IRS Reconsiders Salary “Restructuring” Arrangements

Decision means such arrangements are not accountable—for now.

Some churches “pay” for their reimbursements of an employee’s business expenses by reducing the employee’s salary. The tax consequences of such an arrangement are summarized below:

1. Salary reduction agreements. Some churches prefer to “reimburse” employee business expenses out of their employee’s own compensation, through a salary reduction arrangement. The objective is to eliminate any additional cost to the church for an employee’s business expenses. To illustrate, assume that a church pays Pastor G an annual salary of $52,000 ($1,000 each week). The church also agreed that it would reimburse Pastor G’s substantiated business expenses through salary reductions. At the beginning of each month, Pastor G substantiates his business expenses for the previous month, and he is issued a paycheck for the first week of the next month consisting of both salary and expense reimbursement. To illustrate, assume that Pastor G substantiates $400 of business expenses for January of 2001 during the first week of February. The church issues Pastor G his customary check of $1,000 for the first week of February, but only $600 of this check represents taxable salary while the remaining $400 represents reimbursement of Pastor G’s business expenses. The church only accumulates the $600 to Pastor G’s W-2 or 1099 that it will issue at the end of the year.

The tax code prohibits employers from paying for accountable reimbursements out of salary reductions. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that use such an arrangement must recognize that all reimbursements paid through salary reduction are “nonaccountable,” and must be reported on the minister’s W-2. The church should have treated the entire January salary of $1,000 (rather than $600) as taxable income.

2. Salary restructuring agreements. What about salary restructuring arrangements? Does the ban on using salary reduction arrangements to fund accountable expense reimbursements apply to these arrangements as well? Under a salary restructuring arrangement, an employer reduces an employee’s salary in advance of the year by an amount that will be used to reimburse business expenses substantiated under an accountable arrangement. In 1999, the IRS ruled that such arrangements can be accountable if they are done in advance, and any “balance” in the reimbursement account is retained by the employer at the end of the year and not distributed to the employee. IRS Letter Ruling 199916011.

In a 2000 ruling, the IRS announced that the whole issue of salary restructuring arrangements was under review and that the 1999 ruling was being withdrawn. IRS Letter Ruling 200035012. Therefore, church treasurers should assume that salary restructuring arrangements will not be accountable until further clarification is provided by the IRS.

Example. In December of 2000 a church board agreed to set aside $40,000 for the pastor’s compensation package for 2001. It allocated this amount as follows: $25,000 salary and $10,000 housing allowance for total compensation of $35,000. In addition, the church agreed to reimburse substantiated business expenses of up to $5,000. The pastor was informed that if he incurred business expenses of less than $5,000 in 2001, he would not be paid or credited any portion of the unused balance. A 1999 IRS ruling suggests that such an arrangement may be accountable, if the following factors are present: (1) The pastor is reimbursed only for those business expenses that would be deductible as a business expense on his personal tax returns; (2) prior to the start of each year, the church determines the amount to be excluded from the pastor’s compensation for the next year; (3) if the pastor’s expenses are less than the reimbursement cap ($5,000), the difference between the expenses and the reimbursement cap will not be paid to the pastor and will not be carried over from one calendar year to the next; and (4) if the pastor does not request any reimbursements under the plan, he receives no additional compensation. However, the IRS withdrew its 1999 ruling in 2000, and so the 1999 ruling should not be relied on until there is further clarification from the IRS.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.
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