A recent Federal District Court case in Wisconsin may have ended a significant tax benefit for clergy – the housing allowance exemption. Leadership of religious organizations should be aware of this development and begin to plan how to respond if the holding takes effect nationwide. The case is Freedom from Religion Foundation, Inc. v. Lew and concludes that a minister’s exemption of a housing allowance for income tax purposes is unconstitutionali. This article will discuss the court’s decision and the judge’s reasoning, and point out implications for those who depend upon this exemption, including members of the clergy, houses of worship, mission organizations, theological seminaries, and other religious entities.
The Exemptions under IRC 107. Section 107 of the Internal Revenue Code contains two tax benefits for ministers/ clergy. A person who qualifies as a “minister of the gospel” (a term that is very broad, not limited to the Christian faith as it may appear)ii can exclude from their income for purposes of income tax: 1) the rental value of a home furnished to them as part of their compensation, or 2) a designated housing allowance paid as part of their compensation to provide a home, as long as the allowance does not exceed the home’s fair rental value. Whether a person qualifies as a “minister of the gospel” for tax purposes can be complex and is based on what services a person performs in the exercise of their ministryiii.
Think of the first exclusion as the traditional parsonage allowance where a minister is employed by a religious organization and lives in a home owned by that organization. The minister may exclude the rental value of that home from their taxable income. The Wisconsin court did not rule on the parsonage allowance. Rather,it focused on the second exclusion under Section 107 – where a portion of a minister’s compensation is excluded from their taxable income as a housing allowance, finding that such exclusion violates the establishment clause of the First Amendment to the United States Constitution.
Reasoning by the Court. The Wisconsin court attempts to balance the two “religion clauses” of the First Amendment. “Congress shall make no law respecting an establishment of religion [the establishment clause] or prohibiting the free exercise thereof [the free exercise clause]….” The author of the opinion in the Wisconsin case, Judge Barbara Crabb, relied heavily on a prior Supreme Court case, Texas Monthly v. Bullock.iv.In Texas Monthly, a state statute exempted from state sales tax certain religious materials published or distributed by a religious entity. The U.S. Supreme Court (in a plurality opinion) concluded that the Texas statute was an unconstitutional violation of the establishment clause, because the state sales tax exemption did not have a secular purpose or effect and conveyed a message of religious endorsement by the government. The Wisconsin court reasoned that the housing allowance income tax exemption is like the Texas sales tax exemption because a primary function of a “minister of the gospel” is to disseminate a religious message – a similar function to publishing religious materials as described in Texas Monthly. Therefore, according to Judge Crabb’s decision, the housing allowance exemption provided only to ministers results in preferential treatment for religious messages over secular messages and is unconstitutional.
Free Exercise. On the other hand, as a general matter, the government may accommodate religious needs by granting certain benefits in contexts where burdens imposed by the government would otherwise severely restrict the free exercise of religion. For example, if the government were to hire a minister of a particular faith to perform religious duties it would appear to violate the establishment clause because there is no secular purpose in hiring a minister to perform religious duties. However, the government regularly hires chaplains and ministers for soldiers and prisoners. Doing so is not a violation of the establishment clause because it is an accommodation to persons who are cut off from civilian opportunities for the free exercise of their religion.v
Holding and Enforcement. The Wisconsin case followed the reasoning in Texas Monthly emphasizing that a tax exemption provided only for religious messages was unconstitutional in the absence of a corresponding showing that the tax exemption was necessary to alleviate a significant burden on the free exercise of religion. Judge Crabb issued an injunction against the Department of the Treasury and the IRS, preventing them from enforcing the housing allowance exemption. However, Judge Crabb postponed the effect of the injunction until appeals conclude. An appeal to the Seventh Circuit Court of Appeals could take several months or even a year or more to resolve. On January 24, 2014, the federal government filed a notice of appeal.
Practical Impact. Right now, the Wisconsin case does not impact ministers outside the Seventh Circuit. The housing allowance exemption will continue until appeals conclude. An important note is that the Wisconsin case does not impact exemptions broadly applicable to religious or non-religious nonprofit entities such as exemptions from property taxes or permitting charitable contribution deductions for income tax purposes.
For now, nothing changes for ministers in Alabama. However, if this case is appealed to the U.S. Supreme Court, the impact would be felt nationwide. Religious entities should begin to consider how to respond. Will the minister absorb some or all of the tax increase? Can the annual budget stand to increase the minister’s salary to make up the tax difference? Is the parsonage allowance a better option – can the religious entity buy a house for the minister to live in? How will the religious entity address retired ministers? The best course of action will depend on many factors – size of budget, number of ministers involved, and the relative size of a minister’s housing allowance, just to name a few. Whatever the outcome of the case, it is best to consider the possibilities now and not be caught by surprise.