Getting Payroll Right

Failure to comply with laws can prove costly for churches.

The payroll taxes reported by 6,000 organizations from across the country are under intensive examinations by the Internal Revenue Service through a new payroll compliance initiative.

Churches should take note of this additional scrutiny for two reasons.

One, among the 6,000 organizations selected, 1,500 are tax-exempt entities. Churches, as well as other nonprofit organizations, may be included since payroll tax examinations are not conducted under the special provisions for church tax inquiries under Internal Revenue Code §7611.

And two, incorrectly reporting the compensation of workers can lead to serious consequences for churches. Church leaders should take special care in this area due to the potential amount of taxes, penalties, and interest that can be assessed for noncompliance.

Whether a church specifically gets reviewed by this payroll compliance initiative or not, all church leaders should use this opportunity to review their own practices, identify any real—or potential—problems, and take corrective measures. A thorough assessment of the following payroll topics can mitigate risk and avoid undue financial penalties for churches and church leaders.

Independent contractor or employee?

Churches struggle most with classifying a worker as either an employee or an independent contractor. In most instances, the worker’s classification can be determined from the law (although a few gray areas do exist). Unfortunately, churches frequently base a classification on either someone’s personal belief or on what other churches are doing with similar workers.

Employers may classify a worker as an independent contractor to save time, paperwork, and/or money. The significant risk a church takes by choosing the seemingly easy path, though, is the payroll tax liability that arises when one of its workers must be reclassified from independent contractor to employee.

Some common misconceptions regarding worker classification include:

  • The worker doesn’t work very frequently and/or only works a few hours at a time;
  • The employer can engage a worker on a short time trial to determine if the arrangement will work and treat them as an independent contractor during the trial period. Later, if the arrangement works out, they can be treated as an employee;
  • First Church Down The Road is a really large church, and they treat similar workers as independent contractors;
  • This is the way the church has classified this type of worker for 20 years, so it must be right.

The basic test for worker classification (a full discussion of the process is beyond the scope of this article) revolves around these factors:

  • Who controls the worker;
  • Where the worker performs their duties;
  • What duties are performed; and,
  • Who supplies tools and work accessories to the worker.

In virtually all circumstances, the IRS classifies a worker as an employee unless that person owns a business providing services to the church as well as to other entities.

The following positions are commonly misclassified by churches:

  • Child care workers
  • Musicians (Don’t be swayed by the musician’s opinion. Musicians are generally not good tax advisors!)
  • Substitute teachers
  • Maintenance workers
  • Consultants

Workers classified by a church as independent contractors who are later classified as employees by the IRS will result in the assessment of taxes, penalties, and interest to the church on the wages paid to misclassified workers. I know of one organization with less than $1 million in annual revenue that paid more than $30,000 in payroll taxes and penalties due to worker classification issues.

What about classifying ministers?

Ministers are treated uniquely for payroll, and churches should take care when classifying them. The following key issues should be addressed regarding ministers:

  • Proper classification and verification of ministerial status and the performance of ministerial duties;
  • Confirmation that the minister is not having FICA/Medicare taxes withheld and matched by the church (this is not optional, but is mandatory); and,
  • Proper designation of any housing allowance to be provided to the ministers.

More than just a paycheck

Reportable payroll is more than just what is paid through the normal paycheck and reported through the payroll system used by the church. The essence of tax law is that every benefit granted to an employee/worker is taxable until the Internal Revenue Code allows for it to be tax free. Churches must review every benefit provided to an employee and confirm the proper tax consequences of the benefit. Many benefits can be provided tax free as long as the proper documentation is in place and certain requirements are met.

The following are examples of benefits that may be taxable to an employee if they are not handled through the proper programs:

  • Tuition reduction at the church-associated school;
  • Life insurance programs;
  • Reimbursement of out-of-pocket medical expenses; and,
  • Child care programs.

Other times, churches call taxable income by a different name and then think it isn’t taxable to the employees, such as the following:

  • Auto allowances;
  • Clothing allowances;
  • Gifts for anniversaries, birthdays, and other special occasions;
  • Employer-provided automobiles;
  • Retirement gifts;
  • Undocumented expense advances.

Not properly classifying fringe benefits opens a church to additional payroll tax assessments by the IRS. Taxable fringe benefits incorrectly reported can be classified as excess benefit transactions and cause the assessment of intermediate sanctions equaling 225 percent to a key employee and 10 percent to the person who agreed to the benefit. Additionally, the employee could be required to repay the benefit to the church.

Taxable fringe benefits can also be determined in the event an employee is audited by the IRS and has additional taxes assessed. In severe cases, employees may be charged with tax fraud or tax evasion due to the underreporting of their taxable income. Both charges carry severe civil penalties and potential criminal charges.

Payroll responsibilities

Don’t forget these three basic responsibilities churches must fulfill as a part of payroll:

  • FICA/Medicare: Churches/religious organizations are required to with- hold FICA/Medicare and pay the employer matching portion on all employees that are not classified as ministers. (Employees classified as ministers, performing ministerial duties may not participate in the Social Security system through the FICA/Medicare program. They are required to participate through the Self Employed Contributions Act and pay self-employment tax. See IRS Publication 517 for more information. This is not optional.) Churches that have properly filed a Form 8274, Certification by Churches and Qualified Church Controlled Organizations Electing Exemption from Employer Social Security and Medicare Taxes, do not withhold FICA/ Medicare taxes from their employees. The employees of an “electing church” must pay self-employment tax with their personal Form 1040.
  • Federal Income Tax Withholding: Wages paid to employees of churches are all subject to the rules regarding mandatory federal income tax withholding with the exception of ministers. Therefore, the church should obtain a completed Form W-4 from all nonministerial employees to determine the proper amount of withholding. Ministers are not obligated to have federal income tax withheld from their pay, but they may elect to have federal income tax withheld from their pay by informing the church of that decision and providing the church with an amount to be withheld.
  • Federal Unemployment Tax: Wages paid to employees of organizations exempt under Internal Revenue Code Section 501(c)(3) are not subject to federal unemployment tax. Whether these wages are subject to state unemployment taxes is dependent on the laws of each state. Many states exempt wages paid to employees of churches. (In states where this exemption exists, it generally means the employee will not be able to receive unemployment in the event of a termination.) Churches should become familiar with the state laws applicable to their employees.

File, report, and pay—or pay some more!

Penalties are imposed on employers that do not file the requisite Forms 941/944 or that do not deposit the related payroll taxes in a timely fashion. Churches are not exempt from these penalties. The portion of the payroll tax obligation that is withheld from an employee’s pay is considered to be the “trust fund” portion of the taxes.

The IRS views the lack of remittance of these taxes to be the equivalent of stealing from the employees. Therefore, the penalty for a failure to deposit is high and quickly adds up. Within 16 days from the date the tax is due, the penalty is already assessed at 10 percent of the tax due. If this isn’t paid upon request of the IRS, the IRS can assess an additional 15 percent of the amount due.

The IRS is very unforgiving of organizations that do not pay these taxes. In only rare instances will the IRS be willing to abate the penalties associated with the late payment of payroll taxes. In St. Paul Cathedral School v. U.S., 102 AFTR 2d 2008-7212, the court agreed that the school should be required to pay all the penalties assessed on the late filing of the school’s Forms 941 and the late payment of the related taxes. The school was required to pay the penalties even though the duties to file and pay had been delegated to the school’s bookkeeper and despite the fact that the bookkeeper had stolen the tax money.

The IRS can move through the corporate entity of the church to collect the trust fund portion of payroll taxes from any responsible party. This can be any person with the church that has the authority or the ability to make sure the taxes are properly paid. Therefore, a church treasurer can have the tax liability assessed to him personally, if it is not properly paid by the church. Further, director and officer liability insurance cannot cover these assessments.

Four steps to avoid noncompliance

Payroll issues present some of the most challenging areas of compliance for churches and religious organizations. Rules tend to be highly technical and not necessarily intuitive. Unfortunately, the consequences of poor compliance in this area can result in monetary damages to employees, employers, and to responsible persons, such as board members, officers, and committee members. To assure that compliance is a high priority, churches should:

  1. Review all persons classified as independent contractors for proper classification;
  2. Review the classification and documentation of all ministers;
  3. Review all benefits provided to employees to determine the proper taxation and reporting of the benefits; and
  4. Appoint a person to review and obtain evidence of the proper payment of payroll taxes and the proper filing of all payroll tax reports.
Elaine L. Sommerville is licensed as a certified public accountant by the State of Texas. She has worked in public accounting since 1985.

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.

ajax-loader-largecaret-downcloseHamburger Menuicon_amazonApple PodcastsBio Iconicon_cards_grid_caretChild Abuse Reporting Laws by State IconChurchSalary Iconicon_facebookGoogle Podcastsicon_instagramLegal Library IconLegal Library Iconicon_linkedinLock IconMegaphone IconOnline Learning IconPodcast IconRecent Legal Developments IconRecommended Reading IconRSS IconSubmiticon_select-arrowSpotify IconAlaska State MapAlabama State MapArkansas State MapArizona State MapCalifornia State MapColorado State MapConnecticut State MapWashington DC State MapDelaware State MapFederal MapFlorida State MapGeorgia State MapHawaii State MapIowa State MapIdaho State MapIllinois State MapIndiana State MapKansas State MapKentucky State MapLouisiana State MapMassachusetts State MapMaryland State MapMaine State MapMichigan State MapMinnesota State MapMissouri State MapMississippi State MapMontana State MapMulti State MapNorth Carolina State MapNorth Dakota State MapNebraska State MapNew Hampshire State MapNew Jersey State MapNew Mexico IconNevada State MapNew York State MapOhio State MapOklahoma State MapOregon State MapPennsylvania State MapRhode Island State MapSouth Carolina State MapSouth Dakota State MapTennessee State MapTexas State MapUtah State MapVirginia State MapVermont State MapWashington State MapWisconsin State MapWest Virginia State MapWyoming State IconShopping Cart IconTax Calendar Iconicon_twitteryoutubepauseplay