• Key point. Contributions to tax-favored retirement plans cannot exceed legal limits.
The IRS ruled that ministers’ housing allowances are not “compensation” for purposes of computing the contribution limits to a tax-sheltered annuity (“403(b) plan”). A church has several employees who are ministers, and who are compensated with salary and housing allowances. The church reports this compensation on Form W-2. The church established a retirement plan under which its employees make salary reduction contributions to a tax-sheltered annuity. Section 415(c) of the tax code specifies that, for years prior to 2002, an employee’s contributions to a tax-sheltered annuity may not exceed the lesser of $35,000 or 25% of the employee’s compensation. The church treated ministers’ housing allowances as “compensation” for purposes of applying the section 415(c) limits. Therefore, the church allowed ministers to contribute up to the lesser of $35,000 or 25% of total compensation (including their housing allowance). This interpretation allowed ministers to contribute larger amounts to their tax-sheltered annuity since their compensation was increased by their housing allowance, and therefore the “25% of employee compensation” limit was a larger amount. The church asked the IRS for a ruling to the effect that the definition of “compensation” under section 415(c) did include ministers’ housing allowances.
The “General Definition”
The IRS began its ruling by noting that the “general definition” of “compensation” for purposes of section 415(c) includes “employee wages … and other amounts received for personal services actually rendered in the course of employment with the employer maintaining the plan to the extent that the amounts are includible in gross income ….” Section 107 of the tax code provides that the gross income of a minister does not include “the rental value of a home furnished to the minister as part of his compensation, or the rental allowance paid to the minister as part of his compensation, to the extent used by the minister to rent or provide a home.” Therefore, under the general definition, a housing allowance is not included in compensation under section 415(c).
The church pointed out, however, that the income tax regulations set forth two “alternative definitions” of compensation, and it argued that these definitions included a housing allowance. Treas. Reg. 1.415-2(d)(3).
The First Alternative Definition
One alternative definition defines “compensation” for purposes of section 415(c) to include income reported on Form W-2. Is a minister’s housing allowance a payment of compensation for which the employer is required to furnish the minister a Form W-2? No, concluded the IRS. It noted that Form W-2 does not report “amounts excluded from income (including a tax-free housing allowance)” and so “a tax-free housing allowance is not required to be reported [on Form W-2] because the tax-free housing allowance is not considered wages … and no amounts would be deducted and withheld as tax … on this amount.”
The church pointed out that the instructions to Form W-2 state that a church may wantto give an employee additional information and, in particular, information on a minister’s housing allowance by entering this item in box 14. The IRS rejected the church’s contention that this language amounted to a “requirement” that the housing allowance be reported on Form W-2.
The IRS noted that “the portion of a housing allowance that is not excluded because it is not used for the housing is income …. However, it is not … required to be reported, because [a church] has no basis to determine how much of the housing allowance was or was not used for housing.”
The Second Alternative Definition
The second alternative definition defines “compensation” for purposes of section 415(c) to include wages subject to income tax withholding. The IRS noted that “income tax withholding is imposed on remuneration paid by an employer only to the extent that an employee recognizes income.[ ]Accordingly, excludable compensation is not considered wages [for purposes of withholding]. Thus, amounts excluded from income (including a tax-free housing allowance) are not considered wages … and are not subject to income tax withholding.”
The church acknowledged that section 3401(a)(9) of the tax code exempts the wages of ministers from income tax withholding, but it insisted that if this section were disregarded, then ministers’ wages would be subject to withholding. The IRS concluded that this argument missed the point, since even if ministers’ wages were subject to withholding, this would not apply to housing allowances and other items that are specifically excluded from taxable income. The IRS observed,
As a general matter, excludable compensation is not wages [subject to withholding] so the tax-free housing allowance is excepted from [withholding]. It is not excluded from wages on account of section 3401(a)(9), a rule that limits the remuneration included in wages based on the nature or location of the employment or the services performed. Section 3401(a)(9) operates to exclude from wages taxable compensation paid to a minister whereas tax-free compensation is excluded under the general definition of wages. Thus, even if section 3401(a)(9) is disregarded as required under the alternative definitions … a tax-free housing allowance still is not wages [subject to withholding] and thus is not included in the alternative definitions of compensation.
The IRS noted that “requiring income tax withholding on amounts not includible in income could result in over-withholding and, in certain cases, would require the filing of a Form 1040 … in order to obtain a refund when filing is not otherwise required.”
Application. Church leaders should consider the following two points:
1. The IRS concluded that “for purposes of determining the limits on contributions under section 415(c) … amounts paid to a minister as a tax-free housing allowance may not be treated as compensation pursuant to the general or alternative definitions of compensation … .” Church pension plans, as well as individual churches that have established a retirement program incorporating tax-sheltered annuities for ministers, should communicate this important ruling with their ministers so that excessive contributions are not made because of a failure to include housing allowances within the definition of “compensation” for purposes of applying the “25% of total compensation” limit.
2. Section 415(c) of the tax code currently specifies that annual contributions to a tax-sheltered annuity plan (and other “defined contribution” plans) cannot exceed the lesser of (1) 25% of compensation, or (2) $35,000 (for 2001). Annual additions are the sum of employer contributions and employee contributions. The $35,000 limit is indexed for cost-of-living adjustments in $5,000 increments. The recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 makes the following changes to the 415(c) limits: (1) It increases the $35,000 limit on annual contributions to $40,000. This amount is indexed in $1,000 increments. (2) It increases the 25% of compensation limit to 100%. According to the congressional conference committee, the 25% limit was repealed because it has operated to reduce the amount that lower and middle-income workers can save for retirement. Further, conforming the contribution limits for tax-sheltered annuities to the limits applicable to retirement plans generally will simplify the administration of the pension laws, and provide more equitable treatment for participants in similar types of plans. These change take effect in 2002. IRS Letter Ruling 200135045 (2001).
© Copyright 2001 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided 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. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m63m96 c0601