SURVIVING AN IRS AUDIT: PART 3
J. M. MONTGOMERY
HOW TO DEAL WITH DEFERRED COMPENSATION AND DESIGNATED GIFTS
The subject of gifts has caused much confusion. Are designated gifts deductible? Are gifts given directly to the pastor taxable to him? These are just two of the questions addressed in this chapter.
Are They Deductible?
First, let us approach the most difficult problem of designated gifts: Are they deductible? Section 170(c) of the Internal Revenue Code defines a deductible contribution or gift as one made to or for the use of certain types of organizations and entities. Notice the phrase “to or for the use of. ” By this definition, gifts to a needy individual, even though actuated by charitable or religious motives, are not deductible.
Often a person entering the ministry, particularly one who is leaving for the mission field, will discuss both congregations and individuals the possibility of receiving support for his ministry. When the check is made out directly to the person, it is not “to or for the use of” the exempt organization and is not a tax-deductible contribution.
What about a check made payable to an exempt organization but designated for a particular individual? The donor still may have a problem in this situation because the IRS contends that in order for a contribution to be deductible the donation or gift must be made to an exempt organization which must “maintain control and responsibility” for the funds.” If the donor has the right to determine where and to whom the funds go, then it is obvious that the exempt organization does not “maintain control and responsibility” for the funds, and the contribution is not considered to be deductible.
Since church schools are becoming increasingly popular, a new area of concern regarding deductibility of gifts is arising. When a donor has children in the church school, his contribution to the church may be suspect in the eyes of the IRS, particularly if the church school does not charge tuition. Why? A gift, to be deductible, must be given without the incentive of anticipated benefits. Thus a gift made to a church, where the donor has children in a free day school may be deductible only to the extent that it exceeds the fair market value of the schooling. Even if the church does not put a price tag on the education, the IRS might.
In order for designated gifts to be deductible, the contributor must be made aware that the contribution is made to the exempt organization and not to the designee. The exempt organization must control the funds. The exempt organization cannot honor contributions as deductible where the donor appears to have a personal interest in the contribution.
Let us look at the position the IRS auditor will take in relation to designated giving. During an audit he will ask if the organization has a written policy regarding designated contributions. The policy should state that the ultimate control of the designated funds rests with the exempt organization. The auditor also will inquire as to whether the stated policy has been communicated to the donors. He more than likely will inquire about specific designated gifts, and he will make a thorough analysis of the manner in which these specific gifts were handled. If the donor is being audited, the exempt organization will be asked to furnish pertinent information and documentation regarding the gift in question.
In a recent seminar I picked up an offering envelope from the back of the pew. I was impressed with a sentence on the bottom of the envelope and would recommend it to you: “Note: In order to conform to IRS regulations, all tax-deductible gifts are under the direction and control of [name of church]. ” This statement on the envelope, as well as on the letter or statement sent to contributors, will go a long way toward satisfying the requirements of the IRS.
Gifts to Pastors
Because the pastor loves his flock and the flock loves the pastor, they show their love be giving gifts to him. The gifts can take many forms: from gifts of little financial value to Large items, such as cars, pianos, and vacations. In many cases the person who helps the pastor with his tax return might forget to ask about gifts. The gifts may be from the congregation for his birthday or Christmas, or it may be a love gift from an individual member of the congregation. In most cases, these gifts are considered to be income, and this income is taxable.
Let me quote from Commerce Clearing House (Code Section 61):
All compensation for personal services, regardless of the form of payment, is gross income when received,… marriage fees and contributions received by clergymen (unless turned over to the church) are all taxable forms of payment for personal services. A pastor’s work, by its very nature qualifies him in the eyes of the code, under “compensation for personal services.” A bequest which is actually payment for a taxpayer’s services prior to the decedent’s death, is includable in gross income (Revenue Ruling 67-375, 1967-2, CB60).
For most taxpayers, a gift is a gift and is not taxed (unless the gift is larger than $10,000). However, the clergyman is considered to be rendering personal services any time he is dealing with his congregation, individually or as a group. It is an area of taxation that has many gray areas within it. Next tax season I hope you will discuss this subject with your tax preparer. You bring up the subject, even if he does not. Remember, at audit time it is you who answers to the IRS.
Love Gifts and Merchandising
I would be remiss if I did not touch on one more problem area before leaving this discussion of gifts. We all have received letters or publications that include a statement similar to the following: For your gift of $25 or more, we will send you a love gift in return-a red letter, giant print Bible valued at $29. 95. Or the offer may be a Living New Testament on tape. In some cases, the gift you receive will be dependent upon the size of the gift you send. For example, for your gift of $5, they will send you a book valued at $2.95; for your gift of $100, you will receive a tape recorder valued at $69.95; and for your gift of $1,000 they will make you a gift of a video recorder valued at $895. Does this sound like merchandising to you?
We must see what the IRS has to say about gifts in return for contributions. The IRS takes the position that the amount of deduction that is allowed is the amount in excess of the fair market value of the item received. This being the case, it would seem that if I sent $25 to an exempt organization, and they sent me a Bible “worth $29. 95, ” I would not be eligible for a deduction. If I am honest, didn’t I really just buy the Bible?
If I bought the book, Bible, or tapes at the store, would I be able to claim a deduction? How do you think the owner of the local TV store would react if he knew that you could buy a video recorder from a “religious organization” and receive a tax deduction? He must compete and pay taxes. This sort of thing is not a good witness, and it is in violation of the Internal Revenue Code.
There is a way to handle this type of situation. Let me give you an illustration of how the Center for Law and Religious Freedom handles its contributions. On the back of its information brochure, you will find an application for membership which reads in part:
Please enroll me as a member of the Center Lay division. Enclosed are my annual dues of $15 ($5
of the dues covers a subscription to The Advocate and the remainder and all other gifts are fully tax deductible).
I highly recommend this type of statement.
Churches and other exempt organizations, which hold banquets for fund raising or sell Christmas trees or other items, need to discuss the subject with a qualified tax adviser.
We need to improve our witness to the world. When you hear or see this sort of thing, inform the offending organization of the law, give them the facts in love, and let them know it concerns you.
Most of us save some of our money, but do we save to save, or do we save to spend? During my last fifteen years as a financial counselor I have made an interesting observation: Most people have been taught some form of thrift by their elders. Most consider it important to save.
Save to Save or Save to Spend?
There are all kinds of savings concepts: Christmas clubs; mutual fund clubs; saving 10 percent of all you earn; setting aside a certain percentage of your dollars first before paying the bills; and starting a savings account for Junior, etc. I am sure we have all tried to save, using one or more of the above systems. In most cases, we save a little; then something happens to our good intentions, and less and less goes into savings until one day we are not saving anything. At that point, we generally decide to start
a new plan. We rationalize, “We might as well use the money we have managed to save. Besides, we need a new TV set.” So, we withdraw what we have saved and we reaffirm our good intentions by starting a new plan.
The problem is: Many people save to spend, but few save to save. Most of us save, but few accumulate for the future.
Let me introduce Pastor I. Savem for this illustration. He receives a fixed salary from a church. He has a wife, two children, and a salary sufficient to provide a comfortable living. Each year Pastor and his wife make definite plans to save some of their income, realizing that there will come a day when they may want to retire. They have watched others try to retire on just Social Security, and they have seen that it is just not enough to provide a comfortable living. They are aware that college costs are rising higher and higher. They want at least to help the children when it is time for college. All of this takes savings, and the Savems have not really put anything aside so far.
The Savems determine that this will be the year they start saving for retirement. So they visit their bank to open a savings account. The pastor compares the different types of accounts and finds that, if he is saving to spend, a passbook account is the easiest way to go. He may put money in and take it out at will, with no strings attached. The passbook account pays less interest than a Certificate of Deposit; however, a CD does not allow him to take money out except at the end of a specified time, unless he wishes to pay a penalty. The CD sounds a bit more like saving to save, and so he opens a five-year Certificate of Deposit account. Pastor deposits $1, 000 into this account and promises himself that he will continue to save at least $100 every two weeks from now on. Savem feels good on the way home. At last he has really started his savings plan.
Now let us look at Savem’s budget and see how hard it
was to save that thousand dollars. Rather than list each
item in his budget, we will only list the major headings.
a. Rent or mortgage payment $350
(including tax and insurance)
b. Maintenance 20
c. Utilities 50
d. Furniture replacement 10
e. Miscellaneous (e.g., personal phone) 20
a. Groceries 250
b. Outside meals (not reimbursed) 20
a. Dry Cleaning 10
b. Replacement and repair 25
a. Doctor 10
b. Dentist 10
c. Medical and disability insurance 65
d. Medications 10
a. Car payments (or purchase fund) 90
(church furnishes one car)
b. Car insurance 15
c. License 7
d. Maintenance and repairs 10
e. Gasoline and oil 50
f. Other (bus, taxi) 5
6. RECREATION AND PERSONAL GROWTH
a. Local recreation (movies, etc. ) 30
b. Family vacation 50
c. Books, newspaper, and magazines 10
d. Club dues and hobbies 10
e. Education expense or savings 25
f. Children’s pocket money 8
g. Gifts: holiday, birthday, etc. 10
a. Church 100
b. Missions 25
a. Income (federal and state) 150
a. Personal savings 200
b. Mutual funds
c. Life insurance 30
d. Other investments
a. Credit card payments 10
b. Installment payments 15
c. Large account payments 40
d. Personal Loan payments
e. Other, including pledges 95
As we can see, the pastor does not live extravagantly, nor has he taken any emergency into account. Pastor Savem receives the following income:
$1500 a month salary
$ 325 a month parsonage allowance
auto fuel and maintenance reimbursement
telephone reimbursement (except personal calls)
With expenses of $1835 he appears to have almost enough to meet his obligations. It isn’t difficult to find holes or low areas in his budget. But at least Pastor Savem has budgeted the $200 he promised would go to savings. How long do you think he will continue to save It is very possible that the first emergency situation that rises will end the savings plan of Pastor Savem.
Now let me reintroduce Rev. E. Van Gelizer and present a new set of circumstances. We will use exactly the same conditions with regard to the number of children, budgeted amounts, and savings. The board of directors of his church realizes that it is difficult for anyone to save money in today’s economy with its rising costs. The board members have a strong desire to have Rev. Van Gelizer continue as their pastor, and so they pass a resolution that gives Rev. Van Gelizer an employment agreement. The agreement spells out such things as car allowance, parsonage allowance, medical expense reimbursements for his family, and a deferred compensation agreement that sets aside funds for his later years. Their concern also includes the possibility that Rev. Van Gelizer could become disabled and not be able to perform his duties (insurance industry publications indicate one in five persons will become disabled). The board also knows that in the event of his premature death, his family will face difficult times; therefore, the agreement includes a death benefit.
Let us examine the deferred compensation agreement. Rev. Van Gelizer, like Pastor Savem, would like to save at least $200 a month. In the past, he has attempted to start a savings plan many times, and he has yet to accumulate very much. His problem is typical; something always comes along that causes him to abort his plan. Realizing how hard saving is for him, the board members decide to Look at what secular businesses do for their key employees.
Businesses have discovered that certain employees do not really need more salary income now because it would just mean higher personal income taxes. What employees need is a plan that will allow them to accumulate money that will not be taxed until sometime later, when their income and taxes are not so high. They also would like this accumulating money to grow. Well, if it is good for businesses why not for pastors?
The board, with the help of counsel draws up a deferred compensation agreement in conjunction with the employment agreement. The deferred compensation agreement states that the church (a tax-exempt, non-profit organization) will provide for Rev. Van Gelizer an amount to be deposited monthly and held by a bank or other investment medium. The funds will remain an asset of the church and are deposited on the condition that he will stay in their employ for a specified length of time.
Let us assume that Rev. Van Gelizer’s church elects to set aside $270 each month for the pastor, having selected a combination of investments, life insurance, and income continuation in the event of his disability. Assuming Rev. Van Gelizer’s age to be forty-five and the agreement to be this: The board buys whole life insurance on Rev. Van Gelizer ($25, 000 insurance-fully paid at age sixty-five) with a disability waiver of premium. So, in the event of his death, the board has $25, 000 to assist his family; in the event of his disability, the insurance premium stops, but the protection and cash values continue as if the premiums were being paid. The board also purchases a disability policy that will pay Rev. Van Gelizer $500 per month until he is sixty-five in the event of his disability, thus taking the burden off the church. The $500 a month, when added to Social Security disability benefits, would provide an income to Rev. Van Gelizer and his family. The board then invests the remaining amount in Certificates of Deposit or other conservative investments. At age sixty-five there will be a fund of over $100,000 (compounding at 7 percent). This fund has grown tax free and has been invested with before-tax dollars.
At retirement, if Rev. Van Gelizer asked the church to purchase an annuity with the retirement fund, the board could buy, at today’s rates, an annuity that would give him about $900 per month for the rest of his life, with at least ten years certain. The annuity income, added to his Social Security benefits, should see the pastor and his wife through retirement quite well. The best part is, much of the money was donated by Uncle Sam.
Income Tax Differences
Let’s look at the income tax difference between Pastor Savem and Rev. Van Gelizer.
Savem Van Gelizer
Gross pay…$1500 Gross pay…$1230
From Pastor Savem’s gross pay we must subtract $200 savings, $30 life insurance, and approximately $90 for medical expense, or a total of $320 per month that he spends “after tax.” We can see that Pastor Savem has an annul income of $18,000, from which he allows $3,500 in Schedule C deductions. He then has a taxable income of $14,500 on which he must pay federal income tax of $1,157, not including self-employment tax or state tax.
Now let’s take a look at Rev. Van Gelizer’s income of $14,760 (12 x $1230). Why does he only receive $1,230 gross pay? Remember that the $270 the board is using to fund the deferred compensation agreement is not considered income until Rev. Van Gelizer receives it. He is not considered to have “constructive receipt” of the funds as long as they remain an asset of the church. We allow the same $3,500 Schedule C deductions. Rev. Van Gelizer then has a taxable income of $11,260 on which he pays taxes of $578, which is $579 less than Pastor Savem pays. Yet Rev. Van Gelizer retires with an income in excess of Social Security, and Uncle Sam has donated over $500 each year to Rev. Van Gelizer’s usable income. Wouldn’t any board prefer to protect and help its pastor and at the same time show a better financial statement?
This illustration has been very general and should not be considered legal advice. It is hoped, however, that it will encourage some pastors and boards to investigate the possibilities and consult competent attorneys and accountants.