Understanding Discretionary Funds: Guidelines for Churches

Discover how churches can use discretionary funds effectively while adhering to IRS regulations and avoiding tax pitfalls.

Last Reviewed: January 1, 2025

Q: Our church has a discretionary account the minister can use for various purposes. No other staff may access this account. Our Board of Pensions guidelines state, “A minister’s taxable wages must include Discretionary Funds if the minister is allowed to distribute funds for his personal benefit; and if the minister has the authority to disburse funds directly to himself.”

This past year money contributed to the fund were included in the minister’s W-2. We are wondering if the following motion allows contributions to not be included in his W-2:

The Session establishes the Emergency Mission Fund and adopts the following standard: no pastor or employee of [the] Church has the authority to disburse any church funds to himself or herself. All disbursements, or reimbursements for disbursement, must be authorized by two other church officers not related to the pastor and must be for bona fide church uses and must be documented. No fund can be used for pastor’s personal benefit.

Discretionary funds are a common practice in many churches, often providing pastors with resources for church-related expenses. However, improper use or lack of oversight can lead to significant tax and accounting issues. This article explains how discretionary funds should be managed to ensure compliance with IRS guidelines and church policies.


Key Takeaways:

  • Discretionary funds controlled solely by a pastor may be taxable income.
  • An accountable expense reimbursement plan avoids tax liability.
  • Oversight and documentation are critical for compliance.

What are the tax implications of discretionary funds? If discretionary funds are used outside an accountable reimbursement plan, they must be reported as taxable income on the pastor’s Form W-2.

Requirements for Accountable Expense Reimbursement Plans

To ensure that discretionary funds are not taxable, they must meet the following requirements:

  • No Personal Expenses: Funds cannot be used for personal expenses under any circumstances.
  • Documentation: All expenses must be supported by receipts or equivalent documentation submitted in a timely manner.
  • Accounting Oversight: The fund should be managed through the church’s accounting system to maintain proper financial records.
  • Policy Adherence: The pastor must comply with all church policies, such as benevolence guidelines, when using the fund.
  • Year-End Funds: Any unspent funds must not be paid out to the pastor and should remain within the church’s control.

Potential Risks of Noncompliance

If discretionary funds do not adhere to these requirements, they may be classified as a nonaccountable expense reimbursement plan, resulting in:

  • Taxable Income: 100% of the funds must be reported as taxable income on the pastor’s Form W-2.
  • No Deduction for Business Expenses: The suspension of unreimbursed employee business expense deductions through 2025 means pastors cannot offset valid business expenses.

Example of Proper Oversight

Scenario:

A church allocates a $5,000 discretionary fund to its pastor for church-related expenses. The pastor:

  • Uses the fund only for documented church expenses, such as community events and supplies.
  • Submits receipts monthly for all expenditures.
  • Ensures that any remaining funds at year-end are not used for personal gain.

By following these steps, the fund complies with IRS guidelines and avoids being taxable income.

FAQs About Discretionary Funds

  • Can discretionary funds be used for personal expenses?
    No, personal use disqualifies the fund from being an accountable reimbursement plan and results in taxable income.
  • Are discretionary funds always taxable?
    No, they are not taxable if they adhere to accountable plan requirements.
  • What happens if the church does not document expenses?
    Undocumented expenses are treated as taxable income for the pastor.
  • Do discretionary funds affect the church’s tax-exempt status?
    Improper use or reporting can raise concerns about private benefit and inurement, jeopardizing tax-exempt status.

Conclusion

Discretionary funds can be a valuable tool for supporting church operations, but they require careful management and compliance with IRS guidelines. Proper documentation, adherence to policies, and oversight ensure that these funds are not only effective but also compliant with tax laws. Church leaders should consult tax professionals to review their policies and procedures.

For more information, visit the IRS website or explore resources on Church Law & Tax.

Elaine L. Sommerville is licensed as a certified public accountant by the State of Texas. She has worked in public accounting since 1985.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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