Background. Only 29 percent (about 3 out of 10) taxpayers are able to itemize deductions on Schedule A. This interesting statistic is buried in the Spring 1994 Statistics of Income Bulletin issued by the IRS in June. What is the relevance of this to church treasurers? It demonstrates that 7 out of 10 ministers and lay church workers who report their federal income taxes as employees (or who are reclassified as employees by the IRS) will be unable to deduct either their unreimbursed business expenses or business expenses reimbursed under a nonaccountable arrangement. Here’s why. Employees can claim unreimbursed business expenses (including travel and transportation expenses), and business expenses reimbursed by their church under a nonaccountable arrangement, only as miscellaneous itemized deductions on Schedule A. Employees who cannot itemize deductions will not be able to deduct any of these expenses. This is particularly unfortunate for employees whose business expenses are reimbursed under a nonaccountable plan, since they must include the full amount of all the expense reimbursements as taxable income but they are denied any deduction of their expenses. Reimbursed expenses are nonaccountable if the employee was not required to or did not “account” to the employer for the expenses or was not required to or did not return any “excess reimbursements” (employer reimbursements in excess of substantiated expenses) to the employer. The most common form of nonaccountable reimbursement is a monthly car allowance paid to a church employee without any requirement that actual business expenses be substantiated.
In addition, most miscellaneous expenses (including unreimbursed and unsubstantiated reimbursed employee business expenses) are deductible on Schedule A only to the extent they exceed 2% of adjusted gross income (only 50% of business meals and entertainment are counted).
Planning tip. Ministers reporting their income taxes as employees can minimize if not eliminate the adverse effect of these rules by having their employing church adopt an accountable reimbursement policy.
Planning tip. Ministers who report their income taxes as employees (or who would be classified as employees by the IRS) cannot deduct any of their unreimbursed business expenses if they have insufficient itemized deductions to use Schedule A. However, these ministers are placed in an even worse position if their church reimburses some or all of their expenses under a nonaccountable arrangement, since all of the reimbursements are includable on the minister’s W-2 as taxable income while the minister is unable to claim any offsetting deduction. This makes it critical for churches to avoid nonaccountable reimbursement arrangements. Here are some examples of nonaccountable reimbursement arrangements that should be avoided. Our recommendation—if you currently have any of these arrangements, immediately convert it to an accountable arrangement.
- Your church pays a monthly “car allowance” to clergy or lay staff members, without requiring any accounting or substantiation.
- Your church reimburses business expenses without requiring adequate written substantiation (with receipts for all expenses of $25 or more) of the amount, date, place, and business purpose of each expense.
- Your church only reimburses business expenses once each year. Business expenses must be accounted for within a “reasonable time” under an accountable arrangement. Generally, this means within 60 days or less.
- Your church provides clergy or lay staff with travel advances and requires no accounting for the use of these funds.
Many ministers assume they can avoid these limitations simply by reporting their income taxes as self employed. This is a very dangerous assumption, since the IRS and the courts would consider most pastoral ministers to be employees for income tax reporting purposes (of course, ministers are self-employed for social security purposes with respect to ministerial services).
Conclusion. According to the recent IRS Statistics of Income Bulletin, 7 out of 10 taxpayers do not have enough deductions to itemize on Schedule A. Among other things, this means that 7 out of 10 taxpayers cannot deduct unreimbursed business expenses or business expenses reimbursed by an employer under a nonaccountable arrangement. This harsh result can be reduced if not eliminated if an employing church simply adopts an accountable reimbursement policy that requires an adequate accounting prior to the reimbursement of any business expense and the return of any excess reimbursements to the church. Failure to do so will needlessly result in the payment of additional taxes.
Example. Rev. B serves a senior minister of a church and reports his federal income taxes as an employee. The church expects Rev. B to pay business expenses out of his own salary, so it reimburses none of Rev. B’s business expenses. In other words, all of Rev. B’s business expenses are “unreimbursed.” For 1994, Rev. B has total church compensation of $35,000, and incurs unreimbursed business expenses of $3,000. He does not have enough itemized deductions to use Schedule A. As an employee, the only way for Rev. B to deduct his unreimbursed business expenses is as an itemized deduction on Schedule A (to the extent that such expenses exceed 2% of his adjusted gross income). Since Rev. B does not have enough deductions to itemize on Schedule A, he cannot deduct any portion of his unreimbursed business expenses. According to the recent IRS report, 70% of all taxpayers cannot use Schedule A. This suggests that 7 out of 10 ministers who report their income taxes as employees (or who would be classified as employees by the IRS in an audit) will be unable to deduct their unreimbursed business expenses. This unfortunate result can be avoided completely if a church simply adopts an accountable business expense reimbursement arrangement.
Example. Rev. H receives a monthly “car allowance” of $300. Rev. H is not required to account for the use of any of these funds. This is an example of a nonaccountable reimbursement arrangement. The church is reimbursing business expenses (through a monthly car allowance) without requiring any accounting or substantiation. If Rev. H reports her income taxes as an employee (or as self employed, but is reclassified as an employee by the IRS in an audit), and has insufficient itemized deductions to use Schedule A, the following reporting requirements apply: (1) the church must report all of the monthly allowances ($3,600) on Rev. H’s W 2 form; (2) Rev. H must report all of the monthly allowances ($3,600) as income on her Form 1040; (3) Rev. H cannot deduct any of her car expenses since these are deductible only as itemized deductions on Schedule A. This result is even worse than the previous example, since in this case all of the monthly car allowances are includable on Rev. H’s W-2 though she is unable to claim any offsetting deduction for her car expenses. As noted before, it can be assumed that 7 out of 10 clergy are not able to use Schedule A, and cannot deduct either unreimbursed business expenses or business expenses reimbursed under a nonaccountable arrangement. This harsh rule can be avoided if a church adopts an accountable reimbursement arrangement. This is especially critical if a church uses a nonaccountable reimbursement arrangement, since not only are all of the expenses nondeductible under such an arrangement but all of the church’s reimbursements are includable as taxable income on the minister’s W-2.
Planning tip. If your church has not yet adopted an accountable reimbursement arrangement, helpful guidance is available in chapter 6 of Richard Hammar’s annual Church and Clergy Tax Guide. This chapter includes a sample resolution that can be adopted by the governing board of your church to implement an accountable reimbursement arrangement.
This article originally appeared in Church Treasurer Alert, August 1994.