Q: Our church has been withholding FICA for its pastors, in some instances for years—or even decades. We recently learned this is a mistake. How do we fix this?
Wages paid to ministers are not included in the definition of wages for the purposes of withholding FICA/Medicare tax. This includes the related employer matching of these taxes by the church.
Instead, ministers must pay into the Social Security/Medicare systems through self-employment tax calculated on Schedule SE with their personal tax returns (unless they obtain an exemption).
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FICA withholding rules are confusing
Improper FICA withholdings is not uncommon. Churches often incorrectly withhold and match the FICA/Medicare taxes on ministers. If the IRS determines this treatment has occurred, it takes the position that the church has determined the employee is not a minister for payroll tax purposes. This may affect the taxation of other benefits. That’s because it’s impossible to claim to be a minister for one portion of the rules but not for another.
For an example of how the incorrect withholding of a minister’s payroll taxes can prove so consequential, look no further than the housing allowance that qualifying ministers are eligible to receive.
The housing allowance is one of the most valuable tax benefits available to ministers. If a church treats a minister incorrectly and withholds and matches the minister’s FICA/Medicare taxes, then the IRS views him or her as an employee, not a minister. The IRS then would tax the housing allowance paid by the church for the minister, representing a sizable financial loss for the minister.
Correcting Improper FICA Withholdings
Churches that have improperly withheld/matched a minister’s FICA/Medicare taxes should amend the payroll reports for the three tax years open under the statute of limitations.
This requires amending quarterly Forms 941 and annual Forms W-2. Taxes paid will be refunded to the church. And, because it mistakenly overpaid its taxes, the church will not face any penalties.
The minister will need to report the compensation as self-employment income for the past three years. This is done by amending the related Forms 1040.
The minister also needs to pay the related self-employment tax owed. Interest will be calculated on the tax owed when he or she amends the Forms 1040.
These amendments can be complicated, so a church may require professional assistance in filing the related amended reports and returns.