Church Members' Donations to Minister Were Taxable Income, Not Gifts

(Parker Tax Publishing October 2018)

The Tax Court held that over $200,000 a minister received in each of two years from members of his congregation in addition to regular church offerings was taxable income rather than a gift. The court found that the contributions, for which the church provided special envelopes that were given directly to the minister, were regular, sizable payments totaling approximately double the minister's salary and patronage allowance, and were made by people for whom the minister provided a service. Felton v. Comm'r, T.C. Memo. 2018-168.

Background

Reverend Wayne Felton is the founder and pastor of Holy Christian Church in St. Paul, Minnesota. The church has a congregation of about 600 families and its Sunday services average around 500 people. Felton and his wife are heavily involved in the church's day to day operations. The Feltons sit on the church's executive board along with deacons and lay members selected by Reverend Felton. Although the board is only advisory, Felton followed its decisions and did not participate in board decisions about his salary. Felton preached at the church for almost 13 years without a salary. Although the executive board authorized a salary for 2008 and 2009, the years at issue, Felton did not take it.

The church relies on contributions from members. It collects donations using three different types of donation envelopes. White envelopes are generally used for the normal contributions that sustain the church, but also include a line marked "pastoral" for donations directly to Felton. Gold envelopes are for special programs and retreats. Blue envelopes are for contributions directly to Felton.

The blue envelopes were implemented because Felton recognized that some congregants wanted to give nondeductible gifts to Felton. Felton announced the blue envelopes at the church's annual business meeting, but ushers did not hand them out, and members had to ask for one if they wished to make such a donation. Felton regularly preached about tithes and offerings made in the white envelopes, but he did not preach about making personal donations to him in the blue envelopes. The church opened the white envelopes and tracked the donations made in them, but all blue envelopes were handed over to Felton unopened.

The blue envelope donations totaled over $250,000 in 2008 and $234,000 in 2009. Felton also received approximately $40,000 in the white envelopes in each year and a parsonage allowance of $6,500 per month. In addition, Felton earned income through a limited liability company (LLC) for private counseling and speaking engagements. The LLC had over $60,000 in gross receipts for both years and net profits of $30,000 in 2008 and $40,000 in 2009, which he reported on Schedule C, Profit or Loss from Business.

Felton prepared the couple's tax returns. The Feltons filed their returns for both of the years at issue over a year late. Felton did not report as income any of the donations he received in the blue envelopes, but did report about $40,000 as wages for each year; these reported wages were the amounts made in the white envelopes that donors had designated as pastoral donations. The Feltons also excluded the parsonage allowance totaling almost $80,000 under Code Sec. 107(2) and deducted more than $50,000 in mortgage interest for each year. The Feltons claimed about $50,000 in charitable deductions for each year, a significant amount compared with the approximately $70,000 to $80,000 of gross income reported. As a result of their exclusions, exemptions, and deductions, the Feltons reported no taxable income for either of the years at issue.

The IRS audited the Feltons and issued a notice of deficiency, making several adjustments and determining penalties for failure to timely file and for understating income. The Feltons took their case to the Tax Court. After settling several issues, the parties went to trial to determine whether the blue envelope donations were income or gifts and whether the Feltons were liable for additions to tax under Code Sec. 6651(a)(1) and accuracy related penalties under Code Sec. 6662(a).

Analysis

Under Code Sec. 61(a)(1), gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items. Code Sec. 102(a) generally excludes from gross income the value of property acquired by gift. However, this exclusion does not apply to any amount transferred by an employer to or for the benefit of an employee. In Comm'r v. Duberstein, 363 U.S. 278 (1960), the Supreme Court held that a gift is distinguished from income by the donor's detached and disinterested generosity. The most critical consideration is the transferor's intention when the payment was made.

In Goodwin v. U.S., 67 F.3d 149 (1995), the Eighth Circuit found that a pastor whose church developed a regular procedure for making "special occasion" gifts to the pastor on the same three days each year received taxable income. Making an objective inquiry, the Eighth Circuit found that the congregation knew it could not keep its popular and successful minister at his relatively low salary without making the gifts. The Eighth Circuit also noted that the gifts were made by the congregation as a whole, were gathered in a routine, highly structured program, and the purported gift amounts were substantial compared to the pastor's salary.

Reviewing Goodwin and other cases, the Tax Court determined that four factors are important in determining whether donations to clergy are taxable payments and gifts: (1) whether the donations are provided in exchange for services; (2) whether the church requested the donations; (3) whether the donations were part of a routine, structured program, and given by individual church members or the congregation as a whole; and (4) whether the cleric receives a separate salary from the church, and the amount of that salary in comparison to the personal donations.

Applying these factors, the Tax Court concluded that the blue envelope donations to Felton were not gifts but income. First, the court found that from an objective perspective, the donations were not gifts because they were meant to allow Felton to continue providing intangible religious benefits to the church's members. In the court's view, the donations would look to any reasonable person like an incentive for Felton to continue providing these benefits.

On the other hand, the Tax Court found that the lack of donation requests by Felton or the church weighed in favor of gift treatment. The court noted that the annual meeting in which Felton introduced the blue envelopes was the last time anyone from the church talked about the blue envelopes with the congregation, and members had to ask specifically for the blue envelopes in order to make such donations. The court found that Felton preached about tithes and offerings in white envelopes but never mentioned personal donations in the blue envelopes.

However, the Tax Court found that the donations were part of a routinized, highly structured program that tilted towards income treatment. Although the court noted that the donations were made by individual members throughout the year as opposed to on designated days, the court found that the blue envelope system itself was evidence of a structured program. The court noted that the envelopes said "pastoral gift" and listed all the necessary information about the Holy Christian Church and how to make checks out to Felton personally. As such, these donations were different from occasional spontaneous donations after an inspiring sermon. The court also noted the sheer size of the donations and the fact that the amounts were within 10 percent of each other in both years. In the court's view, these were regular, sizable payments made by people to whom Felton provided a service, and were therefore hard to distinguish from compensation.

The Tax Court also found that the fourth factor also leaned toward income treatment. The court compared the $40,000 per year Felton reported as wages and the $78,000 per year parsonage allowance to the over $200,000 per year in blue envelope donation amounts. In the court's view, this ratio gave the distinct impression that the transferors knew that, without the donations, they would not be able to keep their minister. The court also noted that while the special occasion gifts in Goodwin were less than the total of the pastor's salary and parsonage allowance, Felton's purported gifts were around double his salary and parsonage allowance.

Turning to penalties, the Tax Court concluded that the Feltons did not act with reasonable cause and good faith and therefore upheld the additions to tax for late filing and the accuracy related penalties. While the court recognized that penalties generally do not apply when a taxpayer makes an honest mistake in an area that lacks clear guidance, the court noted that the Feltons cited no authority to support their position and filed their returns only after being contacted by the IRS. The court also noted that Felton, who prepared the returns himself, presented no evidence of his efforts to compute the proper tax liability when the returns were filed.

For a discussion of the taxation of minister income, see Parker Tax ¶15,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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