Tax Law and Compensation Planning

Important information about salaries, housing allowances, and equity allowances.

Compensation planning for clergy and other church staff presents several unique tax issues that are not well understood by many church leaders and their advisers. This article looks at issues related to three components (or possible components) of the compensation package to review when structuring compensation plans.

1. Salary

The most basic component of church staff compensation is salary. There are two important considerations to keep in mind with respect to staff salaries: the amount of the salary and the use of salary reduction agreements. These two issues will be discussed separately.


Staff salaries ordinarily are set by the church’s governing authority, such as a board or committee. Churches generally may pay any amount they wish, with one important exception. If a church pays unreasonably high compensation to a pastor or other employee, there are two possible consequences:

1. Loss of tax-exempt status

In order for a church or any other charity to maintain its tax-exempt status, it must meet a number of conditions. One condition is that it cannot pay unreasonably high compensation to any person. There are two considerations to note. First, very few charities have lost their exempt status for paying unreasonable compensation. The IRS has been reluctant to impose this remedy. Second, the law does not define what amount of compensation is unreasonable, and neither the IRS nor the courts have provided much clarification.

EXAMPLE A federal appeals court concluded that combined annual income of $115,680 paid by a religious organization to its founder and his wife was not excessive.

EXAMPLE A court ruled that maximum reasonable compensation for a prominent televangelist was $133,100 in 1984, $146,410 in 1985, $161,051 in 1986, and $177,156 in 1987. The court based its conclusions on a comparison of the salaries of other nonprofit officers in the state.

2. Intermediate sanctions

The IRS can assess substantial excise taxes, called intermediate sanctions, against disqualified persons who are paid an excess benefit by a church or other charity. A disqualified person is any officer or director, or a relative of such a person. An excess benefit is compensation and fringe benefits in excess of what the IRS deems reasonable. Note that the IRS still can revoke the exempt status of a charity that pays excessive compensation to an employee. However, it is more likely that excessive compensation will result in intermediate sanctions rather than loss of exempt status.

The intermediate sanctions the IRS can impose include the following:

Tax on disqualified persons. A disqualified person who benefits from an excess benefit transaction is subject to an excise tax equal to 25 percent of the amount of the excess benefit (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is assessed against the disqualified person directly, not against his or her employer.

Additional tax on disqualified persons. If a disqualified person fails to correct the excess benefit by the time the IRS assesses the 25 percent tax or Form 4720 is filed to report the excess benefit, then the IRS can assess an additional tax of up to 200 percent of the excess benefit. The law specifies that a disqualified person can correct the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.”

Tax on organization managers. If the IRS assesses the 25 percent tax against a disqualified person, it is permitted to impose an additional 10 percent tax (up to a maximum of $20,000) on any organization manager who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.” A manager is an officer, director, or trustee. IRS regulations clarify that the managers collectively cannot be liable for more than $20,000 for any one transaction.

Key point. The intermediate sanctions law imposes an excise tax on members of a church’s governing board who vote for a compensation package that the IRS determines to be excessive. This makes it essential for board members to carefully review the reasonableness of compensation packages.

Churches, disqualified persons, and governing boards may rely on a presumption of reasonableness with respect to a compensation arrangement if it was approved by a board of directors (or committee of the board) that

1. was composed entirely of individuals unrelated to and not subject to the control of the disqualified person involved in the arrangement;

2. obtained and relied upon objective comparability information, such as (a) compensation paid by similar organizations, both taxable and tax-exempt, for comparable positions; (b) independent compensation surveys utilized by compensation experts; or (c) actual written offers from similar institutions competing for the services of the disqualified person; and

3. adequately documented the basis for its decision.

Note. The documentation should include the terms of the transaction and the date of its approval, the members of the board present during the debate and vote on the transaction, the comparability data obtained and relied upon, the actions of any members of the board having a conflict of interest, and the basis for the determination.

Key point. Legislation has been proposed that would limit the rebuttable presumption to comparability data from tax-exempt entities. Be sure to check the status of this legislation before using comparability data from non-exempt entities.

The IRS may refute the presumption of reasonableness only if it develops sufficient contrary evidence to rebut the comparability data relied upon by the board.

Key point. The law creates a presumption that a minister’s compensation package is reasonable if approved by a church board that relied upon objective comparability information, including the use of compensation surveys utilized by compensation experts. Comprehensive compensation surveys for church employees can be found on This means that most ministers will be able to use the information on this site as one source of comparable compensation. But it also suggests that the IRS may utilize the data on this site in any attempt to impose intermediate sanctions against ministers.

IRS regulations clarify that revenue-based pay arrangements in which an employee’s compensation is based on a percentage of the employer’s total revenues do not automatically result in an excess benefit transaction triggering intermediate sanctions as long as the church pre-establishes a cap on the total compensation. “All relevant facts and circumstances” must be considered.

CAUTION In a series of rulings published in 2004, the IRS assessed intermediate sanctions against a pastor as a result of excess benefits paid to him and members of his family by his church. The IRS concluded that taxable compensation and benefits a church pays to a disqualified person (any church officer or member of his or her family) that are not reported as taxable income to the recipient constitute automatic excess benefits that trigger intermediate sanctions regardless of the amount involved.

The IRS ruled that the following transactions resulted in excess benefits to the pastor because they were not reported as taxable income: (1) personal use of church property (vehicles, cell phones, credit cards, computers, etc.) by the pastor and members of his family; (2) reimbursements of personal expenses; and (3) nonaccountable reimbursements of business expenses (i.e., reimbursements of expenses that were not supported by adequate documentation of the business purpose of each expense). Since these taxable benefits were not reported as taxable income, they amounted to “automatic” excess benefits resulting in intermediate sanctions.

This interpretation of the tax code and regulations directly affects the compensation practices of every church and exposes some ministers and church board members to intermediate sanctions.

Recommendation. A church that pays a minister (or any staff member) significantly more than the highest 25 percent for comparable positions should obtain a legal opinion from an appropriate compensation expert confirming that the amount paid is not “unreasonable” and will not expose the employee or the board to intermediate sanctions.

TIP Ministers and nonclergy employees should carefully review their Form W-2 or Form 1099 to be sure it does not report more income than was actually received. If an error was made, the church should issue a corrected tax form (Form W-2c for an employee, or a corrected Form 1099 for a self-employed worker).

Salary reduction agreements

Many churches have established salary reduction agreements to handle certain staff expenses. The objective is to reduce an employee’s taxable income, since only the income remaining after the various reductions is reported on the employee’s Form W-2 at the end of the year. However, church leaders cannot reduce an employee’s taxable income through salary reductions unless specifically allowed by law.

Here are three ways that taxable income can be reduced through salary reduction agreements:

1. Tax-sheltered annuity contributions. Salary reduction agreements can be used to contribute to a tax-sheltered annuity (sometimes called a 403(b) annuity) if the salary reductions meet certain conditions.

2. Cafeteria plans. Salary reduction agreements can be used to fund cafeteria plans (including flexible spending arrangements) if several conditions are met. A cafeteria plan is a written plan established by an employer that allows employees to choose between cash and a menu of nontaxable benefits specified by law.

3. Housing allowances. A church can designate a portion of a minister’s salary as a housing allowance, and the amount so designated is not subject to income tax if certain conditions are met. Housing allowances are addressed below.

Observation.Most other forms of salary reduction will not accomplish the goal of reducing a minister’s taxable income. The income tax regulations prohibit the widespread practice of funding “accountable” reimbursement arrangements through salary reductions.

For comprehensive tax information about salaries for church staff, see chapter 4 in the Church & Clergy Tax Guide.

2. Housing allowances

The most important tax benefit available to ministers who own or rent their home is the housing allowance. Ministers who own or rent their home do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a housing allowance to the extent that the allowance represents compensation for ministerial services, is used to pay housing expenses, and does not exceed the annual fair rental value of the home (furnished, plus utilities). Housing-related expenses include mortgage payments, rental payments, utilities, repairs, furnishings, insurance, property taxes, additions, and maintenance.

Unfortunately, many churches fail to designate a portion of a minister’s compensation as a housing allowance. This deprives their minister of an important tax benefit that costs the church nothing.


Ministers who live in a church-owned parsonage that is provided rent free as compensation for ministerial services do not include the annual fair rental value of the parsonage as income in computing their federal income taxes. The annual fair rental value is not deducted from the minister’s income. Rather, it is not reported as additional income anywhere on Form 1040 (as it generally would be by nonclergy workers). Furthermore, ministers who live in a church-provided parsonage do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a parsonage allowance, to the extent that the allowance represents compensation for ministerial services and is used to pay parsonage-related expenses such as utilities, repairs, and furnishings.

TIP Ministers who live in church parsonages and who incur any out-of-pocket expenses in maintaining the parsonage (such as utilities, property taxes, insurance, furnishings, or lawn care) should ask their employing church to designate a portion of their annual compensation in advance as a parsonage allowance. Such an allowance is not included on the minister’s Form W-2 or Form 1099 at the end of the year and is nontaxable in computing federal income taxes to the extent the minister incurs housing expenses of at least that amount. This is a very important tax benefit for ministers living in church-provided parsonages. Many ministers and church boards are not aware of this benefit or are not taking advantage of it.

Note. The parsonage and housing allowance exclusions only apply in computing federal income taxes. Ministers cannot exclude them when computing their self-employment (Social Security) taxes.

Note. The parsonage or housing allowance designated for a minister must be considered part of their total compensation package when reviewing the reasonableness of the minister’s compensation for “intermediate sanctions” purposes (covered above under “Salary”).

Recommendation. Be sure the designation of a housing or parsonage allowance for the subsequent year is on the agenda of the church board for one of its final meetings of the current year. The designation should be an official action of the board or congregation, and it should be duly recorded in the minutes of the meeting. The IRS also recognizes designations included in employment contracts and budget line items—assuming in each case that the designation was duly adopted by the church board (or the congregation in a business meeting). Also, if the minister is a new hire, be sure the church designates a housing allowance prior to the date he or she begins working.

Designating a housing allowance

How much should a church board or congregation designate as a housing allowance? Many churches base the allowance on their minister’s estimate of actual housing expenses for the new year. The church provides the minister with a form on which anticipated housing expenses for the new year are reported. For ministers who own their home, the form asks for projected expenses in the following categories: down payment, mortgage payments, property taxes, property insurance, utilities, furnishings and appliances, repairs and improvements, maintenance, and miscellaneous.

Churches may designate an allowance in excess of the anticipated expenses itemized by the minister. Basing the allowance solely on a minister’s actual expenses will penalize the minister if housing expenses in fact turn out to be higher than expected. In other words, the allowance should take into account unexpected housing costs and inaccurate projections of expenses. Can a church ever reject the housing allowance amount a minister requests? See the Q&A on page 28 for an answer to this question.

Recommendation. Plan a midyear review of the housing allowance to make sure the designated amount is sufficient to cover actual expenses. If a pastor’s expenses will exceed the allowance, the church may amend the allowance. But any amendment will only operate prospectively. reveals that housing allowances are claimed by several associate ministers, administrators, music directors, secretaries, and custodians. However, it is important to note that the housing allowance is available only if two conditions are met: (1) the recipient is a minister, and (2) the allowance is provided as compensation for services performed in the exercise of ministry. In many cases, these conditions will not be satisfied by administrators, music directors, secretaries, or custodians. See chapter 3 in the Church & Clergy Tax Guide.

Status of the legal challenge to the housing allowance

On November 22, 2013, federal district court judge Barbara Crabb of the District Court for the Western District of Wisconsin struck down the ministerial housing allowance as an unconstitutional preference for religion. Freedom From Religion Foundation, Inc., v. Lew, 983 F. Supp.2d 1051 (W.D. Wis. 2013). The ruling was in response to a lawsuit brought by the Freedom From Religion Foundation (FFRF) and two of its officers challenging the constitutionality of the housing allowance and the parsonage exclusion. The federal government, which defended the housing allowance because it is a federal statute, asked the court to dismiss the lawsuit on the ground that the plaintiffs lacked standing to pursue their claim in federal court.

Standing is a constitutional requirement of any plaintiff in a federal case and generally means that a plaintiff must have suffered some direct injury as a result of a challenged law. The Wisconsin court concluded that the plaintiffs had standing on the ground that they would have been denied a housing allowance exclusion had they claimed one on their tax return. The government appealed this ruling to a federal appeals court—the US Court of Appeals for the Seventh Circuit in Chicago.

On November 13, 2014, the appeals court issued its ruling reversing the Wisconsin court’s decision.Freedom From Religion Foundation, Inc., v. Lew, 2014 WL 5861632 (7th Cir. 2014). It concluded that the plaintiffs lacked standing to pursue their challenge to the housing allowance. The plaintiffs had asserted that they had standing due to their “injury” of being denied a tax-free housing allowance should they claim one on their tax returns. But the appeals court refused to base standing on theoretical injury. It concluded: “Only a person that has been denied such a benefit can be deemed to have suffered cognizable injury. The plaintiffs here have never been denied the parsonage exemption because they have never requested it; therefore, they have suffered no injury.”

The appeals court suggested that this deficiency could be overcome if the FFRF’s officers filed tax returns claiming a housing allowance that was later rejected by the IRS in an audit: “The plaintiffs could have sought the exemption by excluding their housing allowances from their reported income on their tax returns and then petitioning the Tax Court if the IRS were to disallow the exclusion. Alternatively, they could have … paid income tax on their housing allowance, claimed refunds from the IRS, and then sued if the IRS rejected or failed to act upon their claims.”

The FFRF responded to the appeals court’s ruling by designating a housing allowance for two of its officers. The officers reported their allowances as taxable income on their tax returns and thereafter filed amended tax returns seeking a refund of the income taxes paid on the amounts of their designated housing allowances. The FFRF claims that in 2015, the IRS denied the refunds sought by its officers (one of whom had died and was represented by her executor).

Having endeavored to correct the standing problem, the FFRF renewed its legal challenge to the housing allowance in the federal district court in Wisconsin. Agreeing that the FFRF had standing, Judge Crabb struck down the ministerial housing allowance as an unconstitutional preference for religion. The federal court’s decision regarding the housing allowance is currently being appealed to the Seventh Circuit, which is expected to deliver a decision sometime this year.

Note the following considerations:

  • Parsonages. The US Department of Justice, which defends the constitutionality of federal legislation (such as the housing allowance), filed a brief with the Wisconsin federal district court asking it to dismiss the FFRF’s challenge to the constitutionality of the parsonage exclusion. The Department of Justice noted that section 107 of the tax code grants tax exclusions both for the rental value of parsonages provided to clergy as compensation for the performance of ministerial services and for housing allowances provided to clergy who own or rent their home. However, since none of the FFRF’s officers were living in housing owned by FFRF, they lacked standing to challenge the constitutionality of section 107’s exclusion of the rental value of church-owned parsonages. Section 107’s allowance for tax-free parsonage is not challenged in the current case.
  • Housing allowances. The Department of Justice brief states that “the United States does not contest plaintiffs’ standing to sue under section 107(2)” (i.e., the housing allowance). This concession means that the federal appeals court has the opportunity to address the merits of the FFRF’s constitutional challenge to the housing allowance. The appeals court may still consider the limits of the trial court’s jurisdiction in this matter. The appeals court ultimately may rule on procedural grounds, or that the housing allowance is constitutional. Or it may decide that it is not. Regardless of the outcome, the ruling likely will be appealed to the United States Supreme Court.
  • Constitutionality. There are arguments that support the constitutionality of the parsonage exclusion and housing allowance. The validity and strength of these arguments will likely be evaluated by the Seventh Circuit.
  • Impact of the loss of the housing allowance exclusion. Should the FFRF and its officers ultimately prevail in their quest to strike down the housing allowance as an unconstitutional preference for religion, what would be the impact? A ruling by the Seventh Circuit would apply to ministers in that circuit, which includes Illinois, Indiana, and Wisconsin. It would become a national precedent binding on ministers in all states if affirmed by the Supreme Court—an unlikely outcome, because the Supreme Court accepts less than 1 percent of all appeals. It could also be binding on the IRS nationally if the appeals court confirms the trial court’s injunction requiring the IRS to disallow the cash housing allowance for all ministers. Absent affirmation of the injunction, the IRS would have the discretion to follow or not follow such a ruling in other circuits and might be inclined to follow it nationwide to promote consistency in tax administration.
Ministers and churches should be aware that the housing allowance remains under attack and one day may be invalidated

In conclusion, ministers and churches should be aware that the housing allowance remains under attack and one day may be invalidated. Should that occur, two actions will need to be implemented within 180 days after the final court ruling.

First, most affected ministers will experience an immediate increase in income taxes. As a result, they should be prepared to increase their quarterly estimated tax payments to reflect the increase in income taxes in order to avoid an underpayment penalty. Note that there will be no effect on self-employment taxes for which the housing allowance is not tax-exempt. Second, many churches will want to increase affected ministers’ compensation to offset the financial impact. Such an increase could be phased out over a period of years to minimize the impact on the church.

Key point. Ministers should address the continuing availability of the housing allowance with a tax professional.

For comprehensive information about housing and personage allowances, see chapter 6 in the Church & Clergy Tax Guide.

3. Equity allowances

Ministers who live in church-owned parsonages are denied one very important benefit of home ownership: the opportunity to accumulate equity in a home over the course of many years.

Many ministers who have lived in parsonages during much of their active ministry often face retirement without housing. Their fellow ministers who purchased a home early in their ministry can often look forward to retirement with a home that is either substantially or completely debt free. To avoid the potential hardship often suffered by a minister who lives in a parsonage, some churches increase their minister’s compensation by an amount that is sometimes referred to as an equity allowance. The idea is to provide the minister with the equivalent of equity in a home. This is an excellent idea that should be considered by any church having one or more ministers living in church-provided housing. Of course, for the concept to work properly, the equity allowance should not be accessible by the minister until retirement. Therefore, some churches choose to place the allowance directly in a minister’s tax-sheltered retirement account.

Recommendation. Equity allowances should also be considered by a church whose minister rents a home.

CAUTION Some churches attempt to rectify the lack of home equity by giving the parsonage to the minister upon retirement. This solution may provide a home for the pastor, but it creates a significant tax burden since the value of the home must be included in the pastor’s income at the time of the transfer. The transaction may also create unreasonable compensation and result in intermediate sanctions to the minister and the church’s decision-makers.

For comprehensive tax information about equity allowances, see chapter 6, section A.7, in the Church & Clergy Tax Guide.

Participate in the National Church Compensation Survey to provide churches with information they need to determine fair pay.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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