Churches typically offer employees a variety of tax-free, tax-deferred benefits. But all too often, church employers take too casual an approach to such benefits. They tell their employees how much money the church has to spend, then ask the employees to decide what fringe benefits they want. Other churches do not adequately document benefit plans.
Better planning would maximize the tax credits of such benefits for employees. It would also help churches to comply with IRS rules about benefits.
Benefits to Include
Health insurance. This is a top priority for church staff. Employer-paid group health insurance premiums are free from income tax and social security tax. Since health plans often cost $10,000 per employee per year or more, the tax-free benefits for churches can run several thousands of dollars per year. This benefit covers group premiums directly paid by a church. (See the Affordable Care Act: Church Administrators Survival Guide by Church Law & Tax for more information on compliance with ACA health insurance regulations.)
Medical expense reimbursement. Coinsurance, deductibles, and other out-of-pocket medical expenses for an employee or his/her dependents can be reimbursed under a Flexible Spending Account (FSA). FSAs are capped at $2,500 per year adjusted annually for inflation.
FSAs can be paid by the church or by a reduction of the employee’s salary. If an FSA is funded through salary reduction, excess funds cannot be paid to the employee without causing all of the benefits to be treated as taxable compensation. Likewise, excess money in a church-funded FSA cannot be carried over to the next year without tax implications for the employee.
Churches cannot offer FSAs only to their highly compensated employees without violating discrimination regulations.
Churches must be careful to comply with changes in the reimbursement rules established under the ACA. Noncompliance can be very costly! (See the free download 5 Roads to Healthcare Reimbursements by Churches and Ministries from ECFA for more information.)
Retirement plans. Most denominations sponsor tax-sheltered annuity plans (403[b] plans), which allow churches and staff to contribute to a retirement account. Contributions to church-sponsored retirement plans are especially important for pastors because income taxes and social security taxes are deferred. Distributions from these plans generally are designated for the housing-allowance benefit. Therefore, the withdrawals are tax-free for social security purposes and may be tax-free for federal and state income taxes.
Life insurance. Up to $50,000 of group term life insurance can be provided tax-free to church employees under a nondiscriminatory plan. Coverage that exceeds $50,000 is taxable but at very favorable rates.
Disability insurance. If a church pays for disability insurance for an employee, the premiums are excluded from the employee’s gross income, but the proceeds must be included. If the employee pays the premiums, disability benefits are not taxable to the employee.
Long-term care insurance. If premiums for long-term care insurance are paid by the church or by a church employee and reimbursed by the church, these amounts are tax-free.
Dependent care. If a church provides childcare or disabled dependent care for children under age 13 to allow the employee to work, part of the benefit may be excluded. Dependent-care plans must comply with nondiscrimination rules.
Church-owned vehicles. Although the personal use of a church vehicle is taxable, it is an excellent fringe benefit. The fair market value of personal use must be included in the employee’s gross income unless the employee fully reimburses that money to the church.
Loans. Loans to church employees are prohibited by many states. If the church does provide below-market compensation-related loans to employees, compensation for interest might have to be added to the employees’ W-2 forms. There are exceptions to the reporting of additional income for loans of $10,000 or less or for employee relocation. Check with an attorney for more details.
Tuition and fee discounts. Employees (plus dependents) of a church-operated school can receive some tax-free tuition and fee discounts. However, these benefits may be viewed as taxable income if they apply to church employees. Check with an attorney for details.
Special Benefit Rules
Many fringe benefits must be nondiscriminatory in order to qualify for tax-free status. A fringe benefit offered only to a senior pastor and not to other staff employees might violate nondiscrimination rules. Failure to comply with nondiscrimination rules wouldn’t jeopardize the entire fringe benefit plan. Only the highly compensated employees (the IRS annually adjusts the “highly compensated” limit) would lose the tax-free benefit.
Benefits to Avoid
Improper use of fringe-benefit plans. To save money for employees, some churches set up plans that really don’t qualify for tax-free or tax-deferred treatment. Here are some examples of improper plans:
- A church sets up a medical-expense reimbursement plan using the salary reduction approach. At yearend, the church refunds left over money in the plan to the minister.
- A church reimburses the out-of-pocket medical expenses of church employees without using a formal plan that meets ACA requirements (cafeteria plan, health reimbursement arrangement (HRA), or a flexible spending account (FSA)).
- A church pays whole life insurance premiums for a senior pastor. The pastor names his wife as beneficiary.
- A church reimburses employees for dependent care under an accountable expense-reimbursement plan. This is an improper mixing of benefits. Each benefit is subject to a specific set of rules.
In summary, fringe benefits, properly designed, can offer a tremendous financial advantage to churches and their employees. Poorly designed plans, however, can only get everyone in trouble with the IRS.