Young v. Commissioner, T.C. Summary Opinion 2005-76.

Background. Under the so-called “Deason rule” (named after a 1964 court case) ministers must reduce their business expense deduction for unreimbursed expenses as well as expenses reimbursed under a nonaccountable arrangement by the percentage of their total church income that consists of a tax-exempt housing allowance.

For example, assume that Pastor Brad has total church income of $40,000, which includes a $10,000 housing allowance. He also incurs unreimbursed business expenses of $4,000. Since one-fourth of his church income is tax-exempt ($10,000 out of $40,000) he must reduce his business expense deduction by one-fourth. This means that only $3,000 of his expenses will be deductible.

The Tax Court applied the Deason rule in a recent case. A pastor was paid compensation of $78,000 consisting of a salary of $36,000 and a housing allowance of $42,000. He also received self-employment earnings of $21,000 for the performance of miscellaneous religious services (including weddings, funerals, and guest speaking). The pastor also incurred business expenses of $25,000 that were not reimbursed by the church, including car expenses, books, office expenses, and business trips. The IRS audited the pastor’s tax return, and claimed that his deduction for business expenses had to be reduced by the percentage of his total church income that consisted of a housing allowance. The pastor insisted that his business expense deduction should not be reduced by the percentage of his total income that was tax-exempt.

The court’s ruling. On appeal, the Tax Court noted that section 265 of the tax code provides that “no deduction shall be allowed for any amount otherwise allowable as a deduction which is allocable to one or more classes of income wholly exempt from taxes.” The court noted that the pastor “received both nonexempt income and a tax-exempt parsonage allowance for his ministry work. The ministry expenses he attempts to deduct were incurred while he was earning both nonexempt income and a tax-exempt parsonage allowance. This is precisely the situation section 265 targets… . The parsonage allowance is a class of income wholly exempt from tax and section 265 expressly disallows a deduction to the extent that the expenses are directly or indirectly allocable to his nontaxable ministry income.”

The court noted that since the pastor “failed to provide evidence that would allow the court to determine which of his ministry activities generated which expenses, the court will allocate the expenses on a pro rata basis. The court concludes that the pastor’s Schedule C ministry activities generated 22% of his total ministry income, and therefore allocates 22% of his ministry expenses to Schedule C, and the balance to Schedule A. Because 54% of his ministry salary was his parsonage allowance ($42,000/$78,000), 54% of his Schedule A deductions are rendered nondeductible because of section 265. The pastor may deduct (subject to the 2% floor) the balance as itemized miscellaneous deductions on Schedule A.”

The court concluded that the reduced deduction for business expenses applied to both income taxes and self-employment taxes. It has generally been assumed that the Deason rule does not apply to the computation of a minister’s self-employment taxes since the housing allowance is not “tax-exempt” in computing self-employment taxes. This understanding is contained in the IRS audit guidelines for ministers. However, the court ignored this logic and applied the Deason rule to the pastor’s self-employment taxes. It observed, “In computing his net earnings from self-employment, a pastor must include all his earnings from his ministry, including his parsonage allowance, and may claim the deductions ‘allowed by chapter 1 of the tax code which are attributable to such trade or business.’ Because a portion of the pastor’s deductions is allocable to his parsonage allowance, and is disallowed as a deduction by section 265, it may not be deducted in computing his net earnings from self-employment.” Fortunately, this case is a “small case” meaning that it cannot be cited as precedent.

This article first appeared in Church Treasurer Alert, November 2005.