2018 Tax Law Highlights

On December 22nd, 2017, President Donald Trump signed into law the 1.5 trillion, 1100-page Tax Cuts and Jobs Act. In this presentation, I will be summarizing for you what I consider to be some of the most important provisions for pastors and church staff.

The first provision was a rejection, in the final text of the law, of any limitations on the so-called Johnson Amendment in the tax code, which generally bans churches and other public charities from participating in political campaigns. The House bill would have provided that a church would not lose its exempt status solely because of the content of any statement that was made in the ordinary course of the church's regular and customary activities in carrying out its exempt functions and resulted in the church incurring only minimal or de minimis expenses. This provision did not make it into the final version of the law, and as a result, the prohibition of political campaign activity by churches remains intact and unchanged. What does this mean for churches? Congress has missed another opportunity to protect churches from the potential loss of exempt status for engaging in campaign activities. To be tax-exempt, a church must meet several conditions, one of which is a complete ban on any participation or intervention in a political campaign on behalf of or in opposition to a candidate for public office. The problem, of course, is that countless churches have violated this restriction in numerous ways. Common examples include endorsing candidates from the pulpit, inviting candidates of only one political party to address the congregation, distributing biased voter education literature reflecting candidates' views on selected topics, and collecting offerings for a candidate. All of these activities are blatant violations of the tax code's ban on campaign intervention, but very few churches that engage in these practices have had their exempt status threatened or revoked by the IRS. And this is because of an unwillingness by the IRS to vigorously enforce the law. Over the years, there have been many attempts by Congress to rectify this situation by allowing churches to engage in some campaign activities with various conditions. The House bill to the recent tax reform legislation was the most recent example, and while the House would have provided relief to churches, the Senate declined to do so, and so it is business as usual for now. By the way, there were a few other provisions in the House bill pertaining to nonprofit organizations that were not included in the final version of the tax reform law. These included changes in the substantiation requirements for charitable contributions and an increase in the charitable mileage rate that volunteers can use to compute a tax deduction for charitable services.

A second notable effect of the new law is its effect on charitable contributions. The law impacts charitable contributions in two ways. First, under prior law, charitable contributions by individual taxpayers were limited to 50% of the donor's AGI. The new law increases the percentage limit from 50% to 60% of AGI. Obviously, not many people give 60% of their adjusted gross income to charity, but for those that do, they now will receive a bigger deduction, and those giving up to 50% of their AGI to their church or favorite charity may be incentivized to give 60%. Second, while the tax reform legislation retains a deduction for charitable contributions, the deduction will be available to a smaller number of donors because of a substantial increase in the standard deduction. The basic standard deduction varies depending on a taxpayer's filing status. For 2017, the amount of the basic standard deduction was $6,350 for single individuals and married individuals filing separate returns, $9,350 for heads of households, and $12,700 for married individuals filing a joint return and surviving spouses. The amount of the standard deduction was indexed annually for inflation. The recent tax reform legislation temporarily increases the basic standard deduction for individuals regardless of filing status. The amount of the standard deduction is almost doubled to $24,000 for married individuals filing a joint return, $18,800 for heads of household filers, and $12,000 for all other individuals. The additional standard deduction for the elderly and the blind is not affected. The increase of the basic standard deduction does not apply to taxable years beginning after December 31st, 2025, unless extended by Congress. The significantly increased standard deduction will reduce the number of persons who are able to itemize deductions on Schedule A of Form 1040 from 30% to as few as 5% of all taxpayers. The result will be a significant decrease in the number of taxpayers who can claim a tax deduction for contributions they make to churches and other charities. Will the loss of a charitable contribution deduction by upwards of 95% of all taxpayers disincentivize them from making contributions to their church or favorite charity? Possibly. Estimates of the impact of the new law on charitable giving differ widely. Many leaders of religious and charitable organizations are warning of dire reductions in charitable giving resulting from the Act's substantial increase in the standard deduction. A recent article in the Journal of Philanthropy estimates that charitable giving will decline by as much as 3 to 4% annually due to the increase in the standard deduction. Also sounding the alarm are many prominent and high-profile charities. But some question the severity of the impact, noting that an expected 3 to 4% decline in charitable giving can hardly be called dire or devastating. Here's another interesting point: which taxpayers donate the largest percentage of their AGI to charity? Is it low-income taxpayers who receive no tax benefit from making charitable contributions because they are unable to itemize deductions on Schedule A, or is it higher-income taxpayers who do receive a tax benefit from donations to charity because they are able to itemize deductions? Consider IRS statistics for a recent year; they demonstrate that taxpayers making the largest gifts to charity as a percentage of AGI were those with AGI under $25,000. These taxpayers contributed, on average, 12.3% of their AGI to charity. In other words, those persons giving the largest percentage of their AGI to charity were those with the least income, even though few of them had itemized deductions in excess of the standard deduction and therefore receive no tax benefit from giving to charity. Conversely, taxpayers making the most income generally gave the smallest percentage to charity. According to those IRS statistics, taxpayers giving the least to charity in that same year were those with an AGI of $200,000 to $500,000; they gave, on average, 2.6% of their AGI to charity, even though these taxpayers could deduct charitable contributions on their tax return. Some are suggesting that some donors will be incentivized to give more to charity because of their concern over the potentially negative impact of the new law's substantial increase in the standard deduction on charitable giving. Perhaps more so than any other charitable donors, those who give to their church or other religious charity do so out of a desire to benefit the recipient rather than provide a tax break for themselves. Of course, the same could be said for many who donate to secular charities. Some tax advisors are recommending that donors consider bunching their contributions to charity, making no contributions in one year and doubling them in the next, so that the augmented amount will exceed the standard deduction and allow persons to deduct their contributions as an itemized deduction. Well, whether this strategy will gain traction with church members remains to be seen. Remember, it would only be appealing to the 5% of taxpayers whose contributions exceed their standard deduction. One more point: should the substantial increase in the standard deduction result in a material decline in charitable giving, there will be increasing pressure on Congress from a wide array of prominent religious and secular charities to provide relief.

A third notable provision in the new law is an expansion of the Section 529 deduction to private church schools. A Section 529 plan is a plan operated by an educational institution with tax advantages and potentially other incentives to make it easier to save for college and other postsecondary training for a designated beneficiary, such as a child or grandchild. The main tax advantage of a 529 plan is that earnings are not subject to federal tax when used for the qualified education expenses of the designated beneficiary, such as tuition fees, books, as well as room and board. Contributions to a 529 plan, however, are not tax-deductible. Further, contributions to a 529 plan cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary. The recent tax reform legislation modifies Section 529 plans to allow them to distribute not more than $10,000 in expenses for tuition incurred during the taxable year in connection with the enrollment of a designated beneficiary at a public, private, or religious elementary or secondary school. A provision in the House bill would have extended the benefits of Section 529 plans to homeschool expenses, but this provision was dropped in the final version of the legislation.

A fourth notable effect of the new law is the need for the IRS to adjust its wage withholding tables. The new law's substantial increase in the standard deduction will necessitate new withholding tables, and the elimination of the personal exemption has the same effect. The House-Senate conference committee directed the IRS to adjust its wage withholding tables to reflect these changes, and the IRS quickly responded by publishing new tables on January 13, 2018. Be sure your church is using the new tables to determine how much tax to withhold from employees' wages. Remember that wages paid to ministers for performing ministerial services are exempt from income tax withholding, so you will not be using the new tables for pastoral staff unless they have elected voluntary tax withholding.

A fifth notable effect of the new law is the submission of new W-4 forms by employees. Many employees will be paying less taxes as a result of the recent tax law, and this will provide an opportunity to have less federal income tax withheld from wages. Again, wages paid to ministers for the performance of ministerial duties are exempt from income tax withholding and are not affected, but ministers who have not elected voluntary withholding should review their estimated quarterly tax liability computed on Form 1040-ES to see if any adjustments in their quarterly payments are warranted.

A sixth notable effect of the new law is an elimination of the shared responsibility payment for individuals failing to maintain minimal essential health coverage under the Affordable Care Act. Individuals must be covered by a health plan that provides at least minimum essential coverage or be subject to a penalty for failure to maintain the coverage, commonly referred to as the individual mandate. The individual adult penalty was $695 for 2017 and 2018. The new tax reform law reduces the penalty to zero for months beginning after December 31st, 2018.

A seventh notable effect of the new law is an elimination of an itemized deduction for miscellaneous expenses on line 21 of Schedule A. These include unreimbursed business expenses and home office expenses. To illustrate, assume that Pastor Tim incurs $4,000 in unreimbursed employee business expenses in 2017 for transportation and education. Pastor Tim could deduct these expenses as a miscellaneous expense on line 21 of Schedule A of Form 1040, subject to a 2% of AGI floor. But in 2018, the new tax law eliminates an itemized deduction for miscellaneous expenses on Schedule A, including unreimbursed employee business expenses. This example illustrates the costs and benefits of tax reform. The substantial increase in the standard deduction plus other favorable tax provisions had to be paid for, and eliminating many itemized deductions was one way this was done. Some have suggested the following workaround to ease the impact: churches could simply reimburse business expenses under an accountable expense reimbursement arrangement. The basis for this workaround is the fact that while Congress eliminated an itemized tax reduction for unreimbursed business expenses, it did not modify or repeal the tax code's exclusion for employer reimbursements of an employee's substantiated business expenses under an accountable plan from the employee's taxable income. Another idea is for churches to treat clergy and lay staff as self-employed rather than employees for income tax reporting, enabling them to deduct their unreimbursed expenses on Schedule C. While it is true that self-employed workers may continue to deduct their work expenses, this strategy should not be implemented without the approval of a tax professional for two reasons: first, the vast majority of ministers and lay staff would be employees rather than self-employed under the prevailing tests used by the IRS and the Tax Court; second, the IRS can assess penalties under Section 3509 of the tax code against employers that treat a worker as self-employed whom the IRS later reclassifies as an employee. The bottom line here is that church leaders should consider adopting an accountable expense reimbursement arrangement if you have not done so already to relieve employees of the burden of paying for their own out-of-pocket church-related business expenses without the benefit of a tax deduction.

An eighth notable effect of the new law is a substantial increase in the child tax credit. Under prior law, an individual could claim a tax credit for each qualifying child under the age of 17. The amount of the credit was $1,000 per child. The credit was phased out for higher-income taxpayers with income over a threshold amount. The new tax law doubles the child tax credit to $2,000 per qualifying child. The credit is further modified to temporarily provide for a $500 non-refundable credit for qualifying dependents other than qualifying children, such as parents or grandparents. These changes are effective for taxable years beginning after 2017 and expire for taxable years beginning after 2025 unless extended by Congress. Note that a tax credit is more valuable than a tax deduction since it represents a dollar-for-dollar reduction in actual taxes rather than in taxable income. To illustrate, consider a taxpayer in the 22% tax bracket; a tax credit of $1,000 will reduce this person's actual tax liability by $1,000, but a tax deduction will reduce taxable income, and the tax savings will depend on the person's tax bracket. This means that a person in the 22% tax bracket will see taxes reduced by 22%, or $220, in this example—much less valuable than a $1,000 credit that will reduce taxes by $1,000.

A ninth notable effect of the new law, and one that has received much of the publicity, is the limitation on the itemized deduction for state and local taxes. Under prior law, individuals were permitted a deduction for state and local property and income taxes at the election of the taxpayer. An itemized deduction could be taken for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes. This election was enacted several years ago to address the unequal treatment of taxpayers in the seven states that do not have an income tax. Taxpayers in these states cannot take advantage of the itemized deduction for state income taxes, and allowing them to deduct sales taxes helps offset this disadvantage. The recent tax reform law caps the itemized deduction for state and local property and income taxes and sales taxes that were elected in lieu of income taxes at $10,000.

In conclusion, let me make two final comments. First, there are many other provisions in the 1100-page tax reform legislation that are beyond the scope of this presentation. I've attempted to highlight those having the greatest significance to churches and church staff. I've written a much more detailed analysis of the new law that you can access on my website, ChurchLawAndTax.com. Second, it is impossible to draw generalizations about the impact of the new law on individuals; it depends on all the unique facts and circumstances of each case. But generally, let me list the items that will likely reduce your tax liability: the lower tax brackets and thresholds, the lower tax rates, the substantial increase in the standard deduction, expansion of the 529 plan rules to allow distributions of up to $10,000 for a student attending an elementary or secondary church school, repeal of the Affordable Care Act's individual responsibility penalty for failure to maintain minimum essential coverage, and the doubling of the child tax credit and a new credit of $500 for non-child dependents. And if you incur any out-of-pocket unreimbursed employee business expenses, be sure that your church adopts an accountable expense reimbursement arrangement to relieve employees of the burden of paying their own out-of-pocket church-related business expenses without the benefit of a tax deduction. Since most of the new law's provisions will not apply until your 2018 tax return, most of us will have to wait until April 15, 2019, to see if we are better off and, if so, by how much.