The new "Audit Technique Guide for Ministers," which was released on June 30, 2009, provides important insight into the key issues the IRS will scrutinize when they audit ministers. The new guide begins by noting that "ministers are accorded some unique tax benefits for income, social security and Medicare taxes, which present several potential examination issues on ministers' tax returns in addition to income and expense issues found in most examinations." The guidelines list the following topics that are "unique to ministers":
- Introduction: Overview Of Issues
- Who Qualifies For Special Tax Treatment As A Minister
- Income Issues:
- Income To Be Reported
- Gift or Compensation for Services
- The Parsonage Allowance
- Retired Ministers
- Members of Religious Orders and Vow of Poverty
- Business Expenses
• Determination of Deductible Expenses Where Some Income is Tax Exempt
- Self-Employment Tax: Exemption
- Computing Self-Employment Tax
- Employee versus Independent Contractor
The guidelines' treatment of each of these issues is summarized below.
1. Introduction: Overview of Issues
The guidelines include the following overview of tax issues for ministers:
Although a minister is considered an employee under the common law rules, payments for services as a minister are considered income from self employment …. A minister, unless exempt, pays social security and Medicare taxes under the Self-Employment Contributions Act (SECA) and is not subject to Federal Insurance Compensation Act (FICA) taxes or income tax withholding.
Payment for services as a minister, unless statutorily exempt, is subject to income tax, therefore the minister should make estimated tax payments to avoid potential penalties for not paying enough tax as the minister earns the income. If the employer and employee agree, an election can be made to have income taxes withheld. Even though a minister may receive a Form 1099-MISC for the performance of services, he or she may be a common law employee and should in fact be receiving a Form W-2.
The determination of whether a minister is an employee or an independent contractor follows the same rules as any other industry determination. The challenge with a minister is the same as with any professional. The control test must be applied only after taking into account the nature of the work to be performed.
How a minister is classified for income tax purposes effects how they treat their expenses. A minister that is a common law employee must claim their trade or business expenses incurred while working as an employee as an itemized deduction on Form 1040 Schedule A, which is subject to the 2%-of-adjusted-gross-income (AGI) limitation and alternative minimum tax.
A minister is frequently provided a parsonage or is paid a housing allowance, which is exempt from income tax …. The "allowable" allowance is subject to self-employment tax …. The "allowable" allowance is computed subject to limitations imposed by law as to the amount and the required designation by the employing church which is discussed in detail under the section on the parsonage allowance. Please be aware of the special rules for retired ministers.
Because of the exemption from income tax for the "allowable" parsonage or housing allowance, the [tax code] requires business expenses to be allocated between taxable and non taxable income. Other business expenses discussed in this guide are common to all other professionals.
2. Who Qualifies For Special Tax Treatment As A Minister
The tax code contains several references to ministers, but the four major references are the following:
(1) The exclusion (for income tax purposes only) for housing allowances or the fair rental value of church-owned parsonages provided to the minister rent-free;
(2) The exemption of some ministers from social security coverage;
(3) Treatment of ministers (who are not exempt) as self-employed for social security tax purposes with respect to ministerial services; and
(4) Exemption of ministerial wages from income tax withholding (unless elected by the minister).
The guidelines correctly point out that these special provisions apply to "ministers" with respect to services performed in the exercise of ministry. The guidelines state: "To qualify for the special tax provisions available to ministers, an individual must be a 'minister' and must perform services 'in the exercise of his ministry.'" It is very important, then, to clarify the meaning of the terms minister and service performed in the exercise of ministry. The guidelines provide IRS agents with the following assistance in defining these critical terms:
The guidelines provide the following clarification on the meaning of the term minister:
- The income tax regulations require that an individual be a "duly ordained, commissioned, or licensed minister of a church."
- The Tax Court, in Salkov v. Commissioner, 46 T.C. 190 (1966), ruled that the phrase "duly ordained, commissioned, or licensed minister of a church" must be interpreted "disjunctively." By this it meant that a person Qualifies as a minister for tax purposes if he or she meets any of these three categories. Ordained status, therefore, is not required.
Service performed in the exercise of ministry
The guidelines state that the income tax regulations provide that "service performed by a minister in the exercise of the ministry" includes:
- Ministration of sacerdotal functions;
- Conduct of religious worship;
- Control, conduct, and maintenance of religious organizations (including the religious boards, societies, and other integral agencies of such organizations), under the authority of a religious body constituting a church or denomination."
- Performance of sacerdotal functions;
- Conduct of religious worship;
- Administration and maintenance of religious organizations and their integral agencies;
- Performance of teaching and administrative duties at theological seminaries.
Observation. It is very significant that the guidelines do not require that all three categories of ministry be met in order for one to be a minister for tax purposes or engaged in the performance of services in the exercise of ministry. Many ministers do not satisfy all three categories of ministry, and to suggest (as the IRS and Tax Court have in the past) that all three are required is inappropriate and naive.
The guidelines note that the income tax regulations specify that whether service performed by a minister constitutes conduct of religious worship or ministration of sacerdotal functions depends on the tenets and practices of the particular religious body constituting the church or denomination.
The guidelines note that the income tax regulations associated with section 107 of the tax code (pertaining to the housing allowance) provide the following examples of services considered duties of a minister:
Observation. Once again, this list does not suggest or require that a person satisfy all of the categories to be a minister or be engaged in service performed in the exercise of ministry. To illustrate, a theology professor at a church-controlled seminary who seldom if ever conducts religious worship or performs sacerdotal functions would still be considered a minister engaged in ministry under the approach taken both in the regulations and the guidelines. This is an important clarification, since some previous IRS and Tax Court rulings have suggested that all categories of ministerial services must be performed.
The guidelines add that "the duties performed by the individual are also important to the initial determination whether he or she is a duly ordained, commissioned, or licensed minister. Because religious disciplines vary in their formal procedures for these designations, whether an individual is duly ordained, commissioned, or licensed depends on these facts and circumstances."
The guidelines then refer to the following legal authorities:
(1) Salkov v. Commissioner (noted above) and Silverman v. Commissioner, 57 T.C. 727 (1972). The Tax Court, in holding that a cantor of the Jewish faith was a duly ordained, commissioned, or licensed minister, looked to "the systematic manner the cantor was called to his ministry and the ecclesiastical functions he carried out in concluding that he was a minister …."
(2) Revenue Ruling 78-301. The IRS followed the Tax Court decisions in Salkov and Silverman and held that a Jewish cantor who is not ordained but has a bona fide commission and is employed by a congregation on a full-time basis to perform substantially all the religious worship, sacerdotal, training, and educational functions of the Jewish denomination's religious tenets and practices is a minister of the gospel for federal tax purposes. The audit guidelines state that this ruling "revoked and modified prior revenue rulings to the extent that they required that an individual must be invested with the status and authority of an ordained minister fully qualified to exercise all of the ecclesiastical duties of a church denomination to be considered ministers …."
(3) Knight v. Commissioner 92 T.C. 199 (1989). The guidelines, in commenting on the Knight case, note:
The Tax Court considered whether a licentiate of the Cumberland Presbyterian Church (a status that was less than full ordination), who had not filed a timely exemption from self-employment tax, was a duly ordained, commissioned, or licensed minister in the exercise of required duties who was thus liable for self-employment tax. The petitioner argued that he was not formally ordained as a minister and could not administer church sacraments or participate in church government. Thus, he could not be a minister subject to IRC §1402(c). The court rejected this view, and looked at all the facts. In concluding that he was a licensed minister, it cited the facts that he was licensed by the church, he conducted worship services, and he was considered by the church to be a spiritual leader. The court also noted the petitioner preached, performed funerals, visited the sick, and ministered to the needy within the context of his duties for the church.
Observation. The guidelines' reference to the Knight case is significant. The Knight case contains perhaps the best analysis of the terms "minister" and "exercise of ministry." The court applied a "balancing test," noting that a minister need not actually perform every category of ministerial service described in the income tax regulations. In prior rulings the IRS omitted any reference to this important decision. The guidelines take a different view. IRS agents will now consider this ruling. As a result, more bona fide ministers will in fact be considered "ministers" for tax purposes. This is an important clarification, and one of the most important aspects of the guidelines.
(4) Lawrence v. Commissioner, 50 T.C. 494 (1968). The guidelines, in commenting on the Lawrence case, note the Tax Court found that
A "minister of education" in a Baptist church was not a "duly ordained, commissioned, or licensed" minister for purposes of IRC §107. The petitioner held a Master's Degree in Religious Education from a Baptist Theological Seminary, but was not ordained. Although his church "commissioned" him after he assumed the position, the court interpreted the commissioning to be for tax purposes, as it did not result in any change in duties. Most significant, however, was the court's analysis of petitioner's duties or rather, the duties he did not perform. He did not officiate at Baptisms or the Lord's Supper, two Ordinances that closely resembled sacraments, nor did he preside over or preach at worship services. The court concluded that the evidence did not establish that the prescribed duties of a minister of education were equivalent to the duties of a Baptist minister.
Observation. The guidelines contain no reference to the Tax Court's decision in Wingo v. Commissioner, 89 T.C. 922 (1987). In the Wingo case, the Court adopted the totally untenable conclusion that a "minister" is one who must satisfy all of the following fi ve conditions: (1 administer sacraments, (2) conduct worship services, (3) perform services in the "control, conduct, or maintenance of a religious organization," (4) be ordained, commissioned, or licensed, and (5) be considered a spiritual leader by one's religious body. This test was so narrow that it denied ministerial status to many bonafide ministers who worked for seminaries, para-church ministries, or as associate pastors within local congregations. Fortunately, the guidelines do not even mention this ruling (despite the fact that the IRS relied on it in some earlier rulings). This is good news, and makes it more likely that IRS agents will consider those claiming to be ministers to be ministers for federal tax purposes.
Observation. Unfortunately, the guidelines do not adequately distinguish between the terms "minister" and "service performed in the exercise of ministry." The failure to distinguish between these key terms has produced much confusion, and the guidelines provide little assistance. This will mean that agents auditing ministers' tax returns will continue to experience confusion. The guidelines' disregard of the Wingo case will help.
3. Taxable Income
With regard to the income to be reported by a minister, the guidelines provide agents with the following list of items that represent reportable income:
- Compensation from an employing church or church agency
- "Special gifts"
- Fees received by a minister directly from parishioners for performing weddings, funerals, baptisms and masses (the guidelines clarify however that "fees for weddings, funerals, etc., which are given directly to the church rather than to the minister, are not considered compensation to the minister")
- Expense allowances for travel, transportation, or other business expenses received under a non-accountable reimbursement arrangement
- Amounts paid to ministers in addition to salary to cover self-employment tax or income tax
- Distributions made to or for the support of individual missionaries to further the objectives of their missions
Observation. While this list will provide IRS agents with some assistance, it does not adequately address a number of critical points. For example, not all "special gifts" to clergy are reportable as taxable income. Also, the guidelines miss an opportunity to inform agents about a number of other items of possible income, including personal use of a church-owned vehicle; property purchased from a church at below market value; low-interest and no-interest loans to clergy; and some forms of ministers' "discretionary funds." These are all common sources of ministerial income, and there is considerable confusion as to the correct tax status of these items.
Gift or Compensation for Services
The guidelines inform IRS agents that "gifts given to a minister, other than retired ministers, may actually be compensation for services, hence includable in gross income" for tax purposes. The guidelines provide agents with the following assistance in deciding if a church's payment to a minister is a tax-free gift or taxable compensation for services rendered:
- The tax code provides that taxable income includes all income from whatever source derived unless specifically excluded. Section 102(a) of the tax code excludes the value of property acquired by gift. The guidelines state: "Whether an item is a gift is a factual question and the taxpayer bears the burden of proof. The most significant fact is the intention of the taxpayer."
- The issue of differentiating tax-free gifts and taxable compensation has been addressed in the following court rulings:
(1) In Commissioner v. Duberstein, 363 U.S. 278 (1960) the United States Supreme Court stated the governing principles in this area: The mere absence of a legal or moral obligation to make such a payment does not establish that it is a gift. And, importantly, if the payment proceeds primarily from "the constraining force of any moral or legal duty," or from "the incentive of anticipated benefit" of an economic nature, it is not a gift. And, conversely, "where the payment is in return for services rendered, it is irrelevant that the donor derives no economic benefit from it." A gift in the statutory sense, on the other hand, proceeds from a "detached and disinterested generosity," "out of affection, respect, admiration, charity or like impulses." And in this regard, the most critical consideration, is the transfer-or's "intention." "What controls is the intention with which payment, however voluntary, has been made."
(2) In Bogardus v. Commissioner , 302 U.S. 34, 43 (1937), the United States Supreme Court provided the following guidance in distinguishing between a taxfree gift and taxable compensation: "What controls is the intention with which payment, however voluntary, has been made. Has it been made with the intention that services rendered in the past shall be requited more completely, though full acquittance has been given? If so, it bears a tax. Has it been made to show good will, esteem, or kindliness toward persons who happen to have served, but who are paid without thought to make requital for the service? If so, it is exempt."
(3) In Banks v. Commissioner, T.C. Memo. 1991-641, the United States Tax Court addressed a "structured and organized" transfer of cash from members of a church to their pastor on four special days of each year. Prior to making the transfers, members of the church met to discuss the transfers. The amounts of the transfers were significant. The testimony of several members indicated that "the primary reason for the transfers at issue was not detached and disinterested generosity, but rather, the church members' desire to reward petitioner for her services as a pastor and their desire that she remain in that capacity." The court ruled the transfers were compensation for services hence included in taxable income.
(4) In Lloyd L. Goodwin v. U.S., 67 F.3d 149 (8th Cir. 1995), a federal appeals court addressed the tax status of offerings collected from a church congregation on special occasion days. The collections were done by congregational leaders in a structured manner. The congregation knew that it probably could not retain the pastor's service at his relatively low salary without the additional payments. The court ruled that the funds were compensation for services, not gifts.
(5) The Tax Court had ruled in Potito v. Commissioner, T.C. Memo 1975-187, aff'd 534 F.2d 49 (5th Cir. 1976), that the) value of a boat, motor and boat trailer was included in taxable income as payment for services. The taxpayer, a minister, had not produced any evidence regarding the intention of the donors that the transfer of the property was out of "detached and disinterested generosity".
Perhaps the biggest surprise in the new guidelines is the following statement:
There are numerous court cases that ruled the organized authorization of funds to be paid to a retired minister at or near the time of retirement were gifts and not compensation for past services. Revenue Ruling 55-422 discusses the fact pattern of those cases which would render the payments as gifts and not compensation.
In 1955 the IRS issued Revenue Ruling 55-422, in which it endorsed four federal appeals court cases holding that retirement distributions from a church to a pastor were tax-free gifts due to the following facts in each case:
- "The payments were not made in accordance with any enforceable agreement, established plan, or past practice"
- The minister "did not undertake to perform any further services for the congregation and was not expected to do so" following his retirement
- "There was a far closer personal relationship between the [minister] and the congregation than is found in lay employment relationships," and
- "The available evidence indicated that the amount paid was determined in light of the financial position of the congregation and the needs of the recipient, who had been adequately compensated for his past services."
The four federal appeals court rulings endorsed by the IRS in Revenue Ruling 55- 422 are summarized below:
(1) Schall v. Commissioner, 174 F.2d 893 (5th Cir. 1949). A federal appeals court ruled that a church's retirement gift to its pastor represented a tax-free gift rather than taxable compensation. The pastor was forced to retire on the advice of his physician as a result of a long illness. He made no request of the congregation that any amount be paid to him after his resignation, and he had no knowledge that the church would agree to do so. He did not agree to render any services in exchange for the gift and in fact did not do so. The court concluded:
We are of opinion the Tax Court clearly erred in holding that the payments to [the pastor] were taxable income. Where, as here, all the facts and circumstances surrounding the adoption of the [gift] clearly prove an intent to make a gift, the mere use of the terms "salary" and "honorarium" do not convert the gift into a payment for services. Moreover, "a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient …." Manifestly, these payments to [the pastor] were non-taxable gifts, within the orbit of the rule defining same, as enunciated by this court in [another case]: "That only is a gift which is purely such, not intended as a return of value or made because of any intent to repay another what is his due, but bestowed only because of personal affection or regard or pity, or from general motives of philanthropy or charity."
(2) Mutch v. Commissioner, 209 F.2d 390 (3rd Cir. 1954). A federal appeals court ruled that monthly retirement gifts made by a church to its retired pastor were tax-free gifts rather than taxable compensation. The court noted that the church's action in providing for the monthly honor-aria "was motivated solely and sincerely by the congregation's love and affection for [the pastor]." The court described the church's action as a "free gift of a friendly, well-to-do group who as long as they were able and because they were, wished their old minister to live in a manner comparable to that which he had enjoyed while actively associated with them." The court also observed:
[The pastor] had been adequately compensated as far as money could for his services in the past. He was not being tied into any promise of services in the future. The installment gift, while it could be stopped or changed at any time by the trustees, had no conditions attached to its acceptance." The court concluded that no other ruling "justifies the taxing of this bona fide gift given [the pastor] with love and affection by his old congregation.
(3) Kavanagh v. Hershman, 210 F.2d 654 (6th Cir. 1954). A federal appeals court, in a one-paragraph opinion, ruled that a distribution of funds to a minister was a tax-free gift rather than taxable compensation. The court based its decision on the Mutch decision (summarized above).
(4) Abernathy v. Commissioner, 211 F.2d 651 (D.C. Cir. 1954). The Abernathy case was a one-paragraph decision issued by a federal appeals court in 1954. The ruling addressed the question of whether a $2,400 retirement gift paid by a church to its pastor "as a token of its gratitude and appreciation" and "in appreciation of his long and faithful service" represented taxable income or a tax-free gift. The federal court concluded that the transfer was a tax-free gift. It cited (without explanation) the Schall, Mutch, and Kavanagh decisions (summarized above).
• Key point. The Abernathy case was referred to, with approval, by a federal court in 1994 in a ruling addressing the tax status of congregational gifts to a minister. Goodwin v. United States, 94-2 U.S.T.C. ¶ 50,597 (S.D. Iowa 1994), affirmed, 67 F.3d 149 (8th Cir. 1995).
The Schall, Mutch, Kavanagh, and Abernathy cases, summarized above, and Revenue Ruling 55-422, suggest that retirement gifts to ministers can, under limited circumstances, be treated as tax-free gifts rather than as taxable compensation so long as the conditions specified in Revenue Ruling 55-422 are satisfied. The IRS has never officially revoked or even modified Revenue Ruling 55-422, and none of the four federal appeals court rulings has been qualified or overturned. However, three considerations have made such a conclusion questionable:
1. The position of the IRS national office
The IRS national office has sent the editor of this newsletter a letter stating that "Revenue Ruling 55-422 ceased to represent the Service's position on or before the date the Supreme Court decided Commissioner v. Duberstein [in 1960]." The Duberstein case is summarized above. The IRS also informed the author that (1) "for years after 1986, section 102(c) ensures that [retirement] payments are not excludable" by ministers who are employees for income tax reporting purposes; and (2) retirement gifts to self-employed ministers are now evaluated under the Duberstein and Stanton cases (summarized above). The IRS's repudiation of Revenue Ruling 55-422, and the four federal appeals court rulings summarized above, is belied by the following considerations:
First, in Revenue Procedure 89-14, the IRS provided the following information concerning revenue rulings:
A revenue ruling is an official interpretation by the IRS of the internal revenue laws and related statutes, treaties, and regulations …. Revenue rulings are issued only by the IRS national office and are published for the information and guidance of taxpayers, IRS officials, and others concerned …. Taxpayers generally may rely upon revenue rulings and revenue procedures in determining the tax treatment of their own transactions and need not request specific rulings applying the principles of a published revenue ruling or revenue procedure to the facts of their particular cases. However, taxpayers, IRS personnel, and others concerned are also cautioned to determine whether a revenue ruling or revenue procedure on which they seek to rely has been revoked, modified, declared obsolete, distinguished, clarified or otherwise affected by subsequent legislation, treaties, regulations, revenue rulings, revenue procedures or court decisions.
The IRS has never revoked, modified, declared obsolete, or distinguished Revenue Ruling 44-422.
Second, Revenue Ruling 55-422 was quoted with approval as recently as 1995 by the United States Tax Court. Osborne v. Commissioner, 69 T.C.M. 1895 (1995). This is several years after the Duberstein case (1960) and effective date of section 102(c) of the tax code (1987), both of which events were previously cited by the IRS as its rationale for no longer following Revenue Ruling 55-422.
Third, other federal courts have affirmed the tax-free status of gifts made to ministers. To illustrate, in Brimm v. Commissioner, 27 T.C.M. 1148 (1968), the United States Tax Court ruled that a severance gift made by a church-affiliated school to a professor was a nontaxable gift rather than taxable compensation. The professor (the "taxpayer") was employed by a church-related, two-year graduate school supported by the Southern Baptist Convention. It became apparent that, because of the small student body and the high cost of operations, the school would have to be closed. Prior to the school's dissolution, its board of trustees adopted a resolution authorizing "a gift equivalent to one year's salary to each faculty member and staff member upon termination of his or her services with the school." Pursuant to this policy, the taxpayer received a "gift" of $8,600 in two annual installments bearing the notation "severance gift." The taxpayer did not report the two installments as taxable income on his tax returns since he regarded them to be a tax-free gift rather than taxable compensation for services rendered.
The IRS audited the taxpayer's tax returns and determined that the severance gifts constituted taxable income. On appeal, the Tax Court concluded that the severance payments were in fact nontaxable gifts: "It is clear from the evidence that the board of trustees of the school took their action in declaring and making a severance gift to the taxpayer, as well as to other members of the small staff, because they were grateful and appreciative of the past faithful and dedicated service rendered to the school." The court noted that the presence of affection, respect, admiration, and a deep sense of appreciation in the minds of trustees was demonstrated by the testimony of a member of the board who testifi ed that the severance gifts were not intended to represent additional compensation, that were authorized solely as a means of showing appreciation to the faculty, and that there was no expectation of additional services being performed in return for the severance gifts. The court concluded:
There is no doubt that the school's trustees were motivated by gratitude for the taxpayer's past faithful services, but, as the Supreme Court said in [the Bogardus case] "a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient." Indeed, long and faithful service may create the atmosphere of goodwill and kindliness toward the recipient which tends to support a finding that a gift rather than additional compensation was intended …. We hold that the school intended to make, and did make, a gift which was made gratuitously and in exchange for nothing.
2. Tax-exempt status
Neither Revenue Ruling 55-422 nor any of the four court decisions from the 1950s explains how a church can distribute any of its assets as a tax-free gift without jeopardizing its tax exempt status. To be exempt from federal income taxation, a church must satisfy a number of requirements. One of these requirements is that none of its assets or income be distributed to any individual except as reasonable compensation for services rendered or for a charitable or religious purpose. IRC 501(c)(3). Treating a retirement gift as a tax-free gift would appear to violate this requirement if the gift is paid out of church funds. The effect of this would be to call into question the tax-exempt status of the church itself. Significantly, the courts have consistently ruled that any amount of income distributed to an individual (other than as reasonable compensation or in furtherance of charitable or religious purposes) will jeopardize a church's tax-exempt status. This problem is avoided by characterizing the retirement gift as taxable compensation, assuming that the gift is reasonable in amount.
3. Section 102(c) of the tax code
Section 102(c) of the tax code, which took effect in 1987, specifi es that the defi nition of the term "gift" shall not include "any amount transferred by or for an employer to, or for the benefit of, an employee." The tax code does permit employees to exclude from income certain employee achievement awards and de minimis fringe benefits whose value is so insignificant that accounting for them would be unreasonable or administratively impracticable. IRC 132(e).
• Key point. A federal appeals court in 1995 made the following observation regarding section 102(c) of the tax code: "Although the legislative history suggests that [this section] was enacted to address other fact situations, its plain meaning may not be ignored in this case. That meaning seems far from plain, however. The church members are not [the pastor's] 'employer,' and the question whether their payments to the [pastor] were made 'for' his employer seems little different than the traditional gift inquiry under Duberstein and Bogardus. We therefore decline the government's belated suggestion that we affirm on the alternative ground of section 102(c)." Goodwin v. United States, 67 F.3d 149 (8th Cir. 1995).
• Key point. Taxpayers generally are not liable for penalties if they rely on a published court decision in support of a tax position. Since the four 1950s cases summarized above have never been overruled, they probably would prevent a minister from being assessed penalties as a result of treating a retirement gift as nontaxable. However, it is virtually certain that the IRS would insist that the entire value of the retirement gift represents taxable income, requiring the minister to pay the additional taxes due on this unreported income. However, if the minister's position is supported by any one or more of the 1950s cases, it is doubtful that the IRS could impose penalties.
For unknown reasons, the IRS, in its recently-issued audit guidelines for ministers, has seemingly changed course in its treatment of gifts to clergy as a result of the following statement:
There are numerous court cases that ruled the organized authorization of funds to be paid to a retired minister at or near the time of retirement were gifts and not compensation for past services. Revenue Ruling 55-422 discusses the fact pattern of those cases which would render the payments as gifts and not compensation.
The Parsonage Allowance
Federal tax law treats ministers' housing arrangements very favorably. Consider the following rules:
- Ministers can exclude from their income for federal income tax reporting purposes the fair rental value of a parsonage provided to them as compensation for ministerial services.
- Ministers who live in a church-provided parsonage can exclude from their income for federal income tax reporting purposes the portion of their ministerial compensation designated by their employer as a "parsonage allowance"- to the extent that it is used to pay for parsonage-related expenses such as utilities, repairs, and furnishings.
- Ministers who own or rent their homes can exclude from their income for federal income tax reporting purposes the portion of their ministerial income designated by their employer as a "housing allowance"- to the extent that the allowance is used to pay for housingrelated expenses such as rent, mortgage payments, utilities, repairs, furnishings, insurance, property taxes, additions, and maintenance. In addition, a housing allowance exclusion for ministers who own their home may not exceed the fair rental value of their home (furnished, including utilities).
How do the new IRS audit guidelines address these tax benefits? They basically restate the three rules summarized above. To illustrate, the audit guidelines' treatment of parsonage allowances begins with the following paragraph:
[The tax code] provides an exclusion from gross income for a "parsonage allowance," housing specifically provided as part of the compensation for the services performed as a minister of the gospel. This includes the rental value of a home furnished to him or her as part of compensation or a housing allowance, to the extent that the payment is used to rent or provide a home and to the extent such allowance does not exceed the fair rental value (FRV) of the home, including furnishings and appurtenances such as a garage and the cost of utilities. The term "parsonage allowance" includes church provided parsonages, rental allowances with which the minister may rent a home and housing allowances with which the minister may purchase a home. A minister can receive a parsonage allowance for only one home.
The guidelines make the following additional clarifications:
(1) The housing allowance is subject to self-employment tax. This is not a problem for ministers who own or rent their home, since they simply add the amount of their housing allowance exclusion to their earnings subject to the self-employment tax. But what about ministers who live in a church-provided parsonage? How much should they add to their earnings subject to the self-employment tax? This has been a difficult question for ministers living in parsonages, and there has been very little guidance from the IRS or the courts. Unfortunately, the guidelines provide little clarification:
If a church-owned parsonage is provided to the minister, instead of an allowance, the fair rental value of the housing must be determined. Determining the fair rental value 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.
(2) The guidelines note that the housing allowance "only applies if the employing church designates the amount of the allowance in advance of the tax year," and that "the designation may appear in the minister's employment contract, the church minutes, the church budget, or any other document indicating official action."
Observation. It is unfortunate that the guidelines state that the housing allowance "only applies if the employing church designates the amount of the allowance in advance of the tax year," since this statement is simply not true. It is true that a church's housing allowance designation may never be made retroactively, and only operates prospectively. But this does not mean that it has to be made in advance of a tax year. To illustrate, many churches fail to designate a housing allowance by the end of a calendar year and discover the omission a few months into the new year. The church can still designate a housing allowance for the minister for the remainder of the new year. Unfortunately, unless the guidelines are amended, IRS agents may unnecessarily disallow any housing allowance exclusion under these facts.
(3) Ministers who own their homes cannot necessarily exclude from taxable income the housing allowance designated by their employing church. The guidelines correctly note that the excludable amount is "the least of (1) the amount actually used to provide a home, (2) the amount officially designated as a housing allowance, or (3) the fair rental value of the home, including furnishings appurtenances such as a garage plus the cost of utilities."
Observation. The guidelines provide agents with the following list of expenses that can be considered in computing the housing allowance: rent, house payments, furnishings, repairs, insurance, taxes, utilities, other expenses (including down payments, interest, etc. but not food or servants or entertainment).
(4) Even though a minister's home mortgage interest and real estate taxes have been paid with money excluded from income as a housing allowance, he or she "may still claim itemized deductions for these items." This is the so-called "double deduction," and it is one reason why home ownership is especially attractive for ministers.
(5) The guidelines address the eligibility of retired ministers for a housing allowance as follows:
A retired minister may receive part of his or her pension benefits as a designated housing allowance based on past services. Trustees of a minister's retirement plan may designate a portion of each pension distribution as a housing allowance that is excluded from income for federal income tax reporting purposes.
Observation. The IRS has stated in recent years that the issue of "whether amounts distributed to a retired minister from a pension or annuity plan should be excludable from the minister's gross income as a parsonage allowance" is "an area under extensive study in which rulings or determination letters will not be issued until the Service resolves the issue through publication of a revenue ruling, revenue procedure, regulations, or otherwise." Such statements have caused some confusion regarding the continuing availability of housing allowances to retired ministers. The guidelines suggest that this is no longer an immediate concern.
(6) Housing allowances paid to retired ministers are excludable from income for federal income tax reporting purposes, but what about self-employment taxes? The guidelines instruct IRS agents as follows:
The retired minister may exclude from his/her net earnings from self-employment the rental value of the parsonage or the parsonage allowance received after retirement. The entire amount of parsonage allowance received is excludible from net earnings from self employment, even if a portion of it is not excludible for income tax purposes. In addition, the retired minister may exclude from net earnings from self-employment any retirement benefits received from a church plan. Rev. Rul. 58-359.
Observation. This is one of the most significant provisions in the guidelines. In the original audit guidelines for ministers published in 1995, the IRS stated that housing allowances paid to retired ministers by their retirement plans represented taxable earnings for self-employment tax purposes, since "amounts received by a retired minister as a parsonage allowance relate to the performance of prior services as a minister." The IRS position was overruled by Congress in the Small Business Jobs Protection Act of 1996, which amended the tax code to include the following provision: "An individual who is a duly ordained, commissioned, or licensed minister of a church or a member of a religious order shall compute his net earnings from self-employment derived from the performance of [ministerial] service without regard to [a parsonage or housing allowance] but shall not include in such net earnings from self-employment the rental value of any parsonage or any parsonage allowance provided after the individual retires, or any other retirement benefit received by such individual from a church plan …." This change in the law was one of the main reasons that the IRS needed to update its audit guidelines for ministers, albeit 12 years too late.
(7) The guidelines instruct agents to enforce the so-called Deason allocation rule. They 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 under IRC §107, the prorated portion of the expenses allocable to the tax exempt income is not deductible, per IRC §265, Deason v. Commissioner, 41 T.C. 465 (1964), Dalan v. Commissioner, T.C. Memo. 1988-106, and McFarland v. Commissioner, T.C. Memo. 1992-440. Before this allocation is made, the total amount of business expenses must be determined. Ministers are subject to the same substantiation requirements as other taxpayers.
• Key point. The guidelines state that a "parsonage allowance" does not refer to "housing specifically provided as part of the compensation for the services performed as a minister." Rather, it refers to that portion of a minister's compensation that is designated in advance by his or her employing church, and that is used by the minister to pay for parsonage-related expenses (i.e., utilities, furnishings, insurance). The term parsonage refers to housing provided to a minister.
(8) The guidelines contain the following 6 examples to assist agents in understanding the application of the housing allowance exclusion. The examples are introduced with the statement that "for simplification assume that mortgage payments include property taxes and insurance." Further, "FRV" means annual fair rental value.
The IRS audit guidelines for ministers contain the following additional clarifications:
(1) The term "parsonage allowance" includes church provided parsonages, rental allowances with which the minister may rent a home and housing allowances with which the minister may purchase a home. A minister can receive a parsonage allowance for only one home.
(2) A housing allowance must be included in a minister's taxable income in the year in which it is received to the extent that it is not used during the year to rent or otherwise provide a home or exceeds the fair rental value of the home including furnishings and appurtenances such as a garage and the cost of utilities.
(3) The value of the "allowed" parsonage allowance is not included in computing the minister's income subject to income tax and should not be included in W-2 wages. However, the parsonage allowance is subject to self-employment tax along with other earnings.
(4) If a church-owned parsonage is provided to the minister, instead of a housing allowance, the fair rental value of the housing must be determined. Determining the fair rental value "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."
(5) An additional requirement "is that the fair rental value of the parsonage or parsonage allowance is not more than reasonable pay for the ministerial services performed."
• Example 1. A is an ordained minister. She receives an annual salary of $36,000 and use of a parsonage which has a FRV of $800 a month, including utilities. She has an accountable plan for other business expenses such as travel. A's gross income for arriving at taxable income for Federal income tax purposes is $36,000, but for self-employment tax purposes it is $45,600 ($36,000 salary + $9,600 FRV of parsonage).
• Example 2. B, an ordained minister, is vice president of academic affairs at Holy Bible Seminary. His compensation package includes a salary of $80,000 per year and a $30,000 housing allowance. His housing costs for the year included mortgage payments of $15,000, utilities of $3,000, and $3,600 for home maintenance and new furniture. The fair rental value of the home, as furnished, is $18,000 per year.
The three amounts for comparison are:
- Actual expenses of $21,600 ($15,000 mortgage payments + $3,000 utilities + $3,600 other costs)
- Designated housing allowance of $30,000
- FRV plus utilities of $21,000 ($18,000 + $3,000 utilities)
- Actual housing costs of $5,000 ($2,000 utilities + $3,000 taxes and insurance)
- Designated housing allowance of $15,000
- FRV + utilities of $11,000 ($9,000 FRV + $2,000 utilities)
B may exclude $21,000 from gross income but must include in income the other $9,000 of the housing allowance. The entire $30,000 will be considered in arriving at net self-employment income.
• Example 3. C is an ordained minister and has been in his church's employ for the last 20 years. His salary is $40,000 and his designated parsonage allowance is $15,000. C's mortgage was paid off last year. During the tax year he spent $2,000 on utilities, and $3,000 on real estate taxes and insurance. The FRV of his home, as furnished, is $750 a month.
The three amounts for comparison are:
C may only exclude his actual expenses of $5,000 for Federal income tax purposes. He may not exclude the FRV of his home even though he has paid for it in previous years. Swaggart v. Commissioner , T.C. Memo. 1984-409. $15,000 will be included in the computation of net self-employment income.
• Example 4. Assume the same facts as in Example 3, except that C takes out a home equity loan and uses the proceeds to pay for his daughter's college tuition. The payments are $300 per month. Even though he has a loan secured by his home, the money was not used to "provide a home" and can't be used to compute the excludible portion of the parsonage allowance. The results are the same as for Example 3. The interest on the home equity loan may be deducted as an itemized deduction subject to the limitations, if any, of IRC §163.
• Example 5. D is an ordained minister who received $40,000 in salary plus a designated housing allowance of $12,000. He spent $12,000 on mortgage payments, $2,400 on utilities, and $2,000 on new furniture. The FRV of his home as furnished is $16,000. D's exclusion is limited to $12,000 even though his actual cost ($16,400) and FRV and utilities ($18,400) are more. He may not deduct his housing costs in excess of the designated allowance.
• Example 6. E's designated housing allowance is $20,000. She and her husband live in one half of a duplex which they own. The other half is rented. Mortgage payments for the duplex are $1,500 per month. E's utilities run $1,800 per year, and her tenant pays his own from a separate meter. During the year E replaced carpeting throughout the structure at a cost of $6,500 and did minor repairs of $500. E must allocate her mortgage costs, carpeting, and repairs between her own unit and the rental unit in determining the amount of the excludible parsonage allowance. Amounts allocable to the rented portion for mortgage interest, taxes, etc., would be reported on Schedule E as usual. Her actual costs to provide a home were $14,300 ($9,000 mortgage payments, $1,800 utilities, and $3,500 for half the carpeting and repairs). The FRV for her unit is the same as the rent she charges for the other half, which is $750 a month, and she estimates that her furnishings add another $150 per month to the FRV. Her FRV plus utilities is $12,600 ($10,800 FRV + $1,800 utilities). E may exclude $12,600 for Federal income tax purposes.
Pursuant to IRC §265(a)(6) and Rev. Rul. 87-32, 1987-1 C.B. 131 even though a minister's home mortgage interest and real estate taxes have been paid with money excluded from income as a housing allowance, he or she may still claim itemized deductions for these items. The sale of the residence is treated the same as that of other taxpayers, even though it may have been completely purchased with funds excluded under IRC §107.
Because expenses attributable to earned income which is exempt from tax are not ordinarily deductible, a minister's business expenses related to his or her earnings must be allocated and become partially nondeductible pursuant to IRC §265 This is discussed in detail in the section on Business Expenses.
Exhibit 1 provides a worksheet for the computation of the amount that is excludible as a parsonage allowance.
Exclusion of Parsonage Allowance under Internal Revenue Code §107
Home Owned Or Rented/ Housing Allowance Received
The exclusion is limited to the least of:
1. Amount designated as housing allowance
2. Amount actually used to provide a home which is composed of the following items:
3. Fair rental value of home, including furniture, utilities, garage
Amount excludible from income tax liability is the least of 1,2, or 3 above.
If Parsonage provided, you can deduct only the fair rental value.
The entire designated housing allowance is subject to self-employment tax unless you have been approved for exemption or are retired.
4. Business Expenses
Ministers' business expenses often are examined by the IRS in an audit, and so information in the guidelines on this topic is of special interest. Here are the key points made in the guidelines:
(1) Ministers who are employees may deduct the following expenses on Schedule A as miscellaneous expenses to the extent that they exceed two percent of adjusted gross income:
- Unreimbursed employee business expenses (that is, expenses for which the minister is not reimbursed under an accountable plan) and
- "Nonaccountable" reimbursed business expenses
(2) The limitations on deductibility of employee business expenses may be avoided if the church adopts an "accountable plan." An accountable plan is an arrangement that meets all of the following requirements:
- Business purpose
- Substantiation within a reasonable period of time
- Return of amounts in excess of substantiated expenses within a reasonable period of time
• Key point. The income tax regulations mention a fourth requirement for an accountable plan. In order for an employer's reimbursement arrangement to be accountable, it must meet a "reimbursement requirement," meaning that its reimbursements of an employee's business expenses come out of the employer's funds and not by reducing the employee's salary.
The guidelines explain the reimbursement requirement as follows:
If the church has a salary reduction arrangement which "reimburses" the minister for employee business expenses by reducing his or her salary, the arrangement will be treated as a nonaccountable plan because it does not meet the reimbursement requirement …. This is the result regardless of whether a specific portion of the minister's compensation is designated for employee expenses or whether the portion of the compensation to be treated as the expense allowance varies from pay period to pay period depending on the minister's expenses. As long as the minister is entitled to receive the full amount of annual compensation, regardless of whether or not any employee business expenses are incurred during the taxable year, the arrangement does not meet the reimbursement requirement.
Observation. The guidelines instruct IRS agents to be alert to salary reduction arrangements that are used to fund reimbursements under an accountable arrangement. According to the IRS, accountable plans cannot reimburse employee business expenses out of salary reductions. In 1993 the IRS ruled that the same principle applies to "salary restructuring" arrangements. The IRS noted that "an employer may not recharacterize a portion of an employee's salary as being paid under a reimbursement arrangement or other expense allowance arrangement. [I]n order to have an accountable plan the reimbursement or other expense allowance arrangement provided by an employer should be amounts paid to an employee in addition to salary." Based on this precedent, the best approach is for churches to adopt accountable reimbursement policies that reimburse clergy (and other church workers) out of church funds. Churches that are concerned with unlimited reimbursement arrangements can set a maximum amount that will be reimbursed per employee.
(3) If an arrangement meets all the requirements for an accountable plan, the amounts paid under the arrangement are excluded from the minister's gross income and are not required to be reported on his or her Form W-2. If, however, the arrangement does not meet one or more of the requirements, all payments under the arrangement are included in the minister's gross income and are reported as wages on the Form W-2, even though no withholding at the source is required.
Observation. This language is misleading. The income tax regulations specify that if an employer establishes an accountable arrangement, but an employee fails to return within a reasonable period of time any reimbursements in excess of substantiated expenses, "only the amounts paid under the arrangement that are not in excess of the substantiated expenses are treated as paid under an accountable plan."
(4) Typical business expenses for ministers include the following:
The guidelines describe transportation expenses as follows:
Many ministers receive a non-accountable auto allowance, which is includible in income. Transportation costs which may be deductible include trips for hospital and nursing home visits, attendance at conferences, or other church business. However trips between the minister's personal residence and the church are considered nondeductible commuting expenses. Hamblen v. Commissioner, 78 T.C. 53 (1982).
The guidelines specify that "a minister may incur travel away from home occasionally for special conferences or other duties out of the area. The same rules regarding the deductibility of meals, entertainment, and lodging apply as for other taxpayers."
Business use of a home
The guidelines provide IRS agents with the following information regarding the business use of a home:
In order for a home to qualify as a principal place of business the functions performed and the time spent at each location where the trade or business is conducted are the primary considerations and must be compared to determine the relative importance of each.
The church often provides an office on the premises for the minister, so the necessity of an office in the home should be questioned closely. Furthermore, since the total cost to provide the home is used in computing the exempt housing allowance, home office deductions for taxes, insurance, mortgage interest, etc. would be duplications. (Note that itemized deductions are allowable for mortgage interest and taxes.)
Observation. The guidelines instruct agents to "question closely" the necessity of a home office. This is a business expense that invites scrutiny. It should not be claimed unless there is a reasonable basis for it.
Observation. The guidelines take the view that a minister who excludes all of his or her housing expenses as a housing allowance exclusion has in effect already "deducted" all of the expenses associated with an office in the home, and accordingly should not be able to claim any additional deduction of such expenses as an itemized (home office) deduction on Schedule A.
Supplies and publications
The audit guidelines specify:
Ministers may incur some out-of-pocket costs for office supplies and job-related books and periodicals for which they are not reimbursed. This may be more common in small churches. Increasingly, ministers are using computers for writing sermons, correspondence, and record-keeping. Personal use should be determined.
Observation. Ministers often use equipment for both personal and business use, and do not realize that the value of the personal use may represent taxable income. It is advisable to keep records documenting all business use so that you can establish this important information if requested.
Dues versus contributions
Some ministers pay a fee to a denominational agency to renew their credentials, and most contribute to their employing church. The guidelines provide IRS agents with the following information regarding the tax treatment of these transactions:
Ministers often pay a small annual renewal fee to maintain their credentials, which constitutes a deductible expense. However, ministers' contributions to the church are not deductible as business expenses. They may argue that they are expected to donate generously to the church as part of their employment. This is not sufficient to convert charitable contributions to business expenses. The distinction is that charitable contributions are given to a qualifying organization (such as a church) for the furtherance of its charitable activities. Dues, on the other hand, are usually paid with the expectation that a financial benefi t will result to the individual, as in a realtor's multi-list dues or an electrician's union dues. A minister's salary and benefits are not likely to directly depend on the donations made to the church. They may still be deducted as contributions on Schedule A but may not be used as a business expense to reduce self-employment tax.
Observation. The guidelines acknowledge that annual renewal fees that are required to maintain a minister's credentials are deductible. This is an important clarification, since the IRS has challenged this proposition in several audits of ministers. There is no doubt that mandatory contributions to a denominational agency to maintain ones professional credentials represent a business expenses, whether the taxpayer is a minister or an attorney or any other professional.
Observation. The guidelines inform agents that ministers' contributions to an employing church are not deductible as business expenses. They can be claimed only as charitable contributions. The Tax Court, in a 1992 unpublished decision, ruled that tithes paid by a minister to her employing church represented a business expense rather than a charitable contribution since the church had instituted a "tithing policy" that required all employees to tithe as a condition of their employment. This ruling is discussed in chapter 7, Section C.17, in Richard Hammar's Church and Clergy Tax Guide. Ministers who treat contributions to their employing church as a business expense are taking an aggressive position that is now more likely to be scrutinized and questioned.
A minister may incur expenses for special vestments that would qualify as "uniforms." Their reasonable cost and care is deductible. Ordinary street clothes or suits for church are not deductible. Unreimbursed long distance phone calls made for business purposes are deductible.
(5) The guidelines instruct agents to apply the so-called Deason allocation rule. They 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 under IRC §107, the prorated portion of the expenses allocable to the tax exempt income is not deductible, per IRC §265, Deason v. Commissioner, 41 T.C. 465 (1964), Dalan v. Commissioner, T.C. Memo. 1988-106, and McFarland v. Commissioner, T.C. Memo. 1992-440.
Before this allocation is made, the total amount of business expenses must be determined. Ministers are subject to the same substantiation requirements as other taxpayers.
Stated simply, if a minister has $40,000 of total compensation, consisting of salary ($30,000) and housing allowance ($10,000), then one-fourth of the minister's income is tax-exempt for income tax purposes. Accordingly, if the minister has $4,000 of business expenses, then one-fourth ($1,000) of the business expenses are not deductible since they are "allocated" to the tax-exempt income.
Observation. Of course, the Deason rule makes no sense when applied to ministers, since their housing allowance is "tax exempt" only to the extent it is actually used to pay for housing expenses. As a result, it is impossible to use any portion of this income to pay for business expenses. The IRS has rejected this reasoning.
How do ministers reduce their business expenses to properly reflect this rule? The guidelines provide IRS agents with the following procedure:
Once total business expenses have been determined, the nondeductible portion can be computed using the following formula. Exhibit 2 provides a computation worksheet.
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 non-accountable 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.
These examples illustrate the computation:
• Example 7. 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 nontaxable income percentage equals $2,376 the 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 two percent of his adjusted gross income.
• Example 8. G received a salary of $12,000, a housing allowance of $9,000, and earned $3,000 for various speaking engagements, weddings, funerals, etc., 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 nontaxable income percentage equals $1,125 nondeductible expenses.
Total expenses $4,500 less $1,125 equals $3,375 deductible expenses.
Note that this $3375 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.
Computation of Allowable Expenses When Tax-Exempt Income Is Received
Step 1: Enter amount of tax-exempt income (housing allowance or fair rental value of parsonage).
Step 2: Total income from ministry computed by adding the following:
- Step 1 Amount
Step 3: Divide step 1 amount by total step 2 amount to obtain the nontaxable income percentage.
Step 4: Compute total business expenses substantiated by adding the following items:
- M & E
Step 5: Multiply step 4 total by step 3 percentage to obtain nondeductible expenses allocable to tax exempt income.
Step 6: Subtract step 5 amount from step 4 amount to obtain the deductible expenses for Federal Income tax purposes.
5. Self-Employment Tax Exemption
The guidelines note that to claim exemption from self-employment tax, a minister must satisfy the following requirements:
- Be an ordained, commissioned or licensed minister of a church or denomination.
- File Form 4361. This is an application for exemption from self-employment tax for use by ministers, members of religious orders, and Christian Science practitioners.
- Be conscientiously opposed to public insurance (Medicare/Medicaid and Social Security benefits) because of religious beliefs.
Observation. The guidelines fail to clarify that a minister must be opposed to the acceptance of benefits under a public insurance program. Opposition to the program is not sufficient.
- File for exemption for reasons other than economic.
- Notify the church or order that he or she is opposed to public insurance.
- Establish that the organization that ordained, licensed, or commissioned the minister is a tax-exempt religious organization.
- Establish that the organization is a church or a convention or association of churches.
- Salaries and fees for services, including offerings and honoraria received for funerals, baptisms, etc. Include gifts which are considered income.
- Any housing allowance or utility allowances.
- Annual fair rental value (FRV) of a parsonage, if provided, including the cost of utilities and furnishings provided.
- Any amounts received for business expenses treated as paid under a nonaccountable plan, such as an auto allowance.
- Income tax or self-employment tax obligation of the minister which is paid by the church.
Observation. Another requirement, not mentioned in the IRS audit guidelines, is that the application must sign and return the statement that the IRS mails to him or her to verify that he or she has requested an exemption based on the grounds listed on the statement.
The guidelines further clarify that:
Form 4361 must be filed by the due date of the Form 1040 (including extensions) for the second tax year in which at least $400 in self-employment ministerial earnings was received. The 2 years do not have to be consecutive. An approved Form 4361 is effective for all tax years after 1967 for which a minister received $400 or more of self-employed income for ministerial services.
The exemption from self-employment tax applies only to services performed as a minister. The exemption does not apply to other self-employment income. To determine if a minister is exempt from self-employment tax, request that he or she furnish a copy of the approved Form 4361 if it is not attached to the return. If the taxpayer cannot provide a copy, order a transcript for the year under examination. The ADP and IDRS Information handbook shows where the ministers' self-employment exemption codes are located on the transcripts and what the codes mean. Transcripts will not show exemption status prior to 1988. If the transcript does not show a MIN SE indicator and the taxpayer still claims that he or she is exempt from self-employment tax, the Taxpayer Relations Branch at the Service Center where the Form 4361 was filed can research this information and provide the taxpayer with a copy. The Social Security Administration in Baltimore also can provide the information on exemption for an individual.
Observation. Many ministers who claim they are exempt from self-employment tax cannot prove that they are exempt. Ministers who file a timely application for exemption that is approved by the IRS will be sent a copy of their exemption application marked "approved." A surprisingly large number of ministers who have filed a timely exemption application cannot produce the approved copy of their application. If they are audited and asked to verify their exemption from self-employment tax, they are unable to do so. The guidelines contain some helpful information for ministers in this situation, for they reveal the procedure that IRS agents are instructed to follow if a minister who claims to be exempt from self-employment taxes cannot produce an approved application. There are a number of recommendations that agents can pursue in verifying the exempt status of a minister who cannot produce a copy of an approved exemption application.
The guidelines contain the following examples:
• Example 9. H has ministerial earnings of $400 in 2007 and $1800 in 2008. He has until April 15, 2009 (if no extension has been filed) to file Form 4361. If the approved Form 4361 is not received by the due date for the 2007 return, the self-employment tax for 2007 is still due by that date. If he later receives the approved 4361, he may amend his 2007 return.
• Example 10. J earned $500 in 2006, $300 in 2007, and $6,000 in 2008 from her ministry. She has until April 15, 2009 (if no extension has been filed) to file Form 4361. If the approval of the exemption is not be received by April 15, 2007, J must pay the self-employment tax with her 2006 return, but may amend it after the exemption is approved. J may file a claim for refund (an amended tax return) within three years from the time the return was filed or within two years from the time the tax was paid, whichever is later.
• Example 11. K, ordained in 2007, has $7,500 in net earnings as a minister in both 2007 and 2008. He files Form 4361 on March 5, 2009. If the exemption is granted, it is effective for 2007 and all following years.
• Example 12. L, an ordained minister, has applied for and received exemption from self-employment tax for his services as a minister. In 2008 he has ministerial income of $12,000 and income from his shoe repair business, a sole proprietorship, of $9,000. He must compute self-employment tax on the $9,000.
6. Computing Self-Employment Tax
Ministers who have not exempted themselves from self-employment taxes must compute and pay the self-employment tax on their ministerial income. Remember that ministers always are considered self-employed for social security purposes with respect to service performed in the exercise of their ministry.
The guidelines specify that "to compute self-employment tax, allowable trade or business expenses are subtracted from gross ministerial earnings, then the appropriate rate is applied." The guidelines instruct agents to include the following items in a minister's gross income for self-employment tax:
The guidelines provide the following additional examples.:
• Example 13. 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. IRC §265 regarding the allocation of business expenses related to exempt income relates to income tax computations but not self-employment tax computations..
• Example 14. G, as shown in Example 8, computes her self-employment taxable income as follows: $12,000 salary plus $9,000 housing allowance plus $3,000 Schedule C income less ($4,500) total business expenses equals $19,500 self-employment income.
Observation. Example 13 illustrates a very important point. Ministers' business expenses should not be reduced in computing their self-employment taxes, since the housing allowance does not represent tax-exempt income when computing self-employment taxes. The so called Deason reduction rule applies only to the computation of income taxes.
7. Employee or Self-Employed for Federal Income Tax Purposes
The question of whether a minister is an employee or self-employed for federal income tax reporting purposes is a question that has vexed many ministers and church treasurers. The IRS audit guidelines introduce this important topic with the following observations:
A minister can be a common law employee for income tax purposes even though the payments for services as a minister is statutorily considered income from self employment for social security and medical taxes and the minister can even apply to be exempt from social security tax.
The handling of business expenses for income tax purposes is determined by whether the minister is classified as an employee or an independent contractor. If an independent contractor, then the business expenses are reported on the Schedule C. If an employee, then the expenses are reportable subject to statutory limitations as an employee business expense itemized deduction. To be properly reported on Schedule C, a minister's expense must come from a trade or business of his own, other than that of being an employee.
How, then, can a minister's correct reporting status be determined? The guidelines provide the following clarifications:
- The tax code defines an employee as one who is such "under the usual common law rules applicable in determining the employer-employee relationship."
- This subject is complex and dependent on the facts and circumstances in each case, which is why it is highly litigated.
- IRS agents are instructed to conduct research on litigation that has occurred in their region to assist in making the correct classifi cation. The guidelines note that litigation "has generally occurred where the minister claims independent contractor status and the Internal Revenue Service determines the minister was an employee."
- The Internal Revenue Services looks at factors that fall within three categories, namely behavioral control, financial control and the relationships of the parties. Behavioral control deals with facts that substantiate the right to direct or control the detail and means by which a worker performs the required services. Financial control deals with facts of the economic aspects of the relationship of the parties and if the worker has the opportunity for the realization of profit or loss. Some factors are: significant investment, un-reimbursed expenses, making services available, and methods of payments. Relationship of the parties is important because it reflects the parties' intent concerning control.
- The courts consider various factors to determine an employment relationship between the parties. Relevant factors include: (1) the degree of control exercised by the principal 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 principal has the right to discharge the individual; (5) whether the work is part of the principals regular business; (6) the permanency of the relationship; and (7) relationship the parties believe they are creating.
The question of whether a minister is an employee or self-employed for federal income tax reporting purposes is a question that has vexed many ministers and church treasurers.
- In Weber v. Commissioner, 60 F.3rd 1104 (4th Cir. 1995), a federal appeals court addressed the issue of whether a minister was an employee or independent contractor. The court stated: "The right-to-control test is the crucial test to determine the nature of the working relationship …. The degree of control is one of great importance, though not exclusive …. Accordingly, we must examine not only the control exercised by the alleged employer, but also the degree to which an alleged employer may intervene to imposed control …. In order for an employer to retain the requisite control over the details of an employee's work, the employer need not stand over the employee and direct every move made by that employee …. Also, the degree of control necessary to fi nd employee status varies according to the nature of the services provided."
- The threshold level of control necessary to fi nd employee status is generally lower when applied to professional services than when applied to nonprofessional service. In James v. Commissioner 25 T.C. 1296 (1956), the Tax Court stated that "despite this absence of direct control over the manner in which professional men shall conduct their professional activities, it cannot be doubted that many professional men are employees." In Azad v. United States, 388 F.2d 74 (8th Circuit, 1968), a federal appeals court said that "from the very nature of the services rendered by professionals, it would be wholly unrealistic to suggest that an employer should undertake the task of controlling the manner in which the professional conducts his activities." Generally a lower level of control applies to professional."
- The absence of the need to control the manner in which the minister conducts his or her duties should not be confused with the absence of the right to control. The right to control contemplated by the common law as an incident of employment requires only such supervision as the nature of the work requires. McGuire v. United States, 349 F.2d 644 (9th Circuit 1965).
- Section 530 of the Revenue Act of 1978 does not apply to ministers "since they are statutorily exempt from FICA and are subject to SECA."
Observation. The guidelines do not say that all ministers are employees for federal income tax reporting purposes. This flexible approach leaves open the possibility that some ministers will not be employees under the applicable tests. Note, however, that self-employed status will be the exception, and that any minister reporting income taxes as selfemployed must expect to have his or her status challenged if audited.
What is the significance of the new IRS audit guidelines for ministers? The guidelines represent official guidance to IRS agents who will be auditing ministers' tax returns. As a result, the guidelines provide ministers with helpful insight into the positions the IRS will take on a series of tax issues when auditing ministers' tax returns.
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