Paul L. Caron

Monday, October 29, 2018

Lesson From The Tax Court: When Payments To A Pastor Are Not Gifts

Tax Court (2017)I don’t think Jesus ever charged for his services.  Jesus instead lived off of gifts.  Sure, some gifts got him in trouble, such as when Mary gave him expensive perfume and his followers complained he should have sold it to raise money for the poor. See John 12:1-8 (dramatized in this clip from Jesus Christ, Superstar).  But mostly Jesus worked off a sandal-strap budget.  He trusted in the generosity of those he encountered on the way. 

Modern preachers usually take a salary for their services.  Churches systematically solicit money from their congregation, both during each worship service and by encouraging yearly pledges.  And the main component of at least most Protestant church budgets (at least based on my experience) is personnel costs, the largest one being compensation for the pastor or minister. 

But modern preachers can receive gifts as well.  And while salary is taxable, gifts are not, thanks to §102.  The question becomes when are payments salary and when are they gifts?  In the recent case of Wayne R. Felton and Deondra J. Felton v. Commissioner, T.C. Memo. 2018-168 (Oct. 10, 2018), Judge Holmes teaches a great lesson how to answer that question. 


The Feltons founded the Holy Christian Church in St. Paul, Minnesota in 2000.  Rev. Felton testified that he “preached at the church for almost thirteen years without a salary” and “although the executive board authorized a salary for him in 2009 and 2009 [the years at issue], he didn’t take it.”  

Judge Holmes believed, but still doubted.  If there was no salary, then what did the Feltons live on?  The facts showed they had four sources of income in 2008 and 2009: (1) weekly payments by congregation members made to the Church, placed in white envelopes with a designation made on the envelope that some or all of the money inside was for pastoral compensation; (2) income from counseling and speaking engagements performed through a personal service corporation; (3) a housing allowance; and (4) weekly payments from congregation members made directly to Rev. Felton, placed in blue envelopes labeled “pastoral gift."

The amounts were as follows:

Income Sources



White envelope “pastoral compensation”



Schedule C income



Housing Allowance ($6,500/month)



Blue envelope “pastoral gifts”



Total (rounded):



When the Feltons eventually filed returns (after being contacted by the IRS), they reported the white envelope pastoral donations as salary income and they reported their Schedule C income as self-employment income.  They did not report the $78,000 in housing allowance, nor the approximately $250,000 in “pastoral gifts,” claiming the exclusion in §107 for the former and the exclusion in §102 for the latter. 

The IRS allowed the §107 exclusion.  I wonder why.  Section 107 allows a “minister of the gospel” to exclude from gross income “the rental allowance paid to him as part of his compensation.”  Both the relevant IRS publication (Pub. 517) and the IRS audit guidance says that the allowed exclusion will be the lesser of three amounts: (1) the minister’s actual housing costs; (2) the amount properly designated as a housing allowance; or (3) the fair rental value of the minister’s home, including furnishings and utilities.  Any amount greater than the lowest of these three numbers must be reported as income.

The opinion does not contain sufficient facts to know whether $78,000 would be the lowest of the three numbers.  A quick search on shows nothing for rent in St. Paul for even half that amount.  A quick Google search shows, however, that the Feltons likely live in Lake Elmo, a fairly swank suburb where the highest rental (for a 4 bedroom 6 bath house) is just under $4,000 per month and where one can find more than a few million dollar homes.  So the fair market rental there (including furnishings and utilities) might well be $6,500 per month.  But we do not know the Feltons’ actual housing costs, which is the third number you need to know to know the allowable exclusion under §107.  So we are left to simply wonder whether the IRS just accepted the number on faith.  It's a mystery.

The IRS did disallow the §102 exclusion, however for the roughly $250,000 the Feltons received each year in blue envelope donations.  That was the issue for Judge Holmes to decide and he does the tax community a great service how he does it.

The Law

Whether §102 excludes payments made to pastors is a matter of common law.  The classic case is Commissioner v. Duberstein, 363 U.S. 278 (1960).  There, Justice Cardozo said that there is no bright-line rule.  Instead, the key judgment is about the intent of the person making the payment.  If the payment “proceeds from a detached and disinterested generosity...out of affection, respect, admiration, charity or like impulses” then the payment is a gift.  But intent is not simply a subjective statement of “I intended a gift.”  It is an objective inquiry that tests the testimony by the transferor against the “the mainsprings of human life.”

Judge Holmes makes the vitally important point that this objective approach to determining “intent” is all the more important when the question is the intent of a collective group.  Writes Judge Holmes: “Our goal is to make a reasonable finding about the intent of the many members of Reverend Felton’s congregation who gave him money in blue envelopes.”  And the objective approach means that it is not what a single judge thinks about the mainsprings of human life that controls, but rather the collective judgment of judges over time.  In other words, it's all about precedent.  Writes Holmes: “trial courts [must] make an objective inquiry by comparing the facts of the cases before them to other cases decided over many decades. This is especially true when we have to gauge the intent of a great many transferors whose identities are unknown to us, and who couldn’t all be reasonably asked to testify.”

Judge Holmes then does a masterful job in synthesizing the law on §102 as it applies to distinguishing excludable gifts from non-excludable compensation payments to ministers of the gospel.  It is really a pleasure to read and I commend it to you.  He concludes his exegesis by listing four objective factors that provide the framework for distinguishing between gifts and taxable payments: (1) whether the payments were objectively provided in exchange for services; (2) whether the minister or church officers specifically solicited the payments; (3) whether the payments were part of a routinized, highly structured program; and (4) the amount of the payments compared to the minister’s salary.

Lesson:  How To Distinguish Gifts from Taxable Compensation

This case is an object lesson for attorneys advising churches on how to match the substance of pastor payments to the form of those payments.  Judge’s Holmes’ four-factor typology teaches a very useful lesson on how to construct your advice and, if necessary, how to organize and defend your position before the IRS.

Here’s how Judge Holmes applies each of those four factors to the Feltons:

(1) The payments were objectively provided in exchange for services. The key fact here for Judge Holmes was the regularity of the blue envelope payments.  They were not like cases where a congregation put out a burst of money for a minister’s retirement.  They were more like an inducement “meant to keep the Rev. Felton preaching where he is.”  He found that the payments were in exchange for “intangible religious benefits” and, objectively, “would to any reasonable person look like an incentive for him to keep providing them."

(2) The payments were not specifically solicited. Judge Holmes found that because the congregation members had to specifically ask for the blue envelopes and because the Rev. Felton never preached about personal donations in blue envelops, there was not the kind of specific solicitation that had caused the courts in prior cases to disallow the gift exclusion. Writes Judge Holmes: “the fact that the church did not solicit blue-envelope donations is an objective sign that the transferors proceeded from a detached and disinterested generosity.

(3) The payments were, however, gathered as part of routinized and highly structured program. Judge Holmes noted that new churches “bring forth ‘first the blade, then the ear, after that the full grain in the ear.’ And for the years at issue here, Holy Christian Church and its affiliates were definitely at the full-grain-in-the-ear stage.” Judge Holmes found that the Rev. Fulton “regularly preached about tithes and offerings.” Each week the congregation was exhorted to come forward to the front to bring their offering.  While ushers did not waved around the blue envelopes like they did the white ones, the blue envelopes were there for the asking.  Given the amount and regularity of the payments, congregants obviously knew to ask.  That is, the very development of the blue envelope system was to enable congregants to give regularly.

Judge Holmes found it objectively important that the amounts given each year totaled to within 10% of each other. “We find it more likely than not that this means there was a regularity of the payments from member to member and year to year which indicates that they were the result of a highly organized program to transfer cash from church members to Reverend Felton.” (internal quotes omitted). 

(4) The payments were waaaaaaaay more than acknowledged compensation.  This was the clincher for Judge Holmes. The payments far exceeded the “official” salary (zero) or unofficial (the $40,000 designated by the white envelope donations as being for the pastor).  Even when you add the housing allowance to the $40,000, the blue envelope donations are more than double.  Concluded Judge Holmes: “This all makes the blue-envelope donations seem more like income than gifts.” 

Coda:  Yes, the IRS sought §6662(a) penalties and showed the proper sign-offs on the paperwork.  The Feltons argued they had reasonable cause for their position because the case law was murky and they simply made an honest mistake.  Judge Holmes rejected that argument.  First, the Feltons filed no tax returns at all until after the IRS contacted them.  That undercut their claim of honesty.  Second, the Feltons sought no advice in preparing their returns and showed no effort to read or follow the published IRS guidance.  Holmes writes: “there is no evidence in the record about their efforts to compute their proper tax liability when they filed their returns; that poses a problem because the regulations say that is generally the most important factor for reasonable cause.”  Finally, the “murky” law was not really that murky.  Cases where taxpayers had won all involved one-off gifts to retiring pastors, not ongoing gifts.  The ongoing gift cases were all IRS wins. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.

Bryan Camp, New Cases, Scholarship, Tax, Tax Practice And Procedure | Permalink


Great distillation of a great decision!

Posted by: Old Ruster | Oct 29, 2018 12:39:33 PM

I appreciate your helpful articles, although I don't always have time to read them.

Thank you,

Posted by: Hal Chiasson | Oct 30, 2018 6:21:17 PM

Very Interesting case to learn from it and teach others.

Posted by: Manuel E Reyes | Oct 31, 2018 7:19:57 AM