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Paying the Pastor
Paying the Pastor
Three tax considerations all churches should note before setting compensation.
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Compensation planning for clergy and other church staff presents several unique tax issues that are not well understood by many church leaders and their advisers.

Here are three quick key considerations to review when structuring compensation plans:

1. Salary. The most basic component of church staff compensation is salary. There are two important considerations to keep in mind with respect to staff salaries—the amount of the salary, and the use of "salary reduction agreements." If a church pays unreasonably high compensation to a pastor or other employee, the church may lose its tax-exempt status or face intermediate sanctions, including tax on disqualified persons, additional tax on disqualified persons, and tax on organization matters.

Recommendation.Churches that pay a minister (or any staff member) significantly more than the highest 25 percent for comparable positions should obtain a legal opinion from an experienced tax attorney confirming that the amount paid is not "unreasonable" and will not expose the employee or the board to intermediate sanctions.

Many churches have established "salary reduction agreements" to handle certain staff expenses. The objective is to reduce an employee's taxable income since only the income remaining after the various "reductions" is reported on the employee's W-2 at the end of the year. It is important for churches to understand that they cannot reduce an employee's taxable income through salary reductions unless specifically allowed by law. Three ways that taxable income can be reduced through salary reduction agreements: (1) Tax-sheltered annuity contributions, (2) "Cafeteria plans," and (3) Housing allowances.

2. Housing and equity allowances. The most important tax benefit available to ministers who own or rent their homes is the housing allowance. Ministers who own or rent their home do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a housing allowance to the extent that the allowance represents compensation for ministerial services, is used to pay housing expenses, and does not exceed the annual fair rental value of the home (furnished, plus utilities). Housing-related expenses include mortgage payments, rental payments, utilities, repairs, furnishings, insurance, property taxes, additions, and maintenance.

Ministers who live in a church-owned parsonage that is provided "rent-free" as compensation for ministerial services do not include the annual fair rental value of the parsonage as income in computing their federal income taxes. The annual fair rental value is not "deducted" from the minister's income. Rather, it is not reported as additional income anywhere on Form 1040 (as it generally would be by non-clergy workers). Further, ministers who live in a church-provided parsonage do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a parsonage allowance, to the extent that the allowance represents compensation for ministerial services and is used to pay parsonage-related expenses such as utilities, repairs, and furnishings.

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