Article summary. There are a number of errors that frequently appear on ministers’ tax returns. These errors may be more common for ministers who prepare their own tax returns, but they also are often seen on returns prepared by professional tax preparers. This article will describe several of these common errors, and show how to handle ministers’ taxes correctly.
The preparation of ministers’ tax returns presents a number of challenging issues that often are not well understood. This can lead to innocent mistakes, which in turn can lead to unexpected additional taxes in the event of an audit. Let’s review some of the mistakes that occur frequently. Ministers who understand these common errors are better equipped to prepare their own returns.
Error No. 1: Reporting Social Security taxes as an employee
Most ministers report their federal income taxes as employees. Many of these ministers naturally assume that they should report their Social Security taxes as employees too. Unfortunately, the tax law is not always logical. Ministers are always self-employed for Social Security with respect to services performed in the exercise of their ministry, even if they report their income taxes as an employee. This is sometimes called the “dual tax status” of ministers.
• Example. Pastor Bill reports his income taxes as an employee. He and his church assume that he is an employee for Social Security purposes, and the church withholds FICA taxes from his wages. This is incorrect. Pastor Bill, as a minister engaged in the exercise of ministry, is self-employed for Social Security even though he reports his income taxes as an employee. This illustrates the so-called dual tax status of ministers. Pastor Bill pays the self-employment tax.
• Key point. Some chaplains are subject to FICA taxes rather than self-employment taxes.
Error No. 2: Reporting income taxes as self-employed
All taxpayers are either employees or self-employed for income tax reporting purposes. Many ministers continue to report their income taxes as self-employed. In many cases this is incorrect, and if these ministers are audited and reclassified as employees by the IRS there often will be additional taxes (and possibly interest and penalties) to pay. Why? Because it is more difficult for employees to deduct business expenses than for self-employed workers. Self-employed workers can deduct their business expenses directly on Schedule C, whether or not they can itemize deductions on Schedule A. Employees on the other hand can deduct business expenses that are either unreimbursed or reimbursed under a nonaccountable arrangement only as an itemized deduction on Schedule A to the extent they exceed 2 percent of adjusted gross income. Since as many as 70 percent of all taxpayers lack enough itemized deductions to use Schedule A, this means that these expenses are not deductible by many employees.
• Example. Pastor Eric reports his income taxes as a self-employed person. He had $3,000 of business expenses in 2010 that were not reimbursed by his church. He deducted all of these expenses on Schedule C. He did not have enough expenses to itemize deductions on Schedule A. Pastor Eric is audited by the IRS, and is reclassified as an employee. He will not be able to deduct any of the $3,000 of business expenses since they are deductible, by an employee, only as an itemized deduction on Schedule A.
• Key point. Ministers who are employees for income tax reporting purposes can avoid the limitations on the deductibility of business expenses by having their employing church adopt an accountable business expense reimbursement arrangement.
How can ministers determine whether they are employees or self-employed for income tax reporting purposes? There are three primary tests:
• The IRS 20-factor test
The IRS often applies a 20-factor test in deciding if a taxpayer is an employee or self-employed. This test is explained fully in chapter 2 of Richard Hammar’s Church and Clergy Tax Guide. Most senior pastors will be employees under this test, as will nearly all associate pastors.
• The Tax Court’s 7-factor test
In 1994, the United States Tax Court issued two rulings addressing the correct tax reporting status of ministers. In one case the court found that a Methodist minister was an employee for federal income tax reporting purposes. Weber v. Commissioner, 103 T.C. 378 (1994). In the second case the court concluded that a Pentecostal Holiness pastor was self-employed for income tax reporting purposes. Shelley v. Commissioner, T.C. Memo. 1994-432 (1994). While the court reached different conclusions in these two cases, it applied the same test for determining the correct tax reporting status of ministers. The test requires consideration of the following 7 factors: (1) the degree of control exercised by the employer over the details of the work; (2) which party invests in the facilities used in the work; (3) the opportunity of the individual for profit or loss; (4) whether or not the employer has the right to discharge the individual; (5) whether the work is part of the employer’s regular business; (6) the permanency of the relationship; and (7) the relationship the parties believe they are creating. This test is explained fully in chapter 2 of Richard Hammar’s Church and Clergy Tax Guide. Most senior pastors will be employees under this test, as will nearly all associate pastors.
• IRS audit guidelines for ministers
The IRS has issued audit guidelines for its agents to follow when auditing ministers. These guidelines inform agents that “the first issue that must be determined is whether the minister is an employee or an independent contractor.” They do not mention either the 20-factor or 7-factor tests, but rather rely on the following test set forth in the income tax regulations:
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. Generally, physicians, lawyers, dentists, veterinarians, contractors, subcontractors, public stenographers, auctioneers, and others who follow an independent trade, business, or profession, in which they offer their services to the public, are not employees. Treas. Reg. 31.3401(c)-1(b)-(c).
• Key point. The IRS has a pro-employee bias. Ministers who report their income taxes as self-employed should recognize that there is a significant chance that they would be reclassified as an employee if audited.
• Key point. Most ministers should report their federal income taxes as employees, because they will be considered employees under the 3 tests summarized above. Further, most ministers will be “better off” reporting as employees, since (1) the value of various fringe benefits will be nontaxable, including the cost of employer-paid health insurance premiums; (2) the risk of an IRS audit is substantially lower; and (3) reporting as an employee avoids the additional taxes and penalties that may apply to self-employed ministers who are audited by the IRS and reclassified as employees. The only disadvantage to employee status is that ministers’ business expenses are more difficult to deduct. However, this limitation can be overcome if a church simply adopts an accountable business expense reimbursement policy.
Error No. 3: Failure to report “special occasion” gifts as income
Most ministers receive special occasions gifts. Common examples include “gifts” that are received on a birthday, Christmas, or anniversary. In many cases, ministers incorrectly assume that these “gifts” are tax-free. Here is a run-down of the key rules:
- Special occasion “gifts” made to a minister by the church out of the general fund should be reported as taxable compensation and included on the minister’s W-2 or 1099, and Form 1040. They represent taxable income, even if they are called a “love gift.”
- Members are free to make personal gifts of nominal value to ministers, such as a card at Christmas accompanied by a $20 bill. Such payments may be nontaxable to the minister, but they are not deductible by the donor.
- Special occasion “gifts” to a minister funded through members’ contributions to the church (i.e., the contributions are entered or recorded in the church’s books as cash received and the members are given receipts) should be reported as taxable compensation and included on the minister’s W-2.
- Special occasion “gifts” to a minister may be taxable if collected by the church, even if donors are informed that their contributions will not be receipted and are not deductible. This is especially true if the church’s involvement in announcing and collecting the gifts is significant, and the amount of the gifts is substantial.
• Example. A church collects an offering for its pastor once each year, at Christmas. This practice has occurred for more than 25 years. A member of the church board announces the offering during a worship service, and members are advised that their offerings will be receipted as charitable contributions by the church. The Christmas gift made to the pastor under these circumstances is taxable compensation and should be added to the pastor’s wages reported on Form W-2
• Example. Same facts as the previous example except that a member of the board, in announcing the offering, informs church members that their contributions will not be receipted and will not be deductible. Members are informed that they will be making their gifts directly to the pastor, and are instructed to make checks payable directly to the pastor and not to the church. The church collects the offering and transfers it to the pastor without receipting any contributions. There are two ways to analyze this example. The conservative approach would treat the “Christmas gift” to the pastor as taxable income due to the church’s role in announcing and collecting the offering. A more aggressive approach would be to treat the gift to the pastor as a tax-free gift rather than as taxable compensation. This view is based on the following considerations and assumptions: (1) The members were not receipted for their contributions. (2) Members were informed that they were giving directly to the pastor. (3) Members did not deduct their contributions. (4) The church was acting merely as an intermediary. The gifts in reality were made by individual members directly to their pastor. (5) The church’s minimal involvement in the arrangement (collecting and turning over the offering) did not amount to sufficient church involvement to prevent the offering from being characterized as an aggregate of individual gifts from members directly to their pastor. (6) Only one special occasion offering was collected each year. (7) Members were not pressured or coerced into making contributions. Participating in the offering was entirely voluntary. (8) The pastor was adequately compensated through salary and fringe benefits mutually agreed to between the pastor and church board. (9) Most members contribute to such an offering out of sincere affection, respect, and admiration, and not out of a desire to compensate the pastor more fully for services rendered. Pastors and churches should not select the “aggressive approach” without the advice of a tax professional.
Error No. 4: Failure to report the personal use of a church-provided car as taxable income
Many churches provide their minister with a car that is used for both business and personal purposes. Often ministers do not understand that the personal use of such a vehicle constitutes taxable income that must be valued and reported. There are four ways for churches to compute the value of a minister’s personal use of a church-provided vehicle.
- General valuation principles. Under the “general valuation principles” method the amount to add to a minister’s income equals the amount it would cost to lease a comparable vehicle for the year multiplied times the percentage of total miles that the vehicle was used for personal purposes. This rule applies unless one of the following 3 rules is selected:
- Special automobile lease valuation rule. Under this special rule, if a church provides a minister with a car that is available for an entire calendar year, the value of the taxable benefit is the annual lease value of the car multiplied times the percentage of total miles driven during the year that are for personal use. The annual lease value is determined from an IRS table.
- Special cents-per-mile rule. Under this rule, the standard mileage rate, which for 2011 is 51 cents per mile, is multiplied times the number of miles the vehicle is used for personal purposes. Business miles must be substantiated and subtracted from total miles to determine personal miles. There are a number of conditions that must be met to qualify for this rule. One of them is that this rule may not be used if the market value of a church-owned car, when first made available to an employee for personal use, exceeds a specified amount ($15,300 in 2010).
- Special commuting valuation rule. If a minister is provided with a church-owned vehicle, and is required to commute to and from work in the vehicle,then the value of the commuting miles (which are always deemed personal rather than business) can be computed at a rate of $3 per round-trip commute or $1.50 per one-way commute. The church includes the value of all commuting on the employee’s W-2. There are a number of conditions that must be met to qualify for this rule.
These rules are explained fully in chapter 5 of Richard Hammar’s Church & Clergy Tax Guide.
“Automatic” Excess Benefits
Most churches provide a variety of fringe benefits to their employees. It is important to recognize that some fringe benefits are taxable, and these benefits must be valued and reported as taxable income on employees’ W-2 forms. If this is not done, there are two possible consequences: (1) The employee is subject to back taxes plus penalties and interest on the unreported income. (2) If the benefits are provided to an officer or director of the church (a “disqualified person”), or a relative of such a person, they will expose the recipient and possibly other members of the church’s governing board to “intermediate sanctions” in the form of substantial excise taxes. The IRS views these benefits as “automatic” excess benefits, regardless of the amount involved, unless reported as taxable income by the church or recipient in the year provided. The excise taxes can be as much as 225 percent of the amount of the excess benefit in the case of a disqualified person. “Managers” who authorize the excess benefit are subject to an additional excise tax of up to 20 percent of the amount of the benefit (although no more than $20,000 can be recovered from the entire board).
The lesson is clear—sloppy church accounting practices can lead to significant liability for a senior pastor, and possibly members of the church’s governing board.
Error No. 5: Not claiming an “adjustment” for half of self-employment tax (Form 1040, line 27)
Ministers are self-employed for Social Security with respect to services performed in the exercise of ministry (except for some chaplains). This means that they pay the self-employment tax, which is 15.3 percent of net self-employment earnings. Unlike employees, they have no employer to pay half of their Social Security tax. However, they are permitted to deduct half of their actual self-employment taxes as an adjustment in computing their adjusted gross income on line 27 of Form 1040, whether or not they are able to itemize deductions on Schedule A. Some ministers fail to claim this adjustment, which can cost them several hundred dollars in extra taxes.
Error No. 6: Claiming the housing allowance in computing self-employment taxes
Ministers who own their home do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a housing allowance, to the extent that the allowance represents compensation for ministerial services, is used to pay housing expenses, and does not exceed the fair rental value of the home (furnished, plus utilities). Housing-related expenses include mortgage payments, utilities, repairs, furnishings, insurance, property taxes, additions, and maintenance.
Ministers who rent a home or apartment do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a housing allowance, to the extent that the allowance represents compensation for ministerial services and is used to pay rental expenses and does not exceed the fair rental value of the home (furnished, plus utilities).
Ministers who live in a church-provided parsonage do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a parsonage allowance, to the extent that the allowance represents compensation for ministerial services; is used to pay parsonage-related expenses such as utilities, repairs, and furnishings; and does not exceed the fair rental value of the parsonage (furnished, plus utilities).
Note that housing allowances, and the annual rental value of a parsonage, are nontaxable only in computing federal income taxes. They are taxable when computing self-employment (Social Security) taxes except for ministers who are retired.
Many ministers incorrectly assume that since the housing allowance, and annual rental value of a parsonage, are nontaxable in computing federal income taxes, they are nontaxable in computing self-employment taxes. This error can result in a substantial tax liability.
• Example. Pastor Karen prepares her own tax return. She owns her home, and received a housing allowance of $18,000 for 2010, all of which was used for housing expenses. Since the fair rental value of her home is more than the housing allowance, she is able to reduce her taxable income by $18,000. She assumes that the housing allowance is not reportable as taxable earnings in computing her self-employment taxes. This is incorrect. In the event her tax return is audited by the IRS, it is likely that this error will be detected. Without considering any other deduction or adjustment, the unreported self-employment tax on this amount would be $2,754 (15.3 percent x $18,000). This liability will be reduced slightly because of the following two deductions: (1) 7.65 percent multiplied times net self-employment earnings (without regard to this deduction) may be deducted in computing earnings subject to the self-employment tax; and (2) half of the self-employment tax is deductible as an adjustment in computing federal income taxes, whether or not a minister can itemize deductions on Schedule A. Despite these deductions, the cost of the mistake will be significant, and will include interest and possibly penalties.
• Key point. Ministers who live in a church-provided parsonage must include the annual fair rental value of the parsonage as income when computing their self-employment (Social Security) taxes on Schedule SE. The IRS audit guidelines for ministers instruct agents that “determining the fair rental value [of a parsonage] is a question of all facts and circumstances based on the local market, but the church and minister have often already agreed on a figure and can provide documentary evidence.”
Error No. 7: Self-employed ministers claiming exclusions available only to employees
One of the advantages of reporting income taxes as an employee is that a number of fringe benefits are tax-free to employees that are taxable to self-employed persons. Examples include employer-paid health insurance premiums, employer-paid group term life insurance up to $50,000, and “cafeteria plans.”
• Example. Pastor Tom is a minister and reports his income taxes as a self-employed person (using Schedule C). His church compensation for 2010 was $35,000. In addition, the church paid the annual premium ($2,500) on a health insurance policy for Pastor Tom. Both the church and Pastor Tom assumed that this was a tax-free fringe benefit, and so it was not added to his 1099-MISC form for 2010. This is incorrect, and if audited by the IRS, Pastor Tom runs the risk of having this amount added as taxable income to his 2010 tax return (plus interest and possible penalties).
Error No. 8: Failure to report income associated with “below-market interest loans”
It is a common practice for churches to make “below-market interest loans” to ministers, often to assist them in obtaining a home. Few churches or ministers recognize that these loans can generate taxable income if the loan amount is at least $10,000. Section 7872 of the tax code treats certain loans in which the interest rate charged is less than the “applicable federal rate” (AFR) as the equivalent to loans bearing interest at the applicable federal rate, coupled with a payment by the lender to the borrower sufficient to fund all or part of the payment of interest by the borrower. Such loans are referred to as “below-market loans.”
• Key point. An advance of money to an employee to defray anticipated expenditures is not treated as a loan for purposes of section 7872 if the amount of money advanced “is reasonably calculated not to exceed the anticipated expenditures and if the advance of money is made on a day within a reasonable period of time of the day that the anticipated expenditure will be incurred.” Treas. Reg. §1.7872-2.
Section 7872 deals with the treatment of loans with below-market interest rates. It specifically applies to what it terms “compensation-related loans,” which include below-market loans directly or indirectly between an employer and an employee. In general, section 7872 operates to impute interest on below-market loans. In the case of employer-employee loans, the employer is treated as transferring the foregone interest to the employee as additional compensation, and the employee is treated as paying interest back to the employer.
Different rules apply depending on whether a loan is a demand loan or a term loan. A demand loan is a below-market loan if it does not provide for an interest rate at least equal to the applicable federal rate. A term loan is a below-market loan if the present value of all amounts due on the loan is less than the amount of the loan (i.e., the yield to maturity is lower than the applicable federal rate). With respect to demand loans, the imputed interest payments and deemed transfer of additional compensation are treated as being made annually. With respect to term loans, the lender is treated at the time of the loans as transferring the difference between the loan amount and the present value of all the future payments under the loan as additional compensation. The term loan is then treated as having original issue discount equal to the amount of the deemed transfer of additional compensation and, thus, subject to the original issue discount provisions of section 1272 of the tax code.
There is a de minimis exception from the application of the section 7872 imputation rules if loans between the parties in aggregate do not exceed $10,000. The de minimis exception does not apply if one of the principal purposes of the loan is tax avoidance.
• Key point. Calculating the amount of income associated with “below-market interest loans” is tricky. You may need the assistance of a tax professional. The point emphasized here is that below-market interest loans are common, and represent a potential source of unreported income.
• Key point. Low-interest or no-interest loans can create problems for a couple of other reasons. First, many state nonprofit corporation laws prohibit incorporated churches from making loans to officers and directors. No church should consider making any loan to a minister (who is a church officer or director), even at a reasonable rate of interest, without first determining that such loans are permissible under state law. Second, no-interest or low-interest loans to a minister or lay employee may be viewed as “inurement” of the church’s income to the recipient that can potentially jeopardize the church’s tax-exempt status, and may constitute an “automatic” excess benefit resulting in substantial excise taxes called “intermediate sanctions” (described earlier in this article).
Error No. 9: Inadequate records to substantiate business expenses
Ministers sometimes have inadequate records to substantiate their business expenses. This can lead to the following two problems:
(1) Treating nonaccountable arrangements as accountable. Ministers who are reimbursed for their business expenses by their church under an “accountable” reimbursement arrangement, and who have inadequate records to substantiate their reimbursed expenses, are risking the reclassification of their reimbursements as “nonaccountable” in the event of an audit. Under an accountable arrangement, a church reimburses only those business expenses that are properly substantiated within a reasonable time (no less often than 60 days). Proper substantiation means that the minister must provide written proof of the amount, date, place, and business purpose of each expense (including receipts for any item of $75 or more). Under such an arrangement, the church’s reimbursements are not included on the minister’s W-2 since they are not considered to be income. Further, there are no business expenses for the minister to deduct, since the reimbursements were not reported as income.
On the other hand, a nonaccountable reimbursement arrangement is one that does not require adequate substantiation of expenses within a timely manner. Here are some common examples:
- A church pays a monthly “car allowance” to a minister without requiring any accounting or substantiation.
- A church reimburses business expenses without requiring adequate written substantiation (with receipts for all expenses of $75 or more) of the amount, date, place, and business purpose of each expense.
- A 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.
- A church provides ministers with travel advances and requires no accounting for the use of these funds.
- A church reimburses business expenses that a minister claims (either orally or with a self-serving statement without any supporting documentation) that he or she incurred.
All reimbursements under a nonaccountable arrangement must be reported as income on the minister’s W-2 at the end of the year, since they represent taxable income. Ministers can then deduct those business expenses that they can substantiate. Ministers who are employees for income tax reporting purposes can deduct their business expenses only as an itemized deduction on Schedule A, to the extent these expenses exceed 2 percent of adjusted gross income. This, of course, means that ministers who are employees and who do not have enough itemized deductions to use Schedule A are not able to deduct any of their business expenses—even though the church’s reimbursements of those expenses is treated as taxable income.
• Example. Pastor Andy receives a monthly “car allowance” of $300. He 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. Both Pastor Andy and the church assume that these allowances are used entirely for the business use of his car, and so the allowances are not reported by either the church or Pastor Andy as taxable income. This is incorrect, and there are two possible consequences: (1) Pastor Andy is subject to back taxes plus penalties and interest on the unreported income. (2) If he is an officer or director of the church (a “disqualified person”), or a relative of such a person, the unreported income will expose him and possibly other members of the church’s governing board to “intermediate sanctions” in the form of substantial excise taxes since the IRS now views these benefits as “automatic” excess benefits unless reported as taxable income by the church or recipient in the year provided.
(2) Inadequate records to support a deduction. Many ministers incur business expenses that either are unreimbursed, or that are reimbursed by their church under a nonaccountable arrangement. In either case, ministers can deduct these expenses on their tax return only if they have sufficient records. Stricter substantiation rules apply to transportation, travel, and entertainment expenses. In general, ministers must have records to document the amount, date, place, and business purpose of each expense. Receipts are required for any expense of $75 of more.
• Example. Pastor Eric travels to a church convention in another state. The church does not reimburse him for his travel expenses. Pastor Eric fails to keep any records of his expenses. When preparing his tax return for the year, he cannot recall exactly how much he spent in traveling to the convention. He estimates that he spent $1,000, and claimed this amount as a business expense deduction on Schedule A (Form 1040). If he is audited, and his business expense deduction is questioned, he will have to produce records substantiating the amount, date, place, and business purpose of his travel expenses incurred in attending the convention. Receipts will be required for any expense of $75 of more. He will be able to deduct only those expenses that he can prove. If he is able to substantiate expenses of only $300, he will lose any deduction for the remaining $700 that he claimed on his tax return.
Error No. 10: Ineligible ministers exempt themselves from Social Security
Ministers may exempt themselves from self-employment (Social Security) taxes with respect to compensation received from the exercise of ministry if several requirements are met. Among other things, the application for exemption (Form 4361) must be filed with the IRS within a limited time period specified by law, and the exemption is available only to ministers who are opposed on the basis of religious considerations to the acceptance of most public insurance benefits (including Social Security) based on their ministerial services.
Many ministers have exempted themselves from self-employment taxes though they were not eligible. The problem is that the deadline for filing an application for exemption occurs shortly after an individual becomes a minister—at a time when many are ill-prepared to decide whether or not to apply for exemption. Many young ministers are encouraged by financial advisers to “opt out” of Social Security solely on the basis of financial considerations, without a full understanding of the eligibility requirements prescribed by law. These ministers run the risk of later being audited by the IRS and having their exempt status questioned or revoked. This obviously can result in a significant tax liability, even though in most cases the IRS is barred from collecting taxes more than three years in the past.
• Example. Shortly after becoming a minister Pastor Tim is contacted by a financial adviser who convinces him that he would be “better off” if he opted out of Social Security. Pastor Tim is not opposed, on the basis of religious convictions, to the acceptance of public insurance benefits (including Social Security). His sole motivation is to reduce his tax liability. Pastor Tim was not eligible for the exemption from self-employment taxes and he runs the risk of being audited by the IRS and having his exemption revoked. If this occurs, he will owe self-employment taxes plus interest for up to three years in the past, and possibly more. This can result in tens of thousands of dollars of additional taxes.
• Example. The Tax Court upheld the revocation of a minister’s exemption from Social Security on the ground that he did not qualify. The court noted that the minister’s exemption application had been filed on time, but it concluded that the minister was not eligible for exemption because of comments he made during his trial. Among other things, the minister made the following response when asked whether he was opposed to accepting Social Security benefits on the basis of religious principles (as required by law to qualify for the exemption): “No. I am not opposed to that, as a religious issue, no. We were advised by our accountant to file for an exemption with the state, providing the state would allow it. And we asked the state to allow it, which it did.” This ruling indicates that filing a timely Form 4361 (which contains a certification by the applicant that he or she meets all of the eligibility requirements) may not be enough. The IRS or the courts may later question whether the minister in fact was eligible for the exemption when the Form 4361 was filed. The court acknowledged that the minister “signed an exemption application stating that he was opposed to public insurance because of his religious principles.” However, it found the minister’s “trial testimony to be more compelling.” This conclusion was reinforced by the mistakes that appeared on the Form 4361, which suggested to the court that the minister had not read the form and was not aware that he was ineligible for exemption. Many ministers have filed a Form 4361 without being eligible for the exemption from self-employment taxes. These ministers must recognize that the validity of their exemption may be questioned in an audit. Hairston v. Commissioner, T.C. Memo. Dec. 51,025(M) (1995).
• Key point. While a minister whose exemption from self-employment taxes is revoked by the IRS will pay a significant amount of back taxes, there is a bright side to this predicament—the minister will rejoin the Social Security program. This means that the minister and his or her family will be eligible for the many benefits provided under the Social Security program. These include inflation-adjusted retirement, survivor and disability benefits, and Medicare participation.
Error No. 11: Excluding the church-designated housing allowance
Many ministers who own their homes wrongly assume that they can exclude from their taxable income the housing allowance designated for them by their employing church. While in some cases this assumption is correct, it often is not. Here’s why. Ministers are able to exclude from their taxable income a housing allowance designated by their employing church but only to the extent it is used for actual housing expenses and does not exceed the fair rental value of the home (furnished, including utilities). Stated another way, the amount that is not taxable in computing federal income taxes is the lowest of the following three amounts:
- The church-designated housing allowance
- Actual housing expenses (such as mortgage interest payments, down payments, real property taxes, insurance, utilities, furnishings, repairs, and improvements)
- The fair rental value of the home (furnished, including utilities)
The problem is that many churches report their minister’s income on a W-2 form as salary less the church-designated housing allowance. Many ministers do not understand that under these circumstances their W-2 form has underreported their income if the allowance exceeds either of the other ceilings (actual expenses or the fair rental value of the home).
• Example. Pastor Emily purchases a new home in 2011. She makes a down payment of $15,000 and incurs other housing expenses (mortgage payments, utilities, furnishings, and so on) of $8,000 during the year. Her church salary for the year is $40,000. Since she knew that she would be making a large down payment in 2011 she had the church board designate a housing allowance of $22,000 for the year. Assume that the annual fair rental value of the home (furnished, including utilities) is $12,000. The church will report income of only $18,000 on Pastor Emily’s W-2 form for 2011, reflecting salary less the housing allowance. Pastor Emily assumes that this $18,000 represents her taxable income. Unfortunately, this is not the case. The housing allowance exclusion for 2011 is the lowest of the following three amounts: (1) the church designated housing allowance ($22,000), (2) actual housing expenses (down payment of $15,000 plus other housing expenses of $8,000), and (3) the fair rental value of the home (furnished, including utilities)—or $12,000. The lowest of these amounts is $12,000, and this is the actual amount of the housing allowance that is nontaxable. Since Pastor Emily’s W-2 income was reduced by the full church-designated housing allowance of $22,000, her taxable income was reduced too much. It was her responsibility to report the excess of the church-designated housing allowance over the actual exclusion amount ($10,000) as “excess housing allowance” on line 7 of her Form 1040. By failing to do so she runs the risk of being audited and having to pay income tax on an additional $10,000 of unreported income, plus interest and possible penalties.
Error No. 12: Failing to deduct unreimbursed and “nonaccountable reimbursed” expenses on Schedule SE
Here is a widely ignored tax tip that can save some ministers hundreds or even thousands of dollars in taxes. Ministers who do not have enough itemized deductions to use Schedule A cannot deduct their unreimbursed business expenses or business expenses reimbursed under a nonaccountable arrangement. But, many do not realize that they are allowed to deduct these expenses in computing self-employment (Social Security) taxes on Schedule SE. Many ministers have incorrectly assumed that if these expenses cannot be deducted in computing income taxes, they cannot be deducted in computing self-employment taxes. This may seem like a logical assumption, but it is incorrect according to an IRS ruling. IRS Revenue Ruling 80-110. This position is reflected in the current edition of IRS Publication 517 (Social Security and Other Information for Members of the Clergy).
• Example. A pastor had $3,000 in unreimbursed business expenses in 2011 that he cannot deduct since he reports his income taxes as an employee and does not have enough itemized deductions to use Schedule A. The pastor assumes that these expenses cannot be deducted on Schedule SE. This assumption is incorrect. By failing to deduct these expenses on Schedule SE, the pastor will overpay his self-employment tax by $459 ($3,000 times the self-employment tax rate of 15.3 percent).
Error No. 13: Disregarding the Deason rule
Many ministers continue to ignore the so-called Deason rule in computing their income taxes. This rule (named after a Tax Court decision) requires ministers to reduce their business expense deduction by the percentage of their total compensation that consists of a tax-exempt housing allowance. How do ministers comply with this rule? In the past, compliance was difficult since the IRS provided no guidance on how or where to compute the reduction in business expenses. However, the IRS addressed this problem in recent editions of Publication 517 (Social Security and Other Information for Members of the Clergy) and in its audit guidelines for ministers.
The guidelines provide IRS agents with the following guidance on applying the Deason rule:
Once total business expenses have been determined, the nondeductible portion can be computed using the following formula:
Divide the allowable housing allowance or fair rental value (FRV) of parsonage by the total ministry income to get the nontaxable income percentage.
Total ministry income includes salary, fees, expense allowances under nonaccountable plans plus the allowable housing allowance or FRV of the parsonage.
Multiply the total business expenses times the nontaxable income percentage from Step 1 to get the expenses allocable to nontaxable income which is not deductible.
Here are two examples in the IRS audit guidelines for ministers that illustrate the application of the Deason rule:
• Example. F receives a salary of $36,000, an exempt housing allowance of $18,000 and an auto expense allowance of $6,000 for his services as an ordained minister. F incurs business expenses as follows: auto, $7,150; vestments, $350; dues, $120; publications and supplies, $300; totaling $7,920. His nondeductible expenses are computed as follows:
Step 1: $18,000 housing allowance/Nontaxable Income divided by $60,000 total ministry income ($36,000 salary, $18,000 housing, and $6,000 car allowance) equals 30 percent nontaxable income percentage;
Step 2: Total business expenses of $7,920 times 30 percent (the non taxable income percentage) equals $2,376 of nondeductible expenses;
Total expenses $7,920 less the nondeductible expenses of $2,376 equals the deductible expenses of $5,544.
F’s deductible expenses are reported as Schedule A miscellaneous deductions since his church considers him an employee and issues a W-2. These expenses, along with any other miscellaneous deductions are subject to a further reduction of 2 percent of his adjusted gross income.
• Example. G received a salary of $12,000, a housing allowance of $9,000, and earned $3,000 for various speaking engagements, weddings, funerals, and so on, all related to her ministry. She reports her salary as “wages” on page 1 of her Form 1040 and her fees on Schedule C. Because her actual housing costs ($6,000) were less than her housing allowance and the FRV of her home for the year, she must include $3,000 of her housing allowance as “other income” for income tax purposes. Her total business expenses are $4,500. The computation of deductible expenses is shown below:
Step 1: $6,000 (housing allowance actually exempt from income tax) divided by $24,000 total ministry income ($12,000 salary + $9,000 housing + $3,000 fees) equals 25 percent Nontaxable income percentage.
Step 2: Total expenses $4,500 times 25 percent non taxable income percentage equals $1,125 nondeductible expenses; Total expenses $4,500 less $1,125 equals $3,375 deductible expenses.
Note that this $3,375 would further be allocable between Schedule A miscellaneous deductions (related to salary) and Schedule C (related to other fees).
However, this allocation will not change G’s self-employment tax, since all ministry income and ministry expenses are included in the computation, regardless of where they are reported on the return for income tax purposes. The allocation between Schedule A and Schedule C will also affect any AGI-dependent computations.
• Key point. The IRS audit guidelines for ministers instruct agents to apply the Deason rule. The guidelines explain this rule as follows: “A minister may deduct ordinary and necessary business expenses. However, if a minister’s compensation includes a parsonage or housing allowance which is exempt from income … the prorated portion of the expenses allocable to the tax exempt income is not deductible …. Before this allocation is made, the total amount of business expenses must be determined.” Ministers must assume that the Deason rule will be raised if their business expense deduction is examined in an audit.
Note that the Deason rule can be avoided if a church adopts an accountable reimbursement arrangement.
Error No. 14: Applying the Deason rule to self-employment taxes
Many ministers who correctly apply the Deason rule in computing their federal income taxes wrongly assume that the rule must be applied in computing self-employment (Social Security) taxes as well. Since the housing allowance is not “tax free” in computing self-employment taxes, a minister’s business expense deduction need not be reduced in computing these taxes. The following example from the audit guidelines illustrate this point.
• Example. M receives a salary from the church of $20,000. His parsonage/ housing 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. Internal Revenue Code section 265 regarding the allocation of business expenses related to exempt income relates to income tax computations but not self-employment tax computations.
Error No. 15: Failing to claim a parsonage allowance
Ministers who live in a parsonage do not pay federal income taxes on the amount of their ministerial compensation designated by their employing church as a “parsonage allowance” to the extent that it is used to pay for parsonage-related expenses such as utilities, repairs, and furnishings. Many ministers and churches are unaware of this potential tax benefit.
Consider the following two examples.
• Example. Pastor Jim received compensation of $35,000 from his church in 2010. In addition, he lived in a church-owned parsonage. He incurred $3,000 in out-of-pocket expenses living in the parsonage in 2010 (for such items as utilities and furnishings). The church failed to designate any portion of his $35,000 salary as a parsonage allowance. Pastor Jim’s W-2 will report taxable income of $35,000.
• Example. Same facts as the previous example, except that the church designated (in advance) $3,000 of Pastor Jim’s salary as a parsonage allowance for 2010. His W-2 would reflect only $32,000 of taxable income. Assuming that he is in a 15-percent tax bracket for federal income tax reporting purposes, he has saved $450 in taxes by having the church designate a portion of his salary as a parsonage allowance. This cost the church absolutely nothing. It simply classified $3,000 of Pastor Jim’s compensation as a parsonage allowance.
Error No. 16: Failure to report reimbursements of a spouse’s travel expenses as taxable income
Many ministers travel to conferences and conventions on church business and often are accompanied by their spouse. It is common for churches to reimburse the travel expenses (transportation, meals, lodging) incurred by both the minister and the minister’s spouse in traveling to such out-of-town events. Many ministers and churches fail to report the church’s reimbursement of a spouse’s travel expenses as additional income to the minister. While the church’s reimbursement of a spouse’s travel expenses will not represent taxable income in some cases, in many cases it will. Here is a rundown of the rules:
- Spouse is a church employee. If the spouse is a church employee, then travel expenses incurred by the spouse in accompanying the minister on a business trip represent a business expense so long as the spouse’s presence on the trip serves a legitimate business purpose. This means that the church can reimburse these expenses under an accountable arrangement. If the church does not have an accountable expense reimbursement arrangement, the spouse can claim the travel expenses as a business expense deduction.
- Spouse is not a church employee; travel expenses reimbursed by church. In most cases, the minister’s spouse is not a church employee. This means that travel expenses incurred by the spouse in accompanying the minister on a business trip cannot be treated as a business expense. However, under IRS regulations, reimbursements of a spouse’s travel expenses will not represent taxable income to the spouse if (1) the spouse’s presence on the trip serves a legitimate business purpose, and (2) the spouse’s expenses are reimbursed under an accountable arrangement. If these conditions are met, the reimbursements represent a nontaxable “working condition fringe benefit” under section 132 of the tax code.
- Spouse is not a church employee; travel expenses not reimbursed by church. Under these circumstances, the spouse may be able to claim a charitable contribution deduction for travel expenses incurred in accompanying the minister on a business trip—but only if the spouse’s primary purpose in going on the trip is to render charitable services.
• Example. Pastor Eric is senior minister of a church. He attends a church convention in another city. He is accompanied by his spouse, who was selected by the church as an official delegate. The spouse is not an employee of the church. The spouse attends business meetings with her husband, and votes on matters addressed at the convention. Pastor Eric’s travel expenses were $800 (transportation, lodging, meals), and travel expenses attributable to his spouse were an additional $400. The church reimburses those travel expenses of both Pastor Eric and his spouse that are adequately substantiated under an accountable arrangement. Since the spouse is not an employee of the church her travel expenses ($400) are not deductible as a business expense. However, since her presence on the trip serves a legitimate business purpose, and her travel expenses were reimbursed under an accountable arrangement, the church’s reimbursement of her travel expenses does not represent taxable income to either her or Pastor Eric.
• Example. Same facts as the previous example except that Pastor Eric’s spouse does not attend the convention as an official delegate of the church. She has no official duties at the convention, and does not attend or participate in business sessions. She spends most of her time with friends and relatives who are at the convention. Since the spouse’s presence on the trip does not serve a legitimate business purpose, the proposed regulations do not apply. As a result, her travel expenses reimbursed by the church ($400) represent taxable income to Pastor Eric.
• Example. A denomination’s bylaws permit churches to send lay delegates to annual denominational meetings. These lay delegates, along with ordained ministers, comprise the eligible voters. Pastor Andy is an ordained minister who attends an annual meeting in another city. Pastor Andy’s church selected his spouse to accompany him as an official delegate. Pastor Andy’s spouse attends all business meetings, and exercises her voting privileges. The travel expenses of Pastor Andy’s spouse are not reimbursed by the church. Pastor Andy’s spouse can deduct her travel expenses as a charitable contribution. This conclusion is supported by the following language in IRS Publication 526 (“Charitable Contributions”): “If you are a chosen representative attending a convention of a qualified organization, you can deduct unreimbursed expenses for travel and transportation, including a reasonable amount for meals and lodging, while away from home overnight in connection with the convention.”
Error No. 17: Failure to report a forgiven debt as taxable income
Churches often make loans to their ministers, often at no interest. In some cases a minister fails to fully repay the debt. Church treasurers often are unsure of their obligations under these circumstances. Consider the following example:
• Example. A church hires Pastor Ben as a youth pastor. Pastor Ben is young and was recently married, and is in need of housing. Pastor Ben would like to buy a home but lacks the $15,000 needed for a down payment. The church board votes to loan Pastor Ben $15,000. Pastor Ben signs a no-interest $15,000 promissory note agreeing to pay the church back the $15,000 in 60 monthly installments of $250. Pastor Ben pays all of the monthly installments for the first year, but in the second and third year he pays only half of the required installments. He accepts another position and leaves the church at the end of the third year. The balance due on his note is now $6,000. Over the next several months the church treasurer writes Pastor Ben on three occasions and requests that the note be paid in full. Pastor Ben does not respond to any of these requests. The church board eventually decides to forgive the debt and makes no further contact with Pastor Ben.
What are the church’s tax reporting obligations under these circumstances? Does the forgiven debt of $6,000 represent taxable income? The forgiveness of debt ordinarily represents taxable income to the debtor. As a result, if a church makes a loan to a minister or other staff member and the debt is later forgiven by the church, the church should report the forgiven debt as income. Here are the rules to follow, using the same facts as in the example:
- If the church has not yet issued a W-2 form to Pastor Ben for his last year of employment, then reflect the forgiven debt on the W-2.
- If the church already has issued a W-2 form to Pastor Ben for the last year of employment, then issue a corrected W-2. A corrected W-2 is prepared on Form W-2c. Be sure to note the year of the Form W-2 that is being corrected.
- In addition to the forgiven debt ($6,000) Pastor Ben received income because no interest was charged by the church on the loan. In essence, this additional “income” consists of the amount of interest Pastor Ben would have paid the church had the prevailing commercial interest rate been charged by the church on the loan. A below-market term loan of less than $10,000 is not subject to these rules (assuming one of its principal purposes is not the avoidance of tax). Check with a CPA or tax attorney for assistance in making this calculation. Different rules apply for “demand loans.”
Error No. 18: Incorrect liability entered from tax tables
The IRS cites this as one of the most common mistakes made by taxpayers, so be sure to double-check that you are obtaining your tax liability from the correct table and line.
Error No. 19: Computational errors
The IRS cites this as one of the most common mistakes made by taxpayers, so be sure that all totals (deductions, income, and so on) are correct.
Error No. 20: Incorrect or missing Social Security numbers
The IRS cites this as one of the most common mistakes made by taxpayers, so be sure to use correct Social Security numbers (they no longer are printed on the mailing label you receive from the IRS).