Compensation planning for clergy and church staff involves unique tax considerations that many church leaders may not fully understand. Proper planning ensures compliance with IRS regulations and maximizes benefits for church employees.
Key Considerations for Pastoral Pay
1. Salary: Setting Fair and Legal Compensation
- Salary is the foundation of church staff compensation.
- Unreasonably high salaries can lead to loss of tax-exempt status or IRS penalties.
- Churches paying salaries in the top 25% for comparable positions should seek a legal opinion to confirm compliance.
Salary Reduction Agreements
Churches often establish salary reduction agreements to manage expenses. These agreements must comply with legal requirements and may only reduce taxable income through:
- Tax-sheltered annuity contributions
- Cafeteria plans
- Housing allowances
2. Housing and Equity Allowances
One of the most important tax benefits for ministers is the **housing allowance**. Ministers who own or rent their homes can exclude designated housing allowances from federal income taxes, provided the allowance:
- Is designated in advance by the church
- Is used for housing expenses
- Does not exceed the home’s fair rental value
Parsonage Allowance
- Ministers living in a church-owned parsonage do not pay federal income tax on its rental value.
- Ministers in a parsonage can still receive a **parsonage allowance** for housing-related expenses such as utilities and repairs.
- Housing and parsonage allowances are not excluded from self-employment (Social Security) taxes.
Recommendation
- Ensure housing and parsonage allowances are approved annually by the church board.
- Record the allowance in official board minutes, employment contracts, or budget line items.
- For new hires, designate the allowance before their start date.
Equity Allowance
- Ministers living in a parsonage do not build home equity.
- Churches can provide an **equity allowance**, contributing to a minister’s retirement account.
- Equity allowances should not be accessible until retirement.
3. Accountable Business Expense Reimbursement Policy
Churches should adopt an **accountable reimbursement plan** for business expenses, which:
- Reimburses only properly documented expenses
- Requires excess reimbursements to be returned
Advantages of an Accountable Plan
- Church staff report expenses to the church instead of the IRS.
- Employees avoid limits on tax deductions for unreimbursed expenses.
- Ministers avoid the **Deason allocation rule**, which reduces deductible expenses for those receiving a housing allowance.
- Business meal deductions are fully reimbursable, avoiding the **50% limitation** on deductions.
- Self-employed ministers avoid IRS reclassification risks.
FAQs About Pastoral Pay
1. How should a church determine a pastor’s salary?
Churches should benchmark salaries against similar roles and ensure compensation is reasonable to avoid IRS penalties.
2. What expenses can be covered under a housing allowance?
Housing allowances can cover mortgage payments, rent, utilities, furnishings, repairs, insurance, and property taxes.
3. Are housing and parsonage allowances tax-free?
Yes, but only for federal income tax purposes. They are still subject to self-employment taxes.
4. How can a church help a minister build home equity?
Churches can provide an **equity allowance**, contributing to a minister’s tax-sheltered retirement account.