Doc 2006-3964 (6 pgs)
Author: Raby, Burgess J.W.;
Raby, William L., Tax Analysts
The government may not, as a general proposition, subsidize any
specific religions, because that would violate the constitutional
prohibition against separation of church and state. But the Constitution
is not interpreted so as to prohibit tax breaks for members of the
clergy, regardless of their denomination, or even to religious 1
organizations themselves, again without regard to denomination.
Christian, Jew, Muslim, Buddhist, Christian Scientist, Scientologist -it matters not. The ordination received by mail after little or no study
is as fully recognized by the tax collector as is the one received after
theological training at Princeton or Harvard. But there are limits -and taxpayers regularly test how far they will stretch.
Tax Break but No Double Dipping
Johnny J. Young et ux. v. Commissioner, T.C. Summ. Op. 2005-76,
Doc 2005-12448, 2005 TNT 109-14, dealt with whether the Rev. Young had
to allocate what otherwise would be expenses fully deductible on
Schedule C between those related to his taxable self-employment income
and his excludable parsonage allowance for income tax purposes, and
whether he had to make the same allocation for self-employment tax
purposes. Of $78,000 paid to him as senior pastor of the Church of God
Pentecostal Inc., Inglewood, Calif., for the year 2000, the church had
allocated $36,000 as actual salary and $42,000 as Young’s housing
allowance. Young also had $21,438 of self-employment income from his
ministry (including such things as honorariums for weddings and
funerals). He reported $24,982 as his ministry expenses on Schedule C,
the self-employment schedule.
Section 265(a)(1) disallows deductions to the extent that expenses
are allocable -- directly or indirectly -- to a class of income wholly
exempt from tax. The parsonage allowance of section 107 was such a class
of exempt income. As the IRS saw the situation, Young received both a
tax-exempt parsonage allowance and taxable income from his only incomeproducing activity, the exercise of his ministry. Therefore, contended
the IRS, the ministry expenses needed to be allocated between Schedule
C, the business schedule, and Schedule A, the schedule of itemized
deductions, for income tax purposes. Young, for his part, thought that
the mere fact that part of his “salary” was excludable from income
should not result in his losing the tax benefit of his business
deductions. After all, the IRS didn’t disallow his tax deductions for
either his real estate taxes on his personal residence or his mortgage
interest on that same residence even though the concept of a parsonage
allowance was that it was designed to cover those occupancy costs.
Allocation between this and that requires some rational basis for
making an allocation. Tax Court Special Trial Judge John F. Dean noted
that “petitioners have failed to provide evidence that would allow the
Court to determine which of his ministry activities generated which
expenses.” The IRS had dealt with the allocation by calculating the
1
See, e.g., Frazer, Douglas H., “The Clergy, the
Constitution, and the Unbeatable Double Dip: The Strange
Case of the Tax Code's Parsonage Allowance,” Doc 2004-3859,
2004 TNT 38-64.
(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
The Clergy and the Tax Collector
Doc 2006-3964 (6 pgs)
Self-Employment Tax Is Different
For self-employment tax purposes, the calculation works
differently. The housing allowance paid to Young might be excludable
from the income tax base under section 107, but it needed to be added
back under section 1402(a)(8) to calculate the self-employment income
tax.
However, while the housing allowance is part of the tax base, the
deductions allowed in calculating self-employment income for section
1402 purposes are only those “allowed by Chapter 1 of the Code.” The
disallowance of the $10,492 occurred under section 265, part of Chapter
1 of the code. Thus, the $10,522 was not only subject to regular income
tax but also to self-employment tax, giving the IRS a type of double-dip
disallowance.
Young argued, however, that as clergy, he owed no self-employment
tax. It’s true, admitted Judge Dean, that “section 1402(e) exempts from
the self-employment tax the self-employment income of certain ministers
and others.” The problem was that the application for that exemption had
to be filed no later than the due date for the second tax year for which
Young had net earnings from self-employment of at least $400, any part
of which was from services as a minister. Young had had ministry selfemployment income of over $2,400 in every year since 1992, which meant
that the application (Form 4361) was due no later than when his 1993
return was due. However, he never filed an application for exemption
until the issue came up in connection with the IRS examination of his
2
2000 return. Thus, he was subject to the full self-employment tax.
‘Gifts’ vs. Compensation
Over and above what he was paid by the church, as mentioned above,
Young reported $21,438 of income from the exercise of his ministry. The
case itself contained no details, but we assume that this income
included the customary honoraria given clergy for solemnizing weddings,
officiating at funeral services, and serving as an after-dinner speaker,
and it possibly included individual gifts from church members or special
collections that might have been taken up in the church as “love
offerings.” Church contracts with the clergy often include a clause such
as the following regarding honoraria:
Ministers often receive honoraria for pastoral services. While we
recommend against ministers soliciting any fees or gratuities from
members, any such unsolicited fees or honoraria are the sole
property of the minister.
Those all tend to be small amounts individually, but can aggregate
thousands of dollars in the course of a year. There are no information
returns filed on those payments, so, for all we know, they may be
significantly underreported. That may be due to the rather vague
2
A parsonage allowance received by a retired clergyperson
is not subject to self-employment tax.
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percent of the exempt income to the total ministry income, which was
certainly a rational approach. But Judge Dean implied that if the
expenses had all related to the $21,438 of income that was not from his
church salary, the full amount might have been allowable as a Schedule C
deduction. As it was, the $21,438 was 22 percent of Rev. Young’s $99,438
of total ministry income. The result was a Schedule C deduction for only
22 percent of $24,982, or $5,496. The remaining $19,486 was then
allocated between the taxable and the exempt portion of the church
income, resulting in 42/78, or $10,492, being rendered nondeductible.
Doc 2006-3964 (6 pgs)
Hubert Swaringer, et. ux v. Commissioner, T.C. Summ. Op. 2001-37,
Doc 2001-8553, 2001 TNT 57-10, illustrated that confusion. Swaringer was
compensated solely through collections from the congregation. He
reported $28,600 as income from the United House of Prayer for All
People on his 1995 Schedule C, although no record was kept by either the
church or the pastor of the offerings that he received. The IRS analyzed
his bank deposits and came up with unexplained deposits of $24,316.
Swaringer explained that most of that was money his parishioners gave
him as gifts on such occasions as his birthday, Father's Day, and
Christmas. He pointed out that everyone knew that gifts were not taxable
income.
Tax Court Special Trial Judge Carleton D. Powell didn’t disagree
with that proposition. "The fundamental problem with petitioners' case,"
he said, "is that we have no evidence as to the dominant reason for the
transfers. Instead, all we have is petitioner's characterization of the
transfers as gifts, which in itself has little or no evidentiary value.”
Judge Powell speculated that the gifts were made because the
parishioners believed Swaringer to be "a good minister" whom they wanted
to reward. "Furthermore," he added, "petitioner testified that without
the gifts his activity as a minister was essentially a money losing
activity.” From that, Judge Powell concluded that "the so-called gifts
were a part of the compensation he received for being a minister. As
such, the transfers are not excludable from income under section
102(a).” Not only were they not excludable from income but the IRS
imposition of a negligence penalty was sustained. After all, commented
Judge Powell, "there is no indication that petitioners sought the advice
of a qualified tax advisor."
’Love Offerings’ and Tax Fraud
The Rev. Fred Snowden served as business manager of the Riverdale
Baptist Church of Largo, Md., in 1977 through 1979, when Riverdale
Baptist was erecting a church building. Snowden received a salary of
$12,710.25 in 1977 and $13,000 in 1978 and 1979. He also received
$80,000 in kickbacks from the company supervising the church
construction.
Indicted for mail fraud and tax fraud after a church investigating
committee uncovered his scheme, Snowden argued that the payments he
received were a series of legitimate love offerings to a minister of the
Gospel. The jury didn’t believe him. He appealed his conviction. In U.S.
v. Snowden, 770 F.2d 393, 85 TNT 165-44 (4th Cir. 1985), Snowden argued
that the First Amendment somehow protected him because the victim of his
theft was a church. "The Free Exercise clause of the First Amendment is
to be used as a shield to protect persons in the free exercise of their
religion," explained the appeals court, rejecting his claim. "Here the
defendants seek to use the clause as a sword against the victim, the
church. Under the defendants' theory the church would be stripped of the
law's protection."
As to the claim that the kickbacks were a "love offering," the
appeals court noted that the checks to Snowden, with one exception, were
claimed as business expense deductions by the construction supervisor
and treated neither as gifts nor as charitable contributions. One
appeals judge, in a concurring opinion, delved deeper and commented that
it was proper for the district court judge to permit the jury to
determine whether the payments were intended "to be as 'love offerings'
under Baptist church doctrine or as 'kickbacks' in a scheme to defraud
the church. Such an inquiry is proper under First Amendment analysis
since, 'although the validity of religious beliefs cannot be questioned,
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distinction between what is compensation and what is a gift that doesn’t
constitute taxable income to the recipient.
Doc 2006-3964 (6 pgs)
Tax Shelter Vehicle
Two years ago, the IRS issued IR-2004-42, Doc 2004-6917, 2004 TNT
61-17, a consumer alert warning taxpayers against a scheme in which the
concept of “corporations sole” was being distorted “to take advantage of
special tax benefits available to legitimate religious groups and church
leaders.” The notice explained that “the IRS has seen signs the scam
could be starting to spread with multiple cases seen recently in states
such as Utah and Washington.”
As promised in the notice, the IRS pursued the promoters as well
as the participants. The day the IRS issued the notice, it filed suits
in federal courts in California, Colorado, Oklahoma, Missouri, and North
Carolina against the lead promoter, Joseph O. Saladino, and others who
worked with him in marketing the corporation sole idea and assisting
taxpayers in implementing it. The most important of those cases was
probably United States v. Joseph O. Saladino et al., No. 04-cv-2100 FMC
(JWJx), Doc 2005-1846, 2005 TNT 19-12(C.C. Ca. June 20, 2005). In that
case, the IRS sought a permanent injunction against Joseph O. Saladino,
both individually and dba Freedom and Privacy Committee (FPC).
Saladino had set up a multilevel marketing organization.
Subpromoters purchased packages containing forms and instructions from
Saladino and FPC and resold those packages to participating taxpayers.
The participating taxpayers were in turn recruited to become
subpromoters themselves and further market the scheme.
The “corporation sole” package sold for $2,295. It was represented
as a means to evade the reporting and payment of federal income taxes
and as a way to conceal assets from both creditors and the reach of IRS
gift and estate taxes. In her findings of fact, U.S. District Court
Judge Florence-Marie Cooper found that:
Saladino falsely or fraudulently advises participants that they
can treat their corporations sole as a “church” with no tax return
filing requirement, and yet can control and use the assets and
income of the corporation sole for their own personal benefit. FPC
promotional material states that “this product will position you
to have full-time ministry which is tax free.” Saladino advises
participants that corporations sole that are used for the
participants’ personal benefit are tax exempt, do not need to file
tax returns of any kind, and do not need to keep records. Saladino
also falsely states that a corporation sole’s church status cannot
be challenged by the Government. . . . [P]articipants can make
donations to their corporations sole and then deduct the donations
on the participants’ federal income tax return (in the event
returns are filed), even though the entities are owned and
controlled by the participants. . . . [A] participant who becomes
the “minister” or “overseer” of the corporation sole and takes a
vow of poverty can assign his income to the corporation sole and
thereby transform taxable individual income into nontaxable income
of the corporation sole. According to Saladino, “Once you declare
your pauper status, your income is tax-free to you and your assets
cannot be encumbered with a property tax.”. . . . [A] corporation
sole can be engaged in any occupation business or profession, and
. . . all earnings therefrom are tax exempt.
Based on those findings, Judge Cooper issued the permanent
injunction sought by the government. It covered “Joseph O. Saladino,
individually and doing business as Freedom & Privacy Committee, or as
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the sincerity of the person claiming to hold such beliefs can be
examined.’" The jury’s finding that the payments were not "love
offerings" thus did not violate the First Amendment, he concluded.
Doc 2006-3964 (6 pgs)
Inurement
Merely creating a church on paper is not a free lunch featuring
tax benefits, of course, contrary to Saladino’s teachings. To be treated
as a church for tax purposes requires that there actually be activity
typical of church activity and that the net income of the church not
inure to the benefit of one or more private individuals. The inurement
issue is illustrated by Unitary Mission Church of Long Island v.
Commissioner, 74 T.C. 507 (1980), aff'd without published opinion, 647
F.2d 163 (2d Cir. 1981).
The teaching of the church was peace, salvation, and freedom
within one's self and soul. Noble goals, but the IRS suspected that
saving taxes and freedom from the IRS also were major, albeit unstated,
objectives. The church's place of worship was the ground floor of
Kenneth Bucher's home in Wantagh, N.Y. Its income over the three years
the court reviewed consisted of $140,000 of contributions, of which 74
percent came from Bucher and 15 percent from its other two ordained
ministers.
Unitary Mission Church's expenses included parsonage allowances to
Bucher and its other two clergy. For the other two ministers, the
parsonage allowances approximated their contributions to the church. At
least $22,000 went for permanent improvements to and maintenance of the
"parsonage," which was the ground floor of the Bucher residence. Loans
were made to Bucher's employer. All this, contended the IRS, was private
inurement. The IRS also pointed out that Bucher was employed full-time
as the manager of an appraisal company and that his "services" for the
church appeared to consist merely of a Sunday sermon followed by a
discussion and a Wednesday meeting for study and meditation, all of
which were conducted in his own living room and attended mainly by his
own family. While Bucher claimed to do pastoral counseling, nothing in
the record provided independent support for that claim.
The church asserted that the First Amendment to the Constitution
prevented both the IRS and the Tax Court from inquiring into the
reasonableness of the parsonage allowances, maintenance expenditures, or
the actual extent of the church activities. The IRS disagreed and the
Tax Court adopted its thinking.
"As long as an exemption is denied without an inquiry into the
merits of religious beliefs, the denial is constitutionally
permissible," wrote the court. The court concluded that "regardless of
who has the burden of proof in this case, we find the evidence clearly
shows that a part of petitioner's net earnings inures to the benefit of
private shareholders or individuals.” Nothing more was needed to deny
the church its tax exemption.
Conclusion
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any other entity, and his representatives, agents, servants, employees,
attorneys, and those persons in active concern or participation with
him, including his distributors.” In addition to all the things Saladino
et al. were enjoined from ever doing (such as “engaging in any conduct
that interferes with the administration and enforcement of the internal
revenue laws by the Internal Revenue Service”), Saladino was also
ordered, at his own expense, to contact by mail everyone who had
previously purchased any of his abusive tax shelters, plans,
arrangements, or programs and inform them of the court’s findings as to
the falsity of his prior representations and furnish them with a copy of
the permanent injunction order. He and all those involved with him were
also instructed to display on the first page of their Web sites for a
period of one year a complete copy of the court’s injunction order.
Doc 2006-3964 (6 pgs)
For the tax practitioner who may have a client who is intrigued by
the siren song of corporations sole or by the fact that “gifts” are not
taxable income, the “SSS cases” of Saladino, Swaringer, and Snowden, as
appropriate, provide relevant war stories that should be sufficient to
dissuade most clients from wanting to proceed further with their Church
of Tax Avoidance. If a client wants to follow in the footsteps of the
SSS cases, the practitioner is well advised to terminate any
professional relationship. If the tax practitioner should perchance
encounter a client or potential client who claims exemption as a church,
it might be well to review with that client the story of Kenneth Bucher
and the Unitary Mission Church of Long Island.
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For clergy, the tax law actually may offer the proverbial free
lunch, even though common sense would tell us there is no such thing.
The price for obtaining the maximum tax benefit from the parsonage
allowance, for example, is the need to keep sufficient records so as to
allocate the clergyperson’s business expenses between nontaxable revenue
(the parsonage allowance) and taxable revenue (everything else), as well
as between Schedules C and A. Tax practitioners advising or doing
returns for clergy should heed Judge Dean’s advice in the Young case
about minimizing the degree to which the tax exemption accorded the
parsonage allowance affects the nondeductibility of the clergyperson’s
business expenses. Which activities generated what expenses? The goal is
to minimize the expenses attributable to the parsonage allowance and
maximize the expenses attributable to the other income of the
clergyperson. Each $10,000 of deduction disallowance avoided can save
the clergyperson in a 25 percent marginal federal income tax bracket,
who also will have 15.3 percent self-employment tax and a possible state
income tax of 5 percent, a total of $4,530.