Tax Court Narrows Definition of “Minister”

New definition requires pastors to meet three factors to qualify for tax benefits.

Bio

In an unfortunate ruling, the Tax Court narrowed the definition of the term “minister” for federal tax purposes. This ruling will have an immediate impact on church treasurers and bookkeepers, since special tax and reporting rules apply to “ministers” under federal tax law. These rules include:

eligibility for housing allowances
self-employed status for social security purposes
exemption of wages from income tax withholding (ministers use the quarterly estimated tax procedure to pay their taxes, unless they elect voluntary withholding)
eligibility under very limited circumstances to exempt themselves from self-employment taxes

The Tax Court ruled that a “minister” for tax purposes is someone who is ordained, licensed, or commissioned, and who satisfies all 3 of the following factors: (1) administers sacerdotal functions (such as marriages, funerals, baptisms, communion); (2) conducts religious worship; and (3) is engaged in the “control, conduct, and maintenance” of a church or church-controlled organization (this refers to directing, managing, or promoting the activities of the church or organization).

There are many ministers who do not satisfy all three factors. Common examples include some associate pastors, youth pastors, and clergy serving in parachurch ministries. The impact of the Court’s narrow definition is illustrated in the following examples.

Example. Rev. G is youth minister at First Church. He conducts a weekly worship service for the youth of the church, and occasionally performs weddings, baptisms, and communion. Rev. G is not affected by the Court’s ruling, and remains a “minister” for federal tax purposes. As such, he is eligible for the housing allowance, his wages are exempt from income tax withholding, and he is self-employed for social security purposes with respect to his church compensation.

Example. K is the full-time music minister at her church. While her official title is “minister of music” she has never been ordained, commissioned, or licensed as a minister. She does not qualify as a minister for federal tax purposes. This is so even if she leads worship and engages in pastoral duties, since she is not ordained, commissioned, or licensed. She is not eligible for a housing allowance, she is an employee for social security purposes (the church should withhold FICA taxes from her wages), her wages are subject to income tax withholding, and she is not eligible for an exemption from self-employment taxes.

Tip. Church treasurers should never treat a minister as an employee for social security purposes. Why? Because federal law states that ministers are always self-employed for social security purposes with respect to their ministerial services. So, do not withhold FICA taxes from a minister’s wages, or report a minister’s wages as subject to FICA taxes on the W-2 form. Ministers pay the self-employment tax (the social security tax for the self-employed). This is very confusing, since most ministers are employees for federal income tax purposes. In other words, ministers have a dual tax status. Church treasurers must keep this important point in mind.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Q&A: Will Our Tax-Exempt Status Be Jeopardized if We Encourage a Senate Confirmation of a Federal Judge?

The answer revolves around whether your church’s actions were substantial in nature and constituted an attempt to influence legislation.

Richard R. Hammar, Attorney, CPA

Bio

Will a church jeopardize its tax-exempt status by encouraging Senate confirmation of federal judicial candidates?

Possibly, concluded the IRS chief counsel’s office in a General Counsel Memorandum (GCM).

Churches jeopardize their tax-exempt status under section 501(c)(3) of the Internal Revenue Code by either (1) engaging in substantial efforts to influence legislation, or (2) intervening or participating in a political campaign on behalf of or in opposition to any candidate for public office.

But do efforts to encourage Senate confirmation of federal judicial candidates fall under either of these restrictions? The IRS concluded that such efforts cannot be characterized as intervention or participation in a political campaign on behalf of or in opposition to a candidate for public office, since the income tax regulations define a “candidate for public office” as a contestant for elective public office. Federal judges, by comparison, are not elected but rather are appointed for life by the President with the consent of the Senate.

However, the IRS concluded that efforts to encourage Senate confirmation of federal judicial candidates did constitute an attempt to influence legislation, since Senate confirmation of judicial candidates constituted “legislation” for purposes of section 501(c)(3) of the Code. The IRS reasoned that Senate confirmation is a “final action by Congress,” much like any other legislation that is enacted. Accordingly, efforts to encourage the Senate to confirm judicial candidates constitute legislative activity, and jeopardize an organization’s tax-exempt status if the efforts are substantial in nature (GCM 39694).

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Is a Minister an Employee or a Self-employed Person for Income Tax Reporting Purposes?

A recent tax court ruling addresses this issue

Richard R. Hammar, Attorney, CPA

Bio

The question of whether a minister should report his or her federal income taxes as an employee or as a self-employed person is one that has generated a good deal of controversy. It is a significant question for many reasons, including the following:

Employees report their compensation directly on Form 1040, and claim unreimbursed business expenses on Schedule A only if they itemize deductions and only to the extent that such expenses (together with most other miscellaneous expenses) exceed 2% of adjusted gross income (only 80% of travel and entertainment expenses are counted). Self-employed persons report compensation and business expenses on Schedule C. Business expenses are in effect deductible whether or not the minister itemizes deductions, and are not subject to the 2% floor.
Adjusted gross income ordinarily will be higher if a minister reports as an employee, since business expenses are deductions from adjusted gross income. Self-employed persons deduct business expenses in computing adjusted gross income. Adjusted gross income is a figure that is important for many reasons. For example, the percentage limitations applicable to charitable contributions and medical expense deductions are tied to adjusted gross income.
Ministers working for a church or church agency should receive a Form W-2 each year if they are employees, and a Form 1099-MISC if they are self-employed (and receive at least $600 in compensation).
Favorable tax-deferred annuities offered by nonprofit organizations (including churches) may only be available to employees.
The disability pay exclusion generally is available only to employees.
For many years, most ministers reported their income taxes as self-employed persons. This was consistent with the treatment of all ministers as self-employed for social security purposes (with respect to services performed in the exercise of ministry). However, beginning in 1978, the IRS began making statements that were interpreted by some to require ministers to report their income taxes as employees. For example, in Revenue Ruling 80-110, the IRS held that a minister who is “an employee of a church’ may not deduct unreimbursed business expenses on Schedule C but rather must use Schedule A. See also Rev. Rul. 79-78. In Publication 517 (“Social Security for Members of the Clergy and Religious Workers”), the IRS lists a comprehensive example demonstrating how a minister who is “an employee of the church” should report his income and business deductions. These pronouncements led some tax advisors to conclude that the IRS now views all ministers serving local churches as employees rather than as self-employed. Reliance has also been placed on section 3401 (a) (9) of the Internal Revenue Code which states that ministers who are employees of a church are exempt from tax withholding.
Your editor has always taken the position that the IRS pronouncements mentioned above merely stated the appropriate manner of reporting income and deductions if employee status was assumed, and were not IRS directives requiring all ministers to report their taxes as employees. Publication 517 itself recognizes that it is possible for ministers who are employees of their churches to be self-employed with respect to certain services (baptisms, marriages, funerals, etc.). And, no one seriously questions that full-time evangelists are self-employed for income tax purposes. It is therefore difficult to support sweeping generalizations that all ministers are employees for income tax purposes.
The best approach to this issue is to treat ministers as employees only if they satisfy the common law employee test adopted by the Treasury Department:
Generally the relationship of employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so. The right to discharge is also an important factor indicating that the person possessing that right is an employer. Other factors characteristic of an employer, but not necessarily present in every case, are the furnishing of tools and the furnishing of a place to work to the individual who performs the services. In general, if an individual is subject to the control or direction of another merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result, he is not an employee. Treas. Reg. sec. 31.3401(c)-1(b). See also Publication 517.
Determining a particular minister’s status under this somewhat ambiguous test is often difficult. The following additional criteria, contained in the Social Security Handbook, are intended to clarify the common law employee test. They are accompanied by the qualification that “all facts must be weighed and the conclusion must be based on careful evaluation of all the facts and the presence or absence of factors which point to an independent contractor status,” and “any single fact or small group of facts is not conclusive evidence of the presence or absence of control.”
(1) A person who is required to comply with instructions about when, where, and how to work is ordinarily an employee.
(2) Training of a person by an experienced employee or by other means is a factor of control and indicates that the worker is an employee.
(3) Integration of a person’s services into the business operations generally shows that the person is subject to direction and control and accordingly is an employee.
(4) If the services must be rendered personally by the individual employed, it suggests an employer-employee relationship. Self-employed status is indicated when an individual has the right to hire a substitute without the employer’s knowledge.
(5) Hiring, supervising, and payment of assistants by the employer generally indicates that all workers on the job are employees. Self-employed persons generally hire, supervise, and pay their own assistants.
(6) The existence of a continuing relationship between an individual and the person for whom the individual performs services is a factor tending to indicate the existence of an employer-employee relationship.
(7) The establishment of set hours of work by the employer is a factor indicating control and accordingly the existence of an employer-employee relationship. Self-employed persons are “masters of their own time.”
(8) If the worker must devote full time to the business of the employer, he or she ordinarily will be an employee. A self-employed person on the other hand may choose for whom and when to work.
(9) Doing the work on the employer’s premises may indicate that the worker is an employee if the work could be done elsewhere.
(10) Persons who must follow established routines and schedules of the employer ordinarily are employees.
(11) A requirement that workers submit regular oral or written reports to the employer is indicative of an employer-employee relationship.
(12) An employee usually is paid by the hour, week, or month, whereas a self-employed person usually is paid by the job on a lump sum basis (although the lump sum may be paid in intervals in some cases).
(13) Payment by the employer of the worker’s business or travel expenses suggests that the worker is an employee. Self-employed persons usually are paid on a job basis and take care of their own incidental and business expenses.
(14) The furnishing of tools and materials by the employer indicates an employer-employee relationship. Self-employed persons ordinarily provide their own tools and materials.
(15) The furnishing of all necessary facilities (equipment and premises) by the employer suggests that the worker is an employee.
(16) Workers who are in a position to realize a profit or suffer a loss as a result of their services generally are self-employed, while employees ordinarily are not in such a position.
(17) A person who works for a number of persons or organizations at the same time is usually self-employed.
(18) Workers who make their services available to the general public are usually self-employed. Individuals ordinarily hold their services out to the public by having their own offices and assistants, hanging out a “shingle” in front of their office, holding a business license, and by advertising in newspapers and telephone directories.
(19) The right to discharge is an important factor in indicating that the person possessing the right is an employer. Self-employed persons ordinarily cannot be fired as long as they produce results which measure up to their contract specifications.
(20) An employee ordinarily has the right to end the relationship with the employer at any time he or she wishes without incurring liability. A self-employed person usually agrees to complete a specific job and is responsible for its satisfactory completion or is legally obligated to make good for failure to complete the job.
Another important factor, not mentioned in the above list, is the parties’ own characterization of their relationship. For example, if a church and its minister enter into a written contract that specifically characterizes the minister as self-employed, this would be an additional factor to consider. The accompanying illustration is a clause that may be used by a church wishing to characterize its minister as self-employed rather than as an employee. The clause could be inserted in the contract of employment, or simply adopted as a resolution by the church board and included in the board’s official minutes. Keep in mind that such a clause by itself will have little, if any, relevance. It is merely one factor that will be considered, but one that could be given considerable weight in a close case. Of course, a church will offset the effect of such a clause by issuing its minister a W-2 instead of a 1099 form at the end of each year.
Sample Clause Characterizing A Minister As Self-Employed
The church board and Rev. Lang agree and intend that Rev. Lang’s status shall be that of a self-employed person rather than that of an employee in view of the board’s determination, based on its review and consideration of all the facts and circumstances, that Rev. Lang does not satisfy the ‘common law employee” test. In particular, it is the board’s conclusion that it does not have the authority to control the methods or means by which Rev. Lang conducts his services on behalf of the church.
There is no doubt that most ministers will be employees under “common law employee test” discussed above. However, such a conclusion is not automatic. As has already been indicated, traveling evangelists ordinarily are self-employed, as are ministers of local congregations with respect to certain personal services rendered directly to church members (baptisms, marriages, funerals, etc.). Ministers of local congregations may be self-employed with respect to their services on behalf of the church as well, provided that they are not “employees” under the common law employee test. The fact that such a conclusion is entirely possible is illustrated by a recent Tax Court ruling. In Cosby v. Commissioner, T.C. Sum. Op. 1987-141, the Tax Court concluded that a Methodist minister was not an employee of his local church but rather was self-employed, and accordingly could report his church income and all business expenses on Schedule C. The court acknowledged that the common law employee test” had to be applied in reaching a determination as to the minister’s status, and referred to most of the twenty criteria discussed above as helpful guidelines. The court relied upon the following considerations in reaching its conclusion: (1) the minister was “free to use his own methods and style in the day-to-day conduct of his activities” and was clearly ‘his own man and operated free from any substantial control”; (2) the procedures that existed for terminating the minister’s services did “not at all approximate the type of day-to-day supervision and control which is characteristic of an employer-employee relationship” and did not enable the church to “control or direct the details and means by which the desired result was to be accomplished”; (3) the minister’s seminary education represented a substantial capital investment in his profession; (4) the minister’s profession requires considerable skill; and (5) the minister and his church regarded him as self-employed rather than as an employee. The court observed that its conclusion was “bolstered by the fact that neither party, nor our own research, disclosed a single case in which a member of the clergy.., was held to be an employee of either his or her local congregation or of the hierarchical structure of his or her denomination.”
In summary, a minister’s reporting status for federal income tax purposes will be determined on the basis of the common law employee test. Ministers wanting to report as self-employed persons should have their church so characterize them in their work agreement or contract, and should have the church issue them a Form 1099 rather than a Form W-2 at the end of each calendar year.
Example. Rev. Perez is a retired minister who serves as an interim minister for churches in a given geographical region that are temporarily in need of ministerial services. Rev. Perez typically spends no more than three months with any particular congregation, is given great freedom with respect to the duties he performs and the manner or method of performance, and its issued a 1099 form by each church. These facts suggest that Rev. Perez could report his income and business expenses as a self-employed person on Schedule C.
Example. Rev. Linn is a minister of education at First Church. She has a specific job description, her services are under the direct supervision and control of her senior pastor, she is issued a W-2 form each year, and is required to follow prescribed methods in the performance of her duties. These facts strongly suggest that Rev. Linn is an employee for income tax reporting purposes.
Example. Rev. Green is senior minister at First Church. The church exercise no control over the methods, means, or results of Rev. Green’s services. Much of his work is performed off of church premises. He is issued a 1099 form each year, and his work agreement with the church characterizes him as self-employed. Under these facts, the Tax Court’s ruling in Crosby v. Commissioner (discussed above) suggests that Rev. Green is free to report his income taxes as a self-employed person.
Example. Rev. Mayfield works in an administrative capacity for a church agency. Ordinarily, ministers who work in such a capacity will satisfy the definition of a common law employee since they are subject to a greater degree of control and supervision with respect to the details and performance of their duties, and accordingly should report their income taxes as employees.
Example. Rev. Hoyle is a youth minister at First church. Ordinarily, ministers who work in such a capacity will satisfy the definition of a common law employee since they are subject to a greater degree of control and supervision with respect to the details and performance of their duties, and accordingly should report their income taxes as employees.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Q&A: When Should Our Church File a Form 990?

Six guidelines to help you file.

Richard R. Hammar, Attorney, CPA

Bio

Must our church file a Form 990 with the federal government? We have received conflicting opinions.

Your church is not required to file a Form 990 with the federal government. Section 6033 of the Internal Revenue Code requires every organization that is exempt from federal income taxes to file an annual return (Form 990) with the IRS. Form 990 consists of 89 questions requesting detailed information about the finances, service, and administration of the exempt organization. However, section 6033 exempts several organizations from the reporting requirements, including:

(1) a church, an interchurch organization of local units of a church, a convention or association of churches, an integrated auxiliary of a church (such as a men’s or women’s organization, religious school, missions society, or youth group), and certain church-controlled organizations (see Rev. Proc. 86-23)

(2) a school below college level affiliated with a church (or operated by a religious order)

(3) a mission society sponsored by or affiliated with one or more churches or church denominations, if more than one-half of the society’s activities are conducted in, or directed at persons in foreign countries

(4) an exclusively religious activity or any religious order

(5) a religious or apostolic organization described in section 501(d) of the Code

(6) and exempt organization whose annual gross receipts are normally $25,000 or less

Efforts are underway in Washington to require all religious organizations (including churches) to file an annual Form 990. You will be fully apprised of any developments in future newsletters.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Should a Minister Revoke an Exemption from Social Security Coverage?

An ethical question.

Richard R. Hammar, Attorney, CPA

Bio

Many ministers exempted themselves from social security coverage because of the advice of a consultant that they would be “better off financially” if they did not enter the system. In other words, the basis for their exemption was purely financial. Should such a minister take advantage of a provision in the Tax Reform Act of 1986 that gives ministers a limited opportunity to revoke an exemption? This is a question that I have been asked repeatedly over the past several months.

It is my opinion that a minister who claimed an exemption for which he or she was not eligible has an ethical duty to re-enter the system. This is the very reason that Congress has given ministers a limited opportunity to revoke an exemption. Congress recognized that the vast majority of ministers who obtained an exemption were in fact not eligible. To be eligible for the exemption, a minister must be conscientiously opposed, because of religious principles, to accepting social security benefits for services performed as a minister. The opposition is not to the payment of the tax, or to the perceived inadequacy of social security benefits. Opposition to receiving benefit checks upon one’s retirement or disability, and not to paying taxes to finance those benefits, is indeed an extraordinary position.

Ministers may revoke an exemption by filing a Form 2031 (revised) by April 15, 1988. Ministers electing to revoke their exemption will not be liable for back taxes and will not be asked to explain the basis for their action. One final thought—ministers should decide as early as possible whether or not to revoke an exemption from social security coverage, since they will be liable for the self-employment tax for all of 1987 if they do elect to revoke the exemption. Many ministers who put off the decision until late 1987 or early 1988 may be forced to maintain their exemption because of an inability to pay the substantial accumulated tax for all of 1987.

Ministers approaching retirement must consider an additional factor. They will not be eligible for most social security benefits unless they have ten years (forty quarters) of covered employment. Revoking an exemption within a few years of retirement therefore makes little sense. Such a minister would be paying into a system from which he or she ordinarily will receive no benefits, Ministers who plan to work at least ten more years must also recognize that under current law their benefits generally are computed on the basis of their thirty-five highest years of taxable wages. Ministers who revoke an exemption and then work only ten or twenty years prior to retirement will find their benefits reduced accordingly.

Ministers who worked at least ten years in secular employment do not lose social security benefits based on their secular earnings, even if they continue to be exempt from coverage as a clergyman. Again, however, they should recognize that each year of exempt wages will have the effect of reducing their benefits.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

Computing Your Housing Allowance Exclusion

How to estimate accurately.

Richard R. Hammar, Attorney, CPA

Bio

The housing allowance is one of the most valuable tax benefits available to ministers. Yet, many ministers either fail to claim it or do not claim enough. In some cases, this results from tax advisors who are unfamiliar with ministers’ taxes. In this article, I will summarize the requirements for obtaining the full benefit available to ministers who live in a church-owned parsonage. In the next issue, I will discuss the rules that apply to ministers who rent or own their homes. Section 107 of the Internal Revenue Code says simply that “in the case of a minister of the gospel, gross income does not include—(1) the rental value of a home furnished to him as part of his compensation, to the extent used by him to rent or provide a home.” There are four important considerations to note in this section, First, the housing allowance is available only to a minister of the gospel. The income tax regulations (drafted by the Treasury Department and interpreting the Code) define a minister of the gospel to include any minister who has been ordained, commissioned, or licensed by a church or church organization that qualifies as a tax-exempt religious organization. Ministers who have been licensed by a religious organization that both licenses and ordains clergy must perform substantially all the religious functions of an ordained minister in order to qualify for the exemption.

Second, the housing allowance is an exclusion from gross income, rather than a deduction in computing or reducing adjusted gross income. As a result, it is not reported anywhere on Form 1040. In effect, the housing allowance is “claimed by not reporting it as income.

Third, section 107 excludes the fair rental value of a parsonage provided rent-free to a minister as well as an allowance paid to a minister to the extent used by him or her to pay expenses incurred in maintaining the parsonage (e.g., utilities, repairs, furnishings). Ministers who live in a church-owned parsonage do not report the fair rental value of the parsonage as income (as they ordinarily would do if they were allowed to live rent-free in a home provided by any other employer). The church is not required to declare an allowance in the amount of the fair rental value of the parsonage. The exclusion is automatic. However, if the minister incurs any expenses in living in the parsonage, then he or she may exclude them only to the extent that they do not exceed a “parsonage allowance” declared in writing and in advance by the church board.

Example. Rev. White lives rent-free at a church owned parsonage having a fair rental value of $6000 in 1986k The church expects Rev. White to incur some expenses in living in the parson age, and accordingly provides him with an allowance of $100 each month. His salary (not including the monthly allowance,) is $20,000 in 1986. On his 1986 federal income tax return Rev. White would not report the fair rental value of the parsonage ($6000) as income, even though the church never designated that amount as a housing allowance. However, he would have to report the total monthly allowances ($1200) as income unless the church board declared a parsonage allowance” in writing and in advance of at least $1200.

Suggestion. Ministers living in parsonages should be sure to have the church board declare a “parsonage allowance” in advice of each calendar year to cover any miscellaneous expenses the minister may incur in living in the parsonage. The allowance should be declared in writing and be incorporated into the board’s minutes.. The allowance can be a portion of the minister’s salary. For example, in the previous example, the church could have declared $1200 of Rev. White’s annual salary of $20,000 to be a parsonage allowance. The effect of this would have been to exclude the $1200 from gross income (to the extent Rev. White incurred expenses of at least that amount).

Churches failing to declare a parsonage allowance before January 1 should not wait until the following year to act. The declaration is effective from the date of its enactment on. Therefore, a church failing to declare a parsonage allowance until Match can still provide its minister with an important tax benefit for the remainder of the year.

Finally, section 107 requires that the parsonage be furnished to the minister as part of his or her compensation for services performed in the exercise of ministry. The regulations define “services performed in the exercise of ministry” to include (1) the performance of sacerdotal functions, (2) the conduct of religious worship, (3) direction, managing or promoting the activities of a religious organization under the authority of a church or church denomination, or (4) teaching or administrative duties at a theological seminary under the authority of a church or church denomination. A parsonage must be provided to a minister as compensation for one or more of these categories of employment in order for the minister to exclude the parsonage’s rental value from gross income.

The housing allowance is an exclusion for federal income tax purposes only. It cannot under any circumstances be excluded in computing a minister’s social security (self-employment) tax liability. Therefore, in computing the social security tax on Schedule SE of Form 1040, a minister must include the fair rental value of his or her parsonage as income on line 2 of Part 1. A minister must also include any parsonage allowance paid by his or her church to cover miscellaneous expenses in maintaining the parsonage. The rental value of a parsonage is a question of fact to be determined in each case on the basis of its particular circumstances.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.