It’s finally over. The October 15th tax deadline is behind us, which means tax practitioners have mercifully finished their filings for the year. Unless of course, you chose to make your career in the not-for-profit world, in which case you deserve the extra month of misery.
On October 19th, thousands of tax advisors simultaneously emerged from their months-long self-quarantine, wiped the sleep from their eyes after a well-deserved weekend of rest, and before they could even reach for their driver on the first tee, were rudely greeted with the realization that they’ve spent so much time preparing tax returns that they have no clue what’s happened in the tax law since the calendar turned to 2015.
Fear not, however, because I’ve got your back. Throughout the remainder of the year I’ll be taking you through the 10 most important tax cases, Revenue Rulings, Notices, and even Private Letter Rulings of 2015. Feel free to bicker with my choices in the comment sections, but know that what I do, I do out of love.
Prior selections:
#10: Perez v. Commissioner, 144 T.C. 4 (2015) Cash for egg donation = taxable income.
#9: Redisch v. Commissioner, TC Memo 2015-95. If you want to convert a home to a rental, you should probably rent it.
Up this week: #8: Freedom From Religion Foundation, Inc. v. Lew, 773 F.3d 815, (CA7, 2014). Priests, pastors and ministers get a huge break from the Seventh Circuit.
OK, I'll admit it. While building my technical tax base, I never paid much attention to Section 107, Rental Value of Parsonages. Perhaps I mistook the provision's brevity -- it's all of 100 words -- for an indication of insignificance. It turns out, however, that Section 107 is anything but insignificant, bestowing an annual benefit on members of the clergy in excess of $700 million. And if that weren't enough, little ol' Section 107 has found its way onto the list of the ten most important cases (and rulings) of 2015.
Section 107 provides tax breaks to a "minister of the gospel" in two ways: First: Section 107(1) provides that if a church provides a home for the minister/priest/pastor (I'm going to just use "minister" from this point on for the sake of simplicity) to reside in free of charge, the rental value of that home is not included in the taxable income of the minister. Of course, some churches aren't large enough to own and provide housing; this is where Section 107(2) comes in. This provision provides that the church can pay the minister a "rental allowance" to be used to find housing, and the value of that rental allowance will not be included in the minister's taxable income.
Section 107 is far from a new provision; rather, it has stood as part of the Code for the better part of a century. A variation of the law was enacted as Section 213(b)(11) in 1921 before eventually becoming Section 107(1), with Section 107(2) added in 1954 during the midst of the Cold War.
Which is precisely why Freedom From Religion resides at #8 on our top ten list for 2015; anytime a taxpayer challenges a long-standing provision as unconstitutional -- and wins, albeit momentarily -- it is worthy of discussion.
Facts in Freedom
It does not require much guesswork to decode what the Freedom from Religion Foundation does; it's primary purpose is to engage in educational activities promoting nontheistic beliefs and the separation of church and state. The foundation's co-presidents, the taxpayers in Freedom, lead the charge on such matters, acting in many ways as a minister in a church by delivering their decidedly atheistic gospel. Each president is paid a salary, and a portion of the salary is designated as a "rental allowance." Because the presidents were not members of the clergy, however, Section 107(2) was not available to exclude the allowance from their income. Painfully aware of this fact, neither president ever bothered to claim that the rental allowance was exempt from income, nor did they later sue in search of a refund of previously paid taxes. Instead, the taxpayers sued the IRS, alleging that Section 107(2) was unconstitutional because it discriminated in favor of certain taxpayers based on their religion.
The position of the taxpayers could be summed up as follows: If I'm doing the same thing day in and day out as a minister in a church, why should my rental allowance represent taxable income when theirs does not?
District Court Opinion
In late 2013, the District Court of the Western District of Wisconsin set out to answer this question by first addressing whether Freedom had legal standing to challenge the constitutionality of Section 107(2). After much discussion, the court concluded that it did have standing, despite the fact that the taxpayers had not been harmed by Section 107(2) because they never bothered to claim the exemption on their tax returns, only to have it denied by the IRS. In reaching its opinion, the court noted, "....plantiffs' alleged injury is clear from the fact of the statute and that there is no plausible argument that the individual plaintiffs could qualify for an exemption as 'ministers of the gospel,' so it would serve no legitimate purpose to require plaintiffs to claim the exemption and wait for the inevitable denial of the claim."
With standing settled, the court moved on to the issue at hand: was Section 107(2) unconstitutional? The First Amendment, after all, states that "Congress shall make no law respecting an establishment of religion." To determine if this Amendment had been violated by the 1954 enactment of Section 107(2), the court first looked to the purpose and effect of the provision.
The IRS maintained that the purpose of Section 107(2) was to provide parity between the treatment of secular and religious employees as well as between large and small churches. To wit, under Section 119, non-religious employees can exclude the value of lodging provided by an employer if it is offered "for the convenience of the employer." Until Section 107(1) was enacted, however, no such benefit existed for religious employees. Section 107(2) was then added, the IRS continued, because Section 107(1) was "unfair to those ministers who are not furnished a parsonage, but who receive larger salaries (which are taxable) to compensate them for expenses they incur in supplying their own home."
Freedom, however, countered with a quote from Representative Peter Mack, who when sponsoring the Section 107(2) law in 1954, stated, "Certainly, in these times when we are being threatened by a godless and anti-religious world movement we should correct this discrimination against certain minsters of the gospel who are carrying on such a courageous fight against this. Certainly this is not too much to do for these people who are caring for our spiritual welfare." This language, the foundation argued, exemplified the discriminatory nature of the provision.
Ultimately, the district court agreed with the taxpayers that Section 107(2) was discriminatory -- and thus unconstitutional -- for several reasons. First, the court reasoned that while Section 107(1) may have well reconciled the treatment of free housing between secular and religious employees, there was no further justification for adding Section 107(2), because it in no way further alleviated religious discrimination. It is not discriminatory that all ministers in all churches may not be able to qualify for Section 107(1) treatment; after all, not all employees can qualify for the benefits of Section 119.
Next, the court shot down the argument that Section 107(2) ended the discriminatory nature of Section 107(1), which favored only large churches, by countering that Section 107(2) only shifted the discrimination inherent in the provision by pushing it to religions that do not have ministers, as they would be unable to qualify for either exemption.
Based on these conclusions, the court held that Section 107(2), which had been in the law for nearly six decades, was unconstitutional, stating, "Defendants do not identify any reason why a requirement on minsters to pay taxes on a housing allowance is more burdensome for them then for the many millions of others who must pay taxes on income used for housing expenses."
And just like that, hundreds of thousands of minsters lost the tax benefit of an exempt rental allowance. But would it last?
Seventh Circuit Decision
(Ed note: Alright, alright...I will admit that the Seventh Circuit's decision in Freedom technically came in 2014, but to be fair, it came at the very end of 2014, after I had already hammered out my Top Ten list for the year. As such, it deserves a free pass into the 2015 listing.)
One short year after the district court figuratively ripped Section 107(2) from the pages of the Code, the Seventh Circuit gathered to hear the Service's appeal. And in far fewer pages than it required the lower court to reach a decision, the Seventh Circuit concluded that Section 107(2) was in fact constitutional, reversing the district court's 2013 decision.
And this is where things get fascinating. Mind you, the Seventh Circuit did not uphold Section 107(2) after a carefully considered examination of the merits of the law. In fact, the Seventh Circuit did not consider the issue of constitutionality at all. Rather, the higher court approved Section 107(2) simply because it looked at an issue that the district court had discussed at great length, only in this instance, the Seventh Circuit reached the exact opposite conclusion: the issue of legal standing.
That's right...if you'll remember, the district court stated that, "it would serve no legitimate purpose to require plaintiffs to claim the exemption and wait for the inevitable denial of the claim" in order for Freedom to have legal standing for its argument to strike down Section 107(2). The Seventh Circuit, however, saw things differently, providing:
The plaintiffs here argue that they have standing because they were denied a benefit (a tax exemption for their employer-provided housing allowance) that is conditioned on religious affiliation. This argument fails, however, for a simple reason, the plaintiffs were never denied the parsonage exemption because they never asked for it. And absent any denial of a benefit, the plaintiffs claim amounts to nothing more than a generalized grievance about Section 107(2)'s unconstitutionality, which does not support standing.
Stated in a simpler manner, in the view of the Seventh Circuit, a taxpayer cannot challenge the constitutionality of a provision unless they have suffered an injury as a result of that provision. And in Freedom, there was no injury to the taxpayers because they never bothered to claim the exemption.
Summary
The law is a fickle mistress. If we start with the baseline assumption that all judges are smart people, how can two different sets look at the same set of facts, the same body of law, and reach entirely different conclusions? The district court dedicated no shortage of words to the task of deciding if Freedom had legal standing, and yet it failed miserable according to the Seventh Circuit. And so here we are, back where we started, with Section 107(2) spared simply because the taxpayers hadn't gone through the pointless paperwork of filing a tax return that claimed an exemption they knew they weren't eligible to receive.
Of course, the Seventh Circuit's decision may amount to little more than a stay of execution. There are ample atheist groups who like nothing more than to take aim at perceived favoritism towards religion, and it's likely only a matter of time before one goes through the proper channels, claims the exemption, gets denied, and then sues the IRS.
Only then will we get an answer to the question that the Seventh Circuit avoided: Is Section 107(2) constitutional?
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