In November 2013, the U.S. District Court for the Western District of Wisconsin declared unconstitutional Section 107(2) of the Internal Revenue Code, which excludes from gross income rental allowances paid to ministers as part of their compensation, on the grounds that it violated the Establishment Clause of the First Amendment to the Constitution of the United States.  Click here for McDermott’s analysis of the district court’s ruling.

A three-judge panel of the U.S. Court of Appeals for the Seventh Circuit recently concluded in Freedom From Religion Foundation Inc. v. Lew, No. 14-1152 (7th Cir. 2014), that the Freedom From Religion Foundation (FFRF) lacked standing to challenge the constitutionality of Section 107(2).  The plaintiffs-appellees included FFRF, an organization devoted to educating the public about nontheistic beliefs, and its co-presidents, Dan Barker and Annie Laurie Gaylor.  The defendants-appellants were Jacob Lew, secretary of the Treasury, and John Koskinen, commissioner of the Internal Revenue Service (IRS), in their official capacities.  Many religious organizations, including Protestant, Catholic, Jewish, Unitarian and Muslim entities, filed amicus briefs against FFRF.

FFRF’s co-presidents receive a housing allowance as part of their compensation package.  Because Gaylor and Barker are not “ministers of the gospel,” however, they must pay income tax on their housing allowances.

Citing various Supreme Court of the United States cases, the Seventh Circuit described a general three-part test for standing: a plaintiff must show that he or she has suffered (or is imminently threatened with) “(1) a concrete and particularized ‘injury in fact’ (2) that is fairly traceable to the challenged action of the defendant, and that is (3) likely to be redressed by a favorable judicial decision.”  Standing, the court explained, “cannot be based on a plaintiff’s mere status as a taxpayer.”  Ariz. Christian Sch. Tuition Org. v. Winn, 131 S. Ct. 1436, 1442 (2011).

The court noted the particular difficulties of demonstrating standing in Establishment Clause cases.  Here, the three-judge panel clarified that the plaintiffs could not establish standing without first claiming a parsonage exemption from the IRS and being denied.  Further, because the Seventh Circuit determined that the individual plaintiffs did not have standing, FFRF could not satisfy the associational standing requirements.

Disagreeing with the district court, the Seventh Circuit found value in providing the IRS and the U.S. Tax Court with an opportunity to “determine the proper construction and application of the law.”  Based on this discussion, it appears that FFRF’s next step will involve formally requesting or claiming the parsonage exemption.  Gaylor and Barker, applying the court’s reasoning, must attempt to exclude their housing allowances from their federal income tax returns or file a claim for refund after payment.

The Seventh Circuit did not reach a conclusion on the parsonage exemption’s constitutionality.  Future challenges to Code Section 107 remain likely.  Notably, this challenge did not address the constitutionality of Code Section 107(1), which is the companion provision to Code Section 107(2) and grants a tax exemption on the rental value of a home directly provided to a minister as part of his or her compensation.  Thus, religious institutions that rely on Code Section 107(1) to provide tax-exempt housing to their ministers are not directly affected.

Religious institutions that provide rental allowances to their ministers should continue to monitor Code Section 107(2) developments in other jurisdictions and review their compensation strategies periodically for legal compliance.  FFRF has vowed to continue its fight against an exemption it claims violates the Establishment Clause.  Given this recent scrutiny, religious organizations might consider adjusting their compensation packages, perhaps shifting to Section 107(1)-type benefits.  For now, religious institutions with clergy in the Western District of Wisconsin, which includes Madison, La Crosse and Eau Claire, should be able to continue providing benefits under Code Section 107(2)’s exclusion, in consultation with their legal counsel and tax advisors.