Q&A: Tax Implications for Terminated Employees

What must a church, and the worker, report?

Our church recently terminated an employee for budgetary reasons. Are there any tax or other issues for the church, and our former employee, to be aware of under these circumstances?

Yes. Consider the following:

  1. If the church paid severance pay to the employee, it is taxable in the year received and should be reported as taxable wages on the employee’s W-2. It is also subject to payroll tax withholding, assuming the employee is not exempt. Note that ministerial employees are exempt from income tax withholding unless they elect voluntary withholding, and a church does not withhold FICA taxes from their wages since they are deemed self-employed for Social Security. In some cases, it may be possible to designate some or all of a terminated ministerial employee’s severance pay as a housing allowance. See Chapter 4, Section B.17, in Richard Hammar’s annual Church & Clergy Tax Guide for details.
  2. If your church pays the employee any accrued vacation pay or sick leave, these payments represent taxable income that must be reported as income on the employee’s W-2.
  3. In some cases, family and friends help support an unemployed person with gifts of cash or property. Generally, the gift is nontaxable to the recipient. However, if the gift produces income (i.e., interest, dividends) the recipient would be responsible for taxes on that income.
  4. Sometimes terminated employees help to pay for living expenses by withdrawing funds from their retirement account. Generally, if funds are withdrawn before a person reaches retirement age, and they are not rolled over into another qualified retirement plan or IRA within 60 days, that amount will be taxable in the year it is withdrawn. An additional 10 percent tax on such early distributions also may apply for persons who make withdrawals before they reach age 59 1/2. There is a “hardship” exception that may apply in some cases. See IRS Publication 575 for details.
  5. Certain expenses incurred by employees in looking for a new job in their present occupation may be tax-deductible. Examples of deductible expenses include employment and outplacement agency fees, résumé preparation, and travel expenses for job searches and interviews.
Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

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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