Church Law and Tax looked at five key aspects of the compensation-setting process—and the significant differences in how churches handle them compared with employers in the for-profit sector.
Building compensation packages for church pastors and staff is a process markedly different than setting salary and benefits in the for-profit world. Accountants and attorneys serving nonprofits know this, but the realization of the differences can be jarring to newcomers to a church setting.
“Clergy compensation is an animal in and of itself,” said Ben Rhodes, a CPA who serves as chief financial officer and business administrator for Faith Assembly of Orlando, Florida. “When we have new board members come on, many of them have never even heard of a housing allowance exclusion. When I begin to explain how we compensate our clergy, their eyes begin to glass over.”
Board members and new church financial managers may not have experience setting compensation for church staff. Knowing the distinctive features driving nonprofit compensation is vital to adequately pay staff, be good stewards of the congregation’s giving, and stay on the right side of the Internal Revenue Service.
To help financial managers navigate this complex process, Church Law and Tax interviewed Rhodes, along with two other CPAs and an attorney who serve as editorial advisors for this publication, to address five key differences.
Difference No. 1: tax-exempt considerations
Churches and other 501(c)(3) organizations are subject to unique federal tax rules covering compensation. Specifically, 501(c)(3) organizations are prohibited under federal tax law from paying compensation above that which is “reasonable” to their leaders. Although situations in which churches pay excessive compensation are rare, these regulations should nevertheless be taken into consideration.
The difference is that a church has tax-exempt status and the private business does not.
“In a for-profit business, such as a corporation, if the IRS determines there is unreasonable compensation, the deduction for the unreasonable portion of the compensation is disallowed and the business goes on. More taxes will be paid, but the business still exists,” said Elaine Sommerville, a CPA focusing primarily on tax compliance aspects of nonprofit organizations.
However, if the IRS determines a church paid excessive compensation, the church could lose its tax-exempt status, explained Sommerville. Or the recipient of the unreasonable compensation could be forced to return the portion deemed to be “unreasonable” to the church, owe the IRS an intermediate sanction of 25 percent, and if not corrected, be assessed an additional penalty of 200 percent. Those who authorized the payment of the excessive compensation may individually be assessed a penalty of 10 percent of the unreasonable amount.
“Reasonable compensation is defined as what other similar organizations pay similarly qualified people to perform similar work,” added Michael Batts, a CPA and managing partner of Batts Morrison Wales & Lee, a firm that exclusively serves nonprofit organizations and their affiliates.
Difference No. 2: housing arrangements
Under IRS rules, ordained, licensed, or commissioned ministers who perform their duties in the exercise of ministry may qualify for parsonage or housing allowances. Either option is among the most valuable tax breaks for ministers—and not common in other employment sectors, making it all the more important for church leaders to understand parsonage and housing allowances.
With a parsonage, the church provides the home to the minister as a part of the minister’s compensation package. In return, the minister does not include the annual rental value of the parsonage, nor any allowance provided for utilities, repairs, and furnishings, as income in computing federal income taxes—as long as the total amount does not exceed the fair rental value of the parsonage (including furnishings and utilities).
Although a parsonage allowance may prove valuable during active ministry, it poses one potentially significant drawback down the road. Pastors who live in a parsonage for many years are unable to build equity. Some churches compensate for this by giving the pastor an equity allowance, which is deposited annually into a tax-favored retirement program not currently accessible to the minister, and used upon retirement to fund a home.
“Funding the retirement plan does not create current taxable income,” Sommerville said. “Additionally, certain retirement plans may designate a portion of the retirement payment as a housing allowance to assist in providing a home during retirement years.”
If ministers own or rent their own home, they are eligible to have part of their salaries set aside for housing allowances. Like a parsonage allowance, the amount designated is exempt from federal income tax. When determining the amount of a housing allowance, the tax code stresses the church and minister must make sure the funds are actually used for housing expenses—and that the allowance does not exceed the residence’s fair rental value plus utilities.
The church board should set the pastor’s parsonage or housing allowance, in writing, and in advance of payment.
For more help with parsonage and housing allowances, see chapter 6 in the Church & Clergy Tax Guide.
Difference No. 3: 403(b) retirement plans
The major difference between churches and for-profit entities regarding retirement planning is the availability of 403(b) plans for nonprofit employees, said Danny Miller, an attorney who advises churches and nonprofits on employee benefit issues. One particular option for churches—403(b)(9) accounts—offers two major advantages, he said. One is that it allows churches to use investment options that are screened to reflect a particular church’s faith and belief. A 403(b)(9) plan also permits an annuity form of benefit to be paid directly from the plan.
Regarding 403(b) plans in general, another benefit “is that a church can continue to contribute to them five years after an employee’s termination of employment,” Miller said. “That can be a nice way for a church to make a substantial contribution for pastors who haven’t saved enough for retirement.”
Retirement benefits payable from 403(b) plans also can be applied toward housing costs on a tax-excludible basis, another benefit not available outside of the church world.
Yet another benefit: flexibility on applying the plan to different employees.
“The plan allows for a church to discriminate on its contributions, so the church can make contributions just for one pastor or different amounts for different staff members,” Sommerville said. In contrast, she added, for-profit retirement plans generally have strict nondiscrimination requirements.
For more details about common retirement options and various issues that must be addressed with retirement planning, chapter 10 of the Church & Clergy Tax Guide.
Difference No. 4: Social Security for clergy
When working with church compensation, one important aspect to know is that clergy are treated as self-employed for Social Security tax purposes.
“Instead of living in the FICA tax world where employers pay half and the employee pays the other half of FICA taxes, ministers are responsible for paying all of their Social Security taxes under SECA (Self-Employed Contributions Act),” Miller said.
The tax code related to this is Internal Revenue Code Section 1402(c), which “states that a ‘trade or business’ for purposes of SECA will include the performance of services by a duly ordained, commissioned, or licensed minister in the exercise of his ministry—if no exemption as provided by IRC Sec. 1402(e) is in effect,” Sommerville said. “This explanation demonstrates that, by law, the compensation paid to a minister—for the performance of ministerial duties—is a trade or business subject to self-employment tax. It can’t be considered as wages for FICA withholding and matching.”
One final note about Social Security: those new to church finance and taxes often are surprised to learn that ministers can opt-out permanently if they conscientiously object to the program and complete necessary paperwork within the first two years of their ministry work. However, ministers must evaluate this option with extreme caution before proceeding.
See chapter 9 of the Church & Clergy Tax Guide, which covers Social Security for ministers.
Difference No. 5: healthcare options
The health insurance climate remains challenging for small and medium-sized churches. One possible stabilizing influence is known as QSEHRA (qualified small employer health reimbursement arrangement), a plan for employers with fewer than 50 full-time equivalent employees that do not otherwise offer group health plans to their employees. A QSEHRA is defined as an arrangement that:
- is provided on the same terms to all eligible employees of an eligible employer;
- is funded solely by the eligible employer and no salary reduction contributions may be made under the arrangement;
- provides, after an employee provides proof of minimum essential coverage, for the payment or reimbursement of medical expenses of the employee and family members; and
- the amount of payments and reimbursements under the arrangement for a year cannot exceed specified dollar limits.
QSEHRAs sound attractive, but churches must exercise caution. “A small- to medium-sized church does not have the ability to offer it just to their ministers as they might prefer to do. Many churches have heard that reimbursing individual premiums is all okay now and they just keep doing it without going through all the required steps of establishing a QSEHRA,” Sommerville said.
A healthcare variable unique to churches is whether or not a denominational plan is available or even mandatory for clergy. If small and medium-sized churches have a choice, it may take a look at QSEHRA, but “a QSEHRA will not work for every church,” Miller said.
Alternatively, some smaller churches are opting to participate in co-operative coverage plans, such as MediShare or Christian Healthcare Ministries, Faith Assembly’s Rhodes said.
For additional information on QSEHRA, see “New Act Restores Tax-Free Premium Reimbursements for Many” on ChurchLawAndTax.com.