The Church as Employer--Unemployment Taxes
By Richard R. Hammar, J.D., LL.M., CPA
© Copyright 1991, 1998 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m76
Congress enacted the Federal Unemployment Tax Act (FUTA) in 1935 in response to the widespread unemployment that accompanied the great depression. The Act called for a cooperative federal--state program of benefits to unemployed workers. It is financed by a federal excise tax on wages paid by employers in covered employment. An employer, however, is allowed a credit of up to 90 percent of the federal tax for “contributions” paid to a state fund established under a federally approved state unemployment compensation law. All 50 states have employment security laws implementing the federal mandatory minimum standards of coverage. States are free to expand their coverage beyond the federal minimum.
From 1960 to 1970, the Act excluded from the definition of covered employment all “service performed in the employ of a religious, charitable, educational, or other organization described in section 501(c)(3) which is exempt from income tax under section 501(a).” A 1970 amendment in effect narrowed this broad exemption of nonprofit organizations by conditioning federal approval of state compensation plans on the coverage of all nonprofit organizations except those specifically exempted. The Act was then amended to exempt service performed
(1) in the employ of (A) a church or convention or association of churches, or (B) an organization which is operated primarily for religious purposes and which is operated, supervised, controlled,or principally supported by a church or convention or association of churches; (2) a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry or by a member of a religious order in the exercise of duties required by such order; (3) in the employ of a school which is not an institution of higher education.1
The Act continues the exemption of “service performed in the employ of a religious . . . organization” from the federal tax. Thus, while the exemption of religious organizations under federal law remains broad, the requirement imposed on states has been significantly narrowed.
In 1976, Congress eliminated the exemption of services performed “in the employ of a school which is not an institution of higher education” from the categories of employment that could be exempted from coverage under state programs without loss of federal approval.
In 1978 the Secretary of the Department of Labor announced that the elimination of this exemption required mandatory coverage of all the employees of church--related schools. This ruling was followed by many states, prompting a number of lawsuits.
In 1981, the United States Supreme Court ruled that the elimination of service performed “in the employ of a school which is not an institution of higher education” did not require the coverage of the employees of unincorporated church--related schools, since the continuing exemption of church employees was broad enough to cover the employees of unincorporated church--controlled elementary and secondary schools.2 The Court concluded that the employees of separately incorporated church schools are exempt from coverage only if the school is operated primarily for religious purposes and is operated, supervised, controlled, or principally supported by a church or convention or association of churches.
In summary, the following activities ordinarily are exempt from state unemployment taxes:
1. Service performed in the employ of a church, a convention or association of churches, or an organization that is operated primarily for religious purposes and that is operated, supervised, controlled, or principally supported by a church or convention or association of churches. The exemption is not limited to employees performing strictly “religious” duties.
2. Service performed in the employ of an unincorporated church--controlled elementary or secondary school.
3. Service performed in the employ of an incorporated religious elementary or secondary school if it is operated primarily for religious purposes and is operated, supervised, controlled, or principally supported by a church or a convention or association of churches.
4. Service performed by a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry or by a member of a religious order in the exercise of duties required by such order.
In a highly controversial decision that eventually may affect churches in other states, the Oregon Supreme Court ruled in 1989 that all religious organizations, including churches, are subject to state unemployment taxes.1 As noted above, the Federal Unemployment Tax Act contains a set of guidelines that a state's unemployment tax program must meet in order to avoid federal unemployment taxes. Although compliance with the federal guidelines is optional, states normally comply in order to avoid subjecting local employers to double taxation (under both federal and state law). One of the federal guidelines with which states must comply exempts services performed in the employ of a church, a convention or association of churches, or certain church--controlled organizations from unemployment tax. There is no exemption for religious organizations not affiliated with a church or convention or association of churches. Accordingly, under FUTA, states must subject non--church--affiliated religious organizations to state unemployment tax or risk losing their exemption from federal unemployment tax. However, the Oregon Supreme Court previously had ruled that the state could not make distinctions between church--affiliated and non--church--affiliated religious organizations, since such a distinction “contravenes the equality among pluralistic faiths and kinds of religious organizations embodied in the Oregon constitution's guarantees of religious freedom.”
How should these conflicting provisions be reconciled? The Employment Division of the Oregon Department of Human Resources (the agency responsible for enforcing the Oregon unemployment law) took the position that it had to assess unemployment taxes against all religious organizations—including churches—in order to keep Oregon in compliance with the FUTA guidelines and the Oregon constitution. The Oregon Supreme Court agreed. It emphasized that in order to satisfy the state constitution's requirement of “treating all religious organizations similarly” it had two options: (1) completely exempt all religious organizations (whether or not church--affiliated), or (2) eliminate the exemption of all religious organizations (including churches). The court elected the second alternative, since the other option would have led to a broader exemption then permitted by FUTA and accordingly would have subjected Oregon employers to double unemployment tax under both state and federal law. The court acknowledged that taxing all religious organizations “creates potential constitutional problems involving the free exercise of religion.” However, it concluded that its decision did not violate the constitutional guaranty of religious freedom. It observed:
When governmental action is challenged as a violation of the free exercise clause of the first amendment it must first be shown that the governmental action imposes a burden on the party's religion. Assuming that imposing unemployment payroll taxes on all religious organizations will burden at least some of those groups (although not necessarily their freedom of belief or worship), that assumption is only the beginning, however, rather than the end of the inquiry. Not all burdens on religious liberty are unconstitutional. The state may justify a limitation on religion by showing that it is essential to accomplish an overriding governmental interest. In the present case the state of Oregon has two governmental interests which, when taken together, are sufficiently important to support the burden on religion represented by unemployment payroll taxes. There are few governmental tasks as important as providing for the economic security of its citizens. A strong unemployment compensation system plays a significant role in providing this security. Given the existence of FUTA, any state's unemployment tax must, as a practical matter, comply with FUTA's requirements or the state's employers would face a double tax. Such a double tax would, in turn, create a very undesirable business climate in the state. This, combined with Oregon's constitutional interest in treating all religious organizations equally, creates an overriding state interest in applying the unemployment payroll taxes to all religious organizations. Our construction of the coverage of Oregon's unemployment compensation taxation scheme does not offend the first amendment's free exercise clause or . . . the Oregon constitution.2
Perhaps most disturbing was the court's insensitivity to the imposition of a direct tax upon churches. For example, the court observed that the state “can draw its tax line anywhere it desires” and “may require the Catholic church to pay unemployment taxes for the work performed by nuns and monks.”
For related information on this topic see the following articles: