Tax issues for Ordained Ministers

I. FEDERAL INCOME TAX

A. Dual Tax Status: While most clergy are employees for federal income tax reporting purposes, all clergy are self-employed for social security purposes with respect to services performed in the exercise of ministry.

B. Employee or Self-employed: This is probably the most frequently asked tax question by pastors. Most clergy should report their federal income taxes as employees, because

1. the value of various fringe benefits will be non-taxable.

2. audit risk is much lower.

3. reporting as an employee avoids the additional taxes and penalties that often are assessed against clergy who are reclassified as employees by the IRS.

4. the IRS considers most clergy to be employees.

5. most clergy are employees under the “common law employee” test.

C. There are negative consequences of being reclassified as an employee.

1. Clergy who report as self-employed face a significant risk of additional taxes and penalties if they are audited by the IRS and reclassified as employees. This is because many clergy who report as self-employed deduct their unreimbursed (and “nonaccountable” reimbursed) business expenses as a deduction on Schedule C. If they are reclassified by the IRS as employees, their business expense deduction will be allowable only as an itemized deduction on Schedule A, and then only to the extent that the expenses exceed 2% of adjusted gross income. Clergy who are not able to itemize end up with no deduction for their business expenses. This can result in a substantial increase in taxable income.

2. The primary disadvantage of employee status is that most business expenses are deductible only as itemized deductions on Schedule A (i.e., the minister must be able to itemize deductions in order to deduct them), and they are deductible only to the extent they exceed 2% of adjusted gross income. This “disadvantage” can be overcome simply by having your employing church adopt an accountable expense reimbursement policy under which the church reimburses you for those business expenses that you periodically substantiate.

D. Certain special tax provisions apply only to ministers.

1. Exclusion (for income tax purposes) of the housing allowance and the fair rental value of a church-owned parsonage provided to clergy rent free.

2. Exemption of some clergy from social security coverage.

3. Treatment of clergy, who do not elect exemption, as self-employed for social security tax purposes with respect to ministerial services.

4. Exemption of clergy wages from mandatory income tax withholding.

5. Eligibility for a voluntary income tax withholding arrangement between the minister and the church.

6. Potential double deduction of mortgage interest and real estate taxes as itemized deduction and as housing expenses for housing allowance purposes.

E. Housing Allowance Considerations

1. The housing allowance must be officially designated before payment by the church. The allowance may be prospectively amended at any time.

2. The housing allowance is not reportable by a church on any IRS form. The church should provide the minister with the housing allowance information in a letter or memo. There is no need to attach the statement to your income tax returns.

3. The IRS does not place a limit on how much of a minister’s compensation may be designated as a housing allowance by the employing body. However, practical and reasonable limits usually apply.

4. For a minister-owned home, the lower of actual expenses or the fair rental value, including utilities, will normally be the limiting factor. For a minister renting a home, the actual expenses will typically be the limit.

5. The determination of the fair rental value is totally the responsibility of the minister. The church is not responsible to set the value. Actual housing expenses that exceed the fair rental value limitations are not excludable.

 

II. SOCIAL SECURITY

A. Ministers are always self-employed for social security purposes with respect to their ministerial services. Churches must not treat clergy as employees for social security purposes, even if they treat them as employees for federal income tax purposes.

B. Social Security tax under the Federal Insurance Contribution Act (FICA) should never be withheld from the compensation of a qualified minister for services performed in the exercise of ministry, matched by the church, and remitted to the IRS. These persons are always treated as self-employed for social security purposes. Ministers pay social security under the Self-Employment Contributions Act (SECA) instead of under FICA. The minister pays SECA social security tax as calculated on Schedule SE.

C. You may take an income tax deduction equal to one-half of your self-employment tax liability. The deduction is claimed against gross income on line 27 of Form 1040.

D. Churches commonly reimburse ministers for a portion or all of their self-employment tax liability. Any social security reimbursement must be reported as taxable income in the year it is paid to the minister. (It is taxable for income and social security tax purposes.)

E. A social security earnings record is sent to participants on a regular basis by the Social Security Administration. When you receive your record, review it and immediately correct any errors you find by contacting the Social Security Administration.

 

III. HELPFUL RESOURCES

A. Church & Clergy Tax Guide. This material is updated annually. It may be ordered by contacting:

Church Law & Tax Resources

P. O. Box 2600

Big Sandy, TX 75755

(800) 222-1840

ChurchLawCatalog.com

 

B. Church Treasurer Alert! This newsletter provides a monthly review of accounting, financial, and tax developments affecting churches and clergy.

Church Law & Tax Resources

P. O. Box 2600

Big Sandy, TX 75755

(800) 222-1840

ChurchLawCatalog.com

C.  Here is a list of websites that may be helpful for church treasurers or pastors: