Does a church have a legal obligation to review the housing allowance requested by a pastor to determine both how it was computed and whether it fairly reflects the value of expected housing expenses for the new year?
The simple answer is that while a church is free to exercise this level of oversight over the pastor’s housing allowance, this is not legally required and, in fact, is rarely done. Section 107 of the tax code specifies that “in the case of a minister of the gospel, gross income does not include—(1) the rental value of a home furnished to him as part of his compensation; or (2) the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.”
The income tax regulations state: “In order to qualify for the exclusion, the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel.”
In summary, the tax code and regulations only require that a “church” designate a housing allowance out of the compensation paid to a “minister” for services performed in the exercise of ministry. There is no requirement that the church inquire as to the reasonableness of the allowance that it declares. Let me make several additional comments:
1. Neither the IRS, nor any court, has ever imposed a duty upon a religious congregation to determine the reasonableness of a housing allowance. This is not to say that such a determination would be inappropriate. To the contrary, if a congregation wants to exercise this level of vigilance, it is certainly free to do so.
2. In order for a congregation to determine the reasonableness of a housing allowance, it would have to examine all of its minister’s anticipated housing expenses for the new year. In some cases, this could involve a significant administrative burden. Further, many if not all of the expenses will be estimates, some of which might change significantly, thereby undermining the congregation’s selfimposed obligation to determine the allowance’s reasonableness.
3. It is unlikely that a church would be subject to penalties for failing to exercise this degree of control over its pastors’ housing allowances. The principal penalty would be aiding and abetting in the substantial understatement of tax. Section 6701 of the tax code gives the IRS authority to impose a monetary penalty of $1,000 upon persons who knowingly aid and abet in the understatement of the tax liability of another person if the person: (1) aids, assists, or gives advice in the preparation or presentation (e.g., during an IRS examination) of any portion of a tax return or other document; (2) knows or has reason to believe that the portion of the return or document will be used in connection with any material matter arising under the tax code; and (3) knows that if the portion of the tax return or other document is used, an understatement of the tax liability of another person would result. The penalty is $10,000 if the return or document relates to the tax liability of a corporation. The aiding and abetting penalty has never been applied to a religious congregation in a reported case on the basis of a failure to determine the reasonableness of a housing allowance.
4. A housing allowance must represent compensation for “services performed in the exercise of ministry.” This means that it consists of some, or in some cases all, of a minister’s compensation. Linking the allowance to compensation is an inherent safeguard against excessive allowances.
5. While there is no limit on the amount of a minister’s compensation that can be designated as a housing allowance, it serves no purpose for an allowance to exceed the fair rental value of his or her home since the allowance is nontaxable (in computing income taxes) only to the extent it is used for housing expenses and does not exceed this amount. As a result, churches generally should not designate housing allowances that are significantly above this limit.
6. The most common practice among religious congregations is to reduce a minister’s W-2 income by the amount of the housing allowance designated by the congregation. It then becomes the minister’s responsibility to compute the nontaxable portion of the housing allowance and report any “excess allowance” (the amount by which the allowance exceeds the nontaxable amount) as additional wages on line 7 of Form 1040. This method has the following advantages: (1) It imposes less administrative inconvenience on the congregation. (2) It is the method illustrated in IRS Publication 517. (3) It avoids a lack of reconciliation between a congregation’s Forms 941 and W-2.
7. Most religious congregations are small, and many lack the sophistication needed to ascertain the reasonableness of housing allowances.
