Do we need to report taxable income on the rental value of a parsonage to a noncredentialed pastor?
Answer: Four issues need to be addressed when considering an issue like this:
- The annual fair rental value of a church-owned parsonage that is made available to a staff member on a rent-free basis is nontaxable to the staff member in computing federal income taxes if (1) the staff member who lives in the parsonage is a minister, and (2) the parsonage is provided for services performed by the minister in the exercise of ministry.
The IRS defines ministers as “individuals who are duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination [and] given the authority to conduct religious worship, perform sacerdotal functions, and administer ordinances or sacraments according to the prescribed tenets and practices of that church or denomination.”
According to this definition, a noncredentialed youth pastor would not be a minister for federal tax purposes even though he or she performs pastoral duties, and so your church’s youth pastor would not be eligible for the parsonage exclusion. This means that the church would need to report the annual fair rental value of the parsonage as taxable income to the youth pastor (for both income taxes and Social Security) unless the home is furnished to the youth pastor for the convenience of the employer and as a condition of employment, as noted below.
- The tax code allows employers to exclude the value of lodging furnished to an employee from the employee’s wages if it meets the following three tests: (1) it is furnished on the employer’s premises; (2) it is furnished for the convenience of the employer; and (3) the employee must accept it as a condition of employment. Different tests may apply to lodging furnished by educational institutions.
Whether lodging is furnished by an employer for its convenience depends on all the facts and circumstances. You furnish the lodging to your youth pastor for the church’s convenience if you do so for a substantial business reason other than to provide the pastor with additional pay. A written statement that the lodging is furnished for the church’s convenience is not sufficient.
Lodging is furnished as a condition of employment if your church requires the youth pastor to accept the lodging because it needs him to live on your church premises to be able to properly perform his duties. Examples include employees who must be avail- able at all times and employees who could not perform their required duties without being furnished the lodging.
In most cases, a noncredentialed youth pastor who lives in a church parsonage would not meet the “convenience of the employer” or the “condition of employment” tests, and so the rental value of the lodging would be taxable for both income taxes and Social Security.
- Another important question is whether and how the church should withhold taxes from the rental value of the parsonage. As noted previously, if the minister is not credentialed, and the condition of employment or convenience of the employer tests are not met, then the rental value of the parsonage will constitute taxable income for both income taxes and Social Security. In such a case, the church is required by law to withhold income taxes and Social Security (and Medicare) taxes from the youth pas- tor’s wages. But how is this done for a noncash benefit such as free lodging? The IRS provides the following guidance in Publication 15-B:
- Generally, you must determine the value of noncash benefits no later than January 31 of the next year. Before January 31, you may reasonably estimate the value of the fringe benefits for purposes of withholding and depositing on time.
- For employment tax and withholding purposes, you can treat fringe benefits as paid on a pay period, quarter, semiannual, annual, or other basis. But the benefits must be treated as paid no less frequently than annually. You can change the period as often as you like as long as you treat all of the benefits provided in a calendar year as paid no later than December 31 of the calendar year.
- Several states exempt parsonages from property (ad valorem) taxes. However, these laws generally limit the exemption to church-owned residences that are occupied by a pastor, member of the clergy, or minister. Would a parsonage provided to a noncredentialed youth pastor qualify for exemption? This has never been addressed by any court. It is possible that a court would interpret such an exemption to apply only to church- owned residences occupied by members of the clergy who are formally ordained or licensed and not to persons who have not been ordained or licensed, even if they per- form ministerial duties. On the other hand, some courts may interpret the exemption more broadly and extend it to church-owned residences that are occupied by persons who perform ministerial functions regardless of whether they are ordained or licensed.
Our church uses offering envelopes. How long should we keep them?
Answer: Many churches use offering envelopes. They have a number of advantages, including the following: (1) they help the church connect cash contributions to individual donors; (2) they promote privacy in the collecting of contributions; (3) they give members the opportunity to designate specific programs or projects; (4) they provide members with a weekly reminder of the need to make contributions and honor pledges; and (5) they reduce the risk of offering counters pocketing loose bills. In the past, another reason offering envelopes were used was that they provided donors with a means of substantiating cash contributions of less than $250. This no longer is the case.
In 2006, Congress amended the law to require that all cash contributions, regardless of amount, be substantiated with (1) either a bank record (such as a canceled check) or a written communication from the charity (2) showing the charity’s name, date of the contribution, and the amount of the contribution. Offering envelopes will not satisfy these requirements and cannot be used to substantiate a donor’s cash contributions. However, as noted above, there are other reasons your church may want to use them.
Church leaders often ask how long they must keep offering envelopes. If your church uses offering envelopes, then one option is to issue donors a periodic (i.e., quarterly, semiannual, or annual) summary of contributions and include in this summary a statement similar to the following: “Any documentation, including offering envelopes, that the church relied upon in preparing this summary will be disposed of within six months. Therefore, please review this summary carefully and inform the church treasurer of any apparent discrepancies within six months of the date of this summary.” Of course, you can change the six-month period to any other length of time you desire. This statement will relieve the church of the responsibility of warehousing offering envelopes and other supporting documentation for long periods of time.
Is a church required to apply to the IRS for recognition of tax exemption, or are we automatically exempt because they are a church?
Answer: Churches that meet the requirements of section 501(c)(3) of the federal tax code are automatically considered tax exempt and are not required to apply for and obtain recognition of tax-exempt status from the IRS. Section 501(c)(3) imposes the following five requirements: (1) a church must be organized exclusively for exempt purposes; (2) a church must be operated exclusively for exempt purposes; (3) none of a church’s resources can inure to the benefit of a private individual other than reasonable compensation for services performed; (4) the church may not engage in substantial efforts to influence legislation; and (5) the church may not intervene or participate in any political campaign on behalf of or in opposition to a candidate for public office. Churches that satisfy these five requirements are automatically exempt from federal income taxes. They are not required to obtain official recognition of exemption from the IRS by submitting an exemption application form (Form 1023) like most other public charities.
Although there is no requirement to do so, many churches seek recognition of tax-exempt status from the IRS because such recognition assures church leaders, members, and contributors that the church is recognized as exempt and qualifies for related tax benefits. For example, contributors to a church that has been recognized as tax exempt would know that their contributions generally are tax deductible.
A church with a parent organization may wish to contact the parent to see if it has a group ruling. If the parent holds a group ruling, then the IRS may already recognize the church as tax exempt. Under the group-exemption process, the parent organization becomes the holder of a group ruling that identifies other affiliated churches or other affiliated organizations. A church is recognized as tax exempt if it is included in a list provided by the parent organization. The parent is then required to submit an annual group-exemption update to the IRS in which it provides additions, deletions, and changes within the group. If the church or other affiliated organization is included on such a list, it does not need to take further action to obtain recognition of tax-exempt status.
A part-time associate pastor asks the church to designate his entire salary as a housing allowance. Do they need to issue him a W-2 form at the end of the year—reporting “no income”?
Answer: This is a surprisingly complex question. Here’s why. Up until 1974, section 6051 of the federal tax code required a Form W-2 to be issued to (1) each employee from whom income, Social Security, or Medicare tax is withheld or (2) each employee from whom income tax would have been withheld if the employee had claimed no more than one withholding allowance or had not claimed exemption from withholding on Form W-4. Churches were not required to issue a W-2 to pastors under this provision, since their wages are exempt from tax withholding.
In 1974, Congress enacted a massive pension law (the Employee Retirement Income Security Act, or ERISA). This law added the following phrase to section 6051: “Every employer engaged in a trade or business who pays remuneration for services performed by an employee, including noncash payments, must file a Form W-2 for each employee.” Unfortunately, the legislative history contains no explanation of why this language was added. In any event, it was broad enough to require churches to issue a W-2 form to ministers even though they are not subject to tax withholding.
Unfortunately, the 1974 amendment created some ambiguities, and your question highlights one of them. Read literally, the revised section 6051 requires a church to issue a W-2 form to a minister even though all of the minister’s income is designated as a housing allowance, no amount is shown in box 1 (wages), and no withholdings of income taxes or Social Security or Medicare taxes are reported. Why? Because the church is an employer “engaged in a trade or business who pays remuneration for services performed by an employee, including noncash payments.” Of course, submitting a W-2 form to the IRS that identifies a minister by name and Social Security number but that has blank boxes for income and withholdings is not consistent with the purpose of the W-2 form, which is to report wages and withholdings to the IRS to ensure that the correct amount of taxes is paid. This purpose is not furthered by submitting blank forms. However, this does not necessarily mean that a church is relieved of the obligation to issue a Form W-2.
In 2000, the IRS addressed the question of whether election workers should be issued W-2 forms. Election workers are individuals who are generally employed to perform services for states and local governments at election booths in connection with national, state, or local elections. Government agencies typically pay election workers a set fee for each day of work. The IRS quoted section 6051 of the tax code and concluded that this section “does not require reporting of compensation that is not subject to withholding of FICA tax or income tax. . . . Section 6051 requires reporting of compensation subject to either FICA tax or income tax withholding. No reporting is required . . . for items of income that are not subject to withholding of FICA tax or income tax. If an election worker’s compensation is subject to withholding of FICA tax, reporting is required by section 6051 regardless of the amount of compensation.” IRS Revenue Ruling 2000-6.
This ruling suggests that a church may not be required to issue a W-2 to a part-time pastor whose entire income is designated as a housing allowance.
The IRS operates a centralized call site to answer questions about reporting information on W-2 forms. If you have any questions about completing a Form W-2, call the IRS at 1-866- 455-7438, Monday through Friday, 8:30 a.m. to 4:30 p.m. eastern time.
In which year is a check deductible if it is mailed in one year but postmarked in the following year?
Answer: Section 170 of the tax code states that “there shall be allowed as a deduction any charitable contribution payment of which is made within the taxable year.” Section 1.170A-1 of the regulations states that “the unconditional delivery or mailing of a check which subsequently clears in due course will constitute an effective contribution on the date of delivery or mailing.” Similarly, Publication 526 states that “a check that you mail to a charity is considered delivered on the date you mail it.”
In none of these cases is there a requirement that the check be postmarked as well as mailed in a particular year in order for a deduction to be available in that year. However, this is the position that is taken by the vast majority of charities, including major universities, government agencies, the American Bar Association, and the Association of Fundraising Professionals. The reasons are obvious. Charities must determine how to allocate contribution checks that are received in the mail during the first week of each new year. Are they current- or prior-year contributions? True, the charity could ignore the postmarks and proceed to question every one of those donors to ascertain the date they placed their checks in the mail. But I am aware of no charity that does this.
It is far more prudent and reasonable to use the postmark as conclusive evidence of when a check was mailed. Yes, this will work to the detriment of a very small number of donors who slip their check in the mailbox in the closing moments of the prior year, after the last mail pickup. Technically, those donors could claim a charitable contribution deduction in the prior year, based on the tax code and regulations quoted above. However, keep in mind one additional point. It is the taxpayer who has the burden of proving his or her entitlement to any tax deduction, including one for a charitable contribution. Donors are certainly free to claim a charitable contribution on their prior year’s tax return for checks dropped in the mail on December 31 of that year but not postmarked until January of the current year. However, bear in mind that the donor has the burden proving that this in fact was the case. In most cases, this will be a difficult if not impossible task.
In other words, what evidence could a donor present to prove that the postmark is wrong? There would be rare exceptions where this would be possible. For example, a donor asks a disinterested person (his neighbor) to accompany him to a mailbox just before midnight on December 31; has the neighbor examine the contribution check before it is placed in an envelope (making a written record of the name of the donee and the amount of the check); makes a record of the addressee identified on the envelope and ensures that proper postage is affixed; observes the donor place the envelope in the mailbox; and notes and records the precise time the envelope is placed in the mailbox. How many donors would be able to satisfy their burden of proof in this manner?
For all of these reasons, the vast majority of charities receipt contributions they receive by mail according to the postmark date.
Finally, note that neither the IRS nor any court has ever addressed the question you have raised, so we have no definitive precedent either way. I suspect that if this issue was ever raised, the most likely outcome would be that the IRS or a court would rule that the postmark date is the best evidence of when a check is mailed and that a taxpayer has a heavy burden to prove that a check was mailed in a year prior to its postmark date.
Who owns a church’s accounting records, and what are best practices for handling records?
Answer: Here are six observations in response to this question:
- The nonprofit corporation laws under which most churches are incorporated require that corporations maintain various kinds of records, including financial books of ac- count. To illustrate, the Model Nonprofit Corporation Act, which has been adopted by most states, provides that “a corporation shall maintain appropriate accounting records.” While this language does not directly address ownership, how can a church maintain appropriate accounting records if they are possessed and “owned” by the treasurer? As a result, it should be assumed that the church is the owner of its financial records, and not a volunteer treasurer who takes them home. The takeaway point is that location, or even possession, does not determine ownership.
- Allowing a volunteer treasurer to take the church’s accounting records home is not recommended, for several reasons, including the following: (1) Such a procedure violates two of the core principles of internal control—segregation of duties and oversight over operations. Imagine the financial improprieties that could go undetected under such an arrangement. (2) Irreplaceable financial records may be lost, stolen, or destroyed while in the home of the church treasurer, and confidential information may be accessed by family members. (3) Church staff will be frustrated in the performance of their duties because of the inaccessibility of the church’s financial records. (4) Such an arrangement can provide a treasurer with “leverage” that can be exerted to achieve ulterior objectives. (5) Such an arrangement may result in the permanent inaccessibility of church records in the event of a dispute with the treasurer or at such time as the treasurer leaves office voluntarily or involuntarily.
- Church leaders should check the church’s bylaws or other governing document to determine what, if any, authority the treasurer may have over the church’s financial re- cords. Some church bylaws state that the treasurer shall have “custody” of the church’s financial records, or “be responsible” for them. But custody and responsibility are not the same as ownership, although such terminology suggests that the treasurer is authorized to remove the church’s financial records to his or her home. For the reasons stated, this generally is not advisable, and so church leaders should review their governing document in order to identify and amend such a provision, should one exist.
- The same logic applies to paid employees. A church’s bookkeeper, business administrator, or other paid employee should not keep financial records at home. An additional consideration applies to employees—the federal Fair Labor Standards Act. The FLSA guarantees overtime pay for hours worked in excess of 40 during the same week. States have their own requirements. The point is that churches have no way to monitor hours worked by an employee in his or her residence, and so compliance with the FLSA is virtually impossible. Some churches allow employees to take church records home to work on them as unpaid “volunteers.” But this is not permissible, according to Department of Labor interpretations of the FLSA. The bottom line is that allowing church employees to take church records home in order to work with them may expose a church to significant liability under the FLSA or a state counterpart.
- Some church leaders allow financial records to be kept in the private residence of a treasurer or other church officer or employee to preserve them from theft or a natural disaster affecting the church office. This risk can be managed by storing the records in a locked and immovable fireproof cabinet. After data on financial records are integrated into the church’s computer software, backup copies can be stored off-site.
- The American Institute of Certified Public Accountants (AICPA) Statement on Auditing Standards (SAS) no. 96 (“Audit Documentation”) requires CPAs to maintain specified kinds of documentation when performing an audit. Most states have enacted laws specifying that CPAs own the working papers and other documentation they prepare in performing their duties. As a result, a church ordinarily cannot assert ownership of the working papers of CPAs who are retained to perform an audit of the church.
What tax considerations impact a no-interest loan between a church and a pastor?
Answer: There are several key points to consider when making no-interest loans to church leaders.
First, if the church makes a below-market interest loan of more than $10,000 to an employee, it would have to report the forgone interest as taxable income to the employee.
Second, employers that make below-market interest loans of $10,000 or less to an employee are not required to report the foregone interest as taxable income, but only to the extent that a principal purpose of the transaction was not the avoidance of tax. To the extent that the church fixed the amount of the loan as $10,000 for the express purpose of avoiding the realization of taxable income, the exemption may be lost.
Third, any agreement or understanding that would involve the church “forgiving” the employee’s obligation would immediately result in the entire balance of the loan being realized as taxable income. It also might trigger the new and complex regulations that apply to non- qualified deferred compensation arrangements, since this arrangement might well be deemed nonqualified deferred compensation under the new and expansive definition contained in the regulations under section 409A of the tax code.
Fourth, many state nonprofit corporation laws prohibit corporate boards from making loans to any officer or director, even if the loan includes a reasonable rate of interest. So if your church is incorporated, be sure to check your state’s nonprofit corporation law so that you are aware of any such restriction.
Fifth, any time a church makes a below-market interest loan to an employee, the question of inurement arises. One of the requirements for tax-exempt status is that none of a church’s in- come inures to the private benefit of any individual other than as reasonable compensation for services rendered. To the extent that the taxable income associated with below-market interest loans is fully reported, this will eliminate that risk.
Sixth, any taxable fringe benefit that is provided by a tax-exempt employer to an officer or di- rector (or a relative of one) and that is not reported as taxable income exposes the recipient to substantial excise taxes (called “intermediate sanctions”) of up to 225 percent of the amount of the unreported benefit. Board members who authorized the benefit are subject to an additional penalty of 10 percent of the amount of the benefit (up to a maximum penalty of $20,000). As a result, it is important for church leaders to correctly report any taxable benefit associated with below-market interest loans.
Question 8: Can a church reimburse their pastor’s Holy Land travel expenses under an accountable reimbursement policy if they’ve asked him or her to take the trip?
Answer: No. For many years, the tax code allowed employers and employees to treat “travel as a form of education” as a business expense. Section 1.162-5(d) of the income tax regulations specified: “Expenditures for travel (including travel while on sabbatical leave) as a form of education are deductible only to the extent such expenditures are attributable to a period of travel that is directly related to the duties of the individual in his employment or other trade or business. For this purpose, a period of travel shall be considered directly related to the duties of the individual in his employment or other trade or business only if the major portion of the activities during such period is of a nature which directly maintains or improves skills required by the individual in such employment or other trade or business.”
In 1986, Congress enacted section 274(m)(2) of the tax code, which states, simply, that “no deduction shall be allowed . . . for expenses for travel as a form of education.” The congressional committee report that accompanied section 274(m)(2) indicates that no deduction is to be allowed for costs of travel that would be deductible only on the ground that the travel itself constitutes a form of education (e.g., where a teacher of French travels to France to maintain general familiarity with the French language and culture, or where a social studies teacher travels to another state to learn about or photograph its people). The committee report indicates that section 274(m)(2) was intended to overrule section 1.162-5(d) of the regulations to the extent that such regulation allows deductions for travel as a form of education.
In summary, while the pastor’s trip may enrich and improve his ministry, this is not enough to make it a business trip; therefore, the church cannot reimburse his travel expenses under its ac- countable expense reimbursement arrangement. If the primary purpose of the pastor’s trip was business related (speaking, teaching, etc.), then his expenses may be reimbursable under the church’s accountable plan. Such a conclusion depends on several factors, including the length of the trip and the time devoted to business and personal purposes. This issue is addressed fully in chapter 7 of Richard Hammar’s Church & Clergy Tax Guide.
Question 9: Are churches required to report embezzlement to the IRS?
Answer: Here are several factors to consider:
- Embezzled funds constitute taxable income to the embezzler. The embezzler has a legal duty to report the full amount of the embezzled funds as taxable income on his or tax return, regardless of whether the employer reports the embezzled funds as taxable income on the employee’s Form W-2 or If funds were embezzled in prior years, then the employee will need to file amended tax returns for each of those years to report the illegal income, since embezzlement occurs in the year the funds are misappropriated.
IRS Publication 525 states: “Illegal income, such as stolen or embezzled funds, must be included in your income on line 21 of Form 1040, or on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) if from your self-employment activity.”
- Federal law does not require employers to report embezzled funds on an employee’s W-2 or on a Form This makes sense, since in most cases an employer will not know how much was stolen. How can an employer report an amount that is undetermined? Embezzlers are not of much help, since even when they confess to their acts, they typically admit to stealing far less than they actually took. This means that any attempt by an employer to report embezzled funds on an employee’s W-2 or 1099 will almost always represent an understatement of what was taken.
- In rare cases, an employer may be able to determine the actual number of embezzled funds as well as the perpetrator’s In such a case, the full amount may be added to the employee’s W-2, or it can be reported on a Form 1099 as miscellaneous income. But remember, do not use this option unless you are certain you know the amount that was stolen as well as the thief ’s identity.
- In most cases, employers do not know the actual number of embezzled funds. The embezzler’s “confession” is unreliable, if not Reporting inaccurate estimates on a W-2 or 1099 will be misleading. Also, if you report allegedly embezzled funds on an employee’s W-2 or 1099 without proof of guilt, this may expose the church to liability on the basis of several grounds. One of these is section 7434 of the tax code, which imposes a penalty of the greater of $5,000 or actual damages plus attorney’s fees on employers that willfully file a fraudulent Form 1099.
- Employers who cannot determine the actual number of funds an employee embezzled
Question 10: Is a church required to pay employees overtime for volunteer or other work unrelated to their main job?
Answer: I am frequently asked this question. A few years ago, I submitted the following question to the chief counsel’s office of the United States Department of Labor (DOL), Wage and Hour Division:
Must an employer pay overtime to an hourly employee who works 40 hours per week at a regular job, and also works additional hours for the same employer performing work unrelated to her regular employment. For example, assume that a church secretary works 40 hours each week, and several weeks during the year she works 5–10 additional hours doing custodial services. Must she be paid overtime for the custodial services, even though they are completely unrelated to her regular job? If so, at what rate?
Here is the answer I received:
Yes. Section 788.115 of the regulations states that where an employee in a single workweek works at two or more different types of work for which different straight-time rates of pay (not less than minimum wage) have been established, the regular rate for that week is the weighted average of such rates. That is, the earnings for all such rates are added together and this total is then divided by the total number of hours worked for all jobs.
Here are some additional points for you to consider:
- A church is not required to pay exempt employees overtime compensation for hours worked in excess of 40 during the same work Exempt employees are administrative, executive, and professional employees who are paid a weekly salary of at least $455 and perform duties specified by law.
- A church cannot make an employee exempt simply by paying him or her a To be exempt, the employee also must perform the duties of an exempt employee as pre- scribed by law.
- In a 1983 opinion letter, the United States Department of Labor concluded:
Individuals who volunteer their services, usually on a part-time basis, to a church or synagogue not as employees or in contemplation of pay are not considered to be employees within the meaning of FLSA. For example, persons who volunteer their services as lectors, cantors, ushers or choir members would not be considered employees. Likewise, persons who volunteer to answer telephones, serve as doorkeepers, or perform general clerical or administrative functions would not be employees. However, in situations where the understanding is that the person will work for wages there will be an employment relation- ship. On the other hand, a bookkeeper could not be treated as an unpaid volunteer bookkeeper
for the employing institution in the same workweek in which he or she is also an employee.
- The preamble to the DOL regulations cautions that “some state laws have stricter ex- emption standards than those described [in these regulations]. The FLSA does not preempt any such stricter state standards. If a state or local law establishes a higher standard than the provisions of the FLSA, the higher standard applies.” This is an important point. Several states have enacted legislation mandating a higher minimum wage than the federal minimum wage. However, when Congress enacts increases in the federal minimum wage, the federal rate will transcend some state minimum wage rates. So it is important for church leaders to be aware of both the federal and state rates. Whichever is higher applies.
Question 11: Do Churches have liability for volunteers currently receiving workers’ compensation from their employer?
Answer: Workers’ compensation benefits are based on the nature and degree of an injured worker’s work-related injury. “Total disability” benefits may be awarded upon a finding that the injured employee can no longer perform compensated employment. As a result, a person’s eligibility to receive total disability benefits is directly affected if he or she begins performing compensated employment. In addition, such employment may result not only in a discontinuation of benefits but also in a legal obligation to return benefits already paid.
Is a church subject to any penalties if it knowingly hires and compensates a person who is receiving workers’ compensation benefits? In most cases, the answer is no. It is the employee, not the employer, who may be required to return benefits paid while he or she was earning wages from a job. Still, it is a best practice for churches to consider the following precautions:
- If a church employee is injured on the job (either at church or at a “second job”) and is receiving workers’ compensation benefits, be sure the employee is legally permitted to perform compensated employment before allowing him or her to continue working.
- If a church employee is injured on the job (either at church or at a “second job”) and is receiving workers’ compensation benefits, be sure the employee complies with any notification requirements prescribed by state law. Persons receiving workers’ compensation benefits may be required to notify a state agency if there is any improvement in their condition or if they perform compensated employment. Failure to do so may make the recipient legally obligated to return some or all of the workers’ compensation benefits that were paid.
- Note that an injured employee is performing “compensated employment” (which may jeopardize eligibility for workers’ compensation benefits) if he or she is receiving compensation for performing services. The fact that the amount of compensation is small may be irrelevant. The employee cannot avoid disqualification by characterizing church compensation as “love gifts.”
- If your church has at least 15 employees and is engaged in commerce, then you are subject to the Americans with Disabilities Act. This Act generally prohibits covered employers from discriminating in employment decisions on the basis of the disability of a person who is able to perform the essential functions of a job with or without reasonable accommodation by the employer. There are exceptions. For example, churches are permitted to discriminate on the basis of religion in their employment decisions. Many states have their own disability laws, and some of these laws apply to employers with fewer than 15 employees (and none requires interstate commerce).
Question 12: Is Internet access for personal research (or similar minor benefits) a taxable or nontaxable fringe benefit?
Answer: Note the following considerations:
- The tax code specifies that “de minimis fringe benefits” are not taxable to an employee. This refers to benefits that are so immaterial in value that it would be unreasonable and/ or administratively impractical to account for them. This exception would apply, for example, to an employee who uses an employer-provided Internet connection for a few minutes each month. It would not apply to employees who use an employer-provided Internet connection several times each month for significant amounts of time.
- Internet usage is considered to be a “utility” expense by the Tax Court and, as a result, is not subject to the strict substantiation rules that apply to listed property. To illustrate, in a recent case, the Tax Court noted that “Internet expenses are utility expenses. Strict substantiation therefore does not apply, and the Court may . . . estimate petitioners’ deductible expense, provided that the Court has a reasonable basis for making an estimate.”
- Many employers, including many charities, have adopted cell phone and Internet usage policies. While the use by employees of their employer’s Internet connection for personal purposes is not listed property, it is nonetheless taxable. So, like cell phones, the personal use needs to be segregated, valued, and then reported as taxable income. The substantiation rules for Internet use are less stringent than those that apply to cell phones, but the income recognition for personal use is the same. What several employers have done is adopt a policy with the following features: (1) the employer no longer provides cell phones to any employee (after current contracts expire); (2) the employer grants employees (with a need for a cell phone) a monthly taxable stipend with which the employees can purchase and pay the monthly fees for their own cell phone; (3) the employer grants employees (with employer-provided Internet access) a monthly tax- able stipend to cover personal use of the Internet. This is an increasingly popular way for employers to handle these issues.
Question 13: Should a church allow members space for their personal business use?
Answer: Many churches have considered or even implemented such arrangements. After all, most churches have rooms that are unused during the week, so why not let members use them? There are many reasons these arrangements are not advisable, including the following:
- Your church property is exempt from property taxation so long as it is used exclusively for religious purposes. By allowing a for-profit business to operate on your premises, you are jeopardizing the church’s property tax exemption in whole or in part, depending on the circumstances.
- Is your church property zoned for commercial use? Often, churches are in residential zones in which the operation of commercial businesses is not legally permitted.
- Is the church member going to pay the church a rental fee for use of the room? If so, this may implicate the federal unrelated business income tax.
- The church may be responsible for injuries that occur during the member’s use of church property. As a result, there should be a written agreement that addresses each party’s obligations, and this agreement needs to address liability and insurance. For ex- ample, the agreement could include indemnification and “hold harmless” clauses and require the member to obtain adequate liability insurance (naming the church as an additional insured) in an amount that is acceptable to the church. An attorney should be retained to prepare such an agreement.
- Before agreeing to such an arrangement, church leaders must consider how they will respond to other members who would like to use church property for commercial purposes. After all, once members see the favorable arrangement that this person has received, what’s to stop others from wanting similar treatment? The church could be inundated with such requests, and by rejecting all or most of them, you will be perceived as showing inappropriate favoritism to the one member who is granted permission to use church property. This could result in a negative backlash.
The takeaway point is that church leaders should not allow a member to use church property for commercial purposes without careful consideration of the legal, tax, and risk-management implications, including those mentioned in this response. When in doubt, legal counsel should be retained.
Question 14: Should ministers opt out of Social Security?
Answer: Financial advisors sometimes tell ministers to opt out of Social Security. This advice is usually based on the common misconception that financial considerations are a legitimate basis for opting out of Social Security. They are not. Ministers may exempt themselves from self-employment taxes with respect to services performed in the exercise of ministry only if several requirements are met. Among other things, the exemption must be filed within a limited time period, and it is available only to ministers who are opposed on the basis of religious considerations to the acceptance of public insurance benefits that make payments “in the event of death, disability, old age, or retirement, or that make payments toward the cost of, or provides services for, medical care.” Public insurance includes Social Security and Medicare.
Ministers who exempt themselves from Social Security for invalid reasons may have their ex- emption questioned in an IRS audit. To illustrate, in 1995 the Tax Court upheld the revocation of a minister’s exemption from Social Security on the ground that he did not qualify. The court noted that the minister’s exemption application had been filed on time, but it concluded that the minister was not eligible for exemption because of comments he made during his trial. Among other things, the minister gave the following response when asked whether he was op- posed to accepting Social Security benefits on the basis of religious principles (as required by law to qualify for the exemption): “No. I am not opposed to the—to that, as a religious issue, no. We were advised to—by our accountant, to file for an exemption with the state, providing the state would allow it. And we asked the state to allow it, which they did.”
This is an extraordinary ruling that is significant for ministers who are trying to decide whether to file an application for exemption from self-employment taxes (Form 4361). The ruling indicates that filing a timely Form 4361—which contains a certification by the applicant that he or she meets all of the eligibility requirements—may not be enough. The IRS or the courts may later question whether the minister was eligible for the exemption when the Form 4361 was filed.
The court acknowledged that the minister “signed an exemption application stating that he was opposed to public insurance because of his religious principles.” However, it found the minister’s “trial testimony to be more compelling.” Hairston v. Commissioner, T.C. Memo. Dec. 51,025(M) (1995).
In summary, opposition to Social Security based entirely on financial considerations is not a basis for exemption. In fact, ministers who heed “experts’” advice to do so are exposing them- selves to substantial penalties plus back taxes and interest. These could easily amount to tens of thousands of dollars.
Question 15: Can a minister or board members inspect the contribution records of members?
Answer. This is a controversial question. Let me make a few comments that may be helpful.
- The obvious question, of course, is why would a pastor and church board want to inspect the contribution records of members? One reason might be to enforce a bylaw requirement that members in good standing tithe or make some other specified financial commitment to the church. However, it is far more common for church bylaws to require that members “support the church financially,” and this is an ambiguous standard that would not warrant accessing individual members’ contribution records.
- Many pastors do not want to see donor records, since they do not want this information to influence their relationship with individual members.
- The nonprofit corporation statutes of most states give members of incorporated churches the legal right to inspect various corporate records. However, individual do- nor records generally are not included among those records that can be inspected. A few years ago, the Texas Supreme Court ruled that a nonprofit corporation law did not confer any authority to inspect the contribution records of individual members. The Texas Nonprofit Corporation Act specifies that “all records, books, and annual reports of the financial activity of the corporation shall be kept at the registered office or principal office of the corporation . . . and shall be available to the public for inspection and copying there during normal business hours.” Based on this provision, a group of persons demanded that a charity turn over documents revealing the identities of donors and the amounts of their annual contributions. The charity resisted this request, claiming that the inspection right provided under the nonprofit corporation law did not refer to inspection or disclosure of donor lists, and even if it did, such a provision would violate the First Amendment freedom of association. The court ruled that the right of inspection did not extend to donor lists. It noted that “the statute does not expressly require that contributors’ identities be made available to the public.” In addition, it found that the intent of the legislature in enacting the inspection right “was not to force nonprofit corporations to identify the exact sources of their income; rather, it was to expose the nature of the expenditures of that money once received from the public and to make nonprofit organizations accountable to their contributors for those expenditures.” As a result, the statute “can be upheld as constitutional when interpreted as not requiring disclosure of contributors’ names.”
- If a state’s nonprofit corporation law does not specifically authorize pastors and board members to inspect individual members’ contribution records, then such a practice could expose the church to possible liability for invasion of privacy. While this risk may be remote, it should not be ignored.
- In the final analysis, the question comes down to the membership requirements in the church’s governing documents. If a church’s bylaws mandate tithing or some other specified amount of financial commitment, then there would be stronger justification for the senior pastor, and possibly the church board, to access individual donor records in order to enforce the membership requirement. Of course, if the church bylaws require a specific financial commitment, and if the pastor or members of the board inspect the contribution records of individual members in order to enforce this requirement, this means that members who fail to satisfy the contribution requirement may need to be suspended or dismissed from the active voting roll. Obviously, this would be a highly controversial action in many churches. Also, in order to determine whether individual members are in fact complying with a contribution requirement, a church would need to have access to members’ tax returns so that an accurate judgment could be made regarding their compliance with the membership requirements. This is the only realistic way this can be enforced. There is no way that a church’s contribution records, by themselves, will indicate compliance with a minimum contribution requirement in most cases.
Few churches would want to make a specified financial commitment a requirement of church membership in light of these consequences and ramifications. And if a specified financial commitment is not a membership requirement, there is little if any justification for the senior pastor or board members having access to members’ contribution records.
Question 16: What should a church do if a “self-employed” minister isn’t filing taxes?
Answer: Unfortunately, this is a common problem for ministers, and the reason is simple— churches are not required to withhold either income taxes or Social Security taxes from the wages of ministers who are performing ministerial services. This is due to the fact that (1) ministers are classified as self-employed by the tax code for Social Security (so they pay the self-employment tax in lieu of having Social Security and Medicare taxes withheld from their wages by their employing church), and (2) the tax code exempts the wages of ministers from income tax withholding.
Unless they elect voluntary tax withholding, ministers are required to prepay their federal income taxes and self-employment taxes using the estimated tax procedure. This requires the minister to estimate income taxes and self-employment taxes for the year and to pay one- fourth of this amount on each of the following four dates: April 15, June 15, September 15, and the following January 15.
The problem is that few seminaries inform ministerial students of their obligation to prepay their taxes using the estimated tax procedure. Many new ministers assume that their church will operate like a secular employer and withhold these taxes. When they realize that nothing is being withheld, they may rationalize their failure to pay taxes or file tax returns (e.g., “Ministers must be exempt from taxes” or “I probably am not earning enough to trigger withholding”). This leads to nonpayment of taxes and, in many cases, failure to file a tax return.
In time, some of these ministers realize that they owe back taxes, but they are unsure how to proceed. Some fear imprisonment. What should be done? Consider the following nine points.
- If a tax return is not filed by the due date (including extensions), a taxpayer may be subject to the “failure to file” penalty unless a reasonable cause
- Taxpayers who did not pay their tax liability in full by the due date of the return (excluding extensions) may also be subject to the “failure to pay” penalty unless reasonable cause
- Interest is charged on taxes not paid by the due Interest is also charged on penalties.
- Ministers who have not filed one or more tax returns should consult with a CPA or tax attorney to determine if taxes were owed and, if so, to discuss
- Taxpayers who owe taxes but are financially unable to pay them may qualify for assistance in making payments through either an installment agreement or an offer in compromise. Discuss these options with your tax
- There is no penalty for failure to file if you are due a refund. But if you want to file a return or otherwise claim a refund, you risk losing a refund altogether. A return claiming a refund would have to be filed within three years of its due date for a refund to be allowed.
- After the expiration of the three-year window, the refund statute prevents the issuance of a refund check and the application of any credits, including overpayments of estimated or withholding taxes, to other tax years that are underpaid.
- The statute of limitations for the IRS to assess and collect any outstanding balances does not start until a return has been filed. In other words, there is no statute of limitations for assessing and collecting the tax if no return has been filed.
- Church leaders should discuss tax filing requirements with every new minister, especially those who are recent seminary graduates. How do they plan to pay their income taxes and self-employment taxes? Through voluntary withholding? The estimated tax procedure? If the latter, provide them with a current copy of IRS Form 1040-ES (including the instructions). This is the form used to compute estimated taxes. It also includes payment vouchers for use with each quarterly tax payment.
Question 17: If a church has lost or deleted its contribution records, what can be done?
Answer: A church contacted me once after their bookkeeper accidentally deleted all of their contribution records on the church’s computer from the past year. The church feared that donors would not be able to deduct contributions they made to the church. If this happens to you, here’s what you can do:
- First, have a computer technician examine your computer to see if the contribution records can be recovered. This is often
- The good news is that most members will not be directly Here’s why:
- Only 30 percent of taxpayers itemize deductions on Schedule A, so 70 percent get no tax benefit from making charitable contributions (these persons are not affected by the church’s loss of giving records).
- Donors can substantiate individual cash contributions of less than $250 with
- a bank record (a statement from a financial institution, an electronic fund transfer receipt, a canceled check, a scanned image of both sides of a canceled check obtained from a bank website, or a credit card statement) showing the charity’s name, date of the contribution, and amount of the contribution or
- a written communication (including “electronic mail correspondence”) from the charity showing the charity’s name, date of the contribution, and amount of the contribution. Many donors make contributions by check, and they will have a bank record that can be used to substantiate their contributions of less than $250. Also, note that many churches provide written acknowledgments to donors on a periodic basis (i.e., quarterly) that provide a summary of their These records can be used by donors to support at least a partial charitable contribution deduction if the church’s contribution records are inadvertently deleted.
- Individual contributions of $250 or more must be substantiated with a written acknowledgment from the church that meets certain requirements. Canceled checks or other bank records may not be used. Many churches provide donors with contribution summaries periodically (i.e., quarterly) that, in some cases, can be used to support at least a partial charitable contribution deduction if the church’s contribution records are inadvertently This assumes that a written acknowledgment can be constructed that meets the requirements of the tax code.
- If a church inadvertently loses its records through a computer mistake, natural disaster, fire, etc., the IRS permits the amount of a deduction to be reconstructed by any reasonable means. This means that in some cases, periodic contribution statements for a portion of the year can be used to reconstruct a reasonable estimate of annual contributions.
- Only 1 percent of individual tax returns are audited by the IRS, so the chances of someone in your church having his or her tax return selected for audit is very low. Even if a member’s return is audited, the audit may address issues other than charitable contributions.
- In the future, be sure to regularly back up data and store copies at an off-site location.
Question 18: When are credit card donations receiptable—on the date the charge is made, on the date the donor pays the credit card statement, or some other date?
Answer: The IRS addressed this question for the first time in a 1971 revenue ruling in which it concluded that a taxpayer who used a bank credit card to contribute to a qualified charity could not deduct any part of the contribution until the year the cardholder made payment of the amount of the contribution to the bank (Revenue Ruling 71-216). The IRS concluded that a charitable contribution made by a taxpayer using a credit card was tantamount to a charitable contribution made by the issuance and delivery of a promissory note by the donor to a charitable organization and, therefore, represented a mere promise to pay at some future date that was not currently deductible.
The IRS reconsidered this question in a 1978 ruling in which it revoked its earlier ruling. It concluded:
Upon further study, it has been concluded that there are major distinctions between contributions made by the use of credit cards and contributions made by promissory notes. . . . A credit card holder . . . by using the credit card to make the contribution, becomes immediately indebted to a third party (the bank) in such a way that the cardholder cannot thereafter prevent the charitable organization from receiving payment. . . . Since the cardholder’s use of the credit card creates the cardholder’s own debt to a third party, the use of a bank credit card to make a charitable contribution is equivalent to the use of borrowed funds to make a contribution.
The general rule is that when a deductible payment is made with borrowed money, the deduction is not postponed until the year in which the borrowed money is repaid. Such expenses must be deducted in the year they are paid and not when the loans are repaid. Accordingly, a taxpayer discussed who makes a contribution to a qualified charity by a charge to the taxpayer’s bank credit card is entitled to a charitable contribution deduction in the year the charge was made and the deduction may not be postponed until the taxpayer pays the indebtedness resulting from such charge.
The current edition of IRS Publication 526 (“Charitable Contributions”) confirms this conclusion by noting that “contributions charged on a donor’s bank credit card are deductible in the year the donor makes the charge.”
Of course, in order to substantiate a charitable contribution, a donor must maintain adequate records to show that the contribution was made. For contributions by credit cards, which are considered similar to a cash contribution, you must keep the credit card statement that shows the name of the charitable organization, the amount of the contribution, and the date of the contribution. Additional requirements apply to any individual charitable contribution (including by credit card) of $250 or more. Generally, these contributions can be substantiated only with a written acknowledgment from the donee charity that meets certain requirements.
Question 19: Should unpaid credit card charges be listed as taxable income on a minister’s W-2?
Answer: A church contacted me once to find out what to do about the unpaid balance on their pastor’s church-issued credit card. The church board had agreed to provide the pastor with a credit card in the church’s name because his credit rating was too poor for him to obtain one on his own. They did this with the understanding that the pastor would be using the card for mostly personal expenses and that he would reimburse the church for the charges he made. During the previous year, he had made $6,000 in charges to the card but had only paid back about half of this. The church didn’t know what to do. Should they cancel the card? Was it in- appropriate to issue the pastor a credit card in the church’s name for mostly personal expenses? How much of the charges, if any, should the church report as taxable income on the minister’s W-2?
Here are the points I shared with them:
- One of the requirements for exemption from federal income tax is that none of a church’s funds or assets inures to the benefit of a private individual other than as reasonable compensation for services. Inurement may occur in many ways, including excessive compensation, payment of excessive rent, receipt of less than fair market value in sales or exchanges of property, inadequately secured loans, and the payment of personal expenses of an officer that the church did not characterize as compensation at the time of payment. It is possible that your pastor’s use of a church credit card for his own personal needs and expenses constitutes inurement, especially if he fails to reimburse the church for all personal charges. This exposes the church to loss of its tax-exempt status.
- Excess The IRS deems any taxable fringe benefit provided to an officer or director of a tax-exempt charity (including a church), or a relative of such a person, to be an automatic excess benefit that may trigger substantial excise taxes (called “intermediate sanctions”) of up to 225 percent of the amount of the benefit unless it was timely reported as taxable income by the charity. A nonaccountable expense reimbursement is an example of a taxable fringe benefit. As a result, to the extent that a pastor uses a church credit card for some business expenses and fails to comply with the strict requirements for an accountable reimbursement arrangement, those charges constitute nonaccountable reimbursements. If the church fails to report them as taxable income on the pastor’s W-2 form, then this amounts to a taxable fringe benefit that was not reported as taxable income, thereby exposing the pastor to intermediate sanctions, assuming that he or she is an officer or director of the church. The penalty may be avoided if the pastor reports the benefit as taxable income, but this rarely happens if the church fails to do so.
- Nonaccountable reimbursement. As noted above, a nonaccountable expense reimbursement represents taxable income to the employee. A reimbursement (including a charge to an employer’s credit card) is nonaccountable if it fails to meet all of the following requirements for an accountable plan: (1) only business expenses are reimbursed; (2) no reimbursement is allowed without an adequate accounting of expenses within a reason- able period of time (not more than 60 days after an expense in incurred); (3) any excess reimbursement or allowance must be returned to the employer within a reasonable period of time (not more than 120 days after an excess reimbursement is paid); and
(4) an employer’s reimbursements must come out of the employer’s funds and not by reducing the employee’s salary.
The fact that the pastor fails to return to the church all credit card charges (“reimbursements”) over and above substantiated business expenses within 120 days renders them nonaccountable.
- Risk management. The best practice would be for a church not to provide a credit card to employees who, for whatever reason, are unable to obtain a card on their own. Such an arrangement may constitute prohibited inurement of church funds to a private individual, even if all charges are properly reported as taxable income, since the employee in effect is converting a church resource into a personal benefit.
In most cases, churches provide credit cards to employees as a convenient way to reimburse them for business expenses they incur (travel, meals, church equipment, etc.). So long as a card is used primarily for business expenses and the employee substantiates all charges on a timely basis under an accountable arrangement, reimbursing the church within 120 days for any incidental personal expenses, there are no problems.
To protect against abuses, church leaders should consider the following precautions:
- Be sure your church has implemented an accountable reimbursement pol- icy that only reimburses credit card charges that are adequately substantiated within 60 days of each expense and that requires the refund of any personal charges within 120 days.
- Nonaccountable reimbursements (those not fully complying with the requirements of an accountable plan) must be reported as taxable income by the church.
- Consider inserting “merchant category codes” on church-issued credit cards that prevent the cards from being used at specified locations or with designated vendors or facilities (e.g., ATM machines, salons, drug stores, clothing stores, etc.). Most employers, including churches, are not aware of this option.
- Impose low spending limits on each card. After all, why would a church want a $20,000 limit on a card that is to be used for reimbursement of business travel, meals, lodging, and miscellaneous business expenses?
- Adopt a written policy for the use of church credit cards that fully explains how they may be used, the limitations and conditions that apply, and potential tax consequences. The lack of such a policy often leads to abuse. Be sure that your policy applies to all employees who use church credit cards. Don’t exclude the senior pastor.
- Restrict the use of church credit cards to those employees with a legitimate need to charge purchases. Not all employees need access to a church credit card.
- Issuing a separate church credit card to each approved employee makes it easier to account for individual employee’s charges and to enforce purchase limits.
Question 20: When dismissing an employee, how much severance pay should a church give?
Answer. That’s entirely up to you. There are no definitive standards. The amount of severance pay is often expressed in terms of a specified number of weeks of salary and benefits. It should be discussed openly with the employee, and a mutually acceptable number of weeks should be chosen. Higher paid employees will receive greater severance benefits because of their higher rate of pay. Other important factors to consider include the following:
- Whether the employee is a member of a protected class under an applicable state or federal discrimination law. If so, be prepared to agree to a higher amount in order to avoid a possible discrimination claim under state or federal law that could result in a protracted legal dispute.
- The likelihood the employee would pursue a legal claim against the church.
- Whether the church has employment practices insurance coverage that would provide a legal defense and indemnification in the event of a lawsuit. Many churches do not have insurance for employment practices, meaning that the church would be responsible for retaining and compensating its own attorney in the event of a claim of discrimination. In some cases, this can result in a substantial and unbudgeted expense to the church.
- The results of the employee’s last several job performance evaluations. If they are all average or above average, this is a strong incentive to resolve any potential claims by entering into a severance agreement. If a severance agreement is not signed and the employee sues the church, those average or above-average job evaluations will be compelling evidence that the church did not have any job-related reason for dismissing the employee. The implication is that the church’s decision to terminate the employee was a product of unlawful discrimination.
- Congress added section 409A to the tax code in 2004 in response to public outrage over the Enron scandal. Section 409A imposes strict new requirements on most non- qualified deferred compensation plans (NQDPs). In 2007, the IRS published final regulations interpreting section 409A. The final regulations define an NQDP broadly to include any plan that provides for the deferral of compensation. This definition is broad enough to include severance agreements and many other kinds of church compensation arrangements. Any church that is considering a severance agreement with a current employee (or any other arrangement that defers compensation to a future year) should contact an attorney to have the arrangement reviewed to ensure compliance with both section 409A and the final regulations. Such a review will protect against the substantial penalties the IRS can assess for noncompliance. It also will help clarify whether a deferred compensation arrangement is a viable option in light of the limitations imposed by section 409A and the final regulations.
- Of course, it is important for an attorney to draft any severance agreement to be sure that it will be legally enforceable and complies with all applicable laws.