Recent Developments in IRS Documents Related to Clergy Income Tax

A recently released confidential IRS memo dating back to 1992 concluded that the so-called Deason rule must be applied in the computation of self-employment taxes as well as income taxes.

Church Law and Tax 1998-09-01

Clergy-Income Tax

Key point. Clergy do not have to apply the so—called “Deason rule” in computing their self—employment taxes. This means that they do not need to reduce their business expense deduction by the percentage of their total compensation that is comprised of a “tax—exempt” housing allowance.

A recently released confidential IRS memo dating back to 1992 concluded that the so—called Deason rule must be applied in the computation of self—employment taxes as well as income taxes. The memo was issued by the IRS national office in response to the following question received from a district director: “Does the self—employment tax on ministers’ tax exempt parsonage allowances remove deductions allocable to such allowances from the section 265 restriction on deductions allocable to tax exempt income?” Stated more clearly, do ministers have to reduce their business expense deduction when computing self—employment taxes by the percentage of their total compensation that consists of a nontaxable housing allowance? Let’s illustrate this question with an example. Assume that Rev. G has total compensation of $50,000 for 1998 (which includes a $10,000 housing allowance) plus business expenses of $5,000 that are reimbursed under a nonaccountable arrangement. The Deason rule requires Rev. G to reduce his business expense deduction in computing his income taxes by the percentage of his total compensation that consists of a tax—exempt housing allowance. Since 20 percent of Rev. G’s total compensation is “tax—exempt” ($10,000 is 20 percent of $50,000), Rev. G must reduce his business expense deduction by 20 percent. This means that he must reduce his $5,000 of business expenses by $1,000 yielding a deduction of $4,000. The idea here is that taxpayers should not be allowed to deduct expenses that are paid for out of tax—exempt income.

But what about self—employment taxes? Does Rev. G have to apply the Deason rule in computing his business expense deduction? The obvious answer is “no,” since the housing allowance (or fair rental value of a parsonage) is fully taxable in computing self—employment taxes and so there is no basis whatever for applying the Deason rule. And yet the IRS reached the opposite conclusion in its recently published 1992 memo. However, its reasoning was so dubious that it conceded that “litigation hazards” were associated with its conclusion. In fact, it even acknowledged that “an argument can be made” that the Deason rule does not apply in computing self—employment taxes. Fortunately, the flawed reasoning in the secret memo was rejected by the IRS itself a few years later. In 1995 the IRS issued “audit guidelines” for ministers that its agents are to follow when auditing ministers’ tax returns. These guidelines are addressed fully in the September—October 1995 issue of this newsletter. They contain the following example:

Example. M receives a salary from the church of $20,000. His parsonage allowance is $12,000. The church withholds federal income tax (by mutual agreement) and issues him a Form W—2. He has unreimbursed employee business expenses (before excluding nondeductible amounts attributable to his exempt income) of $5,200. His net earnings for self—employment tax are $26,800 ($20,000 + $12,000—$5,200). Note that all of M’s unreimbursed business expenses are deductible for self—employment tax purposes, although the portion attributable to the exempt housing allowance is not deductible for federal income tax purposes. [The Deason rule] regarding the allocation of business expenses related to exempt income relates to income tax computations but not self—employment tax computations.

Application. Ministers can continue to disregard the Deason rule in computing their self—employment taxes. This means that they do not need to reduce the amount of their business expense deduction by the percentage of their total compensation that consists of a housing allowance. This conclusion is based not only on the IRS audit guidelines for ministers, but also upon the last several editions of IRS Publication 517. Finally, note that the Deason rule can be avoided for income taxes too if a minister and church adopt an accountable business expense reimbursement arrangement. In such a case, the minister does not report church reimbursements as income and there are no deductions to claim. The minister is reporting business expenses to the church rather than to the IRS.

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