Clergy housing allowance under fire
Warren v. Commissioner has sparked a debate about the constitutionality
of the clergy housing allowance. Attorney Frank Sommerville explains the
case and what ministers can do to avoid being penalized should the housing
allowance exemption be overturned.
Since 1921, clergy of all faiths have enjoyed a unique tax break: a
housing allowance. As enacted in 1921, if the church, temple or synagogue
(referred to herein as "church") provided housing to its
minister, rabbi or priest (referred to herein as "minister"),
the value of the provided housing was tax-free to the minister. For 80
years this tax break went unchallenged, until late 2001 when the Ninth
Circuit Court of Appeals considered whether this tax break was
constitutionally permitted.
The genesis of the allowance
From 1921 until 1954, the church-provided
housing tax break remained unchanged. In response to a growing trend of
clergy owning their homes, Congress amended the housing allowance in 1954
to include a cash housing allowance. After the amendment, Section 107 of
the Internal Revenue Code stated: "In the case of a minister of the
Gospel, gross income does not include (1) the rental value of a home
furnished to him as part of his compensation or (2) the rental allowance
paid to him as part of his compensation to the extent used by him to rent
or provide a home." Congress intended for the tax burden to be equal
for ministers who were in church-provided housing and those who owned and
occupied their homes.
In 1960 the Internal Revenue Service (IRS) published regulations that
interpreted the cash housing allowance. Regulations generally have the
same status as the law passed by Congress because they are subject to
considerable deliberation and public comment. The regulations stated that
the minister could exclude the cash housing allowance from taxable income
to the extent it was used to provide a home. The IRS lists "down
payment" as an acceptable housing expenditure. The 1960 regulations
did not limit the housing allowance exclusion to the fair rental value.
Under the 1960 regulations, a minister's cash housing allowance was
limited to the lower of 1) the amount designated as housing allowance by
the church or 2) the cash actually spent owning and occupying a home.
In 1967 Rev. Fred Marine had his church designate his entire compensation
($13,474) as housing allowance. He bought a new home that cost more than
the designated amount but paid for the new house with the assistance of a
mortgage. Rev. Marine claimed the amount he paid for the house as housing
allowance. The Tax Court held that Rev. Marine's housing allowance
exclusion was limited to his out-of-pocket expenses (his down payment and
utilities).
After Rev. Marine's case, the IRS began to worry that some ministers might
actually take their entire compensation and pay cash for a home. The IRS
issued Revenue Ruling 71-280 stating that a minister's cash housing
allowance exclusion was limited to the fair rental value of the minister's
home. After applying this revenue ruling, a minister owning his home could
exclude from taxable income the lowest of (1) the amount designated by the
church, (2) the amount of cash actually spent owning and occupying the
home, or (3) the fair rental value of the home. Revenue rulings, while not
having the effect of law (like regulations), notify the public of the
IRS's opinion when presented with facts similar to those contained in the
revenue ruling. Revenue rulings are not subject to public comment and have
a lower level of deliberation than regulations. The IRS believed that
Revenue Ruling 71-280 represented a reasonable interpretation of the
statute and regulations governing the housing allowance exclusion.
Rev. Rick Warren challenges the IRS
Like Rev. Marine had in 1967, in the mid-1990s
Rev. Rick Warren, pastor of Saddleback Community Church in Lake Forest,
CA, received 100 percent of his compensation from his church as housing
allowance because he had a sizeable additional income from his book
royalties. Rev. Warren then spent that allowance on qualified housing
expenses. Rev. Warren and the IRS both agreed that the amount designated
and the amount spent exceeded the fair rental value of the house and its
furnishings. They asked the Tax Court to decide whether the amount of the
housing allowance excluded from income tax was limited to the fair rental
value amount as suggested by Revenue Ruling 71-280.
The Tax Court, in a 14-3 decision, ruled that the housing allowance
exclusion was not limited to the fair rental value of the minister's home,
effectively voiding Revenue Ruling 71-280. The Tax Court also ruled that a
church could designate 100 percent of the minister's compensation as
housing allowance. Based on this decision, it was hoped that most churches
and ministers could revise their housing allowances upward in the future
and designate annual housing allowances in amounts greater than the fair
rental value of their homes. However, the IRS was not pleased with the Tax
Court decision and appealed the decision to the Ninth Circuit Court of
Appeals. The IRS believed that the fair rental value limitation was needed
to prevent abuse by ministers.
Ninth Circuit Court hears IRS appeal
On December 3, 2001 the Ninth Circuit Court of
Appeals heard oral arguments in Warren v. Commissioner. The issues were
whether (1) Rev. Warren's housing allowance exclusion from income tax
extended beyond the fair rental value of his home and (2) whether the Tax
Court gave proper deference to Revenue Ruling 71-280.
The National Association of Church Business Administrators (NACBA) and
other ministry groups retained my law firm (Hammar & Sommerville) to
file an amici curiae (friend of the court) brief with the Ninth Circuit
Court of Appeals. These ministry groups wanted the court to understand the
impact any housing allowance decision would have on their members.
In the appellate brief, Warren argued that the plain meaning of the
housing allowance statute mandated no fair rental value limitation. Our
amici curiae brief argued that the fair rental value limitation caused
ministers to incur debt against their faith and practices. We also argued
that the abuse alleged by the IRS would actually result in higher tax
revenue for the IRS than the fair rental value limitation. The lower tax
revenue is a result of the double deduction for mortgage interest
ministers are allowed (itemized deduction and housing allowance expense).
We also argued that abuse was highly unlikely because the church and the
minister had strong incentives to avoid overcompensating the minister - if
the church pays a minister $1 over a reasonable amount of compensation,
then it could lose its tax-exempt status. Similarly, if a minister accepts
compensation that exceeds a reasonable amount, then that person is subject
to intermediate sanctions that can amount to 200 percent of the excess
compensation. Finally, because the amounts designated as housing allowance
do not count as compensation for pension purposes, ministers who claim
large housing allowances receive much smaller pensions when they retire.
In its brief, the IRS also argued that a revenue ruling is entitled to
deference in the courts. In 2001 the United States Supreme Court issued a
decision in United States v. Mead, which held that government agency
rulings are entitled to deference by trial courts. Stated another way, the
court must prefer the agency's interpretation unless the challenger
presents strong arguments for the court to overrule it. After the Mead
decision was released, the IRS asked the court to consider reversing the
Tax Court in Warren because it did not give deference to Revenue Ruling
71-280. Rev. Warren's brief and our brief opposed the IRS request.
Collectively, we argued that the revenue ruling did not qualify for
judicial deference because it did not follow the statute, did not follow
accepted statutory interpretation principles, and was not consistent with
the previously issued IRS regulations on the subject.
The court throws a curve ball at the parties
involved
Shortly before the oral arguments, the Ninth
Circuit Court of Appeals asked the parties to argue whether the housing
allowance exclusion itself was unconstitutional under Bullock v. Texas
Monthly, Inc., a 1989 United States Supreme Court decision. The Bullock
decision held a sales tax exemption that only applied to religious
organizations was unconstitutional. The Ninth Circuit Court was
questioning whether the housing allowance exclusion was similarly
unconstitutional because it only applied to religious professionals. This
new wrinkle is of substantial consequence because the Ninth Circuit Court
could rule that the cash housing allowance is unconstitutional and not
just whether the amounts claimed could exceed fair rental value.
In oral arguments before the Ninth Circuit Court in December 2001, Judge
Reinhardt questioned whether the court could review the constitutionality
of the housing allowance exclusion. He observed that ministers would not
question the constitutionality because they benefited from the statute. He
also observed that the IRS is bound by law to support the
constitutionality of statutes passed by Congress. In theory Congress could
pass unconstitutional statutes because no one interested in the
constitutionality of the statute would have standing to question its
constitutionality.
The Bullock decision was relevant to the Ninth Circuit Court because in
that case, three Supreme Court justices held that any tax exemption must
include nonreligious groups for it to be constitutional. Three more
justices wrote that they based their decision on the basis that the
statute granted an exemption solely for religious teachings. Since the
exemption was based solely on religious content, it was unconstitutional.
The last three justices dissented from the opinion, which would have held
that the sales tax exemption was constitutional. If the Ninth Circuit
Court follows the majority in Bullock, the cash housing allowance
provision could be declared unconstitutional and eliminated.
The Ninth Circuit Court notified the parties on March 5, 2002 that it
wanted briefs from the parties and amici concerning the constitutionality
of the cash housing allowance. The court appointed Prof. Edwin Chemerinsky
of the University of Southern Calfornia Law School to address whether the
cash housing allowance is unconstitutional. Most observers believe his
brief will argue that the statute is unconstitutional. The briefing will
conclude around the end of May 2002.
The parties will likely argue that the Supreme Court has previously
approved an exclusion for religious organizations from the religious
discrimination mandate in Title VII. In 1987, the U.S. Supreme Court
unanimously held that the exclusive exemption for religious organizations
contained in the employment discrimination statute was constitutional. The
opinion stated that the exemption was appropriate because it did not imply
sponsorship of religion, and the exemption reduced the entanglement
between religion and the government. It is possible that this rationale
could be used to uphold the housing allowance.
A decision from the Ninth Circuit Court is expected sometime in late 2002.
Unfortunately, we do not know a date when the opinion will be released.
What to do now if you are in Warren's position
Ministers who spent more than the fair rental
value of their homes in 1999, 2000 or 2001 have a dilemma in filing their
2001 tax returns. If a minister applies Warren in any of those years and
the IRS ultimately prevails, the minister will owe taxes, interest and
penalties for up to three years from the filing of the return. If a
minister does not apply Warren and it takes more than three years to get a
final decision from the courts, the minister may overpay their income
taxes and not be allowed to receive a refund.
Most tax practitioners are advising ministers to file their tax returns,
assuming the fair rental value limit is upheld. The minister should then
file an amended return a few days later reflecting a Warren win, whereby
the fair rental value limit is struck down. This two-step approach avoids
all interest and penalties while preserving the right to get a refund from
overpaid taxes as long as is necessary to reach a final conclusion in
Warren. Besides, the IRS will pay interest on the amended return refund at
a rate that exceeds passbook savings rates. It may turn out to be a great
investment.
What everyone else can do now
All ministers should continue filing their tax
returns normally until a final resolution is reached in the Warren case.
Since this case could reach the Supreme Court, it could still be years
before a final resolution is reached. I believe it is highly unlikely that
the IRS will apply an unconstitutional decision retroactively.
Frank Sommerville of Hammar & Sommerville participated in the oral
arguments in the Ninth Circuit Court of Appeals. He can be reached at
fsommerville@abanet.org for more information.
Source: ChurchExecutive Magazine used by permission
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