Are gifts to clergy from their parishioners taxable income for federal income tax purposes? The answer involves a careful consideration of the surrounding circumstances. In its recent opinion in Brown, T.C. Memo. 2019-69, the Tax Court considered whether amounts a clergyman and his wife received were nontaxable gifts or whether the payments crossed the line into taxable income. The court's decision in this case could be informative for CPAs with tax clients who are members of the clergy.
In an audit of the 2007, 2008, and 2009 returns of Mikel A. Brown Sr., a church pastor, and his wife, Debra A. Brown, the IRS used the bank-deposit method to reconstruct their taxable income. The IRS revenue agent analyzed the taxpayers' bank statements and records to identify total deposits and asked the taxpayers where the deposits came from. Deposits for which the taxpayers could not identify the source (beyond the extent of their reported income) were classified as taxable by the revenue agent. Using this method, the IRS asserted unreported income in each of the three years under audit. The taxpayers asserted that the unreported amounts represented either the church's housing, or "parsonage," allowance excludable from income under Sec. 107(2) or nontaxable gifts from church members.
Citing cases including a Fifth Circuit opinion, Bass v. Hawley, 62 F.2d 721 (5th Cir. 1933), which found that gifts arise from "personal affection or regard or pity," the court focused on four criteria used in prior case law (see Felton, T.C. Memo. 2018-168; see also Terrell, 754 F.2d 1139 (5th Cir. 1985)), to examine payments to clergy and differentiate between payments that are nontaxable and those that are taxable:
- Were the payments given in exchange for services? For example, did they compensate for a lower salary, or were they offered in an effort to retain the clergy member's services? The court cited the size of the gifts as an indication that the payments were made to encourage Brown to remain in his position.
- Were the payments requested by the clergy member or other officials of the religious group? In this case, the court noted the use of a single-envelope giving system, rather than an envelope for church contributions and a separate envelope for gifts to the pastor (as in Felton). In addition, church members gave more heavily on two specific days of the year chosen to honor the pastor, which the court found indicated that church members had been requested to give at those specified times.
- Were the payments part of a routine, structured program? The court found that the church had a bookkeeping system that "smoothly aggregated contributions made to the [church] but intended for Reverend Brown personally" and remitted those payments to Brown. The court viewed this routine as supporting the characterization of the payments as income rather than gifts.
- How did the amount of salary compare to the amount of the unreported payments? The unreported payments were in excess of the salary amounts reported for Brown in 2007 and 2008 and only slightly lower than his salary amount reported in 2009, which the court determined supported the position that they were income rather than gifts.
The court found the payments qualified as income rather than gifts under all four criteria and consequently concluded that the unreported payments were taxable income.
Regarding the taxpayers' parsonage allowance claim, the Tax Court noted that regular payments were designated on checks as parsonage allowance payments in 2007 but only in a few instances in 2008 and 2009. And at no time did the couple show the amounts were in fact spent on housing alone and that the allowance did not exceed the sum of their mortgage payments and utilities, as required by Sec. 107(2). The court therefore sustained the disallowance of any exclusion in this respect.
The Browns argued that the Sec. 6662(a) accuracy-related penalties the IRS imposed against them should not apply because they had relied on tax professionals to prepare their returns. Although neither of the two tax preparers who prepared returns for the Browns during the audited period had asked the couple whether they had received any gifts, the court came to different conclusions with respect to each preparer about whether the Browns' reliance on that preparer was reasonable.
The court found that the preparer of the couple's 2007 return had no knowledge of the gifts. Also, this preparer, although holding an accounting degree, was not a CPA and told the Browns he did not feel competent to prepare a partnership return for another ministry in which they engaged. Consequently, the Browns did not act with reasonable cause and in good faith in relying upon his services, and the court therefore held the accuracy-related penalty applied for 2007. However, a CPA who prepared the couple's 2008 and 2009 returns had done some accounting for the church. The court determined that it was reasonable for the Browns to believe that the preparer was aware of the existence of the gifts and would report them correctly. Therefore, the court found that the taxpayers acted with reasonable cause and in good faith in relying on this preparer and, consequently, were not liable for an accuracy-related penalty for 2008 or 2009.
All tax practitioners should be aware that according to Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), Section 10.34(d), they need not verify client information, but they are required to inquire of the client in cases where information appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete. As it is typical for clergy to receive gifts from congregants, CPAs should ask about this issue when preparing tax returns for clients who are clergy members.
Editor's note: A version of this column was first published in the Tax Insider newsletter.
Linda Franks, CPA, is controller at B&Z Manufacturing Co. Inc. in San José, Calif.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com.