his principal opponent) was contained in an official program of the church.

Finally, the IRS rejected the church's argument that the political statements should be disregarded since they were "insubstantial." The IRS noted that section 501(c)(3) contains no exception for insubstantial campaign intervention (although an exception does exist for insubstantial attempts to influence legislation).

Section 4955

The IRS concluded that revocation of the church's exempt status was not warranted, and instead imposed a tax under section 4955 of the tax code. Section 4955 permits the IRS to assess a tax against an exempt organization that spends funds for political activities in violation of 501(c)(3). This tax can be assessed in addition to revocation of exempt status, or instead of revocation. The tax is equal to 10% of “political expenditures” made by an exempt organization. An additional tax of 2.5% of the amount of political expenditures can be assessed against any “manager” who authorized the expenditure unless the manager did not act willfully or his or her decision was based on reasonable cause. If the exempt organization does not “correct” its political expenditure, then the tax can be increased to 100% of the amount of a political expenditure (for the organization) or 50% (for the manager). “Correction” is defined as “recovering part or all of the expenditure to the extent recovery is possible, establishment of safeguards to prevent future political expenditures, and where full recovery is not possible, such additional corrective action as is prescribed by the [income tax regulations].”

The IRS noted that the church made a political “expenditure” when it purchased broadcast airtime for the broadcasts in which the statements were made opposing a presidential candidate. As a result, the church, as a section 501(c)(3) organization, was liable for a tax equal to 10% of the amount of each political expenditure. In addition, the founder "is an organization manager liable for a tax of 2.50% of the value of each political expenditure." Further, there was "no evidence to suggest that his political statements on those shows were not willful or were due to reasonable cause. Accordingly, waiver of the tax is not warranted."

Since the political expenditures were not "corrected" by the church within the taxable period, the church was liable for a 100% tax on the amount of each political expenditure, as provided in section 4955, and the founder was liable for a tax of 50% of the amount of each political expenditure. The IRS concluded that the church's other directors did not have "sufficient knowledge to be held jointly and severally liable with the founder for the taxes under section 4955."

The IRS noted that the regulations explaining section 4955 provide, "There may be individual cases where, based on the facts and circumstances such as the nature of political intervention and the measures that may have been taken by the organization to prevent a recurrence, the IRS may exercise its discretion to impose a tax under section 4955 but not to seek revocation of the organization's tax-exempt status." The IRS concluded that this case was one in which it should impose only the section 4955 tax, and not revoke exempt status. It concluded, "Out of [numerous] two-hour broadcasts during the presidential election campaign, the political intervention statements constituted only two brief paragraphs. No other political intervention statements during the three years in issue appear to have occurred. The organization has since adopted a policy to prevent recurrences of such statements. The Section 501(c)(3) exemption ruling should not be revoked."

Definition of "church"

The IRS concluded that the church had ceased to qualify as a "church" for federal tax purposes. In reaching its decision, the IRS noted that the organization failed most of the 14 criteria used by the IRS in identifying churches. These 14 criteria are: (1) a distinct legal existence; (2) a recognized creed and form of worship; (3) a definite and distinct ecclesiastical government; (4) a formal code of doctrine and discipline; (5) a distinct religious history; (6) a membership not associated with any other church or denomination; (7) an organization of ordained ministers; (8) ordained ministers selected after completing prescribed studies; (9) a literature of its own; (10) established places of worship; (11) regular congregations; (12) regular religious services; (13) Sunday schools for religious instruction of the young; and (14) schools for the preparation of its ministers. The IRS concluded that "while some of these are relatively minor, others, e.g. the existence of an established congregation served by an ordained ministry, the provision of regular religious services and religious education for the young, and the dissemination of a doctrinal code, are of central importance."

Conceding that "both the courts and the IRS agree that there is no bright-line test as to whether an organization is a religious organization or a church," it concluded, based on an analysis of the 14 criteria that the organization in this case no longer qualified as a church. The IRS observed, "Most important, it no longer possesses the regular church services which have been held to be a prerequisite for church status. It no longer has the minimum for church status—a body of believers or communicants that assembles regularly in order to worship. It no longer has a defined congregation of worshipers, nor an established place of worship, nor regular religious services. Nor does it have other substantial church characteristics. Its ministers officiated at no more than [a few] weddings or other ministerial events or sacerdotal functions during the years. . . ." IRS Letter Ruling 200437040.

58. An Illinois court ruled that a storm drainage service charge based upon the amount of a property owner's run-off surface was a fee, not a tax, that could be assessed against churches without violating a state law exempting churches from property taxation. A city enacted an ordinance establishing a "storm water utility fund" to provide for the "management, protection, control, regulation, use and enhancement of the storm water systems" owned by the city. The ordinance imposed a "storm water service charge" on all "developed property" in the city, including church-owned property. Several churches, each of which owns developed property within the city, sued the city to prevent the assessment of the storm water service charge against them. The annual service charge was based on the number of "impervious area units" on a tract of property (2,800 square feet of impervious area was one unit). The ordinance defined impervious area or impervious surface to mean "those areas that prevent or impede the infiltration of storm water into the soil" including rooftops, sidewalks, walkways, patios, driveways, parking lots, storage areas, compacted aggregate and awnings."

The churches argued that the service charge amounted to a form of "property tax" that could not be assessed against churches that were exempt from property taxation. A trial court ruled that the service fee was a "user fee" rather than a tax, and so it could be legally assessed against churches. The churches appealed on the following grounds: (1) under Illinois law, the definition of a tax upon real property clearly encompasses the service fee charged by the city, and (2) several other states have found similar ordinances to be a tax and not a user fee.

On appeal, the churches argued that the term "property tax" under state law was sufficiently broad to cover service charges. The state property tax statute defines a tax as "any tax, special assessment or costs, interest or penalty imposed upon property." Property is defined as "the land itself, with all things contained therein, and also all buildings, structures and improvements and other permanent fixtures thereon." The court disagreed. It noted that a tax "is a charge having no relation to the service rendered and is assessed to provide general revenue rather than compensation." A user fee, on the other hand, "is proportional to a benefit or service rendered."

The court concluded that the storm water service charge was clearly a user fee since there was a "direct and proportional relationship between imperviousness and storm water run-off, thus creating a rational relationship between the amount of the fee and the contribution of a parcel to the use of the storm water system." The court reviewed several similar cases in other states and concluded that "the more recent case law favors the position that storm water service charges are a fee." Church of Peace v. City of Rock Island, 2005 WL 1140427 (Ill. App. 2005).

59. New York's highest court ruled that four parsonages owned by a church were all exempt from property tax since they were occupied by "officiating clergy" employed by the church. New York law exempts from property tax "property owned by a religious corporation while actually used by the officiating clergymen thereof for residential purposes shall be exempt from taxation." A church owned four residences, each of which was occupied by an assistant pastor. A local tax assessor refused to exempt these properties from tax on the ground that the term "officiating clergyman" should be construed to mean the "spiritual and settled leader" of a church. The church appealed.

The New York Court of Appeals (the highest state court) noted that the city was claiming that there is only one officiating clergyman per congregation--the minister who "has ultimate supervisory authority over the other clergy," and that in the city's view an "assistant pastor," by virtue of title alone, can rarely constitute officiating clergy within the meaning of the statute.

The court "declined to read the statute so narrowly." It conceded that "officiating clergymen" does not mean all clergymen. But "neither does it mean only one clergy person who presides over subordinates. Rather, we construe officiating as looking outward to a cleric's relationship with his or her congregation, and not to the hierarchical structure of the various clergy persons. Thus, a full-time, ordained member of the clergy who presides over an established church's ecclesiastical services and ceremonies, conducts weddings and funerals, and administers the sacraments of the church--in short, one who officiates--is entitled to the statutory tax exemption."

The court concluded that the church "is entitled to a parsonage exemption for each of the four properties." It "declined to hold that the mere designation of one of the pastors here as the 'Senior Pastor' means that as a matter of law he and he alone is the officiating clergy. All of the pastors, including those living at the residences in question, were ordained and held no outside employment. All took part in church services and shared in the preaching. All provided marital counseling, officiated at marriages and funerals, and administered the sacraments recognized by the church. They also ministered to the youth of the church and took part in outreach to the homeless. Indeed, the pastors ministered to at least 2,000 people weekly. Because the pastors' salaries are low, [the church] provides them with housing, located near the church. We thus reject the city's argument that the residents in question are not officiating clergy." Word of Life Ministries v. Nassau County, 787 N.Y.S.2d 705 (N.Y. 2004).

60. Social Security changes for 2006. Full retirement age (the age at which you are entitled to full retirement benefits) for persons born in 1941 is 65 years and 8 months. There is no reduction in Social Security benefits for income earned in the month full retirement age is attained (and all future months). For months prior to full retirement age, Social Security retirement benefits are reduced by $1 for every $3 of earned income above $2,770 (for 2006).

61. Retaining W-2 forms. It is a good practice for employees to keep copies of all W-2 forms issued to them by their employer until they confirm that the earnings reported on their W-2s correspond to the earnings credited to them on the Social Security Statement that is automatically issued each year to all Americans aged 25 and over. One of the main purposes of the Social Security Statement is to encourage taxpayers to check the accuracy of Social Security records and to make corrections. If earnings reflected on an employee’s Social Security Statement are underreported, the easiest way to correct the record is for the employee to present a copy of his or her W-2 for the year in question to the nearest Social Security office. While proof of earnings is possible without a W-2 form, it is much more difficult and time-consuming.

62. Changes in 2005 W-2 forms. Here are the changes in Form W-2 for 2005:

(1) A new Code Y is added to the list of codes for box 12 to report deferrals under a section 409A nonqualified deferred compensation plan. Any earnings during the year on current or prior year deferrals must also be reported here.

(2) A new Code Z is added to the list of codes for box 12. This code is used to identify income recognized due to participation in a nonqualified deferred compensation plan that fails to meet the requirements of Internal Revenue Code section 409A (added by the American Jobs Creation Act of 2004).

(3) The last year for filing Forms W-2 on tapes and cartridges was tax year 2004 (forms timely filed with the SSA in 2005). The last year for filing Forms W-2 on diskette is tax year 2005 (forms timely filed with the SSA in 2006).

63. Recommendations of the Panel on the Nonprofit Sector. In the midst of the financial scandals involving several prominent companies in 2002 and 2003, the media began focusing on allegations of questionable conduct by trustees and executives of public charities. In some cases the alleged abuses were clear violations of the law. In others the issue was whether certain practices met the high ethical standards expected of the charitable sector. These disclosures caught the attention of Congress. In September of 2004 the chairman of the Senate Finance Committee, Senator Charles Grassley (R-Iowa), and the ranking member, Senator Max Baucus (D-Mont.), sent a letter to the Independent Sector (a national coalition of several hundred public charities) encouraging it to assemble an independent group of leaders from the charitable community to consider and recommend actions "to strengthen governance, ethical conduct, and accountability within public charities and private foundations." The Senate Finance Committee leadership requested a final report in 2005.

The Independent Sector responded by creating a Panel on the Nonprofit Sector consisting of 24 leaders of public charities. The Panel embarked upon a wide-ranging examination of how to strengthen the governance, accountability, and ethical standards of public charities. It convened several public hearings, obtained valuable input from advisory groups and work groups, and consulted with dozens of professionals. The Panel's final report was submitted to the Senate Finance committee on June 22, 2005. It consists of nearly 100 recommendations for changes to be adopted by Congress, the IRS, or charities themselves.

Application of the Panel's recommendations to churches

Many of the Panel's recommendations pertain to public charities that file Form 990 with the IRS. Churches and many other religious organizations are exempt from this requirement, and on this basis are not targeted by many of the recommendations. In addition, many of the Panel's recommendations specifically exempt churches and some other religious organizations. However, it is worth noting that several points "consistently came through" in the field hearings conducted by the Panel around the country, and one of these points was that "religious groups should be held to the same standards of ethical conduct" as other charities. Because of the widespread acceptance of this principle, it is possible that Congress or the IRS may choose to apply some of the Panel's recommendations to churches even though the Panel concluded that they should be exempt. Also relevant in this regard is the following statement by Senator Grassley, who requested the Panel to provide recommendations for strengthening the accountability of charitable organizations: "I want to make certain that the vitality of nonprofits, particularly small charities and churches, is not unduly burdened by governance reforms."

Summary of the Panel's recommendations

The Panel made nearly 100 recommendations. Some recommendations, if enacted by Congress, could affect churches. These include the following:

• Congress should strengthen the definition of a qualified appraisal and a qualified appraiser for purposes of substantiating gifts to charity of noncash property valued by the donor at more than $5,000.

• Congress should enact a new penalty for persons who claim a tax deduction for donated property if the value of the donated property exceeds the market value of the property by 50% or more.

• Congress should enact new penalties for appraisers of donated property if the appraised value of donated property exceeds the market value by 50% or more.

• Congress should amend the tax code to mandate electronic filing of Forms 8283 and 8282, and require donors to complete information on Form 8283 pertaining to the name of the appraiser and the appraised value before asking the charity to substantiate that it received the donation.

• The IRS should establish a list of the value that taxpayers can claim for donations of specific items of clothing and household goods based on the sale price of such items identified by major thrift store operations or similar assessments.

• Congress should amend the tax code to impose penalties on board members of charities for approving an "excess benefit transaction" with a board member (or family member of a board member) not only if they knew the transaction was improper (this is current law), but also if they "should have known" it was improper—unless they qualify for a "rebuttable presumption" based on due diligence in basing compensation on comparability data.

• Congress should increase the collective penalty (intermediate sanctions) on board members who approve an excess benefit transaction for a board member from $10,000 to $20,000.

• Congress should amend the tax code to prohibit loans to board members.

• The Panel "generally discourages payment of compensation to board members of charitable organizations." However, "where compensation is deemed necessary due to the complexity of the responsibility, the time commitment involved in board service, and the skills required" charities should base compensation on a review of the practices of comparable organizations.

• Congress should amend the tax code to require "disqualified persons" (generally officers or directors, or their relatives) who are charged with receiving excessive compensation to demonstrate that the compensation they receive is reasonable.

• Congress should amend the tax code to impose penalties on board members of charities for approving an "excess benefit transaction" involving any disqualified person not only if they knew the transaction was improper (this is current law), but also if they "should have known" it was improper—unless they qualify for a "rebuttable presumption" based on due diligence in basing compensation on comparability data.

• Congress should increase the collective penalty (intermediate sanctions) on board members who approve an excess benefit transaction for any disqualified person from $10,000 to $20,000.

• Governing boards or compensation committees should review the charity's staff compensation program periodically, including salary ranges for particular positions.

• "Charitable organizations that pay for or reimburse travel expenses of board members, officers, employees, consultants, volunteers, or others traveling to conduct the business of the organization should establish and implement policies that provide clear guidance on their travel rules, including the types of expenses that can be reimbursed and the documentation required to receive reimbursement. Such policies should require that travel on behalf of the charitable organization is to be undertaken in a cost-effective manner. The travel policy should be provided to and adhered to by anyone traveling on behalf of the organization."

• "Charitable organizations should not pay for nor reimburse travel expenditures (not including de minimis expenses of those attending an activity such as a meal function of the organization) for spouses, dependents, or others who are accompanying individuals conducting business for the organization unless they, too, are conducting business for the organization."

• Congress should amend the tax code to require public charities to have at least three members of the board of directors as a requirement for tax-exempt status.

• Congress should amend the tax code to require at least one-third of a charity's board to be "independent," meaning individuals "(1) who have not been compensated by the organization within the past twelve months, including full-time and part-time compensation as an employee or as an independent contractor, except for reasonable compensation for board service; (2) whose own compensation, except for board service, is not determined by individuals who are compensated by the organization; (3) who do not receive, directly or indirectly, material financial benefits (i.e., service contracts, grants, or other payments) from the organization except as a member of the charitable class served by the organization; and (4) who are not related to (as a spouse, sibling, parent, or child) any individual described above."

It is important to stress once again that the Panel's recommendations are just that—recommendations. Some urge Congress to enact legislation, others urge the IRS to modify forms or procedures, and several are directed at charities themselves and seek voluntary compliance. What impact would the Panel's recommendations have on churches if they are adopted by Congress or the IRS? The following examples will illustrate how churches might be affected. But remember, these examples are assuming that the Panel's recommendations are adopted.

Example. A church member informs the pastor that she is considering a donation of her house to the church. Will the Panel's recommendations apply to such a transaction? Yes they may, if Congress adopts the Panel's recommendations regarding donations of noncash property. These recommendations contain no exemption for churches. Among other things, these recommendations will strengthen the definition of a qualified appraisal and a qualified appraiser, to make it less likely that donors will inflate the value of donated noncash property. Church leaders should remain alert to any developments (which will be addressed fully in future issues of this publication).

Example. A church member donates a tract of undeveloped property to his church. The donor obtains a qualified appraisal, and claims a charitable contribution deduction of $15,000 (the appraised value). The church resells the property within 6 months. If the Panel's recommendations are adopted by Congress, then the church will need to file a Form 8282 (donee information return) with the IRS electronically.

Example. Same facts as the previous example. The donor asks the church treasurer to sign the "donee acknowledgment" in Section B of Form 8283 before filling in the rest of the form. If the Panel's recommendations are adopted by Congress, then the church treasurer must not sign the Form 8283 until after the donor has completed the section of the form listing the name of the qualified appraiser and the appraised value of the donated property.

Example. A church frequently receives donations of clothing and household items. Will it be affected by the Panel's recommendations? Yes, if the IRS adopts the Panel's recommendation regarding valuation of donations of such items. Of course, churches are not appraisers and are not required to provide a cash value for these donated items in a receipt. A receipt simply describes the donated items and their condition (additional requirements apply if the combined value of a donor's contribution of such items is $250 or more). If this recommendation is adopted, the IRS will publish a "value guide" to assist taxpayers in valuing gifts of clothing and household goods to charity. This can be used by a church to assist the donor in establishing a value for the donated items.

Example 1. A church pays an honorarium to board members each year. Is this practice prohibited by the Panel's recommendations? The answer is no. The Panel did not recommend that Congress or the IRS take any action to prohibit this practice, but it did "discourage payment of compensation to board members of charitable organizations." As a result, compliance with this "best practice" is purely voluntary. Further, the Panel's recommendations state that "where compensation is deemed necessary due to the complexity of the responsibility, the time commitment involved in board service, and the skills required" charities should base compensation on a review of the practices of comparable organizations.

Example 2. A church board votes to "give" a church-owned parsonage to its senior pastor at his retirement. The value of the parsonage is $150,000. The church did not report the value of the parsonage as taxable income on the pastor's Form W-2, and the pastor did not report the value as income on his Form 1040. This is an excess benefit transaction since the value of this benefit was not reported as taxable income. Generally, the IRS can assess an excise tax (called "intermediate sanctions") against board members who authorize an excess benefit transaction. However, the board members in this case insist that they cannot be liable for this tax since they did not know that giving the parsonage to the pastor was an excess benefit transaction. The Panel recommended that this tax be assessed against board members if they "should have known" that a transaction was improper (actual knowledge would not be required).

Example 3. A church board approves excessive compensation for the senior pastor that the IRS later determines to be an excess benefit transaction. Under current law, board members of a public charity who approve an excess benefit transaction may be subject to an excise tax ("intermediate sanctions") of up to 10% of the amount of the excess, up to a maximum of $10,000 for the entire board. The Panel recommended that the maximum collective liability of board members for such a transaction be increased from $10,000 to $20,000.

64. Katrina Emergency Tax Relief Act of 2005. In September 2005 Congress passed the Katrina Emergency Tax Relief Act of 2005 by a unanimous vote of 422 - 0. The legislation provides tax relief for individuals and families, along with incentives for charitable donations. Here is a summary of the main provisions:

Relief for individuals

• Persons displaced from their principal residence by Hurricane Katrina have the option of using their 2004 income to calculate the child credit and the earned income credit on their 2005 tax returns.

• Persons affected by the hurricane are not taxed on personal debt reduction or cancellation related to the hurricane, such as the cancellation of a mortgage, provided before 2007.

• Persons who provide rent-free housing to dislocated persons for at least 60 days are given a special tax deduction of $500 for each dislocated person housed in the individual's principal residence (up to a maximum of $2,000). The deduction can be claimed in either 2005 or 2006, but cannot be claimed in both years with respect to the same person.

• Under current law, individuals who itemize their deductions may deduct personal casualty losses to the extent they exceed 10% of adjusted gross income and a $100 floor. The Act waives the 10% and $100 floors, allowing individuals to fully deduct their losses.

• Permits affected individuals to withdraw a maximum of $100,000 from their IRAs and pensions without paying the 10% penalty on early withdrawals. The Act also increases the limit on loans from pension plans from $50,000 to $100,000.

Extension of tax deadlines

• The IRS took administrative action following the hurricane to extend the deadlines for filing tax returns and making tax payments until January 3, 2006. These extensions apply to income, estate and gift taxes for those affected by Hurricane Katrina. The Act extends the deadline until February 28, 2006, and applies this extension to employment taxes, in addition to income, estate and gift taxes.

Incentives for charitable donations

• Generally, for individuals, contributions to charitable organizations are limited to 50% of the taxpayer’s adjusted gross income for the year. Any excess amount may be carried over for a period of up to five years. The Katrina Emergency Tax Relief Act of 2005 removes the 50% limitation for all cash donations to a charitable organization for the period beginning on August 28, 2005, and ending on December 31, 2005. Under the new law, an individual’s deduction for qualified contributions is allowed up to the amount by which the taxpayer’s AGI exceeds the deduction for other charitable contributions. Contributions in excess of this amount are carried over to succeeding tax years. The Act also exempts donations from the application of the phase-out of itemized deductions for high-AGI taxpayers. A taxpayer must also elect to have contributions treated as qualified contributions under these provisions. Note that this provision is one of the few that does not require a connection with Hurricane Katrina. Any and all cash contributions made by an individual taxpayer made after August 27th through the end of the year qualify for exemption from the contribution base rule.

• Under current law, corporations may deduct charitable donations up to 10% of their taxable income. The proposal waives the 10% income limitation for cash donations related to Hurricane Katrina if the donations are made before January 2006.

• Under current law, individuals may claim a tax deduction for the unreimbursed costs of using a personal vehicle for charitable work. The deduction is calculated by using a charitable standard mileage rate of 14 cents-per-mile. The Act sets the charitable mileage rate for charitable contributions at 70% of the standard business mileage rate (rounded to the next higher cent). This provision is effective through December 31, 2006.

• For volunteers who are reimbursed for the use of their personal vehicle, the Act provides that they do not pay income taxes on reimbursements up to the full business standard mileage rate. This provision is effective through December 31, 2006.

• Exempts from tax any reimbursements received by volunteers from tax-exempt organizations for the use of their personal vehicles in connection with providing relief relating to Hurricane Katrina victims through the end of 2006.

• Under current law, C-corporations may deduct the cost of food inventory donations. The value of the deduction is equal to the lesser of two times the basis or basis plus one-half of the added value. The proposal extends the current-law deduction for food donations to S-corporations, partnerships and sole proprietors through the end of the 2005 calendar year.

65. Changes to Form 1099-MISC. The American Jobs Creation Act of 2004 added section 409A to the tax code. Section 409A provides that all amounts deferred under a nonqualified deferred compensation plan for all tax years are includible in taxable income for the current year unless certain requirements specified in section 409A are met. In addition, there are two new reporting requirements:

(1) Amounts required to be included in taxable income because the requirements of section 409A are not met are required to be reported on the Form 1099 of an independent contractor for the year includible in income. This is done on Form 1099-MISC in the new box 15b (this amount is also included in box 7).

(2) Employers are required to report amounts deferred under a nonqualified deferred compensation plan. Such amounts must be reported on an independent contractor's Form 1099-MISC in box 15a. The congressional conference committee report to section 409A states: "It is expected that annual reporting of annual amounts deferred will provide the IRS greater information regarding such arrangements for enforcement purposes. It is intended that the information reported would provide an indication of what arrangements should be examined and challenged."

66. The neighborhood land rule. In general, rental income received by a church is exempt from the federal unrelated business income tax, but an exception applies in the case of rental income derived from debt-financed property. Section 514 of the tax code provides a special "neighborhood land rule" that exempts rents from debt-financed property from the unrelated business income tax so long as a church (1) has a definite plan to use the land for exempt purposes within 15 years, including a "specific improvement and a completion date, and some affirmative action toward the fulfillment of such a plan"; (2) informs the IRS of its plan at least 90 days before the end of the fifth year after acquiring the land, and requests a ruling; (3) does not abandon its intent during the 15 years following acquisition; and (4) demolishes any structures on the property as part of its plans to use the property for exempt purposes.

Example. A church purchased two adjacent parcels of land with debt financing. The land had no structures other than a level ground parking lot. The church used the land in part for church parking. It also leased the property to a company under a 10-year lease for public parking during periods (most of the week) when the church was not in session. The rent payments were a flat fee. The lessee was responsible for paving, lighting, and cleaning. The church purchased the land for church expansion. Its proposed plans called for constructing a building that would be used for church activities. The church submitted a letter to the IRS within 5 years of acquiring the property asking for a ruling that the rental income would be exempt from the unrelated business income tax based on the neighborhood land rule.

The IRS issued a ruling in which it concluded: "You purchased land with debt financing and leased it to a third party for operating a parking lot. The amounts derived appear to constitute rents from real property excepted from unrelated business taxable income . . . unless the land is debt-financed property. You have requested a ruling that the neighborhood land rule applies to exempt the land from the definition of debt-financed property for 15 years from acquisition. You submitted your ruling request in a timely manner, and the information submitted satisfies us that it is reasonably certain that you will use the land in an exempt purpose or function within 15 years of acquisition. Accordingly, we rule that it is reasonably certain that the land will be used for an exempt purpose within 15 years of its acquisition, and that the properties are exempt from the debt-financed property provisions of the tax code as a result of the neighborhood land rule for 15 years beginning with the dates that you acquired them." IRS Letter Ruling 200537037 (2005).

67. Religious publishing. The Tax Court ruled that a church did not qualify for tax-exempt status because its publishing activities constituted a substantial nonexempt activity. The pastor of the church wrote a number of books and pamphlets that were published and sold by the church. He claimed that the church's book publishing activities were a significant aspect of its activities. The court concluded, "Although the books had a religious theme, writing and publishing books is not a religious activity unless petitioner can prove the primary purpose for publishing the books was not for profit but for the furtherance of a nonexempt purpose. [The pastor] testified that the church distributed the books at cost; however, he introduced no evidence in support of this statement. Absent introduction of any financial statements from the church whatsoever, the court cannot evaluate whether the church did not in fact profit from the publishing and distribution of books. Therefore, the court finds that the publishing and distributing of books by the church was a substantial nonexempt activity. The existence of this substantial nonexempt purpose precludes the church from qualifying as an exempt organization."

The court further concluded, "The nature of this nonexempt activity, publishing books, was conducted for the exclusive benefit of the pastor, not the public. [He] authored each of the books the church published. He then paid all publishing costs from his personal bank account and deducted the costs as a charitable deduction on his federal income tax returns. The IRS argues that the pastor essentially incorporated the church to enable the publishing of books he authored. This argument is well founded. A substantial percentage of the pastor's earnings went to the church; yet, his was the sole authorized signature of this account. No evidence was offered to establish that the church had members or received contributions from others. It did not maintain any books and records. In effect, the pastor was using a claimed church as his pocket book. Therefore . . . the church fails the "private inurement" test of section 501(c)(3)." Triplett v. Commissioner, T.C. Summary Opinion 2005-148.