Key point 1-03.02. Most ministers should report their federal income taxes as employees, because they will be considered employees under the tests currently used by the IRS and the Tax Court.
The question of whether a minister is an employee or self-employed for federal income tax reporting purposes is an important one. The IRS thinks so too, for its audit guidelines for ministers state that “the first issue that must be determined is whether the minister is an employee or an independent contractor.” Why is this distinction so important? Consider the following reasons:
- Reporting compensation. Employees report their compensation as wages on line 7 of Form 1040, while self employed persons report compensation on Schedule C (of Form 1040).
- Business expenses. Employees deduct unreimbursed (and “nonaccountable” reimbursed) business expenses on Schedule A only if they itemize deductions and only to the extent that such expenses exceed 2% of adjusted gross income. Self employed persons report their 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. Adjusted gross income ordinarily will be higher if a minister reports income taxes as an employee, since unreimbursed (and “nonaccountable” reimbursed) 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.
- W 2 or 1099? 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 annual compensation).
- Tax deferred annuities. Favorable “tax deferred annuities” (also known as “403(b) annuities”) offered by nonprofit organizations (including churches) generally are available only to employees. However, they are available to ministers whether they report their federal income taxes as employees or self-employed.
- Tax treatment of various fringe benefits. Certain fringe benefits provided by a church on behalf of a minister are excludable from the minister’s income only if he or she is an employee. Examples include group term life insurance (up to $50,000) provided by a church on behalf of a minister, and employer sponsored “cafeteria plans” which permit employees to choose between receiving cash payments or a variety of fringe benefits.
- Audit risk. Self employed persons face a much higher risk of having their tax returns audited. The tests used by the IRS and the courts in determining whether or not a minister or other church worker is an employee or self-employed for federal income tax reporting purposes are complex and beyond the scope of this text. They are addressed fully in a companion text.32 Id.
Observation. The IRS and the courts will apply the same tests used in determining the correct reporting status of ministers to determine the reporting status of nonminister church workers for income tax reporting purposes.